**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**




________________





**FORM
      10-Q**


________________




**(MARK
      ONE)**


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





**FOR
      THE QUARTERLY PERIOD ENDED** **JUNE 30, 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 x No o




Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). (Check
      one):





Large
      accelerated filer o Accelerated filer oNon-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 10,090,365 shares of the Registrant’s Common Stock, par value $.0001,
      outstanding on July 30, 2006.









PAGE
          1 OF
          32


**COSINE
      COMMUNICATIONS, INC.**





**FORM
      10-Q**





**Quarter
      ended June 30, 2006**





**TABLE
      OF CONTENTS**





**PART
                I**
            
            **Page**FINANCIAL
                INFORMATIONItem
                1. Condensed Consolidated Financial Statements:Condensed
                Consolidated Balance Sheets as of June 30, 2006 and December 31,
                2005
            
            3Condensed
                Consolidated Statements of Operations for the Three and Six Months
                Ended
                June 30, 2006 and 2005
            
            4Condensed
                Consolidated Statements of Cash Flows for the Six Months Ended June
                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
            
            24Item
                1A. Risk Factors
            
            25Item
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds
            
            29Item
                4. Submission of Matters to a Vote of Security Holders
            
            29Item
                6. Exhibits
            
            30Signature
            
            31Exhibit
                Index
            
            32Certifications
            
            42




PAGE
          2 OF
          32


**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)**





**June
                30,**
              **2006**
            
            **December
                31,**
              **2005****(Unaudited)**
            
            **(1)**ASSETSCurrent
                assets:Cash
                and cash equivalents
            
            $
            19,180
            
            $
            12,417Short-term
                investments
            
            
            3,922
            
            
            10,749Accounts
                receivable:Trade
                (net of allowance for doubtful accounts of nil at June 30, 2006 and
                December 31, 2005)
            
            
            207
            
            
            96Other
            
            
            65
            
            
            209Prepaid
                expenses and other current assets
            
            
            87
            
            
            119Total
                current assets
            
            
            23,461
            
            
            23,590Long-term
                deposits and other assets
            
            
            150
            
            
            250$
            23,611
            
            $
            23,840LIABILITIES
                AND STOCKHOLDERS' EQUITYCurrent
                liabilities:Accounts
                payable
            
            $
            249
            
            $
            237Accrued
                other liabilities
            
            
            486
            
            
            874Deferred
                revenue
            
            
            153
            
            
            126Total
                current liabilities
            
            
            888
            
            
            1,237Stockholders'
                equity:Preferred
                stock, 3,000,000 authorized, none issued and outstanding
            
            
            —
            
            
            —Common
                stock, $.0001 par value, 22,000,000 shares authorized; 10,090,365
                shares
                issued and outstanding at June 30, 2006 and December 31, 2005,
                respectively
            
            
            1
            
            
            1Additional
                paid-in capital
            
            
            538,968
            
            
            538,947Accumulated
                other comprehensive income
            
            
            652
            
            
            632Accumulated
                deficit
            
            
            (516,898
            )
            
            (516,977
            )Total
                stockholders' equity
            
            
            22,723
            
            
            22,603$
            23,611
            
            $
            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
          32


**COSINE
      COMMUNICATIONS, INC.**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


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


**(Unaudited)**





**Three
                Months Ended**
              **June
                30****,**
            
            **Six
                Months Ended**
              **June
                30****,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenue:Product
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            216Service
            
            
            520
            
            
            699
            
            
            1,099
            
            
            1,380Total
                revenue
            
            
            520
            
            
            699
            
            
            1,099
            
            
            1,596Cost
                of revenue1
            
            
            533
            
            
            389
            
            
            1,103
            
            
            843Gross
                profit (loss)
            
            
            (13
            )
            
            310
            
            
            (4
            )
            
            753Operating
                expenses:Research
                and development
            
            
            —
            
            
            —
            
            
            —
            
            
            103Sales
                and marketing
            
            
            —
            
            
            —
            
            
            —
            
            
            105General
                and administrative
            
            
            234
            
            
            1,098
            
            
            611
            
            
            2,403Restructuring
                and impairment charges
            
            
            —
            
            
            —
            
            
            —
            
            
            (91
            )Total
                operating expenses
            
            
            234
            
            
            1,098
            
            
            611
            
            
            2,520Loss
                from operations
            
            
            (247
            )
            
            (788
            )
            
            (615
            )
            
            (1,767
            )Interest
                income and other
            
            
            452
            
            
            166
            
            
            694
            
            
            279Income
                (Loss) before income tax provision
            
            
            205
            
            
            (622
            )
            
            79
            
            
            (1,488
            )Income
                tax provision
            
            
            —
            
            
            11
            
            
            —
            
            
            23Net
                income (loss)
            
            $
            205
            
            $
            (633
            )
            $
            79
            
            $
            (1,511
            )Basic
                and diluted net income (loss) per share
            
            $
            0.02
            
            $
            (0.06
            )
            $
            0.01
            
            $
            (0.15
            )Shares
                used in computing per share amounts
            
            
            10,090
            
            
            10,091
            
            
            10,090
            
            
            10,097





See
      accompanying notes to condensed consolidated financial statements.




1  Cost
        of
        revenues includes non-cash (credits) charges related to equity issuances
        of $40
        and nil for the three months ended June 30, 2006 and 2005, respectively,
        and
        $100 and nil for the six months ended June 30, 2006 and 2005,
        respectively.


PAGE
          4 OF
          32


**COSINE
      COMMUNICATIONS, INC.**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(In
      thousands)**


**(Unaudited)**





**Six
                Months Ended**
              **June
                30,****2006**
            
            **2005****Operating
                activities:**Net
                income (loss)
            
            $
            79
            
            
            ($1,511
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Amortization
                of warrants issued for services
            
            
            100
            
            
            219Stock
                compensation expense
            
            
            21
            
            
            —Change
                in operating assets and liabilities:
            
            
            —
            
            
            —Accounts
                receivable, trade
            
            
            (111
            )
            
            1,108Other
                receivables
            
            
            144
            
            
            389Prepaid
                expenses and other current assets
            
            
            32
            
            
            419Accounts
                payable
            
            
            12
            
            
            (49
            )Provision
                for warranty claims
            
            
            —
            
            
            (57
            )Accrued
                other liabilities
            
            
            (388
            )
            
            (1,761
            )Accrued
                compensation
            
            
            —
            
            
            (412
            )Deferred
                revenue
            
            
            27
            
            
            (177
            )Net
                cash used in operating activities
            
            
            (84
            )
            
            (1,832
            )**Investing
                activities:**Purchase
                of short-term investments
            
            
            (3,201
            )
            
            (10,930
            )Proceeds
                from sales and maturities of short-term investments
            
            
            (10,048
            )
            
            16,308Net
                cash provided by investing activities
            
            
            6,847
            
            
            5,378Net
                increase (decrease) in cash and cash equivalents
            
            
            6,763
            
            
            3,546Cash
                and cash equivalents at the beginning of the period
            
            
            12,417
            
            
            9,203Cash
                and cash equivalents at the end of the period
            
            $
            19,180
            
            $
            12,749**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
          32


**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 June 30, 2006, we have an accumulated
      deficit of $517 million and we sustained net losses every year since our
      inception. As of June 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
          32




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 six months ended June 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
      “ *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 six months ended June 30,
      2005 (in
      thousands, except per share data):




**Three
                Months ended**
              **June
                30, 2005**
            
            **Six
                Months ended**
              **June
                30, 2005**Net
                loss, as reported
            
            
            ($
                633
            )
            
            ($1,511
            )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
            
            
            ($
                633
            )
            
            ($1,511
            )Basic
                and diluted net loss per share, as reported
            
            
            ($0.06
            )
            
            ($0.15
            )Pro
                forma basic and diluted net loss per share
            
            
            ($
                0.06
            )
            
            ($0.15
            )








PAGE
          7 OF
          32




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





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





**Three
                Months Ended**
              **June
                30, 2006**
            
            **Six
                Months Ended**
              **June
                30, 2006**Stock-based
                compensation expense
            
            $
            15
            
            $
            20Tax
                effect on stock-based compensation
            
            
            —
            
            
            —Net
                effect on net loss
            
            $
            15
            
            $
            20Effect
                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 puAblic offering in 2000, and
      the
      shares reserved and unissued under the 1997 Plan were reserved for issuance
      under the 2000 Plan.





Under
      the
      Director’s Stock 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
      June
      30, 2006, the Company had the following stock plans:




Reserved
                  for
                Issuance
              
              Shares
                Available
                  for
                Grant
              
              Options
                Outstanding2000
                  Stock Option Plan
              
              
              2,035,000
              
              
              1,918,000
              
              
              117,0002002
                  Stock Option Plan
              
              
              1,000,000
              
              
              1,000,000
              
              
              --Director
                  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
            32
 During
          the six months ended June 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
          June 30, 2006, the unrecorded stock-based compensation balance related
          to stock
          options was $ 110,000 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:





**Six
                Months Ended June 30,****2006**
            
            **2005**Dividend
                yield
            
            
            0.0
            %
            
            0.0
            %Volatility
            
            
            0.40
            
            
            0.95Risk
                free interest rate
            
            
            5.0
            %
            
            2.6
            %Expected
                life
            
            
            6.25
                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
          32


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, 2003**
            
            
            1,747
            
            
            1,246
            
            $
            7.01Repurchased
            
            
            113
            
            
            —
            
            
            —Granted
            
            
            (86
            )
            
            86
            
            
            6.67Exercised
            
            
            —
            
            
            (29
            )
            
            5.00Canceled
            
            
            713
            
            
            (713
            )
            
            5.50**Balance
                as of December 31, 2004**
            
            
            2,487
            
            
            590
            
            
            8.88Repurchased
            
            
            10
            
            
            —
            
            
            —Granted
            
            
            (112
            )
            
            112
            
            
            2.56Canceled
            
            
            555
            
            
            (555
            )
            
            7.72**Balance
                as of December 31, 2005**
            
            
            2,940
            
            
            147
            
            
            8.37Repurchased
            
            
            —
            
            
            —
            
            
            —Granted
            
            
            (6
            )
            
            6
            
            
            2.45Canceled
            
            
            6
            
            
            (6
            )
            
            18.88**Balance
                as of June 30, 2006**
            
            
            2,940
            
            
            147
            
            $
            8.37




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


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





**Options
                Outstanding at June 30, 2006**
            
            **Options
                Exercisable at June 30, 2006****Range
                  of**
                **Exercise
                  Prices**
            
            **Number**
                  **Of**
                  **Shares**
            
            **Weighted-**
                      **Average**
                      **Remaining**
                      **Contractual**
                      **Life
                        (Years)**
            
            **Weighted**
                    **Average**
                    **Exercise**
                    **Price**
            
            **Number**
                  **Of**
                  **Shares**
            
            **Weighted**
                    **Average**
                    **Exercise**
                    **Price**$2.15-2.60
            
            
            118
            
            
            9.4
            
            $
            2.56
            
            
            50
            
            $
            2.605.20
            
            
            4
            
            
            7.0
            
            
            5.20
            
            
            4
            
            
            5.206.96
            
            
            12
            
            
            7.4
            
            
            6.96
            
            
            8
            
            
            6.968.80
            
            
            4
            
            
            5.9
            
            
            8.80
            
            
            4
            
            
            8.8022.30
            
            
            4
            
            
            5.0
            
            
            22.30
            
            
            4
            
            
            22.3040.00-120.00
            
            
            5
            
            
            4.2
            
            
            120.00
            
            
            5
            
            
            120.00147
            
            
            8.8
            
            $
            8.37
            
            
            75
            
            $
            12.39





***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 June 30, 2006.





PAGE
          10
          OF 32





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





***Accounts
      Receivable***





******Two North
      American customers accounted for 61% amd 18%, respectively, of total
      accounts receivable as of June 30, 2006, as compared to three customers
      comprising greater than 10% of total accounts receivable at December 31,
      2005.




PAGE
          11
          OF 32


***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 June 30, 2006, all inventory had been sold, scrapped
      or
      written-off and there was no inventory awaiting customer acceptance.





During
      the six months ended June 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:





**Six
                Months Ended June 30,****2006**
            
            **2005**Beginning
                balance
            
            $
            —
            
            $
            157Warranty
                charged to cost of revenue
            
            
            —
            
            
            —Utilization
                of warranties
            
            
            —
            
            
            —Changes
                in estimated liability based on experience
            
            
            —
            
            
            —Ending
                balance
            
            $
            —
            
            $
            157





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 397,000 shares for the six months ended June
      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**
              **June
                30,**
            
            **Six
                Months Ended**
              **June
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                income (loss)
            
            $
            205
            
            
            ($
                633
            )
            $
            79
            
            
            ($1,511
            )Basic
                and diluted:Weighted-average
                shares of common stock outstanding
            
            
            10,091
            
            
            10,091
            
            
            10,091
            
            
            10,097Weighted-average
                shares subject to repurchase
            
            
            —
            
            
            —
            
            
            —
            
            
            —Weighted-average
                shares used in basic and diluted net loss per share
            
            
            10,091
            
            
            10,091
            
            
            10,091
            
            
            10,097Basic
                and diluted net income (loss) per share
            
            $
            0.02
            
            
            ($0.06
            )
            $
            0.01
            
            
            ($0.15
            )








PAGE
          12
          OF 32





5.
      COMPREHENSIVE INCOME (LOSS)





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





**Three
                Months Ended**
              **June
                30,**
            
            **Six
                Months Ended**
              **June
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                income (loss)
            
            $
            205
            
            
            ($633
            )
            $
            79
            
            
            ($1,511
            )Other
                comprehensive loss:Unrealized
                gains (losses) on investments
            
            
            1
            
            
            (9
            )
            
            6
            
            
            (10
            )Currency
                translation adjustment
            
            
            2
            
            
            —
            
            
            14
            
            
            —Total
                other comprehensive loss
            
            
            3
            
            
            (9
            )
            
            20
            
            
            (10
            )Comprehensive
                loss
            
            $
            208
            
            
            ($642
            )
            $
            99
            
            
            ($1,521
            )





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 six months ended June
      30,
      2006 and 2005, respectively, were as follows, in thousands:





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended**
              **June
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Region**North
                America
            
            $
            465
            
            $
            400
            
            $
            1,010
            
            $
            863Italy
            
            
            —
            
            
            57
            
            
            —
            
            
            109France
            
            
            48
            
            
            63
            
            
            82
            
            
            153Korea
            
            
            —
            
            
            14
            
            
            —
            
            
            30Japan
            
            
            —
            
            
            100
            
            
            —
            
            
            314Other
                EMEA.
            
            
            7
            
            
            65
            
            
            7
            
            
            127Other
                Asia/Pacific
            
            
            —
            
            
            —
            
            
            —
            
            
            —Total
            
            $
            520
            
            $
            699
            
            $
            1,099
            
            $
            1,596








Two
      North
      American customers accounted for 89% and 92% of total revenues, respectively,
      in
      the three months ended June 30, 2006 as compared to two North American customers
      accounting for 94% and 11% of total revenues, respectively in the three months
      ended June 30, 2005.





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.


PAGE
          13
          OF 32


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





**Worldwideworkforce****reduction**
            
            **Lease****Terminations**
            
            **Software
                License****Terminations**
            
            **Total**Provision
                balance at December 31, 2005
            
            $
            3
            
            $
            —
            
            $
            450
            
            $
            453Cash
                payments
            
            
            (3
            )
            
            —
            
            
            (225
            )
            
            (228
            )Write
                offs
            
            
            —
            
            
            —
            
            
            —
            
            
            —Provision
                balance at June 30, 2006
            
            $
            —
            
            $
            —
            
            $
            225
            
            $
            225





The
      balance of the software license termination costs at June 30, 2006 will be
      paid
      in full in the year ending December 31, 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 six months ended
      June 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 six months ended June 30,
      2005 is as follows (in thousands):





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


PAGE
            14
            OF 32


**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, including the Quarterly Reports on Form 10-Q that we will file
      in
      the remainder of fiscal year 2006.





**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 SIX MONTH PERIODS ENDED
      JUNE
      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
          15
          OF 32


**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.





**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 June 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.





PAGE
          16
          OF 32




**Long-lived
      assets**





At
      December 31, 2005 and June 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





**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 six months ended June 30, 2006 we amortized
      $40,000 and $100,000, respectively, to cost of revenue. During the three months
      ended June 30, 2005, we amortized $61,000 to cost of sales and during the six
      months ended June 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.





PAGE
          17
          OF 32




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**
              **June
                30,**
            
            **Six
                Months Ended**
              **June
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Dividend
                yield
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %Volatility
            
            
            0.40
            
            
            0.97
            
            
            0.40
            
            
            0.95Risk
                free interest rate
            
            
            5.0
            %
            
            2.5
            %
            
            5.0
            %
            
            2.6
            %Expected
                life
            
            
            6.25
                years
            
            
            4
                years
            
            
            6.24
                years
            
            
            4
                years





In
      the three and six months ended June 30, 2006
      and 2005, no shares were issued under the Employee Stock Purchase Plan and
      that 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.




**RESULTS
      OF OPERATIONS**





**Revenue**





Revenue
      for the three months ended June 30, 2006 was $520,000 compared to $699,000
      for
      the three months ended June 30, 2005. Revenues for the three months ended June
      30, 2006 and 2005 consisted entirely of service. The decrease in revenues for
      the three months ended June 30, 2006 compared to the three months ended June
      30,
      2005 is due primarily to our announcement in September 2004 that we were laying
      off all our employees and would no longer offer our product for sale and the
      fact that certain of our customers decommissioned their CoSine products in
      late
      2005 or early 2006 and no longer purchase service contracts. Our business
      currently consists of a service operation provided by a third party contractor.





Revenues
      for the six months ended June 30, 2006 consisted entirely of service as compared
      to revenues for the six months ended June 30, 2005 wherein service revenues
      were
      $1,380,000 and product sales were $216,000. The decrease in service revenues
      from 2005 to 2006 is due to the discontinuation of our products in Septemeber
      2004 and to the fact that our customers are decommissioning CoSine products
      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.





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





**Three
                Months Ended June 30,**
            
            **Six
                Months Ended**
              **June
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Region**United
                States
            
            $
            465
            
            $
            400
            
            $
            1,010
            
            $
            863Italy
            
            
            —
            
            
            57
            
            
            —
            
            
            109France
            
            
            48
            
            
            63
            
            
            82
            
            
            153Korea
            
            
            —
            
            
            14
            
            
            —
            
            
            30Japan
            
            
            —
            
            
            100
            
            
            —
            
            
            314Other
                EMEA.
            
            
            7
            
            
            65
            
            
            7
            
            
            127Other
                Asia/Pacific
            
            
            —
            
            
            —
            
            
            —
            
            
            —Total
            
            $
            520
            
            $
            699
            
            $
            1,099
            
            $
            1,596





PAGE
          18
          OF 32




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





During
      the three months ended June 30, 2006 and 2005, we recorded $55,000 and $158,000,
      respectively, of non-cash charges related to equity issuances to cost of revenue
      and operating expenses. During the six months ended June 30, 2006 and 2005,
      we
      recorded $120,000 and $219,000, 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 six months ended June 30, 2006 and 2005, as presented in our statement
      of
      operations, in thousands:





**Three
                Months Ended**
              **June
                30,**
            
            **Six
                Months Ended**
              **June
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Stock-based
                compensation expense
            
            $
            15
            
            
            —
            
            $
            20
            
            
            —Amortization
                of charges related to warrants or stock options issued to non-employees
                in
                conjunction with lease and debt agreements and re-seller
                agreement
            
            
            40
            
            
            158
            
            
            100
            
            
            219Net
                non-cash charges related to equity issuances
            
            $
            55
            
            $
            158
            
            $
            120
            
            $
            219





**Cost
      of Revenue**





For
      the
      three months ended June 30, 2006, cost of revenue was $533,000, which
      represented cost of our third party support contract as well as amortization
      of
      a warrant related to a reseller agreement. For the three months ended June
      30,
      2005, cost of revenue was $389,000, which represented the costs of our third
      party support contract, net of a reduction in our warranty accrual.





For
      the
      six months ended June 30, 2006, cost of revenue was $1,103,000 which represented
      cost of our third party support agreement and amortization of a warrant related
      to a reseller agreement. For the six months ended June 30, 2005, cost of revenue
      was $843,000, which represented costs of our third party support contract,
      net
      of a reduction of our warranty accrual.





**Gross
      Profit (Loss)**





For
      the
      three months ended June 30, 2006 and 2005, gross profit (loss) was ($13,000)
      and
      $310,000, 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
      six months ended June 30, 2006 and 2005, gross profit (loss) was ($4,000) and
      $753,000, 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 while we are maintaining a fully functioning
      third party support operation.





PAGE
          19
          OF 32




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.





**Research
      and Development Expenses**





Research
      and development expenses were nil for the three months ended June 30, 2006
      and
      June 30, 2005, respectively. Research and development costs for the six months
      ended June 30, 2006 and 2005 were nil and $103,000. Such costs for the six
      months ended June 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 June 30, 2006 and 2005,
      respectively. Sales and marketing expenses for the six months ended June 30,
      2005 and 2004 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 six months ended June 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 $234,000 and $1.1 million for the three months
      ended June 30, 2006 and 2005, respectively and were $611,000 and $2.4 million
      for the six month periods ended June 30, 2006 and 2005, respectively. General
      and administrative costs for the three months and six months ended June 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 six months ended June
      30,
      2005 consisted of consulting fees, contractor fees, 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 six months ended June 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
            )
            
            —
            
            
            (225
            )
            
            (228
            )Write
                offs
            
            
            —
            
            
            —
            
            
            —
            
            
            —Provision
                balance at June 30, 2006
            
            $
            —
            
            $
            —
            
            $
            225
            
            $
            225





PAGE
          20
          OF 32




*September
      2004 Restructuring*





In
      September 2004, CoSine announced actions to terminate most of its 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 six months ended
      June 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 six months ended June 30,
      2005 is as follows (in thousands):





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





During
      the six months ended June 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 June 30, 2006 and 2005, interest income and other income
      was
      $452,000 and $166,000, respectively. The increase from June 30, 2005 to June
      30,
      2006 is due to the sale of our patent portfolio for cash consideration of
      $180,000 in April 2006 as well as higher interest rates, partially offset by
      a
      lower balance of short term investments.





**Income
      Tax Provision**





Provision
      (benefit) for income taxes of nil and $11,000 for the three months ended June
      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. 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.





PAGE
          21
          OF 32





**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
      June
      30, 2006, cash, cash equivalents and short-term investments were $23.1 million.
      This compares with $23.2 million at December 31, 2005.





PAGE
          22
          OF 32


**Operating
      Activities**




We
      used
      $84,000 and $1.8 million in cash for operations for the six months ended June
      30, 2006 and 2005, respectively. The reduced cash usage is due primarily to
      the
      $1.6 million reduction in net loss from the six months ended June 30, 2006
      as
      compared to the six months ended June 30, 2005.




**Investing
      Activities**





Investing
      activities generated $6.8 million in cash in the six months ended June 30,
      2006,
      as compared to $5.4 million in cash generated for the six months ended June
      30,
      2005.





**Financing
      Activities**





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








**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
      June
      30, 2006, we had $23.1 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 June 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 $31,000 decrease in the fair value of our
      investments in debt securities as of June 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.





PAGE
          23
          OF 32




**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.




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 six month periods ended June 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.





PAGE
          24
          OF 32




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 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;





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·
            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.





***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.





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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."





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.





PAGE
          27
          OF 32




***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.***




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
      June
      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.





PAGE
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***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.





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





On
      May
      24, 2006, we held our 2006 Annual Meeting of Stockholders at which the two
      proposals were considered. We recommended that the stockholders vote for each
      of
      the proposals. The results of each matter considered and voted upon are as
      follow:





Proposal
                1:
            To
                elect a Board of Directors to serve for the ensuing
                year.Of
                the aggregate 9,726,284 shares were represented in person or by proxy
                at
                the Annual, the shares were voted as
                follows:




PAGE
          29
          OF 32




Nominee
              
              Donald
                Green
              Charles
                J. Abbe
              Jack
                L. Howard
              Terry
                R. Gibson
            Votes
                For
              
              9,681,834
              9,682,404
              9,646,448
              9,648,724
            Withheld
              
              44,450
              43,880
              79,836
              77,560Proposal
                2:
            To
                approve a proposal to amend our Third Amended and Restated Certificate
                of
                Incorporation to reduce our authorized number of shares of Common
                Stock
                from 300,000,000 to 22,000,000Of
                the aggregate 9,726,284 shares were represented in person or by proxy
                at
                the Annual, 9,527,774 shares voted for the proposal, 35,205 shares
                voted
                against the proposal, and 163,305 shares
                abstained.





**ITEM
      6. EXHIBITS**





Exhibit
      Index on page 32.




PAGE
          30
          OF 32


**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.Dated:
              August 2, 2006
            By:
            /s/ Terry
              R.
              GibsonTerry
              R. Gibson,Chief
              Executive Officer and Chief Financial
              Officer  PAGE
            31
            OF 32




**EXHIBIT
      INDEX**





Exhibit
                Number
            
            Description3.1
            
            Fourth
                Amended and Restated Certificate of Incorporation filed with the
                Delaware
                Secretary of State on May 30, 2006.31.1
            
            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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