**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

----

 

**FORM 10-Q**

 

| **ý**                            | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                        |
|---------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                  |       |                                                                                                                                                           |
|                                  |       | **For the quarterly period ended March 31,  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 000-51846** |

 

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**CLAYTON HOLDINGS, INC.**

(Exactname of registrant as specified in its charter)

 

 

| **Delaware**                                                                        | ** ** | **20-2660764**                        |
|-------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State of  incorporation)                                                           |       | (I.R.S.  Employer Identification No.) |
|                                                                                |       |                                  |
| **2  Corporate Drive, Shelton, CT**                                                 | ** ** | **06484**                             |
| (Address of  principal executive offices)                                           |       | (Zip Code)                            |
|                                                                                |       |                                  |
| Registrant’s  telephone number, including area code: **(203) 926-5600**   |
|                                                                                |       |                                  |
|                                                                                |       |                                  |
| (Former  Name, Former Address and Former Fiscal year, if changed since last report) |

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.   Yes  o    No  ý

 

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

 

Large accelerated filer                            o                                                                                                                                    Accelerated filer         o                                                                                                                                    Non-accelerated filer                                  ý

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).   Yes  o    No  ý

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 

20,523,040 shares of CommonStock, par value $0.01 per share, outstanding as of May 5, 2006.

 

 

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**CLAYTONHOLDINGS, INC. AND SUBSIDIARIES**

 

**INDEX**

 
| ** **                         | ** **                                                                                                                             | ** **                                                                                  | **Page** |
|------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|----------|
| Part I. Financial Information |                                                                                                                                   |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item 1. Financial Statements                                                                                                           |                                                                                        |     |
|                               |
|                               | Condensed  Consolidated Balance Sheets as of** **March 31, 2006 (unaudited) and December 31,  2005                      | 1                                                                                           |
|                               |                                                                                                                                   |                                                                                        |
|                               | Condensed  Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2006 and 2005              | 2                                                                                           |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Condensed  Consolidated Statement of Changes in Stockholders’ Equity (unaudited) for the  three months ended March 31,  2006 | 3                                                                                           |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Condensed  Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2006 and 2005                   | 4                                                                                           |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Notes to  Condensed Consolidated Financial Statements (unaudited)                                                                      | 6                                                                                           |
|                               |                                                                                                                                   |                                                                                        |
|                               | Item 2.                                                                                                                                | Management’s Discussion and Analysis of Financial Condition and  Results of Operations | 15       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item 3.                                                                                                                                | Quantitative and Qualitative Disclosures  About Market Risk                                 | 22       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item 4.                                                                                                                                | Controls and Procedures                                                                     | 22       |
|                               |                                                                                                                                   |                                                                                        |     |
| Part II. Other Information    |
|                               |
|                               | Item 1.                                                                                                                                | Legal Proceedings                                                                           | 24       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item 1A.                                                                                                                               | Risk Factors                                                                                | 24       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item  2.                                                                                                                               | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 32       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item 3.                                                                                                                                | Defaults Upon Senior Securities                                                             | 32       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item  4.                                                                                                                               | Submission  of Matters to a Vote of Security Holders                                        | 32       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item 5.                                                                                                                                | Other  Information                                                                          | 33       |
|                               |                                                                                                                                   |                                                                                        |     |
|                               | Item 6.                                                                                                                                | Exhibits                                                                                    | 33       |
|                               |                                                                                                                                   |                                                                                        |     |
| Signatures                         |                                                                                                                                   |
|                               |                                                                                                                                   |                                                                                        |     |
| Exhibit Index                 |                                                                                                                                   |
|                                    |                                                                                                                                        |                                                                                             |          |  |  |

 

----

 

**PART I.FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                         | ** ** | **March 31, 2006** | ** **  | **December 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                                                                         | ** ** | **(unaudited)**              | ** **  | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                                                                         | ** ** | ** **                   | ** **  | ** **                      | ** ** |
| Current assets                                                                                                                                                                                                                     |       |                         |        |                            |       |
| Cash and  cash equivalents                                                                                                                                                                                                         |       | $                            | 8,450,379   |                            | $          | 7,208,875 |   |
| Cash held in  escrow                                                                                                                                                                                                               |       | 600,656                      |        | —                          |       |
| Restricted  cash                                                                                                                                                                                                                   |       | 15,585,947                   |        | 4,966,839                       |       |
| Accounts  receivable, net of allowance for doubtful accounts of $72,264 as of March 31,  2006 and December 31, 2005                                                                                                      |       | 39,438,044                   |        | 37,205,223                      |       |
| Unbilled  receivables                                                                                                                                                                                                              |       | 16,309,944                   |        | 14,925,988                      |       |
| Prepaid  expenses and other current assets                                                                                                                                                                                         |       | 2,656,579                    |        | 3,942,676                       |       |
| Prepaid  income taxes                                                                                                                                                                                                              |       | 3,812,874                    |        | 3,730,970                       |       |
| Deferred tax  assets                                                                                                                                                                                                               |       | 970,970                      |        | 165,566                         |       |
| Due from  affiliated entities                                                                                                                                                                                                      |       | 23,246                       |        | 23,434                          |       |
| Total  current assets                                                                                                                                                                                                              |       | 87,848,639                   |        | 72,169,571                      |       |
|                                                                                                                                                                                                                               |       |                         |        |                            |       |
| Property and  equipment, net                                                                                                                                                                                                       |       | 20,732,026                   |        | 18,175,717                      |       |
| Goodwill                                                                                                                                                                                                                           |       | 75,273,653                   |        | 69,843,468                      |       |
| Intangible  assets, net                                                                                                                                                                                                            |       | 82,198,570                   |        | 84,739,774                      |       |
| Other  assets, net                                                                                                                                                                                                                 |       | 1,832,143                    |        | 2,576,827                       |       |
|                                                                                                                                                                                                                               |       |                         |        |                            |       |
| Total assets                                                                                                                                                                                                                       |       | $                            | 267,885,031 |                            | $          | 247,505,357 |   |
|                                                                                                                                                                                                                               |       |                         |        |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                     | ** ** | ** **                   | ** **  | ** **                      | ** ** |
| Current liabilities                                                                                                                                                                                                                |       |                         |        |                            |       |
| Long term  debt and capital lease obligations, current portion                                                                                                                                                                     |       | $                            | 1,079,162   |                            | $          | 1,639,411 |   |
| Accounts  payable and accrued expenses                                                                                                                                                                                             |       | 19,359,880                   |        | 18,842,078                      |       |
| Servicer  escrow liability                                                                                                                                                                                                         |       | 15,585,947                   |        | 4,966,839                       |       |
| Total  current liabilities                                                                                                                                                                                                         |       | 36,024,989                   |        | 25,448,328                      |       |
|                                                                                                                                                                                                                               |       |                         |        |                            |       |
| Long-term debt and capital lease  obligations, net of current portion                                                                                                                                                              |       | 79,862,692                   |        | 148,777,172                     |       |
| Deferred tax liabilities                                                                                                                                                                                                           |       | 3,405,443                    |        | 3,381,001                       |       |
| Deferred revenue                                                                                                                                                                                                                   |       | 168,103                      |        | 217,888                         |       |
| Deferred rent                                                                                                                                                                                                                      |       | 1,035,087                    |        | 1,013,687                       |       |
|                                                                                                                                                                                                                               |       |                         |        |                            |       |
| Total  liabilities                                                                                                                                                                                                                 |       | 120,496,314                  |        | 178,838,076                     |       |
|                                                                                                                                                                                                                               |       |                         |        |                            |       |
| Commitments and contingencies                                                                                                                                                                                                      |       |                         |        |                            |       |
|                                                                                                                                                                                                                               |       |                         |        |                            |       |
| Series A  convertible preferred stock, par value $0.01 per share, no shares authorized,  issued and outstanding as of March 31, 2006; 8,825,241 shares  authorized, issued and outstanding as of December 31, 2005  |       | —                       |        | 12,258,319                      |       |
| Series B  convertible preferred stock, par value $0.01 per share, no shares authorized,  issued and outstanding as of March 31, 2006; 24,185,493 shares  authorized, issued and outstanding as of December 31, 2005 |       | —                       |        | 43,866,683                      |       |
| Stockholders’ equity                                                                                                                                                                                                          |       |                         |        |                            |       |
| Common  stock, par value $0.01 per share, 150,000,000 and 60,000,000 shares  authorized and 20,516,306 and 3,281,607 shares issued and outstanding as of  March 31, 2006 and December 31, 2005, respectively             |       | 205,163                      |        | 32,816                          |       |
| Class B  common stock, par value $0.01 per share, no shares authorized, issued and  outstanding as of March 31, 2006; 357,020 shares authorized, issued and  outstanding as of December 31, 2005                    |       | —                       |        | 3,570                           |       |
| Preferred  stock, par value $ 0.01 per share, 10,000,000 shares authorized, no shares  issued and outstanding as of March 31, 2006                                                                                       |       | —                       |        | —                          |       |
| Additional  paid in capital                                                                                                                                                                                                        |       | 139,870,652                  |        | 4,115,827                       |       |
| Retained  earnings                                                                                                                                                                                                                 |       | 7,312,902                    |        | 8,390,066                       |       |
| Total stockholders’ equity                                                                                                                                                                                                    |       | 147,388,717                  |        | 12,542,279                      |       |
| Total liabilities and stockholder’ equity                                                                                                                                                                                     |       | $                            | 267,885,031 |                            | $          | 247,505,357 |   |

 

The accompanying notes are an integral part ofthese statements.

 

1

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

 

**(unaudited)**

 
| ** **                                                      | ** ** | ** ** | ** ** | **For the three months ended March 31:** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-----------------------------------------------|------------|
| ** **                                                      | ** ** | ** ** | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
|                                                            |       |       |       |                                          |       |   |   |
| Revenue                                                         |       |       |       | $                                             | 55,227,612 |   | $ | 47,895,677 |   |
|                                                            |       |       |       |                                          |       |   |   |
| Cost of services                                                |       |       |       |                                          |       |   |   |
| Compensation  expense                                           |       | 29,463,767 |       | 23,368,100                                    |       |
| Travel and  related expenses                                    |       | 7,126,568  |       | 7,354,068                                     |       |
| Other direct  costs                                             |       | 2,344,298  |       | 1,312,360                                     |       |
| Total cost  of services                                         |       | 38,934,633 |       | 32,034,528                                    |       |
|                                                            |       |       |       |                                          |       |   |   |
| Gross profit                                                    |       | 16,292,979 |       | 15,861,149                                    |       |
|                                                            |       |       |       |                                          |       |   |   |
| Operating expenses                                              |       |       |       |                                          |       |   |   |
| Salaries and  benefits                                          |       | 5,372,029  |       | 4,054,990                                     |       |
| Other  selling, general and administrative expenses             |       | 4,882,623  |       | 3,439,293                                     |       |
| Depreciation  and amortization                                  |       | 1,538,330  |       | 869,789                                       |       |
| Amortization  of intangibles                                    |       | 2,541,852  |       | 2,547,000                                     |       |
| Total  operating expenses                                       |       | 14,334,834 |       | 10,911,072                                    |       |
|                                                            |       |       |       |                                          |       |   |   |
| Income from  operations                                         |       | 1,958,145  |       | 4,950,077                                     |       |
|                                                            |       |       |       |                                          |       |   |   |
| Interest expense, net                                           |       |       |       | 3,070,284                                     |       | 1,817,218 |   |
| Loss from extinguishment of debt                                |       |       |       | 746,002                                       |       | — |   |
|                                                            |       |       |       |                                          |       |   |   |
| Income (loss) before provision for (benefit  from) income taxes |       |       |       | (1,858,141                                    | )     | 3,132,859 |   |
|                                                            |       |       |       |                                          |       |   |   |
| Income tax expense (benefit)                                    |       |       |       | (780,977                                      | )     | 1,242,196 |   |
|                                                            |       |       |       |                                          |       |   |   |
| Net income  (loss)                                              |       | $          | (1,077,164 | )                                             | $          | 1,890,663 |   |
|                                                            |       |       |       |                                          |       |   |   |
| Earnings (loss) per share:                                      |       |       |       |                                          |       |   |   |
| Basic                                                           |       | $          | (0.09      | )                                             | $          | 0.16 |   |
| Diluted                                                         |       | $          | (0.09      | )                                             | $          | 0.15 |   |
|                                                            |       |       |       |                                          |       |   |   |
| Weighted average shares outstanding:                            |       |       |       |                                          |       |   |   |
| Basic                                                           |       | 12,178,806 |       | 11,886,705                                    |       |
| Diluted                                                         |       | 12,178,806 |       | 12,200,468                                    |       |

 

The accompanying notes are an integral part ofthese statements.

 

2

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’EQUITY**

 

**(unaudited)**

 
| ** **                                                                                                                 | ** ** | **Number of shares** | ** ** | **Value**                     | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|-------------------------------|------------|
| ** **                                                                                                                 | ** ** | **Common Stock**     | ** ** | **Class B Common Stock** | ** ** | **Common Stock** | ** ** | **Class B Common Stock** | ** ** | **Additional paid in capital** | ** ** | **Retained Earnings** | ** ** | **Total** | ** ** |
| ** **                                                                                                                 | ** ** | ** **           | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, December 31, 2005                                                                                            |       | 3,281,607            |       | 357,020                       |       | $ | 32,816 |   | $ | 3,570 |   | $ | 4,115,827 |   | $ | 8,390,066 |   | $ | 12,542,279 |   |
|                                                                                                                       |       |                 |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Issuance of common stock                                                                                                   |       | 8,625,000            |       | —                        |       | 86,250 |   | — |   | 131,762,430 |   | — |   | 131,848,680 |   |
|                                                                                                                       |       |                 |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Conversion of convertible preferred stock to  redeemable preferred stock and redemption of redeemable preferred stock, net |       | 8,252,679            |       | —                        |       | 82,527 |   | — |   | 3,277,523 |   | — |   | 3,360,050 |   |
|                                                                                                                       |       |                 |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Conversion of series B common stock                                                                                   |       | 357,020              |       | (357,020                      | )          | 3,570 |   | (3,570 | ) | — |   | — |   | — |   |
|                                                                                                                       |       |                 |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Stock based compensation                                                                                                   |       | —               |       | —                        |       | — |   | — |   | 714,872 |   | — |   | 714,872 |   |
|                                                                                                                       |       |                 |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Net loss for the three months ended March 31,  2006                                                                   |       | —               |       | —                        |       | — |   | — |   | — |   | (1,077,164 | ) | (1,077,164 | ) |
|                                                                                                                       |       |                 |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Balance, March 31, 2006                                                                                               |       | 20,516,306           |       | —                        |       | $ | 205,163 |   | $ | — |   | $ | 139,870,652 |   | $ | 7,312,902 |   | $ | 147,388,717 |   |

 

The accompanying notes are an integral part of these statements.

 

3

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

 

**(unaudited)**

 
| ** **                                                                                         | ** ** | ** **  | ** ** | **For the three months ended March 31:** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------|------------|-----------------------------------------------|------------|
| ** **                                                                                         | ** ** | ** **  | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
|                                                                                               |       |        |       |                                          |       |   |   |
| Cash flows from operating activities                                                               |       |        |       |                                          |       |   |   |
| Net income  (loss)                                                                                 |       | $           | (1,077,164 | )                                             | $          | 1,890,663 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating activities |       |        |       |                                          |       |
| Depreciation  and amortization                                                                     |       | 1,538,330   |       | 869,789                                       |       |
| Amortization  of intangibles                                                                       |       | 2,541,852   |       | 2,547,000                                     |       |
| Amortization  of debt issuance cost                                                                |       | 112,452     |       | 150,279                                       |       |
| Accretion of  note                                                                                 |       | —      |       | 23,171                                        |       |
| Loss from  extinguishment of debt                                                                  |       | 746,002     |       | —                                        |       |
| Stock based  compensation                                                                          |       | 714,872     |       | 28,232                                        |       |
| Deferred  income taxes                                                                             |       | (780,966    | )          | —                                        |       |
| Gain on sale  of fixed assets                                                                      |       | (2,095      | )          | —                                        |       |
| Changes in  operating assets and liabilities, net of business combinations                         |       |        |       |                                          |       |
| Accounts  receivable, net                                                                          |       | (1,425,682  | )          | (8,814,794                                    | )          |
| Unbilled  receivables                                                                              |       | (1,383,956  | )          | 3,063,594                                     |       |
| Prepaid  expenses and other current assets                                                         |       | 1,301,189   |       | 108,928                                       |       |
| Prepaid  income taxes                                                                              |       | (81,904     | )          | (105,407                                      | )          |
| Due to an  affiliated entity                                                                       |       | 188         |       | (71,600                                       | )          |
| Other  assets, net                                                                                 |       | (14,274     | )          | —                                        |       |
| Accounts  payable and accrued expenses                                                             |       | 358,076     |       | (3,518,407                                    | )          |
| Deferred  revenue                                                                                  |       | (614,398    | )          | 136,913                                       |       |
| Deferred  rent                                                                                     |       | 21,400      |       | 130,372                                       |       |
| Net cash  provided by (used in) operating activities                                               |       | 1,953,922   |       | (3,561,267                                    | )          |
|                                                                                               |       |        |       |                                          |       |
| Cash flows from investing activities                                                               |       |        |       |                                          |       |
| Proceeds  from sale of fixed assets                                                                |       | 35,000      |       | —                                        |       |
| Capital  expenditures                                                                              |       | (2,955,580  | )          | (2,260,120                                    | )          |
| Acquisition  of businesses                                                                         |       | (6,120,011  | )          | (825,326                                      | )          |
| Cash held in  escrow from acquisition of businesses inclusive of interest earned                   |       | (600,656    | )          | —                                        |       |
| Net cash  used in investing activities                                                             |       | (9,641,247  | )          | (3,085,446                                    | )          |
|                                                                                               |       |        |       |                                          |       |
| Cash flows from financing activities                                                               |       |        |       |                                          |       |
| Proceeds  from revolving credit facility                                                           |       | 7,400,000   |       | 9,750,000                                     |       |
| Repayments  of revolving credit facility                                                           |       | (7,400,000  | )          | (3,500,000                                    | )          |
| Repayments  of loans payable                                                                       |       | —      |       | (15,843                                       | )          |
| Repayments  of capital lease obligations                                                           |       | (80,743     | )          | (21,438                                       | )          |
| Repayment of  term loan                                                                            |       | (70,000,000 | )          | (1,125,000                                    | )          |
| Deferred  charges related to the issuance of debt                                                  |       | (74,158     | )          | —                                        |       |
| Proceeds  from issuance of common stock upon initial public offering                               |       | 146,625,000 |       | —                                        |       |
| Underwriting  commisssions and offering expenses                                                   |       | (14,776,320 | )          | —                                        |       |
| Redemption  of convertible preferred stock                                                         |       | (52,764,950 | )          | —                                        |       |
| Net cash  provided by financing activities                                                         |       | 8,928,829   |       | 5,087,719                                     |       |
|                                                                                               |       |        |       |                                          |       |
| Net increase  (decrease) in cash and cash equivalents                                              |       | 1,241,504   |       | (1,558,994                                    | )          |
|                                                                                               |       |        |       |                                          |       |
| Cash and cash equivalents at the beginning  of the period                                          |       |        |       | 7,208,875                                     |       | 12,450,147 |   |
|                                                                                               |       |        |       |                                          |       |   |   |
| Cash and cash equivalents at the end of the  period                                                |       |        |       | $                                             | 8,450,379  |   | $ | 10,891,153 |   |

 

The accompanying notes are an integral part ofthese statements.

 

4

----

 

**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES**

** **

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)**

 

**(unaudited)**

 
| ** **                                           | ** ** | ** ** | ** ** | **For the three months ended March 31:** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
|                                                 |       |       |       |                                          |       |   |   |
| Supplementary disclosures of cash flow  information: |       |       |       |                                          |       |   |   |
| Cash paid  during the period for                     |       |       |       |                                          |       |
| Income taxes                                         |       | $          | 79,536     |                                          | $          | 2,070,246 |   |
| Interest                                             |       | $          | 2,234,872  |                                          | $          | 1,683,646 |   |
|                                                 |       |       |       |                                          |       |   |   |
| Other noncash investing and financing  activities:   |       |       |       |                                          |       |   |   |
| Assets  acquired under capital lease                 |       | $          | 581,244    |                                          | $          | 172,412 |   |
| Liabilities  assumed from acquisitions               |       | $          | 1,108,270  |                                          | $          | 588,714 |   |

 

Theaccompanying notes are an integral part of these statements.

 

5

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**(unaudited)**

 

**Note 1—Organization, Description ofBusiness and Basis of Presentation**

 

Clayton Holdings, Inc.(collectively with its wholly owned subsidiaries, the “Company”) was formed on March 31,2005 as a Delaware corporation. The Company was formed to combine two companieswhich were under common control, GRP Holdings, Inc. (“GRP”), a Delawarecorporation, and TMHC Holdings, Inc. (“TMHC”), a Delaware corporation. GRPwas formed to acquire Clayton Services, Inc. (“CSI”) and First MadisonServices, Inc. (“FMS”) from unrelated parties on August 2, 2004. TMHCwas formed to acquire Clayton Fixed Income Services Inc., formerly known as “TheMurrayhill Company” (“CFIS”), from an unrelated party on May 24, 2004.Each holding company was controlled by TA Associates (“TA”) prior to thecombination. In accordance with accounting principles generally accepted in theUnited States of America. (“US GAAP”), assets transferred between entitiesunder common control are accounted for at historical cost similar to a poolingof interests, and the financial statements of previously separate companies forperiods they were under common control are restated on a combined basis. TheCompany’s consolidated financial statements include the results of GRP and TMHCbeginning from the date of acquisition of a controlling interest by TA, whichwere August 2, 2004 and May 24, 2004, respectively.

 

The Company provides a full suite ofoutsourced services, information-based analytics and specialty consulting forbuyers and sellers of, and investors in, mortgage-related loans and securitiesand other debt instruments. The Company’s services include transactionmanagement, which consists of due diligence, conduit support, professionalstaffing, compliance products and services as well as credit risk managementand securities surveillance, and special servicing. The Company usesproprietary technology and processes to provide these services across thelifecycle of a loan, from loan origination, aggregation and securities issuanceto the surveillance and administration of loans and securities. The Companyprovides a majority of its services to participants in the non-agency segmentof the mortgage-backed securities, or MBS, market and the non-conformingmortgage loan market.

 

***Basis ofPresentation***

 

The accompanying condensed consolidated financial statements are unaudited. In the opinion of management, all adjustments, consisting of only normal recurring adjustments considered necessary for a fair presentation, have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements, accounting policies and notes included in the Company’s registration statement on Form S-1 (File No. 333-129526) declared effective by the Securities and Exchange Commission on March 23, 2006, which includes audited financial statements for the year ended December 31, 2005. Results for the interim periods are not necessarily indicative of results for the full year.

 

***Initial Public Offering of CommonStock***

 

On March 29, 2006, theCompany sold 8,625,000 shares, inclusive of an over-allotment of 1,125,000shares, of its common stock, in an initial public offering (“IPO”) of commonstock at a price to the public of $17.00 per share, for net proceeds ofapproximately $131,800,000 after deducting the underwriting discount and approximately $4,500,000 of offering expenses.The Company used approximately $130,200,000 of the proceeds to pay downindebtedness and to redeem all outstanding shares of redeemable preferredstock, which were issued upon the conversion of the Company’s convertible  preferred stock. The Company retainedapproximately $1,600,000 for general corporate purposes, including workingcapital, and possible acquisitions or investments. After giving effect to this offering, theCompany had 20,516,306 shares of common stock outstanding.

 

All share information hasbeen adjusted to reflect a 1-for-4 reverse stock split of common stock and class Bcommon stock, which was consummated on March 1, 2006.

 

**Note 2—Summary of SignificantAccounting Policies**

 

Significant accountingpolicies followed by the Company, as summarized below, are in conformity withUS GAAP.

 

***Principles ofConsolidation***

 

The consolidated financialstatements include the accounts of the Company. All significant intercompanytransactions and balances have been eliminated in consolidation.

 

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***Use of Estimates***

 

The preparation ofconsolidated financial statements in conformity with US GAAP requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses, as well as the disclosure ofcontingent assets and liabilities in the financial statements and accompanyingnotes. Some of these accounting policies require the application of significantjudgment by management in the selection of appropriate assumptions fordetermining these estimates. By their nature, these judgments are subject to aninherent degree of uncertainty; therefore, the Company cannot give assurancethat actual results will not differ significantly from estimated results. Managementbases these judgments on the Company’s historical experience, management’sforecasts and other available information, as appropriate. The most significantestimates reflected in the financial statements include deferred tax assets andliabilities, income tax accruals, valuation allowance for accounts receivable,unbilled receivables, asset impairments, the valuation of stock options and thevaluation of intangible assets and assessments of their useful lives, andrelated party transactions. Actual results could differ from estimated amounts.The Company also makes estimates in determining other ordinary accruals.

 

***Segment Reporting***

 

The Company’s activities areconsidered to be in a single industry segment for financial reporting purposes.The Company provides services that support the purchase and sale of, andinvestment in, mortgage loans and related securities across the mortgage loanlifecycle. Revenues from the Company’s various products and services areaffected by the same factors, primarily the origination of non-conformingmortgage loans and the issuance of non-agency mortgage-backed securities.

 

***DeferredFinancing Costs***

 

The Company amortizes thecosts that it incurs to obtain debt financing over the terms of the underlyingobligations using the effective interest method for the portion of the costsassociated with term loan debt and using the straight line method for theportion of the costs associated with the revolving credit facility. Theamortization of deferred financing costs is included in interest expense.Unamortized deferred financing costs are included in other assets, net in theaccompanying condensed consolidated balance sheets. As a result of the Company’sIPO (see Note 1) on March 29, 2006, the Company repaid $70,000,000 ofprincipal on its $150,000,000 term loan and wrote off a proportionate share ofthe unamortized deferred financing costs associated with the term loan. A losson extinguishment of $746,002 reflecting this write off is reflected in thestatement of operations for the three months ended March 31, 2006.Unamortized deferred financing costs at March 31, 2006 and December 31,2005 were $1,569,803 and $2,354,099, respectively.

 

***RevenueRecognition***

 

Revenue is recognized whenpersuasive evidence of an arrangement exists, the service has been performed,the fee is fixed and determinable, and collection of the resulting receivableis reasonably assured.

 

The Company derives most ofits revenues from professional service activities. The majority of theseactivities are provided under “time-and-materials” billing arrangements.Revenues consisting of billed fees and pass-through expenses are recorded aswork is performed and expenses are incurred. Revenues also include expensesbilled to clients, which includes travel and other out-of-pocket expenses, andother reimbursable expenses. Based on aggregate volume of all travel expensesincurred for both corporate purposes and client service activities, the Companyis eligible to receive certain retroactive volume discounts from several of itstravel providers. Such amounts are accrued as earned, are netted against traveland related expenses and historically have not been material. For the quartersended March 31, 2006 and 2005, pass-through expenses included in revenueswere $7,126,568 and $7,354,068, respectively.

 

The Company recordsprovisions for fee adjustments and discretionary pricing adjustments as areduction of revenues. Revenues recognized, but not yet billed to clients, havebeen recorded as unbilled receivables in the accompanying condensedconsolidated balance sheets.

 

***Stock-basedCompensation***

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123(R), “Accounting for Stock BasedCompensation” which establishes standards for transactions in which an entityexchanges its equity instruments for goods or services. This standard requiresan issuer to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award.This eliminates the exception to account for such awards using the intrinsicmethod previously allowable under Accounting Principles Board (“APB”) Opinion No. 25.In March 2005, the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-BasedPayment,” which expresses views of the SEC Staff about the application of SFAS No. 123(R).SFAS No. 123(R) became effective for annual reporting periods beginning onor after June 15, 2005. The Company previously adopted the fair valuerecognition provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation,” for all awards granted to employees. On January 1, 2006,the Company adopted SFAS No. 123(R) and believes SFAS No. 123(R) doesnot have a material impact on its financial statements.

 

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According tothe provisions of the incentive stock option agreements between the Company andits employees, the vesting term for certain options outstanding as of the dateof the IPO accelerated by either one year or twenty percent, varying inaccordance with the terms of the employee’s specific incentive stock optionagreement.. In addition, 130,208 of performance based options becameimmediately vested. Therefore, on March 29, 2006, the Company recognized$611,696 of additional compensation expense from this accelerated vesting.

 

***Concentration of Credit Risk and SignificantCustomers***

 

At March 31,2006, 25.9% of the Company’s billed and unbilled receivables were related toits largest client. At December 31, 2005, 30.1% and 25.5% of the Company’sbilled and unbilled receivables were related to its two largest clients,respectively.

 

For the threemonths ended March 31, 2006 and 2005, revenue from theCompany’s largest three clients accounted for an aggregate of 33.1% and 35.2%of total revenue, respectively. Revenue from one client exceeded 10% of revenuefor the three months ended March 31, 2006 and revenue from two clientsexceeded 10% of revenue for the three months ended March 31, 2005.

 

***Earnings (Loss)Per Share***

 

Basic earnings(loss) per share is computed by dividing net income (loss) by theweighted-average number of shares of common stock and common stock equivalentsoutstanding during the period. The Company’s convertible preferred stock isdeemed to be a common stock equivalent and included in the computation of basicearnings (loss) per share because it receives dividends at a rate that resultsin a per share amount that is equivalent to the per share amount paid on commonstock. Diluted earnings (loss) per share gives effect to dilutive options,warrants and other potential common stock outstanding during the period. Common share equivalents of 815,542 for thethree months ended March 31, 2006 were excluded from the calculationas their effect was antidilutive.

 

The followingtable presents a reconciliation of the numerators and denominators of basic anddiluted net income (loss) per share for the periods indicated:

 
| ** **                                                         | ** ** | **For the three months ended  March 31, 2006** | ** ** | **For the three months ended  March 31, 2005** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                         | ** ** | **Basic**                                           | ** ** | **Diluted**                                         | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                               |       |                                                |       |                                                |       |   |   |   |   |
| Net income (loss)                                                  |       | $                                                   | (1,077,164 | )                                                   | $          | (1,077,164 | ) | $ | 1,890,663 |   | $ | 1,890,663 |   |
|                                                               |       |                                                |       |                                                |       |   |   |   |   |
| Weighted  average number of common shares outstanding              |       | 12,178,806                                          |       | 12,178,806                                          |       | 11,886,705 |   | 11,886,705 |   |
|                                                               |       |                                                |       |                                                |       |   |   |   |   |
| Dilutive effect of stock options                                   |       | —                                              |       | —                                              |       | — |   | 313,763 |   |
|                                                               |       |                                                |       |                                                |       |   |   |   |   |
| Total  weighted average number of common common shares outstanding |       | 12,178,806                                          |       | 12,178,806                                          |       | 11,886,705 |   | 12,200,468 |   |
|                                                               |       |                                                |       |                                                |       |   |   |   |   |
| Earnings (loss) per share                                          |       | $                                                   | (0.09      | )                                                   | $          | (0.09 | ) | $ | 0.16 |   | $ | 0.15 |   |
|                                                                    |            |                                                     |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |

 

**Note 3—Business Acquisitions**

 

***Asset Purchasefrom M R Network I, Ltd.***

 

On February 3, 2006, the Company entered intoan asset purchase agreement through a subsidiary pursuant to which thesubsidiary acquired substantially all of the assets and assumed certainliabilities of M R Network I, Ltd. (d/b/a MortgageResource Network) for an estimated aggregate purchase price of $6,120,011,pending a final closing balance sheet. The asset purchase agreement providedfor a 60-day period subsequent to the closing date to provide a closing balancesheet which will be used to determine final fair market values. The agreementalso established two escrow accounts aggregating $600,000 which are reflectedin the accompanying condensed consolidated balance sheet at March 31, 2006as cash held in escrow. Of this amount, $350,000 of this escrow is held againstany claims the Company may have for indemnification or a working capitalshortfall upon preparation of the final closing balance sheet. The 60-dayperiod to reach agreement on the final closing balance sheet was extended sothat the Company can better evaluate the fair value of assets acquired. Theremaining $250,000 of the escrow will be retained by the Company if the Companyis not able to execute a new services agreement with a primary MortgageResource Network client before August 3, 2007. This acquisition has notbeen presented on a pro forma basis because it is not deemed to be material.

 

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Pending the final agreement as to the closingbalance sheet the purchase price was preliminarily allocated as follows:

 
| Accounts  receivable   |   | $          | 807,139   |   |
|------------------------|--------|------------|-----------|--------|
| Prepaid expenses       |   | 15,417     |      |
| Property and equipment |   | 949,555    |      |
| Intangible assets      |   | 5,430,185  |      |
| Deposit                |   | 25,986     |      |
| Liabilities assumed    |   | (1,108,271 | )         |
|                   |   | $          | 6,120,011 |   |

 

**Note 4—Cash, Cash Equivalentsand Restricted Cash**

 

At March 31, 2006 and December 31,2005, the Company maintained cash and cash equivalent balances in excess of $100,000at two separate financial institutions. Accounts at these institutions areinsured by the Federal Deposit Insurance Corporation up to $100,000. At March 31,2006 and December 31, 2005, the cash balances exceeded $100,000 by$24,204,883 and $13,447,318, respectively, including restricted cash.

 

At March 31, 2006 and December 31,2005, the Company maintained restricted cash balances of $15,585,947 and$4,966,839, respectively. This balance represented funds received in connectionwith certain loan servicing functions the Company performs for a customer. Suchfunds are received throughout the month and remitted to the customer on amonthly basis. The balance on hand is included in servicer escrow liability inthe accompanying condensed consolidated balance sheet.

 

**Note 5—Property and Equipment, net**

 

Property and equipmentconsists of the following:

 
| ** **                                      | ** ** | **March 31,  2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | ** **               | ** ** | ** **                      | ** ** |
| Computer and office equipment                   |       | $                        | 8,090,360  |                            | $          | 6,526,737 |   |
| Software                                        |       | 9,541,174                |       | 8,100,020                       |       |
| Furniture and fixtures                          |       | 3,220,708                |       | 2,926,452                       |       |
| Leasehold improvements                          |       | 1,584,180                |       | 1,391,952                       |       |
| Website                                         |       | 280,317                  |       | 280,317                         |       |
| Automobiles                                     |       | 112,336                  |       | 171,395                         |       |
|                                            |       | 22,829,075               |       | 19,396,873                      |       |
| Less accumulated depreciation and  amortization |       | 7,630,036                |       | 6,117,862                       |       |
|                                            |       | 15,199,039               |       | 13,279,011                      |       |
| Software under development                      |       | 5,532,987                |       | 4,896,706                       |       |
|                                            |       | $                        | 20,732,026 |                            | $          | 18,175,717 |   |

 

Included in software at March 31,2006 and December 31, 2005, is $3,929,306 and $3,189,915, respectively, ofinternally developed software placed in service. Software under development at March 31,2006 and December 31, 2005 represents other internally developed softwarethat has not yet been placed in service.

 

For the three months ended March 31,2006 and 2005 depreciation and amortization expense charged to operations was$1,538,330 and $869,789, respectively.

 

**Note 6—Goodwill and OtherIntangible Assets**

 

As of March 31, 2006and December 31, 2005, intangible assets not subject to amortizationconsist of goodwill of $75,273,653 and $69,843,468, respectively, and tradenames and trademarks of $15,504,737 and $15,504,338, respectively.

 

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At March 31, 2006, theCompany’s intangible assets with identifiable useful lives, which continue tobe amortized, consist of the following:

 
| ** **                           | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|--------------------------------------|------------|----------------------------|------------|-------------------------------|------------|------------|------------|
| Customer relationships               |       |                       |       |                          |       |       |       |
| Transaction  management and advisory |       | $                          | 36,400,000 |                          | $          | 3,370,370  |       | $ | 33,029,630 |   |
| Staffing  services                   |       | 4,300,000                  |       | 716,667                       |       | 3,583,333  |       |
| Portfolio  management                |       | 10,714,600                 |       | 2,076,325                     |       | 8,638,275  |       |
| Client backlog                       |       | 2,146,200                  |       | 796,171                       |       | 1,350,029  |       |
| Technology                           |       | 26,842,900                 |       | 9,062,151                     |       | 17,780,749 |       |
| Noncompetition agreements            |       | 3,494,950                  |       | 1,200,439                     |       | 2,294,511  |       |
| Patent                               |       | 20,451                     |       | 3,145                         |       | 17,306     |       |
|                                 |       | $                          | 83,919,101 |                          | $          | 17,225,268 |       | $ | 66,693,833 |   |

 

At December 31, 2005, the Company’s intangibleassets with identifiable useful lives, which continue to be amortized, consistof the following: 

 
| ** **                           | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|--------------------------------------|------------|----------------------------|------------|-------------------------------|------------|------------|------------|
| Customer relationships               |       |                       |       |                          |       |       |       |
| Transaction  management and advisory |       | $                          | 36,400,000 |                          | $          | 2,864,815  |       | $ | 33,535,185 |   |
| Staffing  services                   |       | 4,300,000                  |       | 609,167                       |       | 3,690,833  |       |
| Portfolio  management                |       | 10,714,600                 |       | 1,776,817                     |       | 8,937,783  |       |
| Client backlog                       |       | 2,146,200                  |       | 688,861                       |       | 1,457,339  |       |
| Technology                           |       | 26,842,900                 |       | 7,720,006                     |       | 19,122,894 |       |
| Noncompetition agreements            |       | 3,494,950                  |       | 1,022,292                     |       | 2,472,658  |       |
| Patent                               |       | 20,204                     |       | 1,460                         |       | 18,744     |       |
|                                 |       | $                          | 83,918,854 |                          | $          | 14,683,418 |       | $ | 69,235,436 |   |

 

Amortization expense for thethree months ended March 31, 2006 and 2005 was $2,541,852 and $2,547,000,respectively.

 

**Note 7—Revolving Credit Facility,Long-Term Debt and Capital Lease Obligations**

 

Long-term debt and capitallease obligations consist of the following: 

 
| ** **                              | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Term loans                              |       | $                        | 80,000,000 |                        | $          | 150,000,000 |   |
|                                    |       |                     |       |                        |       |
| Capital lease obligations               |       | 941,854                  |       | 416,583                     |       |
|                                    |       |                     |       |                        |       |
| Total  long-term debt                   |       | 80,941,854               |       | 150,416,583                 |       |
| Less current portion                    |       | 1,079,162                |       | 1,639,411                   |       |
|                                    |       |                     |       |                        |       |
| Long-term  debt, net of current portion |       | $                        | 79,862,692 |                        | $          | 148,777,172 |   |

 

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***Credit Agreement***

 

On December 8, 2005 theCompany entered into a credit agreement (the “Credit Agreement”) with afinancial institution. The Credit Agreement, provided the Company with a$150,000,000 term loan, all of which was funded at closing, and a $40,000,000revolving credit facility, none of which was funded at closing. Subject to theagreement of the lenders to increase their commitments, the Company had theoption to borrow up to an additional $10,000,000 under the revolving creditfacility, for an aggregate revolving credit facility of $50,000,000. On January 11,2006 and April 28, 2006, the Company exercised its option and amended theCredit Agreement to increase the revolving credit facility by $5,000,000 oneach date, such that the Company had an aggregate revolving credit facility of$50,000,000 as of April 28, 2006. The Credit Agreement expires on December 8,2011.

 

As a result of the Company’sinitial public offering completed on March 29, 2006 the Company repaid$70,000,000 of the $150,000,000 outstanding term loan balance without incurringany prepayment penalty. In addition, $7,400,000 which was outstanding under therevolving credit facility was repaid. The first $375,000 of the $70,000,000term loan payment was applied against the principal payment due on March 31,2006 and future principal repayments were recalculated pro rata based on theremaining balance compared to the balance prior to the $70,000,000 repayment.Therefore, scheduled quarterly payments of the term loan through December 31,2010 were reduced from $375,000 to $200,501 with the remaining balance of$76,190,476 payable in four quarterly installments of $19,047,619 in 2011. As aresult of the repayment of the term loan the Company wrote off a proportionateshare of deferred financing costs associated with the term loan (see Note 2)and reflected a loss on extinguishment of $746,002 in the condensed consolidatedstatement of operations for the three months ended March 31, 2006.

 

The Credit Agreement iscollateralized by substantially all of the assets of the Company. The agreementcontains covenants which, among other matters, require the Company to maintaincertain levels of interest coverage ratio, fixed charge ratio and totalleverage ratio. Such covenants commenced effectiveness on March 31, 2006and the Company is in compliance with these covenants. In addition, the CreditAgreement places limitations on total annual capital expenditures,indebtedness, liens, dividends and distributions, asset sales, transactionswith affiliates, acquisitions and conduct of business, all as defined in theagreement. The Credit Agreement also contains provisions for an increased rateof interest during periods of default.

 

Loans under the CreditAgreement bear interest at the applicable London interbank offer rate (“LIBOR”)plus 3.00% or Prime rate plus 2.0%, at the Company’s option. In addition, theCompany is required to pay a commitment fee of 0.5% based on the calculation ofthe excess of the revolving credit loan commitment over the revolvingoutstanding balance as defined.

 

At March 31, 2006 and December 31,2005, the revolving credit facility had no outstanding balance and there was anoutstanding balance of $80,000,000 and $150,000,000, respectively, under theterm loan with an interest rate of 7.67% and 9.25%, respectively.

 

***Interest Rate Cap***

 

In September 2004, CSIpurchased an interest rate cap agreement to reduce the potential impact thatinterest rate increases could have on its floating-rate debt interest expense.The terms of the interest rate cap provide that the Company would receivequarterly payments equal to the notional amount multiplied by the difference bywhich LIBOR exceeds 5%. The initial notional amount was $20,000,000 anddeclines during the term of the agreement, which expires on September 30,2006. As of March 31, 2006 and December 31, 2005, the notionalamounts were $16,125,000 and $16,937,500, respectively. The interest rate capdoes not qualify for hedge accounting under SFAS No. 133, as amended. Theinitial premium of $29,900 was recorded as an asset on the date of purchase.Subsequent declines in the fair value of this derivative are recorded asinterest expense in the accompanying condensed consolidated statements ofoperations. For the three months ended March 31, 2006 and 2005, theCompany did not record interest expense as there was no decline in the fairvalue of this derivative during the periods.

 

***Capitalized LeaseObligations***

 

At March 31, 2006, theCompany leased $1,048,828 of equipment under agreements accounted for ascapital leases with accumulated depreciation of $100,052. The obligations forthe equipment required the Company to make monthly payments through March 2011,with implicit interest rates from 7.06% to 19.06%.

 

At December 31, 2005,the Company leased $444,050 of equipment under agreements accounted for ascapital leases with accumulated depreciation of $51,597. The obligations forthe equipment required the Company to make monthly payments through August 2010,with implicit interest rates from 7.06% to 19.06%.

 

**Note 8—Preferred Stock**

 

As of December 31, 2005 the Company had8,825,241 shares designated as Series A Redeemable Preferred Stock, parvalue $0.01 per share, and 27,837,046 shares designated as Series BRedeemable Preferred Stock, par value $0.01 per share, none of which wereoutstanding. As of December 31, 2005, the Company had 8,825,241 sharesdesignated as Series A Convertible Preferred Stock, par value $0.01 pershare, and 24,185,493 shares designated as Series B Convertible Preferred

 

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Stock, par value $0.01 per share, all of which were outstanding. Asof December 31, 2005, the Series A and Series B convertiblepreferred stock were carried on the consolidated balance sheet at theirliquidation preference of $12,258,319 and $43,866,683, respectively.

 

On March 29, 2006, the Company completed itsinitial public offering of common stock, resulting in the conversion of the Series AConvertible Preferred Stock into 2,206,308 shares of common stock, par value$0.01 per share, and 8,825,241 shares of Series A Redeemable PreferredStock, and the conversion of 24,185,493 shares of Series B ConvertiblePreferred Stock into 6,046,371 shares of common stock, par value $0.01 pershare, and 24,185,493 shares of Series B Redeemable Preferred Stock. Aportion of the proceeds from the initial public offering was used to redeem allshares of the Series A Redeemable Preferred Stock and Series BRedeemable Preferred Stock for $52,764,950, and all of the Series A and Series BRedeemable Preferred Stock were immediately retired. The difference between theliquidation preference amount of the convertible preferred stock and theredemption amount of the redeemable preferred stock was allocated to the commonstock resulting from the conversion and credited to additional paid-in capital.

 

**Note 9—Commitments andContingencies**

 

***Operating Leases***

 

The Company leases itsoffice facilities and certain equipment under noncancelable operating leasearrangements expiring on various dates through 2013. Such leases include fixedor minimum payments plus, in some cases, scheduled base rent increases over theterm of the lease and additional rents based on the Consumer Price Index.Certain leases provide for monthly payments of real estate taxes, insurance andother operating expenses applicable to the property.

 

In conjunction with theasset purchase from M R Network I, Ltd. on February 3, 2006, the Companywas assigned an office lease for approximately 20,000 square feet of officespace in Dallas, Texas from which the newly acquired operation conducts itsoperations. This lease expires on December 31, 2008 and includes minimummonthly rent with scheduled increases, as well as additional rent for increasesin real estate taxes and operating expenses over the base year of the lease,which was 2004. In addition, other leases for computer and scanning equipmentand software necessary to the operation were assumed and have been reflected inthe condensed consolidated financial statements for the three months ended March 31,2006. Approximately $400,000 of this leased equipment was reflected as capitalleases.

 

For the three months ended March 31,2006 and 2005, rent expense was approximately $910,632 and $693,339,respectively.

 

***Litigation***

 

In the normal course ofbusiness, the Company is subject to various legal proceedings and claims, theresolution of which, in management’s opinion, will not have a material adverseeffect on the financial position or the results of operations of the Company.

 

**Note 10—Common Stock**

 

At December 31, 2005, the Company had60,000,000 shares of common stock authorized, of which 3,281,607 wereissued and outstanding.

 

Prior to the initial public offering, theCompany’s outstanding capital stock consisted of: (i) 3,281,607  shares of common stock, par value $0.01 pershare; (ii) 357,020 shares of Class B common stock, par value $0.01per share; (iii) 8,825,241 shares of Series A Convertible PreferredStock, par value $0.01 per share; and (iv) 24,185,493 shares of Series BConvertible Preferred Stock, par value $0.01 per share.

 

In connection with, and upon the completionof, the initial public offering on March 29, 2006, 8,825,241 shares of Series AConvertible Preferred Stock were converted into 2,206,308 shares of commonstock and 8,825,241 shares of Series A Redeemable Preferred Stock, and24,185,493 shares of Series B Convertible Preferred Stock were convertedinto 6,046,371 shares of common stock and 24,185,493 shares of Series BRedeemable Preferred Stock.

 

Upon the consummation of the initial publicoffering, all outstanding shares of Class B common stock were convertedinto 357,020 shares of common stock, par value $0.01 per share, and each shareof Class B Common Stock was retired.

 

Inclusive ofan over-allotment option of 1,125,000 shares of its common stock, the Companysold 8,625,000 shares of common stock in its initial public offering at a priceto the public of $17.00 per share, for net proceeds of approximately$131,800,000 after deducting the underwriting discount and approximately $4,500,000 of offering expenses.After giving effect to this offering and the conversion transactions describedabove, the Company had 20,516,306 shares of common stock outstanding.

 

On March 29, 2006, in connection withthe Company’s initial public offering, the Fourth Amended and RestatedCertificate of Incorporation, which was adopted by the stockholders prior tothe initial public offering, was filed with the State of Delaware. The

 

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Company’s Certificate of Incorporation was amended to change theauthorized capital stock of the Company from an aggregate of 160,000,000shares, consisting of (a) 69,673,021 shares of preferred stock, par value$0.01 per share, consisting of Series A Convertible Preferred Stock, Series BConvertible Preferred Stock, Series A Redeemable Preferred Stock and Series BRedeemable Preferred Stock, (b) 80,326,979 shares of common stock,consisting of common stock and Class B common stock, and (c) 10,000,000shares of undesignated preferred stock to a total of 160,000,000 shares ofcapital stock consisting of (i) 150,000,000 shares of common stock, parvalue $0.01 per share, and (ii) 10,000,000 shares of undesignatedpreferred stock, par value $0.01 per share.

 

All share information hasbeen adjusted to reflect a 1-for-4 reverse stock split of common stock and class Bcommon stock, which was consummated on March 1, 2006.

 

**Note 11- Related Party Transactions**

 

OnMarch 29, 2006 the Company paid $52,764,950 from proceeds from its IPO toredeem from investment funds affiliated with TA Associates and other preferredstockholders, including Brian L. Libman, a director of the Company, all of theshares of redeemable preferred stock outstanding immediately following theconversion of Series A Convertible Preferred Stock and Series BConvertible Preferred Stock.

 

The Company’s ChiefExecutive Officer, who was appointed in April 2005, has served on theBoard of Directors of another public company since 1995 and is currently thechairman of this entity’s audit committee. This unrelated entity acquires andoriginates non-conforming residential and commercial loans. The Company hasprovided due diligence and staffing services to this entity since 2002 andrevenues aggregated approximately $0 and $402,631 for the three months ended March 31,2006 and 2005, respectively.

 

CFIS has contracts to perform CreditRisk Management services for portfolios managed by a stockholder. Revenuesgenerated from the contracts for the three months ended March 31, 2006 and2005 were approximately $149,797 and $154,612, respectively, and were includedin service fee revenue in the condensed consolidated statements of operations.Accounts receivable from this party at March 31, 2006 and December 31,2005, were $35,532 and $74,555, respectively.

 

At March 31, 2006 therewas $27,000 due from a related party, representing travel related expenses andprofessional fees paid by the Company and later determined to be theresponsibility of a former officer and current director of the Company, and a Companyaffiliated with him. As of May 15, 2006, there are no amounts outstanding. Inaddition, in January 2006 this former officer paid $34,000 to the Companyfor an automobile, laptop and cell phone and the Company recognized a gain of$2,718.

 

Until December 8, 2005,the Company had subordinated note and subordinated convertible note purchaseagreements with certain stockholders of the Company. For the three months endedMarch 31, 2005 interest expense on these notes was $906,667. There was nointerest expense on these notes in the three months ended March 31, 2006.

 

**Note 12—Stock Options**

 

The Company’s 2005 StockOption and Grant Plan (“2005 Option Plan”) permitted the Company to make grantsof incentive stock options, non-qualified stock options, restricted stockawards and unrestricted stock awards to officers, employees, directors,consultants and other key persons. Stock options granted under the 2005 OptionPlan have a maximum term of ten years from the date of grant and incentivestock options have an exercise price of no less than the fair market value ofthe common stock on the date of grant. In connection with the adoption of theCompany’s 2006 Option Plan, which is discussed in detail below, the board ofdirectors determined not to grant any further awards under the 2005 OptionPlan.

 

On January 26, 2006,the Company’s Board of Directors approved the adoption of the Company’s 2006Stock Option and Incentive Plan (“2006 Option Plan”), and the 2006 Option Planwas subsequently approved by stockholders on March 8, 2006. The 2006Option Plan permits us to make grants of incentive stock options, non-qualifiedstock options, stock appreciation rights, deferred stock awards, restrictedstock awards, unrestricted stock awards and dividend equivalent rights. TheCompany has reserved 1,814,130 shares of common stock for issuance of awardsunder the 2006 Option Plan, subject to adjustment for any stock split, dividendor other change in the Company’s capitalization. Generally, shares that areforfeited or cancelled from awards under the 2006 Option Plan will be availablefor future grants. Stock options granted under the 2006 Option Plan have amaximum term of ten years from the date of grant and incentive stock optionawards have an exercise price of no less than the fair market value of thecommon stock on the date of grant, which will be on the last day of the monthof the award. As of March 31, 2006, 20,500 awards had been granted underthe 2006 Option Plan.

 

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Changes in optionsoutstanding during the three months ended March 31, 2006 are as follows:

 
| ** **                                                                                      | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|
| Options outstanding, December 31, 2005                                                     |       | 1,460,656             |       | $                                     | 4.52       |   |
|                                                                                            |       |                  |       |                                  |       |
| Granted                                                                                         |       | 20,500                |       | 17.83                                 |       |
| Forfeited                                                                                       |       | 3,125                 |       | 6.80                                  |       |
|                                                                                            |       |                  |       |                                  |       |
| Options  outstanding, March 31, 2006                                                       |       | 1,478,031             |       | $                                     | 4.70       |   |
|                                                                                            |       |                  |       |                                  |       |
| Weighted  average fair value of options granted for the three months ended March 31,  2006 |       |                  |       | $                                     | 6.75       |   |
| Options  available for future grant at March 31, 2006                                      |       | 1,793,630             |       |                                  |       |

 
| **March 31, 2006** | ** ** |
|-------------------------|------------|
| ** **              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
| **Exercise  Price**     | ** ** | **Options  Outstanding** | ** ** | **Remaining  Contractual  Life (yrs.)** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $                       | 0.98       |   | 421,375 |   | 8.66 |   | 245,827 |   | $ | 0.98 |   |
| 4.00                    |       | 62,500 |   | 8.14 |   | 53,385 |   | 4.00 |   |
| 4.13                    |       | 89,062 |   | 8.74 |   | 59,834 |   | 4.13 |   |
| 6.00                    |       | 520,834 |   | 9.07 |   | 317,382 |   | 6.00 |   |
| 6.36                    |       | 111,680 |   | 9.32 |   | 44,477 |   | 6.36 |   |
| 6.80                    |       | 252,080 |   | 9.50 |   | 94,313 |   | 6.80 |   |
| 17.00                   |       | 15,500 |   | 10.00 |   | 1,062 |   | 17.00 |   |
| 20.40                   |       | 5,000 |   | 10.00 |   |   |   |   |   |
|                    |       | 1,478,031 |   | 9.00 |   | 816,280 |   | $ | 4.35 |   |
|                         |            |  |  |  |  |  |  |  |  |  |  |

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123(R), “Accounting for Stock BasedCompensation” which establishes standards for transactions in which an entityexchanges its equity instruments for goods or services. This standard requiresan issuer to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award.This eliminates the exception to account for such awards using the intrinsicmethod previously allowable under Accounting Principles Board (“APB”) Opinion No. 25.In March 2005, the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-BasedPayment,” which expresses views of the SEC Staff about the application of SFAS No. 123(R).SFAS No. 123(R)   became effectivefor annual reporting periods beginning on or after June 15, 2005. TheCompany previously adopted the fair value recognition provisions of SFAS No. 123,“Accounting for Stock-Based Compensation,” for all awards granted to employees.On January 1, 2006 the Company adopted SFAS No. 123(R) and believesSFAS No. 123(R) does not have a material impact on its financialstatements.

 

The Company completed itsinitial public offering on March 29, 2006. According to theprovisions of incentive stock option agreements between the Company and itsemployees, the vesting term for certain options outstanding as of the date ofthe IPO accelerated by either one year or twenty percent, varying in accordancewith the terms of the employee’s specific incentive stock option agreement. In addition, 130,208 of performance basedoptions became immediately vested. Therefore on March 29, 2006 the Companyrecognized $611,696 of additional compensation expense from this acceleratedvesting.

 

The ongoing effect onconsolidated results of operations of financial condition will be dependentupon future stock based compensation awards granted. Prior to its initialpublic offering the Company utilized the Black-Scholes option valuation methodto calculate the fair market value of the options using assumptions in effecton the date of the grant, as follows: 

 
| Expected life (in years) |   | 6.5–7.5 |   |
|--------------------------|--------|--------------|--------|
| Risk-free interest rate  |   | 3.5–4.7 | %      |
| Volatility               |   | 2.5–5.7 | %      |
| Dividend                 |   | 0            | %      |

 

For the three months ended March 31,2006 and 2005 the Company recognized expenses related to the stock optiongrants summarized above over the vesting period of such options ofapproximately $715,000 and $28,000, respectively. In addition, the Company willrecognize approximately $1,018,000 of expense related to these grants over theremaining vesting period of such options.

 

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**Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**Forward Looking Statements andProjections**

 

*This Quarterly Report on Form 10-Q contains forward lookingstatements. Forward looking statements relate to future events or our futurefinancial performance. We generally identify forward looking statements byterminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,”“could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,”“predicts,” “potential” or “continue” or the negative of these terms or othersimilar words. These statements are only predictions. We have based theseforward looking statements largely on our current expectations and projectionsabout future events and financial trends that we believe may affect ourbusiness, results of operations and financial condition. The outcome of theevents described in these forward looking statements is subject to risks,uncertainties and other factors described in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” “Risk Factors” andelsewhere in this Quarterly Report on Form 10-Q. Accordingly, you shouldnot rely upon forward looking statements as predictions of future events. Wecannot assure you that the events and circumstances reflected in the forwardlooking statements will be achieved or occur, and actual results could differmaterially from those projected in the forward looking statements. The forwardlooking statements made in this Quarterly Report on Form 10-Q relate onlyto events as of the date on which the statements are made. We undertake noobligation to update any forward looking statement to reflect events orcircumstances after the date on which the statement is made or to reflect theoccurrence of unanticipated events.*

 

**Overview**

 

We provide a full suite of outsourcedservices, mortgage-related analytics and specialized consulting services forbuyers and sellers of, and investors in, mortgage-related loans and securitiesand other debt instruments. Our services include transaction management, whichconsists of due diligence, mortgage processing services for buyers of mortgageloans (conduit support services), professional staffing, and complianceproducts and services, as well as monitoring of mortgage-backed securities(credit risk management and surveillance), and specialized loan servicingservices (special servicing). We provide a majority of our services toparticipants in the non-agency mortgage-backed securities, or MBS, market andthe non-conforming mortgage loan market. We believe that several trends supportthe demand for our services, including:

 

•                  the growth in outsourced services by capital marketsfirms and other major mortgage loan market participants;

 

•                  the increased complexities and requirements offederal, state and local regulations applicable to the mortgage loan industry;

 

•                  investors’ growing demand for loan performance data;and

 

•                  buyers purchasing smaller pools of loans from alarger number of sellers, increasing the need for our conduit services.

 

Our revenue is also driven by non-agency MBSissuance and the aggregate number of non-conforming mortgage loan originations.Changes in the volume of non-agency MBS issuances and non-conforming mortgageloan originations may impact the number of loans for which we perform ourservices, leading to a corresponding change in gross revenue. We areincreasingly utilizing our centralized underwriting facilities to perform ourservices which should reduce the  amountof per loan travel expenses.

 

We expect the non-agency MBS securitizationand non-conforming mortgage loan origination markets to continue growing overthe long term, although the rate of growth may be slower than in recentyears. We believe there is an increasing demand for and the availability of newloan products, increased home ownership driven in part by first-timehomeowners, minorities and immigrants, and increased liquidity in thenon-agency MBS market. We face a number of risks in our industry and the marketfor our services is highly competitive. Our business is driven in part bythe MBS market, the mortgage lending industry and the housing market, eachof which is highly sensitive to trends in the general economy, includinginterest rates, perceived and actual economic conditions, taxation policies,availability of credit, employment levels and wage and salary levels. Adversechanges in any of these trends, or a decline in the sale of both new andexisting homes or in home values, could lessen the demand for mortgage loans,which could result over time in a reduced demand for our services and diminishour revenue. A material reduction in the number of loans available forsecuritization may cause our clients to engage us for fewer services,which could have an adverse effect on our business and results of operations. Moreover,the majority of our business is generated through our largest 20 clients. Theloss of one or more of these clients could adversely affect our business andresults of operations. Lastly, we are dependent on our independent loan reviewspecialists to perform our services. Our business could suffer if we areunable to recruit and retain additional qualified independent loan reviewspecialists.

 

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**Basis of Presentation**

 

We were formed as a Delaware corporation in March 2005,following the combination of the holding companies of each of Clayton Servicesand its subsidiaries, including First Madison, and CFIS, formerly TheMurrayhill Company, or Murrayhill. Prior to the combination, each holdingcompany was controlled by TA Associates. In accordance with US GAAP relating tocompanies under common control prior to their combination, the financialstatements of the previously separate companies under common control arerestated on a combined basis from the dates of their respective acquisitions bythe controlling entity. Accordingly, for accounting purposes, the date of ourinception was May 24, 2004, the date that TA Associates acquired CFIS, thefirst of the combined entities that were brought under common control.

 

Our condensed consolidated financial statements are unaudited. In our opinion, all adjustments, consisting of only normal recurring adjustments considered necessary for a fair presentation, have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements, accounting policies and notes included in our registration statement on Form S-1 (File No. 333-129526) declared effective by the Securities and Exchange Commission on March 23, 2006, which includes audited financial statements for the year ended December 31, 2005. Results for the interim periods are not necessarily indicative of results for the full year.

 

**Critical Accounting Policies**

 

In preparing our financial statements inconformity with US GAAP, we have to make estimates and assumptions about futureevents that affect the amounts of reported assets, liabilities, revenues andexpenses, as well as the disclosure of contingent assets and liabilities in thefinancial statements and accompanying notes. Some of our accounting policiesrequire the application of significant judgment by management in the selectionof appropriate assumptions for determining these estimates. By their nature,these judgments are subject to an inherent degree of uncertainty; therefore, wecannot assure you that actual results will not differ significantly fromestimated results. We base these judgments on our historical experience,management’s forecasts and other available information, as appropriate.

 

Our most critical accounting policies, whichreflect significant management estimates and judgment in determining reportedamounts in the condensed consolidated financial statements are a follows:

 

*Revenue Recognition*

 

Revenue is recognized when persuasiveevidence of an arrangement exists, the service has been performed, the fee isfixed and determinable, and collection of the resulting receivable isreasonably assured.

 

We derive most of our revenue fromprofessional service activities. The majority of these activities are providedunder “time-and-materials” billing arrangements. Revenue consisting of billedfees and pass-through expenses is recorded as work is performed and expensesare incurred. Revenue also includes expenses billed to clients, which includetravel and other out-of-pocket expenses, and other reimbursable expenses.

 

We record provisions for fee adjustments anddiscretionary pricing adjustments as a reduction of revenue. Revenuerecognized, but not yet billed to clients, has been recorded as unbilledreceivables in the Company’s condensed consolidated balance sheets.

 

*Stock-Based Compensation*

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123(R), “Accounting for Stock BasedCompensation” which establishes standards for transactions in which an entityexchanges its equity instruments for goods or services. This standard requiresan issuer to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award.This eliminates the exception to account for such awards using the intrinsicmethod previously allowable under Accounting Principles Board (“APB”) Opinion No. 25.In March 2005, the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-BasedPayment,” which expresses views of the SEC Staff about the application of SFAS No. 123(R).SFAS No. 123(R) became effective for annual reporting periods beginning onor after June 15, 2005. We previously adopted the fair value recognitionprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” forall awards granted to employees. On January 1, 2006 we adopted SFAS No. 123(R)and believe it does not have a material impact on our financial statements.

 

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According to the provisions of incentivestock option agreements between the Company and its employees, the vesting termfor certain options outstanding as of the date of the IPO accelerated by eitherone year or twenty percent, varying in accordance with the terms of theemployee’s specific incentive stock option agreement. In addition,130,208 of performance based options became immediately vested. Therefore, on March 29,2006, we  recognized $611,696 ofadditional compensation expense from this accelerated vesting.

 

Options to purchase 20,500 shares weregranted in the three months ended March 31, 2006 with an average exerciseprice of $17.83 per share.

 

*Earnings(Loss) Per Share*

 

Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock and common stock equivalents outstanding during the period. Our convertible preferred stock is deemed to be a common stock equivalent and included in the computation of basic earnings (loss) per share because it receives dividends at a rate that results in a per share amount that is equivalent to the per share amount paid on common stock. Diluted earnings (loss) per share gives effect to dilutive options, warrants and other potential common stock outstanding during the period. Common share equivalents of 815,542 for the three months ended March 31, 2006 were excluded from the calculation as their effect was antidilutive.

 

**Revenue**

 

We generate a majority of our revenue byproviding professional outsourced services across the lifecycle of a mortgageloan.

 

Our transaction management services areprovided under “time-and-materials” or per file billing arrangements. Under “time-and-materials”arrangements, which represent a majority of our transaction management revenue,we bill our clients on an hourly basis with travel and other reimbursableexpenses passed through and recognized as revenue. Under per file billingarrangements, we bill our clients for each file reviewed with travel and otherreimbursable expenses passed through separately or included in the per filerate. Revenues consisting of billed fees and pass-through expenses, whichinclude travel and other reimbursable expenses, are recorded as work isperformed and expenses are incurred. Revenues recognized, but not yet billed toclients, have been recorded as unbilled receivables in our condensedconsolidated balance sheets. For the three months ended March 31, 2006,transaction management revenue accounted for 79.5% of total revenue.

 

Our credit risk management, surveillance andspecial servicing services provide a revenue stream which is generallyrecurring in nature. In a typical MBS transaction for which we providesurveillance services, we are engaged by the trustee of an MBS issuance toprovide our services over the life of the trust and are paid monthly directlyfrom the cash flow of the trust. A majority of our surveillance revenue isbased upon a negotiated rate multiplied by the outstanding principal balance ofthe underlying mortgage loans in the MBS issuance. These fees are recognizedeach month as services are rendered. Our special servicing activities areconducted under annual or multi-year contracts for which we typically receiverevenue on a per loan per month basis. For the three months ended March 31,2006, surveillance and special servicing services revenue accounted for 20.5%of total revenue.

 

For the three months ended March 31,2006 and 2005, revenue from our largest three clients accounted for anaggregate of 33.1% and 35.2% of our total revenue, respectively. Revenue fromone client exceeded 10% of revenue for the three months ended March 31,2006 and revenue from two clients exceeded 10% of revenue for the three monthsended March 31, 2005. Each of these clients is a leading global investmentbank.

 

**Cost of Services**

 

*Compensation Expense*

 

Compensation expense consists primarily ofcompensation for independent loan review specialists and employees directlyinvolved in the delivery of our services, which include our client servicemanagers who manage our engagements. Compensation expense also includes payrollrelated benefits for our direct employees. The professionals we retain from aprofessional employment organization, including our independent loan reviewspecialists, do not receive any Company-related benefits and are onlycompensated for actual hours worked. Our direct cost of operations does notinclude an allocation of overhead costs.

 

*Travel and Related Expenses*

 

Travel and related expenses consist ofexpenses incurred in enabling employees and independent loan review specialiststo travel to clients’ sites and are comprised of airfare, hotel and car rentalexpenses. A majority of these expenses is either directly billed to clients orincluded in the per file rates charged. As such, these expenses are directly orindirectly included in our revenue.

 

*Other Direct Costs*

 

Other direct costs include the cost of thirdparty mortgage loan services (primarily collateral appraisal fees), outsidesupport for our compliance services used in connection with our loan reviews,independent loan review specialist training and miscellaneous non-billabletransaction costs.

 

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**Operating Expenses**

 

Operating expenses primarily consist of corporateoverhead costs not directly associated with a specific transaction or contract,such as salaries and benefits, marketing and administrative expenses,professional fees and depreciation and amortization expenses.

 

In connection with becoming a public company,we expect that we will incur significant additional operating expenses such asincreased audit fees, professional fees, directors and officers’ insurancecosts, compensation for our board of directors, and expenses related to hiringadditional personnel and expanding our administrative functions. Many of theseexpenses either were not incurred or were incurred at a lower level by us as aprivate company prior to our becoming a public company.

 

*Salaries and Benefits*

 

Salaries and benefits consist of employeecompensation for those employees who are not directly billable to a particularassignment including costs of administrative, finance, human resources,technology and executive personnel.

 

*Other Selling, General and AdministrativeExpenses*

 

Other selling, general and administrativeexpenses consist of costs such as rent and utilities, marketing, advertisingand promotion expenses, non-reimbursable travel and entertainment, informationtechnology, insurance, education, training and hiring expenses other than forindependent loan review specialists and professional fees consisting of legal,accounting and other consulting fees in connection with the ongoing operationof our business including audit and Sarbanes-Oxley Act of 2002 compliance.

 

*Depreciation and Amortization*

 

We incur depreciation and amortizationexpenses for costs related to the capitalization of property and equipment andsoftware developed for internal use on a straight-line basis over the estimateduseful lives of the assets, which range from three to seven years. Leaseholdimprovements and assets under capital lease are amortized over the shorter ofthe estimated useful life of the asset or the lease term.

 

*Treatment of Goodwill and Amortization ofIntangibles*

 

We also incur amortization expenses for costsrelated to the capitalization of identifiable intangible assets includingcustomer relationships, technology and non-competition agreements.

 

We account for acquisitions of companies inaccordance with Statement of Financial Accounting Standards (SFAS) No. 141,*Business Combinations* (SFAS No. 141).We allocate purchase price to tangible assets, intangible assets, andliabilities based on fair values with the excess of purchase price amount beingallocated to goodwill. The allocation of the purchase price to these intangibleassets is based on a number of significant assumptions as determined by us andin the case of material acquisitions our independent appraisal expert,including evaluations of the future income producing capabilities of theseassets and related future expected cash flows. We also make estimates about theuseful lives of the acquired intangible assets. Should different conditionsresult in the determination that the value of the goodwill and acquiredintangible assets has been impaired, we could incur write-downs of goodwill orintangible assets, or changes in the estimation of useful lives of thoseintangible assets. In accordance with SFAS No. 142, *Goodwill and Other Intangible Assets* (SFASNo. 142), goodwill is not amortized, but is subject to annual impairmenttesting which is discussed in greater detail below.

 

In accordance with SFAS No. 142,goodwill is subject to annual impairment tests or on a more frequent basis ifevents or conditions indicate that goodwill may be impaired. Goodwill istested for impairment at a level of reporting referred to as a reporting unit.We as a whole are considered one reporting unit. Therefore, the first step ofour annual test is to compare the fair value of our shares to the carryingvalue of our net assets. If we determine that our carrying value exceeds ourfair value, we would conduct a second step to the goodwill impairment test. Thesecond step compares the implied fair value of the goodwill (determined as theexcess fair value over the fair value assigned to our other assets andliabilities) to the carrying amount of goodwill. When the carrying amount ofgoodwill exceeds the implied fair value of goodwill, an impairment loss isrecognized.

 

We evaluate all of our long-lived assets,including intangible assets other than goodwill and fixed assets, periodicallyfor impairment in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-lived Assets*(SFAS No. 144). SFAS No. 144 requires that long-lived assets beevaluated for impairment when events or changes in facts and circumstancesindicate that their carrying value may not be recoverable. If events orcircumstances indicate that the carrying value of an asset may not berecoverable, the amount of impairment will be measured as the differencebetween the carrying value and the fair value of the impaired asset. Animpairment will be recorded as an operating expense in the period of theimpairment and as a reduction in the carrying value of that asset.

 

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**Net Interest Expense**

 

Net interest expense consists of interestpaid on our debt net of interest received on our cash balances. Interestexpense for the three months ended March 31, 2006 primarily consisted of intereston our $150,000,000 term loan, amortization of debt issuance costs related tothe term loan and interest on our revolving line of credit. Interest expensefor the three months ended March 31, 2005 primarily consisted of intereston our prior term loan, which had a balance of $37,750,000 at the start of theperiod, and interest on 12% subordinated and 12% senior subordinated notesissued to TA Associates and our other noteholders in connection with theacquisitions of  our predecessor andCFIS, respectively, by TA Associates. The combined balance of the 12% seniorsubordinated and 12% subordinated notes at the start of the period was$29,486,478. The remaining balances of the prior term loan, the 12%subordinated notes and the 12% senior subordinated notes were repaid with theproceeds from our $150,000,000 term loan on December 8, 2005.

 

**Loss from Extinguishment of Debt**

 

On March 29, 2006, following our initialpublic offering, we repaid $70,000,000 of the outstanding balance on the termloan and the entire $7,400,000 outstanding balance on the revolving line ofcredit. Due to the repayment of $70,000,000 on the term loan, we wrote-off aportion of the debt issuance costs on the term loan and recognized a loss fromextinguishment of debt of $746,002.

 

**Results ofOperations**

 

***Comparison of ThreeMonth Periods Ended March 31, 2006 and 2005***

 

**Revenue**

 

Our revenue was $55.2 million for the three months ended March 31,2006, an increase of $7.3 million or 15.3%, compared to revenue of$47.9 million for the three months ended March 31, 2005*.*The increase was primarily due to an increase in volume inour conduit support services as well as growth in our surveillance services duein part to an increased joint sales effort following the combination ofCFIS and Clayton. Revenue for the three months ended March 31, 2006included $1.3 million from Mortgage Resource Network, following the Company’sacquisition of substantially all of the assets of that business in February 2006.Due to growth in our non-loanrelated services and higher average revenues per loan in our core due diligencebusiness, our total revenues per loan increased 34.1%. This increase offset a14.0% decrease in the number of loans serviced during the quarter.

 

***Cost of Services***

 

Our cost of services was $38.9 million for the three months ended March 31,2006, an increase of $6.9 million or 21.5%, compared to cost of servicesof $32.0 million for the three months ended March 31, 2005. Thisincrease was attributable to the specific factors discussed below.

 

*Compensation Expense.*Compensationexpense was $29.5 million for the three months ended March 31, 2006,an increase of $6.1 million or 26.1%, compared to compensation expense of$23.4 million for the three months ended March 31, 2005*.*The increase was primarily due to the growth in ourconduit services, special servicing and consulting businesses. Compensationexpense in our due diligence business also resulted in an increase incompensation expense per loan, due to increased training expenses, reduced productivitydue to a quality assurance initiative, investments in product development andhigher variable compensation rates.

 

*Travel and Related Expenses.*Traveland related expenses were $7.1 million for the three months ended March 31,2006, a decrease of $0.3 million or 3.1%, compared to travel and relatedexpenses of $7.4 million for the three months ended March 31, 2005. Thedecrease was primarily due to a 14.0% reduction in the number of loans serviced.Travel expenses per loan increased by 12.7% as higher average airline ticketcosts offset the impact of an increase in the percentage of loans serviced inour central underwriting facility.

 

*Other Direct Costs.*Otherdirect costs were $2.3 million for the three months ended March 31,2006, an increase of $1.0 million or 78.6%, compared to other direct costsof $1.3 million for the three months ended March 31, 2005. Theincrease was primarily due to an increase in third-party appraisal fees due toan increase in appraisal revenue in our due diligence business.

 

***Operating Expenses***

 

Operating expenses were $14.3 million for the three months ended March 31,2006, an increase of $3.4 million or 31.4%, compared to operating expensesof $10.9 million for the three months ended March 31, 2005. Thisincrease was attributable to the specific factors discussed below.

 

*Salaries and Benefits.*Salariesand benefits were $5.4 million for the three months ended March 31,2006, an increase of $1.3 million or 33.2%, compared to salaries andbenefits of $4.1 million for the three months ended March 31, 2005.Salaries and benefits

 

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expense forthe three months ended March 31, 2006 included $0.5 million of expenserelated to the acceleration of vesting of certain stock options as a result ofthe Company’s initial public offering in March 2006. The remainingincrease was primarily due to the costs of additional administrative, finance,human resources, technology and executive personnel which were added inpreparation for becoming a public company.

 

*Other Selling,General and Administrative Expenses.*Other selling,general and administrative expenses were $4.9 million for the three monthsended March 31, 2006, an increase of $1.5 million or 41.2%, comparedto selling, general and administrative expenses of $3.4 million for thethree months ended March 31, 2005*.*This increasewas due to general increases in occupancy, advertising and promotion,non-reimbursable travel and telecommunications costs relating to growth in ourbusiness.

 

*Depreciation andAmortization.*Depreciation and amortization was$1.5 million for the three months ended March 31, 2006, an increaseof $0.6 million or 76.8%, compared to depreciation and amortization of$0.9 million for the three months ended March 31, 2005*.*This increase was primarily due to depreciation recordedon additional property and equipment and software developed for internal use.These additions were made to enhance our corporate infrastructure andtechnology platform in support of the growth in business operations and inpreparation for becoming a public company.

 

*Amortization ofIntangibles.*Amortization of intangibles was$2.5 million for the three month periods ended March 31, 2006 and2005.

 

***Interest Expense, net***

 

Interest expense, net was $3.1 millionfor the three months ended March 31, 2006, an increase of$1.3 million or 69.0%, compared to interest expense, net of$1.8 million for the three months ended March 31, 2005*.*This increase was due to increased borrowings outstandingunder our credit facilities. *See “—Liquidity andCapital Resources.”*

 

***Loss from Extinguishment ofDebt***

 

For the three months ended March 31,2006, we recognized a loss from extinguishment of debt of $0.7 million due tothe write-off of debt issuance costs as a result of a $70.0 million prepaymenton a term loan following our initial public offering. *See “—Liquidityand Capital Resources.”*

 

**Liquidity and Capital Resources**

 

Historically, we have financed our growthfrom cash flow from operations and bank borrowings. We believe that fundsgenerated from operations, together with existing cash and available borrowingsunder our credit agreement, will be sufficient to finance our currentoperations, planned capital expenditures and internal growth at least throughthe next twelve months. On March 29, 2006, we issued 8,625,000 shares ofcommon stock, including 1,125,000 shares issued through the exercise of theunderwriters’ over-allotment option, at a price of $17.00 per share through ourinitial public offering of common stock

 

On March 1, 2006, we consummated a 1-for-4 reverse stock split ofour common stock and class B common stock.

 

Immediately prior to the completion of theoffering, the following transactions occurred:

 

•                  all of our357,020 outstanding shares of class B common stock converted into 357,020shares of common stock.

•                  our series Aconvertible preferred stock converted into 2,206,308 shares of common stock and8,825,241 shares of series A redeemable preferred stock.

•                  our series Bconvertible preferred stock converted into 6,046,371 shares of common stock and24,185,493 shares of series B redeemable preferred stock.

 

Our net proceeds of $131.8 million, net of$14.8 million of offering expenses and the underwriting discount, were used to:

 

•                  redeem $52.8 millionof redeemable preferred stock that resulted from the conversion of our Series Aconvertible preferred stock and Series B convertible preferred stockimmediately prior to the completion of the initial public offering.

•                  repay $70.0million owed under the senior term loan portion of our credit facility.

•                  repay $7.4million owed under the revolving credit portion of our credit facility.

•                  fund$1.6 million of working capital.

 

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On February 3, 2006, we acquiredsubstantially all of the assets and assumed certain liabilities of MortgageResource Network for an aggregate purchase price and fees aggregatingapproximately $6.1 million. Working capital was used to fund the acquisition ofsuch assets and assumed liabilities. Mortgage Resource Network is engaged inthe business of providing outsourced mortgage processing and fulfillmentservices to the mortgage industry, including mortgage brokers, lenders andsecuritizers.

 

Our operating activities provided cash of$2.0 million in the three months ended March 31, 2006 and used cash of$3.6 million in the three months ended March 31, 2005. Cash provided fromand used in operations is generated primarily from net income and the timing ofaccounts receivable collections and disbursements of accounts payable. Cashprovided by operations for the three months ended March 31, 2006 wasgenerated from a net loss of $1.1 million plus $5.7 million of non cash chargesless $2.6 million from a net increase in assets primarily due to an increase in accounts receivable and unbilled receivables. Cash used in operationsfor the three months ended March 31, 2005 was generated  from $1.9 million of net income plus $3.5million of non cash charges and was negatively impacted by a net increase inassets of $9.0 million primarily from an increase in the balance of accountsreceivable****as a result of an increase in theamount of time receivables remained outstanding. We believe cash flow fromoperations will be sufficient to finance our current operations for the nexttwelve months.

 

Our investing activities used cash of $9.6million and $3.1 million in the three months ended March 31, 2006 and2005, respectively. Cash used in investing activities in the three months endedMarch 31, 2006 primarily consisted of the Mortgage Resource Networkacquisition and increased capital expenditures. Cash used in investingactivities in the three months ended March 31, 2005 primarily consisted ofcapital expenditures and the acquisition of NYSIS, Inc.

 

Our financing activities provided cash of$8.9 million and $5.1 million in the three months ended March 31, 2006 and2005, respectively. The principal sources of cash from financing activities inthe three months ended March 31, 2006 were the proceeds from the initialpublic offering described above and, to a lesser extent, borrowings under ourrevolving credit agreement. This was partially offset by the redemption ofpreferred stock and repayments of outstanding debt under our credit facilitydescribed above. The principal sources of cash from financing activities in thethree months ended March 31, 2005 were borrowings under our priorrevolving credit agreement.

 

Cash paid for interest expense was $2.3million and $1.7 million in the three months ended March 31, 2006 and March 31,2005, respectively. In the three months ended March 31, 2006, the majorityof interest expense was paid on borrowings outstanding under our term loan. Inthe three months ended March 31, 2005, the majority of interest expensewas paid on borrowings outstanding under our subordinated notes, seniorsubordinated notes, prior revolving line of credit and prior term loan.

 

***Credit Agreement***

 

On December 8, 2005, we entered into a$190.0 million senior credit facility. The credit facility provided for a$150.0 million term loan, and a revolving credit facility of$40.0 million. The credit facility also provided us with an option,subject to the consent of the lenders, to increase the revolving creditfacility by $10.0 million to an aggregate of $50.0 million. We exercised theoption to increase our revolving credit facility on January 11, 2006 and April 28,2006, and amended our credit facility to increase the revolving loan facilityby $5.0 million  on each date, foran aggregate revolving credit facility of $50.0 million as of April 28,2006. Following our initial public offering in March 2006, we repaid $70.0million outstanding under the term loan and repaid  $7.4 million outstanding under the revolvingcredit facility.

 

The credit agreement terminates on December 8,2011. Principal repayments on the term loan of $200,500 are required on aquarterly basis for each quarter through 2010, and the remaining principalbalance at the end of 2010 is repayable in equal quarterly installments during2011. This facility can be used to fund acquisitions requiring cash, as well asto fund short-term liquidity needs. Liquidity needs occasionally arise as aresult of differences in the timing between collecting our accounts receivableand making disbursements to support our operations.

 

The credit agreement is collateralized bysubstantially all of our assets. The agreement contains covenants which, amongother matters, require us to maintain certain levels of interest coverageratio, fixed charge ratio and total leverage ratio. As of  March 31, 2006, we were in compliancewith all debt covenants. In addition, the credit agreement places limitationson total annual capital expenditures, indebtedness, liens, dividends anddistributions, asset sales, transactions with affiliates, acquisitions andconduct of business, all as defined in the agreement. The credit agreement alsocontains provisions for an increased interest rate during periods of default. Wedo not believe that these covenants will affect our ability to operate ourbusiness.

 

Loans under the credit agreement bearinterest at the applicable LIBOR rate plus 3.0% or Prime Rate plus 2.0%, at ouroption. In addition, we are required to repay a commitment fee of 0.5% based onthe calculation of the excess of the revolving credit loan commitment over theoutstanding balance as defined.

 

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At March 31, 2006, there was anoutstanding balance of $80.0 million under the term loan and no outstandingbalance under the revolving credit facility.

 

***Interest Rate Cap***

 

In September 2004, we purchased aninterest rate cap agreement to reduce the potential impact that interest rateincreases could have on our floating-rate debt interest expense. At March 31,2006, the notional amount of the interest rate cap agreement was$16.1 million. The terms of the interest rate cap agreement, which expireson September 30, 2006, provide that we would receive quarterly paymentsequal to the notional amount multiplied by the difference by which LIBORexceeds 5%. The initial premium of $29,900 was recorded as an asset on the dateof purchase. Subsequent declines in the fair value of this derivative wererecorded as interest expense.

 

***ContractualObligations***

 

The following table describes our cashcommitments, in thousands, to settle contractual obligations as of March 31,2006.

 
| ** **                   | ** ** | **Total** | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **More than  5 years** | ** ** |
|------------------------------|------------|-----------|------------|------------------------|------------|---------------|------------|---------------|------------|------------------------|------------|
| Term loans and loans payable |       | $         | 80,000     |                   | $          | 602           |       | $             | 2,406      |                   | $          | 76,992 |   | $ | — |   |
| Capital lease obligations    |       | 1,118     |       | 270                    |       | 733           |       | 115           |       | —                 |       |
| Operating lease obligations  |       | 10,457    |       | 2,096                  |       | 6,772         |       | 1,114         |       | 475                    |       |
|                         |       |      |       |                   |       |          |       |          |       |                   |       |
| Total                        |       | $         | 91,575     |                   | $          | 2,968         |       | $             | 9,911      |                   | $          | 78,221 |   | $ | 475 |   |

 

**Off-Balance-Sheet Arrangements**

 

As of March 31, 2006, we did not haveany significant off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) ofRegulation S-K of the SEC.

 

**Item 3. Quantitative and Qualitative Disclosuresabout Market Risk**

 

During the three months ended March 31, 2006,there were no material changes in our market risk exposure. For a discussion ofour market risk associated with interest rate risk and equity price risk as of December 31,2005, see Risk Factors and Management’s Discussion and Analysis of FinancialCondition and Results of Operations contained in our  registration statement on Form S-1 (FileNo. 333-129526), declared effective by the Securities and ExchangeCommission on March 23, 2006, which includes audited financial statementsfor the year ended December 31, 2005.

 

**Item 4.****          ****Controlsand Procedures**

 

***Evaluation of Disclosure Controls andProcedures***

 

In connectionwith the preparation and review of this Quarterly Report on Form 10-Q, ourindependent registered public accounting firm identified adjustments to ourfinancial statements as part of their quarterly review procedures.  These adjustments were made prior to theissuance of our financial statements for the three months ended March 31,2006.  Our management, with theparticipation of our chief executive officer and chief financial officer, andafter consideration of these adjustments and in consultation with our AuditCommittee and our independent registered public accounting firm, evaluated theeffectiveness of our disclosure controls and procedures as of March 31, 2006.  The term “disclosure controls andprocedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct, means controls and other procedures of a company that are designed toensure that information required to be disclosed by a company in the reports thatit files or submits under the Exchange Act is recorded, processed, summarizedand reported, within the time periods specified in the SEC’s rules andforms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the company’s management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure. Management recognizes that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving their objectives and management necessarily applies its judgment inevaluating the cost-benefit relationship of possible controls andprocedures.   Based on the evaluation ofour disclosure controls and procedures as of March 31, 2006, and after consideringthe results of the Quarterly Report on Form 10-Q preparation and reviewprocess, our chief executive officer and chief financial officer concluded thatcertain control deficiencies existed in our internal control over financialreporting as of such date, which, as discussed below, constituted a materialweakness.  As a result, our chiefexecutive officer and chief financial officer concluded that our disclosurecontrols and procedures were not effective at the reasonable assurance level asof March 31, 2006.

 

 

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Notwithstandingthe material weakness described below, management believes the condensedconsolidated financial statements included in this Quarterly Report on Form10-Q fairly present in all material respects our financial condition, resultsof operations and cash flows at and for the periods presented in accordancewith accounting principles generally accepted in the United States of America(“US GAAP”).

 

*Material Weakness in Internal Control over Financial Reporting*

 

                A “material weakness” is a controldeficiency, or combination of control deficiencies, that results in more than aremote likelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected.    

 

As of March31, 2006, we did not have a sufficient complement of personnel with anappropriate level of accounting knowledge, experience and training in theapplication of US GAAP to support our financial accounting and reportingrequirements. As a result, we did not maintain effective controls over theapplication of our accounting policies related to the timing of expenserecognition sufficient to ensure such charges and expenses were accounted forin accordance with US GAAP.  If leftunremediated, these control deficiencies could potentially result inmisstatement of significant accounts and disclosures that could result in amaterial misstatement to our interim or annual consolidated financialstatements that would not be prevented or detected.  Accordingly, management has determined thatthese control deficiencies constituted a material weakness in internal controlover financial reporting.

 

*Management’s Remediation Initiatives*

 

We are in theprocess of remediating the material weakness in our internal control overfinancial reporting described above.  Wehave taken or expect to take the following actions: 

 
| • |   | We have recently added several professionals possessing significant  accounting and control expertise. These individuals will be included in the  preparation and review of our periodic financial statements and evaluate  transactions and accounting treatments that may give rise to additional  research and control considerations.            |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                 |
| • |   | We are actively recruiting to supplement our finance and accounting  staff with an individual with significant public company financial reporting  experience.                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                 |
| • |   | We have drafted critical accounting policies and procedures to ensure  that account reconciliations and amounts recorded in our books and records  are substantiated by detailed and contemporaneous documentary support. These  policies and procedures include strengthened reconciliation procedures,  approvals and supervisory review controls. |
|   |   |                                                                                                                                                                                                                                                                                                                                                 |
| • |   | We will engage the services of external advisors, as necessary, in  relation to significant accounting matters.                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                 |
| • |   | We will further train certain key personnel with responsibilities for  financial and tax reporting in order to improve the quality, communication  and review processes and procedures over these functions.                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                 |
| • |   | We will conduct an assessment of the accounting and finance  organization in order to assess competencies and responsibilities and take  corrective actions as necessary                                                                                                                                                                             |

  

***Changes in Internal Control Over FinancialReporting***

 

No change inour internal control over financial reporting (as defined in Rules 13a-15(f)and 15d-15(f) under the Exchange Act) occurred during the three months endedMarch 31, 2006, other than the material weakness described above, that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting. 

 

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**Part II– OTHER INFORMATION**

 

**Item 1.****           LegalProceedings**

 

Not applicable.

 

**Item 1A. Risk Factors**

 

*We caution you that the following important factors, among others,could cause our actual results to differ materially from those expressed inforward-looking statements made by us or on our behalf in filings with the SEC,press releases, communications with investors and oral statements. Any or allof our forward-looking statements in this Quarterly Report on Form 10-Qand in any other public statements we make may turn out to be wrong. Theycan be affected by inaccurate assumptions we might make or by known or unknownrisks and uncertainties. Many factors mentioned in the discussion below will beimportant in determining future results. Consequently, no forward-lookingstatement can be guaranteed. Actual future results may vary materially. Weundertake no obligation to update any forward-looking statements, whether as aresult of new information, future events or otherwise.*

 

**Risks Related to Our Business**

 

***Adverse changes inthe mortgage-backed securities, or MBS, market, the mortgage lending industryor the housing market could result in a reduced demand for our services.***

 

Our business is driven in part by theMBS market, the mortgage lending industry and the housing market, each of whichis highly sensitive to trends in the general economy, including interest rates,perceived and actual economic conditions, taxation policies, availability ofcredit, employment levels and wage and salary levels. Adverse changes in any ofthese trends, or a decline in the sale of both new and existing homes or inhome values, could lessen the demand for mortgage loans, which could result ina reduced demand for our services and diminish our revenues. A materialreduction in the number of loans available for securitization may causeour clients to engage us for fewer services, which could have an adverse effecton our business and results of operations.

 

***A sustained downturnin the residential mortgage loan origination business, which is a cyclicalindustry currently at a historically high level, may adversely affect ourbusiness and harm our operations.***

 

The residential mortgage lending originationbusiness has historically been a cyclical industry. The residential mortgagelending industry experienced rapid growth from 2001 through 2005 due, in largepart, to declining interest rates. During periods of rising interest rates, mortgageloan originations generally decrease, as higher interest rates provide reducedeconomic incentives for borrowers to refinance their existing mortgages. Anextended decrease in mortgage loan originations may lead to fewerissuances of mortgage-backed securities and, consequently, demand for ourtransaction management services may be materially reduced. Our historicalperformance may not be indicative of results that would occur in a risinginterest rate environment during which our results of operations may bematerially adversely affected.

 

***The market for ourservices is highly competitive, and if we are not able to compete effectively,our business and results of operations may be adversely affected.***

 

The market for our services is highlyfragmented, intensely competitive and subject to rapid change. Our existingcompetitors, or future competitors, may have greater name recognition,larger client bases, better technology or data, easier access to data, lowerpriced services or greater financial, technical, personnel or other resourcesthan we have. We compete with several providers of due diligence services,including large accounting firms and other providers focused on technologyproducts, staffing services, surveillance and special servicing. Larger competitorswith greater technical, personnel and financial resources may be betterable to respond to the need for technological changes, compete for skilledprofessionals, build upon efficiencies based on a larger volume of loantransactions, fund internal growth and compete for market share generally.Among the ways in which we may encounter new or increased competition isthe hiring or establishment by a competitor of a pool of skilled offshoreworkers that can provide many of the same services that we provide atsubstantially lower cost. Also, we may face competition from our clientsif they choose to provide such services internally, as opposed to outsourcingthese services to us, and from third parties who decide to expand theirservices, either organically or through merger or acquisition, to include someor all of the services that we provide. Increased competition could result inlower revenues and higher expenses, which could have an adverse effect on ourbusiness and results of operations.

 

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***The loss of one ormore of our largest clients could adversely affect our business and results ofoperations.***

 

For the three months ended March 31,2006, revenue from our largest three clients accounted for an aggregate of33.1% of our total revenue and revenue from one client exceeded 10% of revenuefor the period. We have experienced similar levels of customer concentration inprior years. We expect that these clients will continue to account for asubstantial portion of our revenue for the foreseeable future. While we havelong-standing relationships with our major clients, we generally do not havelong-term contracts with these or our other clients. As a result, such clientscould significantly decrease or cease their business with us upon limited or nonotice. Any loss of major clients or a reduction in the type or scope ofservices for which such clients engage us could adversely affect our businessand results of operations.

 

Additionally, there has been, and may continueto be, substantial merger, acquisition and consolidation activity in thebanking and financial services industry. The financial services industryincludes many of our largest clients, and these clients may seek todiversify their service providers by utilizing our competitors to perform certainservices that we provide. If our clients merge with or are acquired by otherentities that are not our clients, or that use fewer of our services, they may discontinueor reduce their use of our services. Finally, the larger banks or financialinstitutions resulting from mergers or consolidations could decide tointernally perform some or all of the services that we currently provideor may provide in the future, and thus terminate our engagements or decreasethe level or volume of services we provide. Any of these developments couldhave an adverse effect on our business and results of operations.

 

***If we are inefficient in deliveringservices to our customers, our profit margins may decrease and we may notbe able to compete effectively.***

 

The success of our businessdepends on delivering high-quality services to our clients in a timely manner.  Our independent loan review specialists are akey component of our ability to deliver services.  If we do not properly manage the activities ofour independent loan review specialists and we experience a decrease in theirproductivity, especially in connection with client engagements that are billedon a per file basis, our profit margins will be adversely affected. In orderto maintain our profit margins in times of decreased productivity, we may increasethe cost of our services to clients, which could result in reduced demand forour services and/or termination of client engagements with us.  A reduction in services, a prematuretermination of engagements or our inability to increase prices could have anadverse effect on our business and results of operations.

 

***Clients canterminate engagements with us at any time.***

 

A majority of our transaction managementengagements are project-based. Therefore, the utilization of our independentloan review specialists depends on our ability to secure additional engagementson a continual basis. Also, if a client terminates an engagement and we areunable to re-deploy our independent loan review specialists on anotherengagement within a short period of time, the independent loan reviewspecialists may seek other opportunities for their services, which wouldincrease our labor, recruiting and training costs and could have an adverseeffect on our business and results of operations.

 

***Maintaining ourprofessional reputation is critical to our future success, and any damage toour reputation may adversely affect our business and results ofoperations.***

 

Our ability to secure new engagements andrecruit and retain qualified employees and independent loan review specialistsdepends heavily on our strong reputation in the mortgage loan industry. Becausewe obtain a majority of our new engagements from existing clients, a client’sdissatisfaction with our performance could seriously impair our ability tosecure new engagements from that client and its affiliates. Diminution of ourbusiness reputation for any reason could make it substantially more difficultfor us to compete successfully for new engagements.

 

***Our engagements may resultin professional liability.***

 

Our services typically involve difficultanalytical assignments and carry risks of professional and other liability.Many of our engagements involve matters that could have an impact on our client’sbusiness. For example, our clients depend on us to accurately evaluatecompliance with underwriting and regulatory criteria in connection with theiranalysis of mortgage securities. If a client incurs losses as a result of theservices we provide, the client could threaten or bring litigation in order torecover damages or to contest its obligation to pay all or part of ourfees. In some cases, a client may seek to recover its losses pursuant toindemnification rights. Litigation alleging that we performed negligently orotherwise breached our obligations to the client could expose us to significantliabilities and tarnish our reputation. In addition to the costs associatedwith litigation and claims, the perceived exposure to professional liability may makeit more expensive to obtain and maintain insurance, including errors andomissions insurance. While we have not experienced any such claims or beensubject to litigation to date, any such occurrence could have an adverse effecton our business and results of operations.

 

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***If we are not ableto maintain accurate, comprehensive or reliable systems and data, we couldexperience reduced demand for our services.***

 

Our success depends on our clients’confidence in the comprehensiveness, accuracy and reliability of ourproprietary systems, transaction data and database of loan information.Additionally, we must continuously monitor changes to state predatory lendingregulations, and update our compliance software and data accordingly. The taskof establishing and maintaining accurate and reliable systems and data is acontinuous, complex, multi-step process. If our data, including the data weobtain from third parties, is not current, accurate, comprehensive or reliableor if there is an error in our systems resulting from events such as miscodingof rules or miscalculations of critical data elements, we could experiencedamage to our reputation or be subject to legal action, either of which could resultin reduced demand for our services.

 

***Our business couldbe adversely affected if we are unable to safeguard the security and privacy ofthe personal financial information we receive.***

 

In connection with our loan file duediligence reviews and other consulting and advisory services that we provide tothird parties relating to mortgage loans and mortgage-backed securities, wehave access to personal financial information of the borrowers. This personalfinancial information is highly sensitive and confidential. If we or a thirdparty were to misappropriate this information, we potentially could be subjectto both private and public legal actions. Although we have policies andprocedures designed to safeguard confidential information, we cannot assure youthat these policies and safeguards are sufficient to prevent themisappropriation of confidential information or that our policies andsafeguards will be deemed compliant with any existing or future federal orstate laws or regulations governing privacy.

 

***An interruption inor breach of our information systems may result in lost business.***

 

We rely heavily upon information systems toconduct our business. As we implement our growth strategy this reliance willincrease. Any failure or interruption, or breach in security, of ourinformation systems or the third party information systems on which we relycould significantly impede our ability to operate our business. Although suchfailures, interruptions or breaches have not occurred in the past, we cannot assureyou that one will not happen in the future, or if they do occur that we or thethird parties on which we rely will adequately address them. We haveimplemented precautionary measures to avoid systems outages and to minimize theeffects of any data systems interruptions, but we have not instituted fullyredundant systems. If we do not build and maintain redundant systems for ourdata, current clients may terminate their engagements with us andpotential clients may utilize one of our competitors for their serviceneeds. The occurrence of any failure, interruption or breach couldsignificantly harm our business. We may be required to expend significantcapital and other resources to license encryption technology and additionaltechnologies to protect against security breaches or to alleviate problemscaused by any breach. We may be liable for any breach in our security andany breach could harm our reputation, reduce demand for our services or causeclients to terminate their relationships with us.

 

***StephenM. Lamando, our founder, recently resigned, which may adverselyimpact our business.***

 

Mr. Lamando resigned as our President,effective December 31, 2005, to pursue personal interests. Mr. Lamando’sresignation may adversely affect our ability to execute our businessstrategy, manage our growth or compete effectively. Mr. Lamando willcontinue to serve as a director.

 

***If we lose theservices of any additional key executive officers, we may not be able toexecute our business strategy, manage our growth or compete effectively.***

 

Our future success depends in large part onthe continued service of our key executive officers, including Frank P.Filipps, our President and Chief Executive Officer, and Frederick C.Herbst, our Chief Financial Officer. Although we have employment andnon-competition agreements with these executive officers, these individuals may neverthelessleave us. We cannot assure you that these executive officers can be replacedwith equally skilled and experienced professionals. Because these executiveofficers would be difficult to replace, the loss of their services could havean adverse effect on our business and results of operations.

 

***Our business couldsuffer if we are unable to recruit and retain qualified independent loan reviewspecialists.***

 

Our businessrequires us to continually recruit and retain highly qualified and experiencedindependent loan review specialists to perform due diligence andtransaction related services. Our failure to recruit and retain a significantnumber of qualified independent loan review specialists could limit our abilityto accept or complete engagements and adversely affect our business and resultsof operations. We face significant competition for these specialists from ourdirect competitors as well as other companies that seek highly qualified,highly educated candidates. Additionally, our competitors currently solicit andmay hire our independent loan review specialists after they have completedour thorough training program. Competition for these independent loan reviewspecialists may increase labor and training costs, which could have anadverse effect on our business and results of operations.

 

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***Efforts to expandour product offerings beyond our current markets may not succeed.***

 

We have focused on selling our servicesprimarily in the residential non-agency MBS market. Although we currently offerservices for other consumer and commercial loan types and related securities,we may expand further into these and other asset classes. Efforts toexpand our product offerings beyond the principal market that we currentlyserve, however, may divert management resources from existing operationsand require us to commit significant financial resources to developing newproduct offerings, which could have a material adverse effect on our businessand results of operations. Moreover, efforts to expand beyond our existingmarkets may not result in the creation of new products that achieve marketacceptance, create additional revenues or become profitable.

 

***We may makeacquisitions that prove unsuccessful or strain or divert our resources.***

 

We intend to consider acquisitions of othercompanies in our industry that could complement our business, including theacquisition of entities that would expand our service offerings, increase ourmarket share or offer access to other asset classes that we do not currentlyserve. We have limited experience in completing acquisitions of otherbusinesses. If we do acquire other businesses, we may not be able tosuccessfully integrate these businesses with our own and we may be unableto maintain our standards, controls and policies. We may fail in ourattempt to integrate acquired companies and businesses in such a way that wecan realize cross-selling opportunities and other synergies. Further,acquisitions may place additional constraints on our resources bydiverting the attention of our management from our business operations. Throughacquisitions, we may enter areas in which we have no or limitedexperience, and an acquisition may be unsuccessful in accomplishing theintended benefits of the transaction. Moreover, any acquisition may resultin substantial transaction-related expenses, a potentially dilutive issuance ofequity securities, the incurrence of debt or amortization of expenses andrelated intangible assets, all of which could have an adverse effect on ourbusiness and results of operations.

 

***We may not beable to manage our growth or meet marketplace demands effectively.***

 

We have expanded significantly in the lastfew years and intend to maintain our focus on growth. However, our growth willplace additional demands on our resources and we cannot be sure that we will beable to manage our growth effectively. In order to successfully manage ourgrowth, we may need to:

 

•                  expand and enhance ouradministrative infrastructure;

 

•                  continue to improve ourmanagement, financial and information systems and controls; and

 

•                  recruit, train, manage andretain our employees and our independent loan review specialists effectively.

 

Continued growth could place a strain on ourmanagement, operations and financial resources. In addition, this growth may adverselyaffect our ability to service the demands of our clients or the quality of serviceswe provide. If we are unable to meet these demands, our competitors may beable to gain a greater market share in the transaction management and creditrisk surveillance services market generally, as well as gain a greater share ofour clients’ business. We cannot assure you that our infrastructure,operational, financial and management controls, reporting systems andprocedures, facilities and personnel will be adequate to support our futureoperations or to effectively adapt to future growth. Our expected additionalheadcount and capital investments will increase our costs, which will make itmore difficult for us to offset any future revenue shortfalls by offsettingexpense reductions in the short term. If we cannot manage our growtheffectively, our business and results of operations may be adverselyaffected.

 

***Changes in theregulation of our business and our failure to comply with applicable laws andregulations may adversely affect our business and results of operations.***

 

Our business is subject to various federal,state and local laws and regulations. Proposals for further regulation andchanges in existing regulation that affect our business are regularly beingintroduced and passed in state legislatures and the U.S. Congress. Proposalsthat are now receiving a great deal of attention include consumer protectioninitiatives relating to privacy and security of customer information, andpredatory lending regulations. It is possible that one or more otherlegislative proposals or regulatory changes may be adopted that would havean adverse effect on our business. For example, any changes to the currentpredatory lending regulations may increase our costs in connection withupdating and conforming our High Cost Analyzer compliance application, or, conversely,reduce demand for our compliance related services. Our failure to comply withthese laws and regulations could harm our client relationships or ourreputation, inhibit our ability to obtain new engagements, and expose us to class actionlawsuits, breach of contract claims, and governmental proceedings, all of whichcould have an adverse effect on our business and results of operations.

 

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***Third parties may claimwe are infringing their intellectual property rights, or may infringe uponor design around our intellectual property rights.***

 

Our competitive position depends largely uponour proprietary products, processes and services. Third parties, however, may claimthat we or our products, systems or operations infringe their intellectualproperty rights, and we may be unaware of intellectual property rights ofothers that may cover some aspects of our technology, products orservices. Any litigation regarding trademarks, copyrights or other intellectualproperty rights could be costly and time consuming, and divert our managementand key personnel from operating our business. If any third party has ameritorious or successful claim that we are infringing their intellectualproperty rights, we may be forced to change our products or services or tocompensate such third parties, which may be costly or impractical. Whilewe have not experienced any material claims or been subject to litigation todate, any such occurrence could have an adverse effect on our business andresults of operations.

 

Our success and competitive position dependin part on our ability to obtain and maintain intellectual property rightsprotecting our products and services. We rely on a combination of copyrights,trademarks, service marks, trade secrets, confidentiality provisions andlicensing arrangements to establish and protect our intellectual property andproprietary rights. We have received federal trademark registrations forCLAYTON and BEYOND DILIGENT, and have filed federal trademark applications tohelp protect certain trademarks that we use in conjunction with our business,including HIGH COST ANALYZER, HIGH COST FOCUS, CLAS, GREEN MACHINE,MASTEREPORTER and our Clayton logo. Our pending applications may not beregistered by the U.S. Patent and Trademark Office, and third parties may challengethe validity or scope of the trademark applications or registrations. Despiteour proprietary rights, there can be no assurance that others will not developsimilar products, duplicate our products or design around our products.

 

***Our loan agreementcontains operating and financial covenants that may restrict our businessand financing activities.***

 

We have entered into a senior loan agreementproviding for a $150.0 million term loan and a $50.0 millionrevolving line of credit. Among other things, this senior loan agreementrestricts our ability to:

 

•                  incur or guarantyadditional indebtedness;

 

•                  make capital expenditures;

 

•                  create liens;

 

•                  enter into transactionswith affiliates;

 

•                  make loans or investments;

 

•                  sell assets;

 

•                  pay dividends or makedistributions on, or repurchase, our stock; or

 

•                  consolidate or merge withother entities.

 

In addition, our senior credit facilityrequires us to maintain specified financial covenants, which we have compliedwith as of March 31, 2006. The operating and financial restrictions andcovenants in this credit facility, as well as any future financing agreements, may restrictour ability to finance our operations, engage in business activities or expandor pursue our business strategies. Our ability to comply with our obligationsunder the credit facility may be affected by events beyond our control. Wemay not be able to meet those obligations. A breach of any of ourobligations under the credit facility could result in a default, cause anyfuture indebtedness under the revolving line of credit that may beoutstanding to become immediately due and payable, and terminate allcommitments to extend further credit. We cannot assure you that we will havesufficient assets to repay our credit facility upon any default. If we wereunable to repay any outstanding indebtedness, the bank could proceed againstthe collateral granted to them to secure that indebtedness. We have pledgedsubstantially all of our assets, including certain intellectual property, ascollateral under the credit facility.

 

***We have begun to,and will in the future, incur significant increased costs as a result of ourbeginning to operate as a public company, and our management will be requiredto devote substantial time and expense to various compliance issues.***

 

We became a publicly traded company on March 24, 2006. As a resultof becoming a publicly-traded company, we have begun to, and will in thefuture, incur substantial additional legal, accounting, and other expenses thatwe did not incur as a private company. In addition, the Sarbanes-Oxley Act of2002, along with rules promulgated by the SEC and the Nasdaq NationalMarket, the market on which our stock trades, have imposed significant newrequirements on public companies, including many changes involving corporategovernance. Management and other company personnel have already begun, and willbe required to continue, to devote a substantial amount of time to ensuring ourcompliance with these regulations. Accordingly, our legal and accountingexpenses will significantly increase, and certain corporate actions will becomemore time-consuming and costly. For example, these regulations may make itmore difficult to attract and retain qualified members of our board ofdirectors and various corporate committees, and obtaining director and officerliability insurance will be more expensive.

 

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***Ifwe are unable to effectively and efficiently implement the necessaryinitiatives to eliminate the material weakness identified in our internalcontrol over financial reporting, or if we have other material weaknesses inour internal control over financial reporting, there could be an adverse effecton our financial reporting.***

*** ***

In connectionwith the preparation and review of this Quarterly Report on Form 10-Q, ourindependent registered public accounting firm identified adjustments to ourfinancial statements as part of their quarterly review procedures.  These adjustments were made prior to theissuance of our financial statements for the three months ended March 31,2006.  Asrequired by Securities and Exchange Commission Rule 13a-15(b), we carried outan evaluation, under the supervision and with the participation of ourmanagement, including our chief executive officer and chief financial officer,and after consideration of these adjustments and in consultation with our AuditCommittee and our independent registered public accounting firm, of the effectiveness of the design and operationof our disclosure controls and procedures as of March 31, 2006, the end of theperiod covered by this Quarterly Report on Form 10-Q.  In connection with this evaluation, our chiefexecutive officer and chief financial officer, after considering theresults of the Quarterly Report on Form 10-Q preparation and review process, determined that certain control deficienciesexisted in our internal control over financial reporting as of March 31, 2006,which, constituted a material weakness. Notwithstanding this material weakness, management believes thecondensed consolidated financial statements included in this Quarterly Reporton Form 10-Q fairly present in all material respects our financial condition,results of operations and cash flows at and for the periods presented inaccordance with US GAAP.

 

We have commenced several remediation initiatives, which we arecontinuing to pursue, in an effort to remediate this material weakness. Formore information regarding the material weakness identified by management inour internal control over financial reporting, and our remediation efforts tocure such weakness, please see “Part I, Item 4. Controls and Procedures”above.  If we cannot remediate ourexisting material weakness or produce reliable financial reports, investorscould lose confidence in our reported financial information, the market priceof our stock could decline significantly, we may be unable to obtain additionalfinancing to operate and expand our business and our business and financialcondition could be harmed. 

 

***Our auditors identified several significantdeficiencies during their audits of the fiscal periods 2003, 2004 and 2005. Inorder to comply with public reporting requirements, we must continue to strengthenour financial systems and controls, and the failure to do so could adverselyaffect our ability to provide timely and accurate financial statements.***

 

In connection with the preparation of ouryear end audited financials statements for fiscal 2003, 2004 and 2005, ourindependent auditors identified several deficiencies in our internal controlover financial reporting. Certain of these were matters that could, in ourauditor’s judgment, adversely affect our ability to record, process, summarizeand report financial data, and were “significant deficiencies” pursuant toAuditing Standard No. 2 issued by the Public Company Accounting OversightBoard. The comments and recommendations provided by our auditors in 2005included, but were not limited to:  the needto augment financial reporting staffing in connection with the preparation ofconsolidated financial statements on a timely basis; the need to implementstricter control procedures regarding internal capitalization expenses andaccounting for employment and personnel agreements; the need to implementappropriate security measures with respect to access to our internal softwareapplications; the need to segregate duties in key information technologyfunctions so that individuals are limited in their ability to improperly impactour software, and create a change management policy to insure data integrityand control of our proprietary software; the need to improve control procedureswith respect to internal access to client files; and the need for enhancedmonitoring and oversight of our tax function.

 

In prior years, our auditors recommended thatwe improve documentation of our client engagements so that key terms forengagements with clients are documented in writing; create policies andprocedures to strengthen our accounts receivable function in order to moreefficiently bill customers and apply customer payments appropriately; maintaincontemporaneous documentation to support our books and records; segregateduties in key accounting functions so that individuals are limited in theirability to improperly impact our accounting records, including with respect toinformation technology access; and implement appropriate security measures withrespect to the preparation of financial statements.

 

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If the significant deficiencies identified byour auditors are left unremediated, they could materially adversely affect ourbusiness and results of operations. For example, the auditors noted asignificant deficiency regarding the documentation and recordkeeping of certainof our internal projects that are eligible for capitalization. Inadequatedocumentation or recordkeeping could result in erroneous payroll and accountingrecords. Additionally, our auditors noted a significant deficiency with respectto segregation of duties in our information technology department, as well as asignificant deficiency with respect to inadequate control over financialreporting software. The effect of such deficiencies could materially harm ourinternal accounting, since multiple accounting personnel would have access toour accounting system, and potentially impair the integrity of our accountingand reporting. Our auditors noted a significant deficiency with respect to ourtax recordkeeping and documentation. If this deficiency is not addressed, we may facepenalties from state and federal tax authorities for underpayment, and ourfinancial statements may not properly reflect all taxes incurred. Ourauditors noted a significant deficiency with respect to our change managementprocesses. Failure to address weak change management procedures may resultin improper access to our source code for our proprietary software, which may impaircertain software critical to our clients. Finally, our auditors identified adeficiency with respect to our ability to prepare financial statements on atimely basis. If we are unable to prepare our financial statements on time, it may adverselyaffect our business and compliance with SEC reporting obligations.

 

All remediation actions taken by managementsubsequent to December 31, 2005 will be subject to the consideration ofour auditors during the audit of our financial statements as of and for theyear ending December 31, 2006. Although we believe we have madesubstantial progress in addressing the areas identified by our auditors asneeding improvement, there are no assurances that these matters will have beensufficiently addressed in the opinion of our independent auditors or that otherdeficiencies will not be identified in connection with their next audit of ourfinancial statements.

 

Continued improvement of our internalcontrols and procedures will be required in order for us to manage futuregrowth successfully and operate effectively as a public company. The continuedimprovement of our internal controls, as well as compliance with the SarbanesOxley Act of 2002 and related requirements, is, and will continue to be, costlyand will place a significant burden on management. We have had only limited operatingexperience with the improvements we have made. We cannot assure you that themeasures we have taken or any future measures will enable us to provideaccurate and timely financial reports, particularly if we are unable to hireadditional personnel in our accounting and financial department, or if we losepersonnel in this area. Any failure to improve our internal controls couldresult in delays or inaccuracies in reporting financial information, or noncompliance with SEC reporting and other regulatory requirements, any of whichcould adversely affect our business and results of operations.

 

**RisksRelated to the Common Stock and Our Capital Structure**

 

***There is a limitedhistory of a trading market for our common stock, and the market price of ourcommon stock may be highly volatile or may decline regardless of ouroperating performance.***

 

There has only been a public market for ourcommon stock since the completion of our initial public offering in late March 2006.The trading market in our common stock may be volatile. The market pricesof the securities of newly public companies have been volatile, and have beenknown to decline rapidly. Broad market and industry conditions and trends may causefluctuations in the market price of our common stock, regardless of our actualoperating performance.

 

***Future sales of ourshares could adversely affect the market price of our common stock.***

 

Our stockholders that held our stock prior toour initial public offering now hold approximately 58.0% of our outstandingshares of common stock. These stockholders will not be contractually prohibitedfrom selling these shares following the 180-day lock-up period following ourinitial public offering, which expires on September 19, 2006, subject tocertain extensions. Stockholders may sell these shares earlier ifconsented to by the underwriters of our initial public offering. Inaddition, after the expiration of the lock-up period, we will not becontractually prohibited from issuing and selling additional shares of our commonstock. Any sale by us or our current stockholders of our common stock in thepublic market, or the perception that sales could occur, could adversely affectthe prevailing market price for our common stock.

 

Substantially all of the holders of our commonstock prior to our initial public offering have rights, subject to some limitedconditions, to demand that we file a registration statement on theirbehalf to register their shares or that we include their shares in aregistration statement that we file on our behalf or on behalf of otherstockholders. If such demand rights are exercised pursuant to the terms andconditions of the registration rights agreement and we are required to file anadditional registration statement, we will incur significant expenses inconnection with the filing of such registration statement. Additionally, thefiling of an additional registration statement at the request of thestockholders may divert the attention of our senior management from ourbusiness operations.

 

***Our directors andcertain significant stockholders exercise significant control over Clayton.***

 

Our directors, and significant stockholdersand their affiliates, including TA Associates and Stephen M. Lamando,collectively control approximately 48.6% of our outstanding common stock. Investmentfunds affiliated with TA Associates hold an aggregate of

 

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40.4% of our outstanding common stock. As a result, these stockholders,if they act together, are able to influence our management and affairs and allmatters requiring stockholder approval, including the election of directors andapproval of significant corporate transactions. This concentration of ownershipmay have the effect of delaying or preventing a change in control ofClayton and might affect the market price of our common stock.

 

***We may requireadditional capital in the future, which may not be available to us.Issuances of our equity securities to provide this capital may dilute yourownership in us.***

 

We may need to raise additional fundsthrough public or private debt or equity financings in order to:

 

•                  take advantage ofexpansion opportunities;

 

•                  acquire complementarybusinesses or technologies;

 

•                  develop new services andproducts; or

 

•                  respond to competitivepressures.

 

Any additional capital raised through theissuance of our equity securities may dilute your percentage ownershipinterest in us. Furthermore, any additional financing we may need may notbe available on terms favorable to us or at all. The unavailability of neededfinancing could adversely affect our ability to execute our growth strategy.

 

***Provisions in ourcertificate of incorporation and by-laws may deter third parties fromacquiring us.***

 

Our certificate of incorporation and by-lawscontain provisions that may make the acquisition of Clayton more difficultwithout the approval of our board of directors, including the following:

 

•                  our board of directors isdivided into three classes serving staggered three-year terms;

 

•                  only our board ofdirectors may call special meetings of our stockholders;

 

•                  our stockholders may takeaction only at a meeting of our stockholders and not by written consent;

 

•                  we have authorizedundesignated preferred stock, the terms of which may be established and sharesof which may be issued without stockholder approval;

 

•                  stockholder approval ofamendments of our certificate of incorporation or by-laws require a vote of 75%of our outstanding shares;

 

•                  vacancies on the board ofdirectors may be filled only by the directors;

 

•                  our directors may beremoved only for cause by the affirmative vote of the holders of 75% of thevotes that all stockholders would be entitled to cast in the election ofdirectors; and

 

•                  we require advance noticefor stockholder proposals.

 

These anti-takeover defenses coulddiscourage, delay or prevent a transaction involving a change in control ofClayton. These provisions could also discourage proxy contests and make it moredifficult for you and other stockholders to elect directors of your choosingand cause us to take other corporate actions that you desire.

 

***Section 203 ofthe Delaware General Corporation Law may delay, defer or prevent a changein control that our stockholders might consider to be in their best interests.***

 

We are subject to Section 203 of theDelaware General Corporation Law which, subject to certain exceptions,prohibits “business combinations” between a Delaware corporation and an “interestedstockholder,” which is generally defined as a stockholder who becomes a beneficialowner of 15% or more of a Delaware corporation’s voting stock for a three-yearperiod following the date that such stockholder became an interestedstockholder absent prior approval of our board of directors. Section 203could have the effect of delaying, deferring or preventing a change in controlthat our stockholders might consider to be in their best interests.

 

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**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

 

(a)                                  Notapplicable.

 

(b)                                 On March 23, 2006, our registrationstatement on Form S-1 (Registration No. 333-129526) was declaredeffective for our initial public offering, pursuant to which we offered andsold 8,625,000 shares of common stock, which included 1,125,000 shares sold inconnection with the underwriters’ exercise of their over-allotment optiondescribed below, at an initial public offering price of $17.00 per share. Theunderwriters exercised their over-allotment option to purchase the additional1,125,000 common shares at the initial public offering price of $17.00 pershare on March 27, 2006. The offering, including the underwriters’over-allotment option,  closed on March 29,2006 and, after the sale of all securities registered, including theunderwriters’ over-allotment option shares, we received net proceeds ofapproximately $136.4 million (after underwriters’ discounts of  $10.3 million). The underwriters of theoffering were William Blair & Company, L.L.C., Piper Jaffray &Co., SunTrust Capital Markets, Inc., JMP Securities LLC and America’sGrowth Capital, LLC. We incurred estimated offering related expenses ofapproximately $4.5 million, of which approximately $2.3 million were paid priorto the closing of the initial public offering. These offering related expenses,together with the underwriters’ discount, totaled approximately $14.8 millionin estimated expenses related to the offering, and resulted in net proceeds tous of approximately $131.8 million. No offering expenses were paid directly orindirectly to directors, officers (or their associates), or to persons owning10% or more of any of our equity securities.

 

Upon the closing of theoffering, we immediately repaid approximately $52.8 million to investment fundsaffiliated with TA Associates, Inc. and our other preferred stockholders,including Brian L. Libman, a director of the Company, to redeem all of theshares of redeemable preferred stock that were issued and outstandingimmediately following the conversion of our series A convertible preferredstock and series B convertible preferred stock. The conversion of the series Aconvertible preferred stock and series B convertible preferred stockoccurred upon the closing of the initial public offering. Investment fundsaffiliated with TA Associates, Inc. received approximately $51.4 millionof the $52.8 million upon the redemption of the redeemable preferred stock. Mr. Libmanreceived approximately $0.9 million upon the redemption of the redeemablepreferred stock. We also repaid $70.0 million of the $150.0 million owed underthe term loan portion of our senior credit facility with BNP Paribas, and theentire $7.4 million owed under the revolving credit portion of our seniorcredit facility with BNP Paribas. We intend to use remaining $1.6 million ofthe net proceeds for general corporate purposes, including working capital andpossible acquisitions and investments. We currently have no agreements orcommitments with respect to any acquisitions or investments and we do notcurrently have any acquisitions or investments planned. Pending specificapplication of our net proceeds, we plan to invest our net proceeds ingovernment securities and other short-term, investment-grade, marketablesecurities.

 

(c)                                  Not applicable.

 

**Item 3.****           Defaults Upon SeniorSecurities**

 

Not applicable.

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

On February 3, 2006, the holders of ourconvertible preferred stock took action by written consent to approve ouracquisition of Mortgage Resource Network. A total of 8,059,710 shares of ourpreferred stock (on an as-converted to common stock and split-adjusted basis)voted in favor of the matters contained in the consent, and there were no votesagainst and no abstentions.

 

On February 28, 2006, we sent a writtenconsent to our stockholders requesting the approval of a one-for-four reversestock split of our common stock and class B common stock and to approve acertificate of amendment to our Second Amended and Restated Certificate ofIncorporation effecting such stock split. A total of 8,283,227 shares of ourstock (on an as-converted to common stock and split-adjusted basis) voted infavor of these matters, and there were no votes against and no abstentions.

 

On March 8, 2006, we sent a writtenconsent to our stockholders requesting approval of the following matters inconnection with our proposed initial public offering: (i) the approval ofour Third Amended and Restated Certificate of Incorporation to provide forcertain takeover protection and corporate governance measures, to be effectiveimmediately prior to the pricing of the initial public offering; (ii) theapproval of our Fourth Amended and Restated Certificate of Incorporation toprovide for changes to our capital stock structure, to be effective immediatelyprior to the closing of the initial public offering; (iii) the election ofMargaret Sue Ellis, Frank Filipps and Stephen Lamando, to serve as Class Idirectors until the date of the annual meeting of stockholders in 2006 or untilhis or her earlier death, resignation or removal; (iv) the election ofBrian Libman and Todd Crockett to serve as Class II directors until thedate of the annual meeting of stockholders in 2007 or until his earlier death,resignation or removal; (v) the election of Roger Kafker and Frank Raiterto serve as Class III directors until the date of the annual meeting ofstockholders in 2008 or until his earlier death, resignation or removal; (vi) theamendment and restatement of our by-laws to provide for certain changesconsistent with our 

 

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becoming a public company; (vii) the form of indemnificationagreement for directors and executive officers of the Company; and (viii) theadoption of our 2006 Stock Option and Incentive Plan. All such actions wereeffected pursuant to an action by unanimous written consent of our stockholderspursuant to Section 228 of the Delaware General Corporation Law.

 

**Item 5. Other Information**

 

Not applicable.

 

**Item 6. Exhibits**

 

The exhibits listed in the Exhibit Indeximmediately preceding the exhibits are filed as part of this QuarterlyReport on Form 10-Q and such Exhibit Index is incorporated herein byreference.

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 
| ** **              | **CLAYTON HOLDINGS, INC.** |
|-------------------------|---------------------------------|
| ** **              | ** **                      |
| Date: May 15, 2006 | By:                             | /s/ Frederick C. Herbst | ** ** |
|                    |                            | Frederick C. Herbst |
|                    |                            | *Chief Financial Officer* |
|                    |                            | (Duly Authorized Officer and Principal  Financial Officer) |

 

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**EXHIBIT INDEX**

 

Listed and indexed below are all Exhibitsfiled as part of this report.

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                             |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                        |
| 31.1                 |       | Certification pursuant to Section 302  of the Sarbanes-Oxley Act of 2002, Rule 13a-14(a)/15d-14(a), by Chief  Executive Officer.                                                  |
|                 |       |                                                                                                                                                                                        |
| 31.2                 |       | Certification pursuant to Section 302  of the Sarbanes-Oxley Act of 2002, Rule 13a-14(a)/15d-14(a), by Chief  Financial Officer.                                                  |
|                 |       |                                                                                                                                                                                        |
| 32.1                 |       | Certification pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by  Chief Executive Officer and Chief Financial Officer. |

 

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