SecProbe.io

CORRESP
1
filename1.htm

  8911 Capital of Texas Hwy.
  North

  Westech 360, Suite 3350

  Austin, TX 78759-8497

  PHONE 512.338.5400

  FAX 512.338.5499

  www.wsgr.com

December 27, 2005

VIA EDGAR

Securities and Exchange Commission

Division of Corporation Finance

100 F Street, N.E.

Washington, D.C.  20549

  Attn:

  Kathleen Collins

  Kari Jin

  Re:

  NEON Systems, Inc.

  Form 10-K
  for Fiscal Year Ended March 31, 2005

  Filed June 29,
  2005

  File No. 0-25457

Dear Ms. Collins and
Ms. Jin:

On
behalf of NEON Systems, Inc. (the “Company” or “NEON”), we submit this
letter in response to the comment letter dated December 16, 2005 (the “Staff
Comment Letter”) from the staff (the “Staff”) of the Securities and Exchange
Commission (the “Commission”) relating to the above-referenced Annual Report on
Form 10-K (the “Form 10-K”).

In this letter, we have reproduced the comments from
the Staff in italicized, bold type and have followed the comment with the
Company’s response.  The numbered
paragraphs of this letter set forth below correspond to the numbered paragraphs
of the Staff Letter.    References in
this letter to “we,” “our” or “us” means NEON Systems, Inc. All
information included in this letter related to the activities and stock
ownership of NEON Enterprise Software, Inc. (“NESI”), Scalable Software, Inc.
(“Scalable”) and Mr. John J. Moores was provided to NEON by such persons,
including through questionnaires completed by Mr. Moores. Information
related to the beneficial ownership of Mr. Moores and his affiliated
entities is based on public filings and/or non-confidential information
available to the Company. NEON is relying on the truth and accuracy of all such
information and all information provided by all third parties referred to
herein.

PALO ALTO    AUSTIN
NEW YORK    RESTON
SALT LAKE CITY    SAN DIEGO    SAN FRANCISCO    SEATTLE

Form 10-K for the Fiscal Year Ended March 31, 2005

Note 4 – Related Party Transactions, page 41

Neon Enterprise Software, Inc.
(NESI)

1.              With
regards to your response to our previous comment no. 2.b, please provide the
following:

•                  You indicate that the
Company concluded that the NEON and NESI did not meet the definition of the
companies under common control pursuant to EITF 02-5. We note that Mr. Moore
(individually) does not hold more than 50% of NEON’s outstanding common stock
and therefore common control does not exist pursuant to paragraph 3.a. of EITF
02-5. Tell us how you applied the guidance in paragraphs 3.b and 3.c in
determining that these were not entities under common control.

Response:

The Company considered
all aspects of Emerging Issues Task Force (“EITF”) Issue No. 02-5 in
determining whether NESI and the Company were under the common control of Mr. Moores.

Paragraph 3 of EITF Issue
No. 02-5 states that “common control” of separate entities exists only in
the following situations:

a.               An
individual holds more than 50 percent of the voting ownership interests of each
entity.

b.              Immediate
family members hold more than 50 percent of the voting ownership interests of each
entity (with no evidence that those family members will vote their shares other
than in concert).

1)              Immediate
family members include a married couple and their children, but not the married
couple’s grandchildren.

2)              Entities
might be owned in varying combinations among living siblings and their
children. Those situations would require careful consideration regarding the
substance of the ownership and voting relationships.

c.               A
group of shareholders holds more than 50 percent of the voting ownership of
each entity, and contemporaneous written evidence of an agreement to vote a
majority of the entities’ shares in concert exists.

2

In determining Mr. Moores’
ownership of the Company, we considered the ownership of Mr. Moores’
immediate family members, including ownership of immediate family members
through family trusts, in addition to the voting common stock that Mr. Moores
owned directly. The Company also considered whether Mr. Moores was a
member of a group of shareholders that collectively held more than 50% of the
voting ownership and that had contemporaneously entered into a written
agreement with respect to the voting and control of such shares.

Based on the information
included in Mr. Moores’ Form 5 filed on April 11, 2005, as of March 31,
2005, the John J. Moores and Rebecca Baas Moores Family Trust owned 3,458,303
shares, or 36%, of the Company’s common stock directly and Mr. Moores
controlled an additional 744,265 shares, or 8%, indirectly through family
trusts. The Company reviewed its March 31, 2005 stock register and
contacted agents of Mr. Moores to determine if any immediate family
members directly held stock in the Company or had an ownership interest in an
entity that held the Company’s voting stock. Based on our inquiry and review,
the Company determined that Mr. Moores’ immediate family members held no
additional shares of the Company’s voting common stock. Siblings of Mr. Moores
and their children held less than 1% of outstanding voting shares of the
Company.

In addition, Mr. Moores
has not declared in his filings with the Commission or to the Company that he
has control over any shares of the Company voting stock other than the common
stock he directly owns and the shares held by the family trusts for which he is
a trustee.   No group of shareholders has
provided to the Company evidence of any existing or effective agreement to vote
more than 50% equity interest in concert. During the time that Mr. Moores
served on the Board of Directors of the Company (from 1993 to 2003), Mr. Moores
stated in his director questionnaires that he was not party to any such voting
or other control agreements.  Upon our
direct inquiry, Mr. Moores’ representatives confirmed that no such
agreements existed as of the transaction date.

Based on our analysis,
under the guidance set forth in EITF 02-5, the Company determined that Mr. Moores
owned and controlled approximately 44% of the Company’s voting common stock on March 31,
2005, and did not have common control of the Company and NESI.

•                  Tell us if Mr. Moores
has any other arrangements with any of the parties involved that provided him
with effective control

3

Response:

The Company inquired with
representatives of Mr. Moores and received confirmation that there were no
arrangements between Mr. Moores and any other parties that would provide
for the effective control of the Company. Mr. Moores has not declared in
his filings with the Commission nor to the Company that he has control over any
shares of the Company’s voting stock other than the common stock he directly
owns and the shares held by the family trusts for which he is a trustee.

•                  We note your statement
that the Company believed the consideration received from Mr. Moores was
not in excess of the fair value of the underlying collateral of the NESI notes.
Provide a summary of the analysis used determine the fair value of the
collateral. Include the significant assumptions and method used in your valuation.
We note the valuation used was performed on March 31, 2004 yet the sale of
the Notes took place in April 2005.

Response:

In order to determine the
fair value of the NESI Notes on April 15, 2005, the date of the note sale,
the Company utilized the valuation model and assumptions provided in NESI’s
external valuation report performed on March 31, 2004.  The Company reviewed changes to any of the
significant assumptions utilized in this valuation for the intervening period
between the valuation date of March 31, 2004 and the notes sale date of April 15,
2005. As part of our analyses, the Company obtained NESI’s interim financial
statements for the period from April 1, 2004 through March 31, 2005
and compared their performance to prior periods. The Company also regularly
inquired with NESI’s management as to the business prospects and outlook for
the business. Such results were then compared to the assumptions utilized in
the March 31, 2004 valuation report.

The March 31, 2004
independent valuation estimated NESI’s fair value at $10.1 million. The
valuation considered three generally accepted valuation methods:  the cost
approach, the market approach and the income approach.  The Company, in
conjunction with its valuation consultants, determined the income approach was
the most appropriate method. The calculation of NESI’s fair value was based on
the probability-weighted average of multiple discounted future cash flow
scenarios. The valuation model utilized the following data and assumptions:

4

Critical
Data Used:

•                  Ten year projections of future
revenues and operating expenses as provided by NESI management

•                  Federal tax depreciation calculation
methods

•                  Current state and federal income tax
rates

Critical
Assumptions Used:

•                  Revenue growth rate

•                  EBITDA margins (multiple scenarios)

•                  EBITDA multiple to calculate the
residual value of the cash flows after year 10

•                  Risk adjusted discount rate

•                  Working capital rate (cost of
capital)

•                  Future capital expenditures and
inflation rates

•                  Future income taxes

In April 2005, the
date of the notes sale, the Company performed an analysis of the changes in
NESI’s operations since March 2004, the date of the last valuation, in
order to evaluate the impact of such changes on NESI’s current fair value.  The Company reviewed NESI’s results of
operations for the period from April 2004 through March 2005 and
noted that their operating results remained relatively consistent with prior
periods. The Company discussed NESI’s business outlook with NESI’s management,
who noted that NESI’s sales prospects and business outlook had improved since March 2004.
Based on this analysis, the Company believed that the fair value of NESI at April 15,
2005 was not materially different than the fair value at March 31, 2004,
and that the consideration received from Mr. Moores was not in excess of
the fair value of the collateral on the date of the notes sale..

Scalable Software, Inc.

2.              We note that the
Company accounted for its investment in Scalable under the modified equity
method through January 2003. It appears that subsequent to such date, you
discontinued applying the modified equity method and accordingly stopped
recognizing additional equity losses against the carrying value of the notes.
Tell us how you considered EITF D-68 in your accounting for this investment
subsequent to January 2003 or tell us the specific accounting guidance you
applied to this investment at such time. Please explain what impact the
termination of the distribution agreement had on your analysis.

5

Response:

The Company considered
the requirements of EITF Topic D-68 in accounting for its investment in
Scalable prior to and subsequent to January 2003.  Prior to January 2003, the Company
accounted for its investment in Scalable, which consisted solely of the
Scalable Notes, under the modified equity method. Subsequent to the execution
of the Option Agreement and upon providing additional non-guaranteed bridge
financing to Scalable, the Company recorded losses in Scalable up to the amount
of the non-guaranteed note receivable. Scalable’s losses in excess of the
Company’s non-guaranteed note receivable were not recorded by the Company, as
the Company determined that the note guarantors were sufficiently able to
fulfill their obligations of the guarantee with respect to the $3.5 million
guaranteed note receivable.

In January 2003,
Scalable exhausted the available funds under the Company’s bridge financing
arrangement and the Company ceased providing any additional funding to
Scalable. As a result, the Company had no further obligations or commitments to
provide future funding to Scalable. Additionally, the Company’s special
committee to the Board of Directors decided that it did not want to pursue the
acquisition of Scalable under the terms of the Option Agreement. Scalable’s
Board of Directors notified the Company that they did not wish to amend the
terms of the Option Agreement, thus the Company decided not to exercise its
right to acquire Scalable under the Option Agreement. As a result, the Company
no longer chose to exercise its influence over Scalable.

As of January 31,
2003, the Company’s guaranteed note receivable from Scalable was recorded at
the guaranteed amount of $3.5 million, and the Company’s non-guaranteed note
receivable was recorded at $0.

Based on the termination
of Company’s bridge financing obligation and its reduction in influence over
Scalable in January 2003, and the fact that the non-guaranteed note
receivable had a book value of $0, the Company determined that it was no longer
appropriate to account for its investment in Scalable, which in January 2003
only consisted of the $3.5 million guaranteed note, under the modified equity
method of accounting subsequent to January 2003.

3.              With
regards to your response to our previous comment no. 3, please provide the
following:

•                  You indicate that the
Company concluded that the NEON and Scalable did not meet the definition of
companies under common control pursuant to EITF 02-5. We note that Mr. Moores
(individually) does not hold more than 50% of NEON’s outstanding common stock
and therefore common control does not exist pursuant

6

to paragraph 3.a. of EITF 02-5. Tell us how you applied the guidance in
paragraphs 3.b and 3.c in determining that these were not entities under common
control.

Response:

In determining Mr. Moores’
ownership of the Company, we considered the ownership of Mr. Moores’
immediate family members, including ownership of immediate family members
through family trusts, in addition to the voting common stock that Mr. Moores
owned directly. The Company also considered whether Mr. Moores was a
member of a group of shareholders that collectively held more than 50% of the
voting ownership that had contemporaneously entered into a written agreement
with respect to the voting and control of such shares.

Based on the information
included in Mr. Moores’ Form 5 filed on April 14, 2004 and
subsequent filings with the Commission, as of June 17, 2004, the John J.
Moores and Rebecca Baas Moores Family Trust owned 2,905,702 shares, or 33%, of
the Company’s common stock directly and Mr. Moores controlled an
additional 744,265 shares, or 8%, indirectly through family trusts. The Company
also reviewed its May 31, 2004 stock register and contacted agents of Mr. Moores
to determine if any immediate family members directly held stock in the Company
or had an ownership interest in an entity that held the Company’s voting stock.
Based on our inquiry and review, the Company determined that Mr. Moores’
immediate family members held no additional shares of the Company voting common
stock. Siblings of Mr. Moores and their children held less than 1% of outstanding
voting shares of the Company.

In addition, Mr. Moores
has not declared in his filings with the Commission or to the Company that he
has control over any shares of the Company’s voting stock other than the common
stock he directly owns and the shares held by the family trusts for which he is
a trustee.   No group of shareholders has
provided to the Company evidence of any existing and effective agreement to
vote more than 50% equity interest in concert.
During the time that Mr. Moores served on the Board of Directors of
the Company (from 1993 to 2003), Mr. Moores stated in his annual director
questionnaires that he was not a party to any such voting or other control
agreements.  Upon our direct inquiry, Mr. Moores’
representatives confirmed that no such