10-Q 1 a5273920.txt AFFINITY TECHNOLOGY GROUP, INC. 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended September 30, 2006 Commission file number: 0-28152 Affinity Technology Group, Inc. (Exact name of registrant as specified in its charter) Delaware 57-0991269 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) Affinity Technology Group, Inc. 8807-A Two Notch Road Columbia, SC 29223 (Address of principal executive offices) (Zip code) (803) 758-2511 (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 [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large Accelerated Filer [ ] Accelerated Filer [ ] Non-Accelerated Filer [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 45,267,398 shares of Common Stock, $0.0001 par value, as of November 1, 2006. AFFINITY TECHNOLOGY GROUP, INC. AND SUBSIDIARIES INDEX PAGE PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005.................................. 4 Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005..... 5 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005............... 6 Notes to Condensed Consolidated Financial Statements......... 7 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................................... 12 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk..... 16 ITEM 4. Controls and Procedures........................................ 16 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings.............................................. 16 ITEM 1A. Risk Factors................................................... 17 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.... 17 ITEM 3. Defaults Upon Senior Securities................................ 19 ITEM 5. Other Information.............................................. 19 ITEM 6. Exhibits....................................................... 19 Signature................................................................... 20 2 Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 Statements in this report (including Management's Discussion and Analysis of Financial Condition and Results of Operations) that are not descriptions of historical facts, such as statements about the Company's future prospects and cash requirements, are forward-looking statements and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may vary due to risks and uncertainties, including the Company's very limited capital resources and the possibility that it may be unable to raise additional capital in amounts sufficient to permit it to continue operations; the risk that the Company may lose all or part of the claims covered by its patents as a result of challenges to its patents; the risk that its patents may be subject to additional reexamination by the U.S. Patent and Trademark Office or challenge by third parties; the results of ongoing litigation; and unanticipated costs and expenses affecting the Company's cash position. If the Company is not able to raise additional capital to fund its ongoing operations and patent infringement litigation expenses, it may be forced to consider alternatives for winding down its business, which may include offering its patents for sale or filing for bankruptcy protection. Moreover, there can be no assurance that the Company will prevail on its claims of patent infringement against third parties or that such claims will result in the award of monetary damages to the Company. These and other factors discussed in the Company's filings with the Securities and Exchange Commission, including the information set forth in Part I, Item 1A. "Risk Factors" of the Company's Annual Report on Form 10-K for the year ended December 31, 2005, may cause actual results to differ materially from those anticipated. 3 Part I. Financial Information Item 1. Financial Statements
Affinity Technology Group, Inc. and Subsidiaries Condensed Consolidated Balance Sheets September 30, 2006 December 31, (Unaudited) 2005 ------------------------------------ Assets Current assets: Cash and cash equivalents $ 1,567,695 $ 13,776 Receivables - 100,000 Prepaid expenses 49,291 33,739 ------------------------------------ Total current assets 1,616,986 147,515 Property and equipment, net 1,953 4,796 ------------------------------------ Total assets $ 1,618,939 $ 152,311 ==================================== Liabilities and stockholders' deficiency Current liabilities: Accounts payable $ 161,063 $ 119,768 Accrued expenses 860,066 390,564 Accrued interest - 294,570 Convertible notes - 1,301,336 Deferred revenue 33,333 33,333 ------------------------------------ Total current liabilities 1,054,462 2,139,571 Non-current liabilities: Convertible notes 3,140,666 - Accrued interest 21,609 - Deferred revenue 36,111 61,111 ------------------------------------ Total non-current liabilities 3,198,386 61,111 ------------------------------------ Total liabilities 4,252,848 2,200,682 Commitments and contingent liabilities Stockholders' deficiency: Common stock, par value $0.0001; authorized 100,000,000 shares, issued 47,435,406 and 44,393,104 shares at September 30, 2006 and December 31, 2005, respectively 4,744 4,439 Additional paid-in capital 72,031,018 70,696,896 Treasury Stock, at cost (2,168,008 shares at September 30, 2006 and December 31, 2005) (3,505,287) (3,505,287) Accumulated deficit (71,164,384) (69,244,419) ------------------------------------ Total stockholders' deficiency (2,633,909) (2,048,371) ------------------------------------ Total liabilities and stockholders' deficiency $ 1,618,939 $ 152,311 ====================================
See accompanying notes to Condensed Consolidated Financial Statements. 4
Affinity Technology Group, Inc. and Subsidiaries Condensed Consolidated Statements of Operations (Unaudited) Three months ended Nine months ended September 30, September 30, 2006 2005 2006 2005 --------------------------------- --------------------------------- Revenues: Patent license revenue $ 8,333 $ 4,411 $ 25,000 $ 13,235 Costs and expenses: Cost of revenues 833 442 2,500 1,324 General and administrative expenses 1,588,962 113,912 1,867,139 369,418 --------------------------------- --------------------------------- Total cost and expenses 1,589,795 114,354 1,869,639 370,742 --------------------------------- --------------------------------- Operating loss (1,581,462) (109,943) (1,844,639) (357,507) Other income (expense) Interest income 2,181 85 2,903 146 Interest expense (30,773) (25,118) (78,229) (72,570) --------------------------------- --------------------------------- Net loss $ (1,610,054) $ (134,976) $ (1,919,965) $ (429,931) ================================= ================================= Net loss per share - basic and diluted: $ (0.04) $ (0.00) $ (0.04) $ (0.01) ================================= ================================= Shares used in computing net loss per share 45,007,822 42,215,096 43,833,020 42,196,699 ================================= =================================
See accompanying notes to Condensed Consolidated Financial Statements. 5
Affinity Technology Group, Inc. and Subsidiaries Condensed Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, 2006 2005 ------------------------------------ Operating activities Net loss $ (1,919,965) $ (429,931) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 3,629 5,226 Amortization of stock compensation 740,367 - Deferred revenue (25,000) (13,235) Other 3,200 (305) Changes in current assets and liabilities: Accounts receivable 100,000 - Other current assets (15,552) 21,337 Accounts payable and accrued expenses 589,026 249,154 ------------------------------------ Net cash used in operating activities (524,295) (167,754) Investing activities (Purchase) sale of property and equipment, net (786) 305 ------------------------------------ Net cash (used in) provided by investing activities (786) 305 Financing activities Proceeds from convertible notes 2,055,000 120,000 Exercise of stock options 24,000 - ------------------------------------ Net cash provided by financing activities 2,079,000 120,000 ------------------------------------ Net increase (decrease) in cash 1,553,919 (47,449) Cash and cash equivalents at beginning of period 13,776 62,756 ------------------------------------ Cash and cash equivalents at end of period $ 1,567,695 $ 15,307 ====================================
See accompanying notes to Condensed Consolidated Financial Statements. 6 Notes to Condensed Consolidated Financial Statements 1. The Company - Going Concern Affinity Technology Group, Inc. (the "Company") was formed to develop and market technologies that enable financial institutions and other businesses to provide consumer financial services electronically with reduced or no human intervention. Products and services previously offered by the Company include its DeciSys/RT(R) loan processing system, which automated the processing and consummation of consumer financial services transactions; the Affinity Automated Loan Machine (the ALM), which allowed an applicant to apply for and, if approved, obtain a loan in as little as ten minutes; the Mortgage ALM, which allowed an applicant to apply for a mortgage loan; e-xpertLender(R), which permitted a financial institution to make automated lending decisions through its call centers and branches; iDEAL, which permitted automobile lenders to make automobile lending decisions for loan applications originated at automobile dealers; and rtDS, which permitted lenders to deliver credit decisions to applicants over the Internet. Due to capital constraints, the Company has suspended all efforts to further develop market and operate these products and services. The Company's last processing contract terminated in late 2002, and the Company has no plans in the near term to engage in further sales or other activities related to its products or services, other than to attempt to license certain of the patents that it owns. Currently, the Company's business activities consist exclusively of attempting to enter into license agreements with third parties to license the Company's rights under certain of its patents. In conjunction with its product development activities, the Company applied for and obtained three patents. The Company has been granted two patents covering its fully-automated loan processing systems (U.S. Patent Nos. 5,870,721 C1 and 5,940,811 C1). In August 2000, the U.S. Patent and Trademark Office ("PTO") issued to the Company a patent covering the fully-automated establishment of a financial account, including credit accounts (U.S. Patent No. 6,105,007 C1). All of these patents have been subject to reexamination by the PTO as a result of challenges to such patents by third parties. On January 28, 2003, the Company received a Reexamination Certificate (U. S. Patent No. 5,870,721 C1) from the PTO which formally concluded the reexamination of U. S. Patent No. 5,870,721. On December 20, 2005, the Company received a Reexamination Certificate (U.S. Patent No. 5,940,811 C1) from the PTO which formally concluded the reexamination of U.S. Patent No. 5,940,811. On July 25, 2006 the Company received a Reexamination Certificate (U.S. Patent No. 6,105,007 C1) from the PTO which formally concluded the reexamination of U.S. Patent No. 6,105,007 and which indicated that the reexamination resulted in the full allowance of all the claims of this patent. It is possible that third parties may bring additional actions to contest all or some of the Company's patents. The Company can make no assurances that it will not lose all or some of the claims covered by its existing patents. To date, the Company has generated substantial operating losses and has been required to use a substantial amount of cash resources to fund its operations. At September 30, 2006, the Company had cash and cash equivalents of $1,567,695. The Company believes that its existing cash resources are sufficient to fund its ordinary course operating expenses and its estimated expenses related to its ongoing patent litigation through the remainder of 2006 and into the first quarter of 2007. To date, the Company generally has been unable to enter into licensing agreements with potential licensees upon terms that are acceptable to the Company. Accordingly, the Company has been forced to become involved in litigation with alleged infringers. The Company believes that these lawsuits may require substantial resources and take an extended period of time to complete, and no assurance can be given that the Company will have the resources necessary to complete these lawsuits or that it will be successful in obtaining a favorable outcome. To vigorously prosecute these lawsuits, the Company anticipates that it will need to increase its operating expenses due to, among other things, increased litigation costs and related expenses. Accordingly, to remain viable through 2007, it is critical that the Company raise additional capital through the sale of debt and/or equity securities or generate capital from licensing its patents. No assurances can be given that the Company will be able to raise additional capital or generate capital from its patent licensing business. Unless the Company raises additional capital, it may have to consider alternatives for winding down its business, which may include offering its patents for sale or filing for bankruptcy protection. 7 Management's plan to continue the operations of the Company has included the restructuring of its convertible notes, which were in default through August 2006 and the continuation of its efforts to sell additional debt and/or equity securities to fund the Company's patent litigation and licensing efforts. In July 2006, the Company engaged an investment banking firm to assist with the efforts to sell additional debt and/or equity securities and to provide other services associated with its patent licensing program. As more fully explained in Note 6, in August 2006, the Company reached an agreement with the holders of its convertible notes, all of which were in default, to extend the maturity date of these convertible notes to August 2008. In September 2006, the Company sold additional notes in the aggregate principal amount of $1,905,000. There is substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or amounts and classification of liabilities that may result from this uncertainty. However, management believes that any adjustments to reflect the possible future effects on the recoverability and classification of assets and amounts of liabilities would not materially change the Company's financial position. 2. Basis of Presentation The accompanying unaudited financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The balance sheet at December 31, 2005 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal, recurring accruals) which, in the opinion of management, are necessary for a fair presentation of the results for the periods shown. The results of operations for such periods are not necessarily indicative of the results expected for the full year or for any future period. The accompanying financial statements should be read in conjunction with the audited consolidated financial statements of the Company included in the Company's Annual Report on Form 10-K for the year ended December 31, 2005. In accordance with management's oversight of the Company's operations, the Company conducts its business in one industry segment - financial services technology (see Note 7). Certain amounts in 2005 have been reclassified to conform to 2006 presentation for comparability. These reclassifications have no effect on previously reported stockholders' equity or net loss. 3. New Accounting Standards The following is a summary of recent authoritative pronouncements that affect accounting, reporting, and disclosure of financial information by the Company: In March 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 156, "Accounting for Servicing of Financial Assets" ("SFAS 156"), which amends SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", with the respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 permits the choice of the amortization method or the fair value measurement method, with changes in fair value recorded in income, for the subsequent measurement for each class of separately recognized servicing assets and servicing liabilities. The statement is effective for years beginning after September 15, 2006, with earlier adoption permitted. The Company does not expect SFAS 156 to have a material impact on the Company's financial position or results of operations. In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"), which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes." FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not expect FIN 48 to have a material impact on the Company's financial position or results of operations. 8 On September 13, 2006, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 108 ("SAB 108"), which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 is effective for the first fiscal year ending after November 15, 2006. The adoption of this statement is not expected to have a material impact on the Company's financial position or results of operations. Also in September 2006, the FASB issued SFAS No. 157, "Fair Value Measurement", effective for our fiscal year beginning January 1, 2008. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement does not require any new fair value measurements, but simplifies and codifies related guidance within GAAP. This Statement applies under other accounting pronouncements that require or permit fair value measurements. The Company is currently reviewing this pronouncement, but believes it will not have a material impact on our financial statements. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company's consolidated financial statements upon adoption. 4. Stock Based Compensation The Company adopted Statement of Financial Accounting Standards (SFAS) No. 123R, "Share-Based Payments" (SFAS 123R), on January 1, 2006. This statement requires the Company to recognize the cost of employee and director services received in exchange for the stock options it has awarded. Under SFAS 123R the Company is required to recognize compensation expense over an award's vesting period based on the award's fair value at the date of grant. The Company has elected to adopt SFAS 123R on a modified prospective basis; accordingly, the financial statements for the periods prior to January 1, 2006 do not include stock based compensation under the fair value method. The Company uses the Black-Scholes option pricing model to value its stock option grants. During the three month period ended September 30, 2006, the Company granted to its management and directors 4,350,000 stock options. All options granted were at the market value or above the market value at the date of grant. The grant date fair value of stock options granted during the three month period ended September 30, 2006 was $1,136,000. Of the stock options granted, 1,616,666 vested as of the grant date. The fair value of these options, $425,333, was recognized as compensation expense as of the date of grant. The remaining 2,733,334 options with a fair value of $710,667 vest over a two year period and during the three month period ended September 30, 2006, the Company recognized $112,973 as compensation expense associated with these options. Total compensation expense associated with stock options, including expense related to options granted before January 1, 2006, during the three and nine months ended September 30, 2006 was $538,771 and $540,367, respectively. Additionally, during the three month period ended September 30, 2006, the Company granted 2,500,000 warrants to a third party as compensation for investment banking and advisory services. The warrants vested at the grant date and are exercisable at $.50 per common share. The fair value of the warrants was $200,000, which the Company recognized as compensation expense at the date of grant. Prior to January 1, 2006, the Company applied APB Opinion No. 25, "Accounting for Stock Issued to Employees" for measurement and recognition of stock based transactions with its employees and directors. If the Company had recognized compensation expense for its stock based transactions based on the fair value method prescribed by SFAS 123R, net loss and net loss per share for the three and nine month period ended September 30, 2005 would have been as follows: 9
Three Months Nine Months Ended September 30, Ended September 30, 2005 2005 --------------------- --------------------- Net loss: As reported $ (134,976) $ (429,931) Deduct: stock-based compensation expense determined under the fair value based method for all awards (899) (5,701) ----------- ----------- Pro forma net loss $ (135,875) $ (435,632) =========== =========== Net loss per common share: As reported: Basic and diluted $ (0.00) $ (0.01) Pro forma: Basic and diluted $ (0.00) $ (0.01)
Using the Black-Scholes option-pricing model, the fair value at the date of grant for these options was estimated using the following assumptions: expected volatility, 85% to 142%; risk free rate of return, 1.99% to 6.60%; dividend yield, 0%; and expected option life, 3 years. The Black-Scholes and other option pricing models were developed for use in estimating fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions. The Company's employee stock options have characteristics significantly different than those of traded options, and changes in the subjective assumptions can materially affect the fair value estimate. Accordingly, in management's opinion, these existing models may not necessarily provide a reliable single measure of the fair value of employee stock options. 5. Net Loss Per Share of Common Stock Net loss per share of Common Stock amounts presented on the face of the consolidated statements of operations have been computed based on the weighted average number of shares of Common Stock outstanding in accordance with the SFAS No. 128, "Earnings Per Share." Stock warrants and stock options were not included in the calculation of diluted loss per share because the Company has experienced operating losses in all periods presented and, therefore, the effect would be anti-dilutive. 6. Convertible Notes In 2002, the Company initiated a convertible note program under which it was authorized to issue up to $1,500,000 principal amount of its 8% convertible secured notes (the "notes"). In April 2006, the convertible note program was amended to allow the Company to issue up to $3,000,000 of its notes. Prior to August 2006, the Company had issued an aggregate of $1,575,336 principal amount of notes under this program, including notes with an aggregate principal amount of $536,336 that have been converted into shares of the Company's common stock. These notes bear interest at 8%, are convertible into the Company's common stock at a conversion rate of $.20 per share (for notes issued prior to the April 2006 amendment to the program) or $.50 per share (for notes issued in May 2006), and are secured by the Company's equity interest in decisioning.com, Inc., which owns the Company's patent portfolio. Principal and interest under these notes generally become payable in full on the second anniversary of the date on which these notes were issued. However, under the terms of the notes, the full amount of principal and interest under all notes may be declared immediately due and payable in certain events, including bankruptcy or similar proceedings involving the Company, a default in the payment of principal and interest under any note, or a change in control of the Company. From June 2004 through August 2006, the Company was in default regarding payment of principal and interest due under certain of the notes. Accordingly, the full amount of principal and interest outstanding under all notes was payable at the option of all noteholders. At December 31, 2005, the amount of principal and accrued interest outstanding under all of the notes was $1,595,906. 10 In August 2006, the Company and the holders of all outstanding notes entered into an amended and restated note purchase agreement under which such holders agreed to extend the maturity date of such notes by exchanging them (including all interest accrued thereon) for new two-year notes due in August 2008 in the aggregate principal amount of $1,268,027. Under the amended note purchase agreement, the Company may issue notes in the aggregate principal amount of up to $5,000,000 (including the notes issued to current noteholders, as described in the preceding sentence) having an exercise price determined by the Company and each investor at the time of issuance. The new notes issued in August 2006 have the same terms as the old notes exchanged therefor, except that the new notes will mature in August 2008. Of the new notes issued, notes with a principal amount of $1,115,068 are convertible into shares of the Company's common stock at $.20 per share, and notes with a principal amount of $152,959 are convertible into shares of the Company's common stock at $.50 per share. The new notes include a note in the principal amount of $166,863 issued to the Company's Chief Executive Officer and a note in the principal amount of $122,115 issued to a subsidiary of The South Financial Group. The South Financial Group Foundation, a non-profit foundation established by the South Financial Group, owns approximately 10% of the Company's outstanding capital stock. In September 2006, The Company sold additional convertible notes in the aggregate principal amount of $1,905,000. The terms of these notes are the same as the notes previously issued by the Company, except that they may be converted into the Company's common stock at a rate of $.42 per share, and the Company has agreed to prepare and file with the Securities and Exchange Commission, on or before January 31, 2007, a registration statement with respect to the Company's common stock issuable upon conversion of these notes. 7. Segment Information The Company conducts its business within one industry segment - financial services technology. To date, all revenues generated have been from transactions with North American customers. 8. Commitments, Contingencies and Subsequent Event The Company and its founder, Jeff Norris, are defendants in a lawsuit filed by Temple Ligon on November 30, 1996 in the Court of Common Pleas for the County of Richland in Columbia, South Carolina. Mr. Ligon claims, among other things, that the Company and Mr. Norris breached an agreement to give him a 1% equity interest in the Company in consideration of services Mr. Ligon claims to have performed in 1993 and 1994 in conjunction with the formation of the Company, and seeks monetary damages of $5,463,000. This lawsuit initially resulted in a jury verdict against the Company of $68,000. However, Mr. Ligon subsequently requested and was granted a new trial. In January 2004, this lawsuit resulted in another jury verdict against the Company of $382,148. In connection with the litigation and the resulting jury verdict, the Company filed post-trial motions with the trial court in which, among other things, it claimed that the jury verdict should be set aside. On July 23, 2004, the trial judge granted the Company's motions, set aside the jury verdict, and ordered entry of a judgment in favor of the Company. The plaintiff appealed the trial judge's ruling to the South Carolina Court of Appeals (the "Appeals Court"). On October 30, 2006, the Appeals Court reversed the trial judge's decision and reinstated the jury verdict of $382,148. The Company will petition the Appeals Court for a rehearing of the case and will seek further appeals, if necessary. If the Company becomes obligated to pay more than an insignificant amount of damages in connection with this litigation, it could be forced to consider alternatives for winding down its business, which may include offering its patents for sale or filing for bankruptcy protection. The Company is involved in three other lawsuits involving claims by the Company that third parties have infringed its patents. 11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 Statements in this report (including Management's Discussion and Analysis of Financial Condition and Results of Operations) that are not descriptions of historical facts, such as statements about the Company's future prospects and cash requirements, are forward-looking statements and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may vary due to risks and uncertainties, including the Company's very limited capital resources and the possibility that it may be unable to raise additional capital in amounts sufficient to permit it to continue operations; the risk that the Company may lose all or part of the claims covered by its patents as a result of challenges to its patents; the risk that its patents may be subject to additional reexamination by the U.S. Patent and Trademark Office or challenge by third parties; the results of ongoing litigation; and unanticipated costs and expenses affecting the Company's cash position. If the Company is not able to raise additional capital to fund its ongoing operations and patent infringement litigation expenses, it may be forced to consider alternatives for winding down its business, which may include offering its patents for sale or filing for bankruptcy protection. Moreover, there can be no assurance that the Company will prevail on its claims of patent infringement against third parties or that such claims will result in the award of monetary damages to the Company. These and other factors discussed in the Company's filings with the Securities and Exchange Commission, including the information set forth in Part I, Item 1A. "Risk Factors" of the Company's Annual Report on Form 10-K for the year ended December 31, 2005, may cause actual results to differ materially from those anticipated. Overview Affinity Technology Group, Inc. (the "Company") was formed to develop and market technologies that enable financial institutions and other businesses to provide consumer financial services electronically with reduced or no human intervention. Products and services previously offered by the Company include its DeciSys/RT(R) loan processing system, which automated the processing and consummation of consumer financial services transactions; the Affinity Automated Loan Machine (the ALM), which allowed an applicant to apply for and, if approved, obtain a loan in as little as ten minutes; the Mortgage ALM, which allowed an applicant to apply for a mortgage loan; e-xpertLender(R), which permitted a financial institution to make automated lending decisions through its call centers and branches; iDEAL, which permitted automobile lenders to make automobile lending decisions for loan applications originated at automobile dealers; and rtDS, which permitted lenders to deliver credit decisions to applicants over the Internet. Due to capital constraints, the Company has suspended all efforts to further develop, market and operate these products and services. The Company's last processing contract terminated in late 2002, and the Company has no plans in the near term to engage in further sales or other activities related to its products or services, other than to attempt to license certain of the patents that it owns. Currently, the Company's business activities consist exclusively of attempting to enter into license agreements with third parties to license the Company's rights under certain of its patents. In conjunction with its product development activities, the Company applied for and obtained three patents. The Company has been granted two patents covering its fully-automated loan processing systems (U.S. Patent Nos. 5,870,721 C1 and 5,940,811 C1). In August 2000, the U.S. Patent and Trademark Office ("PTO") issued to the Company a patent covering the fully-automated establishment of a financial account, including credit accounts (U.S. Patent No. 6,105,007 C1). 12 All of these patents have been subject to reexamination by the PTO as a result of challenges to such patents by third parties. On January 28, 2003, the Company received a Reexamination Certificate (U. S. Patent No. 5,870,721 C1) from the PTO which formally concluded the reexamination of U. S. Patent No. 5,870,721. On December 20, 2005, the Company received a Reexamination Certificate (U.S. Patent No. 5,940,811 C1) from the PTO which formally concluded the reexamination of U.S. Patent No. 5,940,811. On July 25, 2006, the Company received a Reexamination Certificate (U.S. Patent No. 6,105,007 C1) from the PTO which formally concluded the reexamination of U.S. Patent No. 6,105,007 and which indicated that the reexamination resulted in the full allowance of all the claims of this patent. It is possible that third parties may bring additional actions to contest all or some of the Company's patents. The Company can make no assurances that it will not lose all or some of the claims covered by its existing patents. To date, the Company has generated substantial operating losses and has been required to use a substantial amount of cash resources to fund its operations. At September 30, 2006, the Company had cash and cash equivalents of $1,567,695. The Company believes that its existing cash resources are sufficient to fund its ordinary course operating expenses and its estimated expenses related to its ongoing patent litigation through the remainder of 2006 and into the first quarter of 2007. To continue its operations thereafter, the Company must secure additional working capital through the licensing of its patents or through the sale of additional debt and/or equity securities. The Company generally has been unable to enter into licensing agreements with potential licensees upon terms that are acceptable to the Company. As discussed elsewhere, the Company has been forced to become involved in litigation with alleged infringers. See Part II Item 1, "Legal Proceedings." The Company believes that these lawsuits may require substantial resources and take an extended period of time to complete, and no assurance can be given that the Company will have the resources necessary to complete these lawsuits or that it will be successful in obtaining a favorable outcome. To vigorously prosecute these lawsuits, the Company anticipates that it will need to increase its operating expenses due to, among other things, increased litigation costs and related expenses. Accordingly, to remain viable through 2007, it is critical that the Company raise additional capital through the sale of debt and/or equity securities or from licensing its patents. No assurances can be given that the Company will be able to raise additional capital or generate capital from its patent licensing business. Unless the Company raises additional capital, it may have to consider alternatives for winding down its business, which may include offering its patents for sale or filing for bankruptcy protection. Critical Accounting Policies The Company applies certain accounting policies, which are critical in understanding the Company's results of operations and the information presented in the condensed consolidated financial statements. The Company considers critical accounting policies to be those that require more significant judgments and estimates in the preparation of its financial statements, the most critical of which pertains to the valuation reserve on net deferred tax assets. The Company records a valuation allowance to reduce its deferred tax assets to the amount that it estimates is more likely than not to be realized. As of September 30, 2006 and December 31, 2005, the Company recorded a valuation allowance that reduced its deferred tax assets to zero. Results of Operations Revenues Patent license revenue. The Company recognized $8,333 and $25,000 for the three and nine month periods ended September 30, 2006, respectively, compared to $4,411 and $13,235 in the corresponding periods in 2005. All the Company's patent licensing revenues are related to a license agreement entered into in 1999, which is renewable every three years. 13 Costs and Expenses Cost of Revenues. Cost of revenues for the three month and nine month periods ended September 30, 2006 was $833 and $2,500, respectively, compared to $442 and $1,324 in the corresponding periods in 2005. Cost of revenues consists of commissions paid to the Company's patent licensing representatives. General and Administrative Expenses. General and administrative expenses were $1,588,962 for the three month period ended September 30, 2006 compared to $113,912 in the corresponding period in 2005, an increase of $1,475,050. For the nine month period ended September 30, 2006, general and administrative expenses were $1,867,139 compared to $369,418 in the corresponding period in 2005, an increase of $1,497,721. The increase in both periods was primarily related to: an increase in professional fees related to legal and other expenses associated with the Company's ongoing patent litigation; the recognition of stock-based compensation expense in July 2006; and, the accrual of a jury verdict against the Company recognized in September 2006. The Company is attempting to enforce its patents in three lawsuits. For more information on these lawsuits, see Part II, Item 1, "Legal Proceedings." The lawsuits were initiated in 2003, but were stayed during the reexamination of the Company's U.S. Patent No. 6,105,007 from March 2004 until March 2006, at which time the stays were lifted. For the three and nine month periods ended September 30, 2006, professional fees increased $312,251 and $406,061, respectively, compared to the corresponding periods in 2005. Additionally, during the three months ended September 30, 2006, the Company recognized a non-cash expense of $738,771 in accordance with stock options issued to management and directors and warrants issued to Morgan Keegan for investment banking and advisory services. General and administrative expenses also include the accrual of a jury verdict of $382,148 recorded by the Company to reflect the reinstatement of the verdict by the South Carolina Court of Appeals. Recent developments in this matter are discussed further under the caption Part II, Item 1, "Legal Proceedings." Interest expense. Interest expense for the three and nine month periods ended September 30, 2006, was $30,773 and $78,229, respectively, compared to $25,118 and $72,570 for the corresponding periods in 2005. Interest expense is related to the Company's convertible notes, which accrue interest at 8%. The changes in interest expense during the three and nine month periods ended September 30, 2006 compared to the corresponding periods in 2005 are due to changes in the aggregate average balance of the convertible notes outstanding during the respective periods resulting from the issuance of new notes and conversions of existing notes. In May 2006 and September 2006, the Company issued convertible notes in an aggregate principal amount of $150,000 and $1,905,000, respectively. During the three and nine month periods ended September 30, 2006, notes in an aggregate principal amount of $32,361 and $444,697, respectively were converted into shares of the Company's common stock. Liquidity and Capital Resources The Company has generated net losses of $71,164,384 since its inception and has financed its operations primarily through net proceeds from its initial public offering in May 1996 and cash generated from operations and other financing transactions. Net proceeds from the Company's initial public offering were $60,088,516. Net cash used by operations during the nine months ended September 30, 2006, was $524,295, compared to $167,754 used by operations for the same period in 2005. The change in operating cash flows was primarily attributable to the collection of a $100,000 patent license payment in the first quarter of 2006, offset by the payment of deferred accounts payable and accrued expenses during the nine month ended September 30, 2006 with the proceeds from the issuance of additional notes in an aggregate principal amount of $2,055,000. Patent infringement litigation expenses also increased during the period and the Company anticipates that its expense and operating cash needs will increase as it continues to actively pursue its patent infringement litigation. At September 30, 2006 cash and liquid investments were $1,567,695, as compared to $13,776 at December 31, 2005. At September 30, 2006 working capital was $562,524 as compared to a deficit of $1,992,056 at December 31, 2005. To date, the Company has generated substantial operating losses and has been required to use a substantial amount of cash resources to fund its operations. At September 30, 2006, the Company had cash and cash equivalents of $1,567,695. The Company believes that its existing cash resources are sufficient to fund its ordinary course operating expenses and its estimated expenses related to its ongoing patent litigation through the remainder of 2006 and into the first quarter of 2007. To continue its operations thereafter, the Company must secure additional capital through the licensing of its patents or through the sale of additional debt and/or equity securities. 14 The Company generally has been unable to enter into licensing agreements with potential licensees upon terms that are acceptable to the Company. As discussed elsewhere, the Company has been forced to become involved in litigation with alleged infringers. The Company believes that these lawsuits may require substantial resources and take an extended period of time to complete, and no assurance can be given that the Company will have the resources necessary to complete these lawsuits or that it will be successful in obtaining a favorable outcome. To vigorously prosecute these lawsuits, the Company anticipates that it will need to increase its operating expenses due to, among other things, increased litigation costs and related expenses. Accordingly, to remain viable through 2007, it is critical that the Company raise additional capital. No assurances can be given that the Company will be able to raise additional capital or generate capital from its patent licensing business. Unless the Company raises additional capital, it may have to consider alternatives for winding down its business, which may include offering its patents for sale or filing for bankruptcy protection. In 2002, the Company initiated a convertible note program under which it was authorized to issue up to $1,500,000 principal amount of its 8% convertible secured notes (the "notes"). In April 2006, the convertible note program was amended to allow the Company to issue up to $3,000,000 of its notes. Prior to August 2006, the Company had issued an aggregate of $1,575,336 principal amount of notes under this program, including notes with an aggregate principal amount of $536,336 that have been converted into shares of the Company's common stock. These notes bear interest at 8%, are convertible into the Company's common stock at a conversion rate of $.20 per share (for notes issued prior to the April 2006 amendment to the program) or $.50 per share (for notes issued in May 2006), and are secured by the Company's equity interest in decisioning.com, Inc., which owns the Company's patent portfolio. Principal and interest under these notes generally becomes payable in full on the second anniversary of the date on which these notes were issued. However, under the terms of the notes, the full amount of principal and interest under all notes may be declared immediately due and payable in certain events, including bankruptcy or similar proceedings involving the Company, a default in the payment of principal and interest under any note, or a change in control of the Company. From June 2004 through August 2006, the Company was in default regarding payment of principal and interest due under certain of the notes. Accordingly, the full amount of principal and interest outstanding under all notes was payable at the option of all noteholders. At December 31, 2005, the amount of principal and accrued interest outstanding under all of the notes was $1,595,906. 15 In August 2006, the Company and the holders of all outstanding notes entered into an amended and restated note purchase agreement under which such holders agreed to extend the maturity date of such notes by exchanging them (including all interest accrued thereon) for new two-year notes due in August 2008 in the aggregate principal amount of $1,268,027. Under the amended note purchase agreement, the Company may issue notes in the aggregate principal amount of up to $5,000,000 (including the notes issued to current noteholders, as described in the preceding sentence) having an exercise price determined by the Company and each investor at the time of issuance. The new notes issued in August 2006 have the same terms as the old notes exchanged therefor, except that the new notes will mature in August 2008. Of the new notes issued, notes with a principal amount of $1,115,068 are convertible into shares of the Company's common stock at $.20 per share, and notes with a principal amount of $152,959 are convertible into shares of the Company's common stock at $.50 per share. The new notes include a note in the principal amount of $166,863 issued to the Company's Chief Executive Officer and a note in the principal amount of $122,115 issued to a subsidiary of The South Financial Group. The South Financial Group Foundation, a non-profit foundation established by the South Financial Group, owns approximately 10% of the Company's outstanding capital stock. In September 2006, The Company sold additional convertible notes in the aggregate principal amount of $1,905,000. The terms of these notes are the same as the notes previously issued by the Company, except that they may be converted into the Company's common stock at a rate of $.42 per share, and the Company has agreed to prepare and file with the Securities and Exchange Commission, on or before January 31, 2007, a registration statement with respect to the Company's common stock issuable upon conversion of these notes. Item 3. Quantitative and Qualitative Disclosures About Market Risk. The Company does not believe that its current business exposes it to significant market risk for changes in interest rates. Item 4. Controls and Procedures The Company has carried out an evaluation, under the supervision and with the participation of the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as defined in Rule 13a-15 of the Securities Exchange Act of 1934 (the "Exchange Act"). Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of September 30, 2006, in recording, processing, summarizing and reporting information required to be disclosed by the Company (including consolidated subsidiaries) in the Company's Exchange Act filings. There were no changes in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Part II. Other Information Item 1. Legal Proceedings As previously reported, the Company and its founder, Jeff Norris, are defendants in a lawsuit filed by Temple Ligon on November 30, 1996 in the Court of Common Pleas for the County of Richland in Columbia, South Carolina. Mr. Ligon claims, among other things, that the Company and Mr. Norris breached an agreement to give him a 1% equity interest in the Company in consideration of services Mr. Ligon claims to have performed in 1993 and 1994 in conjunction with the formation of the Company, and seeks monetary damages of $5,463,000. This lawsuit initially resulted in a jury verdict against the Company of $68,000. However, Mr. Ligon subsequently requested and was granted a new trial. In January 2004, this lawsuit resulted in another jury verdict against the Company of $382,148. In connection with the litigation and the resulting jury verdict, the Company filed post-trial motions with the trial court in which, among other things, it claimed that the jury verdict should be set aside. On July 23, 2004, the trial judge granted the Company's motions, set aside the jury verdict, and ordered entry of a judgment in favor of the Company. The plaintiff appealed the trial judge's ruling to the South Carolina Court of Appeals (the "Appeals Court"). On October 30, 2006, the Appeals Court reversed the trial judge's decision and reinstated the jury verdict of $382,148. The Company will petition the Appeals Court for a rehearing of the case and will seek further appeals, if necessary. If the Company becomes obligated to pay more than an insignificant amount of damages in connection with this litigation, it could be forced to consider alternatives for winding down its business, which may include offering its patents for sale or filing for bankruptcy protection. 16 In June 2003, the Company filed a lawsuit against Federated Department Stores, Inc. ("Federated"), and certain of its subsidiaries alleging that Federated has infringed one of the Company's patents (U. S. Patent No. 6,105,007). In September 2003, the Company filed a similar lawsuit against Ameritrade Holding Corporation and its subsidiary, Ameritrade, Inc. (collectively "Ameritrade"), alleging infringement of the same patent. Both lawsuits were filed in the United States District Court in Columbia, South Carolina (the "Columbia Federal Court"), and both seek unspecified damages. In 2004, at the request of Federated and Ameritrade, the PTO determined to reexamine U.S. Patent No. 6,105,007. As a result of the reexamination of U.S. Patent No. 6,105,007, the Company jointly, with Federated and Ameritrade, requested the Columbia Federal Court to stay the lawsuits against Federated and Ameritrade pending resolution of the reexamination of U. S. Patent No. 6,105,007. In March 2006, the Company was notified that the PTO had concluded the reexamination of U.S. Patent No. 6,105,007 and that such reexamination resulted in the full allowance of all the claims of this patent. As a result of the completion of the PTO's reexamination of U.S. Patent No. 6,105,007, the stay of these lawsuits against Federated and Ameritrade was automatically lifted, and these lawsuits are now proceeding. In November 2003, Household International, Inc. ("Household") filed a declaratory judgment action against the Company in the United States District Court in Wilmington, Delaware (the "Delaware Federal Court"). In its complaint Household requested the Delaware Federal Court to rule that Household was not infringing any of the claims of the Company's patents (U.S. Patent No. 5,870,721 C1, No. 5,940,811 C1, and No. 6,105,007) and that the patents were not valid. The Company filed counterclaims against Household claiming that Household infringes U. S. Patent No. 5,870,721 C1, No. 5,940,811 C1 and No. 6,105,007. The Company also filed a motion with the Delaware Federal Court to transfer the case to the Columbia Federal Court. In April 2004, the Delaware Federal Court granted the Company's motion to transfer the case to Columbia Federal Court. As a result of the reexamination of U.S. Patent No. 6,105,007, the Company jointly, with Household, requested and received a stay of the Household action from the Columbia Federal Court pending the resolution of the PTO's reexamination of U.S. Patent No. 6,105,007. As discussed above, the PTO has concluded the reexamination of U.S. Patent No. 6,105,007. Accordingly, the stay of this lawsuit was automatically lifted, and this lawsuit is now proceeding. In accordance with the patent infringement lawsuits with Federated, TD Ameritrade and HSBC (formerly Household), as described above, a "Markman Hearing" is currently scheduled for December 4, 2006. Markman hearings are proceedings under U.S. patent law in which plaintiffs and defendants present their arguments to the court as to how they believe the patent claims - which define the scope of the patent holder's rights under the patent - should be interpreted for purposes of determining at trial whether the patents have been infringed. For purposes of the Markman hearing, the Federated, TD Ameritrade and HSBC cases will be consolidated into one hearing and will be held by the Columbia Federal Court. No assurances can be given as to the outcome of the Markman hearing and whether its results will be favorable in whole, in part, or at all, to the Company. The Company believes that the lawsuits with Federated, TD Ameritrade and HSBC may require substantial resources and take an extended time to complete. No assurances can be given that the Company will have the resources necessary to complete these lawsuits or that it will be successful in obtaining a favorable outcome. Item 1A. Risk Factors In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A. "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or results of operations. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds (a) On August 31, 2006, a noteholder converted $32,361 principal and $158 accrued interest related to the Company's convertible secured notes into 162,596 shares of the Company's common stock. All shares issued upon conversion of the Company's convertible secured notes were issued in transactions exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933. 17 On September 13, 2006, the Company issued $1,905,000 principal amount of its convertible secured notes for cash in a transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. These notes are convertible into shares of common stock of the Company at a price of $0.42 per share. Additional information regarding this sale of notes is set forth in a Current Report on Form 8-K filed on September 20, 2006. (b) Not applicable. (c) Not applicable. 18 Item 3. Defaults Upon Senior Securities See Note 6 to the Company's unaudited condensed consolidated financial statements included in this report for information regarding defaults on the Company's 8% convertible secured notes, which were cured in August 2006 with the refinancing of such notes. Item 5. Other Information On August 31, 2006, holders of certain 8% convertible secured notes issued by the Company converted $32,361 principal amount and $158 of accrued interest under their convertible secured notes into 162,596 shares of the Company's common stock. All shares issued upon conversion of the Company's convertible secured notes were issued in transactions exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933. Item 6. Exhibits Exhibit Number Description 3.1 Certificate of Incorporation of Affinity Technology Group, Inc. (the "Company"), which is hereby incorporated by reference to Exhibit 3.1 to the Registration Statement on Form S-1 of Affinity Technology Group, Inc. (File No. 333-1170). 3.2 Certificate of Amendment to Certificate of Incorporation of the Company 3.3 Bylaws of the Company, which is hereby incorporated by reference to Exhibit 3.2 to the Registration Statement on Form S-1 of Affinity Technology Group, Inc. (File No. 333-1170). 4.1 Amended and Restated Convertible Note Purchase Agreement, dated August 9, 2006, among the Company and the investors named therein. 4.2 Form of 8% Convertible Secured Note 4.3 Amended and Restated Security Agreement, dated August 9, 2006, among the Company and the investors named therein. 4.4 Letter Agreement, dated as of September 12, 2006, among Affinity Technology Group, Inc. and certain purchasers of convertible notes under the Amended and Restated Convertible Note Purchase Agreement, dated as of August 9, 2006, among the Company and the investors named therein, which is hereby incorporated by reference to Exhibit 4.1 to the Company's Current Report on Form 8-K filed on September 20, 2006. 10.1 Letter Agreement, effective as of April 17, 2006, between the Company and the holders of the 8% convertible secured notes issued under the Convertible Note Purchase Agreement, dated as of June 3, 2002, among the Company and the investors named therein, which is hereby incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on April 17, 2006. 10.2 Letter Agreement, dated July 10, 2006, between the Company and Morgan Keegan & Company, which is hereby incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on July 14, 2006. 10.3 Amended and Restated Legal Representation Agreement, dated July 10, 2006, among the Company, decisioning.com, Inc. and Withrow & Terranova, PLLC, which is hereby incorporated by reference to Exhibit 10.2 to the Company's Current Report on Form 8-K filed on July 14, 2006. 10.4 Engagement Agreement, dated July 10, 2006, among the Company, decisioning.com, Inc. and McBride Law, PC, which is hereby incorporated by reference to Exhibit 10.3 to the Company's Current Report on Form 8-K filed on July 14, 2006. 31 Rule 13a-14(a) 15d-14(a) Certifications 32 Section 1350 Certifications 19 SIGNATURE 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. Affinity Technology Group, Inc. By: /s/ Joseph A. Boyle ------------------- Joseph A. Boyle Chairman, President, Chief Executive Officer and Chief Financial Officer (principal executive and financial officer) Date: November 14, 2006 20 EXHIBIT INDEX Exhibit 31 Rule 13a-14(a) 15d-14(a) Certifications Exhibit 32 Section 1350 Certifications 21