**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

| **x**                                 |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934**                                                       |
|---------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                  |   |                                                                                                                                                           |
|                                  |   | **For the quarterly period ended June 30, 2007**                                                                                                               |
| ** **                            |   |                                                                                                                                                           |
| **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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**CLAYTONHOLDINGS, INC.**

(Exact name 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 mark whether the registrant:(1) has filed all reports required to be filed by Section 13 or15(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  x    No  o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer o | Accelerated filer o |  Non-accelerated  filer x |
|---------------------------|---------------------|--------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o    No  x

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

21,111,969 shares of Common Stock, par value $0.01 pershare, outstanding as of July 31, 2007.

 

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**INDEX**
| Part I.  Financial Information |                          |          |
|-------------------------------------|-------------------------------|---------------|
|                                |                          |          |   |   |   |
|                                | Item 1. Financial  Statements |          |   |
|                                |                          |          |   |   |   |
|                                |                          |          | Condensed  Consolidated Balance Sheets as of June 30, 2007 (unaudited) and  December 31, 2006 |   |   |
|                                |                          |          |   |   |   |
|                                |                          |          | Condensed  Consolidated Statements of Operations (unaudited) for the three and six  months ended June 30, 2007 and 2006 |   |   |
|                                |                          |          |   |   |   |
|                                |                          |          | Condensed  Consolidated Statement of Changes in Stockholders’ Equity (unaudited) for the  six months ended June 30, 2007 |   |   |
|                                |                          |          |   |   |   |
|                                |                          |          | Condensed  Consolidated Statements of Comprehensive (Loss) Income (unaudited) for the  three and six months ended June 30, 2007 and 2006 |   |   |
|                                |                          |          |   |   |   |
|                                |                          |          | Condensed  Consolidated Statements of Cash Flows (unaudited) for the six months ended  June 30, 2007 and 2006 |   |   |
|                                |                          |          |   |   |   |
|                                |                          |          | Notes to  Condensed Consolidated Financial Statements (unaudited) |   |   |
|                                |                          |          |   |   |   |
|                                | Item 2.                       |          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |   |
|                                |                          |          |   |   |   |
|                                | Item 3.                       |          | Quantitative  and Qualitative Disclosures About Market Risk |   |   |
|                                |                          |          |   |   |   |
|                                | Item 4.                       |          | Controls and  Procedures |   |   |
|                                |                          |          |   |   |   |
| Part II. Other  Information    |                          |          |
|                                |                          |          |   |   |   |
|                                | Item 1.                       |          | Legal Proceedings |   |   |
|                                |                          |          |   |   |   |
|                                | Item  1A.                     | Risk  Factors |   |   |
|                                |                          |          |   |   |   |
|                                | Item 2.                       |          | Unregistered  Sales of Equity Securities and Use of Proceeds |   |   |
|                                |                          |          |   |   |   |
|                                | Item 3.                       |          | Defaults  Upon Senior Securities |   |   |
|                                |                          |          |   |   |   |
|                                | Item 4.                       |          | Submission  of Matters to a Vote of Security Holders |   |   |
|                                |                          |          |   |   |   |
|                                | Item 5.                       |          | Other Information |   |   |
|                                |                          |          |   |   |   |
|                                | Item  6.                      |          | Exhibits |   |   |
|                                |                          |          |   |   |   |
| Signatures                          |                          |          |
|                                |                          |          |   |
| Exhibit Index                  |                          |          |   |   |
|                                     |                               |               |  |  |  |  |  |

 

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**PART I. FINANCIALINFORMATION**

**Item1.   Financial Statements**

**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                    | ** ** | **June 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **(unaudited)**             | ** **  | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                                    |       |                        |        |                            |       |
| Current assets:                                                                                                                                                                               |       |                        |        |                            |       |
| Cash and cash  equivalents                                                                                                                                                                    |       | $                           | 16,361,458  |                            | $          | 22,881,553 |   |
| Restricted cash                                                                                                                                                                               |       | —                      |        | 11,738,871                      |       |
| Accounts  receivable, net of allowance for doubtful accounts of $325,697 and $191,569  as of June 30, 2007 and December 31, 2006, respectively                                                |       | 29,441,713                  |        | 37,452,008                      |       |
| Unbilled  receivables                                                                                                                                                                         |       | 16,417,133                  |        | 14,950,591                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                    |       | 2,852,020                   |        | 3,251,642                       |       |
| Prepaid income  taxes                                                                                                                                                                         |       | 5,390,678                   |        | 1,790,828                       |       |
| Deferred tax  assets                                                                                                                                                                          |       | 605,198                     |        | 571,835                         |       |
| Assets of  discontinued operations                                                                                                                                                            |       | —                      |        | 5,014,936                       |       |
| Total current  assets                                                                                                                                                                         |       | 71,068,200                  |        | 97,652,264                      |       |
|                                                                                                                                                                                          |       |                        |        |                            |       |
| Property and equipment,  net                                                                                                                                                                  |       | 18,880,496                  |        | 19,621,749                      |       |
| Goodwill                                                                                                                                                                                      |       | 70,008,616                  |        | 69,843,468                      |       |
| Intangible assets, net                                                                                                                                                                        |       | 71,820,124                  |        | 74,293,680                      |       |
| Other assets, net                                                                                                                                                                             |       | 1,466,528                   |        | 1,501,430                       |       |
|                                                                                                                                                                                          |       |                        |        |                            |       |
| Total assets                                                                                                                                                                                  |       | $                           | 233,243,964 |                            | $          | 262,912,591 |   |
|                                                                                                                                                                                          |       |                        |        |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                |       |                        |        |                            |       |
| Current liabilities:                                                                                                                                                                          |       |                        |        |                            |       |
| Long term debt  and capital lease obligations, current portion                                                                                                                                |       | $                           | 742,975     |                            | $          | 928,633 |   |
| Accounts payable  and accrued expenses                                                                                                                                                        |       | 14,745,339                  |        | 22,831,882                      |       |
| Servicer escrow  liability                                                                                                                                                                    |       | —                      |        | 11,738,871                      |       |
| Liabilities of  discontinued operations                                                                                                                                                       |       | —                      |        | 18,880                          |       |
| Total current  liabilities                                                                                                                                                                    |       | 15,488,314                  |        | 35,518,266                      |       |
|                                                                                                                                                                                          |       |                        |        |                            |       |
| Long-term debt and  capital lease obligations, net of current portion                                                                                                                         |       | 54,030,528                  |        | 64,423,566                      |       |
| Deferred tax  liabilities                                                                                                                                                                     |       | 3,500,141                   |        | 4,088,816                       |       |
| Deferred revenue                                                                                                                                                                              |       | 283,031                     |        | 203,729                         |       |
| Deferred rent                                                                                                                                                                                 |       | 1,676,349                   |        | 949,165                         |       |
| Other long-term  liabilities                                                                                                                                                                  |       | 2,136,506                   |        | —                          |       |
|                                                                                                                                                                                          |       |                        |        |                            |       |
| Total  liabilities                                                                                                                                                                            |       | 77,114,869                  |        | 105,183,542                     |       |
|                                                                                                                                                                                          |       |                        |        |                            |       |
| Commitments and  contingencies                                                                                                                                                                |       |                        |        |                            |       |
|                                                                                                                                                                                          |       |                        |        |                            |       |
| Stockholders’ equity:                                                                                                                                                                    |       |                        |        |                            |       |
| Common stock,  par value $0.01 per share, 150,000,000 shares authorized and 21,105,813 and  20,688,556 shares issued and outstanding as of June 30, 2007 and December 31,  2006, respectively |       | 211,059                     |        | 206,886                         |       |
| Additional  paid-in capital                                                                                                                                                                   |       | 144,048,866                 |        | 141,255,632                     |       |
| Retained  earnings                                                                                                                                                                            |       | 11,829,708                  |        | 16,266,531                      |       |
| Accumulated  other comprehensive income, net of tax                                                                                                                                           |       | 39,462                      |        | —                          |       |
| Total  stockholders’ equity                                                                                                                                                              |       | 156,129,095                 |        | 157,729,049                     |       |
| Total liabilities and  stockholder’ equity                                                                                                                                               |       | $                           | 233,243,964 |                            | $          | 262,912,591 |   |

 

The accompanying notes are an integral part of thesestatements.

1

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**
| ** **                                                                                                   | ** ** | **For the three months ended June 30,** | ** ** | **For the six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2007**                                                              | ** ** | **2006**                                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Revenue                                                                                                      |       | $                                                                     | 43,153,459 |                                                                | $          | 59,897,052 |   | $ | 96,505,624 |   | $ | 113,841,981 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Cost of  services:                                                                                           |       |                                                                  |       |                                                                |       |   |   |   |   |
| Compensation expense                                                                                         |       | 20,205,613                                                            |       | 29,098,804                                                          |       | 45,925,806 |   | 57,609,954 |   |
| Travel and related expenses                                                                                  |       | 3,546,523                                                             |       | 6,753,220                                                           |       | 9,090,073 |   | 13,879,788 |   |
| Other direct costs                                                                                           |       | 1,534,270                                                             |       | 3,035,020                                                           |       | 4,011,630 |   | 5,368,432 |   |
| Total cost of services                                                                                       |       | 25,286,406                                                            |       | 38,887,044                                                          |       | 59,027,509 |   | 76,858,174 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Gross profit                                                                                                 |       | 17,867,053                                                            |       | 21,010,008                                                          |       | 37,478,115 |   | 36,983,807 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Operating expenses:                                                                                          |       |                                                                  |       |                                                                |       |   |   |   |   |
| Salaries and benefits                                                                                        |       | 5,524,916                                                             |       | 5,087,032                                                           |       | 11,196,490 |   | 10,115,422 |   |
| Other selling, general and administrative expenses                                                           |       | 5,596,633                                                             |       | 4,539,709                                                           |       | 11,029,791 |   | 9,163,235 |   |
| Depreciation and amortization                                                                                |       | 2,432,600                                                             |       | 1,864,260                                                           |       | 4,487,608 |   | 3,365,728 |   |
| Amortization of intangibles                                                                                  |       | 2,571,240                                                             |       | 2,541,870                                                           |       | 5,068,985 |   | 5,083,722 |   |
| Total operating expenses                                                                                     |       | 16,125,389                                                            |       | 14,032,871                                                          |       | 31,782,874 |   | 27,728,107 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income from operations                                                                                       |       | 1,741,664                                                             |       | 6,977,137                                                           |       | 5,695,241 |   | 9,255,700 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Interest expense,  net                                                                                       |       | 1,022,070                                                             |       | 1,659,653                                                           |       | 2,214,012 |   | 4,724,235 |   |
| Loss from  extinguishment of debt                                                                            |       | 45,289                                                                |       | —                                                              |       | 90,332 |   | 746,002 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income from  continuing operations before income taxes                                                       |       | 674,305                                                               |       | 5,317,484                                                           |       | 3,390,897 |   | 3,785,463 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income tax  expense                                                                                          |       | 207,143                                                               |       | 2,103,274                                                           |       | 1,294,302 |   | 1,459,267 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income from  continuing operations                                                                           |       | 467,162                                                               |       | 3,214,210                                                           |       | 2,096,595 |   | 2,326,196 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Loss from  discontinued operations:                                                                          |       |                                                                  |       |                                                                |       |   |   |   |   |
| Loss from operations (net of income tax benefit of  $221,251, $624,749, $810,058 and $761,719, respectively) |       | (434,918                                                              | )          | (862,752                                                            | )          | (1,402,994 | ) | (1,051,897 | ) |
| Loss on disposal (net of income tax benefit of  $131,653 and $1,922,724, respectively)                       |       | (385,718                                                              | )          | —                                                              |       | (3,330,424 | ) | — |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Net (loss) income                                                                                            |       | $                                                                     | (353,474   | )                                                                   | $          | 2,351,458 |   | $ | (2,636,823 | ) | $ | 1,274,299 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Basic income  (loss) per share:                                                                              |       |                                                                  |       |                                                                |       |   |   |   |   |
| Continuing operations                                                                                        |       | $                                                                     | 0.02       |                                                                | $          | 0.15 |   | $ | 0.10 |   | $ | 0.14 |   |
| Discontinued operations                                                                                      |       | (0.04                                                                 | )          | (0.04                                                               | )          | (0.23 | ) | (0.06 | ) |
| Total                                                                                                        |       | $                                                                     | (0.02      | )                                                                   | $          | 0.11 |   | $ | (0.13 | ) | $ | 0.08 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Diluted income  (loss) per share:                                                                            |       |                                                                  |       |                                                                |       |   |   |   |   |
| Continuing operations                                                                                        |       | $                                                                     | 0.02       |                                                                | $          | 0.15 |   | $ | 0.10 |   | $ | 0.13 |   |
| Discontinued operations                                                                                      |       | (0.04                                                                 | )          | (0.04                                                               | )          | (0.23 | ) | (0.06 | ) |
| Total                                                                                                        |       | $                                                                     | (0.02      | )                                                                   | $          | 0.11 |   | $ | (0.13 | ) | $ | 0.07 |   |
|                                                                                                         |       |                                                                  |       |                                                                |       |   |   |   |   |
| Weighted average  shares outstanding:                                                                        |       |                                                                  |       |                                                                |       |   |   |   |   |
| Basic                                                                                                        |       | 20,926,048                                                            |       | 20,522,449                                                          |       | 20,860,989 |   | 16,373,676 |   |
| Diluted                                                                                                      |       | 21,513,975                                                            |       | 21,522,106                                                          |       | 21,574,185 |   | 17,302,704 |   |

 

The accompanying notes are an integral part of thesestatements.

2

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**(unaudited)**
| ** **                                                                                                     | ** ** | **Common Stock** | ** ** | **Additional paid  in capital** | ** ** | **Accumulated Other  Comprehensive  Income** | ** ** | **Retained   Earnings** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------------------------|------------|---------------------------------------------------|------------|------------------------------|------------|------------|------------|
| ** **                                                                                                     | ** ** | **Number**            | ** ** | ** **                                | ** ** | ** **                                        | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                     | ** ** | **of shares**    | ** ** | **Value**                                 | ** ** |
| ** **                                                                                                     | ** ** | ** **            | ** ** | ** **                                | ** ** | ** **                                        | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, January  1, 2007                                                                                      |       | 20,688,556            |       | $                                         | 206,886    |                                              | $          | 141,255,632                  |       | $          | —     |   | $ | 16,266,531 |   | $ | 157,729,049 |   |
|                                                                                                           |       |                  |       |                                      |       |                                              |       |                         |       |       |       |   |   |
| Adjustment for  the cumulative effect as of January 1, 2007 on prior years of the adoption of  FIN 48 (Note 9) |       | —                |       | —                                    |       | —                                            |       | —                       |       | (1,800,000 | )          | (1,800,000 | ) |
|                                                                                                           |       |                  |       |                                      |       |                                              |       |                         |       |       |       |   |   |
| Stock based  compensation                                                                                      |       | 156,350               |       | 1,564                                     |       | 639,047                                           |       | —                       |       | —     |       | 640,611 |   |
|                                                                                                           |       |                  |       |                                      |       |                                              |       |                         |       |       |       |   |   |
| Exercise of stock  options                                                                                     |       | 260,907               |       | 2,609                                     |       | 911,291                                           |       | —                       |       | —     |       | 913,900 |   |
|                                                                                                           |       |                  |       |                                      |       |                                              |       |                         |       |       |       |   |   |
| Tax benefit of  options exercised                                                                              |       | —                |       | —                                    |       | 1,242,896                                         |       | —                       |       | —     |       | 1,242,896 |   |
|                                                                                                           |       |                  |       |                                      |       |                                              |       |                         |       |       |       |   |   |
| Other  comprehensive income                                                                                    |       | —                |       | —                                    |       | —                                            |       | 39,462                       |       | —     |       | 39,462 |   |
|                                                                                                           |       |                  |       |                                      |       |                                              |       |                         |       |       |       |   |   |
| Net loss for the  six months ended June 30, 2007                                                               |       | —                |       | —                                    |       | —                                            |       | —                       |       | (2,636,823 | )          | (2,636,823 | ) |
|                                                                                                           |       |                  |       |                                      |       |                                              |       |                         |       |       |       |   |   |
| Balance, June 30, 2007                                                                                         |       | 21,105,813            |       | $                                         | 211,059    |                                              | $          | 144,048,866                  |       | $          | 39,462     |   | $ | 11,829,708 |   | $ | 156,129,095 |   |

 

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME**

**(unaudited)**
| ** **                                            | ** ** | **For the three months ended June 30,** | ** ** | **For the six months ended June 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                            | ** ** | **2007**                                                              | ** ** | **2006**                                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                                                  |       |                                                                |       |   |   |   |   |
| Net (loss)  income                                    |       | $                                                                     | (353,474   | )                                                                   | $          | 2,351,458 |   | $ | (2,636,823 | ) | $ | 1,274,299 |   |
| Foreign currency  translation adjustments, net of tax |       | 39,462                                                                |       | —                                                              |       | 39,462 |   | — |   |
| Total  comprehesive (loss) income                     |       | $                                                                     | (314,012   | )                                                                   | $          | 2,351,458 |   | $ | (2,597,361 | ) | $ | 1,274,299 |   |

 

The accompanying notes are an integral part ofthese statements.

3

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                               | ** ** | **For the six months ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2007**                                                            | ** ** | **2006** | ** ** |
|                                                                                     |       |                                                                |       |   |   |
| Cash flows from  operating activities:                                                   |       |                                                                |       |   |   |
| Net (loss) income                                                                        |       | $                                                                   | (2,636,823 | ) | $ | 1,274,299 |   |
| Add: Loss on disposal of discontinued operations                                         |       | 3,330,424                                                           |       | — |   |
| Loss from discontinued operations                                                        |       | 1,402,994                                                           |       | 1,051,897 |   |
| Adjustments to reconcile net (loss) income to net  cash provided by operating activities |       |                                                                |       |   |   |
| Depreciation and amortization                                                            |       | 4,487,608                                                           |       | 3,365,728 |   |
| Amortization of intangibles                                                              |       | 5,068,985                                                           |       | 5,083,722 |   |
| Amortization of debt issuance cost                                                       |       | 132,983                                                             |       | 187,488 |   |
| Adoption of FIN 48                                                                       |       | 336,506                                                             |       | — |   |
| Loss from extinguishment of debt                                                         |       | 90,332                                                              |       | 746,002 |   |
| Stock based compensation                                                                 |       | 640,611                                                             |       | 853,314 |   |
| Deferred income taxes                                                                    |       | (733,390                                                            | )          | 67,977 |   |
| Loss (gain) on sale of fixed assets                                                      |       | 30,004                                                              |       | (2,095 | ) |
| Provision for doubtful accounts                                                          |       | 545,945                                                             |       | 208,962 |   |
| Changes in operating assets and liabilities, net of  business combinations:              |       |                                                                |       |   |   |
| Accounts receivable                                                                      |       | 6,878,927                                                           |       | (264,142 | ) |
| Unbilled receivables                                                                     |       | (1,465,760                                                          | )          | (1,797,642 | ) |
| Prepaid expenses and other current assets                                                |       | 380,846                                                             |       | 907,728 |   |
| Prepaid income taxes                                                                     |       | (755,752                                                            | )          | 753,095 |   |
| Due to an affiliated entity                                                              |       | —                                                              |       | 23,434 |   |
| Other assets, net                                                                        |       | (129,107                                                            | )          | (89,253 | ) |
| Accounts payable and accrued expenses                                                    |       | (9,729,571                                                          | )          | (2,157,492 | ) |
| Deferred revenue                                                                         |       | (91,373                                                             | )          | (605,882 | ) |
| Deferred rent                                                                            |       | 727,184                                                             |       | 12,120 |   |
| Net cash provided by operating activities                                                |       | 8,511,573                                                           |       | 9,619,260 |   |
|                                                                                     |       |                                                                |       |   |   |
| Cash flows from  investing activities:                                                   |       |                                                                |       |   |   |
| Proceeds from sale of fixed assets                                                       |       | 23,968                                                              |       | 35,000 |   |
| Capital expenditures                                                                     |       | (3,999,677                                                          | )          | (5,349,916 | ) |
| Acquisition of businesses                                                                |       | (2,959,829                                                          | )          | (6,120,010 | ) |
| Cash held in escrow from acquisition of businesses  inclusive of interest earned         |       | —                                                              |       | (603,247 | ) |
| Net cash used in investing activities                                                    |       | (6,935,538                                                          | )          | (12,038,173 | ) |
|                                                                                     |       |                                                                |       |   |   |
| Cash flows from  financing activities:                                                   |       |                                                                |       |   |   |
| Proceeds from revolving credit facility                                                  |       | —                                                              |       | 7,400,000 |   |
| Repayments of revolving credit facility                                                  |       | —                                                              |       | (7,400,000 | ) |
| Repayments of capital lease obligations                                                  |       | (77,423                                                             | )          | (69,657 | ) |
| Repayment of term loan                                                                   |       | (10,312,810                                                         | )          | (70,200,501 | ) |
| Deferred charges related to the issuance of debt                                         |       | (59,305                                                             | )          | (124,158 | ) |
| Proceeds from issuance of common stock upon initial  public offering                     |       | —                                                              |       | 146,625,000 |   |
| Underwriting commisssions and offering expenses                                          |       | —                                                              |       | (14,795,756 | ) |
| Redemption of convertible preferred stock                                                |       | —                                                              |       | (52,764,950 | ) |
| Excess tax benefits from share-based payment  arrangements                               |       | 1,242,896                                                           |       | — |   |
| Proceeds from the exercise of stock options                                              |       | 913,900                                                             |       | 26,000 |   |
| Net cash (used in) provided by financing activities                                      |       | (8,292,742                                                          | )          | 8,695,978 |   |
|                                                                                     |       |                                                                |       |   |   |
| Cash flows from  discontinued operations (revised - see Note 3):                         |       |                                                                |       |   |   |
| Operating cash flows                                                                     |       | 382,814                                                             |       | (2,171,314 | ) |
| Investing cash flows                                                                     |       | —                                                              |       | (81,576 | ) |
| Financing cash flows                                                                     |       | (188,463                                                            | )          | (77,559 | ) |
|                                                                                     |       |                                                                |       |   |   |
|                                                                                     |       | 194,351                                                             |       | (2,330,449 | ) |
|                                                                                     |       |                                                                |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                            |       | 2,261                                                               |       | — |   |
|                                                                                     |       |                                                                |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                     |       | (6,520,095                                                          | )          | 3,946,616 |   |
|                                                                                     |       |                                                                |       |   |   |
| Cash and cash equivalents  at the beginning of the period                                |       | 22,881,553                                                          |       | 7,208,875 |   |
|                                                                                     |       |                                                                |       |   |   |
| Cash and cash  equivalents at the end of the period                                      |       | $                                                                   | 16,361,458 |   | $ | 11,155,491 |   |

 

The accompanying notes are an integral part ofthese statements.

4

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| ** **                                           | ** ** | **For the six months ended June 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                                            | ** ** | **2006** | ** ** |
|                                                 |       |                                                                |       |   |   |
| Supplementary  disclosures of cash flow information: |       |                                                                |       |   |   |
| Cash paid during the period for:                     |       |                                                                |       |   |   |
|                                                 |       |                                                                |       |   |   |
| Income taxes                                         |       | $                                                                   | 451,941    |   | $ | 661,418 |   |
|                                                 |       |                                                                |       |   |   |
| Interest                                             |       | $                                                                   | 2,524,707  |   | $ | 4,209,919 |   |
|                                                 |       |                                                                |       |   |   |
| Other noncash  investing and financing activities:   |       |                                                                |       |   |   |
| Assets acquired under capital lease                  |       | $                                                                   | —     |   | $ | 220,279 |   |
| Liabilities assumed from acquisitions                |       | $                                                                   | 964,049    |   | $ | 1,013,143 |   |

 

The accompanying notes are an integral part ofthese statements.

5

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

**Note 1—Organization, Description of Business and Basis ofPresentation**

Clayton Holdings, Inc. (collectively with itswholly owned subsidiaries, the “Company”) was formed on March 31, 2005 asa Delaware corporation. The Company was formed to combine two companies whichwere 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.

The Company provides a full suite of outsourcedservices, information-based analytics and specialty consulting for buyers andsellers of, and investors in, mortgage-related loans and securities and other debtinstruments. The Company’s services include (i) transaction management, whichconsists of due diligence, conduit support services, professional staffingservices, and compliance products and services, (ii) credit risk management andsecurities surveillance and (iii) 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 of Presentation***

The accompanying condensed consolidated financialstatements are unaudited. In the opinion of management, all adjustments,consisting of only normal recurring adjustments considered necessary for a fairpresentation, have been included. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States (“US GAAP”) havebeen condensed or omitted. It is suggested that these unaudited condensedconsolidated financial statements be read in conjunction with the consolidatedfinancial statements, accounting policies and notes included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2006, which includesaudited financial statements. Results for the interim periods are notnecessarily indicative of results for the full year.

***Initial Public Offering of Common Stock***

On March 29, 2006, the Company sold8,625,000 shares, inclusive of an over-allotment option 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 andapproximately $4,500,000 of offering expenses. The Company used approximately$130,200,000 of the proceeds to pay down indebtedness and to redeem alloutstanding shares of redeemable preferred stock, which were issued upon theconversion of the Company’s convertible preferred stock. The Company usedthe remaining approximately $1,600,000 for general corporate purposes. Aftergiving effect to this offering, the Company had 20,516,306 shares ofcommon stock outstanding.

Allshare information has been adjusted to reflect a 1-for-4 reverse stock split ofcommon stock and class B common stock, which was consummated onMarch 1, 2006.

**Note 2—Summary of Significant Accounting Policies**

Significant accounting policies followed by theCompany, as summarized below, are in conformity with US GAAP.

6

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***Principles of Consolidation***

The consolidated financial statements include theaccounts of the Company. All significant intercompany transactions and balanceshave been eliminated in consolidation.

***Use of Estimates***

The preparation of consolidated financial statementsin conformity with US GAAP requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses, as well as the disclosure of contingent assets and liabilities inthe financial statements and accompanying notes. Some of these 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,the Company cannot give assurance that actual results will not differsignificantly from estimated results. Management bases these judgments on theCompany’s historical experience, management’s forecasts and other availableinformation, as appropriate. The most significant estimates reflected in thefinancial statements include deferred tax assets and liabilities, income taxaccruals, valuation allowance for accounts receivable, unbilled receivables,asset impairments, the valuation of stock options and the valuation of intangibleassets and assessments of their useful lives, and related party transactions.Actual results could differ from estimated amounts. The Company also makesestimates in determining other ordinary accruals.

***Segment Reporting***

The Company hasthree reportable segments which are operated and managed as strategic businessunits: Transaction Management, Special Servicing and Surveillance.  For more information concerning thesebusiness segments, see Note 14.

***Accounts Receivable and Allowance for Doubtful Accounts***

The Company’saccounts receivable are due from customers in the normal course of business.Credit decisions are made based on an evaluation of a customers’ financialcondition. Accounts receivable are generally due within 30 days. Interest isnot charged on delinquent payments.

The Company makesestimates to determine the amount of the allowance for doubtful accountsnecessary to reduce accounts receivable and unbilled receivables to theirexpected net realizable value. The Company estimates the amount of the requiredallowance by reviewing the status of significant past-due receivables and byanalyzing historical bad debt trends and realization adjustments to revenue.Actual collection experience has not varied significantly from estimates, due primarilyto credit policies, the controls and procedures designed to estimaterealization adjustments to revenue and a lack of concentrations of accountsreceivable. Accounts receivable balances are not collateralized.

***Deferred Financing Costs***

TheCompany amortizes the costs that it incurs to obtain debt financing over theterms of the underlying obligations using the effective interest method for theportion of the costs associated with term loan debt and using the straight linemethod for the portion of the costs associated with the revolving creditfacility. The amortization of deferred financing costs is included in interestexpense. Unamortized deferred financing costs are included in “other assets,net” in the accompanying condensed consolidated balance sheets. On February 5,2007 and on May 4, 2007, the Company repaid $5,000,000 of its outstanding termloan balance on each date and wrote off a proportionate share of theunamortized deferred financing costs associated with the term loan.  There were no penalties associated with thisrepayment.  In addition, as a result ofthe Company’s IPO (see Note 1) on March 29, 2006, the Company repaid$70,000,000 of principal on its $150,000,000 term loan and wrote off aproportionate share of the unamortized deferred financing costs associated withthe term loan. Losses on extinguishment of $90,332 and $746,002 reflectingthese write-offs are reflected in the statements of operations for the sixmonths ended June 30, 2007 and 2006, respectively. Unamortized deferred financingcosts at June 30, 2007 and December 31, 2006 were $1,123,714 and$1,287,694, respectively, and are included on the accompanying consolidatedbalance sheets in “other assets, net.”

7

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***Escrow andFiduciary Funds***

The Company maintains segregated bank accounts intrust for the benefit of clients for payments on mortgage loans serviced forclients. The Company also maintains bank accounts for the benefit of borrowers’property tax and hazard insurance premium payments that are escrowed byborrowers. These bank accounts totaled $22,626,421 at June 30, 2007, and havebeen excluded from the Company’s assets and liabilities effective January 1,2007, because the Company does not have title to or use of the funds.  The Company believes this treatment ispreferential because it more accurately represents the operations and cashposition of the Company.

At December 31, 2006, the Company maintained arestricted cash balance of $11,738,871. This balance represented funds receivedin connection with certain loan servicing functions the Company performs for acustomer. Such funds are received throughout the month and remitted to thecustomer on a monthly basis. The balance on hand is included in servicer escrowliability in the accompanying condensed consolidated balance sheet at December31, 2006.

***Revenue Recognition***

Revenue is recognized when persuasive evidence of anarrangement exists, the service has been performed, the fee is fixed anddeterminable, and collection of the resulting receivable is reasonably assured.

The Company derives most of its revenues fromprofessional service activities.  Revenues consisting of billed fees andpass-through expenses are recorded as work is performed and expenses areincurred. Revenues also include expenses billed to clients, which includestravel and other out-of-pocket expenses, and other reimbursable expenses. Basedon aggregate volume of all travel expenses incurred for both corporate purposesand client service activities, the Company is eligible to receive certainretroactive volume discounts from several of its travel providers. Such amountsare accrued as earned, are netted against travel and related expenses andhistorically have not been material.  For the three months ended June 30,2007 and 2006, pass-through expenses included in revenues were $3,546,523 and$6,753,220, respectively.  For the sixmonths ended June 30, 2007 and 2006, pass-through expenses included in revenueswere $9,090,073 and $13,879,788, respectively.

The Company records provisions for fee adjustments anddiscretionary pricing adjustments as a reduction of revenues. Revenuesrecognized, but not yet billed to clients, have been recorded as unbilledreceivables in the accompanying condensed consolidated balance sheets.

***Cost of Services***

Direct cost of operationsconsists primarily of employee compensation and related payroll benefits, thecost of billable labor assigned to revenue-generating activities as well ascorresponding travel and related expenses incurred in providing such servicesto clients. Direct cost of operations does not include an allocation ofoverhead costs.

***Income Taxes***

The Companyrecognizes deferred income tax liabilities and assets for the expected futuretax consequences of events that have been included in the financial statementsor tax returns. Deferred income tax liabilities and assets are determined basedon the difference between the financial statement and the tax basis of assetsand liabilities using enacted tax rates in effect for the year in which thedifferences are expected to reverse. The Company recognizes deferred tax assetsif it is more likely than not that the assets will be realized in future yearsand a valuation allowance on the deferred tax assets if they are deemed to beimpaired.

The Company adopted FASB Interpretation (“FIN”) No.48, “Accounting for Uncertainty in Income Taxes,” on January 1, 2007 (see Note9).

8

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***Stock-based Compensation***

The Companyadopted the fair value measurement provisions of SFAS No. 123(R), “Share-BasedPayment,” using the prospective method under which the Company recognizes thecompensation expense of a stock-based award to an employee over the vestingperiod based on the fair value of the award on the grant date consistent withthe method described in Note 13.

***Concentration of Credit Risk andSignificant Customers***

At June 30, 2007, 21.8% and 20.4% of the Company’sbilled and unbilled receivables were related to its two largest clients,respectively. At December 31, 2006, 23.1% and 29.2% of the Company’sbilled and unbilled receivables, respectively, were related to its two largestclients.

For the three months ended June 30, 2007 and 2006,revenue from the Company’s largest two clients accounted for an aggregate of18.8% and 27.4% of total revenue, respectively. Revenue from one client exceeded 10% of revenue for the three monthsended June 30, 2007.  Revenue from twoclients exceeded 10% of revenue for the three months ended June 30, 2006.  This revenue is primarily associated with theTransaction Management segment.

For the six months ended June 30, 2007 and 2006,revenue from the Company’s largest two clients accounted for an aggregate of20.0% and 26.5% of total revenue, respectively. Revenue from one clientexceeded 10% of revenue for the six months ended June 30, 2007.  Revenue from two clients exceeded 10% ofrevenue for the six months ended June 30, 2006. This revenue is primarilyassociated with the Transaction Management segment.

***Earnings Per Share***

Basic earnings per share is computed by dividing net(loss) income by the weighted-average number of shares of common stock andcommon stock equivalents outstanding during the period.  Diluted earnings per share gives effect todilutive options, restricted stock awards and units, and other potential commonstock outstanding during the period.  At June 30, 2007, outstandingoptions to purchase 52,500 and 37,500 common shares had exercise prices inexcess of the average market price of common shares for the three and six monthperiods ended June 30, 2007.  At June 30, 2006, outstanding options topurchase 28,000 and 130,000 common shares had exercise prices in excess of theaverage market price of common shares for the three and six month periods endedJune 30, 2006.  These options were not included in the computation ofdiluted earnings per share for the respective periods because the effect wouldbe antidilutive.

At June 30, 2007, 156,350 shares of restricted stockare excluded from basic weighted average shares of common stock outstanding andincluded in dilutive shares of common stock using the treasury stockmethod.  Such shares will be included inbasic weighted average shares of common stock outstanding when they are nolonger contingent upon the satisfaction of all specified conditions.  In addition, at June 30, 2007, 15,476deferred stock units issued under the Company’s Non-Employee Directors’Compensation Plan have not been included in the diluted earnings per sharecalculation because their inclusion would have had an antidilutive effect.

9

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The following table presents a reconciliation of thenumerators and denominators of basic and diluted earnings per share for thethree and six months ended June 30, 2007 and 2006:
| ** **                                                  | ** ** | **For the three months ended** | ** ** | **For the three months ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                  | ** ** | **June 30, 2007**                        | ** ** | **June 30, 2006**                        | ** ** |
| ** **                                                  | ** ** | **Basic**                                          | ** ** | **Diluted**                                        | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Income from  continuing operations                          |       | $                                                  | 467,162    |                                               | $          | 467,162 |   | $ | 3,214,210 |   | $ | 3,214,210 |   |
| Loss from  discontinued operations                          |       | (820,636                                           | )          | (820,636                                           | )          | (862,752 | ) | (862,752 | ) |
| Net (loss)  income                                          |       | $                                                  | (353,474   | )                                                  | $          | (353,474 | ) | $ | 2,351,458 |   | $ | 2,351,458 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Weighted average  number of common shares outstanding       |       | 20,926,048                                         |       | 20,926,048                                         |       | 20,522,449 |   | 20,522,449 |   |
| Effect of  dilutive shares                                  |       | —                                             |       | 587,927                                            |       | — |   | 999,657 |   |
| Total weighted  average number of common shares outstanding |       | 20,926,048                                         |       | 21,513,975                                         |       | 20,522,449 |   | 21,522,106 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Income per share  from continuing operations                |       | $                                                  | 0.02       |                                               | $          | 0.02 |   | $ | 0.15 |   | $ | 0.15 |   |
| Loss per share  from discontinued operations                |       | (0.04                                              | )          | (0.04                                              | )          | (0.04 | ) | (0.04 | ) |
| Net (loss) income per  share                                |       | $                                                  | (0.02      | )                                                  | $          | (0.02 | ) | $ | 0.11 |   | $ | 0.11 |   |

 
| ** **                                                  | ** ** | **For the six months ended** | ** ** | **For the six months ended** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                  | ** ** | **June 30, 2007**                      | ** ** | **June 30, 2006**                      | ** ** |
| ** **                                                  | ** ** | **Basic**                                        | ** ** | **Diluted**                                      | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                        |       |                                             |       |                                             |       |   |   |   |   |
| Income from  continuing operations                          |       | $                                                | 2,096,595  |                                             | $          | 2,096,595 |   | $ | 2,326,196 |   | $ | 2,326,196 |   |
| Loss from  discontinued operations                          |       | (4,733,418                                       | )          | (4,733,418                                       | )          | (1,051,897 | ) | (1,051,897 | ) |
| Net (loss)  income                                          |       | $                                                | (2,636,823 | )                                                | $          | (2,636,823 | ) | $ | 1,274,299 |   | $ | 1,274,299 |   |
|                                                        |       |                                             |       |                                             |       |   |   |   |   |
| Weighted average  number of common shares outstanding       |       | 20,860,989                                       |       | 20,860,989                                       |       | 16,373,676 |   | 16,373,676 |   |
| Effect of  dilutive shares                                  |       | —                                           |       | 713,196                                          |       | — |   | 929,028 |   |
| Total weighted  average number of common shares outstanding |       | 20,860,989                                       |       | 21,574,185                                       |       | 16,373,676 |   | 17,302,704 |   |
|                                                        |       |                                             |       |                                             |       |   |   |   |   |
| Income per share  from continuing operations                |       | $                                                | 0.10       |                                             | $          | 0.10 |   | $ | 0.14 |   | $ | 0.13 |   |
| Loss per share  from discontinued operations                |       | (0.23                                            | )          | (0.23                                            | )          | (0.06 | ) | (0.06 | ) |
| Net (loss) income per  share                                |       | $                                                | (0.13      | )                                                | $          | (0.13 | ) | $ | 0.08 |   | $ | 0.07 |   |

 

***Adoption of New Accounting Pronouncements***

The Company adopted FASB Interpretation (“FIN”) No. 48,“Accounting for Uncertainty in Income Taxes,” on January 1, 2007 (see Note 9).

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.”   SFAS No. 157establishes a common definition for fair value to be applied to US GAAPguidance requiring use of fair value, establishes a framework for measuringfair value, and expands disclosure about such fair value measurements. SFAS No.157 is effective for fiscal years beginning after November 15, 2007. TheCompany is currently assessing the impact of SFAS No. 157 on its consolidatedfinancial position and results of operations.

***Foreign Currency Translation***

The functional currency for Clayton’s foreignoperations is the local currency.   TheCompany translates income statement amounts at average exchange rates for theperiod, and assets and liabilities are translated at end-of-period exchangerates.  These translation adjustments arerecorded in Accumulated Other Comprehensive Income, a separate component ofStockholders’ Equity, in the Company’s consolidated balance sheets.  Exchange gains and losses on intercompanyforeign currency transactions of a long-term nature are reported in AccumulatedOther Comprehensive Income.  Otherexchange gains and losses are reported in income.

***Reclassifications***

Certain reclassifications have been made to priorperiods’ financial statements to conform to the current year presentation.  These reclassifications had no effect onpreviously reported results of operations or retained earnings.

10

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**Note 3—Recent Transactions**

***Acquisition of Euro Risk ManagementLimited, Bristol***

On April 10, 2007, the Company completed theacquisition of Euro Risk Management Limited, Bristol, (subsequently renamedClayton Euro Risk (“CER”)) a credit and risk consultancy operating in theUnited Kingdom, Italy and Holland for an aggregate purchase price of$2,959,829. Dependant on the exchange rate at the time of payment, the purchaseprice may be increased by up to an additional $2,500,000 based on futureearnings.  This acquisition was not presentedon a pro forma basis because it was not deemed to be material.

The purchase price was allocated as follows:
| Accounts receivable                                |   | $         | 1,193,508 |   |
|----------------------------------------------------|--------|-----------|-----------|--------|
| Goodwill                                           |   | 163,298   |      |
| Intangible  assets – customer relationships   |   | 2,368,689 |      |
| Intangible  assets – noncompetition agreement |   | 198,383   |      |
| Liabilities  assumed                               |   | (964,049  | )         |
|                                               |   |      |      |
|                                               |   | $         | 2,959,829 |   |

 

***Asset Purchase fromM R Network I, Ltd.***

On February 3, 2006, the Company entered into anasset purchase agreement through a subsidiary pursuant to which the subsidiaryacquired substantially all of the assets and assumed certain liabilities ofM R Network I, Ltd. (formerly d/b/a Mortgage ResourceNetwork and thereafter d/b/a Clayton Lender Solutions, Inc. (“CLS”)) foran aggregate purchase price of $5,344,970. This acquisition was not presented on a pro forma basis because it wasnot deemed to be material.

The purchase price was allocated as follows:
| Accounts receivable                                |   | $          | 952,943   |   |
|----------------------------------------------------|--------|------------|-----------|--------|
| Prepaid expenses                                   |   | 19,030     |      |
| Property and  equipment                            |   | 957,792    |      |
|                                               |   |       |      |
| Goodwill                                           |   | 3,558,177  |      |
| Intangible  assets – customer relationships   |   | 771,000    |      |
| Intangible  assets – noncompetition agreement |   | 74,000     |      |
| Deposit                                            |   | 25,986     |      |
| Liabilities  assumed                               |   | (1,013,958 | )         |
|                                               |   |       |      |
|                                               |   | $          | 5,344,970 |   |

 

***Discontinued Operations***

On March 28, 2007, the Company’s Board ofDirectors approved the recommendation of management that it discontinue theoperations of CLS.  The pre-tax chargerecorded during the first quarter of 2007 in connection with the CLS shutdownwas $4,735,777 ($2,944,706, after tax) and consisted of a pre-tax non-cashimpairment charge related to the impairment of goodwill, intangible assets andproperty and equipment.  During thesecond quarter of 2007, the Company recorded a $517,371 pre-tax ($385,718,after tax) adjustment to the previously estimated loss on disposal whichconsisted of facility closure costs and the write off of property andequipment.  CLS ceased operations on June30, 2007.

In accordance with SFAS No. 144, any component of theCompany’s business that is disposed of or is classified as held for sale thathas operations and cash flows clearly distinguishable from operations, and forfinancial reporting purposes, and that will be eliminated from the ongoingoperations, should be classified as discontinued operations.  Accordingly, the Company has classified theresults of operations of CLS as discontinued operations in the consolidatedstatement of operations and has restated prior periods.

11

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Summarized financial information for CLS (discontinuedoperations) is set forth below:
| ** **                    | ** ** | **For the Three Months Ended June 30,** | ** ** | **For the Six Months Ended June 30,** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                                              | ** ** | **2006**                                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue                       |       | $                                                                     | 196,228    |                                                                | $          | 1,906,982 |   | $ | 739,626 |   | $ | 3,189,665 |   |
| Operating loss                |       | (647,440                                                              | )          | (1,458,117                                                          | )          | (2,171,496 | ) | (1,778,534 | ) |
| Income tax benefit            |       | 221,251                                                               |       | 624,749                                                             |       | 810,058 |   | 761,719 |   |
| Net loss                      |       | (434,918                                                              | )          | (862,752                                                            | )          | (1,402,994 | ) | (1,051,897 | ) |
| Loss on disposal, net  of tax |       | (385,718                                                              | )          | —                                                              |       | (3,330,424 | ) | — |   |
|                               |            |                                                                       |            |                                                                     |            |  |  |  |  |  |  |  |  |

 
|                                          | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|
| Net property and  equipment              |       | $                           | 743,117    |   |
| Goodwill                                 |       | 3,558,177                   |       |
| Other  intangibles                       |       | 713,642                     |       |
| Total assets of  discontinued operations |       | $                           | 5,014,936  |   |

 

AtDecember 31, 2006, liabilities of discontinued operations represent deferredrent.

**Note 4—Cash, Cash Equivalents and Restricted Cash**

At June 30, 2007 and December 31, 2006, theCompany maintained cash and cash equivalent balances in excess of $100,000 attwo separate financial institutions. Accounts at these institutions are insuredby the Federal Deposit Insurance Corporation up to $100,000. At June 30, 2007and December 31, 2006, the cash balances exceeded $100,000 by $17,455,479and $31,862,444, respectively, including restricted cash at December 31, 2006.

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

Property and equipment, net consists of the following:
|                                                 | ** ** | **June 30,  2007** | ** ** | **December 31,   2006** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------------------|------------|
|                                            |       |                    |       |                              |       |
| Computer and  office equipment                  |       | $                       | 11,299,483 |                              | $          | 10,013,262 |   |
| Software                                        |       | 18,035,158              |       | 17,461,869                        |       |
| Furniture and  fixtures                         |       | 3,304,040               |       | 3,105,350                         |       |
| Leasehold  improvements                         |       | 2,501,011               |       | 1,814,635                         |       |
| Website                                         |       | 280,317                 |       | 280,317                           |       |
| Automobiles                                     |       | 108,883                 |       | 112,336                           |       |
|                                            |       | 35,528,892              |       | 32,787,769                        |       |
| Less accumulated  depreciation and amortization |       | 17,914,157              |       | 13,748,487                        |       |
|                                            |       | 17,614,735              |       | 19,039,282                        |       |
| Construction in  progress                       |       | 1,016,292               |       | 65,925                            |       |
| Software under  development                     |       | 249,469                 |       | 516,542                           |       |
|                                            |       | $                       | 18,880,496 |                              | $          | 19,621,749 |   |

 

Included in software at June 30, 2007 andDecember 31, 2006, is $10,585,417 and $10,383,256, respectively, ofinternally developed software placed in service. Software under developmentrepresents other internally developed software that has not yet been placed inservice.

For the three months ended June 30, 2007 and 2006depreciation and amortization expense charged to operations was $2,432,600 and$1,864,260, respectively.  For the sixmonths ended June 30, 2007 and 2006 depreciation and amortization expensecharged to operations was $4,487,608 and $3,365,728, respectively.

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**Note 6—Goodwill and Other Intangible Assets**

As of June 30, 2007 and December 31, 2006,intangible assets not subject to amortization consisted of goodwill of$70,008,615 and $69,843,468, respectively, and trade names and trademarks of$15,504,917.

At June 30, 2007, the Company’s intangible assets withidentifiable useful lives, which continue to be amortized, consisted of thefollowing:
| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer  relationships             |       |                            |       |                          |       |       |       |
| Transaction management and advisory |       | $                               | 38,795,522 |                          | $          | 5,958,036  |       | $ | 32,837,486 |   |
| Staffing services                   |       | 4,300,000                       |       | 1,254,167                     |       | 3,045,833  |       |
| Portfolio management                |       | 10,008,599                      |       | 3,059,075                     |       | 6,949,524  |       |
| Client backlog                      |       | 2,146,200                       |       | 1,332,721                     |       | 813,479    |       |
| Technology                          |       | 26,842,900                      |       | 15,772,876                    |       | 11,070,024 |       |
| Noncompetition  agreements          |       | 3,695,580                       |       | 2,105,504                     |       | 1,590,076  |       |
| Patent                              |       | 20,452                          |       | 11,667                        |       | 8,785      |       |
|                                |       | $                               | 85,809,253 |                          | $          | 29,494,046 |       | $ | 56,315,207 |   |

 

At December 31, 2006, the Company’s intangibleassets with identifiable useful lives, which continue to be amortized,consisted of the following: 
| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer  relationships             |       |                            |       |                          |       |       |       |
| Transaction management and advisory |       | $                               | 36,400,000 |                          | $          | 4,887,037  |       | $ | 31,512,963 |   |
| Staffing services                   |       | 4,300,000                       |       | 1,039,167                     |       | 3,260,833  |       |
| Portfolio management                |       | 10,008,599                      |       | 2,548,308                     |       | 7,460,291  |       |
| Client backlog                      |       | 2,146,200                       |       | 1,118,101                     |       | 1,028,099  |       |
| Technology                          |       | 26,842,900                      |       | 13,088,586                    |       | 13,754,314 |       |
| Noncompetition  agreements          |       | 3,494,950                       |       | 1,734,880                     |       | 1,760,070  |       |
| Patent                              |       | 20,452                          |       | 8,259                         |       | 12,193     |       |
|                                |       | $                               | 83,213,101 |                          | $          | 24,424,338 |       | $ | 58,788,763 |   |

 

In connection with the CLS shutdown, in March 2007 theCompany recorded an impairment charge of $4,735,777 to reflect the write-off ofgoodwill and intangible assets.

In December 2006,the Company recorded an impairment charge of $279,458 to reflect the write-offof certain customer relationships associated with portfolio management.

Amortization expense for the three months ended June30, 2007 and 2006 was $2,571,240 and $2,541,870, respectively.  Amortization expense for the six months endedJune 30, 2007 and 2006 was $5,068,985 and $5,083,722, respectively.

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

Long-term debt and capital lease obligations consistof the following: 
|                                         | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Term loans                              |       | $                       | 54,286,188 |                        | $          | 64,598,998 |   |
|                                    |       |                    |       |                        |       |
| Capital lease  obligations              |       | 487,315                 |       | 753,201                     |       |
|                                    |       |                    |       |                        |       |
| Total long-term debt                    |       | 54,773,503              |       | 65,352,199                  |       |
| Less current  portion                   |       | 742,975                 |       | 928,633                     |       |
|                                    |       |                    |       |                        |       |
| Long-term debt,  net of current portion |       | $                       | 54,030,528 |                        | $          | 64,423,566 |   |

 

***Credit Agreement***

OnDecember 8, 2005 the Company entered into a credit agreement (the “CreditAgreement”) with a financial institution. The Credit Agreement provided theCompany with a $150,000,000 term loan, all of which was funded at closing, anda $40,000,000 revolving credit facility, none of which was funded at closing.Subject to the agreement of the lenders to increase their commitments, theCompany had the option to borrow up to an additional $10,000,000 under therevolving credit facility, for an aggregate revolving credit facility of$50,000,000. On January 11, 2006 and April 28, 2006, the Companyexercised its option and amended the Credit Agreement to increase the revolvingcredit facility by $5,000,000 on each date, such that the Company had anaggregate revolving credit facility of $50,000,000 as of, and subsequent to,April 28, 2006.

After the Company’sinitial public offering was 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. In both February 2007 and May 2007, theCompany prepaid $5,000,000 outstanding under the term loan.

The Credit Agreement terminates on December 8,2011. Principal repayments on the term loan of $137,433 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 accounts receivable andmaking disbursements to support operations.

The Credit Agreement is collateralized bysubstantially all of the assets of the Company. The Credit Agreement containscovenants which, among other matters, require the Company to maintain certaininterest coverage, fixed charge and total leverage ratios. These covenantsbecame effective on March 31, 2006. The Company is in compliance withthese covenants as of June 30, 2007. In addition, the Credit Agreement placeslimitations on total annual capital expenditures, indebtedness, liens,dividends and distributions, asset sales, transactions with affiliates,acquisitions and conduct of business, all as defined in the agreement. TheCredit Agreement also contains provisions for an increased rate of interestduring periods of default.

On March 15, 2007, the terms of the Credit Agreementwere amended.  The amendment lowered theinterest rate on borrowings under the Credit Agreement to the applicable Londoninterbank offered rate (“LIBOR”) plus 1.75%, or Prime Rate plus 0.75%, at theCompany’s option.  Prior to theamendment, loans under the Credit Agreement bore interest at LIBOR plus 3.00%or Prime rate plus 2.00%, at the Company’s option.  In addition, the Company is required to pay acommitment fee of 0.5% based on the calculation of the excess of the revolvingcredit loan commitment over the revolving outstanding balance as defined in theCredit Agreement.

14

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At June 30, 2007 and December 31, 2006, therevolving credit facility had no outstanding balance and there was anoutstanding balance of $54,286,188 and $64,598,998, respectively, under theterm loan with an interest rate of 7.07% and 8.55%, respectively.

On July 27, 2007 the Company repaid $5,000,000outstanding under the term loan.

***Capitalized Lease Obligations***

At June 30, 2007, the Company leased $707,123 ofequipment under agreements accounted for as capital leases with accumulateddepreciation of $355,961. The obligations for the equipment require the Companyto make monthly payments through March 2011, with implicit interest ratesfrom 7.06% to 19.06%.

At December 31, 2006, the Company leased$1,068,087 of equipment under agreements accounted for as capital leases withaccumulated depreciation of $311,169. The obligations for the equipment requirethe Company to make monthly payments through August 2011, with implicitinterest rates from 7.06% to 19.06%.

**Note 8—Preferred Stock**

On March 29, 2006, the Company completed itsinitial public offering of common stock, resulting in the conversion of theSeries A Convertible Preferred Stock into 2,206,308 shares of commonstock, par value $0.01 per share, and 8,825,241 shares of Series ARedeemable Preferred Stock, and the conversion of 24,185,493 shares ofSeries B Convertible Preferred Stock into 6,046,371 shares of commonstock, par value $0.01 per share, and 24,185,493 shares of Series BRedeemable Preferred Stock. A portion of the proceeds from the initial publicoffering was used to redeem all shares of the Series A RedeemablePreferred Stock and Series B Redeemable Preferred Stock for $52,764,950,and all of the Series A and Series B Redeemable Preferred Stock wereimmediately retired. The difference between the liquidation preference amountof the convertible preferred stock and the redemption amount of the redeemablepreferred stock was allocated to the common stock resulting from the conversionand credited to additional paid-in capital.

**Note 9—Income Taxes**

On January 1, 2007, the Company adopted FIN 48. As aresult of the implementation of FIN 48, the Company recognized an increase of$1,800,000 in the liability for unrecognized tax benefits, which was accountedfor as a decrease to the January 1, 2007 balance of retained earnings. Asof the date of adoption and after the impact of recognizing the increase inliability noted above, the Company’s unrecognized tax benefits totaled$1,943,000, all of which would impact the effective income tax rate ifrecognized.  Within the next twelvemonths, it is not expected that there will be any material changes to thisbalance.

The Company recognizes potential accrued interest andpenalties related to unrecognized tax benefits within its operations in incometax expense. In conjunction with the adoption of FIN 48, the Company recognizedapproximately $64,000 for the payment of interest and penalties atJanuary 1, 2007 which is included as a component of the $1,800,000unrecognized tax benefit noted above. There were no significant changes tothese amounts during the six months ended June 30, 2007.

The Company and its subsidiaries file income taxreturns in the United States Federal jurisdiction and in various state andforeign jurisdictions.  With fewexceptions, the Company is subject to U.S. Federal, and to state and localincome tax examinations for the tax years 2004 through 2006 and is subject toforeign income tax examinations for the period ended December 31, 2006.

**Note 10—Commitments and Contingencies**

***Operating Leases***

The Company leases its office facilities and certainequipment under operating lease arrangements expiring on various dates through2017, unless terminated earlier. Such leases include fixed or minimum paymentsplus, in some cases, scheduled base rent increases over the term of the leaseand additional rents

15

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basedon the Consumer Price Index. Certain leases provide for monthly payments ofreal estate taxes, insurance and other operating expenses applicable to the property.

For the three months ended June 30, 2007 and 2006,rent expense was approximately $1,226,234 and $928,066, respectively.  For the six months ended June 30, 2007 and2006, rent expense was approximately $2,456,336 and $1,840,137, respectively.

***Litigation***

In the normal course of business, the Company issubject to various legal proceedings and claims, the resolution of which, inmanagement’s opinion, will not have a material adverse effect on the financialposition or the results of operations of the Company.

**Note 11—Common Stock**

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

In connection with, and upon the completion of, theinitial public offering on March 29, 2006, 8,825,241 shares ofSeries A Convertible Preferred Stock were converted into 2,206,308 sharesof common stock and 8,825,241 shares of Series A Redeemable PreferredStock, and 24,185,493 shares of Series B Convertible Preferred Stock wereconverted into 6,046,371 shares of common stock and 24,185,493 shares ofSeries B Redeemable Preferred Stock.

Upon the consummation of the initial public offering,all outstanding shares of Class B common stock were converted into 357,020shares of common stock, par value $0.01 per share, and each share ofClass B common stock was retired.

Inclusive of an over-allotment option of 1,125,000shares of its common stock, the Company sold 8,625,000 shares of common stockin its initial public offering at a price to the public of $17.00 pershare, for net proceeds of approximately $131,800,000 after deductingthe underwriting discount and approximately $4,500,000 of offeringexpenses. After giving effect to this offering and the conversion transactionsdescribed above, the Company had 20,516,306 shares of common stockoutstanding as of March 29, 2006.

On March 29, 2006, in connection with the Company’sinitial public offering, the Fourth Amended and Restated Certificate ofIncorporation, which was adopted by the stockholders prior to the initialpublic offering, was filed with the State of Delaware. The Company’sCertificate of Incorporation was amended to change the authorized capital stockof the Company from an aggregate of 160,000,000 shares, 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 andSeries B Redeemable Preferred Stock, (b) 80,326,979 shares of commonstock, consisting of common stock and Class B common stock, and(c) 10,000,000 shares of undesignated preferred stock to a total of160,000,000 shares of capital stock consisting of (i) 150,000,000 sharesof common stock, par value $0.01 per share, and (ii) 10,000,000 shares ofundesignated preferred stock, par value $0.01 per share.

All share information has been adjusted to reflect a1-for-4 reverse stock split of common stock and Class B common stock,which was consummated on March 1, 2006.

At June 30, 2007, the Company had 150,000,000 sharesof common stock authorized, of which 21,105,813 and 20,688,556 were issued andoutstanding at June 30, 2007 and December 31, 2006, respectively.

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**Note 12—Related Party Transactions**

On March 29, 2006 the Company paid $52,764,950from proceeds from its IPO to redeem from investment funds affiliated with TAAssociates and other preferred stockholders, including Brian L. Libman, adirector of the Company, all of the shares of redeemable preferred stockoutstanding immediately following the conversion of Series A ConvertiblePreferred Stock and Series B Convertible Preferred Stock.

The Company’s chief executive officer, who wasappointed in April 2005, has served on the Board of Directors of anotherpublic company since 1995 and is currently the chairman of this entity’s auditcommittee. This unrelated entity acquires and originates non-conformingresidential and commercial loans. The Company has provided due diligence andprofessional staffing services to this entity. The Company received no revenues from this entity for the three and sixmonths ended June 30, 2007 or 2006.

The Company has contracts to perform services forportfolios managed by a stockholder. Revenues generated from the contracts forthe three months ended June 30, 2007 and 2006 were approximately $35,191 and$163,926, respectively.   Revenuesgenerated from the contracts for the six months ended June 30, 2007 and 2006were approximately $95,165 and $313,723, respectively.  Accounts receivable from this party at June30, 2007 and December 31, 2006, were $29,859 and $141,056,respectively.  Certain of these contractswere cancelled effective December 31, 2006.

**Note 13—Stock Plans**

On January 26, 2006, the Company’s Board ofDirectors approved the adoption of the Company’s 2006 Stock Option andIncentive Plan (“2006 Option Plan”), and the 2006 Option Plan was subsequentlyapproved by stockholders on March 8, 2006. The 2006 Option Plan permits grantsof incentive stock options, non-qualified stock options, stock appreciationrights, deferred stock awards, restricted stock awards, unrestricted stockawards and dividend equivalent rights. The Company reserved 1,814,130 shares ofcommon stock for issuance of awards under the 2006 Option Plan, subject toadjustment for any stock split, dividend or other change in the Company’scapitalization. Generally, shares that are forfeited or cancelled from awardsunder the 2006 Option Plan will be available for future grants. Stock optionsgranted under the 2006 Option Plan have a maximum term of ten years from thedate of grant and incentive stock option awards have an exercise price of noless than the fair market value of the common stock on the date of grant, whichwill be on the last day of the month of the award.  The options generallyvest over a period of four years, with 25% of each grant vesting after one yearand the remaining shares vesting monthly over the following three years. The Company issues new shares upon the exercise of stock options.  Cash received upon the exercise of optionsfor the six months ended June 30, 2007 and 2006 was $913,900 and $26,000,respectively.

Changes in options outstanding during the six monthsended June 30, 2007 are as follows:
|                                                                                        | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Options  outstanding, January 1, 2007                                                  |       | 1,470,774                  |       | $                                          | 6.33       |   |
|                                                                                   |       |                       |       |                                       |       |
| Granted                                                                                |       | 15,000                     |       | 16.38                                      |       |
| Exercised                                                                              |       | 260,907                    |       | 3.48                                       |       |
| Forfeited                                                                              |       | 88,644                     |       | 9.63                                       |       |
| Expired                                                                                |       | 3,290                      |       | 7.64                                       |       |
|                                                                                   |       |                       |       |                                       |       |
| Options  outstanding, June 30, 2007                                                    |       | 1,132,933                  |       | $                                          | 6.86       |   |
|                                                                                   |       |                       |       |                                       |       |
| Weighted average  fair value of options granted for the six months ended June 30, 2007 |       |                       |       | $                                          | 6.72       |   |
| Options available for  future grant at June 30, 2007                                   |       |                       |       | 1,624,630                                  |       |

 

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The intrinsic value of options exercised during thesix months ended June 30, 2007 was approximately $4,200,000.

Changes in unvested restricted stock outstandingduring the six months ended June 30, 2007 are as follows:
| ** **                                    | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** | **Aggregate Fair  Value at  June 30, 2007** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|-------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                                          |       |                       |       |                                                        |       |                                                            |       |
| Unvested shares  outstanding, January 1, 2007 |       | —                     |       | $                                                           | —     |                                                            | $          | — |   |
|                                          |       |                       |       |                                                        |       |                                                            |       |
| Granted                                       |       | 165,000                    |       | 18.48                                                       |       | 1,879,350                                                       |       |
| Vested                                        |       | —                     |       | —                                                      |       | —                                                          |       |
| Cancelled or forfeited                        |       | 8,650                      |       | 18.48                                                       |       | —                                                          |       |
|                                          |       |                       |       |                                                        |       |                                                            |       |
| Unvested shares  outstanding, June 30, 2007   |       | 156,350                    |       | $                                                           | 18.48      |                                                            | $          | 1,780,827 |   |

 

The Company recorded compensation expense ofapproximately $151,000 and $277,000 related to restricted stock for the threeand six months ended June 30, 2007, respectively.  In addition, the Company will recognizeapproximately $2,600,000 of expense related to these grants over the remainingvesting period of such shares of 3.6 years.

During the six months ended June 30, 2007, the Companygranted 15,476 deferred stock awards to members of its Board of Directors underthe Company’s Non-Employee Directors’ Deferred Compensation Plan.  The Company recorded compensation expense ofapproximately $47,000 and $57,000 related to these awards for the three and sixmonths ended June 30, 2007.  In addition,the Company will recognize approximately $212,000 of expense related to thesegrants over the remaining vesting period of such awards.

The following table summarizes information about stockoptions at June 30, 2007:
| **June 30, 2007** | ** **  |
|-----------------------------|-------------|
| ** **                  | ** **  | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
| **Exercise Price**     | ** **  | **Number  Outstanding** | ** ** | **Remaining  Contractual  Life (yrs.)** | ** ** | **Aggregate Intrinsic  Value as of  June 30, 2007** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic Value as  of June 30, 2007** | ** ** |
| $                      | 0.98-0.98   |   |   | 147,524 |   | 7.41 |   | $ | 1,536,380 |   | 122,707 |   | $ | 0.98 |   | $ | 1,277,925 |   |
|                        | 4.00-6.00   |   |   | 606,816 |   | 7.73 |   | 3,438,313 |   | 518,990 |   | 5.70 |   | 2,952,866 |   |
|                        | 6.36-6.80   |   |   | 189,093 |   | 8.22 |   | 886,002 |   | 105,373 |   | 6.72 |   | 492,150 |   |
|                        | 12.34-17.00 |   |   | 152,000 |   | 8.99 |   | — |   | 37,067 |   | 14.54 |   | — |   |
|                        | 18.46-21.38 |   |   | 37,500 |   | 9.27 |   | — |   | 4,009 |   | 20.97 |   | — |   |
|                        |        |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |        |   | 1,132,933 |   | 7.99 |   | $ | 5,860,695 |   | 788,146 |   | 5.59 |   | $ | 4,722,941 |   |
|                             |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted average contractual life of optionsexercisable at June 30, 2007 was 7.80 years.

The weighted average fair value of options grantedduring the six months ended June 30, 2006 was $5.87.  The aggregate intrinsic value of optionsoutstanding and exercisable at June 30, 2006 was approximately $12,236,000 and$7,668,000, respectively.

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Accounting for Stock Based Compensation” which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. This standard requires an issuer to measure the cost ofemployee services received in exchange for

18

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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”) OpinionNo. 25. In March 2005, the SEC released Staff Accounting Bulletin (“SAB”)107, “Share-Based Payment,” which expresses views of the SEC staff about theapplication 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 SFASNo. 123, “Accounting for Stock-Based Compensation,” for all awards grantedto employees. On January 1, 2006 the Company adopted SFAS No. 123(R)and it did not have a material impact on the Company’s financial statements.

The Company completed its initial public offering onMarch 29, 2006. According to the provisions of incentive stock optionagreements between the Company and its employees, the vesting term for certainoptions outstanding as of the date of the IPO accelerated by either one year ortwenty percent, varying in accordance with the terms of the employee’s specificincentive stock option agreement. In addition, 130,208 of performance basedoptions became immediately vested. Therefore, on March 29, 2006 theCompany recognized $611,696 of additional compensation expense from thisaccelerated vesting.

The ongoing effect on consolidated results ofoperations of financial condition will be dependent upon future stock basedcompensation awards granted.  The Company utilizes the Black-Scholesoption valuation method to calculate the fair market value of the options usingassumptions in effect on the date of the grant, as follows:
| ** **                | ** ** | **Six Months Ended** | ** ** |
|---------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **June 30, 2007**    | ** ** | **June 30, 2006** | ** ** |
| Expected life  (in years) |       | 7.0                            |       | 6.5 – 7.5 |   |
| Risk-free  interest rate  |       | 4.5                            | %          | 4.7 – 5.1 | % |
| Volatility                |       | 28                             | %          | 25 | % |
| Dividend                  |       | 0                              | %          | 0 | % |

 

For the three months ended June 30, 2007 and 2006 theCompany recognized expenses related to the stock option grants summarized aboveover the vesting period of such options of approximately $143,000 and $138,000,respectively.  For the six months endedJune 30, 2007 and 2006 the Company recognized expenses related to stock optiongrants of approximately $307,000 and $853,000, respectively.  In addition, the Company will recognizeapproximately $1,200,000 of expense related to these grants over the remainingvesting period of such options.  This expense is expected to be recognizedover a weighted-average period of 2.5 years.

**Note14—Segment Information**

**ReportableSegments**

The Company has organizedits business portfolio into three reportable segments to reflect its businessstrategy.  The Company measures andevaluates its reportable segments based on segment operating income.  The Company generally accounts forintersegment transactions at cost. Segment operating income is equal to gross profit less direct selling,general and administrative expenses.  TheCompany’s segments and their principal activities consist of the following:

***Transaction Management***

The transactionmanagement segment provides a full range ofoutsourced transaction management services to clients, including:

·                  due diligence services - assisting loan buyers andsellers in making decisions on how they price portfolios and manage risk;

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·                  conduit support services - providing thetechnology and systems required to manage key aspects of a buyer’s loanacquisition pipeline, including overall process management, due diligence,fulfillment, funding and integration with third-party service providers;

·                  compliance products and services - providingproprietary compliance testing engine through the High Cost Analyzer suite tomarket participants including loan originators;

·                  professional staffing services – providing accessto qualified independent mortgage loan professionals to clients to augmenttheir staffs on both a long- and short-term basis; and

·                  consulting services – providing advice toclients on issues related to business process improvement, risk management,regulatory compliance, and technology enablement.

***Special Servicing***

Thespecial servicing segment provides comprehensive loan management for defaultedand delinquent loans and reverse mortgages, collection management, oversightand reporting, foreclosure and bankruptcy administration, eviction and realestate owned disposition oversight.

***Surveillance***

Thesurveillance segment provides credit risk management and surveillance servicesconsisting of the oversight and monitoring of predominantly residentialnon-agency MBS to MBS underwriters, issuers and investors.

The following tablesprovide operating financial information for the Company’s three reportablesegments:
| ** **                     | ** ** | **For the Three Months Ended June 30, 2007** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Transaction  Management**                                                     | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
|                           |       |                                                                            |       |   |   |   |   |   |   |
| Revenue                        |       | $                                                                               | 28,086,147 |   | $ | 2,434,438 |   | $ | 12,632,874 |   | $ | 43,153,459 |   |
| Depreciation and  amortization |       | 3,437,515                                                                       |       | 429,044 |   | 1,137,281 |   | 5,003,840 |   |
| Segment  operating income      |       | 6,484,503                                                                       |       | 504,774 |   | 7,722,152 |   | 14,711,429 |   |
| Capital expenditures           |       | 123,263                                                                         |       | — |   | 12,143 |   | 135,406 |   |
|                                |            |                                                                                 |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **For the Three Months Ended June 30, 2006** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Transaction  Management**                                                     | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
|                           |       |                                                                            |       |   |   |   |   |   |   |
| Revenue                        |       | $                                                                               | 48,238,610 |   | $ | 3,408,328 |   | $ | 8,250,114 |   | $ | 59,897,052 |   |
| Depreciation and  amortization |       | 3,436,560                                                                       |       | 324,165 |   | 645,405 |   | 4,406,130 |   |
| Segment  operating income      |       | 11,415,371                                                                      |       | 1,815,546 |   | 4,785,501 |   | 18,016,418 |   |
| Capital expenditures           |       | 2,075,359                                                                       |       | 95,000 |   | 52,514 |   | 2,222,873 |   |
|                                |            |                                                                                 |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **For the Six Months Ended June 30, 2007** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Transaction  Management**                                                   | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
|                           |       |                                                                          |       |   |   |   |   |   |   |
| Revenue                        |       | $                                                                             | 67,963,126 |   | $ | 4,179,908 |   | $ | 24,362,590 |   | $ | 96,505,624 |   |
| Depreciation and  amortization |       | 6,637,396                                                                     |       | 826,746 |   | 2,092,451 |   | 9,556,593 |   |
| Segment  operating income      |       | 16,773,260                                                                    |       | 88,914 |   | 14,469,247 |   | 31,331,421 |   |
| Capital expenditures           |       | 2,803,017                                                                     |       | 12,526 |   | 14,567 |   | 2,830,110 |   |
|                                |            |                                                                               |            |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                     | ** ** | **For the Six Months Ended June 30, 2006** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Transaction  Management**                                                   | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
|                           |       |                                                                          |       |   |   |   |   |   |   |
| Revenue                        |       | $                                                                             | 91,778,873 |   | $ | 6,318,797 |   | $ | 15,744,311 |   | $ | 113,841,981 |   |
| Depreciation and  amortization |       | 6,601,257                                                                     |       | 619,942 |   | 1,228,251 |   | 8,449,450 |   |
| Segment  operating income      |       | 18,863,885                                                                    |       | 3,297,715 |   | 9,106,684 |   | 31,268,284 |   |
| Capital expenditures           |       | 3,713,466                                                                     |       | 187,842 |   | 155,936 |   | 4,057,244 |   |
|                                |            |                                                                               |            |  |  |  |  |  |  |  |  |  |  |

 

The following tables arereconciliations of certain segment items to the total consolidated amount:
| ** **                                           | ** ** | **For the Three Months Ended June 30,** | ** ** | **For the Six Months Ended June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                                              | ** ** | **2006**                                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Segment  Operating Income:                           |       |                                                                  |       |                                                                |       |   |   |   |   |
| Total  consolidated segment operating income         |       | $                                                                | 14,711,429 |                                                                | $     | $ 18,016,418 |   | $  | 31,331,421 |   | 31,268,284 |   |
| Direct selling,  general and administrative expenses |       | 3,155,624                                                             |       | 2,993,590                                                           |       | 6,146,694 |   | 5,715,523 |   |
|                                                 |       |                                                                  |       |                                                                |       |   |   |   |   |
| Consolidated reported  gross profit                  |       | $                                                                     | 17,867,053 |                                                                | $          | 21,010,008 |   | $ | 37,478,115 |   | $ | 36,983,807 |   |
|                                                      |            |                                                                       |            |                                                                     |            |  |  |  |  |  |  |  |  |

 
| ** **                          | ** ** | **For the Three Months Ended June 30,** | ** ** | **For the Six Months Ended June 30,** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                                              | ** ** | **2006**                                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Capital  Expenditures:              |       |                                                                  |       |                                                                |       |   |   |   |   |
| Total segment capital  expenditures |       | $                                                                     | 135,406    |                                                                | $          | 2,222,873 |   | $ | 2,830,110 |   | $ | 4,057,244 |   |
| General assets                      |       | 1,029,304                                                             |       | 171,463                                                             |       | 1,169,567 |   | 1,292,672 |   |
|                                |       |                                                                  |       |                                                                |       |   |   |   |   |
| Consolidated capital  expenditures  |       | $                                                                     | 1,164,710  |                                                                | $          | 2,394,336 |   | $ | 3,999,677 |   | $ | 5,349,916 |   |

 

**Note 15—Subsequent Event**

On July 27, 2007, theCompany prepaid $5,000,000 of its outstanding term loan balance.  There were no penalties associated with thispayment.  At June 30, 2007, the$5,000,000 used to make this payment was included in “cash and cash equivalents”in the accompanying condensed consolidated balance sheet.

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**Item 2. Management’s Discussionand Analysis of Financial Condition and Results of Operations **

**Forward Looking Statements and Projections**

*This Quarterly Report onForm 10-Q contains forward looking statements. Forward looking statementsrelate to future events or our future financial performance. We generallyidentify forward looking statements by terminology such as “may,” “will,” “should,”“expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,”“believes,” “estimates,” “predicts,” “potential” or “continue” or the negativeof these terms or other similar words. These statements are only predictions.We have based these forward looking statements largely on our current expectationsand projections about future events and financial trends that we believemay affect our business, results of operations and financial condition.The outcome of the events described in these forward looking statements issubject to risks, uncertainties and other factors described in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” elsewhere in this Quarterly Report on Form 10-Q and in our Annual Reporton Form 10-K for the year ended December 31, 2006. Accordingly, you should notrely upon forward looking statements as predictions of future events. We cannotassure you that the events and circumstances reflected in the forward lookingstatements will be achieved or occur, and actual results could differ materiallyfrom those projected in the forward looking statements. The forward lookingstatements made in this Quarterly Report on Form 10-Q relate only toevents 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 outsourced services,mortgage-related analytics and specialized consulting services for buyers andsellers of, and investors in, mortgage-related loans and securitizations. Ourservices include transaction management, which consists of due diligence andmortgage processing services for buyers of mortgage loans (conduit supportservices), professional staffing services, and compliance products andservices, oversight and reporting on mortgage-backed securities (credit riskmanagement and surveillance), and specialized loan servicing (specialservicing) and consulting services. 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 factorssupport the demand for our services, including:

·                  thedesire for outsourced services by capital markets firms and other majormortgage loan market participants;

·                  theincreased complexities and requirements of federal, state and local regulationsapplicable to the mortgage loan industry; and,

·                  investors’growing demand for operational risk assessment and loan performance data.

Our revenue is also driven by non-agency MBS issuanceand the aggregate number of non-conforming mortgage loan originations. Changesin the volume of non-agency MBS issuances and non-conforming mortgage loanoriginations 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 toperform our services which should reduce the amount of per loantravel expenses.

We believe the volume of non-agency MBSsecuritizations and non-conforming mortgage loan originations will be lower in2007 than in 2006.  We do not expect thatthese markets will experience significant growth in the short term, but theycould experience moderate growth over the long term. We believe there will becontinued demand for new loan products and increased home ownership driven inpart by first-time homeowners, minorities and immigrants. We face a numberof risks in our industry and the market for our services is highly competitive.Our business is driven in part by the MBS market, the mortgagelending industry and the housing market, each of which is highly sensitive totrends in the general economy, including interest rates, perceived and actualeconomic conditions, taxation policies, availability of credit, employmentlevels, more strict underwriting guidelines in effect at a given time and wageand

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salarylevels. Adverse changes in any of these trends, the recent downturn in thenon-prime mortgage loan market, including the failure of additional non-primelenders, the failure of hedge funds that invest in mortgage-backed securities,additional downgrades of mortgage-backed securities by the major ratingagencies, or a decline in the sale of both new and existing homes or in homevalues, could lessen the demand for mortgage loans, which could result overtime in a reduced demand for our services and diminish our revenue. 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. Moreover, the majority of ourbusiness is generated through our largest 20 clients. The loss of one or moreof these clients could adversely affect our business and results of operations.Lastly, we are dependent on our independent loan review specialists toperform our services. Our business could suffer if we are unable to recruitand retain additional qualified independent loan review specialists.

**Basis of Presentation**

We were formed as a Delaware corporation inMarch 2005, following the combination of the holding companies of each ofClayton Services and its subsidiaries, including FMS and CFIS. Prior to thecombination, each holding company was controlled by investment funds affiliatedwith TA Associates. In accordance with US GAAP relating to companies undercommon control prior to their combination, the financial statements of the previouslyseparate companies under common control are restated on a combined basis fromthe dates of their respective acquisitions by the controlling entity.Accordingly, for accounting purposes, the date of our inception wasMay 24, 2004, the date that investment funds affiliated with TA Associatesacquired CFIS, the first of the combined entities that were brought undercommon control.

**Critical Accounting Policies**

*Basis of Presentation*

Our condensed consolidated financial statements areunaudited. In our opinion, all adjustments, consisting of only normal recurringadjustments considered necessary for a fair presentation, have been included.Certain information and footnote disclosures normally included in financialstatements prepared in accordance with US GAAP have been condensed or omitted.It is suggested that these unaudited condensed consolidated financialstatements be read in conjunction with the consolidated financial statements,accounting policies and notes included in our Annual Report on Form 10-K forthe year ended December 31, 2006, which includes audited financial statements.Results for the interim periods are not necessarily indicative of results forthe full year.

In preparing our financial statements in conformitywith US GAAP, we have to make estimates and assumptions about future eventsthat affect the amounts of reported assets, liabilities, revenues and expenses,as well as the disclosure of contingent assets and liabilities in the financialstatements and accompanying notes. Some of our accounting policies require theapplication of significant judgment by management in the selection ofappropriate assumptions for determining these estimates. By their nature, thesejudgments 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, which reflectsignificant management estimates and judgment in determining reported amountsin the consolidated financial statements are as follows:

*Revenue Recognition*

Revenue is recognized when persuasive evidence of anarrangement exists, the service has been performed, the fee is fixed anddeterminable, and collection of the resulting receivable is reasonably assured.

We derive most of our revenue from professionalservice activities. Revenue consisting of billed fees and pass-through expensesis recorded as work is performed and expenses are incurred. Revenue alsoincludes expenses billed to clients, which include travel and otherout-of-pocket expenses, and other reimbursable expenses.

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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 consolidated balance sheets.

*Stock-Based Compensation*

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Accounting for Stock Based Compensation” which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. On January 1, 2006 we adopted SFAS No. 123(R)and it did not have a material impact on our financial statements.

According to the provisions of our incentive stockoption agreements, the vesting term for certain options outstanding as of thedate of our 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 became immediatelyvested. As a result, on March 29, 2006, we recognized $611,696 ofadditional compensation expense from this accelerated vesting.

We granted options to purchase 15,000 shares in thesix months ended June 30, 2007 with an average exercise price of $16.38 pershare.

On January 30, 2007, we granted 165,000 shares ofrestricted stock at the closing stock price on that day of $18.48 per share.

During the six months ended June 30, 2007, we granted15,476 deferred stock units to members of our Board of Directors under theNon-Employee Directors’ Deferred Compensation Plan.

*Valuation of Long-lived AssetsExcluding Goodwill*

We evaluate all of our long-lived assets, includingintangible assets other than goodwill and fixed assets, periodically forimpairment in accordance with SFAS No. 144, Accounting for the Impairment orDisposal of Long-lived Assets (SFAS No. 144). SFAS No. 144 requires thatlong-lived assets be evaluated for impairment when events or changes in factsand circumstances indicate that their carrying value may not be recoverable. Ifevents or circumstances indicate that the carrying value of an asset may not berecoverable, we assess the recoverability of identified intangible assets bycomparing the projected undiscounted net cash flows associated with the relatedasset or group of assets over their remaining lives against their respectivecarrying amounts. 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.

*Accounts Receivable*

We are required to estimate the collectibility of accounts receivable.  A considerable amount of judgment is required in assessing the likelihood of realization of receivables.   Relevant assessment factors include the creditworthiness of the customer, our prior collection history with the customer and related aging of past due balances.  Specific accounts receivable are evaluated when we believe a customer may not be able to meet its financial obligations due to a deterioration of its financial condition or its credit ratings.  The allowance requirements are based on the best facts available and are re-evaluated and adjusted on a regular basis and as additional information is received.

*Intangible Assets*

Intangible assets consist of customer relationships,technology, trade name and trademarks, non-competition agreements and excess ofcost over fair value of net assets acquired, or goodwill. Customer relationshipsare the value of the specifically acquired customer relationships. Technologyis the value of recreating the completed technology infrastructure. Trade nameand trademarks are the value inherent in the recognition of “Clayton” and theother names that we use. The value of the non-competition agreements are anappraisal of potential lost revenues that would arise from an individualinitiating a competing enterprise.

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Except for goodwill, trade names and trademarks, allintangible assets are stated at cost less accumulated amortization. The costsattributable to the identified intangibles were based on a number ofsignificant assumptions as determined by us and our independent appraisalexpert. Identifiable intangible assets with finite lives are amortized underthe straight-line method over their applicable estimated useful lives.

We adopted SFAS No. 142 “Goodwill and Other IntangibleAssets” (“SFAS No. 142”), which provides, among other things, that goodwill andintangibles with indefinite lives are no longer amortized but are reviewed forimpairment at least annually (beginning with the first anniversary of theacquisition date). Annual impairment tests were conducted for Clayton Servicesand CFIS in 2007 and there was no impairment to goodwill or intangibles withindefinite lives of either entity.

On March 28, 2007, our Board of Directorsapproved the recommendation of management that it discontinue the operations ofCLS.  As a result, we recorded animpairment charge of $4,735,777 in connection with the CLS shutdown to reflectthe write-off of goodwill, intangible assets and property and equipment.

In December 2006,we recorded an impairment charge of $279,458 to reflect the write-off ofcertain customer relationships associated with portfolio management.

*Income Taxes*

Our effective tax rate is based on pre-tax income,statutory tax rates and tax planning strategies. Significant managementjudgment is required in determining the effective tax rate and in evaluatingour tax position.

Our accompanying Condensed Consolidated Balance Sheetsinclude certain deferred tax assets resulting from deductible temporarydifferences, which are expected to reduce future taxable income. These assetsare based on management’s estimate of realizability based upon forecastedtaxable income. Realizability of these assets is reassessed at the end of eachreporting period based upon our forecast of future taxable income and availabletax planning strategies, and may result in the recording of a valuationreserve. Failure to achieve forecasted taxable income could affect the ultimaterealization of certain deferred tax assets.

 The Companyadopted FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty inIncome Taxes,” on January 1, 2007 (see Note 9).

Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and our Audit Committee has reviewed our disclosures relating to them.

**Revenue**

We generate a majority of our revenue by providingprofessional outsourced services across the lifecycle of a mortgage loan.

Our transaction management services are provided under“time-and-materials” or per file billing arrangements. Under “time-and-materials”arrangements, we bill our clients on an hourly basis with travel and otherreimbursable expenses passed through and recognized as revenue. Under per filebilling arrangements, we bill our clients for each file reviewed with traveland other reimbursable expenses passed through separately or included in theper file rate. Revenues consisting of billed fees and pass-through expenses,which include 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 consolidated balancesheets.  For the three months ended June30, 2007 and 2006, transaction management revenue accounted for 65.1% and80.5%, respectively, of total revenue. For the six months ended June 30, 2007 and 2006, transaction managementrevenue accounted for 70.4% and 80.6%, respectively, of total revenue.

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Our surveillance and special servicing servicesprovide a revenue stream which is generally recurring in nature. In a typicalMBS transaction for which we provide surveillance services, we are engaged bythe trustee of an MBS issuance to provide our services over the life of thetrust and are paid monthly directly from the cash flow of the trust. A majorityof our surveillance revenue is based upon a negotiated rate multiplied by theoutstanding principal balance of the underlying mortgage loans in the MBSissuance. These fees are recognized each month as services are rendered. Ourspecial servicing activities are conducted under annual or multi-year contractsfor which we typically receive revenue on a per loan per month basis as well asincentive fees. For the three months ended June 30, 2007 and 2006, surveillanceand special servicing services revenue accounted for 34.9% and 19.5%,respectively, of total revenue.  For thesix months ended June 30, 2007 and 2006, surveillance and special servicingservices revenue accounted for 29.6% and 19.4%, respectively, of total revenue.

For the three months ended June 30, 2007 and 2006,revenue from our largest two clients accounted for an aggregate of 18.8% and27.4% of total revenue, respectively. Revenue from one client exceeded 10% of revenue for the three monthsended June 30, 2007.  Revenue from twoclients exceeded 10% of revenue for the three months ended June 30, 2006. Thisrevenue is primarily associated with the Transaction Management segment.

For the six months ended June 30, 2007 and 2006,revenue from our largest two clients accounted for an aggregate of 20.0% and26.5% of total revenue, respectively. Revenue from one client exceeded 10% ofrevenue for the six months ended June 30, 2007. Revenue from two clients exceeded 10% of revenue for the six monthsended June 30, 2006. This revenue is primarily associated with the TransactionManagement segment.

**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 employee benefits from us 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 of expensesincurred in enabling employees and independent loan review specialists totravel 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 third partymortgage loan services (primarily collateral appraisal fees), outside supportfor our compliance services used in connection with our loan reviews,independent loan review specialist training and miscellaneous non-billabletransaction costs.

**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 haveincurred significant additional operating expenses such as increased auditfees, professional fees, directors and officers’ insurance costs, compensationfor our board of directors, and expenses related to hiring additional personneland expanding our administrative functions. Many of these expenses either werenot incurred or were incurred at a lower level by us as a private company.

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*Salaries and Benefits*

Salaries and benefits consist of employee compensationfor those employees who are not directly billable to a particular assignmentincluding costs of administrative, finance, human resources, technology,marketing, business development and executive personnel.

*Other Selling, General and Administrative Expenses*

Other selling, general and administrative expensesconsist of costs such as rent and utilities, marketing, advertising andpromotion 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 amortization expenses forcosts related to the capitalization of property and equipment and softwaredeveloped for internal use on a straight-line basis over the estimated usefullives 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 of Intangibles*

We also incur amortization expenses for costs relatedto the capitalization of identifiable intangible assets including customer relationships,technology and non-competition agreements.

We account for acquisitions of companies in accordancewith 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 issubject to annual impairment tests or on a more frequent basis if events orconditions indicate that goodwill may be impaired. Goodwill is tested forimpairment at a level of reporting referred to as a reporting unit.  Thefirst step of our annual test is to compare the fair value of our shares to thecarrying value of our net assets of the reporting unit. If we determine thatour carrying value exceeds our fair value, we would conduct a second step tothe goodwill impairment test. The second step compares the implied fair valueof the goodwill (determined as the excess fair value over the fair valueassigned to our other assets and liabilities) to the carrying amount ofgoodwill. When the carrying amount of goodwill exceeds the implied fair valueof goodwill, an impairment loss is recognized.

We evaluate all of our long-lived assets, includingintangible assets other than goodwill and fixed assets, periodically forimpairment 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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In connection with the CLS shutdown, in March 2007 theCompany recorded an impairment charge of $4,735,777 to reflect the write-off ofgoodwill and intangible assets. In December 2006, the Company recorded animpairment charge of $279,458 to reflect the write-off of certain customerrelationships associated with portfolio management.

**Net Interest Expense**

Net interest expense consists of interest paid on ourdebt net of interest received on our cash balances.

Interest expense for the three and six months endedJune 30, 2007 and 2006 primarily consisted of interest on our term loan andamortization of debt issuance costs related to the term loan and revolving lineof credit.  Interest expense for thethree and six months ended June 30, 2006 also included interest on ourrevolving line of credit.  Our term loanhad a balance at December 31, 2006 of $64,598,998, and $54,286,188 at June 30,2007.  Our term loan had a balance of$150,000,000 at December 31, 2005, and $79,799,499 at June 30, 2006.

**Loss from Extinguishment of Debt**

Due to the prepayment of $10,000,000 on our term loanduring the six months ended June 30, 2007, we wrote-off a portion of the debtissuance costs on the term loan and recognized a loss from extinguishment ofdebt of $45,043 during the first quarter of 2007 and $45,289 during the secondquarter of 2007.

On March 29, 2006, following our initial publicoffering, we repaid $70,000,000 of the outstanding balance on our $150,000,000term loan and the entire $7,400,000 outstanding balance on our revolving lineof credit. Due to the prepayment of $70,000,000 on our term loan, we wrote-offa portion of the debt issuance costs on the term loan and recognized a lossfrom extinguishment of debt of $746,002 in the first quarter of 2006.

**Results of Operations**

***Comparison of Three Month Periods EndedJune 30, 2007 and 2006***

**Revenue**

Our consolidated revenue was $43.2 million for thethree months ended June 30, 2007, a decrease of $16.7 million or 27.8%,compared to revenue of $59.9 million for the three months ended June 30,2006*.*The decrease was primarilydue to reduced due diligence, conduit, special servicing and staffing servicesrevenues, partially offset by an increase in surveillance revenue and theacquisition of Risk Management, Limited (subsequently renamed Clayton Euro Risk(“CER”)).  Our total revenue per loanincreased by 38.2%, as our non-loan related surveillance and consultingbusinesses increased as a percentage of overall revenues.  The number of loans serviced during the sixmonths ended June 30, 2007 decreased by 47.9% as compared to fiscal 2006, dueto significant reductions in the number of loans serviced in our due diligenceand conduit businesses, due to the weak subprime market during thequarter.  Revenuesper loan in our core due diligence business increased by 4.4% due to anincrease in non-loan related special due diligence projects involvingdistressed lenders and a decrease in the prevalence of other file reviews, inwhich we verify a limited number of data points in a loan file.

***Transaction Management***

Transaction management revenue was $28.1 million forthe three months ended June 30, 2007, a decrease of $20.1 million or 41.7%, comparedto revenue of $48.2 million for the three months ended June 30, 2006*.*The decrease was primarily due to a47.9% reduction in loans serviced, due to the weak subprime market during thequarter.  This decrease was partiallyoffset by the 4.4% increase in due diligence revenues per loan.

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***Special Servicing***

Special servicing revenue was $2.5 million for thethree months ended June 30, 2007, a decrease of $0.9 million or 26.5%, comparedto revenue of $3.4 million for the three months ended June 30, 2006.  Thedecrease was primarily due to the termination of a tax lien servicing contractduring the three months ended September 30, 2006 and reduced incentive andmonthly fees from our non-performing loan servicing contracts.

***Surveillance***

Surveillance revenue was $12.6 million for the threemonths ended June 30, 2007, an increase of $4.3 million or 51.8%, compared torevenue of $8.3 million for the three months ended June 30, 2006*.*The increase was primarily due to anincrease in our putback review business and an increase in the value of assetsmonitored.

**Cost of Services**

Our cost of services was $25.3 million for the threemonths ended June 30, 2007, a decrease of $13.6 million or 35.0%, compared tocost of services of $38.9 million for the three months ended June 30, 2006.This decrease was attributable to the specific factors discussed below.

*Compensation Expense.*Compensationexpense was $20.2 million for the three months ended June 30, 2007, adecrease of $8.9 million or 30.6%, compared to compensation expense of$29.1 million for the three months ended June 30, 2006.****** The decrease was primarily dueto a reduction in variable contractor expense in our due diligence and conduitbusinesses due to reduced loan volumes and, to a lesser extent, reducedtraining, fixed payroll and staffing services contractor expenses.

*Travel and Related Expenses.*Traveland related expenses were $3.6 million for the three months ended June 30,2007, a decrease of $3.2 million or 47.1%, compared to travel and relatedexpenses of $6.8 million for the three months ended June 30, 2006. The decrease was primarily due to reduced field due diligence loan volumes andstaffing services engagements.  Travelexpenses per loan increased by 0.8%.

*Other Direct Costs.*Otherdirect costs were $1.5 million for the three months ended June 30, 2007, adecrease of $1.5 million or 50.0%, compared to other direct costs of$3.0 million for the three months ended June 30, 2006. The decrease wasprimarily due to reduced third-party appraisal vendor fees due to reduced duediligence volumes.

**Operating Expenses**

Operating expenses were $16.1 million for the threemonths ended June 30, 2007, an increase of $2.1 million or 15.0%, compared tooperating expenses of $14.0 million for the three months ended June 30,2006. This increase was attributable to the specific factors discussed below.

*Salaries and Benefits.*Salariesand benefits were $5.5 million for the three months ended June 30, 2007, anincrease of $0.4 million or 7.8%, compared to salaries and benefits of$5.1 million for the three months ended June 30, 2006.  This increasewas primarily due to an increase in information technology compensationexpense, severance expense and stock-based compensation related to restrictedstock grants in the first quarter.  Theseincreases were partially offset by reduced bonus expense due to the weakerfinancial results.

*Other Selling, General andAdministrative Expenses.*Other selling, general andadministrative expenses were $5.6 million for the three months ended June 30,2007, an increase of $1.1 million or 24.4%, as compared to selling, general andadministrative expenses of $4.5 million for the three months ended June30, 2006*.  *This increase was due to higher occupancyexpenses, due to the relocation of the Tampa centralized underwritingoperations to a new facility, and increased bad debt, telecommunications andprofessional fee expenses, partially offset by reduced recruiting expenses.

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*Depreciation and Amortization.*Depreciationand amortization was $2.4 million for the three months ended June 30, 2007, anincrease of $0.5 million or 26.3%, compared to depreciation and amortization of$1.9 million for the three months ended June 30, 2006*.*This increase was primarily due todepreciation recorded on additional property and equipment and softwaredeveloped for internal use.

*Amortization of Intangibles.*Amortizationof intangibles was $2.6 million for the three months ended June 30, 2007, anincrease of $0.1 million or 4.0 %, compared to depreciation and amortization of$2.5 million for the three months ended June 30, 2006*.*This increase was primarily due to theamortization of intangible assets acquired in connection with the acquisitionof CER.

**Interest Expense, net**

Interest expense, net was $1.0 million for the three monthsended June 30, 2007, a decrease of $0.7 million or 41.2%, compared to interestexpense, net of $1.7 million for the three months ended June 30, 2006*.*This decrease was due to reducedborrowings on our term loan and a reduction of the interest rate on our termloan.  *See“—Liquidity and Capital Resources.”*

**Loss from Extinguishment of Debt**

For the three months ended June 30, 2007, werecognized a loss from extinguishment of debt of $0.05 million due to thewrite-off of debt issuance costs as a result of a $5.0 million prepaymentduring this period.  *See “—Liquidity and Capital Resources.”*

**IncomeTaxes**

Income taxes for the three months ended June 30, 2007were $0.2 million, a decrease of $1.9 million, compared to $2.1 millionfor the three months ended June 30, 2006. This decrease was primarily due to changes in taxable income and oureffective tax rate.

**DiscontinuedOperations**

On March 28, 2007, we committed to discontinue the operations of CLS.  Results for the three months ended June 30, 2007 include a pre-tax loss on disposal of a $0.4 million, relating to facility closure costs and the write-off of property and equipment.  CLS operating results for the three months ended June 30, 2007 included revenue of $0.2 million, an operating loss of $0.6 million, a pre-tax loss of $0.6 million, an income tax benefit of $0.2 million and a net loss of $0.4 million.  CLS operating results for the three months ended June 30, 2006 included revenue of $1.9 million, an operating loss of $1.5 million, a pre-tax loss of $1.5 million, an income tax benefit of $0.6 million and a net loss of $0.9 million.

***Comparison of Six Month Periods Ended June30, 2007 and 2006***

**Revenue**

Our consolidated revenue was $96.5 million for the sixmonths ended June 30, 2007, a decrease of $17.3 million or 15.2%, compared torevenue of $113.8 million for the six months ended June 30, 2006*.*The decrease was primarily due toreduced due diligence, conduit, special servicing and staffing servicesrevenues, partially offset by an increase in surveillance revenue and theacquisition of CER.  Our total revenueper loan increased by 15.0%, as revenues from our non-loan related surveillanceand consulting businesses increased as a percentage of overall revenues.  The number of loans serviced during the threemonths ended June 30, 2007 decreased by 26.3% as compared to fiscal 2006, dueto significant reductions in the number of loans serviced in our due diligenceand conduit businesses, due to the weak subprime market during the period.  Revenues perloan in our core due diligence business decreased by 1.6% as an increase in thepercentage of loans serviced in our centralized underwriting facility offset anincrease in non-loan related special due diligence projects involvingdistressed lenders.

***Transaction Management***

Transaction management revenue was $67.9 million forthe six months ended June 30, 2007, a decrease of $23.9 million or 26.0%,compared to revenue of $91.8 million for the six months ended June 30,2006*.* The decrease was primarilydue to a 26.3% reduction in loans serviced, due to the weak subprime marketduring the period.

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***Special Servicing***

Special servicing revenue was $4.2 million for the sixmonths ended June 30, 2007, a decrease of $2.1 million or 33.3%, compared torevenue of $6.3 million for the six months ended June 30, 2006.  The decrease was primarily due to the terminationof a tax lien servicing contract during the three months ended September 30,2006, and reduced incentive and monthly fees from our non-performing loanservicing contracts.

***Surveillance***

Surveillance revenue was $24.4 million for the sixmonths ended June 30, 2007, an increase of $8.7 million or 55.4%, compared torevenue of $15.7 million for the six months ended June 30, 2006*.*The increase was primarily due to anincrease in the value of assets monitored and an increase in our putback reviewbusiness.

**Cost of Services**

Our cost of services was $59.0 million for the sixmonths ended June 30, 2007, a decrease of $17.9 million or 23.3%, compared tocost of services of $76.9 million for the six months ended June 30, 2006. Thisdecrease was attributable to the specific factors discussed below.

*Compensation Expense.*Compensationexpense was $45.9 million for the six months ended June 30, 2007, adecrease of $11.7 million or 20.3%, compared to compensation expense of$57.6 million for the six months ended June 30, 2006.   Thedecrease was primarily due to a reduction in variable contractor expense in ourdue diligence and conduit businesses due to reduced loan volumes and, to alesser extent, reduced training, fixed payroll and staffing services contractorexpenses.

*Travel and Related Expenses.*Traveland related expenses were $9.1 million for the six months ended June 30, 2007,a decrease of $4.8 million or 34.5%, compared to travel and relatedexpenses of $13.9 million for the six months ended June 30, 2006. The decrease was primarily due to reduced field due diligence loan volumes andstaffing services engagements.  Travelexpenses per loan decreased by 11.2% due to an increase in the percentage ofloans serviced in our centralized underwriting facility.

*Other Direct Costs.*Otherdirect costs were $4.0 million for the six months ended June 30, 2007, adecrease of $1.4 million or 25.9%, compared to other direct costs of$5.4 million for the six months ended June 30, 2006.  The decrease was primarily due to reducedthird-party appraisal vendor fees due to reduced due diligence volumes.

**Operating Expenses**

Operating expenses were $31.8 million for the sixmonths ended June 30, 2007, an increase of $4.1 million or 14.8%, compared tooperating expenses of $27.7 million for the six months ended June 30,2006. This increase was attributable to the specific factors discussed below.

*Salaries and Benefits.*Salariesand benefits were $11.2 million for the six months ended June 30, 2007, anincrease of $1.1 million or 10.9%, compared to salaries and benefits of$10.1 million for the six months ended June 30, 2006.  This increasewas primarily due to an increase in information technology, executive andaccounting compensation expense, partially offset by reduced bonus expense dueto the weaker financial results and reduced stock-based compensation expense,as the six months ended June 30, 2006 included expense related to theacceleration of vesting of stock options following the company’s IPO.

*Other Selling, General and AdministrativeExpenses.*Other selling, general and administrative expenseswere $11.0 million for the six months ended June 30, 2007, an increase of $1.9million or 20.9%, as compared to selling, general and administrative expensesof $9.1 million for the six months ended June 30, 2006*.  *Thisincrease was due to higher occupancy expenses, due to the relocation of theTampa centralized underwriting operations to a new facility, and increased baddebt, telecommunications, insurance and professional fee expenses, partiallyoffset by reduced recruiting expenses.

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*Depreciation and Amortization.*Depreciationand amortization was $4.5 million for the six months ended June 30, 2007, anincrease of $1.1 million or 32.4%, compared to depreciation and amortization of$3.4 million for the six months ended June 30, 2006*.*This increase was primarily due todepreciation recorded on additional property and equipment and softwaredeveloped for internal use.

*Amortization of Intangibles.*Amortizationof intangibles was $5.1 million for the six months ended June 30, 2007 and2006.

**Interest Expense, net**

Interest expense, net was $2.2 million for the sixmonths ended June 30, 2007, a decrease of $2.5 million or 53.2%, compared tointerest expense, net of $4.7 million for the six months ended June 30,2006*.*This decrease was due toreduced borrowings on our term loan and, to a lesser extent, reduced borrowingson our line of credit and a reduction of the interest rate on the termloan.  *See“—Liquidity and Capital Resources.”*

**Loss from Extinguishment of Debt**

For the six months ended June 30, 2007, we recognizeda loss from extinguishment of debt of $0.1 million due to the write-off of debtissuance costs as a result of a $10.0 million prepayment on our term loanduring this period.  For the six monthsended June 30, 2006, we recognized a loss from extinguishment of debt of $0.7million due to the write-off of debt issuance costs as a result of a $70.0million prepayment on our term loan following our initial public offering.*See “—Liquidity and Capital Resources.”*

**IncomeTaxes**

Income taxes for the six months ended June 30, 2007were $1.3 million, a decrease of $0.2 million, compared to $1.5 millionfor the six months ended June 30, 2006. This increase was primarily due to changes in taxable income and oureffective tax rate.  Our effective taxrate for the first six months of 2007 was 38.2% as compared with 38.5% for thefirst six months of 2006.

**DiscontinuedOperations**

Results for the six months ended June 30, 2007 include a pre-tax loss on disposal of $5.2 million consisting of a non-cash pre-tax impairment charge of a $4.7 million relating to impairment of goodwill, intangible assets and property and equipment recognized in the first quarter of 2007, and facility closure costs and the write-off of property and equipment during the second quarter of 2007.  CLS operating results for the six months ended June 30, 2007 included revenue of $0.7 million, an operating loss of $2.2 million, a pre-tax loss of $2.2 million, an income tax benefit of $0.8 million and a net loss of $1.4 million.  CLS operating results for the six months ended June 30, 2006 included revenue of $3.2 million, an operating loss of $1.8 million, a pre-tax loss of $1.8 million an income tax benefit of $0.7 million and a net loss of $1.1 million.

**Liquidity and Capital Resources**

Historically, we have financed our growth from cashflow from operations and bank borrowings. We believe that funds generated fromoperations, together with existing cash and available borrowings under ourCredit Agreement, will be sufficient to finance our current operations, plannedcapital expenditures and internal growth through at least the next twelvemonths. On March 29, 2006, we issued 8,625,000 shares of common stock,including 1,125,000 shares issued through the exercise of the underwriters’over-allotment option, at a price of $17.00 per share through our initialpublic offering of common stock.

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

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

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

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·                  ourseries A convertible preferred stock converted into 2,206,308 shares ofcommon stock and 8,825,241 shares of series A redeemable preferred stock.

·                  ourseries B convertible preferred stock converted into 6,046,371 shares ofcommon stock and 24,185,493 shares of series B redeemable preferred stock.

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

·                  redeem$52.8 million of redeemable preferred stock that resulted from the conversionof our Series A convertible preferred stock and Series B convertiblepreferred stock immediately prior to the completion of the initial publicoffering.

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

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

·                  fund$1.6 million of working capital.

Our operating activities provided cash of $8.5 millionand $9.6 million in the six months ended June 30, 2007 and 2006, respectively.Cash provided from operations is generated primarily from net income and thetiming of accounts receivable collections and disbursements of accountspayable. Cash provided by operations for the six months ended June 30, 2007 wasgenerated from a net loss of $2.6 million, which included a $3.3 million losson disposal of discontinued operations and a $1.4 million loss fromdiscontinued operations, and $10.8 million of non-cash charges and wasnegatively impacted by a net increase in operating assets of $4.4million, primarily due to a decrease in accrued expenses.  Cash provided by operations for the six monthsended June 30, 2006 resulted from net income of $1.3 million, whichincluded a $1.1 million loss from discontinued operations, and $10.2 million ofnon-cash charges and was negatively impacted by a net increase in operatingassets of $2.9 million primarily due to an increase in accounts receivable andunbilled receivables and a decrease in deferred revenue. We believe cash flowfrom operations will be sufficient to finance our current operations for thenext twelve months.

Our investing activities used cash of $6.9 million and$12.0 million in the six months ended June 30, 2007 and 2006, respectively.Cash used in investing activities in the six months ended June 30, 2007primarily consisted of capital expenditures and the acquisition of CER.  Cash used in investing activities in the sixmonths ended June 30, 2006 primarily consisted of capital expenditures and theacquisition of CLS.

Our financing activities used cash of $8.3 million inthe six months ended June 30, 2007 and provided cash of $8.7 million in the sixmonths ended June 30, 2006. The principal use of cash from financing activitiesin the six months ended June 30, 2007 was the repayment of principal on theterm loan, partially offset by proceeds from stock option exercises and excesstax benefits from share-based compensation arrangements. The principal sourcesof cash from financing activities in the six months ended June 30, 2006 werethe proceeds from the initial public offering described above and, to a lesserextent, borrowings under our revolving credit agreement. This was partiallyoffset by the redemption of preferred stock and repayments of outstanding debtunder our credit facility described above.

Cash paid for interest expense was $2.5 million and$4.2 million in each of the six months ended June 30, 2007 and 2006,respectively. In the six months ended June 30, 2007 and 2006, the majority ofinterest expense was paid on borrowings outstanding under our term loan.

In July 2007, we prepaid $5.0 million outstandingunder the term loan.

***Credit Agreement***

OnDecember 8, 2005, we entered into a $190.0 million senior creditfacility. The credit facility provided for a $150.0 million term loan, anda revolving credit facility of $40.0 million. The credit facility alsoprovided us with an option, subject to the consent of the lenders, to increasethe revolving credit facility by $10.0 million to an aggregate of $50.0million. We exercised the option to increase our revolving credit facility by$5.0 million on each of January 11, 2006 and April 28, 2006, and asof June 30, 2007 we have an aggregate revolving credit facility of$50.0 million. Following our initial public offering in March 2006,we prepaid $70.0 million outstanding under the term loan and repaid $7.4million

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outstanding under therevolving credit facility.  In February2007, we prepaid $5.0 million outstanding under the term loan.  An additional $5.0 million was repaid in May2007, and another $5.0 million was repaid in July 2007.

The Credit Agreement terminates on December 8,2011. Principal repayments on the term loan of $137,433 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 interest coverage, fixed chargeand total leverage ratios. As of June 30, 2007, we were in compliance withall debt covenants. In addition, the Credit Agreement places limitations ontotal 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.We do not believe that these covenants will affect our ability to operate ourbusiness.

Loans under the Credit Agreement bear interest at theapplicable LIBOR rate plus 1.75% or Prime Rate plus 0.75%, at our option. Inaddition, we are required to pay a commitment fee of 0.5% based on thecalculation of the excess of the revolving credit loan commitment over theoutstanding balance as defined in the Credit Agreement.

At June 30, 2007, there was an outstanding balance of$54.3 million under the term loan and no outstanding balance under therevolving credit facility.

***Contractual Obligations***

The following table describes our cash commitments, inthousands, to settle contractual obligations as of June 30, 2007.
| ** **                    | ** ** | **Total** | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
|-------------------------------|------------|-----------|------------|-----------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|
| Term loans and  loans payable |       | $         | 54,286     |                        | $          | 275                |       | $                  | 1,099      |                             | $          | 52,912 |   | $ | — |   |
| Capital lease  obligations    |       | 487       |       | 111                         |       | 274                |       | 102                |       | —                           |       |
| Operating lease  obligations  |       | 15,132    |       | 1,930                       |       | 5,181              |       | 2,682              |       | 5,339                            |       |
|                          |       |      |       |                        |       |               |       |               |       |                             |       |
| Total                         |       | $         | 69,905     |                        | $          | 2,316              |       | $                  | 6,554      |                             | $          | 55,696 |   | $ | 5,339 |   |

 

As further discussed in Note 9, we adopted theprovisions of FIN 48 on January 1, 2007. At June 30, 2007, we had approximately $1.9 million of unrecognized taxbenefits which were not included in the “Contractual Obligations” table of our2006 Form 10-K.  Due to the inherentuncertainty of the underlying tax positions, it is not practical to assign theliability as of June 30, 2007 to any particular years in the table.

Interest payments due on the above amounts total$16,605.

**Off-Balance-Sheet Arrangements**

As of June 30, 2007, we did not have any significantoff-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) ofRegulation S-K of the SEC.

**Item 3. Quantitative andQualitative Disclosures about Market Risk**

During the six months ended June 30, 2007, there wereno material changes in our market risk exposure. For a discussion of our marketrisk associated with interest rate risk and equity price risk as ofDecember 31, 2006, see Risk Factors and Management’s Discussion andAnalysis of Financial Condition

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andResults of Operations contained in our Annual Report on Form 10-K for theyear ended December 31, 2006, which includes audited financial statements.

**Item 4.  Controls andProcedures**

***Evaluation of Disclosure Controls andProcedures***

Our management,with the participation of our chief executive officer and chief financialofficer, evaluated the effectiveness of our disclosure controls and proceduresas of June 30, 2007.  The term “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms.  Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is accumulated andcommunicated to the company’s management, including its principal executive andprincipal financial officers, as appropriate to allow timely decisionsregarding required disclosure. Management recognizes that any controls and procedures, no matter howwell designed and operated, can provide only reasonable assurance of achievingtheir objectives and management necessarily applies its judgment in evaluatingthe cost-benefit relationship of possible controls and procedures.  Based on the evaluation of our disclosurecontrols and procedures as of June 30, 2007, our chief executive officer andchief financial officer concluded that, as of such date, the Company’sdisclosure controls and procedures were effective at the reasonable assurancelevel.

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

There have been nochanges in our internal control over financial reporting during the quarterlyperiod ended June 30, 2007 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

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**Part II — OTHER INFORMATION**

**Item 1.      Legal Proceedings**

Fromtime to time, we may be party to various claims, suits and complaints.  Currently, there are no such claims, suits orcomplaints that, in our opinion would have a material adverse effect on ourbusiness, results of operations and financial condition.

**Item 1A.   Risk Factors**

Not applicable.

**Item 2.      Unregistered Sales of Equity Securities and Use of Proceeds**

Upontermination, during the three months ended June 30, 2007, employees forfeited7,000 unvested shares of restricted stock, as detailed in the following table:
| Period                                       | ** ** | **Total Number of  Shares Forfeited** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|
| April 1,  2007 – April 30, 2007    |       | 1,500                                                |       |
| May 1, 2007  – May 31, 2007   |       | 1,500                                                |       |
| June 1, 2007 –  June 30, 2007 |       | 4,000                                                |       |

 

**Item 3.      Defaults Upon Senior Securities**

Not applicable.

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

On June 7, 2007, we held our Annual Meeting of Stockholders.  At the meeting, the stockholders electedBrian L. Libman and Michael M. Sonderby to the Board of Directors, each toserve for a three-year term as a Class II Director.  19,955,640 votes were cast for Mr.Libman’selection; 76,739 votes were cast to withhold authority forMr. Libman.  19,955,140 votes werecast for Mr. Sonderby’s election; 77,239 votes were cast to withholdauthority for Mr. Sonderby.  Also atthe meeting, the stockholders ratified the appointment of Grant Thornton LLP asour independent registered public accounting firm for the current year.  The votes cast to ratify Grant Thornton LLP’sappointment were as follows: 19,994,804 shares voted for, 37,275 voted againstand 300 shares abstained from voting.

**Item 5.      Other Information**

Not applicable.

**Item 6.      Exhibits**

Theexhibits listed in the Exhibit Index immediately preceding the exhibitsare filed as part of this Quarterly Report on Form 10-Q and suchExhibit Index is incorporated herein by reference.

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|                                  | **CLAYTON  HOLDINGS, INC.** |
|----------------------------------|----------------------------------|
|                             |                             |
| Date:  August 8,  2007 | 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 Exhibits filed aspart 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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* ThisCertification shall not be deemed “filed” for purposes of Section 18 of theSecurities Exchange Act of 1934, or otherwise subject to the liability of thatSection, nor shall it be deemed to be incorporated by reference into any filingunder the Securities Act of 1933 or the Securities Exchange Act of 1934.

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