**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 SEPTEMBER** **30, 2006**





**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 000-30715**





**COSINE
      COMMUNICATIONS, INC.**


*(Exact
      name of Registrant as specified in its charter)*





**Delaware**
            **94-3280301***(State
                or other jurisdiction of*
            *(I.R.S.
                Employer**incorporation
                or organization)*
            *Identification
                Number)***560
                South Winchester Blvd., Suite 500, San Jose, CA**
            **95128***(Address
                of principal executive offices)*
            *(Zip
                Code)*





**Registrant's
      telephone number including area code: (408) 236-7518**





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 xNo o





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 o
            Accelerated
                filer o
            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 
      x  No o





There
      were 10,090,635 shares of the Registrant’s Common Stock, par value $.0001,
      outstanding on October 31, 2006.




Page
            1 of
            33




**COSINE
      COMMUNICATIONS, INC.**





**FORM
      10-Q**





**Quarter
      ended September 30, 2006**





**TABLE
      OF CONTENTS**





Page**PART
                I**FINANCIAL
                INFORMATIONItem
                1.   Condensed Consolidated Financial
                Statements:Condensed
                Consolidated Balance Sheets as of September 30, 2006 and December
                31,
                2005
            3Condensed
                Consolidated Statements of Operations for the Three and Nine Months
                Ended
                September 30, 2006 and 2005
            4Condensed
                Consolidated Statements of Cash Flows for the Nine Months Ended September
                30, 2006 and 2005
            5Notes
                to Condensed Consolidated Financial Statements
            6Item
                2.    Management's Discussion and Analysis of Financial
                Condition and Results of Operations
            15Item
                3.   Quantitative and Qualitative Disclosures About Market
                Risk
            23Item
                4.   Controls and Procedures
            24**PART
                II**OTHER
                INFORMATIONItem
                1. Legal Proceedings
            25Item
                1A. Risk Factors
            25Item
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds
            29Item
                6. Exhibits
            30Signature
            31Exhibit
                Index
            32Certifications
            42




Page
          2 of
          33


**PART
      I. FINANCIAL INFORMATION**





**ITEM
      1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





**COSINE
      COMMUNICATIONS, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(In
      thousands, except for par value and share data)**





**September**
              **30,**
              **2006**
            
            **December
                31,**
              **2005****(Unaudited)**
            
            **(1)**ASSETSCurrent
                assets:Cash
                and cash equivalents
            
            $
            15,740
            
            $
            12,417Short-term
                investments
            
            
            7,254
            
            
            10,749Accounts
                receivable:Trade
                (net of allowance for doubtful accounts of nil at September 30, 2006
                and
                December 31, 2005)
            
            
            96
            
            
            96Other
            
            
            19
            
            
            209Prepaid
                expenses and other current assets
            
            
            114
            
            
            119Total
                current assets
            
            
            23,223
            
            
            23,590Long-term
                deposits and other assets
            
            
            —
            
            
            250$
            23,223
            
            $
            23,840LIABILITIES
                AND STOCKHOLDERS' EQUITYCurrent
                liabilities:Accounts
                payable
            
            $
            412
            
            $
            237Accrued
                other liabilities
            
            
            210
            
            
            874Deferred
                revenue
            
            
            87
            
            
            126Total
                current liabilities
            
            
            709
            
            
            1,237Stockholders'
                equity:Preferred
                stock, 3,000,000 authorized, none issued and outstanding
            
            
            —
            
            
            —Common
                stock, $.0001 par value, 22,000,000 shares authorized; 10,090,635
                shares
                issued and outstanding at September 30, 2006 and December 31, 2005,
                respectively
            
            
            1
            
            
            1Additional
                paid-in capital
            
            
            538,977
            
            
            538,947Accumulated
                other comprehensive income
            
            
            658
            
            
            632Accumulated
                deficit
            
            
            (517,122
            )
            
            (516,977
            )Total
                stockholders' equity
            
            
            22,514
            
            
            22,603$
            23,223
            
            $
            23,840




See
      accompanying notes to condensed consolidated financial statements.








(1)
      The
      information in this column was derived from the Company's audited consolidated
      financial statements for the year ended December 31, 2005.


Page
          3 of
          33


**COSINE
      COMMUNICATIONS, INC.**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(In
      thousands, except for per share data)**


**(Unaudited)**





**Three
                Months Ended**
              **September
                30****,**
            
            **Nine
                Months Ended**
              **September
                30****,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenue:Product
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            216Service
            
            
            134
            
            
            785
            
            
            1,233
            
            
            2,165Total
                revenue
            
            
            134
            
            
            785
            
            
            1,233
            
            
            2,381Cost
                of revenue1
            
            
            366
            
            
            702
            
            
            1,469
            
            
            1,545Gross
                profit (loss)
            
            
            (232
            )
            
            83
            
            
            (236
            )
            
            836Operating
                expenses:Research
                and development
            
            
            -
            
            
            -
            
            
            -
            
            
            103Sales
                and marketing
            
            
            -
            
            
            -
            
            
            -
            
            
            105General
                and administrative
            
            
            295
            
            
            422
            
            
            906
            
            
            2,825Restructuring
                and impairment credits
            
            
            -
            
            
            -
            
            
            -
            
            
            (91
            )Total
                operating expenses
            
            
            295
            
            
            422
            
            
            906
            
            
            2,942Loss
                from operations
            
            
            (527
            )
            
            (339
            )
            
            (1,142
            )
            
            (2,106
            )Interest
                income and other
            
            
            302
            
            
            191
            
            
            996
            
            
            470Loss
                before income tax benefits
            
            
            (225
            )
            
            (148
            )
            
            (146
            )
            
            (1,636
            )Income
                tax benefits
            
            
            -
            
            
            (117
            )
            
            -
            
            
            (94
            )Net
                loss
            
            $
            (225
            )
            $
            (31
            )
            $
            (146
            )
            $
            (1,542
            )Basic
                and diluted net income (loss) per share
            
            $
            (0.02
            )
            $
            (0.00
            )
            $
            (
                0.01
            )
            $
            (0.15
            )Shares
                used in computing per share amounts
            
            
            10,091
            
            
            10,091
            
            
            10,091
            
            
            10,095




See
      accompanying notes to condensed consolidated financial statements.




1Cost of revenues includes non-cash (credits) charges related to equity
        issuances of $10 and $60 for the three months ended September 30, 2006 and
        2005,
        respectively, and $130 and $279 for the nine months ended September 30, 2006
        and
        2005, respectively.




Page
          4 of
          33


**COSINE
      COMMUNICATIONS, INC.**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(In
      thousands)**


**(Unaudited)**





**Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005****Operating
                activities:**Net
                loss
            
            
            ($
                146
            )
            
            ($1,542
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Amortization
                of warrants issued for services
            
            
            100
            
            
            279Stock
                compensation expense
            
            
            30
            
            
            —Change
                in operating assets and liabilities:Accounts
                receivable, trade
            
            
            —
            
            
            1,157Other
                receivables
            
            
            190
            
            
            321Prepaid
                expenses and other current assets
            
            
            5
            
            
            533Other
                assets
            
            
            150
            
            
            1Accounts
                payable12
            
            
            175
            
            
            (9
            )Provision
                for warranty claims
            
            
            —
            
            
            (114
            )Accrued
                other liabilities
            
            
            (664
            )
            
            (2,118
            )Accrued
                compensation
            
            
            —
            
            
            (412
            )Deferred
                revenue
            
            
            (39
            )
            
            (40
            )Net
                cash used in operating activities
            
            
            (198
            )
            
            (1,944
            )**Investing
                activities:**Purchase
                of short-term investments
            
            
            (8,792
            )
            
            (12,275
            )Proceeds
                from sales and maturities of short-term investments
            
            
            12,313
            
            
            17,129Net
                cash provided by investing activities
            
            
            3,521
            
            
            4,854Net
                increase in cash and cash equivalents
            
            
            3,323
            
            
            2,910Cash
                and cash equivalents at the beginning of the period
            
            
            12,417
            
            
            9,203Cash
                and cash equivalents at the end of the period
            
            $
            15,740
            
            $
            12,113**Supplemental
                information:**Income
                taxes paid
            
            $
            —
            
            $
            23Cancellation
                of notes receivable due to repurchase of unvested stock
            
            $
            —
            
            $
            1,520Issuance
                of warrant to reseller and revaluation
            
            $
            —
            
            $
            439





See
      accompanying notes to condensed consolidated financial
      statements.


Page
          5 of
          33


**COSINE
      COMMUNICATIONS, INC.**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





1.
      BASIS
      OF PRESENTATION





***Description
      of Business***





CoSine
      Communications, Inc. ("CoSine" or the "Company," which may be referred to as
      "we," "us" or "our") was incorporated in California on April 14, 1997 and in
      August 2000 was reincorporated in the State of Delaware. We were a provider
      of
      carrier network equipment products and services until the fourth quarter of
      fiscal year 2004 during which time we discontinued our product lines, took
      actions to lay-off most of our employees, terminated contract manufacturing
      arrangements, contractor and consulting arrangements and various facility
      leases, and sold, scraped or wrote-off our inventory, property and equipment.
      As
      a result of these activities, our business consists primarily of a customer
      support capability for our discontinued products provided by a third party.
      We
      intend to continue such support activities through December 31, 2006, depending
      on customer demand. We are also continuing to seek to redeploy our existing
      resources to identify and acquire one or more new business operations with
      existing or prospective taxable earnings that can be offset by use of our net
      operating loss carry-forwards ("NOLs"). In March 2006, we signed an agreement
      to
      sell the rights to our patent portfolio for cash consideration of $180,000.
      The
      agreement allows us to use the patents in support of our existing customers
      through January 2008.





***Liquidity
      and Redeployment Strategy***





The
      accompanying financial statements have been prepared in conformity with U.S.
      generally accepted accounting principles, which contemplate continuation of
      the
      Company as a going concern. However, at September 30, 2006, we have an
      accumulated deficit of $517 million and we sustained net losses every year
      since
      our inception. As of September 30, 2006, our business consists primarily of
      a
      customer service capability operated under contract by a third party. In July
      2004, we announced that we were exploring various strategic alternatives and
      as
      a result, we initiated, in September 2004, actions to terminate most of our
      employees and discontinue production activities in an effort to conserve cash.
      These actions raised substantial doubt about our ability to continue as a going
      concern. The financial statements do not include any adjustments to reflect
      the
      possible future effects relating to the recoverability and classification of
      the
      recorded asset amounts or amounts and classification of liabilities that might
      result from the outcome of this uncertainty.





In
      July
      2005, we completed a comprehensive review of strategic alternatives, including
      a
      sale of CoSine, a sale or licensing of intellectual property, a redeployment
      of
      our assets into new business ventures, or a winding-up and liquidation of the
      business and a return of capital. The board of directors approved a plan to
      redeploy our existing resources to identify and acquire one or more new business
      operations, while continuing to support our existing customers and continuing
      to
      offer our intellectual property for license or sale. Our redeployment strategy
      involves the acquisition of one or more operating businesses with existing
      or
      prospective taxable earnings that can be offset by use of our NOLs. In March
      2006, we signed an agreement to sell the rights to our patent portfolio for
      cash
      consideration of $180,000. The agreement allows us to use the patents in support
      of our existing customers through January 2008.





***Basis
      of Consolidation***





The
      consolidated financial statements include all of the accounts of CoSine and
      its
      wholly owned subsidiaries. All significant intercompany balances and
      transactions have been eliminated.





***Use
      of Estimates***





The
      preparation of consolidated financial statements in conformity with U.S.
      generally accepted accounting principles requires management to make estimates
      and assumptions that affect the amounts reported in the consolidated financial
      statements and the accompanying notes. Actual results could differ from these
      estimates. Estimates are used in accounting for, but not limited to, revenue
      recognition, allowance for doubtful accounts, inventory valuations, long-lived
      asset valuations, accrued liabilities including warranties, and equity
      issuances. Estimates and assumptions are reviewed periodically and the effects
      of revisions are reflected in the consolidated financial statements in the
      period of determination.




Page
          6 of
          33





The
      unaudited condensed consolidated financial statements have been prepared by
      us
      pursuant to instructions to Form 10-Q and Article 10 of Regulation S-X and
      include the accounts of CoSine Communications, Inc. and its wholly owned
      subsidiaries ("CoSine" or collectively, the "Company" and which may be referred
      to as "we," "us" or "our"). Certain information and footnote disclosures
      normally included in financial statements prepared in accordance with U. S.
      generally accepted accounting principles have been condensed or omitted pursuant
      to the Securities Exchange Commission’s rules and regulations. In the opinion of
      management, all adjustments (consisting of normal recurring items) necessary
      for
      a fair presentation have been included. The results of operations for the three
      and nine months ended September 30, 2006 are not necessarily indicative of
      the
      results to be expected for any subsequent quarter or for the entire year. The
      condensed consolidated balance sheet at December 31, 2005 has been derived
      from
      the audited financial statements as of that date. These unaudited condensed
      consolidated financial statements should be read in conjunction with the audited
      consolidated financial statements and the notes included in our Annual Report
      filed on Form 10-K for the year ended December 31, 2005.





***Stock
      Compensation***





Effective
      January 1, 2006, we adopted the provisions of Statement of Financial Accounting
      Standards No. 123 (R), “ *Share-Based
      Payment”* (“SFAS
      No. 123 (R).” SFAS No. 123 (R) establishes accounting for stock-based awards
      exchanged for employee services. Accordingly, stock-based compensation cost
      is
      measured at grant date, based on the fair value of the award, and is recognized
      as expense over the employee requisite service period. All of our stock
      compensation is accounted for as an equity instrument. We previously applied
      Accounting Principles Board (“APB”) Opinion 25 “ *Accounting
      for Stock Issued to Employees* ,”
and
      related interpretations and provided the required pro forma disclosures of
      SFAS
      No. 123 “ *Accounting
      for Stock-Based Compensation* ”
(“SFAS
      No. 123”).





**Prior
      to the Adoption of SFAS No. 123 (R)**





Prior
      to
      the adoption of SFAS No. 123 (R), we provided the disclosures required under
      SFAS No. 123, as amended by SFAS No. 148, “ *Accounting
      for Stock-Based Compensation - Transition and Disclosures* .”





The
      following table illustrates the effect on our net loss and net loss per share
      if
      we had applied the fair value recognition provisions of SFAS 123 to stock-based
      employee compensation for the three months and nine months ended September
      30,
      2005 (in thousands, except per share data):





**Three
                Months ended**
              **September
                30, 2005**
            
            **Nine
                Months ended**
              **September
                30, 2005**Net
                loss, as reported
            
            
            ($
                31
            )
            
            ($1,542
            )Add:
                Stock-based employee compensation expense, net of tax, included in
                reported net loss
            
            
            —
            
            
            —Deduct:
                Reversal of amortization in excess of vesting, net of tax
            
            
            —
            
            
            —Deduct:
                Stock-based employee compensation expense determined under fair value
                method for all stock option grants (SFAS 123 expense), net of
                tax
            
            
            —
            
            
            —Pro
                forma net loss
            
            
            ($
                31
            )
            
            ($1,542
            )Basic
                and diluted net loss per share, as reported
            
            
            ($0.00
            )
            
            ($0.15
            )Pro
                forma basic and diluted net loss per share
            
            
            ($
                0.00
            )
            
            ($0.15
            )





Page
          7 of
          33




**Impact
      of the Adoption of SFAS No. 123 (R)**





We
      elected to adopt the modified prospective application method as provided by
      SFAS
      No. 123 (R). The effect of recording stock-based compensation for the three
      and
      nine months ended September 30, 2006 was as follows (in thousands except per
      share data):





**Three
                Months Ended**
              **September
                30, 2006**
            
            **Nine
                Months Ended**
              **September
                30, 2006**Stock-based
                compensation expense
            
            $
            10
            
            $
            30Tax
                effect on stock-based compensation
            
            
            —
            
            
            —Net
                effect on net loss
            
            $
            10
            
            $
            30Effect
                on basic and diluted net loss per share
            
            $
            (
                0.00
            )
            $
            (
                0.00
            )




Under
      the 1997, 2000 and 2002 stock option plans, the Board of Directors has the
      authority to determine the type of option and the number of shares subject
      to
      each option. The exercise price is generally equal to fair value of the
      underlying stock at the date of grant. Options generally become exercisable
      over
      a four-year period and, if not exercised, expire ten years from the date of
      grant. The 1997 Plan was terminated in connection with our initial public
      offering in 2000, and the shares reserved and unissued under the 1997 Plan
      were
      reserved for issuance under the 2000 Plan.





Under
      the
      Directors’ Option Plan, option grants are made to new non-employee directors and
      to continuing non-employee directors pursuant to the terms contained in the
      Director Stock Option Plan Agreement. The exercise price is equal to fair value
      of the underlying stock at the date of grant. Initial options vest in four
      equal
      annual increments immediately following the date of grant and the subsequent
      options vest on the fourth anniversary of the date of grant. The options, if
      not
      exercised, expire tem years from date of grant.





At
      September 30, 2006, the Company had the following stock plans:




**Reserved for**
              **Issuance**
            
            **Shares**
              **Available for**
              **Grant**
            
            **Options**
              **Outstanding**2000
                Stock Option Plan
            
            
            2,035,000
            
            
            1,918,000
            
            
            117,0002002
                Stock Option Plan
            
            
            1,000,000
            
            
            1,000,000
            
            
            —Directors’
                Option Plan
            
            
            52,000
            
            
            22,000
            
            
            30,000Totals
            
            
            3,087,000
            
            
            2,940,000
            
            
            147,000




As
      of
      January 1, 2006, we had an unrecorded deferred stock compensation balance
      related to stock options of approximately $139,000 before estimated forfeitures.
      In our pro forma disclosures prior to the adoption of SFAS No. 123 (R), we
      accounted for forfeitures upon occurrence. SFAS No. 123 (R) requires forfeitures
      to be estimated at the time of grant and revised if necessary in subsequent
      periods if actual forfeitures differ from those estimates. Based on our analysis
      of historical experience and review of current option holders, we have assumed
      an annual forfeiture rate of 2.5% for our options. Accordingly, as of January
      1,
      2006, we estimated that the stock-based compensation for the awards not expected
      to vest was approximately $13,000, and therefore, the unrecorded deferred
      stock-based compensation balance related to stock options was adjusted to
      approximately $126,000 after estimated forfeitures.




Page
          8 of
          33




During
      the nine months ended September 30, 2006, there were stock option grants for
      a
      total of 6,000 shares, with an exercise price of $2.45 per share, the market
      price on the date of grant, and 6,000 options were cancelled.





As
      of
      September 30, 2006, the unrecorded stock-based compensation balance related
      to
      stock options was $98,000 and will be recognized over an estimated weighted
      average amortization period of 4 years.





****** **Valuation
      Assumptions**





The
      fair
      value of our options was estimated at the grant date using the Black-Scholes
      option pricing model with the following weighted average assumptions:





**Nine
                Months Ended September 30,****2006**
            
            **2005**Dividend
                yield
            
            
            0.0
            %
            
            0.0
            %Volatility
            
            
            0.85
            
            
            0.95Risk
                free interest rate
            
            
            4.12
            %
            
            2.6
            %Expected
                life
            
            
            4
                years
            
            
            4
                years





The
      dividend yield of zero is based on the fact that we have never paid cash
      dividends and have no present intention to pay cash dividends. Expected
      volatility is based on the historical volatility of our common stock. The
      risk-free interest rates are taken from the Daily Federal Yield Curve Rates
      as
      of the grant dates as published by the Federal Reserve and represent the yields
      on actively traded treasury securities for terms equal to the expected term
      of
      the options. The expected term calculation is based on the observed historical
      option exercise behavior and post-vesting forfeitures of our employees and
      an
      analysis of the existing option holders.


Page
          9 of
          33


Stock
      activity under the Stock Option Plans was as follows (in thousands, except
      per
      share data):





**Shares**
              **Available
                for**
              **Grant**
            
            **Shares**
            
            **Weighted-**
              **Average**
              **Price
                Per**
              **Share****Balance
                as of December 31, 2005**
            
            
            2,940
            
            
            147
            
            
            8.37Repurchased
            
            
            —
            
            
            —
            
            
            —Granted
            
            
            (6
            )
            
            6
            
            
            2.45Canceled
            
            
            6
            
            
            (6
            )
            
            18.88**Balance
                as of September 30, 2006**
            
            
            2,940
            
            
            147
            
            $
            7.69




The
      aggregate intrinsic value of stock options outstanding at September 30, 2006
      is
      $11,000. The aggregate intrinsic value of options vested and expected to vest
      is
      $11,000 at September 30, 2006. The intrinsic value of options exercisable at
      September 30, 2006 is $3,500.





The
      following table summarizes information concerning options outstanding and
      exercisable at September 30, 2006 (in thousands, except years and per share
      data):





**Options
                Outstanding at September 30,**
              **2006**
            
            **Options
                Exercisable at September 30, 2006****Weighted-****Average**
            
            **Weighted**
            
            
            
            **Weighted****Number**
            
            **Remaining**
            
            **Average**
            
            **Number**
            
            **Average****Range
                of**
            
            **Of**
            
            **Contractual**
            
            **Exercise**
            
            **Of**
            
            **Exercise****Exercise
                Prices**
            
            **Shares**
            
            **Life
                (Years)**
            
            **Price**
            
            **Shares**
            
            **Price**$2.15-2.60
            
            
            118
            
            
            9.0
            
            $
            2.56
            
            
            52
            
            $
            2.565.20
            
            
            4
            
            
            6.6
            
            
            5.20
            
            
            0
            
            
            5.206.96
            
            
            12
            
            
            7.1
            
            
            6.96
            
            
            9
            
            
            6.968.80
            
            
            4
            
            
            5.6
            
            
            8.80
            
            
            4
            
            
            8.8022.30
            
            
            4
            
            
            4.7
            
            
            22.30
            
            
            4
            
            
            22.3040.00-120.00
            
            
            5
            
            
            3.9
            
            
            120.00
            
            
            5
            
            
            120.00147
            
            
            8.4
            
            $
            7.69
            
            
            74
            
            $
            12.47





***Guarantees***





We
      may
      enter into certain types of contracts that require that we indemnify parties
      against certain third party claims that may arise. These contracts primarily
      relate to: (i) certain agreements with our officers, directors and
      employees, under which we may be required to indemnify such persons for
      liabilities arising out of their employment relationship, (ii) contracts under
      which we may be required to indemnify customers against loss or damage to
      property or persons as a result of willful or negligent conduct by our employees
      or sub-contractors, (iii) contracts under which we may be required to indemnify
      customers against third party claims that our product infringes a patent,
      copyright or other intellectual property right and (iv) procurement or license
      agreements under which we may be required to indemnify licensors or vendors
      for
      certain claims that may be brought against them arising from our acts or
      omissions with respect to the supplied products or technology.





Generally,
      a maximum obligation is not explicitly stated. Because the obligated amounts
      associated with this type of agreement are not explicitly stated, the overall
      maximum amount of the obligation cannot be reasonably estimated. Historically,
      we have not been obligated to make payments for these obligations, and no
      liabilities have therefore been recorded for these obligations on its
      consolidated balance sheet as of September 30, 2006.





Page
          10
          of 33




2.
      COMMITMENTS AND CONTINGENCIES





On
      November 15, 2001, we along with certain of our officers and
      directors ** were
      named as defendants in a class action shareholder complaint filed in the United
      States District Court for the Southern District of New York, now captioned *In
      re
      CoSine Communications, Inc. Initial Public Offering Securities
      Litigation,* Case No.
      01 CV 10105. The complaint generally alleges that various investment bank
      underwriters engaged in improper and undisclosed activities related to the
      allocation of shares in our initial public offering. The complaint brings claims
      for the violation of several provisions of the federal securities laws against
      those underwriters, and also against us and each of the directors and officers
      who signed the registration statement relating to the initial public offering.
      The plaintiffs seek unspecified monetary damages and other relief. Similar
      lawsuits concerning more than 300 other companies’ initial public offerings were
      filed during 2001, and this lawsuit is being coordinated with those actions
      in
      the Southern District of New York before Judge Shira A. Scheindlin.





On
      or
      about July 1, 2002, an omnibus motion to dismiss was filed in the coordinated
      litigation on behalf of the issuer defendants, of which we and our named officer
      and directors are a part, on common pleading issues. In October 2002, pursuant
      to stipulation by the parties, the Court entered an order dismissing our named
      officers and directors from the action without prejudice. On February 19, 2003,
      the Court dismissed the Section 10(b) and Rule 10b-5 claims against us but
      did
      not dismiss the Section 11 claims against us.





In
      June
      2004, a stipulation of settlement and release of claims against the issuer
      defendants, including us, was submitted to the court for approval. The terms
      of
      the settlement, if approved, would dismiss and release all claims against the
      participating defendants (including us). In exchange for this dismissal, D&O
      insurance carriers would agree to guarantee a recovery by the plaintiffs from
      the underwriter defendants of at least $1 billion, and the issuer defendants
      would agree to an assignment or surrender to the plaintiffs of certain claims
      the issuer defendants may have against the underwriters. On August 31, 2005,
      the
      court issued an order granting preliminary approval of the settlement. The
      settlement is subject to a number of conditions, including final court approval,
      which cannot be assured. If the settlement is not consummated, we intend to
      defend the lawsuit vigorously. However, we cannot predict its outcome with
      certainty. If we are not successful in our defense of this lawsuit, we could
      be
      forced to make significant payments to the plaintiffs and their lawyers, and
      such payments could have a material adverse effect on our business, financial
      condition and results of operations if not covered by our insurance carrier.
      Even if these claims are not successful, the litigation could result in
      substantial costs and divert management’s attention and resources, which could
      adversely affect our business, results of operations and financial position.




In
      the
      ordinary course of business, we are involved in legal proceedings involving
      contractual obligations, employment relationships and other matters. Except
      as
      described above, we do not believe there are any pending or threatened legal
      proceedings that will have a material impact on our consolidated financial
      position or results of operations.





3.
      BALANCE SHEET DETAILS





***Cash***





At
      September 30, 2006, we had deposits with a financial institution that may exceed
      the amount of insurance provided on such deposits.








***Accounts
      Receivable***





****** One
      North
      American customer accounted for 95% of total accounts receivable as of September
      30, 2006, as compared to three customers comprising greater than 10% of total
      accounts receivable at December 31, 2005.




Page
          11
          of 33





Inventory





In
      the
      quarter ended September 30, 2004, we announced that we had discontinued our
      products and accordingly wrote our inventory down to net realizable value.
      At
      December 31, 2005 and September 30, 2006, all inventory had been sold, scrapped
      or written-off and there was no inventory awaiting customer acceptance.





During
      the nine months ended September 30, 2005, $25,000 of previously written-down
      inventory was sold.





***Warranty***





Prior
      to
      discontinuing our products in September 2004, we provided a basic limited
      warranty, including repair or replacement of parts, and technical support for
      products sold on or before September 30, 2004. The specific terms and conditions
      of those warranties varied depending on the customer or region in which we
      did
      business. We estimated the costs that may be incurred under our basic limited
      warranty and recorded a liability in the amount of such costs at the time
      product revenue was recognized. Our warranty obligation was affected by the
      number of installed units, product failure rates, materials usage and service
      delivery costs incurred in correcting product failures. We periodically assess
      the adequacy of its recorded warranty liabilities and adjust the amounts as
      necessary.





Changes
      in our warranty liability were as follows, in thousands:





Nine
                Months Ended September 30,**2006**
            
            **2005**Beginning
                balance
            
            $
            —
            
            $
            157Changes
                in estimated liability based on experience
            
            
            —
            
            
            (114
            )Ending
                balance
            
            $
            —
            
            $
            43





4.
      NET
      LOSS PER COMMON SHARE




Basic
      net
      loss per common share is calculated based on the weighted-average number of
      common shares outstanding during the periods presented, less weighted-average
      shares outstanding that are subject to our right of repurchase. Common stock
      equivalents consisting of stock options and warrants (calculated using the
      treasury stock method), have been excluded from the diluted net loss per common
      share computations, as their inclusion would be antidilutive. These securities
      amounted to 181,000 shares and 107,000 shares for the nine months ended
      September 30, 2006 and 2005, respectively.




The
      calculations of basic and diluted net loss per share are shown below, in
      thousands, except per share data:




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                income (loss)
            
            
            ($
                225
            )
            
            ($
                31
            )
            
            ($
                146
            )
            
            ($1,542
            )Basic
                and diluted:Weighted-average
                shares of common stock outstanding
            
            
            10,091
            
            
            10,091
            
            
            10,091
            
            
            10,095Weighted-average
                shares subject to repurchase
            
            
            —
            
            
            —
            
            
            —
            
            
            —Weighted-average
                shares used in basic and diluted net loss per share
            
            
            10,091
            
            
            10,091
            
            
            10,091
            
            
            10,095Basic
                and diluted net income (loss) per share
            
            
            ($0.02
            )
            
            ($0.00
            )
            
            ($
                0.01
            )
            
            ($0.15
            )





Page
          12
          of 33




5.
      COMPREHENSIVE INCOME (LOSS)





The
      components of comprehensive income (loss) are shown below, in
      thousands:





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                income (loss)
            
            
            ($225
            )
            
            ($31
            )
            
            ($
                146
            )
            
            ($1,542
            )Other
                comprehensive loss:Unrealized
                gains (losses) on investments
            
            
            6
            
            
            (2
            )
            
            13
            
            
            8Currency
                translation adjustment
            
            
            -
            
            
            -
            
            
            13
            
            
            -Total
                other comprehensive gain (loss)
            
            
            6
            
            
            (2
            )
            
            26
            
            
            8Comprehensive
                loss
            
            
            ($219
            )
            
            ($33
            )
            
            ($120
            )
            
            ($1,534
            )





6.
      SEGMENT REPORTING




We
      operate in only one operating segment, and substantially all of our assets
      are
      located in the United States.




Revenues
      from customers by geographic region for the three and nine months ended
      September 30, 2006 and 2005, respectively, were as follows, in
      thousands:





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Region**North
                America
            
            $
            100
            
            $
            457
            
            $
            1,110
            
            $
            1,320Italy
            
            
            -
            
            
            57
            
            
            -
            
            
            166France
            
            
            27
            
            
            63
            
            
            109
            
            
            216Korea
            
            
            -
            
            
            11
            
            
            -
            
            
            42Japan
            
            
            -
            
            
            108
            
            
            -
            
            
            422Other
                EMEA.
            
            
            7
            
            
            89
            
            
            14
            
            
            215Total
            
            $
            134
            
            $
            785
            
            $
            1,233
            
            $
            2,381




Two
      North
      American customers accounted for 47% and 27% of total revenues, respectively,
      and one French customer accounted for 20% of total revenues in the three months
      ended September 30, 2006 as compared to one North American customer accounting
      for 47% and one Japanese customer accounting for 14% of total revenues,
      respectively, in the three months ended September 30, 2005.





Page
          13
          of 33




7.
      RESTRUCTURING CHARGES





***December
      2004 Restructuring***





**** In
      the
      quarter ended December 31, 2004, we continued our previously announced actions
      to terminate the remainder of its workforce, terminate the lease of our
      facilities in Redwood City, California, and terminated our office lease in
      Japan. In addition, we accrued for the termination of non-cancelable software
      license agreements, as the licenses were not expected to be used in the ongoing
      operations.




Activity
      related to the December 2004 restructuring in the nine months ended September
      30, 2006 is as follows, (in thousands):





**Worldwide
                workforce****reduction**
            
            **Lease****Terminations**
            
            **Software
                License****Terminations**
            
            **Total**Provision
                balance at December 31, 2005
            
            $
            3
            
            $
            —
            
            $
            450
            
            $
            453Cash
                payments
            
            
            (3
            )
            
            —
            
            
            (450
            )
            
            (453
            )Provision
                balance at September 30, 2006
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





***September
      2004 Restructuring***





In
      September 2004, we announced actions to terminate most of our workforce,
      retaining a limited team of employees to provide customer support and handle
      matters related to the ongoing exploration of strategic alternatives. The
      specific actions include workforce reductions, announced discontinuance of
      our
      products, and a charge for unrecoverable royalties, and termination of third
      party manufacturing agreements.





Effective
      September 23, 2004, we approved severance agreements to Stephen Goggiano, our
      president and chief executive officer, and Terry R. Gibson, our chief financial
      officer, covering the period of August 1, 2004 through the earlier of (i)
      December 31, 2004 or (ii) the termination of their respective employments due
      to
      the elimination of their respective jobs if caused by a merger, sale,
      acquisition, liquidation, dissolution, consolidation or similar corporate
      transaction, in exchange for their continued service to us as we explored
      strategic alternatives, including a sale of the Company, a sale or licensing
      of
      products, intellectual property, or individual assets or a winding-up and
      liquidation of the business. In exchange for their continued service during
      this
      time period, Mr. Goggiano and Mr. Gibson each received a retention bonus equal
      to 100% of their base 2004 annual salary, paid in January 2005. In addition,
      upon completion of these services, we agreed to pay for the cost of Mr.
      Goggiano's and Mr. Gibson's health care coverage for a period of 12 months
      after
      termination of their respective employment. These amounts were charged to
      restructuring in December 2004 and were paid in 2005.





There
      was
      no activity related to the September 2004 restructuring in the nine months
      ended
      September 30, 2006, as all the planned restructuring activities were completed
      in the three months ended March 31, 2005.




Page
          14
          of 33




Activity
      related to the September 2004 restructuring for the nine months ended September
      30, 2005 is as follows (in thousands):





**Worldwide
                workforce****reduction**
            
            **Write-down
                of inventory and prepaid****royalty**
            
            **Manufacturing
                agreement****termination**
            
            **Total**Provision
                balance at December 31, 2004
            
            $
            424
            
            $
            —
            
            $
            —
            
            $
            424Cash
                payments
            
            
            (424
            )
            
            —
            
            
            —
            
            
            (424
            )Provision
                balance at September 30, 2005, December 31, 2005 and September 30,
                2006
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —




8.
      RECENT
      ACCOUNTING PRONOUNCEMENTS





In
      June
      2006, the FASB issued FASB Interpretation No.48, Accounting for Uncertainty
      in
      Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48), which
      prescribes accounting for and disclosure of uncertainty in tax positions. This
      interpretation defines the criteria that must be met for the benefits of a
      tax
      position to be recognized. The provisions of FIN 48 are effective as of the
      beginning of the Company’s 2007 fiscal year, with the cumulative effect of the
      change in accounting principle recorded as an adjustment to opening retained
      earnings. The Company is currently evaluating the impact of adopting FIN 48
      on
      its financial statements.





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 ("SAB 108"),
      "Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements." SAB 108 is effective for
      fiscal years ending on or after November 15, 2006 and addresses how financial
      statement errors should be considered from a materiality perspective and
      corrected. The literature 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. Historically there have been two common
      approaches used to quantify such errors: (i) the "rollover" approach, which
      quantifies the error as the amount by which the current year income statement
      is
      misstated, and (ii) the "iron curtain" approach, which quantifies the error
      as
      the cumulative amount by which the current year balance sheet is misstated.
      The
      SEC Staff believes that companies should quantify errors using both approaches
      and evaluate whether either of these approaches results in quantifying a
      misstatement that, when all relevant quantitative and qualitative factors are
      considered, is material. The Company is currently evaluating the impact, if
      any,
      of adopting the provisions of SAB 108 on our financial position, results of
      operations and liquidity.




In
      September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements” (“SFAS
      157”), which defines fair value, establishes a framework for measuring fair
      value in generally accepted accounting principles, and expands disclosures
      about
      fair value measurements. SFAS 157 is effective in fiscal years beginning after
      November 15, 2007. The Company is currently assessing the impact of adopting
      SFAS 157 on the consolidated financial condition, results of operations, and
      cash flows of the Company.




9.
      RELATED PARTY TRANSACTIONS





In
      August
      2005 our board of directors worked with Steel Partners II, L.P., (“Steel
      Partners”), an entity that owned 24% of CoSine’s common stock as of August 2005,
      to conduct a review of CoSine’s historical net operating losses and review
      ownership changes sich CoSine’s inception. The study was initiated to determine
      the effect, if any, of such ownership changes on the availability of CoSine’s
      net operating loss carryforwards. Steel Partners incurred direct expenses,
      primarily outside legal fees, in the amount of $40,728, in connection with
      the
      study and CoSine has reimbursed such costs.




In
      the
      nine months ended September 30, 2006, Steel Partners has conducted additional
      research into CoSine’s net operating losses and the potential effect of
      ownership changes on the availability of such losses. The costs of this research
      are primarily outside legal and accounting fees and total $42,094 for the nine
      months ended September 30, 2006. At September 30, 2006, all amounts due to
      Steel
      Partners in connection with the research had been paid.





Page
          15
          of 33





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





This
      Management's Discussion and Analysis of Financial Condition and Results of
      Operations contains forward-looking statements. We use words such as
      "anticipate," "believe," "plan," "expect," "future," "intend" and similar
      expressions to identify forward-looking statements. These forward-looking
      statements are subject to certain risks and uncertainties that could cause
      actual results to differ materially from those reflected in the forward-looking
      statements. Factors that might cause such a difference include, but are not
      limited to, the continued downturn in the telecommunications industry and slow
      development of the market for network-based IP services, technological changes
      affecting the value of our intellectual property to the extent these conditions
      impact strategic alternatives available to us, failure to achieve revenue growth
      and profitability, changes in general economic conditions and in economic
      conditions in the customer service market that we currently serve, our ability
      to identify and acquire new business operations while continuing to provide
      support to our existing customers and continuing to offer our intellectual
      property for license or sale, the time and costs required to identify and
      acquire new business operations, management and board interest in and
      distraction due to identifying and acquiring new business operations, and the
      reactions, either positive or negative, of investors, competitors, customers,
      employees and others to our strategic direction and to any specific business
      opportunity selected by us, all as are discussed in more detail in the section
      entitled "Risk Factors" on pages 25 through 29 of this report, as well as the
      other risk factors discussed in that section. Readers are cautioned not to
      place
      undue reliance on these forward-looking statements, which reflect management’s
      opinions only as of the date hereof. We undertake no obligation to revise or
      publicly release the results of any revision to these forward-looking
      statements. Readers should carefully review the risk factors described in other
      documents that we file from time to time with the Securities and Exchange
      Commission.





**OVERVIEW**





Our
      current business consists primarily of a customer support capability for our
      discontinued products provided by a third party. We intend to continue such
      support activities through December 31, 2006, depending on customer demand.
      We
      have also adopted a strategy of seeking to enhance stockholder value by pursuing
      opportunities to redeploy our assets through an acquisition of one or more
      operating business with existing or prospective taxable earnings that can be
      offset by use of our net operating loss carry-forwards (“NOLs”).





We
      were a
      provider of carrier network equipment products and services until the fourth
      quarter of fiscal year 2004 during which time we discontinued our product lines,
      took actions to lay-off most of our employees, terminated contract manufacturing
      arrangements, contractor and consulting arrangements and various facility
      leases, and sold, scraped or wrote-off our inventory, property and equipment.
      In
      July 2005, we completed a comprehensive review of strategic alternatives,
      including a sale of the Company, a sale or licensing of intellectual property,
      a
      redeployment of our assets into new business ventures, or a winding-up and
      liquidation of the business and a return of capital. At that time, the board
      of
      directors approved the strategy of redeploying our existing resources to
      identify and acquire one or more new business operations, while continuing
      to
      support our existing customers and continuing to offer our intellectual property
      for license or sale. In March 2006 we signed an agreement to sell the rights
      to
      our patent portfolio for cash consideration of $180,000. The agreement allows
      us
      to use the patents in support of our existing customers through January 2008.





DUE
      TO
      THE ADOPTION OF OUR REDEPLOYMENT STRATEGY, THE INFORMATION APPEARING BELOW,
      WHICH RELATES TO PRIOR PERIODS, MAY NOT BE INDICATIVE OF THE RESULTS THAT MAY
      BE
      EXPECTED FOR ANY SUBSEQUENT PERIODS. THE THREE AND NINE MONTH PERIODS ENDED
      SEPTEMBER 30, 2006 PRIMARILY REFLECTS, AND FUTURE PERIODS PRIOR TO A
      REDEPLOYMENT OF OUR ASSETS ARE EXPECTED TO PRIMARILY REFLECT, GENERAL AND
      ADMINISTRATIVE EXPENSES AND TRANSACTION EXPENSES ASSOCIATED WITH THE CONTINUING
      ADMINISTRATION OF THE COMPANY AND ITS EFFORTS TO REDEPLOY ITS
      ASSETS.





Page
          16
          of 33





**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**





**General**





Our
      discussion and analysis of our financial condition and results of operations
      are
      based on our consolidated financial statements, which have been prepared in
      accordance U.S. generally accepted accounting principles. The preparation of
      these consolidated financial statements requires us to make estimates and
      judgments that affect the reported amounts of assets, liabilities, revenue
      and
      expenses, and related disclosures of contingent assets and liabilities. On
      an
      ongoing basis, we evaluate our estimates, including those related to revenue
      recognition, allowance for doubtful accounts, inventory valuation, long-lived
      assets, warranties and equity issuances. Additionally, the audit committee
      of
      our board of directors reviews these critical accounting estimates at least
      annually. We base our estimates on historical experience and on various other
      assumptions that we believe to be reasonable under the circumstances. These
      estimates form the basis for certain judgments about the carrying values of
      assets and liabilities that are not readily apparent from other sources. Actual
      results may differ from these estimates.





The
      following accounting policies are significantly affected by the judgments and
      estimates we use in the preparation of our consolidated financial
      statements.





**Revenue
      Recognition**





Historically,
      prior to discontinuing our products, most of our sales were generated from
      complex arrangements. Recognizing revenue in these arrangements required our
      making significant judgments, particularly in the areas of customer acceptance
      and collectibility.





Certain
      of our historic product sales arrangements required formal acceptance by our
      customers. In such cases, we did not recognize revenue until we received formal
      notification of acceptance. Although we worked closely with our customers to
      help them achieve satisfaction with our products prior to and after acceptance,
      the timing of customer acceptance could greatly affect the timing of the
      recognition of our revenue.





While
      the
      end user of our product was normally a large network service provider, we also
      sold product and services through small resellers and to small network service
      providers in Asia, Europe and North America. To recognize revenue before we
      receive payment, we were required to assess that collection from the customer
      was probable. If we could not satisfy ourselves that collection is probable,
      we
      deferred revenue recognition until we collect payment.





Our
      current business consists primarily of customer service revenue. We record
      revenue as earned for customer service revenue, once we satisfy ourselves that
      collection is probable. If we cannot satisfy ourselves that collection is
      probable, we defer revenue recognition until we collected payment.





**Income
      Taxes**





The
      Company accounts for income taxes using the asset and liability method. Under
      this method, deferred tax assets and liabilities are recognized for operating
      loss and tax credit carryforwards and for the future tax consequences
      attributable to differences between financial statement carrying amounts of
      existing assets and liabilities and their respective tax bases. Deferred tax
      assets and liabilities are measured using enacted tax rates expected to apply
      to
      taxable income in the years in which those temporary differences are expected
      to
      be recovered or settled. A valuation allowance is recorded to reduce the
      carrying amounts of deferred tax assets unless it is more likely than not that
      such assets will be realized.





**Cash,
      Cash Equivalents and Short-Term Investments**





We
      consider all highly liquid investments purchased with original maturities of
      three months or less from the date of purchase to be cash equivalents.
      Investments with maturities in excess of three months and less than one year
      are
      considered to be short term investments. We determine the appropriate
      classification of cash equivalents and investment securities at the time of
      purchase. We have classified our marketable sercurities as available-for-sale
      securities in the accompanying consolidated financial statements.
      Available-for-sale securities are carried at fair value (based on the closing
      price of assets held on the last business day of the period), with unrealized
      gains and losses reported in a separate component of stockholders’ equity.
      Realized gains and losses and declines in value judged to be
      other-than-temporary, if any, on available-for-sale securities are included
      in
      interest income. Interest on securities classified as available-for-sale
      securities is also included in interest income. The cost of securities sold
      is
      based on the specific identification method.




Page
          17
          of 33





**Fair
      Value of Financial Instruments**





**** Carrying
      amounts of certain of the Company’s financial instruments, including cash and
      cash equivalents, prepaid expenses and other current assets, accounts payable
      and accrued liabilities approximate fair value due to short
      maturities.





**Foreign
      Currency Translation**





The
      Company has foreign subsidiaries whose financial statements are denominated
      in
      the local currency. Foreign exchange gains and losses, which result from the
      process of re-measuring foreign currency financial statements into U.S. dollars,
      have been included on the balance sheet as a cumulative foreign currency
      translation adjustment included in other comprehensive income
      (loss).





**Allowance
      for Doubtful Accounts**





We
      maintain allowances for doubtful accounts in connection with estimated losses
      resulting from the inability of our customers to pay our invoices. In order
      to
      estimate the appropriate level of this allowance, we analyze historical bad
      debts, customer concentrations, current customer credit-worthiness, current
      economic trends and changes in our customer payment patterns. In future periods,
      if the financial condition of our customers were to deteriorate and affect
      their
      ability to make payments, additional allowances may be required.





**Inventory
      Valuation**





Our
      inventory was either sold, scrapped or fully written-off at December 31, 2005
      and September 30, 2006, respectively.





In
      assessing the value of our inventory, we are required to make judgments about
      future demand and then compare that demand with current inventory quantities
      and
      firm purchase commitments. If our inventories and firm purchase commitments
      are
      in excess of forecasted demand, we write down the value of our inventory. Prior
      to September 30, 2004, we generally used a 12-month forecast to assess future
      demand. Inventory write-downs are charged to cost of revenue. At September
      30,
      2004, in connection with our decision to discontinue our products, we recorded
      a
      charge of $3.5 million to cost of revenue to write our inventory down to its
      estimated net realizable value. During 2005, we sold $25,000 of previously
      written-down inventory.





**Long-lived
      assets**





At
      December 31, 2005 and September 30, 2006, respectively, all of our long-lived
      assets had been either sold, scrapped or fully written-off.





We
      evaluate the carrying value of long-lived assets, consisting primarily of
      property, plant and equipment, whenever certain events or changes in
      circumstances indicate that the carrying amount of these assets may not be
      recoverable. In assessing the recoverability of long-lived assets, we compare
      the carrying value of the assets to the undiscounted future cash flows the
      assets are expected to generate. If the total of the undiscounted future cash
      flows is less than the carrying amount of the assets, the assets will be written
      down to their estimated fair value. Fair value is generally determined by
      calculating the discounted future cash flows using a discount rate based on
      our
      weighted average cost of capital or specific appraisal, as appropriate.
      Significant judgments and assumptions are required in the forecast of future
      operating results used in the preparation of the estimated future **** cash
      flows, including long-term forecasts of overall market conditions and our
      participation in the market




Page
          18
          of 33





**Warranties**





Prior
      to
      discontinuing our products, we provided a basic limited warranty, including
      repair or replacement of parts, and technical support for our products. The
      specific terms and conditions of those warranties varied depending on the
      customer or region in which we did business. We estimated the costs that could
      be incurred under our basic limited warranty and recorded a liability in the
      amount of such costs at the time product revenue was recognized. Our warranty
      obligation is affected by the number of installed units, product failure rates,
      materials usage and service delivery costs incurred in correcting product
      failures. Each quarter, we assess the adequacy of our recorded warranty
      liabilities and adjust the amounts as necessary. In future periods, if actual
      product failure rates, materials usage or service delivery costs differ from
      our
      estimates, adjustments to cost of revenue may result.





We
      no
      longer offer any warranty on product or service sales.





**Impact
      of Equity Issuances on Operating Results**





Equity
      issuances have historically had a material impact on our operating results.
      The
      equity issuances that have affected operating results to date include warrants
      granted to customers and suppliers, stock options granted to employees and
      consultants, stock issued in lieu of cash compensation to suppliers and
      re-priced stock options.





Our
      cost
      of revenue, operating expenses and interest expense were affected in prior
      years
      by charges related to warrants and options issued for services. Furthermore,
      some of our employee stock option transactions had resulted in deferred
      compensation, which was presented as a reduction of stockholders’ equity on our
      consolidated balance sheet and was amortized over the vesting period of the
      applicable options using the graded vesting method.





Some
      of
      the stock options granted to our employees had resulted in deferred compensation
      as a result of stock options having an exercise price below their estimated
      fair
      value. Deferred compensation is presented as a reduction to stockholders’ equity
      on the consolidated balance sheet and is then amortized using an accelerated
      method over the vesting period of the applicable options. When an employee
      terminates, an expense credit is recorded for any amortization that has been
      previously recorded as an expense in excess of vesting.





In
      the
      second quarter of 2004, we issued to a reseller a warrant to acquire 254,489
      shares of our common stock at an exercise price of $4.65 per share. The warrant
      had a two-year term beginning May 28, 2004 and vested ratably over the term.
      If
      during that two-year term (1) any person or entity acquired a greater than
      50%
      interest in us or the ownership or control of more than 50% of our voting stock
      or (2) we sold substantially all of our intellectual property assets, the
      warrant would have become exercisable. Even if the reseller did not immediately
      exercise the warrant upon the occurrence of such an event that made the warrant
      exercisable (a “trigger event”), the reseller would be entitled to securities,
      cash and property to which it would have been entitled to upon the consummation
      of the trigger event, less the aggregate price applicable to the warrant. We
      calculated the fair value of the warrant to be approximately $487,000 using
      the
      Black-Scholes option pricing model, using a volatility factor of .97, a
      risk-free interest rate of 2.5%, and an expected life of two years. The fair
      value of the warrant was amortized over the two-year expected life of the
      warrant. During the three months and nine months ended September 30, 2006 we
      amortized nil and $100,000, respectively, to cost of revenue. During the three
      months ended September 30, 2005, we amortized $61,000 to cost of sales and
      during the nine months ended September 30, 2005, we amortized $61,000 to cost
      of
      sales and $158,000 to operating expense. The warrants have now expired and
      were
      not exercised. There were no triggering events during the term of the warrants.





The
      fair value of our options was estimated at the grant date using the
      Black-Scholes option pricing model with the following weighted average
      assumptions:





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Dividend
                yield
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %Volatility
            
            
            0.85
            
            
            0.97
            
            
            0.85
            
            
            0.95Risk
                free interest rate
            
            
            4.12
            %
            
            2.5
            %
            
            4.12
            %
            
            2.6
            %Expected
                life
            
            
            4
                years
            
            
            4
                years
            
            
            4
                years
            
            
            4
                years




Page
          19
          of 33




In
      the three and nine months ended September 30, 2006 and 2005, no shares were
      issued under the Employee Stock Purchase Plan and that plan has been terminated.





**Recent
      Accounting Pronouncements**





In
      June 2006, the FASB issued FASB Interpretation No.48, Accounting for Uncertainty
      in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48), which
      prescribes accounting for and disclosure of uncertainty in tax positions. This
      interpretation defines the criteria that must be met for the benefits of a
      tax
      position to be recognized. The provisions of FIN 48 are effective as of the
      beginning of the Company’s 2007 fiscal year, with the cumulative effect of the
      change in accounting principle recorded as an adjustment to opening retained
      earnings. The Company is currently evaluating the impact of adopting FIN 48
      on
      its financial statements.





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 ("SAB 108"),
      "Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements." SAB 108 is effective for
      fiscal years ending on or after November 15, 2006 and addresses how financial
      statement errors should be considered from a materiality perspective and
      corrected. The literature 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. Historically there have been two common
      approaches used to quantify such errors: (i) the "rollover" approach, which
      quantifies the error as the amount by which the current year income statement
      is
      misstated, and (ii) the "iron curtain" approach, which quantifies the error
      as
      the cumulative amount by which the current year balance sheet is misstated.
      The
      SEC Staff believes that companies should quantify errors using both approaches
      and evaluate whether either of these approaches results in quantifying a
      misstatement that, when all relevant quantitative and qualitative factors are
      considered, is material. The Company is currently evaluating the impact, if
      any,
      of adopting the provisions of SAB 108 on our financial position, results of
      operations and liquidity.




In
      September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements” (“SFAS
      157”), which defines fair value, establishes a framework for measuring fair
      value in generally accepted accounting principles, and expands disclosures
      about
      fair value measurements. SFAS 157 is effective in fiscal years beginning after
      November 15, 2007. The Company is currently assessing the impact of adopting
      SFAS 157 on the consolidated financial condition, results of operations, and
      cash flows of the Company.





**RESULTS
      OF OPERATIONS**





**Revenue**





Revenue
      for the three months ended September 30, 2006 was $134,000 compared to $785,000
      for the three months ended September 30, 2005. Revenues for the three months
      ended September 30, 2006 and 2005 consisted entirely of service. The decrease
      in
      revenues for the three months ended September 30, 2006 compared to the three
      months ended September 30, 2005 is due to several of our customers terminating
      or reducing their purchase of service contracts. All of our remaining customers
      will likely terminate their purchase of service contracts in the period ending
      December 31, 2006.




Revenues
      for the nine months ended September 30, 2006 consisted entirely of service
      as
      compared to revenues for the nine months ended September 30, 2005 wherein
      service revenues were $2,165,000 and product sales were $216,000. The decrease
      in service revenues from 2005 to 2006 is due to the discontinuation of our
      products in September 2004 and to the fact that our customers are
      decommissioning CoSine products in their networks and are not renewing their
      service agreements. The $216,000 in product sales in 2005 was related to “last
      time buys” of CoSine products. Our business currently consists of a service
      operation provided by a third party contractor. All of our remaining customers
      will likely terminate their purchase of service contracts in the period ending
      December 31, 2006.




Page
          20
          of 33





Revenues
      from customers by geographic region for the three and nine months ended
      September 30, 2006 and 2005, respectively, were as follows, in
      thousands:





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Region**North
                America
            
            $
            100
            
            $
            457
            
            $
            1,110
            
            $
            1,320Italy
            
            
            -
            
            
            57
            
            
            -
            
            
            166France
            
            
            27
            
            
            63
            
            
            109
            
            
            216Korea
            
            
            -
            
            
            11
            
            
            -
            
            
            42Japan
            
            
            -
            
            
            108
            
            
            -
            
            
            422Other
                EMEA.
            
            
            7
            
            
            89
            
            
            14
            
            
            215Total
            
            $
            134
            
            $
            785
            
            $
            1,233
            
            $
            2,381





**Non-Cash
      Charges Related to Equity Issuances**





During
      the three months ended September 30, 2006 and 2005, we recorded $10,000 and
      $60,000, respectively, of non-cash charges related to equity issuances to cost
      of revenue and operating expenses. During the nine months ended September 30,
      2006 and 2005, we recorded $130,000 and $279,000, respectively, of non-cash
      charges related to equity issuances to cost of revenue and operating expenses.





Below
      is
      a reconciliation of non-cash charges related to equity issuances for the three
      and nine months ended September 30, 2006 and 2005, as presented in our statement
      of operations, in thousands:





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Stock-based
                compensation expense
            
            $
            10
            
            $
            -
            
            $
            30
            
            $
            -Amortization
                of charges related to warrants or stock options issued to non-employees
                in
                conjunction with lease and debt agreements and re-seller
                agreement
            
            
            -
            
            
            60
            
            
            100
            
            
            279Net
                non-cash charges related to equity issuances
            
            $
            10
            
            $
            60
            
            $
            130
            
            $
            279





**Cost
      of Revenue**





**** For
      the
      three months ended September 30, 2006, cost of revenue was $366,000, which
      represented cost of our third party support contract and logistics fees. For
      the
      three months ended September 30, 2005, cost of revenue was $702,000, which
      represented the costs of our third party support contract, amortization of
      $60,000 related to a stock purchase warrant and a $219,000 reclassification
      of
      warrant amortization for the period January 1, 2005 to June 30, 2005, previously
      charged to operating expenses, net of a $57,000 reduction in our warranty
      accrual.





For
      the
      nine months ended September 30, 2006, cost of revenue was $1,469,000 which
      represented cost of our third party support agreement and amortization of a
      warrant related to a reseller agreement. For the nine months ended September
      30,
      2005, cost of revenue was $1,545,000, which represented costs of our third
      party
      support contract and amortization of a stock purchase warrant, net of a
      reduction of our warranty accrual.





**Gross
      Profit (Loss)**





For
      the
      three months ended September 30, 2006 and 2005, gross profit (loss) was
      ($232,000) and $83,000, respectively. The decrease in gross profit is due to
      the
      decline in service revenue from 2005 to 2006 and the relatively fixed nature
      of
      the third party support contract costs.





For
      the
      nine months ended September 30, 2006 and 2005, gross profit (loss) was
      ($236,000) and $836,000, respectively. The decrease in gross profit from 2005
      to
      2006 is due to the fact that we discontinued product sales in September 2004.
      Product sales typically had a higher gross margin than service revenues. In
      addition, our service revenues are declining at a faster rate than the costs
      of
      our third party support operation.




Page
          21
          of 33





We
      expect
      our gross margin to continue to be affected by the volume of our service
      contract sales and the costs we incur with our third party contractor. We have
      the ability to modify our third party support contract every 90 days but we
      may
      not be able to accurately predict our future service contract sales and
      therefore may experience margin fluctuations, including possibly negative gross
      margins. We expect to incur a negative gross margin again in the quarter ending
      December 31, 2006, due to the declining revenue and the need to maintain a
      minimum level of service capability for remaining customers.





**Research
      and Development Expenses**





Research
      and development expenses were nil for the three months ended September 30,
      2006
      and September 30, 2005, respectively. Research and development costs for the
      nine months ended September 30, 2006 and 2005 were nil and $103,000. Such costs
      for the nine months ended September 30, 2005 consisted of consulting expenses
      as
      well as software license amortization costs and payments. With our announcement
      in September 2004 that we were laying off all employees and discontinuing our
      products, our engineering activities have been limited to providing consulting
      to existing customers and our third party contractor. We expect our research
      and
      development costs to be a minimal amount for the balance of the fiscal year.





**Sales
      and Marketing Expenses**





Sales
      and
      marketing expenses were nil for the three months ended September 30, 2006 and
      2005, respectively. Sales and marketing expenses for the nine months ended
      September 30, 2006 and 2005 were nil and $105,000, respectively. With our
      announcement in September 2004 that we were laying off all employees and were
      discontinuing our products, we have ceased essentially all ongoing sales and
      marketing efforts. Sales and marketing expenses for the nine months ended
      September 30, 2005 consisted of expenses related to foreign sales offices,
      all
      of which are winding down. We expect sales and marketing expenses to be a
      minimal amount for the balance of the fiscal year.





**General
      and Administrative Expenses**





General
      and administrative expenses were $295,000 and $422,000 for the three months
      ended September 30, 2006 and 2005, respectively and were $906,000 and $2.8
      million for the nine month periods ended September 30, 2006 and 2005,
      respectively. General and administrative costs for the three months and nine
      months ended September 30, 2006 consisted of costs for our chief executive
      officer, consultants and contractors, office rent, audit and tax services,
      legal
      services, insurance and banking fees. General and administrative expenses for
      the three and nine months ended September 30, 2005 consisted of consulting
      fees,
      contractor fees, accounting and tax services, legal fees, insurance costs,
      and
      office rents, as well as the costs related to the proposed merger with Tut
      Systems, Inc. The proposed merger was terminated in May 2005.





**Restructuring
      and Impairment Charges**





*December
      2004 Restructuring*





**** In
      the
      quarter ended December 31, 2004, we continued our previously announced actions
      to terminate the remainder of our workforce, terminated the lease of our
      facilities in Redwood City, California, and terminated our office lease in
      Japan. In addition, we accrued for the termination of non-cancelable software
      license agreements, as the licenses were not expected to be used in the ongoing
      operations.





Activity
      related to the December 2004 restructuring for the nine months ended September
      30, 2006 is as follows, (in thousands):





**Worldwide
                workforce****reduction**
            
            **Lease**
              **Terminations**
            
            **Software
                License****Terminations**
            
            **Total**Provision
                balance at December 31, 2005
            
            $
            3
            
            $
            —
            
            $
            450
            
            $
            453Cash
                payments
            
            
            (3
            )
            
            —
            
            
            (450
            )
            
            (453
            )Provision
                balance at June 30, 2006
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





Page
          22
          of 33




*September
      2004 Restructuring*





In
      September 2004, we announced actions to terminate most of our workforce,
      retaining a limited team of employees to provide customer support and handle
      matters related to the ongoing exploration of strategic alternatives. The
      specific actions include workforce reductions, announced discontinuance of
      the
      CoSine products, a charge for unrecoverable royalties, and termination of third
      party manufacturing agreements.





Effective
      September 23, 2004, we approved severance agreements to Stephen Goggiano, our
      president and chief executive officer, and Terry R. Gibson, our chief financial
      officer, covering the period of August 1, 2004 through the earlier of (i)
      December 31, 2004 or (ii) the termination of their respective employments due
      to
      the elimination of their respective jobs if caused by a merger, sale,
      acquisition, liquidation, dissolution, consolidation or similar corporate
      transaction, in exchange for their continued service to us as we explored
      strategic alternatives, including a sale of the Company, a sale or licensing
      of
      products, intellectual property, or individual assets or a winding-up and
      liquidation of the business. In exchange for their continued service during
      this
      time period, Mr. Goggiano and Mr. Gibson each received a retention bonus equal
      to 100% of their base 2004 annual salary, paid in January 2005. In addition,
      upon completion of these services, we agreed to pay for the cost of Mr.
      Goggiano's and Mr. Gibson's health care coverage for a period of 12 months
      after
      termination of their respective employment. These amounts were charged to
      restructuring in December 2004 and were paid in 2005.





There
      was
      no activity related to the September 2004 restructuring in the nine months
      ended
      September 30, 2006, as all the planned restructuring activities were completed
      in the three months ended March 31, 2005.





Activity
      related to the September 2004 restructuring for the nine months ended September
      30, 2005 is as follows (in thousands):





**Worldwide
                workforce****reduction**
            
            **Write-down
                of inventory and prepaid****royalty**
            
            **Manufacturing
                agreement****termination**
            
            **Total**Provision
                balance at December 31, 2004
            
            $
            424
            
            $
            —
            
            $
            —
            
            $
            424Cash
                payments
            
            
            (424
            )
            
            —
            
            
            —
            
            
            (424
            )Provision
                balance at September 30, 2005
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





During
      the nine months ended September 30, 2005 we sold previously impaired assets
      for
      a total of $67,000 and settled a software contract at a $23,000 discount to
      our
      restructuring accrual.





**Interest
      Income and Other Income**





For
      the
      three months ended September 30, 2006 and 2005, interest income and other income
      was $302,000 and $191,000, respectively. The increase for both the three month
      and nine-month periods ended September 30, 2005 as compared to the same periods
      ended September 30, 2006 is due to higher interest rates, partially offset
      by a
      lower balance of short term investments.





**Income
      Tax Provision**





Provision
      (benefit) for income taxes of nil and $(117,000) for the three months ended
      September 30, 2006 and 2005, respectively, were comprised entirely of foreign
      corporate income taxes and refunds, which are a function of our operations
      in
      subsidiaries in various countries. The provision for income taxes is based
      on
      income taxes on minimum profits the foreign operations generated for services
      they provided to us. At September 30, 2006, we have ceased operations in all
      foreign locations. Our tax expense for fiscal 2006 will continue to depend
      on
      the amount and mix of income derived from sources subject to corporate income
      taxes of foreign taxing jurisdictions, if any, as we liquidate these
      subsidiaries.





Page
          23
          of 33





**LIQUIDITY
      AND CAPITAL RESOURCES**





Currently,
      we are not generating sufficient revenue to fund our operations. We expect
      our
      operating losses and net operating cash outflows to continue and do not expect
      to sustain our revenue.





Our
      current business consists primarily of a customer support capability for our
      discontinued products provided by a third party. We intend to continue such
      support activities through December 31, 2006, depending on customer demand.
      In
      March 2006, we signed an agreement to sell the rights to our patent portfolio
      for cash consideration of $180,000. We have also adopted a strategy of seeking
      to enhance stockholder value by pursuing opportunities to redeploy our assets
      through an acquisition of one or more operating business with existing or
      prospective taxable earnings that can be offset by use of our net operating
      loss
      carry-forwards. Based on restructuring activities initiated in September 2004
      and completed in the quarter ended December 31, 2004, on the significant
      reduction in cash usage resulting from those restructuring activities, and
      on
      the costs to extend customer support activities through December 2006, we
      believe that we possess sufficient liquidity and capital resources to fund
      our
      operations and working capital requirements for at least the next 12 months.
      However, our restructuring activities and our new redeployment of assets
      strategy raise substantial doubt as to our ability to continue as a going
      concern.





We
      will
      continue to prepare our financial statements on the assumption that we will
      continue as a going concern, which contemplates the realization of assets and
      liquidation of liabilities in the normal course of business. As such, the
      financial statements do not include any adjustments to reflect possible future
      effects of the recoverability and classification of assets or the amounts and
      classification of liabilities that may result from any decisions made with
      respect to an assessment of our strategic alternatives. If at some point we
      were
      to decide to pursue alternative plans, we may be required to present the
      financial statements on a different basis. As an example, if we were to decide
      to pursue a liquidation and return of capital, it would be appropriate to
      prepare and present financial statements on the liquidation basis of accounting,
      whereby assets are valued at their estimated net realizable values and
      liabilities are stated at their estimated settlement amounts.





**Cash,
      Cash Equivalents and Short-Term Investments**





At
      September 30, 2006, cash, cash equivalents and short-term investments were
      $23.0
      million. This compares with $23.2 million at December 31, 2005.





**Operating
      Activities**




We
      used
      $198,000 and $1.9 million in cash for operations for the nine months ended
      September 30, 2006 and 2005, respectively. The reduced cash usage is due
      primarily to the $1.4 million reduction in net loss from the nine months ended
      September 30, 2006 as compared to the nine months ended September 30, 2005,
      partially offset by payments made for restructuring activities.




**Investing
      Activities**





Investing
      activities generated $3.5 million in cash in the nine months ended September
      30,
      2006, as compared to $4.9 million in cash generated for the nine months ended
      September 30, 2005 due to changes in the mix of investments and cash and cash
      equivalents.





**Financing
      Activities**





There
      were no financing activities in the nine month periods ended September 30,
      2006
      and 2005, respectively.




Page
          24
          of 33




**OUTLOOK**





Our
      board
      of directors, on completion of a comprehensive review of strategic alternatives,
      approved a plan to redeploy our existing resources to identify and acquire
      one
      or more new business operations, while continuing to support our existing
      customers and continuing to offer our intellectual property for license or
      sale.
      Our redeployment strategy will involve the acquisition of one or more operating
      businesses with existing or prospective taxable earnings that can be offset
      by
      use of our net operating loss carry-forwards (“NOLs”). As of this date, no
      candidate has been identified, and no assurance can be given that we will find
      suitable candidates, and if we do, that we will be able to utilize our existing
      NOLs. We will continue to support our existing customers through our transition
      support programs as we execute our new strategy.





At
      September 30, 2006, we had $23.0 million in cash and short-term investments.
      We
      believe we possess sufficient liquidity and capital resources to fund our
      operations and working capital requirements for at least the next 12 months.





**ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**





**Interest
      Rate Sensitivity**





We
      do not
      currently use derivative financial instruments for speculative trading or
      hedging purposes. In addition, we maintain our cash equivalents in government
      and agency securities, debt instruments of financial institutions and
      corporations and money market funds. Our exposure to market risks from changes
      in interest rates relates primarily to corporate debt securities. We place
      our
      investments with high credit quality issuers and, by policy, limit the amount
      of
      the credit exposure to any one issuer.





Our
      general policy is to limit the risk of principal loss and ensure the safety
      of
      invested funds by limiting market and credit risk. All highly-liquid investments
      with a maturity of less than three months at the date of purchase are considered
      to be cash equivalents, and all investments with maturities of three months
      or
      greater are classified as available-for-sale and considered to be short-term
      investments.





A
      sensitivity analysis was performed on our investment portfolio as of September
      30, 2006 based on a modeling technique that measures hypothetical fair market
      value changes that would result from a parallel shift in the yield curve of
      plus
      100 basis points. Based on this analysis, a hypothetical 100 basis point
      increase in interest rates would result in a $36,000 decrease in the fair value
      of our investments in debt securities as of September 30, 2006.





**Exchange
      Rate Sensitivity**





Currently,
      all of our revenue and most of our expenses are denominated in U.S. dollars.
      However, since a portion of our operations sales and service activities are
      outside of the U.S., we have entered into transactions in other currencies.
      We
      are primarily exposed to changes in exchange rates for the Euro and British
      Pound. Because we transact expenses only in foreign currency, we are adversely
      affected by a weaker U.S. dollar relative to major currencies worldwide.
      Additionally, because some of our obligations are denominated in foreign
      currencies, a weaker U.S. dollar creates foreign exchange losses. We have not
      engaged in any foreign exchange hedging activities to date.





**ITEM
      4. CONTROLS AND PROCEDURES**





**Evaluation
      of Disclosure Controls and Procedures** .    The
      Securities and Exchange Commission defines the term "disclosure controls and
      procedures" to mean a company's controls and other procedures that are designed
      to ensure that information required to be disclosed in the reports that it
      files
      or submits under the Securities Exchange Act of 1934 is recorded, processed,
      summarized and reported, within the time periods specified in the Commission's
      rules and forms. Our chief executive officer and chief financial officer has
      concluded, based on the evaluation of the effectiveness of the disclosure
      controls and procedures by our management, with the participation of our chief
      executive officer and chief financial officer, as of the end of the period
      covered by this report, that our disclosure controls and procedures were
      effective for this purpose, except as noted below under "Changes in Internal
      Controls."





**Changes
      in Internal Controls** .
      In
      connection with its audit of our consolidated financial statements for the
      year
      ended December 31, 2005, Burr, Pilger & Mayer LLP identified significant
      deficiencies, which represent material weaknesses. The material weaknesses
      were
      related to a lack of adequate segregation of duties. In addition, significant
      audit adjustments and financial statement disclosure changes were needed that
      were the result of an insufficient quantity of experienced resources involved
      with the financial reporting and year end closing process resulting from staff
      reductions associated with our downsizing.




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Prior
      to
      the issuance of our consolidated financial statements, we completed the needed
      analyses and our management review such that we can certify that the information
      contained in our consolidated financial statements for the year ended December
      31, 2005 and the three and nine month periods ended September 30, 2006 fairly
      presents, in all material respects, our financial condition and results of
      operations.





**Limitations
      on Effectiveness of Controls and Procedures** .  Our
      management, including our chief executive officer and chief financial officer,
      does not expect that our disclosure controls and procedures or our internal
      controls will prevent all errors and all fraud. A control system, no matter
      how
      well conceived and operated, can provide only reasonable, not absolute,
      assurance that the objectives of the control system are met. Further, the design
      of a control system must reflect the fact that there are resource constraints
      and the benefits of controls must be considered relative to their costs. Because
      of the inherent limitations in all control systems, no evaluation of controls
      can provide absolute assurance that all control issues and instances of fraud,
      if any, within the Company have been detected. These inherent limitations
      include, but are not limited to, the realities that judgments in decision-making
      can be faulty and that breakdowns can occur because of simple error or mistake.
      Additionally, controls can be circumvented by the individual acts of some
      persons, by collusion of two or more people, or by management override of the
      control. The design of any system of controls also is based in part upon certain
      assumptions about the likelihood of future events and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions. Over time, controls may become inadequate because of changes
      in conditions, or the degree of compliance with the policies or procedures
      may
      deteriorate. Because of the inherent limitations in a cost-effective control
      system, misstatements due to error or fraud may occur and not be detected.





**PART
      II. OTHER INFORMATION**





**ITEM
      1. LEGAL PROCEEDINGS**





On
      November 15, 2001, we along with certain of our officers and
      directors ** were
      named as defendants in a class action shareholder complaint filed in the United
      States District Court for the Southern District of New York, now captioned *In
      re
      CoSine Communications, Inc. Initial Public Offering Securities
      Litigation,* Case No.
      01 CV 10105. The complaint generally alleges that various investment bank
      underwriters engaged in improper and undisclosed activities related to the
      allocation of shares in our initial public offering. The complaint brings claims
      for the violation of several provisions of the federal securities laws against
      those underwriters, and also against us and each of the directors and officers
      who signed the registration statement relating to the initial public offering.
      The plaintiffs seek unspecified monetary damages and other relief. Similar
      lawsuits concerning more than 300 other companies’ initial public offerings were
      filed during 2001, and this lawsuit is being coordinated with those actions
      in
      the Southern District of New York before Judge Shira A. Scheindlin.





On
      or
      about July 1, 2002 an omnibus motion to dismiss was filed in the coordinated
      litigation on behalf of the issuer defendants, of which we and our named officer
      and directors are a part, on common pleading issues. In October 2002, pursuant
      to stipulation by the parties, the Court entered an order dismissing our named
      officers and directors from the action without prejudice. On February 19, 2003,
      the Court dismissed the Section 10(b) and Rule 10b-5 claims against us but
      did
      not dismiss the Section 11 claims against us.




In
      June
      2004, a stipulation of settlement and release of claims against the issuer
      defendants, including us, was submitted to the court for approval. The terms
      of
      the settlement, if approved, would dismiss and release all claims against the
      participating defendants (including us). In exchange for this dismissal, D&O
      insurance carriers would agree to guarantee a recovery by the plaintiffs from
      the underwriter defendants of at least $1 billion, and the issuer defendants
      would agree to an assignment or surrender to the plaintiffs of certain claims
      the issuer defendants may have against the underwriters. On August 31, 2005,
      the
      Court issued an order granting preliminary approval of the settlement. The
      settlement is subject to a number of conditions, including final court approval,
      which cannot be assured. If the settlement is not consummated, we intend to
      defend the lawsuit vigorously. However, we cannot predict its outcome with
      certainty. If we are not successful in our defense of this lawsuit, we could
      be
      forced to make significant payments to the plaintiffs and their lawyers, and
      such payments could have a material adverse effect on our business, financial
      condition and results of operations if not covered by our insurance carrier.
      Even if these claims are not successful, the litigation could result in
      substantial costs and divert management’s attention and resources, which could
      adversely affect our business, results of operations and financial position. ****




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In
      the
      ordinary course of business, we are involved in legal proceedings involving
      contractual obligations, employment relationships and other matters. Except
      as
      described above, we do not believe there are any pending or threatened legal
      proceedings that will have a material impact on our financial position or
      results of operations.





**ITEM
      1A. RISK FACTORS**





Our
      future results and the market price for our stock are subject to numerous risks,
      many of which are driven by factors that we cannot control or predict. The
      following discussion, as well as other sections of this Report on Form 10-Q
      including Item 2 - Management's Discussion and Analysis of Financial Condition
      and Results of Operations, describes certain risk factors related to our
      business. You should carefully consider the risk factors described below in
      conjunction of the other information is this document.





***We
      have sold our operating assets and are executing a redeployment strategy. There
      can be no assurance that the redeployment strategy will increase shareholder
      value, and we may decide to liquidate.***




We
      have
      incurred losses since inception and expect that net losses and negative cash
      flow will continue for the foreseeable future. In September 2004, we announced
      the termination of most of our employees to facilitate the strategic
      alternatives then in consideration and ceased all operations other than a
      customer service and support capability. In July 2005, we completed a
      comprehensive review of strategic alternatives and approved a plan to redeploy
      our existing resources to identify and acquire one or more new business
      operations, while continuing to support our existing customers and continuing
      to
      offer our intellectual property for license or sale. If we are not successful
      in
      executing this strategy we will continue to incur operating losses and negative
      cash flow and may at some point decide to liquidate and return the net proceeds
      to our stockholders. In the case of a liquidation or bankruptcy, we would need
      to hold back or distribute assets to cover liabilities before paying
      stockholders, which may therefore reduce or delay the proceeds that stockholders
      may receive for their ownership in us. However, we believe we have adequate
      cash
      resources to continue to realize our assets and discharge our liabilities as
      a
      company through 2006.




***Failure
      to execute our redeployment strategy could cause our stock price to decline.***




Our
      stock
      price may decline due to any or all of the following potential occurrences:





·  We
      may
      not be able to find suitable acquisition candidates or may not be able to
      acquire suitable candidates with our limited financial resources;





·  We
      may
      not be able to utilize our existing NOLs to offset future earnings;





·  We
      may
      have difficulty retaining our key remaining employee;





**·**  We
      may
      have difficulty retaining our board of directors or attracting suitable
      qualified candidates should
      a
      director resign.





***There
      can be no assurance that we will be able to identify suitable acquisition
      candidates in connection with our redeployment
      strategy.***




We
      have
      incurred recurring operating losses, and operations have not generated positive
      cash flows since inception. If we are unable to acquire suitable acquisition
      candidate(s), we will continue to incur operating losses and negative cash
      flows
      and may decide to liquidate. In the case of a liquidation, we would need to
      hold
      back assets to cover liabilities, which may therefore reduce or delay the
      proceeds that stockholders may receive.




***We
      may elect to dissolve and distribute assets to stockholders if our board of
      directors determines that such action is in the best interest of the
      stockholders.*** ****





If
      our
      redeployment strategy is deemed unsuccessful, our board of directors may deem
      it
      advisable to dissolve the company and distribute assets to stockholders.
      Liquidation and dissolution may not create value to our stockholders or result
      in any remaining capital for distribution to our stockholders. The precise
      nature, amount and timing of any distribution to our stockholders would depend
      on and could be delayed by, among other things, sales of our non-cash assets
      and
      claim settlements with creditors.




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***We
      will incur significant costs in connection with our evaluation of suitable
      acquisition candidates.***





As
      part
      of our plan to redeploy our assets, our management is seeking, analyzing and
      evaluating potential acquisition and merger candidates. We will incur
      significant costs, such as due diligence and legal and other professional fees
      and expenses, as part of these redeployment efforts. Notwithstanding these
      efforts and expenditures, we cannot give any assurance that we will identify
      an
      appropriate acquisition opportunity in the near term, or at all.





***We
      will likely have no operating history in our new line of business, which is
      yet
      to be determined, and therefore we will be subject to the risks inherent in
      establishing a new business.***





We
      have
      not identified what our new line of business will be and, therefore, we cannot
      fully describe the specific risks presented by such business. It is likely
      that
      we will have had no operating history in the new line of business and it is
      possible that the target company may have a limited operating history in its
      business. Accordingly, there can be no assurance that our future operations
      will
      generate operating or net income, and as such our success will be subject to
      the
      risks, expenses, problems and delays inherent in establishing a new line of
      business for us. The ultimate success of such new business cannot be
      assured.





***We
      may be unable to realize the benefits of our net operating loss carry-forwards
      ("NOLs").***





NOLs
      may
      be carried forward to offset federal and state taxable income in future years
      and eliminate income taxes otherwise payable on such taxable income, subject
      to
      certain adjustments. Based on current federal corporate income tax rates, our
      NOLs and other carry-forwards could provide a benefit to us, if fully utilized,
      of significant future tax savings. However, our ability to use these tax
      benefits in future years will depend upon the amount of our otherwise taxable
      income. If we do not have sufficient taxable income in future years to use
      the
      tax benefits before they expire, we will lose the benefit of these NOLs
      permanently. Consequently, our ability to use the tax benefits associated with
      our substantial NOLs will depend significantly on our success in identifying
      suitable acquisition candidates, and once identified, successfully consummate
      an
      acquisition of these candidates.





Additionally,
      if we underwent an ownership change, the NOLs would be subject an annual limit
      on the amount of the taxable income that may be offset by our NOLs generated
      prior to the ownership change. If an ownership change were to occur, we may
      be
      unable to use a significant portion of our NOLs to offset taxable income. In
      general, an ownership change occurs when, as of any testing date, the aggregate
      of the increase in percentage points is more than 50 percentage points of the
      total amount of a corporation's stock owned by "5-percent stockholders," within
      the meaning of the NOLs limitations, whose percentage ownership of the stock
      has
      increased as of such date over the lowest percentage of the stock owned by
      each
      such "5-percent stockholder" at any time during the three-year period preceding
      such date. In general, persons who own 5% or more of a corporation's stock
      are
      "5-percent stockholders," and all other persons who own less than 5% of a
      corporation's stock are treated, together, as a single, public group "5-percent
      stockholder," regardless of whether they own an aggregate of 5% of a
      corporation's stock.





The
      amount of NOLs that we have claimed has not been audited or otherwise validated
      by the U.S. Internal Revenue Service (“IRS”). The IRS could challenge our
      calculation of the amount of our NOLs or our determinations as to when a prior
      change in ownership occurred and other provisions of the Internal Revenue Code,
      may limit our ability to carry forward our NOLs to offset taxable income in
      future years. If the IRS was successful with respect to any such challenge,
      the
      potential tax benefit of the NOLs to us could be substantially
      reduced.





***Certain
      transfer restrictions implemented by us to preserve our NOLs may not be
      effective or may have some unintended negative
      effects.***





On
      November 15, 2005, at our 2005 Annual Meeting of Stockholders, our stockholders
      approved an amendment to our Amended and Restated Certificate of Incorporation
      to restrict certain acquisitions of our securities in order to help assure
      the
      preservation of our NOLs. The amendment generally restricts direct and indirect
      acquisitions of our equity securities if such acquisition will affect the
      percentage of our capital stock that is treated as owned by a "5-percent
      stockholder."




Page
          28
          of 33





Although
      the transfer restrictions imposed on our capital stock is intended to reduce
      the
      likelihood of an impermissible ownership change, there is no guarantee that
      such
      restrictions would prevent all transfers that would result in an impermissible
      ownership change. The transfer restrictions also will require any person
      attempting to acquire a significant interest in us to seek the approval of
      our
      board of directors. This may have an "anti-takeover" effect because our board
      of
      directors may be able to prevent any future takeover. Similarly, any limits
      on
      the amount of capital stock that a stockholder may own could have the effect
      of
      making it more difficult for stockholders to replace current management.
      Additionally, because the transfer restrictions will have the effect of
      restricting a stockholder's ability to dispose of or acquire our common stock,
      the liquidity and market value of our common stock might suffer.





***We
      could be required to register as an investment company under the Investment
      Company Act of 1940, which could significantly limit our ability to operate
      and
      acquire an established business.***





The
      Investment Company Act of 1940 (the "Investment Company Act") requires
      registration, as an investment company, for companies that are engaged primarily
      in the business of investing, reinvesting, owning, holding or trading
      securities. We will seek to qualify for an exclusion from registration including
      the exclusion available to a company that does not own "investment securities"
      with a value exceeding 40% of the value of its total assets on an unconsolidated
      basis, excluding government securities and cash items. This exclusion, however,
      could be disadvantageous to us and/or our stockholders. If we were unable to
      rely on an exclusion under the Investment Company Act and were deemed to be
      an
      investment company under the Investment Company Act, we would be forced to
      comply with substantive requirements of Investment Company Act, including:
      (i)
      limitations on our ability to borrow; (ii) limitations on our capital structure;
      (iii) restrictions on acquisitions of interests in associated companies; (iv)
      prohibitions on transactions with affiliates; (v) restrictions on specific
      investments; (vi) limitations on our ability to issue stock options; and (vii)
      compliance with reporting, record keeping, voting, proxy disclosure and other
      rules and regulations. Registration as an investment company would subject
      us to
      restrictions that would significantly impair our ability to pursue our
      fundamental business strategy of acquiring and operating an established
      business. In the event the SEC or a court took the position that we were an
      investment company, our failure to register as an investment company would
      not
      only raise the possibility of an enforcement action by the SEC or an adverse
      judgment by a court, but also could threaten the validity of corporate actions
      and contracts entered into by us during the period we were deemed to be an
      unregistered investment company. Moreover, the SEC could seek an enforcement
      action against us to the extent we were not in compliance with the Investment
      Company Act during any point in time.





***We
      may issue a substantial amount of our common stock in the future which could
      cause dilution to new investors and otherwise adversely affect our stock
      price.***





A
      key
      element of our growth strategy is to make acquisitions. As part of our
      acquisition strategy, we may issue additional shares of common stock as
      consideration for such acquisitions. These issuances could be significant.
      To
      the extent that we make acquisitions and issue our shares of common stock as
      consideration, your equity interest in us will be diluted. Any such issuance
      will also increase the number of outstanding shares of common stock that will
      be
      eligible for sale in the future. Persons receiving shares of our common stock
      in
      connection with these acquisitions may be more likely to sell off their common
      stock, which may influence the price of our common stock. In addition, the
      potential issuance of additional shares in connection with anticipated
      acquisitions could lessen demand for our common stock and result in a lower
      price than might otherwise be obtained. We may issue common stock in the future
      for other purposes as well, including in connection with financings, for
      compensation purposes, in connection with strategic transactions or for other
      purposes.





***Our
      customers may sue us because we have announced the discontinuance of our
      products and may not meet all our contractual
      commitments.*** ****





Certain
      of our customer contracts contained provisions relating to the availability
      of
      products, spare parts and services for periods up to ten years. We have worked
      with our customers to aid in a smooth transition, but our customers may choose
      to sue us for breach of contract.





***If
      our products contain defects, we may be subject to significant liability claims
      from customers, distribution partners and the end-users of our products and
      incur significant unexpected expenses and lost sales.***




Page
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Our
      products are technically complex and can be adequately tested only when put
      to
      full use in large and diverse networks with high amounts of traffic. They have
      in the past contained, and may in the future contain, undetected or unresolved
      errors or defects. Despite extensive testing, errors, defects or failures may
      be
      found in our products. If this happens, we may experience product returns,
      increased service and warranty costs, any of which could have a material adverse
      effect on our business, financial condition and results of operations. Moreover,
      because our products are designed to provide critical communications services,
      we may receive significant liability claims. We attempted to include in our
      agreements with customers and distribution partners provisions intended to
      limit
      our exposure to liability claims. However, our customers and distribution
      partners may not be willing to agree to such provisions, and in any event such
      provisions may not be effective in any or all cases or under any or all
      scenarios, and they may not preclude all potential claims resulting from a
      defect in one of our products or from a defect related to the installation
      or
      operation of one of its products. Although we maintains product liability and
      errors and omissions insurance covering certain damages arising from
      implementation and use of their products, our insurance may not cover all claims
      sought against it. Liability claims could require it to spend significant time
      and money in litigation or to pay significant damages. As a result, any such
      claims, whether or not successful, could seriously damage our reputation and
      our
      business.




***If
      we became involved in an intellectual property dispute, we could be subject
      to
      significant liability, the time and attention of our management could be
      diverted from pursuing strategic alternatives.***




We
      may
      become a party to litigation in the future to protect its intellectual property
      or because others may allege infringement of their intellectual property. These
      claims and any resulting lawsuits could subject it to significant liability
      for
      damages or invalidate our proprietary rights. These lawsuits, regardless of
      their merits, likely would be time-consuming and expensive to resolve and would
      divert management time and attention. Any potential intellectual property
      litigation alleging our infringement of a third-party’s intellectual property
      also could force us to:





·  Obtain
      from the owner of the infringed intellectual property right a license to sell
      the relevant technology, which license may not be available on reasonable terms,
      or at all; or





·  Redesign
      those products or services that use the infringed technology.





***We
      have a history of losses that we expect will continue, and if we do not achieve
      profitability we may cease operations.***





At
      September 30, 2006, we had an accumulated deficit of $517 million. We have
      incurred net losses since our incorporation. If we do not achieve profitability
      and are unable to obtain additional financing, we will run out of cash and
      cease
      operations.





***If
      we cannot obtain director and officer liability insurance in acceptable amounts
      for acceptable rates, we may have difficulty recruiting and retaining qualified
      directors and officers.***





Like
      most
      other public companies, we carry insurance protecting our officer and directors
      against claims relating to the conduct of our business. This insurance covers,
      among other things, the costs incurred by companies and their management to
      defend against and resolve claims relating to management conduct and results
      of
      operations, such as securities class action claims. These claims typically
      are
      expensive to defend against and resolve. We pay significant premiums to acquire
      and maintain this insurance, which is provided by third-party insurers, and
      we
      agree to underwrite a portion of such exposures under the terms of the insurance
      coverage. One consequence of the current economic downturn and decline in stock
      prices has been a substantial increase in the number of securities class actions
      and similar claims brought against public corporations and their management,
      including the company and certain of its current and former officers and
      directors. Consequently, insurers providing director and officer liability
      insurance have in recent periods sharply increased the premiums they charge
      for
      this insurance, raised retentions (that is, the amount of liability that a
      company is required to pay to defend and resolve a claim before any applicable
      insurance is provided), and limited the amount of insurance they will provide.
      Moreover, insurers typically provide only one-year policies. The insurance
      policies that may cover any current securities claims against us have a $500,000
      retention. As a result, the costs we incur in defending such claims will not
      be
      reimbursed until they exceed $500,000. The policies that would cover any future
      claims may not provide any coverage to us and may cover the directors and
      officers only in the event we are unwilling or unable to cover their costs
      in
      defending against and resolving any future claims. As a result, our costs in
      defending any future claims could increase significantly. Particularly in the
      current economic environment, we cannot assure you that in the future it will
      be
      able to obtain sufficient director and officer liability insurance coverage
      at
      acceptable rates and with acceptable deductibles and other limitations. Failure
      to obtain such insurance could materially harm our financial condition in the
      event that we are required to defend against and resolve any future or existing
      securities class actions or other claims made against us or our management
      arising from the conduct of our operations. Further, the inability to obtain
      such insurance in adequate amounts may impair our future ability to retain
      and
      recruit qualified officers and directors.




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





On
      September 25, 2000, in connection with our initial public offering, a
      Registration Statement on Form S-1 (File No. 333-35938) was declared effective
      by the Securities and Exchange Commission, pursuant to which 1,150,000 shares
      of
      our common stock were offered and sold for our account at a price of $230 per
      share, generating gross offering proceeds of $264.5 million. The managing
      underwriters were Goldman, Sachs & Co., Chase Securities Inc., Robertson
      Stephens, Inc. and JP Morgan Securities Inc. Our initial public offering closed
      on September 29, 2000. The net proceeds of the initial public offering were
      approximately $242.5 million after deducting approximately $18.5 million of
      underwriting discounts and approximately $3.5 million of other offering
      expenses.





We
      did
      not pay directly or indirectly any of the underwriting discounts or other
      related expenses of the initial public offering to any of our directors or
      officers, any person owning 10% or more of any class of our equity securities,
      or any of our affiliates.





We
      have
      used approximately $220 million of the funds from the initial public offering
      to
      fund our operations. We expect to use the remaining net proceeds for general
      corporate purposes, to fund our operations, working capital and capital
      expenditures. Pending further use of the net proceeds, we have invested them
      in
      short-term, interest-bearing, investment-grade securities.




**ITEM
      6. EXHIBITS**





Exhibit
      Index on page 32.


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          31
          of 33


**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.




COSINE
                COMMUNICATIONS, INC.By:
            /s/ Terry
              R.
              GibsonTerry R. Gibson,Dated:
              November 2,
              2006
            Chief Executive Officer and Chief Financial
                Officer  Page
            32
            of 33




**EXHIBIT
      INDEX**





Exhibit
                Number
            
            Description31.1
            
            Certification
                of Terry R. Gibson, Chief Executive Officer and Chief Financial Officer
                of
                CoSine Communications, Inc., pursuant to 15 U.S.C. Section 7241,
                as
                adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002.32.1
            
            Certification
                of Terry R. Gibson, Chief Executive Officer and Chief Financial Officer
                of
                CoSine Communications, Inc., pursuant to 18 U.S.C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.




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