**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-K**





x ANNUAL
      REPORT
      PURSUANT TO SECTION 13 OR 15(d)


OF
      THE SECURITIES EXCHANGE ACT OF 1934


For
      the fiscal year ended December 31, 2006.





o TRANSITION
      REPORT
      PURSUANT TO SECTION 13 OR 15(d)


OF
      THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]


For
      the transition period from  to





Commission
      File Number: 0-26392





**CICERO
      INC.**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            
            **11-2920559**(State
                of incorporation)
            
            *(I.R.S.
                Employer Identification No.)*





**1433
                State Highway 34, Building C, Farmingdale, New Jersey 07727***(Address
                of principal executive offices, including Zip
                Code)***(732)
                919-3150**(*Registrant’s
                telephone number, including area
                code)*


_____________





Securities
                registered pursuant to Section 12(b) of the Act:
            **NONE**Securities
                registered pursuant to Section 12(g) of the Act:
            **Common
                Stock, $.001 par value**


_____________





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes
      o No x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the above Act. Yes
      o No x





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.


Yes
      x No o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of the Registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. o





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


Large
      accelerated filer o   Accelerated
      filer o  Non
      - accelerated filer x




Aggregate
      market value of the outstanding shares of common stock held by non-affiliates
      of
      the Registrant as of June 30, 2006 was approximately $2,153,345 based upon
      the
      closing price quoted on the Over The Counter Bulletin Board.





There
      were 38,873,793 shares of Common Stock outstanding as of March 13, 2007.











**CICERO
      INC.**


(Formerly
      Level 8 Systems, Inc.)


Annual
      Report on Form 10-K


For
      the Fiscal Year Ended December 31, 2006





Item
              Number
            
            
            Page
              NumberPART
                I1.
            
            Business
            11A.
            
            Risk
                factors
            91B
            
            Unresolved
                Staff Comments
            142.
            
            Properties
            143.
            
            Legal
                Proceedings
            144.
            
            Submission
                of Matters to a Vote of Security
                Holders
            15PART
                II5.
            
            Market
                for Cicero Common Stock and Related Shareholder
                Matters
            166.
            
            Selected
                Financial Data
            177.
            
            Management's
                Discussion and Analysis of Financial Condition
                and Results of Operations
            187A.
            
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            288.
            
            Financial
                Statements and Supplementary
                Data
            289.
            
            Changes
                in and Disagreements with Accountants on
                Accounting and Financial Disclosure
            289A.
            
            Controls
                and Procedures
            289B.
            
            Other
                Information
            29PART
                III10.
            
            Directors
                and Executive Officers of
                Cicero
            3011.
            
            Executive
                Compensation
            3312.
            
            Security
                Ownership of Certain Beneficial Owners and
                Management
            3413.
            
            Certain
                Relationships and Related
                Transactions
            3614.
            
            Principal
                Accountant Fees and Services
            40PART
                IV15.
            
            Index
                Exhibits, Financial Statement Schedules, and Reports
                on Form 8-K
            41SIGNATURES
            48INDEX
                TO FINANCIAL STATEMENTS
            F-1














**PART
      I**




**Item
      1.**  **Business**





**Overview**





*Cicero
      Inc, formerly known as Level 8 Systems, Inc. (the “Company”)* is
      a ** provider
      of business integration software, which enables organizations to integrate
      new
      and existing information and processes at the desktop. Our business integration
      software addresses the emerging need for companies’ information systems to
      deliver enterprise-wide views of their business information
      processes. ** In
      addition to software products, the Company also provides technical support,
      training and consulting services as part of its commitment to providing its
      customers with industry-leading integration solutions. The Company’s consulting
      team has in-depth experience in developing successful enterprise-class solutions
      as well as valuable insight into the business information needs of customers
      in
      the largest 500 corporations worldwide (the “Global 5000”).





The
      Company’s focus is on the growing desktop integration and business process
      automation market with our Cicero ® product. Cicero® is a business application integration platform that enhances
      end-user productivity, streamlines business operations and integrates systems
      and applications that would not otherwise work together. Cicero® software offers
      a proven, innovative departure from traditional, costly and labor-intensive
      enterprise application integration, which occurs at the server level. Cicero®
provides non-invasive application integration at the desktop level. Desktop
      level integration provides the user with a single environment with a consistent
      look and feel for diverse applications across multiple operating environments,
      reduces enterprise integration implementation cost and time, and supports a
      Service-Oriented Architecture (“SOA”). Cicero®’s desktop level integration also
      enables clients to transform applications, business processes and human
      expertise into a seamless, cost effective business solution that provides a
      cohesive, task-oriented and role-centric interface that works the way people
      think.





By
      using Cicero® software, companies can decrease their customer management costs,
      improve their customer service and more efficiently cross-sell the full range
      of
      their products and services resulting in an overall increase in return on their
      information technology investments. In addition, Cicero® software enables
      organizations to reduce the business risks inherent in replacement or
      re-engineering of mission-critical applications and extend the productive life
      and functional reach of their application portfolio.





Cicero®
      software is engineered to integrate diverse business applications and shape
      them
      to more effectively serve the people who use them. Cicero® provides an intuitive
      integration and development environment, which simplifies the integration of
      complex multi-platform applications. Cicero® provides a unique approach that
      allows companies to organize components of their existing applications to better
      align them with tasks and operational processes. In addition, Cicero® can
      streamline end-user tasks by providing a single, seamless user interface for
      simple access to multiple systems or be configured to display one or more
      composite applications to enhance productivity. Cicero® software enables
      automatic information sharing among line-of-business applications and tools.
      It
      is ideal for deployment in contact centers where its highly productive,
      task-oriented user interface promotes user efficiency. Finally, Cicero®
software, by integrating diverse applications across multiple operating systems,
      is ideal for the financial services, for which Cicero® was initially developed,
      insurance, telecommunications, intelligence, security, law enforcement,
      governmental and other industries requiring a cost-effective, proven application
      integration solution. Cicero® is also an integration solution for merger and
      acquisition events where the sharing of data and combining of systems is
      imperative.





Some
      of the companies and other users that have implemented or are implementing
      our
      Cicero® software product include Merrill Lynch Pierce Fenner & Smith
      Incorporated, Nationwide Financial Services, IBM and N.E.W. Customer Service
      Companies. We have also sold to intelligence, security, law enforcement and
      other government users.





In
      addition to our Cicero® product, our Ensuredmail email encryption products
      address information and security compliance requirements from the individual
      to
      the enterprise. The Ensuredmail suite of products includes the Enterprise Email
      Encryption Server, and Email Encryption Desktop for individual use. All of
      the
      Ensuredmail products use 3-DES or AES encryption technology and are tested
      and
      federally certified FIPS 140-1. Ensuredmail products are easy to install, use
      and administer. They also use rules and other utilities that allow users to
      flag
      messages including attachments for encryption. Unlike other secure email
      encryption software applications, Ensuredmail products do not require the
      recipient to install software or use special secure keys to open and read
      messages and attachments. In conjunction with Cicero® software, Ensuredmail
      email encryption technology has been used to secure information shared in
      Cicero® integration projects.


1


Some
      of the companies using Ensuredmail server products include the United Postal
      Service, E-Loan, the U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives,
      Science Application International Association, Wilmington Trust, Delta Dental,
      Truog-Ryding Company, and hundreds of individual users with the Ensuredmail
      Email Desktop product. Ensuredmail customers use email encryption primarily
      to
      secure outbound messages with confidential information for compliance (e.g.,
      HIPAA) and security purposes.





Cicero
      Inc. was incorporated in New York in 1988 as, Level 8 Systems, Inc. and
      re-incorporated in Delaware in 1999. Our principal executive offices are located
      at 1433 State Highway 34, Building C, Farmingdale, New Jersey 07727 and our
      telephone number is (732) 919-3150. Our web site is
      www.ciceroinc.com.








**Strategic
      Realignment**





Historically,
      the Company has been a global provider of software solutions designed to help
      companies integrate new and existing applications as well as extend those
      applications to the Internet. This market segment is commonly known as
      Enterprise Application Integration or EAI. Historically, EAI solutions work
      directly at the server or back-office level allowing disparate applications
      to
      communicate with each other.





Until
      early 2001, we focused primarily on the development, sale and support of EAI
      solutions through our Geneva product suite. After extensive strategic
      consultation with outside advisors and an internal analysis of our products
      and
      services, we recognized that a new market opportunity had emerged. This
      opportunity was represented by the increasing need to integrate applications
      that are physically resident on different platforms, a typical situation in
      larger companies. In most cases, companies with large customer bases utilize
      numerous different, or "disparate," applications that were not designed to
      effectively communicate and pass information. In addition, traditional EAI
      is
      often times too costly and time-consuming to implement. It also requires a
      group
      of programmers with the necessary skills and ongoing invasive changes to
      application software code throughout the enterprise. With Cicero® software,
      which non-invasively integrates the functionality of these disparate
      applications at the desktop, we believe that we have found a unique solution
      to
      this disparate application problem. We believe that our existing experience
      in
      and understanding of the EAI marketplace coupled with the unique Cicero®
software solution, which approaches traditional EAI needs in a more effective
      manner, position us to be a competitive provider of business integration
      solutions to the financial services and other industries with large deployed
      contact centers, as well as our other target markets.





We
      originally licensed the Cicero® technology and related patents on a worldwide
      basis from Merrill Lynch, Pierce, Fenner & Smith Incorporated in August of
      2000 under a license agreement containing standard provisions and a two-year
      exclusivity period. On January 3, 2002, the license agreement was amended to
      extend our exclusive worldwide marketing, sales and development rights to
      Cicero® in perpetuity (subject to Merrill Lynch's rights to terminate in the
      event of bankruptcy or a change in control of the Company) and to grant
      ownership rights in the Cicero® trademark. Merrill Lynch indemnifies us with
      regard to the rights granted to us by them. Consideration for the original
      Cicero® license we issued to Merrill Lynch consisted of 1,000,000 shares of our
      common stock. In consideration for the amendment, we issued an additional
      250,000 shares of common stock to MLBC, Inc., a Merrill Lynch affiliate and
      entered into a royalty sharing agreement. Under the royalty sharing agreement,
      we pay a royalty of 3% of the sales price for each sale of Cicero® or related
      maintenance services. The royalties over the life of the agreement are not
      payable in excess of $20 million. We have completely re-engineered the Cicero®
software to provide increased functionality and much more powerful integration
      capabilities.


The
        Company’s future revenues are entirely dependent on acceptance of Cicero® which
        has had limited success in commercial markets to date. The Company has
        experienced negative cash flows from operations for the past three years.
        As of
        December 31, 2006, the Company had a working capital deficiency of approximately
        $7,894,000. Accordingly, there is substantial doubt that the Company can
        continue as a going concern, as is expressed in the independent auditor’s report
        accompanying our financial statements. In order to address these issues and
        to
        obtain adequate financing for the Company’s operations for the next twelve
        months, the Company is actively promoting and expanding its product line
        and
        continues to negotiate with significant customers who have demonstrated interest
        in the Cicero® technology. The Company is experiencing difficulty increasing
        sales revenue largely because of the inimitable nature of the product as
        well as
        customer concerns about the Company’s financial viability. Cicero® software is a
        new “category defining” product in that most EAI projects are performed at the
        server level and Cicero®’s integration occurs at the desktop level without the
        need to open and modify the underlying code for those applications being
        integrated. Many companies are not aware of this new technology or tend to
        look
        toward more traditional and accepted approaches. The Company is attempting
        to
        solve the former problem by improving the market’s knowledge and understanding
        of Cicero® through increased marketing and leveraging its limited number of
        reference accounts while enhancing its list of resellers and system integrators
        to assist in the sales and marketing
  2
  process.
        Additionally, the Company is seeking additional equity capital or other
        strategic transactions in the near term to provide additional liquidity.


**Plan
      of Recapitalization**





In
      December 2006, the Company completed its Plan of Recapitalization which was
      approved by shareholders at a Special Shareholder Meeting held on November
      16,
      2006. The Plan provided the Company’s Board of Directors with discretionary
      authority to affect a reverse stock split ratio from 20:1 to 100:1 and on
      November 20, 2006, the Board of directors set that reverse stock ratio to be
      100:1. In addition, the Company’s shareholders approved an amendment to change
      the name of the Company from Level 8 Systems, Inc. to Cicero Inc., to increase
      the authorized common stock of the Company from 85 million shares to 215 million
      shares and to convert existing preferred shares into a new Series A-1 preferred
      stock. Senior Reorganization Notes in the aggregate principal amount of
      $2,309,000, were cancelled and converted into 3,438,473 shares of common stock.
      Senior Reorganization Notes were issued pursuant to a Note and Warrant Offering
      in 2004 wherein warrant holders of the Company’s common stock were offered a
      one-time conversion of their existing warrants at a conversion price of $0.10
      per share. Those warrant holders who elected to convert, tendered their
      conversion price in cash and received a Note Payable in exchange. In addition,
      holders of Senior Reorganization Notes were granted additional warrants to
      acquire the Company’s common stock. The Company also converted $3,915,000 of
      Convertible Bridge Notes into 30,508,448 shares of common stock. The Plan of
      Recapitalization also included an exchange of existing preferred shares into
      a
      new Series A-1 preferred shares for Cicero Inc. As part of that exchange and
      part of the plan of recapitalization, $992,000 of Convertible Promissory Notes
      were converted into 1,591 Series A-1 preferred shares and $1,061,000 of Series
      D
      preferred stock recorded as mezzanine financing was converted into 53 preferred
      shares.





The
      Company expects that increased revenues will reduce its operating losses in
      future periods; however, there can be no assurance that management will be
      successful in executing its strategy as anticipated or in a timely manner.
      If
      these strategies are unsuccessful, the Company may have to pursue other means
      of
      financing that may not be on terms favorable to the Company or its stockholders.
      If the Company is unable to increase cash flow or obtain financing, it may
      not
      be able to generate enough capital to fund operations for the next twelve
      months. At our current rate of expenses and assuming revenues for the next
      twelve months at an annualized rate of our revenue for the year ended 2006,
      we
      will be able to fund planned operations with existing capital resources for
      a
      minimum of four months and experience negative cash flow of approximately
      $2,000,000 during the next twelve months to maintain planned operations. The
      accompanying financial statements have been prepared on a going concern basis,
      which contemplates the realization of assets and the satisfaction of liabilities
      in the normal course of business. The financial statements presented herein
      do
      not include any adjustments relating to the recoverability of assets and
      classification of liabilities that might be necessary should the Company be
      unable to continue as a going concern.








**Products**





***Desktop
      Integration Segment***





*Cicero* ®.
      Cicero® software integrates disparate applications regardless of the platform,
      enables rapid development of effective, simple-to-maintain composite
      applications, accelerates time to value and deploys cost-effective,
      "best-of-breed" business solutions by leveraging existing IT investments.
      Cicero® software helps the architect maintain consistent integration project
      design and implementation by providing extensible, standardized software methods
      for interacting with Windows applications, COM objects, web pages, commercial
      software packages, legacy applications, and Java applications among others.
      Cicero® software can integrate applications running on the server or desktop,
      giving the architect complete flexibility in determining where, when, and how
      application integration occurs. Cicero® software can also be used to capture and
      aggregate data from many different applications, apply business rules as needed,
      such as data transformation rules, and share that data bi-directionally via
      a
      composite view. An event in one application can cause processing in another
      unrelated application, even if these were implemented using differing
      technologies, such as Windows and Java.





The
      patented Cicero® software technology, as exclusively licensed from Merrill
      Lynch, consists of several components, including the following: The Resource
      Manager, which manages the starting, stopping, and status of applications;
      the
      Event Manager, a Component Object Model (COM)-based messaging service; the
      Context Manager which administers the “publish and subscribe” protocols; and a
      Graphical User Interface (GUI) manager which allows applications to be presented
      to the user in one or more flexible formats selected by the user organization.
      In 2004, we released a version of the Cicero® product which included our newly
      developed Cicero® Studio integration tool, to allow applications to be
      integrated using point-and-click methods. Cicero® software incorporates an
      Application Bus with code modules to handle the inter-application connections.
      There are additional tools that provide ancillary functions for the integrator
      including toolset to debug, view history and trace logs.


3








Cicero®
      Studio provides a nontraditional approach to application integration. By
      providing a high level of object-oriented integration, Cicero® Studio eliminates
      the need for source code modification. It includes high-level integration
      objects called genes (which translate disparate application interface protocols
      to one common interface used by Cicero® software), an event processor, a context
      manager and a publish-subscribe information bus that enables applications to
      share data. It also includes a set of integration wizards that greatly simplify
      the task of application integration.





Cicero®
      Studio is a powerful integration tool that eliminates most of the technical
      complexity associated with application integration. Integrators avoid the high
      cost and complexity of invasive code modifications and extend the scope of
      their
      integration capabilities into new and legacy environments. Cicero® Studio
      provides an open architecture that can be extended to incorporate new behaviors
      by adding genes and communicating with COM objects. This enables Cicero®
software to be extended to accommodate new platforms and interface requirements
      as needed and provides a rich paradigm for evolving integration behaviors over
      time. It also means that Cicero® software can be implemented in both the desktop
      and n-tier server of a service-oriented architecture.





Cicero®
      software runs on Vista, Windows XP, and Windows 2000 to organize applications
      in
      a flexible graphical configuration that keeps all the application functionality
      that the user needs within easy reach. For instance, selecting the “memo” tab
      might cause a Microsoft Word memo-template to be created within the Cicero®
desktop. The end-user need not even know that they are using Microsoft Word.
      Moreover, a customer-tracking database can be linked with a customer
      relationship management software package.





Cicero®
      technology provides non-intrusive integration of desktop and web applications,
      portals, third-party business tools, and even legacy mainframe and client server
      applications, so all co-exist and share their information seamlessly. Cicero®’s
      non-invasive technology means that clients don’t risk modifying either fragile
      source code or sensitive application program interfaces - and they can easily
      integrate off-the-shelf products and emerging technologies.





Cicero®
      software allows end-users to access applications in the most efficient way
      possible, by only allowing them to use the relevant portions of that
      application. For instance, a contact center customer service representative
      may
      not use 90% of the functionality of Microsoft Word, but might need access to
      a
      memorandum and other custom designed forms as well as basic editing
      functionality. Cicero® can be set to control access to only those templates and,
      in a sense, turn-off the unused functionality by not allowing the end-user
      direct access to the underlying application. Under the same Cicero®
implementation, however, a different Cicero® configuration could allow the
      employees in the Marketing department full access to Word because they have
      need
      of the full functionality. The functionality of the applications that Cicero®
integrates can be modulated by the business goals of the ultimate client, the
      parent company. This ability to limit user access to certain functions within
      applications enables companies to reduce their training burden by limiting
      the
      portions of the applications on which they are required to train their customer
      service representatives.


***Messaging
        and Application Engineering Segment***
  *Ensuredmail* *.* Our
          Ensuredmail products provide encrypted email capabilities such as security,
          proof-of-delivery and non-repudiation of origination. The recipient of
          an
          Ensuredmail message does not need to be an
  4
  Ensuredmail
          licensee or install software. When an Ensuredmail user sends a message
          to
          another user, the recipient receives an email message with an attached
          encrypted
          message. The recipient opens the attached, which starts their web browser,
          enters a password, and can read the message and attachments. If the recipient
          replies to the message, the message is fully encrypted and sent back securely
          to
          the original sender. Organizations typically use our server-based Ensuredmail
          products, whereas individuals can use a person-to-person desktop
          variation.


Ensuredmail
      is FIPS140-1 certified, and in use by agencies of the Federal Government, in
      addition to private sector organizations.





***Services***




We
      provide a full spectrum of technical support, training and consulting services
      across all of our operating segments as part of our commitment to providing
      our
      customers industry-leading business integration solutions. Experts in the field
      of systems integration with backgrounds in development, consulting, and business
      process reengineering staff our services organization. In addition, our services
      professionals have substantial industry specific backgrounds with extraordinary
      depth in our focus marketplace of financial services.





***Maintenance
      and Support***




We
      offer customers varying levels of technical support tailored to their needs,
      including periodic software upgrades, and telephone support. Cicero® and
      Ensuredmail software are frequently used in mission-critical business
      situations, and our maintenance and support services are accustomed to the
      critical demands that must be met to deliver world-class service to our clients.
      Many of the members of our staff have expertise in lights-out mission critical
      environments and are ready to deliver service commensurate with those unique
      client needs.




***Training
      Services***





Our
      training organization offers a full curriculum of courses and labs designed
      to
      help customers become proficient in the use of our products and related
      technology as well as enabling customers to take full advantage of our
      field-tested best practices and methodologies. Our training organization seeks
      to enable client organizations to gain the proficiency needed in our products
      for full client self-sufficiency but retains the flexibility to tailor their
      curriculum to meet specific needs of our clients.





***Consulting
      Services***




We
      offer consulting services around our product offerings in project management,
      applications and platform integration, application design and development and
      application renewal, along with expertise in a wide variety of development
      environments and programming languages. We also have an active partner program
      in which we recruit leading IT consulting and system integration firms to
      provide services for the design, implementation and deployment of our solutions.
      Our consulting organization supports third party consultants by providing
      architectural and enabling services.




**Customers**





Our
      customers include both end-users to whom we sell our products and services
      directly and distributors and other intermediaries who either resell our
      products to end-users or incorporate our products into their own product
      offerings. Typical end-users of our products and services are large businesses
      with sophisticated technology requirements for contact centers, in the financial
      services, insurance and telecommunications industries, and intelligence,
      security, law enforcement and other governmental organizations.





Our customers are using our solutions to rapidly deploy applications. Some
      examples of customers' uses of our products include:





·
            *Business
                Process Outsourcers*- use our Cicero®solution in contact centers to provide real time integration among
                existing back-office systems, eliminate redundant data entry, shorten
                call
                times, provide real-time data access and enhance customer service
                and
                service levels.





·
            *A
                financial institution*- uses our Cicero®solution to provide real-time integration among market data, customer
                account information, existing back-office systems and other legacy
                applications, eliminate redundant data entry, provide real-time data
                access and processing, and enhance customer service and service
                levels.





5





·
            *An
                insurance company*- uses our Cicero®solution to integrate their customer information systems with over
                thirty
                software applications including a CRM
                application.





·
            *A
                law enforcement organization*- uses our Cicero®solution to streamline and automate support for arrests and investigations
                while merging federal, state and local systems within a unified
                process.





Other
      customers are systems integrators, which use our Cicero® product to develop
      integration solutions for their customers.





Merrill
      Lynch, N.E.W. Customer Service Companies, IBM, and Pilar Services, Inc. each
      accounted for more than ten percent (10%) of our operating revenues in 2006.
      In
      2005, NEW Customer Service Companies and Innovative System Solutions Corporation
      accounted for more than ten percent (10%) of our operating revenue. Bank of
      America, Convergys, IBM, Nationwide Financial Services and SAIC each accounted
      for more than ten percent (10%) of our operating revenue in 2004.





**Sales
      and Marketing**




***Sales***




An
      important element of our sales strategy is to supplement our direct sales force
      by expanding our relationships with third parties to increase market awareness
      and acceptance of our business integration software solutions. As part of these
      relationships, we continue to jointly sell and implement Cicero® software
      solutions with strategic partners such as systems integrators and embed Cicero®
along with other products through reseller relationships. We provide training
      and other support necessary to systems integrators and Resellers to aid in
      the
      promotion of our products. To date we have entered into strategic partnerships
      with the following resellers, for integrated business solutions: ThinkCentric,
      Hewlett Packard and House of Code. In addition, we have entered into strategic
      partnerships with Silent Systems, Inc., ADPI LLC, and Pilar Services, Inc.
      These
      organizations have relationships with existing customers or have access to
      organizations requiring top secret or classified access. In addition, several
      of
      these partners can bundle Cicero® with other software to provide a comprehensive
      solution to customers. We are not materially dependent on any of these
      organizations. Generally, our agreements with such partners provide for price
      discounts based on their sales volume, with no minimum required
      volume.





***Marketing***




The
      target market for our products and services are large companies operating
      contact centers and in the financial services, insurance and telecommunications
      industries, as well as users in the intelligence, security and law enforcement
      communities and other governmental organizations. Increasing competitiveness
      and
      consolidation is driving companies in such businesses to increase the efficiency
      and quality of their customer contact centers. As a result, customer contact
      centers are compelled by both economic necessity and internal mandates to find
      ways to increase internal efficiency, increase customer satisfaction, increase
      effective cross-selling, decrease staff turnover cost and leverage their
      investment in current information technology.




Our
      marketing staff has an in-depth understanding of the customer contact center
      software marketplace and the needs of these customers, as well as experience
      in
      all of the key marketing disciplines. They also have knowledge of the financial
      services industry and government organizations that have focused on application
      integration solutions to address needs in mergers and acquisitions and homeland
      security.




Core
      marketing functions include product marketing, marketing communications and
      strategic alliances. We utilize focused marketing programs that are intended
      to
      attract potential customers in our target vertical industries and to promote
      our
      company and our brands. Our marketing programs are specifically directed at
      our
      target markets, and include speaking engagements, public relations campaigns,
      focused trade shows and web site marketing, while devoting substantial resources
      to supporting the field sales team with high quality sales tools and ancillary
      material. As product acceptance grows and our target markets increase, we will
      shift to broader marketing programs.




The
      marketing department also produces ancillary material for presentation or
      distribution to prospects, including demonstrations, presentation materials,
      white papers, case studies, articles, brochures, and data sheets.


6


**Research
      and Product Development**




In
      connection with the narrowing of our strategic focus, we have experienced an
      overall reduction in research and development costs. Since Cicero® is a new
      product in a relatively untapped market, it is imperative to constantly enhance
      the feature sets and functionality of the product.





We
      incurred research and development expense of approximately $533,000, $891,000
      and $1,111,000 in 2006, 2005, and 2004, respectively. The decrease in costs
      reflects the reduction in the number of employees by two plus associated
      overheads in 2006, and two employees, plus associated overheads in 2005.





Our
      budgets for research and development are based on planned product introductions
      and enhancements. Actual expenditures, however, may significantly differ from
      budgeted expenditures. Inherent in the product development process are a number
      of risks. The development of new, technologically advanced software products
      is
      a complex and uncertain process requiring high levels of innovation, as well
      as
      the accurate anticipation of technological and market trends.




**Competition**




The
        markets in which we compete are highly competitive and subject to rapid change.
        These markets are highly fragmented and served by numerous firms. We believe
        that the competitive factors affecting the markets for our products and services
        include:
 
 ·
              Product
                  functionality and features;
 
 ·
              Availability
                  and quality of support services;
 
 ·
              Ease
                  of product implementation;
 
 ·
              Price;
 
 ·
              Product
                  reputation; and
 
 ·
              Our
                  financial stability.
  The
          relative importance of each of these factors depends upon the specific
          customer
          environment. Although we believe that our products and services can compete
          favorably, we may not be able to increase our competitive position against
          current and potential competitors. In addition, many companies choose to
          deploy
          their own information technology personnel or utilize system integrators
          to
          write new code or rewrite existing applications in an effort to develop
          integration solutions. As a result, prospective customers may decide against
          purchasing and implementing externally developed and produced solutions
          such as
          ours.
 
 We
          compete with companies that utilize varying approaches to modernize, web-enable
          and integrate existing software applications:
 
 ·
                Portal
                    software offers the ability to aggregate information at a single
                    point,
                    but not the ability to integrate transactions from a myriad of
                    information
                    systems on the desktop. Plumtree is a representative company
                    in the
                    market.
 
 ·
                Middleware
                    software provides integration of applications through messages
                    and data
                    exchange implemented typically in the middle tier of the application
                    architecture. This approach requires modification of the application
                    source code and substantial infrastructure investments and operational
                    expense. Reuters, TIBCO and IBM MQSeries are competitors in the
                    middleware
                    market.
 
 ·
                CRM
                    software offers application tools that allow developers to build
                    product
                    specific interfaces and custom applications. This approach is
                    not designed
                    to be product neutral and is often dependent on deep integration
                    with our
                    technology. Siebel is a representative product in the CRM software
                    category.
 
 ·
                Recently,
                    there have been several companies that offer capabilities similar
                    to our
                    Cicero® software in that these companies advertise that they integrate
                    applications without modifying the underlying code for those
                    applications.
                    OpenSpan is one company who advertises that they can non-invasively
                    integrate at the point of contact or on the
                    desktop.


7


Other
      competitors include Above All Software, Attachmate Corporation, Seagull Software
      Ltd. and Oracle. Our Cicero® product competes directly with other contact center
      solutions offered by Microsoft, Corizon and Jacada. We expect additional
      competition from other established and emerging companies. Furthermore, our
      competitors may combine with each other, or other companies may enter our
      markets by acquiring or entering into strategic relationships with our
      competitors. Many of our current and possible future competitors have greater
      name recognition, a larger installed customer base and greater financial,
      technical, marketing and other resources than we have.





**Intellectual
      Property**




Our
      success is dependent upon developing, protecting and maintaining our
      intellectual property assets. We rely upon combinations of copyright, trademark
      and trade secrecy protections, along with contractual provisions, to protect
      our
      intellectual property rights in software, documentation, data models,
      methodologies, data processing systems and related written materials in the
      international marketplace. In addition, Merrill Lynch holds a patent with
      respect to the Cicero® technology. Copyright protection is generally available
      under United States laws and international treaties for our software and printed
      materials. The effectiveness of these various types of protection can be
      limited, however, by variations in laws and enforcement procedures from country
      to country. We use the registered trademarks “Cicero®” and ,
“Ensuredmail”





All
      other product and company names mentioned herein are for identification purposes
      only and are the property of, and may be trademarks of, their respective
      owners.




**Employees**




As
      of December 31, 2006, we employed 18 employees. Our employees are not
      represented by a union or a collective bargaining agreement.




We
      believe that to fully implement our business plan we will be required to enhance
      our ability to work with the Microsoft Vista, Windows XP, and Windows 2000
      operating systems as well as the Linux operating system by adding additional
      development personnel as well as additional direct sales personnel to complement
      our sales plan. Although we believe that we will be successful in attracting
      and
      retaining qualified employees to fill these positions, no assurance can be
      given
      that we will be successful in attracting and retaining these employees now
      or in
      the future.





**Available
      Information**





Our
      web address is www.ciceroinc.com. We make available free of charge through
      our
      web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current
      reports on Form 8-K, and all amendments to those reports as soon as reasonably
      practicable after such material is electronically filed with or furnished to
      the
      Securities and Exchange Commission.





**Forward
      Looking and Cautionary Statements**





Certain
      statements contained in this Annual Report may constitute "forward looking
      statements" within the meaning of the Private Securities Litigation Reform
      Act
      of 1995 ("Reform Act"). We may also make forward looking statements in other
      reports filed with the Securities and Exchange Commission, in materials
      delivered to shareholders, in press releases and in other public statements.
      In
      addition, our representatives may from time to time make oral forward-looking
      statements. Forward looking statements provide current expectations of future
      events based on certain assumptions and include any statement that does not
      directly relate to any historical or current fact. Words such as "anticipates,"
      "believes," "expects," "estimates," "intends," "plans," "projects," and similar
      expressions, may identify such forward looking statements. In accordance with
      the Reform Act, set forth below are cautionary statements that accompany those
      forward looking statements. Readers should carefully review these cautionary
      statements as they identify certain important factors that could cause actual
      results to differ materially from those in the forward-looking statements and
      from historical trends. The following cautionary statements are not exclusive
      and are in addition to other factors discussed elsewhere in our filings with
      the
      Securities and Exchange Commission and in materials incorporated therein by
      reference: there may be a question as to our ability to operate as a going
      concern, our future success depends on the market acceptance of the Cicero®
product and successful execution of the new strategic direction; general
      economic or business conditions may be less favorable than expected, resulting
      in, among other things, lower than expected revenues; an unexpected revenue
      shortfall may adversely affect our business because our expenses are largely
      fixed; our quarterly operating results may vary significantly because we are
      not
      able to accurately predict the amount and timing of individual sales and this
      may adversely impact our stock price; trends in sales of our products and
      general economic conditions may affect investors' expectations regarding our
      financial performance and may adversely affect our stock price; our
      future


8


results
      may depend upon the continued growth and business use of the Internet; we may
      lose market share and be required to reduce prices as a result of competition
      from our existing competitors, other vendors and information systems departments
      of customers; we may not have the ability to recruit, train and retain qualified
      personnel; rapid technological change could render the Company's products
      obsolete; loss of any one of our major customers could adversely affect our
      business; our products may contain undetected software errors, which could
      adversely affect our business; because our technology is complex, we may be
      exposed to liability claims; we may be unable to enforce or defend our ownership
      and use of proprietary technology; because we are a technology company, our
      common stock may be subject to erratic price fluctuations; and we may not have
      sufficient liquidity and capital resources to meet changing business conditions.





**Item1A.
      Risk Factors**





***There
      is substantial doubt as to whether we can continue as a going
      concern*** .





Because
      we incurred net operating losses of approximately $3.0 million for the year
      ended December 31, 2006 in addition to losses from continuing operations of
      approximately $13.4 million for the previous two fiscal years we experienced
      negative cash flows from operations, had significant working capital
      deficiencies at December 31, 2006, and because we are relying on acceptance
      of a
      newly developed and marketed product, there is substantial doubt that we can
      continue to operate as a going concern. While we have attracted some additional
      capital to continue to fund operations, there can be no assurance that we can
      obtain additional financing and if we do obtain financing that it will be on
      terms that are favorable to us or our stockholders.





***We
      have a history of losses and expect that we will continue to experience losses
      at least through mid 2007*** .





We
      experienced operating losses and net losses for each of the years from 1998
      through 2006. We incurred a net loss of $25.1 million for 1998, $15.5 million
      for 1999, $28.4 million for 2000, $105.1 million for 2001, $18.2 million for
      2002, $10.0 million for 2003, $9.76 million in 2004, $3.68 million in 2005
      and
      $3.0 million in 2006. As of December 31, 2006, we had a working capital deficit
      of $7.9 million and an accumulated deficit of $234 million. Our ability to
      generate positive cash flow is dependent upon sustaining certain cost reductions
      and generating sufficient revenues.





Therefore,
      due to these and other factors, we expect that we will continue to experience
      net losses through the first quarter of 2007. We have not generated sufficient
      revenues to pay for all of our operating costs or other expenses and have relied
      on financing transactions over the last several fiscal years to pay our
      operating costs and other expenses. We cannot predict with accuracy our future
      results of operations and believe that any period-to-period comparisons of
      our
      results of operations are not meaningful. Furthermore, there can be no assurance
      that if we are unable to generate sufficient revenue from operations that we
      will be able to continue to access the capital markets to fund our operations,
      or that if we are able to do so that it will be on satisfactory
      terms.





As
      the number of software products in the industry increases and the functionality
      of these products further overlaps, we believe that software developers and
      licensors may become increasingly subject to infringement claims. Any such
      claims, with or without merit, could be time consuming and expensive to defend
      and could adversely affect our business, operating results and financial
      condition.





***We
      develop new and unproven technology and products.***





Historically,
      the Company has been a global provider of software solutions to help companies
      integrate new and existing applications as well as extend those applications
      to
      the Internet. This market segment is commonly known as Enterprise Application
      Integration or EAI. Historically, EAI solutions work directly at the server
      or
      back-office level allowing disparate applications to communicate with each
      other.





Until
      early 2001, we focused primarily on the development, sale and support of EAI
      solutions through our Geneva product suite. After extensive strategic
      consultation with outside advisors and an internal analysis of our products
      and
      services, we decided to focus on the growing desktop and business process
      automation market with our Cicero® product. Our technology and our products are
      unproven and we have been actively marketing them since 2001. The markets for
      our products are characterized by rapidly changing technologies, evolving
      industry standards, frequent new product introductions and short product life
      cycles. Our future success will depend to a substantial degree upon our ability
      to market and enhance our existing products and to develop and introduce, on
      a
      timely and cost-effective basis, new products and features that meet changing
      customer requirements and emerging and evolving industry
      standards.


9


***We
      depend on an unproven strategy for ongoing revenue.***





The
      Company’s future revenues are entirely dependent on acceptance of Cicero® which
      had limited success in commercial markets to date. The Company has experienced
      negative cash flows from operations for the past three years. At December 31,
      2006, the Company had a working capital deficiency of approximately $7,894,000.
      Accordingly, there is substantial doubt that the Company can continue as a
      going
      concern, and the independent auditor’s report accompanying our financial
      statements raises doubt about our ability to continue as a going concern. In
      order to address these issues and to obtain adequate financing for the Company’s
      operations for the next twelve months, the Company is actively promoting and
      expanding its product line and continues to negotiate with significant customers
      who have demonstrated interest in the Cicero® technology. The Company is
      experiencing difficulty increasing sales revenue largely because of the
      inimitable nature of the product as well as customer concerns about the
      Company’s financial viability. Cicero® software is a new “category defining”
product in that most EAI projects are performed at the server level and
      Cicero®’s integration occurs at the desktop level without the need to open and
      modify the underlying code for those applications being integrated. Many
      companies are not aware of this new technology or tend to look toward more
      traditional and accepted approaches. The Company is attempting to solve the
      former problem by improving the market’s knowledge and understanding of Cicero®
through increased marketing and leveraging its limited number of reference
      accounts while enhancing its list of resellers and system integrators to assist
      in the sales and marketing process. Additionally, the Company is seeking
      additional equity capital or other strategic transactions in the near term
      to
      provide additional liquidity.





Our
      new strategy is subject to the following specialized risks that may adversely
      affect our long-term revenue and profitability prospects:




·
              Cicero®
                  was originally developed internally by Merrill Lynch and has no
                  track
                  record of successful sales to organizations within the financial
                  services
                  industry and may not gain market acceptance;
 ·
              We
                  are approaching a different segment of the financial services industry,
                  the customer contact center, compared to our sales and marketing
                  efforts
                  in the past and there can be no assurance that we can successfully
                  sell
                  and market into this industry; and
 ·
              We
                  have had very limited success because the financial condition of
                  the
                  Company has caused concern for enterprise customers that would
                  be
                  dependent on Cicero® for their long-term
                  needs.




***Economic
      conditions could adversely affect our revenue growth and cause us not to achieve
      desired revenue.***





Our
      ability to generate revenue depends on the overall demand for desktop
      integration software and services. Our business depends on overall economic
      conditions, the economic and business conditions in our target markets and
      the
      spending environment for information technology projects, and specifically
      for
      desktop integration in those markets. A weakening of the economy in one or
      more
      of our geographic regions, unanticipated major events and economic uncertainties
      may make more challenging the spending environment for our software and
      services, reduce capital spending on information technology projects by our
      customers and prospective customers, result in longer sales cycles for our
      software and services or cause customers or prospective customers to be more
      cautious in undertaking larger transactions. Those situations may cause a
      decrease in our revenue. A decrease in demand for our software and services
      caused, in part, by an actual or anticipated weakening of the economy, may
      result in a decrease in our revenue rates.





***The
      so-called “penny stock rule” could make it cumbersome for brokers and dealers to
      trade in our common stock, making the market for our common stock less liquid
      which could cause the price of our stock to decline.***





The
      Company was delisted from the NASDAQ SmallCap market effective January 23,
      2003.
      The Company’s common stock presently is quoted on the Over-the-Counter Bulletin
      Board.





Trading
      of our common stock on the OTCBB may be subject to certain provisions of the
      Securities Exchange Act of 1934, as amended, commonly referred to as the "penny
      stock" rule. A penny stock is generally defined to be any equity security that
      has a market price less than $5.00 per share, subject to certain exceptions.
      If
      our stock is deemed to be a penny stock, trading in our stock will be subject
      to
      additional sales practice requirements on broker-dealers. These may require
      a
      broker-dealer to:


·
              make
                  a special suitability determination for purchasers of our
                  shares;
 
 ·
              receive
                  the purchaser's written consent to the transaction prior to the
                  purchase;
                  and
 
 ·
              deliver
                  to a prospective purchaser of our stock, prior to the first transaction,
                  a
                  risk disclosure document relating to the penny stock
                  market.
  10


Consequently,
      penny stock rules may restrict the ability of broker-dealers to trade and/or
      maintain a market in our common stock. Also, prospective investors may not
      want
      to get involved with the additional administrative requirements, which may
      have
      a material adverse effect on the trading of our shares.





***Because
      we cannot accurately predict the amount and timing of individual sales, our
      quarterly operating results may vary significantly, which could adversely impact
      our stock price*** .




Our
      quarterly operating results have varied significantly in the past, and we expect
      they will continue to do so in the future. We have derived, and expect to
      continue to derive in the near term, a significant portion of our revenue from
      relatively large customer contracts or arrangements. The timing of revenue
      recognition from those contracts and arrangements has caused and may continue
      to
      cause fluctuations in our operating results, particularly on a quarterly basis.
      Our quarterly revenues and operating results typically depend upon the volume
      and timing of customer contracts received during a given quarter and the
      percentage of each contract, which we are able to recognize as revenue during
      the quarter. Each of these factors is difficult to forecast. As is common in
      the
      software industry, the largest portion of software license revenues are
      typically recognized in the last month of each fiscal quarter and the third
      and
      fourth quarters of each fiscal year. We believe these patterns are partly
      attributable to budgeting and purchasing cycles of our customers and our sales
      commission policies, which compensate sales personnel for meeting or exceeding
      periodic quotas.





Furthermore,
      individual Cicero® sales are large and each sale can or will account for a large
      percentage of our revenue and a single sale may have a significant impact on
      the
      results of a quarter. The sales of both our historical products and Cicero® can
      be classified as generally large in size to a small discrete number of
      customers. In addition, the substantial commitment of executive time and
      financial resources that have historically been required in connection with
      a
      customer’s decision to purchase Cicero® and our historical products increases
      the risk of quarter-to-quarter fluctuations. Cicero® sales require a significant
      commitment of time and financial resources because it is an enterprise product.
      Typically, the purchase of our products involves a significant technical
      evaluation by the customer and the delays frequently associated with customers’
internal procedures to approve large capital expenditures and to test, implement
      and accept new technologies that affect key operations. This evaluation process
      frequently results in a lengthy sales process of several months. It also
      subjects the sales cycle for our products to a number of significant risks,
      including our customers’ budgetary constraints and internal acceptance reviews.
      The length of our sales cycle may vary substantially from customer to customer.





We
      typically do not have any material backlog of unfilled software orders, and
      product revenue may fluctuate from quarter to quarter due to the completion
      or
      commencement of significant assignments, the number of working days in a quarter
      and the utilization rate of services personnel. As a result of these factors,
      we
      believe that a period-to-period comparison of our historical results of
      operations is not necessarily meaningful and should not be relied upon as
      indications of future performance. In particular, our revenues in the third
      and
      fourth quarters of our fiscal years may not be indicative of the revenues for
      the first and second quarters. Moreover, if our quarterly results do not meet
      the expectations of our securities analysts and investors, the trading price
      of
      our common stock would likely decline.




***Loss
      of key personnel associated with Cicero*** ® ***development could adversely affect our business*** .




Loss
      of key executive personnel or the software engineers we have hired with
      specialized knowledge of the Cicero® technology could have a significant impact
      on our execution of our new strategy given that they have specialized knowledge
      developed over a long period of time with respect to the Cicero® technology.
      Furthermore, because of our restructuring and reduction in the number of
      employees, we may find it difficult to recruit new employees in the
      future.




***Different
      competitive approaches or internally developed solutions to the same business
      problem could delay or prevent adoption of Cicero*** ®.




Cicero®
        is designed to address in a novel way the problems that large companies face
        integrating the functionality of different software applications by integrating
        these applications at the desktop. To effectively penetrate the market for
        solutions to this disparate application problem, Cicero® will compete with
        traditional Enterprise Application Integration, or EAI, solutions that attempt
        to solve this business problem at the server or back-office level. Server
        level
        EAI solutions are currently sold and marketed by companies such as NEON,
        Mercator, Vitria, and BEA. There can be no assurance that our potential
        customers will determine that Cicero®’s desktop integration methodology is
        superior to traditional middleware EAI solutions provided by the competitors
        described above in addressing this business problem. Moreover, the information
        systems departments of our target customers, large financial institutions,
        are
        large and may elect to attempt to internally develop an internal solution
        to
  11
  this
        business problem rather than to purchase the Cicero® product. Cicero® itself was
        originally developed internally by Merrill Lynch to solve these integration
        needs.
  Accordingly,
      we may not be able to provide products and services that compare favorably
      with
      the products and services of our competitors or the internally developed
      solutions of our customers. These competitive pressures could delay or prevent
      adoption of Cicero® or require us to reduce the price of our products, either of
      which could have a material adverse effect on our business, operating results
      and financial condition.




***Our
      ability to compete may be subject to factors outside our
      control.***





We
      believe that our ability to compete depends in part on a number of competitive
      factors outside our control, including the ability of our competitors to hire,
      retain and motivate senior project managers, the ownership by competitors of
      software used by potential clients, the development by others of software that
      is competitive with our products and services, the price at which others offer
      comparable services and the extent of our competitors’ responsiveness to
      customer needs.




***The
      markets for our products are characterized by rapidly changing technologies,
      evolving industry standards, frequent new product introductions and short
      product life cycles.***





****** Our
      future success will depend to a substantial degree upon our ability to enhance
      our existing products and to develop and introduce, on a timely and
      cost-effective basis, new products and features that meet changing customer
      requirements and emerging and evolving industry standards.




The
      introduction of new or enhanced products also requires us to manage the
      transition from older products in order to minimize disruption in customer
      ordering patterns, as well as ensure that adequate supplies of new products
      can
      be delivered to meet customer demand. There can be no assurance that we will
      successfully develop, introduce or manage the transition to new
      products.




We
      have in the past, and may in the future, experience delays in the introduction
      of our products, due to factors internal and external to our business. Any
      future delays in the introduction or shipment of new or enhanced products,
      the
      inability of such products to gain market acceptance or problems associated
      with
      new product transitions could adversely affect our results of operations,
      particularly on a quarterly basis.





***We
      may face damage to the reputation of our software and a loss of revenue if
      our
      software products fail to perform as intended or contain significant defects.***





Our
      software products are complex, and significant defects may be found following
      introduction of new software or enhancements to existing software or in product
      implementations in varied information technology environments. Internal quality
      assurance testing and customer testing may reveal product performance issues
      or
      desirable feature enhancements that could lead us to reallocate product
      development resources or postpone the release of new versions of our software.
      The reallocation of resources or any postponement could cause delays in the
      development and release of future enhancements to our currently available
      software, require significant additional professional services work to address
      operational issues, damage the reputation of our software in the marketplace
      and
      result in potential loss of revenue. Although we attempt to resolve all errors
      that we believe would be considered serious by our partners and customers,
      our
      software is not error-free. Undetected errors or performance problems may be
      discovered in the future, and known errors that we consider minor may be
      considered serious by our partners and customers. This could result in lost
      revenue, delays in customer deployment or legal claims and would be detrimental
      to our reputation. If our software experiences performance problems or ceases
      to
      demonstrate technology leadership, we may have to increase our product
      development costs and divert our product development resources to address the
      problems.





***We
      may be unable to enforce or defend our ownership and use of proprietary and
      licensed technology*** .




We
        originally licensed the Cicero® technology and related patents on a worldwide
        basis from Merrill Lynch, Pierce, Fenner & Smith Incorporated in August of
        2000 under a license agreement containing standard provisions and a two-year
        exclusivity period. On January 3, 2002, the license agreement was amended
        to
        extend our exclusive worldwide marketing, sales and development rights to
        Cicero® in perpetuity (subject to Merrill Lynch's rights to terminate in the
        event of bankruptcy or a change in control of the Company) and to grant
        ownership rights in the Cicero® trademark. Merrill Lynch indemnifies us with
        regard to the rights granted to us by them. Consideration for the original
        Cicero® license consisted of 1,000,000 shares of our common stock. In exchange
        for the amendment, we granted an additional 250,000 shares of common stock
        to
        MLBC, Inc., a Merrill Lynch affiliate and entered into a royalty sharing
        agreement. Under the royalty sharing agreement, we pay a royalty of 3% of
        the
        sales price for each
  12
  sale
        of Cicero® or related maintenance services. The royalties over the life of the
        agreement are not payable in excess of $20 million. We have completely
        re-engineered the Cicero® software to provide increased functionality and much
        more powerful integration capabilities.
 
 Our
      success depends to a significant degree upon our proprietary and licensed
      technology. We rely on a combination of patent, trademark, trade secret and
      copyright law, contractual restrictions and passwords to protect our proprietary
      technology. However, these measures provide only limited protection, and there
      is no guarantee that our protection of our proprietary rights will be adequate.
      Furthermore, the laws of some jurisdictions outside the United States do not
      protect proprietary rights as fully as in the United States. In addition, our
      competitors may independently develop similar technology; duplicate our products
      or design around our patents or our other intellectual property rights. We
      may
      not be able to detect or police the unauthorized use of our products or
      technology, and litigation may be required in the future to enforce our
      intellectual property rights, to protect our trade secrets or to determine
      the
      validity and scope of our proprietary rights. Additionally, with respect to
      the
      Cicero® line of products, there can be no assurance that Merrill Lynch will
      protect its patents or that we will have the resources to successfully pursue
      infringers. Any litigation to enforce our intellectual property rights would
      be
      expensive and time-consuming, would divert management resources and may not
      be
      adequate to protect our business.




We
      do not believe that any of our products infringe the proprietary rights of
      third
      parties. However, companies in the software industry have experienced
      substantial litigation regarding intellectual property and third parties could
      assert claims that we have infringed their intellectual property rights. In
      addition, we may be required to indemnify our distribution partners and end-
      users for similar claims made against them. Any claims against us would divert
      management resources, and could require us to spend significant time and money
      in litigation, pay damages, develop new intellectual property or acquire
      licenses to intellectual property that is the subject of the infringement
      claims. These licenses, if required, may not be available on acceptable terms.
      As a result, intellectual property claims against us could have a material
      adverse effect on our business, operating results and financial condition.




***Our
      business may be adversely impacted if we do not provide professional services
      to
      implement our solutions.***




Customers
      that license our software typically engage our professional services staff
      or
      third-party consultants to assist with product implementation, training and
      other professional consulting services. We believe that many of our software
      sales depend, in part, on our ability to provide our customers with these
      services and to attract and educate third-party consultants to provide similar
      services. New professional services personnel and service providers require
      training and education and take time and significant resources to reach full
      productivity. Competition for qualified personnel and service providers is
      intense within our industry. Our business may be harmed if we are unable to
      provide professional services to our customers to effectively implement our
      solutions of if we are unable to establish and maintain relationships with
      third-party implementation providers.





***Because
      our software could interfere with the operations of customers, we may be subject
      to potential product liability and warranty claims by these customers.***




Our
      software enables customers’ software applications to integrate and is often used
      for mission critical functions or applications. Errors, defects or other
      performance problems in our software or failure to provide technical support
      could result in financial or other damages to our customers. Customers could
      seek damages for losses from us. In addition, the failure of our software and
      solutions to perform to customers’ expectations could give rise to warranty
      claims. The integration of our software with our customer’s applications,
      increase the risk that a customer may bring a lawsuit us. Even if our software
      is not at fault, a product liability claim brought against us, even if not
      successful, could be time consuming and costly to defend and could harm our
      reputation.





***We
      have not paid any dividends on our common stock and it is likely that no
      dividends will be paid in the future.***




We
      have never declared or paid cash dividends on our common stock and we do not
      anticipate paying any cash dividends on our common stock in the foreseeable
      future.




***Provisions
      of our charter and Bylaws and Delaware law could deter takeover
      attempts.***




Section
        203 of the Delaware General Corporation Law, which prohibits certain persons
        from engaging in business combinations with the Company, may have anti-takeover
        effects and may delay, defer or prevent a takeover attempt that a stockholder
        may consider to be in the holder’s best interests. These provisions of Delaware
        law also may adversely affect the market price of our common stock. Our
        certificate of incorporation authorizes the issuance, without stockholder
        approval, of preferred stock, with such designations, rights and preferences
        as
        the board of directors may determine preferences as from time to time. Such
        designations, rights and preferences
  13
  established
        by the board may adversely affect our stockholders. In the event of issuance,
        the preferred stock could be used, under certain circumstances, as a means
        of
        discouraging, delaying or preventing a change of control of the Company.
        Although we have no present intention to issue any shares of preferred stock
        in
        addition to the currently outstanding preferred stock, we may issue preferred
        stock in the future.
 
 **Item1B.
      Unresolved Staff Issues**





Not
      Applicable





**Item2.**  **Properties**





Our
      corporate headquarters are located in approximately 1,300 square feet of office
      space in Farmingdale, New Jersey, pursuant to a month-to-month sublease from
      one
      of our resellers. The United States operations group and administrative
      functions are based in offices of approximately 2,956 square feet in our Cary,
      North Carolina office pursuant to a lease expiring in 2007. The research and
      development and customer support groups are located in the Farmingdale, New
      Jersey and Cary, North Carolina facilities.





**Item
      3.**  **Legal
      Proceedings**





Various
      lawsuits and claims have been brought against us in the normal course of our
      business. In January 2003, an action was filed in the Circuit Court of Loudon
      County, Virginia, for a breach of a real estate lease. The case was settled
      in
      August 2003. Under the terms of the settlement agreement, we agreed to assign
      a
      note receivable with recourse equal to the unpaid portion of the note should
      the
      note obligor default on future payments. The unpaid balance of the note was
      $545,000, of which the current unpaid principal portion is approximately
      $123,000 and it matures in December 2007. At the maturity date of the note,
      the
      Company will be liable for additional payments totaling approximately $31,000
      which we have recognized as a non-current liability.





In
      October 2003, we were served with a summons and complaint in the Superior Court
      of North Carolina regarding unpaid invoices for services rendered by one of
      our
      subcontractors. The amount in dispute was approximately $200,000 and is recorded
      as part of our accounts payable. Subsequent to March 31, 2004, we settled this
      litigation. Under the terms of the settlement agreement, we agreed to pay a
      total of $189,000 plus interest over a 19-month period ending November 15,
      2005.
      The Company is in the process of negotiating a series of payments for the
      remaining liability of approximately $80,000.





In
      March 2004, we were served with a summons and complaint in the Superior Court
      of
      North Carolina regarding a security deposit for a sublease in Virginia. The
      amount in dispute is approximately $247,000. In October 2004, we reached a
      settlement agreement wherein we agreed to pay $160,000 over a 36-month period
      ending October 2007.





In
      August 2004, we were notified that we were in default under an existing lease
      agreement for office facilities in Princeton, New Jersey. The amount of the
      default is approximately $65,000. Under the terms of the lease agreement, we
      may
      be liable for future rents should the space remain vacant. We have reached
      a
      settlement agreement with the landlord which calls for a total payment of
      $200,000 over a 36-month period ending October 2007.





In
      October 2005, we were notified that Critical Mass Mail, Inc. had filed a claim
      against us in the amount of $45,000 for failure to pay certain liabilities
      under
      an Asset Purchase Agreement dated January 9, 2004. We in turn filed a counter
      claim that Critical Mass Mail, Inc. failed to deliver certain assets and other
      documents under the same Asset Purchase Agreement. We had already reserved
      the
      potential liability under this action as part of the asset purchase accounting.
      In February, 2006, Critical Mass Mail amended their complaint and was seeking
      damages of approximately $600,000 for our failure to timely register the
      underlying securities issued in the Asset Purchase Agreement. In November 2006,
      we negotiated a settlement with Critical Mass Mail that provides for monthly
      payments of the amounts already accrued. In December 2006 we settled the amended
      complaint and agreed to issue $50,000 worth of the Company’s common stock. The
      Company has recorded stock compensation expense as of December 31, 2006 in
      this
      amount.





Under
      the indemnification clause of the Company’s standard reseller agreements and
      software license agreements, the Company agrees to defend the reseller/licensee
      against third party claims asserting infringement by the Company’s products of
      certain intellectual property rights, which may include patents, copyrights,
      trademarks or trade secrets, and to pay any judgments entered on such claims
      against the reseller/licensee.


14




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





The
      annual meeting of Stockholders was held on November 16, 2006 in Cary, North
      Carolina. The agenda for the meeting was (i) to ratify the name of the change
      of
      the Corporation to Cicero Inc., (ii) to ratify a consolidation (a reverse split)
      of the common stock of the Company within a ratio of 20:1 to 100:1 as determined
      by the Board of Directors of the Company, (iii) to ratify an increase in the
      number of authorized shares of common stock of the Company from eighty-five
      million (85,000,000) to two hundred fifteen million (215,000,000) shares, and
      (iv) to ratify the amendment of the conversion prices at which all of the
      outstanding shares of Series A-3, B-3, C and D preferred stock of the Company
      convert into shares of common stock of the Company and then convert such
      outstanding shares into a single class of Series A-1 preferred stock of the
      Company. The record date for the meeting was set for October 1, 2006, at which
      there were 56,544,577 shares of Company stock entitled to vote at the Meeting.
      An aggregate of at least 28,272,280 shares of stock, representing at least
      50.0001% of the shares of votable stock, were represented at the
      Meeting.





The
      votes were tabulated as follows:





Motion
                to ratify the name of the change of the Corporation to Cicero
                Inc:VOTES
                FOR
            
            VOTES
                AGAINST
            
            ABSTAINCommon
                stock and equivalents
            48,855,828
            
            252,752
            
            244,006





Motion
                to ratify a consolidation (a reverse split) of the common stock of
                the
                Company within a ratio of 20:1 to 100:1 as determined by the Board
                of
                Directors of the Company:VOTES
                FOR
            
            VOTES
                AGAINST
            
            ABSTAINCommon
                stock and equivalents
            48,579,012
            
            583,358
            
            190,216Series
                A-3 Preferred Stock
            188,408
            
            --
            
            --Series
                B-3 Preferred Stock
            2,394,062
            
            --
            
            --Series
                C Preferred Stock
            2,607,895
            
            --
            
            --Series
                D Preferred Stock
            3,314,125
            
            --
            
            --





Motion
                to ratify an increase in the number of authorized shares of common
                stock
                of the Company from eighty-five million (85,000,000) to two hundred
                fifteen million (215,000,000) shares:VOTES
                FOR
            
            VOTES
                AGAINST
            
            ABSTAINCommon
                stock and equivalents
            48,136,737
            
            1,028,465
            
            187,384Series
                A-3 Preferred Stock
            188,408
            
            --
            
            --Series
                B-3 Preferred Stock
            2,394,062
            
            --
            
            --Series
                C Preferred Stock
            2,607,895
            
            --
            
            --Series
                D Preferred Stock
            3,314,125
            
            --
            
            --





Motion
                to ratify the amendment of the conversion prices at which all of
                the
                outstanding shares of Series A-3, B-3, C and D preferred stock of
                the
                Company convert into shares of common stock of the Company and then
                convert such outstanding shares into a single class of Series A-1
                preferred stock of the Company:VOTES
                FOR
            
            VOTES
                AGAINST
            
            ABSTAINCommon
                stock and equivalents
            32,012,164
            
            489,259
            
            249,802Series
                A-3 Preferred Stock
            188,408
            
            --
            
            --Series
                B-3 Preferred Stock
            2,394,062
            
            --
            
            --Series
                C Preferred Stock
            2,607,895
            
            --
            
            --Series
                D Preferred Stock
            3,314,125
            
            --
            
            --





15


**PART
      II**





**Item5.**  **Market
      For Registrant's Common Stock, Related Shareholder Matters and Issuer Purchases
      of Equity Securities.**





Our
      common stock had been traded on the Nasdaq National Market under the symbol
      ''LVEL” from 1996 until December 23, 2002. From December 24, 2002, until January
      23, 2003, our common stock traded on the Nasdaq SmallCap Market. As of January
      23, 2003, our common stock was delisted from the Nasdaq SmallCap Market and
      is
      currently quoted on the Over-The-Counter Bulletin Board. In January 2007 we
      formally changed our name to Cicero Inc. and now trade under the ticker CICN.
      We
      have never declared or paid any cash dividends on our common stock. We
      anticipate that all of our earnings will be retained for the operation and
      expansion of our business and do not anticipate paying any cash dividends on
      our
      common stock in the foreseeable future. In accordance with Staff Accounting
      Bulletin Topic 4(c), the chart below sets forth the high and low stock prices
      for the quarters of the fiscal years ended December 31, 2006 and 2005 as
      retroactively adjusted for the 100:1 reverse stock split.


**2006**
            
            **2005****Quarter**
            
            **High**
            
            **Low**
            
            **High**
            
            **Low**First
            
            $
            3.00
            
            $
            1.80
            
            $
            16.00
            
            $
            7.00Second
            
            $
            2.50
            
            $
            1.00
            
            $
            9.00
            
            $
            4.00Third
            
            $
            2.10
            
            $
            1.10
            
            $
            5.00
            
            $
            2.00Fourth
            
            $
            4.50
            
            $
            1.30
            
            $
            5.00
            
            $
            1.00





The
      closing price of the common stock on December 31, 2006 was $2.30 per share.
      As
      of March 16, 2007 we had 228 registered stockholders of record.





**Recent
      Sales of Unregistered Securities**





In
      2004, pursuant to a Note and Warrant Offering that was part of a
      recapitalization plan, warrant holders of the Company’s common stock were
      offered a one-time conversion of their existing warrants at a conversion price
      of $0.10. **** The
      Senior Secured Notes issued in the aggregate principal amount of $2,559,000
      to
      holders of warrants of the Company who loaned to the Company the exercise price
      of their warrants and other investors who lent funds to the Company in exchange
      for Senior Reorganization Notes and additional warrants, pursuant to note and
      warrant offerings in December 2004 ($1,615,000, of which $67,000 was received
      in
      2005) and March 2005 ($944,000) (the “Note and Warrant Offerings”), will be
      cancelled and the existing warrants in respect of which the exercise price
      was
      loaned to the Company, as evidenced by the Senior Reorganization Notes, will
      be
      exercised. Such warrant holders were offered a special one-time exercise price
      of the lesser of $0.10 per share and the original exercise price as part of
      the
      merger agreement. The exercise price of the warrants at that time ranged from
      $0.07 to $0.60.





As
      part of the Note and Warrant Offering and approval of the Plan of
      Recapitalization, the Company issued Additional Warrants to Senior
      Reorganization Noteholders in connection with their loans to the Company,
      exercisable at $0.04. Under the terms of the Note and Warrant Offering, the
      warrants have been automatically exercised by applying the accrued interest
      on
      the Senior Reorganization Notes to the exercise or strike price and by cashless
      exercise to the extent of the balance of the exercise price. The aggregate
      number of shares issued upon exercise of the Additional Warrants was 3,438,473
      shares of Cicero common stock.




Senior
      Reorganization Noteholders who loaned the Company the first $1,000,000 in
      respect of the exercise price of their warrants, pursuant to the Note and
      Warrant Offering will receive warrants of Cicero (“Early Adopter Warrants”) at a
      ratio of 2:1 for shares issuable upon exercise of each existing warrant
      exercised at the special exercise price (before adjustment by the reverse stock
      ratio) of $0.10 per share, as part of the Recapitalization Plan. In the
      Recapitalization Plan, Early Adopter Warrants will convert into warrants of
      Cicero for an aggregate of 201,115 shares of Cicero, at the exercise price
      of
      $10.00 per share.




As
      part of the Plan of Recapitalization, Noteholders of $992,000 of Convertible
      Promissory Notes were offered reduced conversion prices to convert their notes
      into shares of the Company’s new Series A-1 Preferred Stock. All Noteholders
      have agreed to convert their notes. The Company has cancelled these notes and
      issued 1,591 shares of its Series A-1 Preferred Stock.


During
        2005 and 2006, the Company issued several Convertible Bridge Notes to a
        consortium of investors. These notes bear interest at an annual rate of 10%
        and
        matured at various dates beginning on September 15, 2005. The Notes are
        convertible into shares of the Company’s common stock upon approval of the Plan
        of Recapitalization at conversion rates of $0.125 and $0.133. As of December
        31,
        2006, the Company had raised $3,915,000 from the sale of Convertible Bridge
        Notes of which the aggregate principal amount of $746,000 was
  16
  from
        various members of the Company’s Board of Directors. These notes automatically
        converted into 30,508,448 shares of the common stock upon approval of the
        Plan
        of Recapitalization. Accordingly, this conversion has been reflected in the
        Company’s accompanying Balance Sheet as of December 31, 2006.
  These
        securities were issued pursuant to an exemption from registration under Rule
        506
        of Regulation D promulgated under Section UW of the Securities Act of 1933
        as
        amended.





The
      Company has not repurchased any shares of its stock.





**Equity
      Compensation Plan Information**





The
      following table sets forth certain information as of December 31, 2006, about
      shares of Common Stock outstanding and available for issuance under the
      Company’s existing equity compensation plans: the Level 8 Systems, Inc. 1997
      Stock Option Incentive Plan, the 1995 Non-Qualified Option Plan and the Outside
      Director Stock Option Plan. All of the Company’s Equity Compensation Plans were
      approved by the Company’s stockholders.




**Plan
                Category**
            
            **Number
                of Securities to**
              **be
                issued upon exercise of****outstanding
                options**
            
            **Weighted-average**
              **exercise
                price of****outstanding
                options**
            
            **Number
                of securities**
              **remaining
                available under**
              **equity
                compensation plans**
              **(excluding
                securities reflected****in
                the first column)**Equity
                compensation plans approved by stockholders
            
            
            45,315
            
            $
            120.61
            
            
            37,830Equity
                compensation plans not approved by stockholders (1)
            
            
            --
            
            
            --
            
            
            --Total
            
            
            45,315
            
            $
            120.61
            
            
            37,830





(1)
            The
                Company does not have any Equity Compensation Plans that were not
                approved
                by stockholders.





**Item
      6.**  **Selected
      Financial Data.**




The
      following selected financial data is derived from the consolidated financial
      statements of the Company. The data should be read in conjunction with the
      consolidated financial statements, related notes, and other financial
      information included herein.





See
      Item 7 for a discussion of the entities included in operations (in thousands).
      Weighted average shares outstanding have been restated retroactively to reflect
      the 100:1 reverse stock split.




**Year
                Ended December 31,**
              **(in
                thousands, except per share data)****2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006**SELECTED
                STATEMENT OF OPERATIONS DATARevenue
            
            $
            3,101
            
            $
            530
            
            $
            775
            
            $
            785
            
            $
            972Loss
                from continuing operations
            
            $
            (13,142
            )
            $
            (9,874
            )
            $
            (9,731
            )
            $
            (3,681
            )
            $
            (2,997
            )Loss
                from continuing operations per common share - basic and
                diluted
            
            $
            (74.89
            )
            $
            (54.00
            )
            $
            (27.05
            )
            $
            (8.27
            )
            $
            (0.25
            )Weighted
                average common and common equivalent shares outstanding- basic and
                diluted
            
            
            189
            
            
            215
            
            
            360
            
            
            445
            
            
            35,182





**December
                31,****2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006**SELECTED
                BALANCE SHEET DATAWorking
                capital (deficiency)
            
            $
            (6,254
            )
            $
            (6,555
            )
            $
            (10,255
            )
            $
            (13,894
            )
            $
            (7,894
            )Total
                assets
            
            
            11,852
            
            
            5,362
            
            
            530
            
            
            241
            
            
            597Long-term
                debt, including current maturities
            
            
            2,893
            
            
            2,756
            
            
            5,444
            
            
            7,931
            
            
            2,932Senior
                convertible redeemable preferred stock
            
            
            --
            
            
            3,355
            
            
            1,367
            
            
            1,061
            
            
            --Stockholders'
                equity (deficiency)
            
            
            1,653
            
            
            (6,103
            )
            
            (11,857
            )
            
            (15,076
            )
            
            (7,912
            )





17




**Item
      7.** **Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations**





**General
      Information**





Cicero
      Inc. is a global provider of business integration software that enables
      organizations to integrate new and existing information and processes at the
      desktop with our Cicero® software product. Business integration software
      addresses the emerging need for a company's information systems to deliver
      enterprise-wide views of the company's business
      information processes. The Company also provides email encryption products
      that
      address information and security compliance from the individual to the
      enterprise.





In
      addition to software products, the Company also provides technical support,
      training and consulting services as part of its commitment to providing its
      customers industry-leading integration solutions. The Company’s consulting team
      has in-depth experience in developing successful enterprise-class solutions
      as
      well as valuable insight into the business information needs of customers in
      the
      Global 5000. Cicero offers services around our integration and encryption
      software products.




This
      discussion contains forward-looking statements relating to such matters as
      anticipated financial performance, business prospects, technological
      developments, new products, research and development activities, liquidity
      and
      capital resources and similar matters. The Private Securities Litigation Reform
      Act of 1995 provides a safe harbor for forward-looking statements. In order
      to
      comply with the terms of the safe harbor, the Company notes that a variety
      of
      factors could cause its actual results to differ materially from the anticipated
      results or other expectations expressed in the Company's forward-looking
      statements. See ''Item 1. Business—Forward Looking and Cautionary Statements.''







**Business
      Strategy**





Management
      makes operating decisions and assesses performance of the Company’s operations
      based on the following reportable segments: (1) Desktop Integration and (2)
      Messaging and Application Engineering.





The
      Desktop Integration segment is comprised of the Cicero® product. Cicero® is a
      business integration software product that maximizes end-user productivity,
      streamlines business operations and integrates disparate systems and
      applications, while renovating or rejuvenating older legacy systems by making
      them usable in the business processes.




The
      product that comprises the Messaging and Application Engineering segment is
      Ensuredmail. Ensuredmail is an encrypted email technology that can reside on
      either the server or the desktop.





18


**Results
      of Operations**





The
      following table sets forth, for the years indicated, the Company's results
      of
      continuing operations expressed as a percentage of revenue and presents
      information for the three categories of revenue.





**Year
                Ended December 31,****2006**
            
            **2005**
            
            **2004**Revenue:Software
            
            
            21.4
            %
            
            51.9
            %
            
            30.8
            %Maintenance
            
            
            12.3
            %
            
            18.7
            %
            
            39.5
            %Services
            
            
            66.3
            %
            
            29.4
            %
            
            29.7
            %Total
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Cost
                of revenue:Software
            
            
            0.9
            %
            
            2.0
            %
            
            577.8
            %Maintenance
            
            
            21.8
            %
            
            44.6
            %
            
            49.3
            %Services
            
            
            56.2
            %
            
            104.7
            %
            
            131.0
            %Total
            
            
            78.9
            %
            
            151.3
            %
            
            758.1
            %Gross
                margin (loss)
            
            
            21.1
            %
            
            (51.3
            )%
            
            (658.1
            )%Operating
                expenses:Sales
                and marketing
            
            
            35.6
            %
            
            79.9
            %
            
            140.4
            %Research
                and product development
            
            
            54.8
            %
            
            113.5
            %
            
            143.3
            %General
                and administrative
            
            
            124.1
            %
            
            144.8
            %
            
            196.4
            %Impairment
                of intangible assets
            
            
            0.0
            %
            
            0.0
            %
            
            75.7
            %(Gain)
                on disposal of assets
            
            
            (2.5
            )%
            
            0.0
            %
            
            (0.6
            )%Total
            
            
            212.0
            %
            
            338.2
            %
            
            555.2
            %Loss
                from operations
            
            
            (190.9
            )%
            
            (389.5
            )%
            
            (1,213.3
            )%Other
                (expense), net
            
            
            (117.5
            )%
            
            (79.4
            )%
            
            (42.3
            )%Loss
                before taxes
            
            
            (308.4
            )%
            
            (468.9
            )%
            
            (1,255.6
            )%Income
                tax provision (benefit)
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %Loss
                from continuing operations
            
            
            (308.4
            )%
            
            (468.9
            )%
            
            (1,255.6
            )%Loss
                from discontinued operations
            
            
            0.0
            %
            
            0.0
            %
            
            (3.9
            )%Net
                loss
            
            
            (308.4
            )%
            
            (468.9
            )%
            
            (1,259.5
            )%





The
      following table sets forth data for total revenue for continuing operations
      by
      geographic origin as a percentage of total revenue for the periods
      indicated:





**2006**
            
            **2005**
            
            **2004**United
                States
            
            
            100
            %
            
            100
            %
            
            98
            %Europe
            
            
            --
            
            
            --
            
            
            2
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %





19


The
      table below presents information about reported segments for the twelve months
      ended December 31, 2006, 2005, and 2004 (in thousands):





**For
                the year ended December 31,****2006**
            
            **2005**
            
            **2004**Desktop
                Integration
            
            Messaging
                and Application Engineering
            
            Total
            
            Desktop
                Integration
            
            Messaging
                and Application Engineering
            
            Total
            
            Desktop
                Integration
            
            Messaging
                and Application Engineering
            
            TotalTotal
                revenue
            
            $
            965
            
            $
            7
            
            $
            972
            
            $
            760
            
            $
            25
            
            $
            785
            
            $
            707
            
            $
            68
            
            $
            775Total
                cost of revenue
            
            
            767
            
            
            --
            
            
            767
            
            
            1,188
            
            
            --
            
            
            1,188
            
            
            5,662
            
            
            213
            
            
            5,875Gross
                margin (loss)
            
            
            198
            
            
            7
            
            
            205
            
            
            (428
            )
            
            25
            
            
            (403
            )
            
            (4,955
            )
            
            (145
            )
            
            (5,100
            )Total
                operating expenses
            
            
            1,964
            
            
            121
            
            
            2,085
            
            
            2,536
            
            
            119
            
            
            2,655
            
            
            3,348
            
            
            373
            
            
            3,721Segment
                profitability (loss)
            
            $
            (1,766
            )
            $
            (114
            )
            $
            (1,880
            )
            $
            (2,964
            )
            $
            (94
            )
            $
            (3,058
            )
            $
            (8,303
            )
            $
            (518
            )
            $
            (8,821
            )





A
      reconciliation of segment operating expenses to total operating expense follows
      (in thousands):





**2006**
            
            **2005**
            
            **2004**Segment
                operating expenses
            
            $
            2,085
            
            $
            2,655
            
            $
            3,721Write-off
                of intangible assets
            
            
            --
            
            
            --
            
            
            587(Gain)
                on disposal of assets
            
            
            (24
            )
            
            --
            
            
            (5
            )Total
                operating expenses
            
            $
            2,061
            
            $
            2,655
            
            $
            4,303





A
      reconciliation of total segment profitability to net loss from continuing
      operations follows for the fiscal years ended December 31 (in
      thousands):





**2006**
            
            **2005**
            
            **2004**Total
                segment profitability (loss)
            
            $
            (1,880
            )
            $
            (3,058
            )
            $
            (8,821
            )Write-off
                of intangible assets
            
            
            --
            
            
            --
            
            
            (587
            )Gain
                on disposal of assets
            
            
            24
            
            
            --
            
            
            5Interest
                and other income/(expense), net
            
            
            (1,141
            )
            
            (623
            )
            
            (328
            )Net
                loss before provision for income taxes
            
            $
            (2,997
            )
            $
            (3,681
            )
            $
            (9,731
            )








**Years
      Ended December 31, 2006, 2005, and 2004**





*Revenue
      and Gross Margin.* The Company has three categories of revenue: software products, maintenance,
      and
      services. Software products revenue is comprised primarily of fees from
      licensing the Company's proprietary software products. Maintenance revenue
      is
      comprised of fees for maintaining, supporting, and providing periodic upgrades
      to the Company's software products. Services revenue is comprised of fees for
      consulting and training services related to the Company's software products.





The
      Company's revenues vary from quarter to quarter, due to market conditions,
      the
      budgeting and purchasing cycles of customers and the effectiveness of the
      Company’s sales force. The Company does not have any material backlog of
      unfilled software orders and product revenue in any period is substantially
      dependent upon orders received in that quarter. Because the Company's operating
      expenses are based on anticipated revenue levels and are relatively fixed over
      the short term, variations in the timing of the recognition of revenue can
      cause
      significant variations in operating results from period to period. Fluctuations
      in operating results may result in volatility of the price of the Company's
      common stock.


20


Total
      revenues increased 24% from $785,000 in 2005 to $972,000 in 2006. Revenues
      increased slightly, or 1% from $775,000 in 2004 to $785,000 in 2005. The
      increase in revenues in 2006 is primarily due to increased labor billings from
      integration contracts with the Company’s professional services staff. The small
      increase in revenues in 2005 over 2004 reflects a change in the mix of revenues,
      wherein license revenues increased and annual maintenance revenues decreased.
      Gross profit margin (loss) was 21%, (51)% and (658)% for 2006, 2005, and 2004,
      respectively.





The
      Desktop Integration segment had a gross margin (loss) of 21% for the year ended
      December 31, 2006, (56)% for the year ended December 31, 2005, and (701)% for
      the year ended December 31, 2004. The improvement in gross margin from 2005
      to
      2006 reflects a reduction in professional services headcount and an overall
      increase in revenues. In 2004, the Company had recognized a final impairment
      of
      the excess of the unamortized book value of the Cicero® technology in excess of
      the expected net realizable value in accordance with SFAS 86, “Accounting for
      the Costs of Computer Software to be Sold, Leased or Otherwise
      Marketed” *.* A
      charge in the amount of $2,844,000 was recorded as cost of software revenue
      in
      the Statement of Operations for the year ended December 31, 2004.





The
      Messaging and Application Engineering segment gross margin for the years ended
      December 31, 2006 and 2005 was 100%. The gross margin (loss) for the year ended
      December 31, 2004 was (213%). In January 2004 the Company acquired substantially
      all of the assets and assumed certain liabilities of Critical Mass Mail, Inc.,
      d/b/a Ensuredmail, a federally certified encryption software company. The total
      purchase price of the assets being acquired plus assumption of certain
      liabilities was $750,000. The purchase price was allocated to the assets
      acquired and liabilities assumed based on the Company’s estimates of fair value
      at the acquisition date. The Company assessed the net realizable value of the
      Ensuredmail software technology acquired and determined the purchase price
      exceeded the amounts allocated to the software technology acquired less
      liabilities assumed by approximately $587,000. This excess of the purchase
      price
      over the fair values of the assets acquired less liabilities assumed was
      allocated to goodwill, and, because it was deemed impaired, charged to the
      Statement of Operations for the period ended March 31, 2004. The Company
      completed an assessment of the recoverability of the Ensuredmail product
      technology, as of June 30, 2004 in accordance with SFAS 86, “Accounting for the
      Costs of Computer Software to be Sold, Leased or Otherwise Marketed”. This
      assessment was completed due to the Company’s revised cash flow projections from
      software revenue. These revised cash flow projections did not support the
      long-lived asset and accordingly the Company impaired the excess of the
      unamortized book value of the technology in excess of the expected net
      realizable value as of June 30, 2004. This charge, in the amount of $154,000,
      was recorded as software amortization for the period ended June 30,
      2004.





**Software
      Products** .
      Software product revenue decreased from $407,000 in 2005 to $208,000 in 2006
      or
      approximately 49%. Software product revenue increased approximately 70% in
      2005
      from those results achieved in 2004. The decrease in software revenues in 2006
      is attributed the Company entering into only one significant license contract
      during the year. The Company had another pilot installation in-process, however,
      acceptance was not assured by December 31, 2006. In 2005, the Company was able
      to successfully deploy its software to several smaller integration engagements.





The
      gross margin (loss) on software products was 96% for each of the years ended
      December 31, 2006 and 2005, and (1,773%), for the year ended December 31, 2004.
      Cost of software is composed primarily of amortization of software product
      technology, amortization of capitalized software costs for internally developed
      software, impairment of software product technology, and royalties to third
      parties, and to a lesser extent, production and distribution costs. All software
      costs have been fully amortized as of December 31, 2004. The Cicero® software
      technology and related patents was licensed by the Company on a worldwide basis
      from Merrill Lynch in August of 2000 under a license agreement containing
      standard provisions and a two-year exclusivity period. On January 3, 2002,
      the
      license agreement was amended to extend the Company’s exclusive worldwide
      marketing, sales and development rights to Cicero® in perpetuity (subject to
      Merrill Lynch’s rights to terminate in the event of bankruptcy or a change in
      control of the Company) and to grant ownership rights in the Cicero® trademark.
      The Company is indemnified by Merrill Lynch with regard to the rights granted
      to
      Cicero® by them. In consideration for the original Cicero® license we issued to
      Merrill Lynch 1,000,000 shares of the Company’s common stock. In consideration
      for the amendment, the Company issued an additional 250,000 shares of common
      stock to MLBC, Inc., a Merrill Lynch affiliate and entered into a royalty
      sharing agreement pursuant to which, the Company pays a royalty of 3% of the
      sales price for each sale of Cicero® software or related maintenance services.
      The royalties over the life of the agreement are not payable in excess of
      $20,000,000.





The
      software product gross margin (loss) for the Desktop Integration segment was
      96%
      for the years ended December 31, 2006 and 2005, and (1,950%) for the year ended
      December 31, 2004. The software product gross margin (loss) on the Messaging
      and
      Application Engineering segment was 100% for the years ended December 31, 2006
      and 2005 and (587%) for year ended December 31, 2004.


21


The
      Company expects to see significant increases in software sales related to the
      Desktop Integration segment coupled with improving margins on software products
      as Cicero® gains acceptance in the marketplace. The Company’s expectations are
      based on its review of the sales cycle that has developed around the Cicero®
product since being released by the Company, its review of the pipeline of
      prospective customers and their anticipated capital expenditure commitments
      and
      budgeting cycles, as well as the status of in-process proof of concepts or
      beta
      sites with select corporations. The Messaging and Application Engineering
      segment revenue is expected to increase marginally with on-line sales of its
      products.





**Maintenance.** Maintenance
      revenues for the year ended December 31, 2006 decreased by approximately 18%
      or
      $27,000 from 2005. Maintenance revenues for the year ended December 31,
      2005 **** decreased
      by approximately 52% or $159,000 from 2004. The decline in maintenance revenues
      in 2006 and in 2005 is primarily due to the non-renewal of one maintenance
      contract for the Cicero® product in each of those years within the Desktop
      Integration segment.





The
      Desktop Integration segment accounted for approximately 95% of total maintenance
      revenue and the Messaging and Application Engineering segment accounted for
      approximately 5% of total maintenance revenues in 2006.





Cost
      of maintenance is comprised of personnel costs and related overhead and the
      cost
      of third-party contracts for the maintenance and support of the Company’s
      software products. The Company experienced a gross margin (loss) on maintenance
      products of (77%) for 2006. Gross margin (loss) on maintenance products for
      2005
      and 2004 were (138%) and (25%) respectively.





Maintenance
      revenues are expected to increase, primarily in the Desktop Integration segment
      as a result of our expected increase in sales of the Cicero® product. The
      Messaging and Application Engineering segment is now composed of the new
      Ensuredmail encryption technology and maintenance revenues should increase
      as
      the product achieves market acceptance. The cost of maintenance should increase
      slightly for the Desktop Integration segment.





**Services.** Services
      revenue for the year ended December 31, 2006 increased by approximately 179%
      or
      $413,000 over the same period in 2005. Services revenue for the year ended
      December 31, 2005 were approximately the same as in 2004. The increase in
      service revenues as compared to 2005 is attributable to the pilot engagements
      that were incurred during the past two years.





Cost
      of services primarily includes personnel and travel costs related to the
      delivery of services. Services gross margin (loss) was 15%, (256%), and (341%)
      for the years ended 2006, 2005, and 2004 respectively.





Services
      revenues are expected to increase for the Desktop Integration segment as the
      Cicero® product gains acceptance. The Messaging and Application Engineering
      segment service revenues will continue to be deminimus as the new products
      that
      comprise that segment do not require substantial service oriented work.





**Sales
      and Marketing.** Sales
      and marketing expenses primarily include personnel costs for salespeople,
      marketing personnel, travel and related overhead, as well as trade show
      participation and promotional expenses. Sales and marketing expenses decreased
      by 45% or approximately $281,000 in 2006 and decreased by 42% or approximately
      $461,000 in 2005 due to a continued reduction in the Company’s sales and
      marketing workforce, decreased promotional activities and a change in the sales
      compensation structure. Specifically, the Company changed the compensation
      structure to lower fixed costs and increase variable success-based
      costs. ****





Sales
      and marketing expenses are expected to increase as the Company adds additional
      direct sales personnel and supports the sales function with collateral marketing
      materials. The Company's emphasis for the sales and marketing groups will be
      the
      Desktop Integration segment.





**Research
      and Development.** Research
      and development expenses primarily include personnel costs for product authors,
      product developers and product documentation and related overhead. Research
      and
      development expense decreased by 40% or $358,000 in 2006 as compared to 2005
      and
      decreased by 20% or $220,000 in 2005 as compared to 2004. The decrease in costs
      reflects the reduction in headcount by two employees plus associated overheads
      in 2006 and two employees, plus associated overheads in 2005.





The
      Company intends to continue to make a significant investment in research and
      development while enhancing efficiencies in this area.


**General
      and Administrative.** General
      and administrative expenses consist of personnel costs for the executive, legal,
      financial, human resources, investor relations and administrative staff, related
      overhead, and all


22


non-allocable
      corporate costs of operating the Company. General and administrative expenses
      for the year ended December 31, 2006 increased by 6% or $69,000 over the prior
      year. The increase in general administrative costs is primarily due to costs
      associated with the Company’s recapitalization plan in 2006. In fiscal 2005,
      general and administrative expenses decreased by 25% or $385,000 as compared
      to
      2004. The decline in general and administrative costs in 2005 reflects the
      general downsizing conducted by the Company in 2005.




General
      and administrative expenses are expected to slightly increase going forward
      as
      the Company’s revenues increase.





**Write-Off
      of Goodwill and Other Intangible Assets.** Write-off
      of goodwill was $0 for the years ended December 31, 2006 and 2005, and $587,000
      for the year ended December 31, 2004. During 2004, the Company acquired
      substantially all of the assets and assumed certain liabilities of Critical
      Mass
      Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software
      company. The total purchase price of the assets being acquired plus certain
      liabilities assumed was $750,000. The purchase price was allocated to the assets
      acquired and liabilities assumed based on the Company’s estimates of fair value
      at the acquisition date. The Company assessed the net realizable value of the
      Ensuredmail software technology acquired and determined the purchase price
      exceeded the amounts allocated to the software technology acquired less
      liabilities assumed by approximately $587,000. This excess of the purchase
      price
      over the fair values of the assets acquired less liabilities assumed was
      allocated to goodwill, and, because it was deemed impaired, charged to the
      Statement of Operations for the period ended March 31, 2004. At December 31,
      2006, 2005 and 2004, there was no remaining goodwill on the Company’s balance
      sheet.





**Warrants
      Liability.** The
      Company has issued warrants to holders of preferred stock designated Series
      A3
      and Series B3 preferred stockholders which allow the warrant holders to force
      a
      cash redemption for events outside the control of the Company. The fair value
      of
      the warrants is accounted for as a liability and is re-measured at each balance
      sheet date. As of December 31, 2006 and December 31, 2005, the warrant liability
      had a fair value of $0.





**Provision
      for Taxes.** The
      Company’s effective income tax rate for continuing operations differs from the
      statutory rate primarily because an income tax benefit was not recorded for
      the
      net loss incurred in 2006, 2005, or 2004. Because of the Company’s inconsistent
      earnings history, the deferred tax assets have been fully offset by a valuation
      allowance.





**Impact
      of Inflation.** Inflation
      has not had a significant effect on the Company’s operating results during the
      periods presented.








**Liquidity
      and Capital Resources**





***Operating
      and Investing Activities***





The
      Company generated $281,000 of cash for the year ended December 31,
      2006





Operating
      activities utilized approximately $2,224,000 in cash, which was primarily
      comprised of the loss from operations of $2,997,000, offset by non-cash charges
      for depreciation and amortization of approximately $12,000, and stock
      compensation expense of $615,000 and a provision for doubtful accounts of
      $50,000. In addition, the Company had an increase in accounts receivable of
      $202,000, offset by a reduction of prepaid expenses and other assets of $31,000.
      The Company generated approximately $311,000 in cash through an increase in
      the
      amount owing its creditors.





The
      Company utilized approximately $17,000 in cash in the purchase of updating
      the
      Company’s network equipment.





The
      Company generated approximately $2,528,000 of cash during the year from
      financing activities from increases in Convertible Bridge notes of $2,148,000
      and from approximately $380,000 resulting from the conversion of other debt
      to
      e  quity.





The
      Company utilized cash of $78,000 for the year ended December 31,
      2005.




Operating
      activities utilized approximately $2,564,000 in cash, which was primarily
      comprised of the loss from operations of $3,681,000, offset by non-cash charges
      for depreciation and amortization of approximately $11,000, and stock
      compensation expense of $149,000. In addition, the Company had a reduction
      in
      accounts receivable of $146,000, as well as a reduction of prepaid expenses
      and
      other assets of $55,000. The Company generated approximately $804,000 in cash
      through an increase in the amount owing its creditors. The Company had a





23





decrease
      of $29,000 in assets and liabilities of discontinued operations, a decrease
      in
      $12,000 for its provision for uncollectible accounts, and a decrease of $7,000
      in deferred revenue.





The
      Company utilized approximately $6,000 in cash in the purchase of updating the
      Company’s network equipment.





The
      Company generated approximately $2,487,000 of cash during the year from
      financing activities of the extension to its Note and Warrant offering of
      $944,000 and $1,615,000 of financing from its Convertible bridge notes offset
      by
      repayments of the Company’s short-term debt in the amount of $55,000.





***Financing
      Activities***





The
      Company funded its cash needs during the year ended December 31, 2006 with
      cash
      on hand from December 31, 2005, as well as through the use of proceeds from
      borrowings under convertible debt agreements.





The
      Company has a term loan in the principal amount of $1,971,000 from Bank Hapoalim
      bearing interest at LIBOR plus 1.5% (approximately 6.37% at December 31, 2006),
      which is payable quarterly. There are no financial covenants and the term loan
      is guaranteed by Liraz Systems, Ltd., the Company’s former principal
      shareholder. In September 2004, The Company and Liraz Systems Ltd. agreed to
      extend its guaranty on the term loan with Bank Hapoalim, and to extend the
      maturity date on the loan to November 3, 2005. Under the terms of the agreement
      with Liraz, the Company agreed to issue 3,942,000 shares of its common stock.
      In
      November 2005, The Company and Liraz Systems Ltd. agreed to extend its guaranty
      on the term loan with Bank Hapoalim, and to extend the maturity date on the
      loan
      to November 15, 2006. Under the terms of the agreement with Liraz, the Company
      agreed to issue 2,400,000 shares of its common stock and granted a warrant
      to
      purchase an additional 3,600,000 shares of our common stock at an exercise
      price
      of $0.002 per share. Based upon fair market value at the time of issuance,
      the
      Company recognized $48,000 as loan amortization costs in the Statement of
      Operations for the year ended December 31, 2005. Because the warrants are
      contingently issuable upon an event outside the control of the Company (the
      proposed Plan of Recapitalization), the Company did not recognized any value
      to
      these warrants until the contingency is removed. In November 2006, The Company
      and Liraz Systems Ltd. agreed to extend its guaranty on the term loan with
      Bank
      Hapoalim, and to extend the maturity date on the loan to October 31, 2007.
      Under
      the terms of the agreement with Liraz, the Company agreed to issue 6,000,000
      shares of its common stock. Based upon fair market value at the time of
      issuance, the Company recognized $240,000 as loan amortization costs in the
      Statement of Operations for the year ended December 31, 2006. In addition,
      since
      the contingency surrounding the warrants granted in the prior years’ debt
      extension was removed, the Company also recognized $72,000 as the value of
      these
      warrants and as loan amortization costs in the Statement of Operations for
      the
      year ended December 31, 2006.




In
      2004, the Company announced a Note and Warrant Offering in which warrant holders
      of the Company’s common stock were offered a one-time conversion of their
      existing warrants at a conversion price of $0.10 per share as part of a
      recapitalization plan. Under the terms of the Offer, which expired on December
      31, 2004, warrant holders who elected to convert, would tender their conversion
      price in cash and receive a Note Payable in exchange. As of December 31, 2004
      the Company had raised $1,615,000. Upon approval of the plan of recapitalization
      at a Shareholders meeting, these Notes would convert into common shares of
      Cicero Inc. In addition, those warrant holders who elected to convert the first
      $1 million of warrants would receive additional replacement warrants at a ratio
      of 2:1 for each warrant converted, with a strike price of $10.00 per share.
      In
      addition, upon approval of the plan of recapitalization, each warrant holder
      would be entitled to additional warrants to purchase common stock in Cicero
      Inc.
      In early 2005, the Company announced an extension to the Note and Warrant
      offering and as of December 31, 2005, the Company has raised an additional
      $944,000 for a total of approximately $2,559,000. Upon effectiveness of the
      plan
      of recapitalization, $2,309,000 of the Note and Warrant holders agreed to
      convert their notes into 3,438,473 shares of the Company’s common
      stock.





From
      July through December 2006, the Company issued several Convertible Bridge Notes
      with a consortium of investors. The Company had raised a total of $3,915,000
      of
      Convertible Bridge Notes of which $746,000 was from various members of the
      Company’s Board of Directors. Under the terms of these Notes, holders have
      converted their Notes into 30,508,448 shares of Cicero Inc. common stock upon
      effectiveness of the plan of recapitalization approved by stockholders on
      November 16, 2006.





The
      Company believes that the plan of recapitalization will have a positive impact
      on the future operations of the Company and its ability to raise additional
      capital that it will need to continue operations, however, there can be no
      assurance that management will be successful in executing as anticipated or
      in a
      timely enough manner. If these strategies are unsuccessful, the Company may
      have
      to pursue other means of financing that may not be on terms favorable to the
      Company or its stockholders. If the Company is unable to increase cash flow
      or
      obtain financing, it


24


may
      not be able to generate enough capital to fund operations for the next twelve
      months. We do not believe that we currently have sufficient cash on hand to
      finance operations for the next twelve months. At our current rates of expense
      and assuming revenues for the next twelve months at the annualized rate of
      revenue for the year ended 2006, we will be able to fund planned operations
      with
      existing capital resources for a minimum of four months and experience negative
      cash flow of approximately $2.0 million during the next twelve months to
      maintain planned operations. The accompanying financial statements have been
      prepared on a going concern basis, which contemplates the realization of assets
      and the satisfaction of liabilities in the normal course of business. The
      financial statements presented herein do not include any adjustments relating
      to
      the recoverability of assets and classification of liabilities that might be
      necessary should the Company be unable to continue as a going
      concern.





In
      April 2005, the Company borrowed $30,000 from a director of the Company pursuant
      to a convertible loan agreement. Under the term of this agreement, the loan
      bears interest at 1% per month and is convertible upon the option of the
      director into 428,571 shares of our common stock at a conversion price of $0.07
      per share which was the fair market value of the Company’s stock at the time the
      loan was made (pre-reverse stock split ratio). As part of the Plan of
      Recapitalization, this debt together with all other convertible promissory
      notes
      totaling $992,000 was converted into 1,591 shares of preferred stock designated
      Series A-1.





In
      January 2004, the Company completed a common stock financing round wherein
      it
      raised $1,247,000 of capital from several new investors as well as certain
      investors of Critical Mass Mail, Inc. The Company sold 3,369,192 shares of
      common stock at a price of $0.37 per share. As part of the financing, the
      Company has also issued warrants to purchase 3,369,192 shares of the Company’s
      common stock at an exercise price of $0.37. The warrants expire three years
      from
      the date of grant. The shares issued and the conversion price reflected the
      fair
      market value of the Company’s stock on the date of the transaction and are prior
      to effecting the reverse stock split ratio.





The
      Company incurred a loss from continuing operations of approximately $2,997,000
      for the year ended December 31, 2006 in addition to losses from continuing
      operations of approximately $13,412,000 for the previous two fiscal years.
      The
      Company has experienced negative cash flows from operations for the past three
      years. At December 31, 2006, the Company had a working capital deficiency of
      approximately $7,894,000. The Company’s future revenues are entirely dependent
      on acceptance of Cicero®, which has had limited success in commercial markets to
      date. Accordingly, there is substantial doubt that the Company can continue
      as a
      going concern and the independent auditor’s report accompanying our financial
      statements raises doubts about our ability to continue as a going concern.
      In
      order to address these issues and to obtain adequate financing for the Company’s
      operations for the next twelve months, the Company is actively promoting and
      expanding its product line and continues to negotiate with significant customers
      that have expressed interest in the Cicero® technology. The Company is
      experiencing difficulty increasing sales revenue largely because of the
      inimitable nature of the product as well as customer concerns about the
      financial viability of the Company. Cicero® software is a new “category
      defining” product in that most Enterprise Application Integration (EAI) projects
      are performed at the server level and Cicero®’s integration occurs at the
      desktop level without the need to open and modify the underlying code for those
      applications being integrated. Many companies are not aware of this new
      technology or tend to look toward more traditional and accepted approaches.
      The
      Company is attempting to solve the former problem by improving the market’s
      knowledge and understanding of Cicero® software through increased marketing and
      leveraging our limited number of reference accounts, while enhancing our list
      of
      resellers and systems integrators to assist in the sales and marketing process.
      Additionally, we must seek additional equity capital or other strategic
      transactions in the near term to provide additional liquidity.





**Contractual
      Obligations**





Future
      minimum payments for all contractual obligations for years subsequent to
      December 31, 2006 are as follows (in thousands):





**2007**
            
            **2008**
            
            **2009**
            
            **2010**
            
            **Total**Short
                and long-term debt, including interest payments
            
            $
            3,212
            
            $
            31
            
            $
            --
            
            $
            --
            
            $
            3,243Service
                purchase commitments
            
            
            275
            
            
            --
            
            
            --
            
            
            --
            
            
            275Operating
                leases
            
            
            65
            
            
            6
            
            
            --
            
            
            --
            
            
            71Capital
                leases
            
            
            2
            
            
            1
            
            
            --
            
            
            --
            
            
            3Total
            
            $
            3,554
            
            $
            38
            
            $
            --
            
            $
            --
            
            $
            3,592





25


Short
      and long-term debt, including interest payments, includes an outstanding
      indebtedness of approximately $1,971,000 term loan with Bank Hapoalim guaranteed
      by Liraz Systems Inc, and $250,000 short-term note with SDS Merchant Fund.





Under
      the employment agreement between the Company and Mr. Pizi effective January
      1,
      2006, the Company will pay Mr. Pizi an annual base salary of $150,000, and
      performance bonuses in cash of up to $350,000 per annum based upon certain
      revenue goals and operating metrics, as determined by the Compensation Committee
      of the Board of Directors of the Company, in its discretion. Upon termination
      of
      Mr. Pizi's employment by the Company without cause, the Company has agreed
      to
      pay Mr. Pizi (a) a lump sum payment of one year of Mr. Pizi's then current
      base
      salary and all deferred but unpaid salaries and bonuses within thirty (30)
      days
      of termination, and (b) all then outstanding but unvested stock options shall
      vest one hundred percent (100%).





Under
      the employment agreement between the Company and Mr. Broderick effective January
      1, 2006, the Company will pay Mr. Broderick a base salary of $150,000 and
      performance bonuses in cash of up to $350,000 per annum based upon certain
      revenue goals and operating metrics as determined by the Compensation Committee
      of the Board of Directors of the Company. Upon termination of Mr. Broderick's
      employment by the Company without cause, the Company has agreed to provide
      Mr.
      Broderick with a lump sum payment of one year of Mr. Broderick’s then current
      base salary and payment of all deferred salaries and bonuses within thirty
      (30)
      days of termination. In addition, all then outstanding but unvested stock
      options shall vest one hundred percent (100%).





**Off
      Balance Sheet Arrangements**





The
      Company does not have any off balance sheet arrangements. We have no
      subsidiaries or other unconsolidated limited purpose entities, and we have
      not
      guaranteed or otherwise supported the obligations of any other entity.




**Significant
      Accounting Policies and Estimates**





The
      policies discussed below are considered by us to be critical to an understanding
      of our financial statements because they require us to apply the most judgment
      and make estimates regarding matters that are inherently uncertain. Specific
      risks for these critical accounting policies are described in the following
      paragraphs. With respect to the policies discussed below, we note that because
      of the uncertainties inherent in forecasting, the estimates frequently require
      adjustment.





Our
      financial statements and related disclosures, which are prepared to conform
      to
      accounting principles generally accepted in the United States of America,
      require us to make estimates and assumptions that affect the reported amounts
      of
      assets, liabilities, revenues and accounts receivable and expenses during the
      period reported. We are also required to disclose amounts of contingent assets
      and liabilities at the date of the financial statements. Our actual results
      in
      future periods could differ from those estimates. Estimates and assumptions
      are
      reviewed periodically, and the effects of revisions are reflected in the
      Consolidated Financial Statements in the period they are determined to be
      necessary.





We
      consider the most significant accounting policies and estimates in our financial
      statements to be those surrounding: (1) revenue recognition; (2) allowance
      for
      doubtful trade accounts receivable; and (3) valuation of deferred tax assets.
      These accounting policies, the basis for any estimates and potential impact
      to
      our Consolidated Financial Statements, should any of the estimates change,
      are
      further described as follows:





**Revenue
      Recognition.** Our
      revenues are derived principally from three sources: (i) license fees for the
      use of our software products; (ii) fees for consulting services and training;
      and (iii) fees for maintenance and technical support. We generally recognize
      revenue from software license fees when a license agreement has been signed
      by
      both parties, the fee is fixed or determinable, collection of the fee is
      probable, delivery of our products has occurred and no other significant
      obligations remain. For multiple-element arrangements, we apply the “residual
      method”. According to the residual method, revenue allocated to the undelivered
      elements is allocated based on vendor specific objective evidence (“VSOE”) of
      fair value of those elements. VSOE is determined by reference to the price
      the
      customer would be required to pay when the element is sold separately. Revenue
      applicable to the delivered elements is deemed equal to the remainder of the
      contract price. The revenue recognition rules pertaining to software
      arrangements are complicated and certain assumptions are made in determining
      whether the fee is fixed and determinable and whether collectability is
      probable. For instance, in our license arrangements with resellers, estimates
      are made regarding the reseller’s ability and intent to pay the license fee. Our
      estimates may prove incorrect if, for instance, subsequent sales by the reseller
      do not materialize. Should our actual experience with respect to collections
      differ from our initial assessment, there could be adjustments to future
      results.


26




Revenues
      from services include fees for consulting services and training. Revenues from
      services are recognized on either a time and materials or percentage of
      completion basis as the services are performed and amounts due from customers
      are deemed collectible and non-refundable. Revenues from fixed price service
      agreements are recognized on a percentage of completion basis in direct
      proportion to the services provided. To the extent the actual time to complete
      such services varies from the estimates made at any reporting date, our revenue
      and the related gross margins may be impacted in the following
      period.





**Allowance
      for Doubtful Trade Accounts Receivable** .
      In addition to assessing the probability of collection in conjunction with
      revenue arrangements, we continually assess the collectability of outstanding
      invoices. Assumptions are made regarding the customer’s ability and intent to
      pay and are based on historical trends, general economic conditions, and current
      customer data. Should our actual experience with respect to collections differ
      from our initial assessment, there could be adjustments to bad debt
      expense.




**Capitalization
      and Valuation of Software Product Technology.** Our policy on capitalized software costs determines the timing of our
      recognition of certain development costs. In addition, this policy determines
      whether the cost is classified as development expense or cost of software
      revenue. Management is required to use professional judgment in determining
      whether development costs meet the criteria for immediate expense or
      capitalization. Additionally, we review software product technology assets
      for
      net realizable value at each balance sheet date. Should we experience reductions
      in revenues because our business or market conditions vary from our current
      expectations, we may not be able to realize the carrying value of these assets
      and will record a write down at that time. For the year ended December 31,
      2004,
      the Company recorded a write down of software product technology totaling
      $3,585,000 and as of December 31, 2006 and 2005 the Company had $0 in
      capitalized software product technology.





**Valuation
      of Deferred Tax Assets.** Income taxes are accounted for under the asset and liability method. Deferred
      tax assets and liabilities are recognized for the future tax consequences
      attributable to differences between the financial statement carrying amounts
      of
      existing assets and liabilities and their respective tax bases and operating
      loss and tax credit carry forwards. Deferred income tax assets and liabilities
      are measured using enacted tax rates expected to apply to taxable income in
      the
      years in which those temporary differences are expected to be recovered or
      settled. The effect on deferred income tax assets and liabilities of a change
      in
      tax rates is recognized in income in the period that includes the enactment
      date. A valuation allowance is established to the extent that it is more likely
      than not, that we will be unable to utilize deferred income tax assets in the
      future. At December 31, 2006, we had a valuation allowance of $97,265,000
      against $97,265,000 of gross deferred tax assets. We considered all of the
      available evidence to arrive at our position on the net deferred tax asset;
      however, should circumstances change and alter our judgment in this regard,
      it
      may have an impact on future operating results.




At
      December 31, 2006, the Company has net operating loss carryforwards of
      approximately $227,539,000, which may be applied against future taxable income.
      These carryforwards will expire at various times between 2006 and 2025. A
      substantial portion of these carryforwards is restricted to future taxable
      income of certain of the Company’s subsidiaries or limited by Internal Revenue
      Code Section 382. Thus, the utilization of these carryforwards cannot be
      assured.








**Recent
      Accounting Pronouncements:**





In
      July 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income
      Taxes - An Interpretation of SFAS No. 109”. FIN No. 48 clarifies the accounting
      for uncertainty in income taxes recognized in an enterprise’s financial
      statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN
      No. 48 also prescribes a recognition threshold and measurement attribute for
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. In addition, FIN No. 48 provides guidance
      on derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure and transition. The provisions of FIN No. 48 are to be
      applied to all tax positions upon initial adoption of this standard. Only tax
      positions that meet the more-likely-than-not recognition threshold at the
      effective date may be recognized or continue to be recognized as an adjustment
      to the opening balance of accumulated deficit (or other appropriate components
      of equity) for that fiscal year. The provisions of FIN No. 48 are effective
      for
      fiscal years beginning after December 15, 2006. The Company is evaluating the
      impact of the adoption of FIN 48 but does not currently expect the adoption
      of
      this new standard to have a material impact on our financial position, results
      of operations, or cash flows.





In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulleting (“SAB”) 108, to address diversity in practice in
      quantifying financial statement misstatements. SAB 108 requires that the Company
      quantify misstatements based on their impact on each of its financial statements
      and related


27




disclosures.
      SAB 108 is effective for fiscal years
      ending after November 15, 2006. The Company has adopted SAB 108 effective as
      of
      December 31, 2006. The adoption of this bulletin did not have a material impact
      on our financial position, results of operations, or cash flows.




In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS
      No. 157 provides guidance for using fair value to measure assets and
      liabilities. It also responds to investors’ requests for expanded information
      about the extent to which companies measure assets and liabilities at fair
      value, the information used to measure fair value, and the effect of fair value
      measurements on earnings. SFAS No. 157 applies whenever other standards require
      (or permit) assets or liabilities to be measured at fair value, and does not
      expand the use of fair value in any new circumstances. SFAS No. 157 is effective
      for financial statements issued for fiscal years beginning after November 15,
      2007 and is required to be adopted by the Company in the first quarter of 2008.
      The Company is currently evaluating the effect that the adoption of SFAS No.
      157
      will have on our financial position, results of operations, or cash
      flows.





In
      December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based
      Payment, (SFAS 123R).  SFAS 123R addresses the accounting for share-based
      payments to employees, including grants of employee stock options.  Under
      the new standard, companies will no longer be able to account for share-based
      compensation transactions using the intrinsic method in accordance with APB
      Opinion No. 25, “Accounting For Stock Issued To Employees”.  Instead,
      companies will be required to account for such transactions using a fair-value
      method and recognize the expense in the consolidated statement of income. 
SFAS 123R is effective for periods beginning after June 15, 2005 and
      allows, but does not require, companies to restate the full fiscal year of
      2005
      to reflect the impact of expensing share-based payments under SFAS 123R. 
The Company uses the Black-Scholes option-pricing model to determine the
      fair-value of stock-based awards under SFAS No. 123R, consistent with that
      used
      for pro forma disclosures under SFAS No. 123, “Accounting for Stock-Based
      Compensation”. The Company has elected to use the modified prospective
      transition method as permitted by SFAS No. 123R and, accordingly, prior periods
      have not been restated to reflect the impact of SFAS No. 123R. The modified
      prospective transition method requires that stock-based compensation expense
      be
      recorded for all new and unvested stock options that are ultimately expected
      to
      vest as the requisite service is rendered beginning on the first day of the
      Company’s year ended December 31, 2006. Stock-based compensation expense for
      awards granted prior to 2006 is based on the grant-date fair-value as determined
      under the pro forma provisions of SFAS No. 123.






**Item7A.**  **Quantitative
      and Qualitative Disclosures about Market Risk**





As
      the Company has disposed of or closed most of its European offices and
      operations, the majority of revenues are generated from US sources. The Company
      expects that trend to continue for the next year. As such, there is minimal
      foreign currency risk at present. Should the Company continue to develop a
      reseller presence in Europe and Asia, that risk will be increased.








**Item
      8.**  **Financial
      Statements and Supplementary Data**





The
      information required by this item appears beginning on page F-1 of this report.








**Item9.**  **Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure**





During
      the two most recent fiscal years there were no changes in or disagreements
      with
      the Company’s independent public accountants.








**Item9A.**  **Controls
      and Procedures**




The
      Company, under the supervision and with the participation of the Company’s
      management, including the Company’s Chief Executive Officer, President and Chief
      Operating Officer and Chief Financial Officer, carried out an evaluation of
      the
      effectiveness of the design and operation of the Company’s disclosure controls
      and procedures (the “Evaluation”) as of the end of the period covered by this
      Report. Based upon the Evaluation, the Company’s Chief Executive Officer,
      President and Chief Operating Officer and Chief Financial Officer concluded
      that
      the Company’s disclosure controls and procedures are effective to ensure that
      information required to be disclosed in our periodic reports filed with the
      Securities and Exchange Commission is recorded, processed, summarized and
      reported as and when required. In addition, they concluded that there were
      no
      significant deficiencies or material


28


weaknesses
      in the design or operation of internal controls which could significantly affect
      the Company’s ability to record, process, summarize and report financial
      information. It should be noted that any system of controls, however well
      designed and operated, can provide only reasonable, and not absolute, assurance
      that the objectives of the system will be met. In addition, the design of any
      control system is based in part upon certain assumptions about the likelihood
      of
      future events. Because of these and other inherent limitations of control
      systems, there is only reasonable assurance that the Company’s controls will
      succeed in achieving their stated goals under all potential future conditions.




In
      addition, the management of the Company, with the participation of the Company's
      Chief Executive Officer and the Chief Financial Officer, has evaluated whether
      any change in the Company's internal control over financial reporting (as
      defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred
      during the Company's fourth fiscal quarter. Based on that evaluation, the
      Company's Chief Executive Officer and Acting Chief Financial


Officer
      have concluded that there has been no change in the Company's internal control
      over financial reporting during the fourth fiscal quarter that has materially
      affected, or is reasonably likely to materially affect, the Company's internal
      control over financial reporting.








**Item
      9B.**  **Other
      Information**





The
      following disclosure has been filed on Form 8-K under the heading “Item 5.02.
      Departure of Directors or Principal Officers, Election of Directors, Appointment
      of Principal Officers.





On
      January 10, 2006, Mr. Bruce Percelay was elected by the Board of Directors
      to
      serve as a member of the Board of Directors of Level 8 Systems,
      Inc.




On
      March 9, 2006, the Company reported the resignation of Mr. Fredric Mack from
      the
      Board of Directors.





On
      May 15, 2006, Mr. John W. Atherton was elected by the Board of Directors to
      serve as a member of the Board of Directors of Level 8 Systems,
      Inc.





29





**PART
      III**





**Item
      10. Directors and Executive Officers of the
      Registrant**





As
      of December 31, 2006, the Board of Directors of the Company consisted of Mark
      Landis, Bruce Miller, John Broderick, Charles B. Porciello, Anthony Pizi, Bruce
      Hasenyager, Jay Kingley and John W Atherton. On January 10, 2006, Bruce Percelay
      was elected to the Board of Directors by vote a of existing Directors. On May
      15, 2005, John W. Atherton was elected to the Board of Directors by a vote
      of
      the then existing Directors. Messrs. Pizi, Kingley, and Hasenyager were elected
      at the 2003 Special Meeting of Stockholders and Messrs. Landis, Miller,
      Broderick, and Porciello were elected by unanimous vote of the board of
      directors, to serve until the election and qualification of their successors
      or
      until their earlier death, resignation or removal.





Set
      forth below with respect to each director is his name, age, principal occupation
      and business experience for the past five years and length of service as a
      director of the Company.





***Mark
      Landis***


Director
      since July 2005. Age: 65





Mr.
      Mark Landis is the Senior Managing Member of the Security Growth Fund, a newly
      established private equity firm focused on the electronic security industry.
      Prior to joining the Security Growth Fund and since 2003, Mr. Landis was the
      Executive in Residence of The Jordan Company, a private equity firm based in
      New
      York. Mr. Landis retired from being President of the North American Security
      Division of Siemens Building Technologies, Inc. in July of 2003, having spent
      16
      years with the company.





**Anthony
      C. Pizi**


Director
      since August 2000. Age: 47





Mr.
      Pizi has served as Chairman of the Board of Directors from December 1, 2000
      until March 7, 2005 and from June 1, 2005 until July 22, 2005. Mr. Pizi
      currently is Chief Information Officer. He served as Chief Executive Officer
      and
      Chief Technology Officer from February 1, 2001 to July 22, 2005. Mr. Pizi has
      been a director since August 2000. Until December 2000, he was First Vice
      President and Chief Technology Officer of Merrill Lynch’s Private Client
      Technology Architecture and Service Quality Group. Mr. Pizi’s 16 years with
      Merrill Lynch included assignments in Corporate MIS, Investment Banking and
      Private Client. Mr. Pizi earned his B.S. in Engineering from West Virginia
      University.





***Bruce
      W. Hasenyager***


Director
      since October 2002. Age: 65





Mr.
      Hasenyager has been a director of the Company since October 2002. Since November
      2004, Mr. Hasenyager has served as Principal of Bergen & Webster Executive
      Communications. Prior to that, he served as Director of Business and Technology
      Development at the Hart eCenter at Southern Methodist University (SMU) and
      Chief
      Operating Officer of the Guildhall at SMU. From April 1996 to April 2002, Mr.
      Hasenyager was a founder and served as Senior Vice President of Technology
      and
      Operations and Chief Technology Officer at MobilStar Network Corporation. Prior
      to April 1996, Mr. Hasenyager held executive and senior management positions
      in
      information technology at Chemical Bank, Merrill Lynch, Kidder Peabody, and
      Citibank.





***Jay
      R. Kingley***


Director
      since November 2002. Age: 45





Mr.
      Kingley has been a director of the Company since November 2002. Mr. Kingley
      is
      currently the Chief Executive Officer of Kingley Institute LLC, a medical
      wellness company. Prior to that, Mr. Kingley has served as CEO of Warren
      Partners, LLC, a software development and consultancy company. Mr. Kingley
      was
      Managing Director of a business development function of Zurich Financial
      Services Group from 1999-2001. Prior to joining Zurich Financial Services Group,
      Mr. Kingley was Vice President of Diamond Technology Partners, Inc., a
      management-consulting firm.





***Charles
      B. Porciello***


Director
      since June 2005. Age: 71





Mr.
      Porciello has been a director since June 6, 2005. Mr. Porciello graduated from the U.S. Military Academy with a B.S. in
      Engineering and received his Masters Degree in Management from the University
      of
      Nebraska. Mr.


30




Porciello
      is the Chief Executive Officer of Pilar
      Services, Inc. Mr. Porciello retired from the U.S. Air Force in 1982 after
      serving his country for twenty five years.




***Bruce
      D. Miller***


Director
      since July 2005. Age: 56




Mr.
      Bruce D. Miller is a General Partner of Delphi Partners, Ltd. a privately-owned
      investment partnership since 1989. He is the treasurer and a director of
      American Season Corporation. Mr. Miller is a board member of Cape Air/Nantucket
      Airlines, Inc. Mr. Miller is a trustee of the Egan Maritime Foundation and
      is
      involved in other non-profit activities. Mr. Miller received his B.S. in Finance
      from Lehigh University and subsequently earned an M.B.A. from
      Lehigh.





***Bruce
      A. Percelay***


Director
      since January 2006. Age: 51





Mr.
      Percelay has been a director since January 10, 2006. Mr. Percelay is the Founder and Chairman of the Mount Vernon Company, a real
      estate investment company specializing in the acquisition and renovation of
      multi-family and commercial properties in Greater Boston Communities. Since
      2000
      Mr. Percelay has been President of the Board of Habitat for Humanity in Greater
      Boston. Mr. Percelay is currently Chairman of the Board of Make-A-Wish
      Foundation of Greater Boston and Eastern Massachusetts. Since 2002 Mr. Percelay
      has been a Board Member of the Nantucket Historic Association. Mr. Percelay
      received his B.S. from Boston University School of Management, and a BA in
      Business and Economics from City of London Polytechnic, Special Studies in
      Economics.





***John
      P. Broderick***


Director
      since July 2005. Age: 57





Mr.
      Broderick is currently the Chief Executive Officer and Chief Financial Officer
      of the Company. Mr. Broderick has served as the Chief Operating Officer of
      the
      Company since June 2002, as the Chief Financial Officer of the Company since
      April 2001, and as Corporate Secretary since August 2001. Prior to joining
      the
      Company, Mr. Broderick was Executive Vice President of Swell Inc., a sports
      media e-commerce company where he oversaw the development of all commerce
      operations and served as the organization's interim Chief Financial Officer.
      Previously, Mr. Broderick served as Chief Financial Officer and Chief Operating
      Officer for Programmer's Paradise, a publicly held (NASDAQ: PROG) international
      software marketer. Mr. Broderick received his B.S. in accounting from Villanova
      University.





***John
      W. Atherton***


Director
      since May 2006. Age: 64





Mr.
      Atherton has been a director since May 12, 2006. Since 1990, Mr. Atherton is
      the
      Chairman of CityFed Financial, a publicly held financial
      holding company, based in Nantucket, Massachusetts. Mr. Atherton received his BA degree from Wesleyan University
      (Middletown, Connecticut) and an MBA with Distinction from Babson College
      (Wellesley, Massachusetts).





**Compensation
      Committee Interlocks and Insider Participation**





The
      Compensation Committee for 2006 was comprised of Messrs. Kingley and Porciello.
      None of the current members of the Compensation Committee has served as an
      executive officer of the Company, and no executive officer of the Company has
      served as a member of the Compensation Committee of any other entity of which
      Messrs. Kingley and Porciello have served as executive officers. Mr. Porciello
      is the Chief Executive Office of Pilar Services Inc., a reseller partner of
      the
      Company. The Company has recognized approximately $100,000 in revenues with
      Pilar Services Inc. during 2006. There were no interlocking relationships
      between the Company
      and other entities that might affect the determination of the compensation
      of
      the directors and executive officers of the Company.





**Director
      Compensation**





In
      May 1999, stockholders of the Company approved the Outside Director Stock
      Incentive Plan of the Company. Under this plan, the outside directors may be
      granted an option to purchase 12,000 shares of common stock at a price equal
      to
      the fair market value of the common stock as of the grant date. In January
      2002,
      the board of directors approved an amendment to the Outside Director Stock
      Incentive Plan to provide an increase in the number of options to be granted
      to
      outside directors to 24,000. These options vest over a three-year period in
      equal


31




increments
      upon the eligible director’s election to the
      Board, with the initial increment vesting on the date of grant. The Outside
      Director Stock Incentive Plan also permits eligible directors to receive partial
      payment of director fees in common stock in lieu of cash, subject to approval
      by
      the board of directors. In addition, the plan permits the board of directors
      to
      grant discretionary awards to eligible directors under the plan. None
      of the Company’s directors received additional monetary compensation for serving
      on the Board of Directors of the Company in 2001, other than reimbursement
      of
      reasonable expenses incurred in attending meetings.




In
      October 2002, the board of directors approved an amendment to the stock
      incentive plan for all non-management directors. Under the amendment, each
      non-management director will receive 100,000 options to purchase common stock
      of
      the Company at the fair market value of the common stock on the date of grant.
      These shares will vest in three equal increments with the initial increment
      vesting on the date of grant. The option grant contains an acceleration of
      vesting provision should the Company incur a change in control. A change in
      control is defined as a merger or consolidation of the Company with or into
      another unaffiliated entity, or the merger of an unaffiliated entity into the
      Company or another subsidiary thereof with the effect that immediately after
      such transaction the stockholders of the Company immediately prior to the
      transaction hold less than fifty percent (50%) of the total voting power of
      all
      securities generally entitled to vote in the election of directors, managers
      or
      trustees of the entity surviving such merger or consolidation. Under the
      amendment, there will be no additional compensation awarded for committee
      participation. The shares allocated to the Board of Directors were issued out
      of
      the Level 8 Systems, Inc. 1997 Employee Stock Plan. All of the options issued
      are prior to a 100:1 reverse stock split which was affected at December 31,
      2006.





**Executive
      Officers**





The
      Company’s current executive officers are listed below, together with their age,
      position with the Company and business experience for the past five
      years.





**Anthony
      C. Pizi.** Age:
      47





Mr.
      Pizi currently serves as the Chief Information Officer of the Company. He served
      as the Chief Executive Officer and Chief Technology Officer of the Company
      from
      February 1, 2001 until July 22, 2005. Prior to joining our Company, Mr.
      Pizi was First Vice President and Chief Technology Officer of Merrill Lynch’s Private
      Client Technology Architecture and Service Quality Group. Mr. Pizi’s 16 years
      with Merrill Lynch included assignments in Corporate MIS, Investment Banking
      and
      Private Client. Mr. Pizi earned his B.S. in Engineering from West Virginia
      University.





**John
      P. Broderick.** Age:
      57





Mr.
      Broderick serves as the Chief Executive Officer since July 22, 2005 and as
      the
      Chief Financial Officer of the Company since April 2001. He has served as the
      Chief Operating Officer of the Company since June 2002 and as Corporate
      Secretary since August 2001. Prior to joining our Company, Mr. Broderick was
      Executive Vice President of Swell Inc., a sports media e-commerce company where
      he oversaw the development of all commerce operations and served as the
      organization's interim Chief Financial Officer. Previously, Mr. Broderick served
      as Chief Financial Officer and Chief Operating Officer for Programmer's
      Paradise, a publicly held (NASDAQ: PROG) international software marketer. Mr.
      Broderick received his B.S. in accounting from Villanova
      University.





**Audit
      Committee**





The
      Board of Directors has determined that the members of the Audit Committee are
      independent as defined in Rule 4200(a)(15) of the National Association of
      Securities Dealers’ listing standards. Mr. John W. Atherton was designated the
“audit committee financial expert” as defined in Item 401(h) of Regulation S-K.





**Code
      of Ethics and Conduct**




Our
      Board of Directors has adopted a code of ethics and a code of conduct that
      applies to all of our directors, Chief Executive Officer, Chief Financial
      Officer, and employees. We will provide copies of our code of conduct and code
      of ethics without charge upon request. To obtain a copy of the code of ethics
      or
      code of conduct, please send your written request to Cicero Inc., Suite 542,
      8000 Regency Pkwy, Cary, North Carolina 27511, Attn: Corporate Secretary. The code of ethics is also available on the Company’s
      website at www.ciceroinc.com.





32


**C** **ompliance** **** **with** **S** **ection** **16(** **a)
      of the** **E** **xchange** **A** **ct**





Section
      16(a) of the Securities Exchange Act of 1934, as amended, requires the Company’s
      officers, directors and persons who own more than ten percent of the Company’s
      Common Stock (collectively, “Reporting Persons”) to file reports of ownership
      and changes in ownership with the SEC and Nasdaq. Reporting Persons are required
      by SEC regulations to furnish the Company with copies of all Section 16(a)
      reports they file. Based solely on its review of the copies of such reports
      received by it and written representations all Section 16(a) reports were filed
      in a timely manner with the exception of Mr. John W. Atherton. At the time
      Mr.
      Atherton joined the Board, the Company was not aware that he owned 100 shares
      of
      the Company’s common stock in a self -directed IRA. The Company filed Form 3,
      Initial Statement of Beneficial Ownership of Securities, on January 4,
      2007.








**Item
      11. Executive Compensation.**




The
      following summary compensation table sets forth the compensation earned by
      all
      persons serving as the Company’s executive officers during fiscal year
      2006, **** serving
      or having served at the end of fiscal 2005 whose salary and bonus exceeded
      $100,000 for services rendered to the Company during the fiscal year 2006.
      The
      table reflects compensation earned for each of the last three years or for
      such
      shorter period of service as an executive officer as is reflected below. For
      the
      principal terms of the options granted during fiscal 2006, see “Option Grants in
      Fiscal 2006.”





**Summary
      Compensation Table**




**Name
                  and**
                **Principal**
                **Position**
              
              
              **Fiscal**
                **Year**
              
              
              **Salary**
              
              
              **Bonus**
              
              
              **Stock
                  Awards**
              
              
              **Option
                  Awards**
              
              
              **Non-
                  Equity**
                **Incentive**
                **Plan****Compensation**
              
              
              **Nonqualified
                  Deferred Compensation Earnings**
              
              
              **All
                  Other**
                **Compensation**
              
              
              **Total**Anthony
                  C. Pizi
                Chief
                  Information Officer
              
              
              2006
                2005
                2004
              
              $
                $
                $
              150,000(1
                150,000(2
                200,000(3
              )
                )
                )
              $
                $
                $
              --
                --
                --
              
              
              --
                --
                --
              
              
              ---
                --
                5,000
              
              
              --
                --
                --
              
              
              --
                --
                --
              
              $
                $
                $
              --
                --
                --
              
              $
                $
                $
              150,000
                150,000
                200,000John
                  P. Broderick
                Chief
                  Executive Officer Chief Financial Officer, Corporate
                  Secretary
              
              
              2006
                2005
                2004
              
              $
                $
                $
              150,000(4
                150,000(5
                200,000(6
              )
                )
                )
              $
                $
                $
              --
                --
                60,000
              
              
              --
                --
                --
              
              
              --
                --
                5,000
              
              
              --
                --
                --
              
              
              --
                --
                --
              
              $
                $
                $
              --
                --
                --
              
              $
                $
                $
              150,000
                150,000
                200,000




Mr.
      Pizi’s base salary for fiscal 2006 was $150,000. As of December 31, 2006, Mr.
      Pizi is owed approximately $94,935 of deferred salary and $100,000 of his earned
      bonus from 2003.





(1)
            Mr.
                Pizi’s base salary for fiscal 2005 was $200,000. Mr. Pizi had voluntarily
                elected to defer $31,250 of salary from 2005. In August 2005 Mr.
                Pizi
                voluntarily reduced his annual salary to $150,000 for the year. Mr.
                Pizi
                was the Company’s Chief Executive Officer and Chairman until July 22,
                2005.





(2)
            Mr.
                Pizi’s base salary for fiscal 2004 was $200,000. Mr. Pizi had voluntarily
                elected to defer $50,000 of salary from 2004. In December 2004, Mr.
                Pizi
                received approximately $55,000 of deferred salary from 2004 and 2003
                and
                used those proceeds to participate in the Note and Warrant
                Offering.





(3)
            Mr.
                Broderick’s base salary for fiscal 2006 was $150,000. As of December 31,
                2006, Mr. Broderick is owed approximately $112,500 of deferred salary
                and
                $40,000 of earned bonus from 2003.




(4)
            Mr.
                Broderick’s base salary for 2005 was $200,000. Mr. Broderick had
                voluntarily elected to defer $31,250 of salary from 2005. In August
                2005,
                Mr. Broderick voluntarily reduced his annual salary to $150,000 for
                the
                year. Mr. Broderick was appointed the Company’s Chief Executive Officer in
                addition to being the Chief Financial Officer in July 2005. During
                2005,
                Mr. Broderick was paid $13,000 of his accrued bonus from
                2003.




(5)
            Mr.
                Broderick’s base salary for 2004 was $200,000. Mr. Broderick voluntarily
                elected to defer $50,000 of salary from 2004 and all earned bonus
                ($60,000) from 2003.




33


The
      Company did not award any grants of stock options to the named executives during
      fiscal 2006. The Company did not award any stock appreciation rights (“SARs”)
      during fiscal 2006.




The
      following table sets forth information concerning the options exercised during
      fiscal 2006 and held at December 31, 2006 by the Named Executives.





**Fiscal
      2006 Year-End Option Holdings and Values**


**Number
                of Securities**
              **Underlying
                Unexercised**
              **Options
                at December 31, 2006**
            
            **Value
                of Unexercised In-the-Money**
              **Options
                at December 31, 2006(1)****Name**
            
            **Shares
                Acquired****on
                Exercise**
            
            **Value**
              **Realized**
            
            **Exercisable**
            
            **Unexercisable**
            
            **Exercisable**
            
            **Unexercisable**Anthony
                C. Pizi
            
            
            --
            
            
            --
            
            
            15,000
            
            
            -0-
            
            
            -0-
            
            
            -0-John
                P. Broderick
            
            
            --
            
            
            --
            
            
            12,609
            
            
            -0-
            
            
            -0-
            
            
            -0-





(1)
            Based
                on $2.30 per share, the December 31, 2006, closing price as quoted
                on the
                OTC Bulletin Board.








**Employment
      Agreements, Termination of Employment and Change-In-Control
      Arrangements**





Under
      the employment agreement between the Company and Mr. Pizi effective January
      1,
      2006, the Company will pay Mr. Pizi an annual base salary of $150,000 and
      performance bonuses in cash of up to $350,000 per annum based upon certain
      revenue goals and operating metrics, as determined by the Compensation Committee
      of the Board of Directors of the Company, in its discretion. Upon termination
      of
      Mr. Pizi’s employment by the Company without cause, the Company has agreed to
      pay Mr. Pizi a lump sum payment equal to one year of Mr. Pizi’s then current
      base salary within thirty (30) days of termination and any unpaid deferred
      salaries and bonuses. In the event there occurs a substantial change in Mr.
      Pizi’s job duties, there is a decrease in or failure to provide the compensation
      or vested benefits under the employment agreement or there is a change in
      control of the Company, the Company has agreed to pay Mr. Pizi one year salary
      within 30 days of such notice of termination. If Mr. Pizi’s employment is
      terminated for any reason, Mr. Pizi has agreed that, for one (1) year after such
      termination, he will not directly or indirectly solicit or divert business
      from
      the Company or assist any business in attempting to do so or solicit or hire
      any
      person who was an employee of the Company during the term of his employment
      agreement or assist any business in attempting to do so.





Under
      the employment agreement between the Company and Mr. Broderick effective January
      1, 2006, the Company will pay Mr. Broderick a base salary of $150,000 and he
      is
      eligible for performance bonuses in cash of up to $350,000 per annum based
      upon
      certain revenue goals and operating metrics, as determined by the Compensation
      Committee of the Board of Directors of the Company, in its discretion. Upon
      termination of Mr. Broderick’s employment by the Company without cause, the
      Company has agreed to provide Mr. Broderick with one year of his then current
      salary payable within 30 days of termination and any accrued but unpaid deferred
      salaries and bonuses. In the event there occurs a substantial change in Mr.
      Broderick’s job duties, there is a decrease in or failure to provide the
      compensation or vested benefits under the employment agreement or there is
      a
      change in control of the Company, the Company has agreed to pay Mr. Broderick
      a
      lump sum payment of one year of Mr. Broderick’s then base salary within thirty
      (30) days of termination Mr. Broderick will have thirty (30) days from the
      date
      written notice is given about either a change in his duties or the announcement
      and closing of a transaction resulting in a change in control of the Company
      to
      resign and execute his rights under this agreement. If Mr. Broderick’s
      employment is terminated for any reason, Mr. Broderick has agreed that, for
      one
      (1) year after such termination, he will not directly or indirectly solicit
      or
      divert business from the Company or assist any business in attempting to do
      so
      or solicit or hire any person who was an employee of the Company during the
      term
      of his employment agreement or assist any business in attempting to do so.








**Item
      12.**  **Security
      Ownership of Certain Beneficial Owners and Management.**




The following table sets forth information as of December 31, 2006 with respect to beneficial
      ownership of shares by (i) each person known to the Company to be the
      beneficial owner of more than 5% of the outstanding common stock, (ii) each
      of the Company’s directors, (iii) the executive officers of the Company
      named in the


34


Summary
      Compensation Table (the “Named Executives”) and (iv) all current directors
      and executive officers of the Company as a group. Unless otherwise indicated,
      the address for each person listed is c/o Cicero Inc., 1433 State Highway 34,
      Farmingdale, New Jersey 07727.





The
      named person has furnished stock ownership information to the Company.
      Beneficial ownership as reported in this section was determined in accordance
      with Securities and Exchange Commission regulations and includes shares as
      to
      which a person possesses sole or shared voting and/or investment power and
      shares that may be acquired on or before December 31, 2006 upon the exercise
      of
      stock options as well as exercise of warrants. The chart is based on 35,294,810
      common shares outstanding as of December 31, 2006. Except as otherwise stated
      in
      the footnotes below, the named persons have sole voting and investment power
      with regard to the shares shown as beneficially owned by such
      persons.








**Common
                Stock****Name
                of Beneficial Owner**
            
            **No.
                of Shares**
            
            **Percent
                of Class**QueeQueg
                Partners, L.P. (1)
            
            
            4,562,465
                (2
            )
            
            12.2
            %Queequeg
                Ltd. (1)
            
            
            1,504,938
                (3
            )
            
            5
            %Mark
                and Carolyn P. Landis (4)
            
            
            5,069,153
                (5
            )
            
            13.8
            %Anthony
                C. Pizi
            
            
            1,416,241
                (6
            )
            
            4.0
            %Bruce
                Miller
            
            
            1,337,118
                (7
            )
            
            3.8
            %Bruce
                Percelay
            
            
            1,032,786
                (8
            )
            
            2.9
            %John
                P. Broderick
            
            
            15,857
                (9
            )
            
            *John
                W. Atherton
            
            
            148,884
                (10
            )
            
            *Bruce
                W. Hasenyager
            
            
            33,652
                (11
            )
            
            *Charles
                Porciello
            
            
            80,286
                (12
            )
            
            *Jay
                R. Kingley
            
            
            1,000
                (13
            )
            
            *All
                current directors and executive officers as a group (9
                persons)
            
            
            9,134,977(14
            )
            
            24.8
            %




·
            Represents
                less than one percent of the outstanding
                shares.




1.
              The
                  address of QueeQueg Partners and QueeQueg Ltd. is 299 Park Avenue
                  New
                  York, New York 10071.
 
 2.
              As
                  of December 31, 2006, QueeQueg Partners, L.P. owns 4,539,475 shares
                  of
                  common stock, 9.643 shares of the Series A-1 Convertible Preferred
                  Stock,
                  and 13,347 shares issuable upon the exercise of warrants. The exercise
                  prices of the warrants are as follows: 586 at $37.00 per share,
                  249 at
                  $38.00 per share 3,194 at $40.00 per share, and 9,318 at $10.00
                  per share.
                  QueeQueg Partners, L.P disclaims beneficial ownership of 4,029
                  warrant
                  shares because they are
                  anti-dilutive.
 
 3.
              As
                  of December 31, 2006, QueeQueg, Ltd. owns 1,492,558 shares of common
                  stock, 5.193 shares of the Series A-1 Convertible Preferred Stock,
                  and
                  7,187 shares issuable upon the exercise of warrants. The exercise
                  prices
                  of the warrants are as follows: 315 at $37.00 per share, 134 at
                  $38.00 per
                  share 1,720 at $40.00 per share, and 5,018 at $10.00 per share.
                  QueeQueg
                  Ltd disclaims beneficial ownership of 2,169 warrant shares because
                  they
                  are anti-dilutive.
 
 4.
              The
                  address of Mark and Carolyn P. Landis is 503 Lake Drive, Princeton,
                  New
                  Jersey 08540.
 
 5.
              Includes
                  3,673,695 shares of common stock, 1,326.136 shares of the Series
                  A-1
                  Convertible Preferred Stock, and 69,322 shares issuable upon the
                  exercise
                  of warrants.The
                  exercise prices of the warrants are as follows: 18,750 at $8.00
                  per share,
                  20,000 at $10.00 per share, and 30,572 at $10.00 per share.Disclaims
                  beneficial ownership of 38,750 shares because they are anti-dilutive.
 
 6.
              Includes
                  1,274,951 shares of common stock, 111.016shares
                  of the Series A-1 Convertible Preferred Stock,15,000 shares subject to stock options exercisable within sixty
                  (60) days,
                  and 15,274 shares of common stock issuable upon the exercise of
                  warrants.
                  The exercise price of warrants is as follows: 901 shares at $17.00
                  per
                  share of common stock; 2,706 shares at $20.00 per share of common
                  stock;
                  and 11,667 shares at $10.00 per share of common stock. Disclaims
                  beneficial ownership of 18,607 shares of common stock because they
                  are
                  anti-dilutive.
 
 7.
              Consists
                  of 758,624 shares of common stock, 49.418shares of the Series A-1 Convertible Preferred Stock, and 16,295shares
                  of common stock issuable upon the exercise of warrants.The
                  exercise prices of the warrants are as follows: 451 at $37.00 per
                  share,
                  192 at $38.00 per share 2,457 at $40.00 per share, and 13,195 at
                  $10.00
                  per


35


share. Mr. Miller has sole or shared voting or dispositive power with respect to the
      securities held by Delphi Partners, Ltd., which holds 491,267 shares of common
      stock, 18.000 shares of the Series A-1 Convertible Preferred Stock, and 3,514 shares
      of common stock issuable upon the exercise of warrants at $10.00 per
      share.




8.
              Consists
                  of 1,032,786 shares of common
                  stock.
 
 9.
              Includes
                  3,248 shares of common stock and 12,609 shares subject to stock
                  options
                  exercisable within sixty (60) days. Disclaims beneficial ownership
                  of
                  12,609 shares of common stock because they are
                  anti-dilutive.
 
 10.
              Includes
                  148,784 shares of common stock, and 100 shares of common stock
                  held in a
                  self-directed IRA.
 
 11.
              Consists
                  of 32,652 shares of common stock and 1,000 shares subject to stock
                  options
                  exercisable within sixty (60) days.Disclaims
                  beneficial ownership of 1,000 shares of common stock because they
                  are
                  anti-dilutive.
 
 12.
              Consists
                  of 80,286 shares of common stock.
 
 13.
              Consists
                  of1,000
                  shares subject to stock options exercisable within sixty (60) days.Disclaims
                  beneficial ownership of 1,000 shares of common stock because they
                  are
                  anti-dilutive.
 
 14.
              Includes
                  shares issuable upon exercise of options and warrants exercisable
                  within
                  sixty (60) days as described in Notes 7-14 to our financial
                  statements.


**Item
      13.**  **Certain
      Relationships and Related Transactions.**




**Loan
      from Related Parties**





During
      2005, the Company entered into short term notes****payable
      with Anthony Pizi, the Company’s former Chief Executive Officer, and current
      Chief Information Officer, for various working capital needs. The Notes bear
      interest at 1% per month and are unsecured. At December 31, 2006, the Company
      was indebted to Mr. Pizi in the amount of $9,000.




*Convertible
      Promissory Notes*. Directors and executive officers made several loans to us
      in exchange for convertible promissory notes. As part of the Plan of
      Recapitalization which was approved by our shareholders, the Company offered
      to
      adjust the conversion rates and terms on these notes. As a result of the Plan
      of
      Recapitalization, these notes were automatically converted into shares of the
      preferred stock designated as Series A-1 Preferred stock. Each share of Series
      A-1 Preferred Stock is convertible into 1,000 shares of the Company’s common
      stock. Because the conversion rates were adjusted, the Company calculated the
      amount of the beneficial conversion resulting from the adjusted conversion
      rate
      and recorded that amount as a deemed dividend and additional paid in capital.
      See Note 2 to the Consolidated Financial Statements.





In
      June,
      2004, the Company entered into a convertible promissory note with Mr. Pizi
      in
      the face amount of $100,000, bearing interest at 1% per month which was
      converted into 14 shares of the Company’s Series A-1 Preferred Stock. In
      addition, Mr. Pizi was granted 270,270 warrants to purchase the Company’s common
      stock at $0.37 per share. As part of the Note and Warrant Offering, Mr. Pizi
      elected to convert these warrants by loaning the Company the reduced exercise
      price.





In
      July
      2004, the Company entered into a convertible promissory note with Mr. Pizi
      in
      the face amount of $112,000, bearing interest at 1% per month which was
      converted into 78.4 shares of the Company’s Series A-1 Preferred Stock upon
      approval of the Plan of Recapitalization. In addition, at the time of the loan,
      Mr. Pizi was granted warrants to purchase 560,000 shares of our common stock
      at
      $0.20 per share. As part of the Note and Warrant Offering, Mr. Pizi elected
      to
      convert 289,376 of these warrants by loaning the Company the reduced exercise
      price. Mr. Pizi elected not to exercise 270,624 warrants and after the reverse
      stock ratio now total 2,706 warrants with an exercise price of $20 per share.
      Also in July 2004, Mr. Pizi entered into a second convertible promissory note
      in
      the face amount of $15,000 which was converted into 12.62 shares of the
      Company’s Series A-1 Preferred Stock. In addition, at the time of the loan, Mr.
      Pizi was granted warrants to purchase 90,118 shares of the Company’s common
      stock at $0.17 per share. Mr. Pizi has not elected to exercise these warrants
      and after the reverse stock ratio now total 901 warrants with an exercise price
      of $17.





In
      March
      2004, the Company entered into a convertible promissory note with Mr. and Mrs.
      Landis in the amount of $125,000. Under the terms of the note, the loan bore
      interest at 1% per month, and was converted into


36


62.5
      shares of Series A-1 Preferred stock. In addition, Mr. and Mrs. Landis were
      granted warrants to purchase 446,429 shares of the Company’s common stock
      exercisable at $0.28 per share. As part of the Note and Warrant Offering, Mr.
      and Mrs. Landis elected to convert these warrants by loaning the Company the
      reduced exercise price.





In
      June
      2004, the Company entered into a convertible promissory note with Mr. and Mrs.
      Landis in the amount of $125,000. Under the terms of the note, the loan bore
      interest at 1% per month and was converted into 113.64 shares of Series A-1
      Preferred stock. In addition, Mr. and Mrs. Landis were granted warrants to
      purchase 781,250 shares of the Company’s common stock exercisable at $0.16 per
      share. As part of the Note and Warrant Offering, Mr. and Mrs. Landis elected
      to
      convert these warrants by loaning the Company the reduced exercise
      price.





In
      October 2004, the Company entered into a convertible promissory note with Mr.
      and Mrs. Landis in the amount of $100,000. Under the terms of the agreement,
      the
      loan bore interest at 1% per month and was converted into 400 shares of Series
      A-1 Preferred stock. In addition, Mr. and Mrs. Landis were granted 2,000,000
      warrants to purchase the Company’s common stock exercisable at $0.10 per share.
      Mr. and Mrs. Landis elected not to exercise these warrants as part of the Note
      and Warrant Offering and after the reverse stock split ratio these warrants
      total 20,000 with an exercise price of $10.00.





In
      November 2004, the Company entered into a convertible promissory note with
      Mr.
      and Mrs. Landis in the amount of $150,000. Under the terms of the agreement,
      the
      loan bore interest at 1% per month and was converted into 18,750 shares of
      common stock after the reverse stock split ratio. In addition, Mr. and Mrs.
      Landis were granted 1,875,000 warrants to purchase the Company’s common stock
      exercisable at $0.08 per share. Mr. and Mrs. Landis elected not to exercise
      these warrants as part of the Note and Warrant Offering and after the reverse
      stock split ratio these warrants total 18,750 with an exercise price of
      $8.00.





In
      June
      2004, the Company entered into a convertible promissory note with Fredric Mack,
      a former director of the Company, in the amount of $125,000. Under the terms
      of
      the note, the loan bore interest at 1% per month, and was converted into 54.69
      shares of Series A-1 Preferred stock. In addition, Mr. Mack was granted warrants
      to purchase 390,625 shares of the Company’s common stock exercisable at $0.32
      per share. As part of the Note and Warrant Offering, Mr. Mack elected to convert
      these warrants by loaning the Company the reduced exercise price.





In
      April
      2005, the Company entered into a convertible promissory note with Bruce Miller,
      a director of the Company, in the amount of $30,000. Under the terms of the
      note, the loan bore interest at 1% per month and was converted into 60 shares
      of
      Series A-1 Preferred stock.





In
      July
      2004, the Company entered into a convertible promissory note with Nicholas
      Hatalski, who until July 22, 2005 (during the period when the terms of the
      recapitalization plan were being negotiated and at the time of approval of
      the
      plan by our board of directors), was a director of the Company, in the amount
      of
      $25,000. Under the terms of the note, the loan bore interest at 1% per month
      and
      was converted into 10.94 shares of Series A-1 Preferred stock. In addition,
      Mr.
      Hatalski was granted warrants to purchase 78,125 shares of the Company’s common
      stock exercisable at $0.32 per share. Mr. Hatalski elected not to exercise
      these
      warrants as part of the Note and Warrant Offering and after the reverse stock
      split ratio these warrants total 781 with an exercise price of $32.





All
      of
      such warrants expire three years from date of grant.





*Senior
      Reorganization*Notes. From March 2004 to April 2005, directors and
      executive officers made the following loans to the Company evidenced by Senior
      Reorganization Notes: Mr. Pizi held $423,333 of Senior Reorganization Notes,
      which were converted into warrants to purchase an additional 571,659 shares
      of
      Cicero common stock at a purchase price of $0.20 per
      share.****





Mr.
      Landis held $327,860 of Senior Reorganization Notes, which were converted into
      warrants to purchase an additional 442,345 shares of Cicero common stock at
      an
      exercise price of $0.20 per share.





Mr.
      Mack
      held, together with his affiliates, $88,122 of Senior Reorganization Notes,
      which were converted into warrants to purchase an additional 112,205 shares
      of
      Cicero common stock at a purchase price of $0.20 per share.





Mr.
      Miller held, together with his affiliates, $77,706 of Senior Reorganization
      Notes, which were converted into warrants to purchase an additional 114,597
      shares of Cicero common stock at a purchase price of $0.20.





Mr.
      Atherton holds $20,000 of Senior Reorganization Notes which were converted
      into
      warrants to purchase an additional 289,856 shares of Cicero common stock at
      a
      purchase price of $0.20.


37


Mr.
      Broderick, Chief Executive Officer and Chief Financial Officer of the Company,
      held $2,300 of Senior Reorganization Notes, which were converted into warrants
      to purchase 3,222 shares of Cicero Inc. common stock at a purchase price of
      $0.20 per share, and options to purchase 12,609 shares of common stock under
      the
      Company’s stock option plan that will convert into options to purchase Cicero
      common stock.




*Convertible
      Bridge Notes*. From July 2005 to November 2006, directors and executive
      officers made the following loans to us for Convertible Bridge Notes:





Mr.
      Pizi
      held $85,000 of Convertible Bridge Notes which bear interest at 10% and matured
      on September 15, 2005. These notes automatically converted into 680,000 shares
      of Cicero common stock upon approval of the recapitalization plan by
      stockholders.





Mr.
      Landis held $395,000 of Convertible Bridge Notes which bear interest at 10%
      and
      matured on various dates in 2005 and 2006. These notes automatically converted
      into 3,160,000 shares of Cicero common stock upon approval of the
      recapitalization plan by stockholders.





Mr.
      Mack
      held, together with his affiliates, $114,000 of Convertible Bridge Notes which
      bear interest at 10% and matured on various dates in 2005 and 2006. These notes
      automatically converted into 897,564 shares of Cicero common stock upon approval
      of the recapitalization plan by stockholders.





Mr.
      Miller held, together with his affiliates, $120,000 of Convertible Bridge Notes
      which bear interest at 10% and matured on various dates in 2005 and 2006. These
      notes automatically converted into 947,273 shares of Cicero common stock upon
      approval of the recapitalization plan by stockholders.





Mr.
      Hasenyager, a member of our Board of Directors, held $4,061 of Convertible
      Bridge Notes which bear interest at 10% and matured on September 15, 2005.
      These
      notes automatically converted into 32,485 shares of Cicero common stock upon
      approval of the recapitalization plan by stockholders.





Mr.
      Percelay, a member of our Board of Directors, held $130,000 of Convertible
      Bridge Notes which bear interest at 10% and matured on various dates in 2005
      and
      2006. These notes automatically converted into 1,027,273 shares of Cicero common
      stock upon approval of the recapitalization plan by stockholders.





Mr.
      Atherton, a member of our Board of Directors, held $15,000 of convertible Bridge
      Notes which bear interest at 10% and matured during 2006. These notes
      automatically converted into 120,000 shares of Cicero common stock upon approval
      of the recapitalization plan by stockholders.





Mr.
      Porciello, a member of our Board of Directors, held $10,000 of Convertible
      Bridge Notes which bear interest at 10% and matured during 2006. These notes
      automatically converted into 80,000 shares of Cicero common stock upon approval
      of the recapitalization plan by stockholders.





**Transactions
      with Merrill Lynch**





On
      January 3, 2002, the Company entered into a Purchase Agreement with MLBC, Inc.,
      an affiliate of Merrill Lynch. Pursuant to the Purchase Agreement, the Company
      issued 250,000 shares of its common stock to MLBC and entered into a royalty
      sharing agreement for sales of Cicero ® .
      Under the royalty sharing agreement, the Company is obligated to pay a royalty
      of 3% of the sales price for each sale of Cicero ® or related maintenance services. The royalties are not payable in excess of
      $20
      million. As consideration for the issuance of the shares and the royalty
      payments, Merrill Lynch has entered into an amendment to the Cicero ® license agreement, which extends our exclusive worldwide marketing, sales,
      and
      development rights to Cicero ® and granted us certain ownership rights in the Cicero ® trademark. Pursuant to the Purchase Agreement, the Company also entered into
      a
      Registration Rights Agreement granting MLBC certain rights to have the shares
      of
      common stock it received under the Purchase Agreement registered under the
      Securities Act of 1933, as amended.





**Preferred
      Stock Exchange**





As
      part of the Company’s plan of recapitalization presented to shareholders for
      approval, the Company proposed to amend the conversion prices of the existing
      Series A-3, B-3, C and D preferred shareholders and convert each of those shares
      into Series A-1 Preferred stock. The new conversion prices with respect to
      the
      Series A-3, B-3 and D preferred stock were negotiated with the holders of each
      series based upon such factors as the current conversion price in relation
      to
      the market, the dollar amount represented by such series and, waiver of
      anti-dilution, liquidation preferences, seniority and other senior rights.
      The
      conversion price for the Series C preferred


38


stock
      was determined in relation to the conversion price for the Series D preferred
      stock. The board of directors determined the new conversion price of each series
      of Level 8 preferred stock after discussion and review of those rights, ranks
      and privileges that were being waived by the present holders of preferred stock.
      Among those rights being waived are anti-dilution protection, liquidation
      preferences and seniority.





The
      holders of the Series A-1 preferred stock shall have the rights and preferences
      set forth in the Certificate of Designations filed with the Secretary of State
      of the State of Delaware upon the approval of the Recapitalization. The rights
      and interests of the Series A-1 preferred stock of the Company will be
      substantially similar to the rights interests of each of the series of Level
      8
      preferred stock other than for (i) anti-dilution protections that have been
      permanently waived and (ii) certain voting, redemption and other rights that
      holders of Series A-1 preferred stock will not be entitled to. All shares of
      Series A-1 preferred stock will have a liquidation preference *pari
      passu* with all other Series A-1 preferred stock.





The
      Series A-1 preferred stock is convertible at any time at the option of the
      holder into an initial conversion ratio of 1,000 shares of Common Stock for
      each
      share of Series A-1 preferred stock. The initial conversion ratio shall be
      adjusted in the event of any stock splits, stock dividends and other
      recapitalizations. The Series A-1 preferred stock is also convertible on a
      automatic basis in the event that (i) the Company closes on an additional
      $5,000,000 equity financing from strategic or institutional investors, or (ii)
      the Company has four consecutive quarters of positive cash flow as reflected
      on
      the Company’s financial statements prepared in accordance with generally
      accepted accounting principals (“GAAP”) and filed with the Commission. The
      holders of Series A-1 preferred stock are entitled to receive equivalent
      dividends on an as-converted basis whenever the Company declares a dividend
      on
      its Common Stock, other than dividends payable in shares of Common Stock. The
      holders of the Series A-1 preferred stock are entitled to a liquidation
      preference of $500 per share of Series A-1 preferred stock upon the liquidation
      of the Company. The Series A-1 preferred stock is not redeemable.





The
      holders of Series A-1 preferred stock also possess the following voting rights.
      Each share of Series A-1 preferred stock shall represent that number of votes
      equal to the number of shares of Common Stock issuable upon conversion of a
      share of Series A-1 preferred stock. The holders of Series A-1 preferred stock
      and the holders of Common Stock shall vote together as a class on all matters
      except: (i) regarding the election of the board of directors of the Company
      (as set forth below); (ii) as required by law; or (iii) regarding certain
      corporate actions to be taken by the Company (as set forth below).





The
      approval of at least two-thirds of the holders of Series A-1 preferred stock
      voting together as a class, shall be required in order for the Company to:
      (i)
      merge or sell all or substantially all of its assets or to recapitalize or
      reorganize; (ii) authorize the issuance of any equity security having any right,
      preference or priority superior to or on parity with the Series A-1 preferred
      stock; (iii) redeem, repurchase or acquire indirectly or directly any of its
      equity securities, or to pay any dividends on the Company’s equity securities;
      (iv) amend or repeal any provisions of its certificate of incorporation or
      bylaws that would adversely affect the rights, preferences or privileges of
      the
      Series A-1 preferred stock; (v) effectuate a significant change in the principal
      business of the Company as conducted at the effective time of the
      Recapitalization; (vi) make any loan or advance to any entity other than in
      the
      ordinary course of business unless such entity is wholly owned by the Company;
      (vii) make any loan or advance to any person, including any employees or
      directors of the Company or any subsidiary, except in the ordinary course of
      business or pursuant to an approved employee stock or option plan; and (viii)
      guarantee, directly or indirectly any indebtedness or obligations, except for
      trade accounts of any subsidiary arising in the ordinary course of business.
      In
      addition, the unanimous vote of the board of directors is required for any
      liquidation, dissolution, recapitalization or reorganization of the Company.
      The
      voting rights of the holders of Series A-1 preferred stock set forth in this
      paragraph shall be terminated immediately upon the closing by the Company of
      at
      least an additional $5,000,000 equity financing from strategic or institutional
      investors.





In
      addition to the voting rights described above, the holders of a majority of
      the
      shares of Series A-1 preferred stock are entitled to appoint two observers
      to
      the Company’s board of directors who shall be entitled to receive all
      information received by members of the board of directors, and shall attend
      and
      participate without a vote at all meetings of the Company’s board of directors
      and any committees thereof. At the option of a majority of the holders of Series
      A-1 preferred stock, such holders may elect to temporarily or permanently
      exchange their board observer rights for two seats on the Company’s board of
      directors, each having all voting and other rights attendant to any member
      of
      the Company’s board of directors. As part of the Recapitalization, the right of
      the holders of Series A-1 preferred stock to elect a majority of the voting
      members of the Company’s board of directors shall be terminated.





As
      a result of the reduced conversion prices and exchange of the Series A-3, B-3,
      C
      and D preferred stock into Series A-1 preferred stock and using Black-Scholes,
      we calculated a beneficial conversion in the exchange of the


39


Series
      A-3, B-3, C and D shares for Series A-1 preferred stock. The beneficial
      conversion of $21,000 is treated as a deemed dividend in the Statement of
      Operations for the year ended December 31, 2006.





**Borrowings
      and Commitments from Liraz**





Liraz
      Systems Ltd. guarantees certain debt obligations of the Company. In November
      2005, the Company and Liraz Systems Ltd. agreed to extend its guaranty on the
      term loan and with Bank Hapoalim, to extend the maturity date on the loan to
      October 30, 2006. Under the terms of the agreement with Liraz, the Company
      agreed to issue 2,400,000 shares of its common stock and granted a warrant
      to
      purchase an additional 3,600,000 shares of our common stock at an exercise
      price
      of $0.002 per share. Based upon fair market value at the time of issuance,
      the
      Company recognized $48,000 as loan amortization costs in the Statement of
      Operations for the year ended December 31, 2005. In November 2006, the Company
      and Liraz Systems Ltd. agreed to extend its guaranty on the term loan and with
      Bank Hapoalim, to extend the maturity date on the loan until October 31, 2007.
      Under the terms of the agreement with Liraz, the Company agreed to issue
      6,000,000 shares of its common stock. Based upon the fair market value at the
      time of issuance, the Company recognized $240,000 as loan amortization costs
      in
      the Statement of Operations for the year ended December 31, 2006.





**Transactions
      with Board members**





During
      2006, under an existing reseller agreement, the Company recognized $100,000
      of
      software revenue with Pilar Services, Inc. Pilar Services is presently owned
      and
      managed by Charles Porciello who is a member of our Board of Directors. As
      of
      December 31, 2006, the receivable was still outstanding and the Company has
      reserved for possible doubtful accounts.








**Item
      14.**  **Principal
      Accountant Fees and Services**





INDEPENDENT
      REGISTERED PUBLIC ACCOUNTING FIRM





Margolis
      & Company P.C. audited our financial statements for each of the years ended
      December 31, 2006 and 2005.





AUDIT
      FEES





Audit
      fees include fees for the audit of the Company’s annual financial statements,
      fees for the review of the Company’s interim financial statements, and fees for
      services that are normally provided by the Independent Registered Public
      Accounting Firm in connection with statutory and regulatory filings or
      engagements. The aggregate fees billed by Margolis & Company P.C. for
      professional services rendered to our company for the audit of the Company's
      annual financial statements for fiscal years 2006 (and reviews of quarterly
      financial statements on form 10-Q), 2005 and 2004 was $36,000 for each year.





AUDIT-RELATED
      FEES





Audit-related
      fees include fees for assurance and related services that are reasonably related
      to the performance of the audit or review of the Company’s financial statements.
      There were no audit-related fees paid to Margolis & Company P.C. for fiscal
      years 2006 and 2005.





TAX
      FEES





Tax
      fees include fees for tax compliance, tax advice and tax planning. There were
      no
      fees billed by either Margolis & Company P.C. for these services in 2006 and
      2005.





OTHER
      FEES





All
      other fees include fees for all services except those described above. There
      were no other fees paid to Margolis & Company P.C. for fiscal year 2006. The
      aggregate other fees billed by Margolis & Company P.C. was $18,000 related
      to the review of the Company’s S-4 filing in 2005, and $6,100 for the Company’s
      S-1 filing in 2004. In addition, other fees billed by Deloitte & Touche in
      2005 amounted to $27,500. These fees relate to the review of the Company’s S-4
      filing during 2005.




40


DETERMINATION
      OF AUDITOR INDEPENDENCE





The
      Audit Committee considered the provision of non-audit services by Margolis
&
Company P.C. and determined that the provision of such services was consistent
      with maintaining the independence of Margolis & Company P.C.





AUDIT
      COMMITTEE'S PRE-APPROVAL POLICIES





The
      Audit Committee has adopted a policy that all audit, audit-related, tax and
      any
      other non-audit service to be performed by the Company’s Independent Registered
      Public Accounting Firm must be pre-approved by the Audit Committee. It is the
      Company’s policy that all such services be pre-approved prior to commencement of
      the engagement. The Audit Committee is also required to pre-approve the
      estimated fees for such services, as well as any subsequent changes to the
      terms
      of the engagement.











**PART
      IV**




**Item
      15. Exhibits, Financial Statement Schedules, and Reports on Form
      8-K.**




(A)
                  1.
              FINANCIAL
                  STATEMENTS
  The
        following financial statements of the Company and the related reports of
        Independent Registered Public Accounting Firms thereon are set forth immediately
        following the Index of Financial Statements which appears on page F-1 of
        this
        report:
  Independent
        Registered Public Accounting Firm Report
 
 Consolidated
        Balance Sheets as of December 31, 2006 and 2005
  Consolidated
        Statements of Operations for the years ended December 31, 2006, 2005 and
        2004
  Consolidated
        Statements of Stockholders' Equity for the years ended December 31, 2006,
        2005
        and 2004
  Consolidated
        Statements of Comprehensive Loss for the years ended December 31, 2006, 2005
        and
        2004
 
 Consolidated
        Statements of Cash Flows for the years ended December 31, 2006, 2005 and
        2004
  Notes
        to Consolidated Financial Statements
  2.
              FINANCIAL
                  STATEMENT SCHEDULES
  All
        other schedules for which provision is made in the applicable accounting
        regulations of the Securities and Exchange Commission are not required under
        the
        related instructions or are inapplicable and therefore have been
        omitted.
  3.
              EXHIBITS
 
 The
        exhibits listed under Item 15(c) hereof are filed as part of this Annual
        Report
        on Form 10-K.
 
 (B)
              REPORTS
                  ON FORM 8-K


On
      November 21, 2006, the Company filed a Form 8-K reporting that shareholders
      approved an amendment to the Certificate of Incorporation to provide the
      Company’s Board of Directors with discretionary authority to effect a reverse
      stock split ratio from 20:1 to 100:1 and that on November 20, 2006, the Board
      of
      directors set that reverse stock ratio to be 100:1. In addition, the Company
      also reported that shareholders approved an amendment to change the name of
      the
      Company from Level 8 Systems, Inc. to Cicero Inc., to increase the authorized
      common stock of the Company from 85 million shares to 215 million shares and
      to
      convert existing preferred shares into a new Series A-1 preferred stock of
      Cicero Inc The proposals at the Special Meeting of Stockholders of Level 8
      comprised a proposed recapitalization of Level 8 which is also subject to the
      receipt of amendments to outstanding convertible promissory notes, senior
      reorganization notes and the convertible bridge notes.


41





On
      May 15, 2006 the Company filed a Form 8-K reporting the election of Mr. John
      W.
      Atherton to the Board of Directors.





On
      March 9, 2006 the Company filed a Form 8-K reporting the resignation of Frederic
      Mack as a member of the Board of Directors.





On
      January 13, 2006 the Company filed a Form 8-K reporting the election of Mr.
      Bruce Percelay to the Board of Directors.





On
      December 12, 2005 the Company filed a Form 8-K reporting the filing of
      participation in a recapitalization reorganization merger filed on Form S-4/A
      on
      December 9, 2005, an amendment to Form S-4 filed May 13, 2005, subject to
      approval by the stockholders, of a recapitalization reorganization merger of
      the
      Company to Cicero Inc.





On
      December 5, 2005, Level 8 Systems filed a Form 8-K reporting the Company reached
      an agreement with Liraz Systems, Ltd. (“Liraz”), the guarantor of the Bank
      Hapoalim term loan, to extend the guaranty and maturity of the Bank Hapoalim
      debt until November 2006.





On
      March 10, 2005, Level 8 Systems filed a Form 8-K reporting the election of
      Mr.
      Ralph Martino as Chairman of the Board of Directors replacing Mr. Anthony Pizi
      who remains as a director.





On
      June 3, 2005, the Company filed a Form 8-K reporting the resignation of Mr.
      Ralph Martino as Chairman of the Board of Directors.





On
      June 6, 2005 the Company filed a Form 8-K reporting the election of Mr. Charles
      B. Porciello to the Board of Directors.





On
      June 17, 2005 the Company filed a Form 8-K reporting the approval by the Board
      of Directors, subject to approval by the stockholders, of a recapitalization
      reorganization merger of the Company to Cicero Inc.





On
      July 27, 2005, the Company filed a Form 8-K reporting the resignations and
      appointments of members to the Company’s Board of Directors.








(C)
      EXHIBITS


**Exhibit**
              **Number**
            **Description**2.1
            Asset
                Purchase Agreement, dated as of January 9, 2004, by and among Level
                8
                Systems, Inc. and Critical Mass Mail, Inc. (incorporated by reference
                to
                exhibit 2.1 to Level 8’s Form 8-K filed January 23, 2004).3.1
            Certificate
                of Incorporation of Level 8 Systems, Inc., a Delaware corporation,
                as
                amended and restated December 29, 2006 (incorporated by reference
                to
                exhibit 3.1 to Level 8’s Form 8-K filed January 17,
                2007).3.2
            Certificate
                of Designation relating to Series A1 Convertible Redeemable Preferred
                Stock (incorporated by reference to exhibit 3.2 to Level 8’s Form 8-K
                filed January 17, 2007).3.3
            Certificate
                of Designation relating to Series A3 Convertible Redeemable Preferred
                Stock, as amended December 29, 2006 (incorporated by reference to
                exhibit
                3.3 to Level 8’s Level 8’s Form 8-K filed January 17,
                2007).3.4
            Certificate
                of Designation relating to Series B3 Convertible Redeemable Preferred
                as
                amended December 29, 2006 (incorporated by reference to exhibit 3.4
                to
                Level 8’s Level 8’s Form 8-K filed January 17,
                2007).


42





3.5
            Certificate
                of designation relating to Series C Convertible Redeemable Preferred
                Stock
                as amended December 29, 2006 (incorporated by reference to exhibit
                3.5 to
                Level 8’s Level 8’s Form 8-K filed January 17, 2007).3.6
            Certificate
                of designation relating to Series C Convertible Redeemable Preferred
                Stock
                as amended December 29, 2006 (incorporated by reference to exhibit
                3.5 to
                Level 8’s Level 8’s Form 8-K filed January 17, 2007).3.7
            Certificate
                of designation relating to Series D Convertible Redeemable Preferred
                Stock
                as amended December 29, 2006 (incorporated by reference to exhibit
                3.5 to
                Level 8’s Level 8’s Form 8-K filed January 17, 2007).3.8
            Certificate
                of Incorporation of Level 8 Systems, Inc., a Delaware corporation,
                as
                amended August 4, 2003 (incorporated by reference to exhibit 3.1
                to Level
                8’s Form 10-K filed March 31, 2004).3.9
            Bylaws
                of Level 8 Systems, Inc., a Delaware corporation (incorporated by
                reference to exhibit 3.2 to Level 8’s Form 10-K filed April 2,
                2002).3.10
            Certificate
                of Designations, Preferences and Rights dated March 19, 2003 relating
                to
                Series D Convertible Redeemable Preferred Stock (incorporated by
                reference
                to exhibit 3.1 to Level 8's Form 8-K, filed March 31,
                2003).3.11
            Certificate
                of Designation relating to Series A3 Convertible Redeemable Preferred
                Stock (incorporated by reference to exhibit 3.1 to Level 8’s Form 10-Q
                filed November 15, 2002).3.12
            Certificate
                of Designation relating to Series B3 Convertible Redeemable Preferred
                Stock (incorporated by reference to exhibit 3.1 to Level 8’s Form 10-Q
                filed November 15, 2002).3.13
            Certificate
                of designation relating to Series C Convertible Redeemable Preferred
                Stock
                (incorporated by reference to exhibit 3.1 to Level 8’d Form 8-K filed
                August 27, 2002).4.1
            Registration
                Rights Agreement dated July 2006, by and among Level 8 Systems, Inc.
                and
                the Purchasers in the Senior Placement listed on Schedule I thereto
                relating to the Security Purchasers Agreement (filed
                herewith).4.2
            Registration
                Rights Agreement, dated January 2004, by and among Level 8 Systems,
                Inc.
                and the Purchasers in the January 2004 Private Placement listed on
                Schedule I thereto relating to the Security Purchasers Agreement
                (incorporated by reference to exhibit 4.1 to Level 8’s Form 10-K/A filed
                April 21, 2004).4.3
            Registration
                Rights Agreement dated as of March 19, 2003 by and among Level 8
                Systems,
                Inc. and the Purchasers listed on Schedule I thereto relating to
                the
                Series D Convertible Redeemable Preferred Stock (incorporated by
                reference
                to exhibit 4.1 to Level 8’s Form 8-K, filed March 31,
                2003).4.4
            Registration
                Rights Agreement dated as of October 15, 2003 by and among Level
                8
                Systems, Inc. and the Purchasers in the October Private Placement
                listed
                on schedule I thereto (incorporated by reference to exhibit 4.2 to
                Level
                8’s Form 10-K, filed March 31, 2004).4.5
            Registration
                Rights Agreement, dated as of January 16, 2002, by and among Level
                8
                Systems, Inc. and the Purchasers in the January Private Placement
                listed
                on Schedule I thereto (incorporated by reference to exhibit 4.1 to
                Level
                8's Report on Form 8-K, filed January 25, 2002).4.6
            Registration
                Rights Agreement, dated as of January 3, 2002, between Level 8 Systems,
                Inc. and MLBC, Inc. (incorporated by reference to exhibit 4.1 to
                Level 8's
                Report on Form 8-K, filed January 11, 2002).4.7
            Registration
                Rights Agreement, dated as of August 29, 2002, entered into by and
                between
                Level 8 Systems, Inc. and the holders of Series A2/A3 Preferred Stock
                and
                Series B2/B3 Preferred Stock (incorporated by reference to exhibit
                10.4 to
                Level 8’s Form 8-K filed August 30,
                2002).


43





4.7A
            First
                Amendment to Registration Rights Agreement, dated as of October 25,
                2002,
                entered into by and between Level 8 Systems, Inc. and the holders
                of
                Series A2/A3 Preferred Stock and Series B2/B3 Preferred Stock
                (incorporated by reference to exhibit 10.4 to Level 8’s Form 10-Q filed
                November 15, 2002).4.8
            Registration
                Rights Agreement, dated as of June 13, 1995, between Level 8 Systems,
                Inc.
                and Liraz Systems Ltd. (incorporated by reference to exhibit 10.24
                to
                Across Data Systems, Inc.'s (Level 8's predecessor) Registration
                Statement
                on Form S-1, filed May 12, 1995, File No. 33-92230).4.8A
            First
                Amendment to Registration Rights Agreement, dated as of August 8,
                2001, to
                the Registration Rights Agreement dated as of June 13, 1995, by and
                between Across Data Systems, Inc. (Level 8's predecessor) and Liraz
                Systems Ltd. (incorporated by reference to exhibit 4.1 to Level 8's
                Report
                on Form 8-K, filed August 14, 2001).4.9
            Registration
                Rights Agreement, dated as of August 14, 2002, entered into by and
                between
                Level 8 Systems, Inc. and the investors in Series C Preferred Stock
                (incorporated by reference to exhibit 4.1 to Level 8’s Form 8-K filed
                August 27, 2002).4.10
            Form
                of Registration Rights Agreement, dated January 2004, by and among
                Level 8
                Systems, Inc. and the Purchasers of Convertible Promissory Note
                (incorporated by reference to exhibit 4.2 to Level 8's Report on
                Form
                10-Q, filed May 12, 2004).4.11
            Form
                of Stock Purchase Warrant issued to Purchasers in the January 2004
                Private
                Placement (incorporated by reference to exhibit 4.3 to Level 8's
                Report on
                Form 10-Q, filed May 12, 2004).4.12
            Form
                of Stock Purchase Warrant issued to Purchasers of Convertible Promissory
                Note (incorporated by reference to exhibit 4.3 to Level 8's Report
                on Form
                10-Q, filed May 12, 2004).4.13
            Form
                of Warrant issued to the Purchasers in the Series D Preferred Stock
                transaction dated as of March 19, 2003 (incorporated by reference
                to
                exhibit 4.2 to Level 8's Form 8-K, filed March 31,
                2003).4.13A
            Form
                of Warrant issued to the Purchasers in the Series D Preferred Stock
                transaction dated as of March 19, 2003 (incorporated by reference
                to
                exhibit 4.2 to Level 8's Form 8-K, filed March 31,
                2003).4.14
            Form
                of Stock Purchase Warrant issued to Purchasers in the October 2003
                Private
                Placement (incorporated by reference to exhibit 4.9 to Level 8’s Form
                10-K, filed March31, 2004).4.15
            Form
                of Stock Purchase Warrant issued to the Purchasers in the January
                Private
                Placement (incorporated by reference to exhibit 10.2 to Level 8's
                Report
                on Form 8-K, filed January 25, 2002).4.16
            Form
                of Series A3 Stock Purchase Warrant (incorporated by reference to
                exhibit
                10.2 of Level 8’s Form 10-Q filed November 15, 2002).4.17
            Form
                of Series B3 Stock Purchase Warrant (incorporated by reference to
                exhibit
                10.3 of Level 8’s Form 10-Q filed November 15, 2002).4.18
            Form
                of Series C Stock Purchase Warrant (incorporated by reference to
                exhibit
                10.2 to Level 8’s Form 8-K filed August 27, 2002)10.1
            Securities
                Purchase Agreement for Consortium IV (filed herewith).10.2
            Securities
                Purchase Agreement dated January 2004 by and among Level 8 Systems,
                Inc.
                and the Purchasers in the January 2004 Private Placement (incorporated
                by
                reference to exhibit 10.1 to Level 8’s Form 10-K/A filed April 21,
                2004).10.3
            Securities
                Purchase Agreement dated March 2004 by and among Level 8 Systems,
                Inc. and
                the Purchasers of Convertible Promissory Note (incorporated by reference
                to exhibit 10.2 to Level 8's Form 10-Q, filed May 12,
                2004).


44





10.3
            Form
                of Convertible Promissory Note dated March 2004 by and among Level
                8
                Systems, Inc. and the Purchasers of Convertible Promissory Note
                (incorporated by reference to exhibit 10.3 to Level 8's Form 10-Q,
                filed
                May 12, 2004).10.4
            Securities
                Purchase Agreement dated as of March 19, 2003 by and among Level
                8
                Systems, Inc. and the Purchasers (incorporated by reference to exhibit
                10.1 to Level 8's Form 8-K, filed March 31, 2003).10.5
            Securities
                Purchase Agreement dated as of October 15, 2003 by and among Level
                8
                Systems, Inc. and the Purchasers in the October Private Placement
                (incorporated by reference to exhibit 10.2 to Level 8’s Form 10-K, filed
                March 31, 2004).10.6
            Securities
                Purchase Agreement, dated as of January 16, 2002, by and among Level
                8
                Systems, Inc. and the Purchasers in the January Private Placement
                (incorporated by reference to exhibit 10.1 to Level 8's Report on
                Form
                8-K, filed January 25, 2002).10.7
            Purchase
                Agreement, dated as of January 3, 2002, between Level 8 Systems,
                Inc. and
                MLBC, Inc. (incorporated by reference to exhibit 10.1 to Level 8's
                Report
                on Form 8-K, filed January 11, 2002).10.7A
            Purchase
                Agreement, dated as of July 31, 2000, between Level 8 Systems, Inc.
                and
                Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated by
                reference to Exhibit 10.1 to Level 8's Report on Form 8-K, filed
                August
                11, 2000).10.8
            Securities
                Purchase Agreement, dated as of August 14, 2002, by and among Level
                8
                Systems, Inc. and the purchasers of the Series C Preferred Stock
                (incorporated by reference to exhibit 10.1 to Level 8’s Form 8-K filed
                August 27, 2002).10.9
            Agreement
                by and among Level 8 Systems, Inc. and the holders of Series A1/A2/A3
                and
                B1/B2/B3 Preferred Stock, dated as of August 14, 2002 (incorporated
                by
                reference to exhibit 10.3 to Level 8’s Form 8-K filed August 27,
                2002).10.10
            Exchange
                Agreement among Level 8 Systems, Inc., and the various stockholders
                identified and listed on Schedule I, dated as of August 29, 2002
                (incorporated by reference to exhibit 10.1 to Level 8’s Form 8-K filed
                August 30, 2002).10.11A
            First
                Amendment to Exchange Agreement, dated as of October 25, 2002, among
                Level
                8 Systems, Inc., and the various stockholders identified and listed
                on
                Schedule I to that certain Exchange Agreement, dated as of August
                29, 2002
                (incorporated by reference to exhibit 10.1 to Level 8’s Form 10-Q filed
                November 15, 2002).10.11B
            Securities
                Purchase Agreement, dated as of June 29, 1999, among Level 8 Systems,
                Inc.
                and the investors named on the signature pages thereof for the purchase
                of
                Series A Preferred Stock (incorporated by reference to exhibit 10.1
                to
                Level 8's Form 8-K filed July 23, 1999).10.11C
            Securities
                Purchase Agreement, dated as of July 20, 2000, among Level 8 Systems,
                Inc.
                and the investors named on the signature pages thereof for the purchase
                of
                Series B Preferred Stock (incorporated by reference to Exhibit 10.1
                to
                Level 8's Report on Form 8-K filed July 31, 2000).10.12
            Amended
                PCA Shell License Agreement, dated as of January 3, 2002, between
                Level 8
                Systems, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated
                (incorporated by reference to exhibit 10.2 to Level 8's Form 8-K,
                filed
                January 11, 2002).10.12A
            PCA
                Shell License Agreement between Level 8 Systems, Inc. and Merrill
                Lynch,
                Pierce, Fenner & Smith Incorporated (incorporated by reference to
                exhibit 10.2 to Level 8’s Report on Form 8-K, filed September 11,
                2000).


45





10.14
            Promissory
                Note of Level 8 Systems, Inc., dated as of September 28, 2001, among
                Level
                8 Systems, Inc. and Bank Hapoalim (incorporated by reference to exhibit
                10.2 to Level 8’s Form 10-K filed April 2, 2002).10.14
                A
            Amendment
                No. 1 to Promissory Note of Level 8 Systems, Inc., dated as of October
                30,
                2006, letter dated October 30, 2006, and Late Payment Rider among
                Level 8
                Systems, Inc. and Bank Hapoalim (filed herewith).10.14
                A
            Amendment
                No. 2 to Promissory Note of Level 8 Systems, Inc., dated as of November
                30, 2005 and letter dated November 3, 2005 among Level 8 Systems,
                Inc. and
                Bank Hapoalim (filed herewith).10.14
                B
            Amendment
                No. 1 to Promissory Note of Level 8 Systems, Inc., dated as of November
                8,
                2004 and letter dated November 8, 2004 among Level 8 Systems, Inc.
                and
                Bank Hapoalim (incorporated by reference to exhibit 10.14A to Level
                8’s
                Form 10-K/A filed April 21, 2004).10.14
                C
            Amendment
                to Promissory Note of Level 8 Systems, Inc., dated as of November
                15, 2003
                among Level 8 Systems, Inc. and Bank Hapoalim (incorporated by reference
                to exhibit 10.10 A to Level 8’s Form 10-K, filed March 31,
                2004).10.15
            Employment
                Agreement between Anthony Pizi and the Company effective January
                1, 2006
                (filed herewith).*10.16
            Employment
                Agreement between John P. Broderick and the Company effective January
                1,
                2006 (filed herewith).*10.18
            Level
                8 Systems Inc. 1997 Stock Option Plan, as Amended and Restated
                (incorporated by reference to exhibit 10.2 to Level 8’s Registration
                Statement of Form S-1/A, filed September 22, 2000, File No.
                333-44588).*10.18A
            Fifth
                Amendment to Level 8 Systems Inc. 1997 Stock Option Plan (incorporated
                by
                reference to exhibit 10.9A to Level 8’s Form 10-K filed April 2,
                2002).*10.18B
            Seventh
                Amendment to Level 8 Systems Inc. 1997 Stock Option Plan (incorporated
                by
                reference to exhibit 10.14 B to Level 8’s Form 10-K, filed March 31,
                2004).*10.20
            Lease
                Agreement for Cary, N.C. offices, dated March 31, 1997, between Seer
                Technologies, Inc. and Regency Park Corporation (incorporated by
                reference
                to exhibit 10.47 to Seer Technologies, Inc.'s Quarterly Report on
                Form
                10-Q for the period ended March 31, 1997, File No.
                000-26194).10.16A
            Addendum
                #1 to the Lease Agreement for Cary, N.C. offices, dated July 6, 1998
                (incorporated by reference to exhibit 10.58 to Seer Technology Inc.'s
                Quarterly Report on Form 10-Q for the period ended June 30, 1998,
                File No.
                000-26194).10.16B
            Amendment
                to Lease Agreement for Cary, N.C. offices, dated January 21, 1999
                (incorporated by reference to exhibit 10.21A to Level 8's Annual
                Report on
                Form 10-K for the fiscal year ended December 31, 1998).10.17
            Lease
                Agreement for Cary, N.C. offices, dated November 7, 2003, between
                Level 8
                Systems, Inc. and Regency Park Corporation (incorporated by reference
                to
                exhibit 10.17 to Level 8’s Form 10-K, filed March 31,
                2004).10.18
            Office
                Lease Agreement, dated April 25, 1996, between Template Software,
                Inc. and
                Vintage Park Two Limited Partnership (incorporated by reference to
                an
                exhibit to Template Software, Inc.'s Registration Statement on Form
                S-1,
                File No. 333-17063).


46





10.18A
            Amendment
                to Office Lease Agreement, dated August 18, 1997, between Template
                Software, Inc. and Vintage Park Two Limited Partnership (incorporated
                by
                reference to an exhibit to Template Software, Inc.'s Annual Report
                on Form
                10-K for the fiscal year ended December 31, 1997, File No.
                000-21921).10.19
            Lease
                Agreement, dated February 23, 2001, between Level 8 Systems, Inc.
                and
                Carnegie 214 Associates Limited Partnership (incorporated by reference
                to
                exhibit 10.15 to Level 8's Annual Report on Form 10-K, filed March
                29,
                2001).14.1
            Code
                of Ethics (incorporated by reference to exhibit 14.1 to Level 8’s Form
                10-K/A, filed March 31, 2004).16.1
            Letter
                from Margolis & Company PC regarding change of accountant
                (incorporated by reference to Exhibit 16.1 to Level 8’s Current Report on
                Form 8-K, filed February 6, 2004).21.1
            List
                of subsidiaries of the Company (filed herewith).22.1
            Consent
                of Margolis & Company P.C. (filed herewith).31.1
            Certification
                of Chief Executive and Financial Officer pursuant to Rule 13a-14(a)
                (filed
                herewith).32.1
            Certification
                of John P. Broderick pursuant to 18 USC § 1350, as adopted pursuant to
                §906 of the Sarbanes-Oxley Act of 2002 (filed
                herewith).





*
      Management contract or compensatory agreement.


47


***SIGNATURES***
  Pursuant
        to the requirements of Section 13 or 15(d) of the Securities Exchange Act
        of
        1934, the Registrant has duly caused this Report to be signed on its behalf
        by
        the undersigned, thereunto duly authorized.
  CICERO
                  INC.By:/s/
                  John P. BroderickJohn
                  P. BroderickChief
                  Executive OfficerDate:
                  March 30, 2007
  Pursuant
        to the requirements of the Securities Exchange Act of 1934, the following
        persons on behalf of the Registrant and in the capacities and on the dates
        indicated have signed this Report below.
   Signature
              
              Title
              
              Date/s/
                  Mark Landis
              
              Chairman
                  of the Board
              
              March
                  30, 2007Mark
                  Landis/s/
                  John P. Broderick
              
              Chief
                  Executive Officer/Chief Financial Officer
              
              March
                  30, 2007John
                  P. Broderick
              
              (Principal
                Executive
                Officer)/s/
                  Anthony C. Pizi
              
              Chief
                  Information Officer
              
              March
                  30, 2007Anthony
                  C. Pizi/s/
                  Bruce Hasenyager
              
              Director
              
              March
                  30, 2007Bruce
                  Hasenyager/s/
                  Jay Kingley
              
              Director
              
              March
                  30, 2007Jay
                  Kingley/s/
                  Bruce D. Miller
              
              Director
              
              March
                  30, 2007Bruce
                  D. Miller/s/
                  Charles Porciello
              
              Director
              
              March
                  30, 2007Charles
                  Porciello/s/
                  Bruce Percelay
              
              Director
              
              March
                  30, 2007Bruce
                  Percelay/s/
                  John W. Atherton
              
              Director
              
              March
                  30, 2007John
                  W. Atherton
 
  49
 48
   **INDEX
        TO FINANCIAL STATEMENTS**
 
  Report
                  of Independent Registered Public Accounting Firm
              F-2Financial
                  Statements:Consolidated
                  Balance Sheets
              F-3Consolidated
                  Statements of Operations
              F-4Consolidated
                  Statements of Stockholders' Equity (Deficit)
              F-5Consolidated
                  Statements of Comprehensive Loss
              F-6Consolidated
                  Statements of Cash Flows
              F-7Notes
                  to Consolidated Financial Statements
              F-9


F-1





REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








To
      the Board of Directors and Stockholders of


Cicero
      Inc.


Farmingdale,
      New Jersey





We
      have audited the accompanying consolidated balance sheet of Cicero Inc.
      (formerly Level 8 Systems, Inc.) and subsidiaries (the "Company") as of December
      31, 2006 and 2005, and the related consolidated statements of operations,
      stockholders' equity (deficit), comprehensive loss and cash flows, for the
      years
      then ended. These financial statements are the responsibility of the Company’s
      management. Our responsibility is to express an opinion on these financial
      statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our opinion, the consolidated financial statements referred to above present
      fairly, in all material respects, the financial position of Cicero Inc. and
      subsidiaries as of December 31, 2006 and 2005, and the results of their
      operations and their cash flows for each of the years then ended, in conformity
      with accounting principles generally accepted in the United States of America.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. As discussed in Note 1 to the
      consolidated financial statements, the Company's recurring losses from
      operations and working capital deficiency raise substantial doubt about its
      ability to continue as a going concern. Management's plans concerning these
      matters are also described in Note 1. The consolidated financial statements
      do
      not include any adjustments that might result from the outcome of this
      uncertainty.





/s/
      Margolis &
Company P.C.




Certified
      Public
      Accountants








Bala
      Cynwyd, PA


March
      16, 2007







F-2


**CICERO
      INC.**


**(Formerly
      LEVEL 8 SYSTEMS, INC.)**


**CONSOLIDATED
      BALANCE SHEETS**


**(in
      thousands, except share and per share amounts)**


**December
                31, 2006**
            
            **December
                31, 2005****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            310
            
            $
            29Assets
                of operations to be abandoned
            
            
            80
            
            
            131Trade
                accounts receivable, net
            
            
            170
            
            
            18Prepaid
                expenses and other current assets
            
            
            22
            
            
            53Total
                current assets
            
            
            582
            
            
            231Property
                and equipment, net
            
            
            15
            
            
            10Total
                assets
            
            $
            597
            
            $
            241**LIABILITIES
                AND STOCKHOLDERS' DEFICIT**Current
                liabilities:Senior
                reorganization debt(Note 2)
            
            $
            --
            
            $
            2,559Convertible
                bridge notes (Note 2)
            
            
            --
            
            
            1,760Short-term
                debt(Note 2)
            
            
            2,899
            
            
            3,481Accounts
                payable
            
            
            2,360
            
            
            2,528Accrued
                expenses:Salaries,
                wages, and related items
            
            
            1,012
            
            
            1,036Other
            
            
            1,732
            
            
            2,193Liabilities
                of operations to be abandoned
            
            
            435
            
            
            490Deferred
                revenue
            
            
            38
            
            
            78Total
                current liabilities
            
            
            8,476
            
            
            14,125Long-term
                debt
            
            
            33
            
            
            131Senior
                convertible redeemable preferred stock(Note 2)
            
            
            --
            
            
            1,061Total
                liabilities
            
            
            8,509
            
            
            15,317Commitments
                and contingencies (Notes 15 and 16)Stockholders'
                equity (deficit):Convertible
                preferred stock, $0.001 par value, 10,000,000 shares
                authorized.Series
                A-1 - 1,763.5 shares issued and outstanding at December 31, 2006,
                $500 per
                share liquidation preference (aggregate liquidation value of
                $880)
            
            
            --
            
            
            --Series
                A3 - no shares outstanding at December 31, 2006, 10,070 shares issued
                and
                1,571 shares outstanding at December 31, 2005 , $1,000 pershare
                liquidation preference (aggregate liquidation value of
                $1,571)
            
            
            --
            
            
            --Series
                B3 - no shares outstanding at December 31, 2006, 30,000
                shares issued and outstanding at December 31, 2005, $1,000 per share
                liquidation preference (aggregate liquidation value of
                $30,000)
            
            
            --
            
            
            --Series
                C - no shares outstanding at December 31, 2006, 1,590 shares issued
                and
                991 outstanding at December 31, 2005, $1,000 per share liquidation
                preference (aggregate liquidation value of $991)
            
            
            --
            
            
            --Common
                stock, $0.001 par value, 215,000,000 shares authorized at December
                31,
                2006, 85,000,000 shares authorized at December 31, 2005; 35,182,406
                and
                480,399 issued and outstanding at December 31, 2006 and 2005, respectively
                (Note 2)
            
            
            35
            
            
            48Additional
                paid-in-capital
            
            
            226,407
            
            
            210,594Accumulated
                deficit
            
            
            (234,345
            )
            
            (225,715
            )Accumulated
                other comprehensive loss
            
            
            (9
            )
            
            (3
            )Total
                stockholders' (deficit)
            
            
            (7,912
            )
            
            (15,076
            )Total
                liabilities and stockholders' deficit
            
            $
            597
            
            $
            241





The
      accompanying notes are an integral part of the consolidated financial
      statements.


F-3


**CICERO
      INC.**


**(
      Formerly**  **LEVEL
      8 SYSTEMS, INC.)**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**(in
      thousands, except per share amounts)**


**Years
                Ended December 31,****2006**
            
            **2005**
            
            **2004**Revenue:Software
            
            $
            208
            
            $
            407
            
            $
            239Maintenance
            
            
            120
            
            
            147
            
            
            306Services
            
            
            644
            
            
            231
            
            
            230Total
                operating revenue
            
            
            972
            
            
            785
            
            
            775Cost
                of revenue:Software
            
            
            9
            
            
            16
            
            
            4,478Maintenance
            
            
            212
            
            
            350
            
            
            382Services
            
            
            546
            
            
            822
            
            
            1,015Total
                cost of revenue
            
            
            767
            
            
            1,188
            
            
            5,875Gross
                margin (loss)
            
            
            205
            
            
            (403
            )
            
            (5,100
            )Operating
                expenses:Sales
                and marketing
            
            
            346
            
            
            627
            
            
            1,088Research
                and product development
            
            
            533
            
            
            891
            
            
            1,111General
                and administrative
            
            
            1,206
            
            
            1,137
            
            
            1,522Write-off
                of intangible assets
            
            
            -
            
            
            -
            
            
            587(Gain)
                on disposal of assets
            
            
            (24
            )
            
            -
            
            
            (5
            )Total
                operating expenses
            
            
            2,061
            
            
            2,655
            
            
            4,303Loss
                from operations
            
            
            (1,856
            )
            
            (3,058
            )
            
            (9,403
            )Other
                income (charges):Interest
                expense
            
            
            (853
            )
            
            (593
            )
            
            (264
            )Change
                in fair value of warrant liability
            
            
            -
            
            
            -
            
            
            198Other
                expense
            
            
            (288
            )
            
            (30
            )
            
            (262
            )(1,141
            )
            
            (623
            )
            
            (328
            )Loss
                from continuing operations
            
            
            (2,997
            )
            
            (3,681
            )
            
            (9,731
            )Loss
                from discontinued operations
            
            
            -
            
            
            -
            
            
            (30
            )Net
                loss
            
            
            ($2,997
            )
            
            ($3,681
            )
            
            ($9,761
            )Accretion
                of preferred stock and deemed dividends
            
            
            5,633
            
            
            -
            
            
            -Net
                loss applicable to common stockholders
            
            
            ($8,630
            )
            
            ($3,681
            )
            
            ($9,761
            )Loss
                per share:Net
                loss applicable to common stockholders - basic and diluted
            
            
            ($0.25
            )
            
            ($8.27
            )
            
            ($27.11
            )Weighted
                average common shares outstanding - basic and diluted
            
            
            35,182
            
            
            445
            
            
            360





The
      accompanying notes are an integral part of the consolidated financial
      statements.





F-4


**CICERO
      INC.**


**(Formerly
      LEVEL 8 SYSTEMS, INC.)**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)**


**(in
      thousands)**




**Common
                  Stock**
              
              **Preferred
                  Stock**
              
              **Additional**
                **Paid-in**
              
              **Accumulated**
              
              **Accumulated**
                **Other**
                **Comprehensive****Shares**
              
              **Amount**
              
              **Shares**
              
              **Amount**
              
              **Capital**
              
              **(Deficit)**
              
              **Income
                                (Loss)**
              
              **Total**Balance
                  at December 31, 2003
              
              
              26,645
              
              $
              27
              
              
              36
              
              
              --
              
              $
              206,149
              
              
              ($212,273
              )
              
              ($6
              )
              
              ($6,103
              )Conversion
                  of preferred shares to common
              
              
              824
              
              
              1
              
              
              (3
              )
              
              
              
              
              --
              
              
              
              
              
              
              
              
              1Shares
                  issued as compensation
              
              
              1,068
              
              
              1
              
              
              
              
              
              
              
              
              188
              
              
              
              
              
              
              
              
              189Shares
                  issued for bank guarantee
              
              
              5,579
              
              
              5
              
              
              
              
              
              
              
              
              603
              
              
              
              
              
              
              
              
              608Conversion
                  of senior convertible redeemable preferred stock
              
              
              3,792
              
              
              4
              
              
              
              
              
              
              
              
              1,210
              
              
              
              
              
              
              
              
              1,214Shares
                  issued in private placement of common stock
              
              
              3,369
              
              
              3
              
              
              
              
              
              
              
              
              1,244
              
              
              
              
              
              
              
              
              1,247Issuance
                  of common stock from acquisition
              
              
              2,027
              
              
              2
              
              
              
              
              
              
              
              
              748
              
              
              
              
              
              
              
              
              750Foreign
                  currency translation adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2
              )
              
              (2
              )Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (9,761
              )
              
              
              
              
              (9,761
              )Balance
                  at December 31, 2004
              
              
              43,304
              
              
              43
              
              
              33
              
              
              --
              
              
              210,142
              
              
              (222,034
              )
              
              (8
              )
              
              (11,857
              )Conversion
                  of preferred shares to common
              
              
              395
              
              
              
              
              
              
              
              
              
              
              
              --
              
              
              
              
              
              
              
              
              --Shares
                  issued as compensation
              
              
              961
              
              
              2
              
              
              
              
              
              
              
              
              101
              
              
              
              
              
              
              
              
              103Shares
                  issued for bank guarantee
              
              
              2,400
              
              
              2
              
              
              
              
              
              
              
              
              45
              
              
              
              
              
              
              
              
              47Conversion
                  of senior convertible redeemable preferred stock
              
              
              957
              
              
              1
              
              
              
              
              
              
              
              
              306
              
              
              
              
              
              
              
              
              307Foreign
                  currency translation adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5
              
              
              5Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (3,681
              )
              
              
              
              
              (3,681
              )Balance
                  at December 31, 2005
              
              
              48,017
              
              
              48
              
              
              33
              
              
              --
              
              
              210,594
              
              
              (225,715
              )
              
              (3
              )
              
              (15,076
              )Reversed
                  stock split 100:1
              
              
              (47,536
              )
              
              (48
              )
              
              (33
              )
              
              
              
              
              48
              
              
              
              
              
              
              
              
              --Shares
                  issued from conversion of senior reorganization debt
              
              
              3,438
              
              
              3
              
              
              
              
              
              
              
              
              1,705
              
              
              
              
              
              
              
              
              1,708Shares
                  issued from conversion of convertible bridge notes
              
              
              30,508
              
              
              32
              
              
              
              
              
              
              
              
              3,877
              
              
              
              
              
              
              
              
              3,909Shares
                  issued for bank guarantee
              
              
              96
              
              
              
              
              
              
              
              
              
              
              
              312
              
              
              
              
              
              
              
              
              312Shares
                  issued from short term debt conversion
              
              
              224
              
              
              
              
              
              
              
              
              
              
              
              190
              
              
              
              
              
              
              
              
              190Shares
                  issued from conversion of convertible promissory notes
              
              
              
              
              
              
              
              
              2
              
              
              
              
              
              992
              
              
              
              
              
              
              
              
              992Conversion
                  of senior convertible redeemable preferred stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,061
              
              
              
              
              
              
              
              
              1,061Conversion
                  of warrants
              
              
              99
              
              
              
              
              
              
              
              
              
              
              
              1,086
              
              
              
              
              
              
              
              
              1,086Shares
                  issued for interest conversion
              
              
              211
              
              
              
              
              
              
              
              
              
              
              
              629
              
              
              
              
              
              
              
              
              629Shares
                  issued as compensation
              
              
              125
              
              
              
              
              
              
              
              
              
              
              
              280
              
              
              
              
              
              
              
              
              280Accretion
                  of preferred stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              529
              
              
              (529
              )
              
              
              
              
              --Deemed
                  dividend
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,104
              
              
              (5,104
              )
              
              
              
              
              --Foreign
                  currency translation adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (6
              )
              
              (6
              )Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2,997
              )
              
              
              
              
              (2,997
              )Balance
                  at December 31, 2006
              
              
              35,182
              
              $
              35
              
              
              2
              
              
              --
              
              $
              226,407
              
              
              ($234,345
              )
              
              ($9
              )
              
              ($7,912
              )




The
      accompanying notes are an integral part of the consolidated financial
      statements.





F-5


**CICERO
      INC.**


**(Formerly
      LEVEL 8 SYSTEMS, INC.)**


**CONSOLIDATED
      STATEMENTS OF COMPREHENSIVE LOSS**


**(in
      thousands)**





**Years
                Ended December 31,****2006**
            
            **2005**
            
            **2004**Net
                loss
            
            
            ($2,997
            )
            
            ($3,681
            )
            
            ($
                9,761
            )Other
                comprehensive income (loss), net of tax:Foreign
                currency translation adjustment
            
            
            (6
            )
            
            5
            
            
            (2
            )Comprehensive
                loss
            
            
            ($3,003
            )
            
            ($3,676
            )
            
            ($
                9,763
            )







The
      accompanying notes are an integral part of the consolidated financial
      statements.





F-6


**CICERO
      INC.**


**(Formerly
      LEVEL 8 SYSTEMS, INC.)**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(in
      thousands)**


**Years
                Ended December 31,****2006**
            
            **2005**
            
            **2004**Cash
                flows from operating activities:Net
                loss
            
            
            ($2,997
            )
            
            ($3,681
            )
            
            ($9,761
            )Adjustments
                to reconcile net loss to net cash (used in) operating
                activities:Depreciation
                and amortization
            
            
            12
            
            
            11
            
            
            4,287Change
                in fair value of warrant liability
            
            
            --
            
            
            --
            
            
            (198
            )Stock
                compensation expense
            
            
            615
            
            
            149
            
            
            635Impairment
                of intangible assets and software product technology
            
            
            --
            
            
            --
            
            
            587Provision
                (credit) for doubtful accounts
            
            
            60
            
            
            (12
            )
            
            (4
            )Gain
                on disposal of assets
            
            
            23
            
            
            --
            
            
            --Changes
                in assets and liabilities, net of assets acquired and liabilities
                assumed:Trade
                accounts receivable and related party receivables
            
            
            (212
            )
            
            146
            
            
            (143
            )Assets
                and liabilities of operations to be abandoned
            
            
            (27
            )
            
            (29
            )
            
            86Prepaid
                expenses and other assets
            
            
            31
            
            
            55
            
            
            216Accounts
                payable and accrued expenses
            
            
            311
            
            
            804
            
            
            884Deferred
                revenue
            
            
            (40
            )
            
            (7
            )
            
            46Net
                cash (used in) operating activities
            
            
            (2,224
            )
            
            (2,564
            )
            
            (3,365
            )Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (17
            )
            
            (6
            )
            
            --Net
                cash (used in) investing activities
            
            
            (17
            )
            
            (6
            )
            
            --Cash
                flows from financing activities:Proceeds
                from issuance of common shares, net of issuance costs
            
            
            380
            
            
            --
            
            
            1,250Proceeds
                from exercise of warrants
            
            
            --
            
            
            --
            
            
            112Borrowings
                under credit facility, term loans and notes payable
            
            
            2,148
            
            
            2,542
            
            
            2,540Repayments
                of term loans, credit facility and notes payable
            
            
            --
            
            
            (55
            )
            
            (447
            )Net
                cash provided by financing activities
            
            
            2,528
            
            
            2,487
            
            
            3,455Effect
                of exchange rate changes on cash
            
            
            (6
            )
            
            5
            
            
            (2
            )Net
                increase (decrease) in cash and cash equivalents
            
            
            281
            
            
            (78
            )
            
            88Cash
                and cash equivalents at beginning of year
            
            
            29
            
            
            107
            
            
            19Cash
                and cash equivalents at end of year
            
            $
            310
            
            $
            29
            
            $
            107SUPPLEMENTAL
                DISCLOSURES OF CASH FLOW INFORMATIONCash
                paid (refunds) during the year for:Income
                taxes
            
            $
            20
            
            $
            1
            
            $
            2Interest
            
            $
            865
            
            $
            645
            
            $
            749





The
      accompanying notes are an integral part of the consolidated financial
      statements.


F-7


**CICERO
      INC.**


**(Formerly
      LEVEL 8 SYSTEMS, INC.)**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS - CONTINUED**





Non-Cash
      Investing and Financing Activities





**2006**





During
      2006, the Company issued 111,000 shares of common stock to vendors for
      outstanding liabilities valued at $237,000.





In
      November 2006, the Company issued 60,000 shares of common stock to Liraz Systems
      Ltd. as compensation for extension of a bank debt guaranty valued at
      $240,000.





In
      December 2006, the Company issued 224,000 shares of common stock to Liraz
      Systems Ltd. for its short term debt and interest of $191,000.





In
      December 2006, the Company issued 50,000 shares of common stock to Brown Simpson
      Partners I, Ltd. as compensation for assisting in its
      recapitalization.





**2005**





During
      2005, the Company issued 961,329 shares of common stock to vendors for
      outstanding liabilities valued at $103,000.





In
      November 2005, the Company issued 2,400,000 shares of common stock to a
      designated subsidiary of Liraz Systems Ltd. as compensation for extension of
      a
      bank debt guarantee valued at $48,000.





During
      2005, the Company issued 956,375 shares of Level 8 Systems common stock upon
      conversion of 1,367 shares of Series D Convertible Redeemable Preferred Stock.





During
      2005, 150 shares of Series C Convertible Redeemable Preferred Stock were
      converted into 394,737 shares of Level 8 Systems common stock.





**2004**





During
      2004, the Company issued 600,948 shares of common stock to vendors for
      outstanding liabilities valued at $92,000. The Company also issued 466,668
      shares of common stock to contractors for compensation valued at
      $47,000.





In
      January 2004, the Company acquired substantially all assets and certain
      liabilities of a federally certified encryption software company. The Company
      issued 2,027,027 shares of common stock valued at $750,000.





During
      2004, the Company issued 4,092,000 shares of common stock to a designated
      subsidiary of Liraz Systems Ltd. as compensation for extension of a bank debt
      guarantee valued at $447,000.





In
      October 2004, 750 shares of Series D Convertible Redeemable Preferred Stock
      were
      redeemed in
      return for $775,000 as a condition of escrow in the event that a joint venture
      for the Asian market was not formed or operational by July 17, 2003. Such
      redemption was concluded in November 2004 and the escrowed proceeds, including
      $4,000 of interest, were distributed back to the holders of Series D Preferred
      Stock. During
      2004, the Company issued 3,791,999 shares of Level 8 Systems common stock upon
      conversion of 1,213 shares of Series D Convertible Redeemable Preferred Stock.





During
      2004, 179 shares of Series C Convertible Redeemable Preferred Stock were
      converted into 523,684 shares of Level 8 Systems common stock.





In
      May 2004, the Company issued 135,135 shares of common stock on conversion of
      a
      $50,000 convertible note.





F-8




**CICERO
      INC.**


**(Formerly
      LEVEL 8 SYSTEMS, INC.)**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
                1.**
            **SUMMARY
                OF OPERATIONS, SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING
                PRONOUNCEMENTS**





Cicero
      Inc., formerly Level 8 Systems, Inc. (''Cicero'' or the ''Company''), is a
      provider of business integration software which enables organizations to
      integrate new and existing information and processes at the desktop. Business
      integration software addresses the emerging need for a company's information
      systems to deliver enterprise-wide views of the company's business information
      processes.





**Going
      Concern:**





The
      accompanying financial statements have been prepared on a going concern basis,
      which contemplates the realization of assets and the satisfaction of liabilities
      in the normal course of business. The Company has incurred an operating loss
      of
      approximately $2,997,000 for the year ended December 31, 2006 and has
      experienced negative cash flows from operations for each of the years ended
      December 31, 2006, 2005 and 2004. At December 31, 2006, the Company had a
      working capital deficiency of approximately $7,894,000. The Company’s future
      revenues are entirely dependent on acceptance of a newly developed and marketed
      product, Cicero®, which has had limited success in commercial markets to date.
      These factors among others raise substantial doubt about the Company’s ability
      to continue as a going concern for a reasonable period of time.





The
      financial statements presented herein do not include any adjustments relating
      to
      the recoverability of assets and classification of liabilities that might be
      necessary should the Company be unable to continue as a going concern. In order
      to address these issues and to obtain adequate financing for the Company’s
      operations for the next twelve months, the Company is actively promoting and
      expanding its Cicero®-related product line and continues to negotiate with
      significant customers who have expressed interest in the Cicero® software
      technology. The Company is experiencing difficulty increasing sales revenue
      largely because of the inimitable nature of the product as well as customer
      concerns about the financial viability of the Company. Cicero® software is a new
“category defining” product in that most Enterprise Application Integration
      (EAI) projects are performed at the server level and Cicero®’s integration
      occurs at the desktop without the need to open and modify the underlying code
      for those applications being integrated. Many companies are not aware of this
      new technology or tend to look toward more traditional and accepted approaches.
      The Company is attempting to solve the former problem by improving the market’s
      knowledge and understanding of Cicero® software through increased marketing and
      leveraging its limited number of reference accounts while enhancing its list
      of
      resellers and system integrators to assist in the sales and marketing process.
      Additionally, the Company is seeking additional equity capital or other
      strategic transactions in the near term to provide additional liquidity. In
      2004, the Company announced a Note and Warrant Offering in which warrant holders
      of the Company’s common stock were offered a one-time conversion of their
      existing warrants at a conversion price of $0.10 per share as part of a
      recapitalization plan. Under the terms of the Offer, warrant holders who elect
      to convert, would tender their conversion price in cash and receive a Note
      Payable in exchange. Upon approval of the recapitalization plan at a
      Shareholders meeting, these Notes would convert into common shares of the
      Company. The Company raised a total of $2,559,000 from the Note and Warrant
      Offering. During 2005 and 2006, the Company also entered into several
      Convertible Bridge Notes with a consortium of investors. The Company raised
      a
      total of $3,915,000 of Convertible Bridge Notes. The Convertible Bridge Notes
      convert into common stock of the Company upon approval of the recapitalization
      plan. The Recapitalization was approved by stockholders at a special meeting
      on
      November 16, 2006. Management expects that it will be able to raise additional
      capital, post stockholder approval of the recapitalization plan, and to continue
      to fund operations and also expects that increased revenues will reduce its
      operating losses in future periods, however, there can be no assurance that
      management’s plan will be executed as anticipated.








**Principles
      of Consolidation:**





The
      accompanying consolidated financial statements include the accounts of the
      Company and its subsidiaries. All of the Company's subsidiaries are wholly-owned
      for the periods presented.





All
      significant inter-company accounts and transactions are eliminated in
      consolidation.





F-9


**Use
      of Estimates:**





The
      preparation of financial statements in conformity with accounting principals
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and the reported amounts of revenues and expenses
      during the reporting period. Actual amounts could differ from these estimates.





**Financial
      Instruments:**




The
      carrying amount of the Company’s financial instruments, representing accounts
      receivable, notes receivable, accounts payable and debt approximate their fair
      value.





**Foreign
      Currency Translation:**





The
      assets and liabilities of foreign subsidiaries are translated to U.S. dollars
      at
      the current exchange rate as of the balance sheet date. The resulting
      translation adjustment is recorded in other comprehensive income as a component
      of stockholders' equity. Statements of operations items are translated at
      average rates of exchange during each reporting period.





Transaction
      gains and losses that arise from exchange rate fluctuations on transactions
      denominated in a currency other than the functional currency are included in
      the
      results of operations as incurred.





**Cash
      and Cash Equivalents:**





Cash
      and cash equivalents include all cash balances and highly liquid investments
      with maturity of three months or less from the date of purchase. For these
      instruments, the carrying amount is considered to be a reasonable estimate
      of
      fair value. The Company places substantially all cash and cash equivalents
      with
      various financial. At times, such cash and cash equivalents may be in excess
      of
      FDIC insurance limits.





**Trade
      Accounts Receivable:**





Trade
      accounts receivable are stated in the amount management expects to collect
      from
      outstanding balances. Management provides for probable uncollectible amounts
      through a charge to earnings and a credit to a valuation allowance based on
      its
      assessment of the current status of individual accounts. Balances that are
      still
      outstanding after management has used reasonable collection efforts are written
      off through a charge to the valuation allowance and a credit to trade accounts
      receivable. Changes in the valuation allowance have not been material to the
      financial statements.





**Property
      and Equipment:**





Property
      and equipment purchased in the normal course of business is stated at cost,
      and
      property and equipment acquired in business combinations is stated at its fair
      market value at the acquisition date. All property and equipment is depreciated
      using the straight-line method over estimated useful lives.





Expenditures
      for repairs and maintenance are charged to expense as incurred. The cost and
      related accumulated depreciation of property and equipment are removed from
      the
      accounts upon retirement or other disposition and any resulting gain or loss
      is
      reflected in the Consolidated Statements of Operations.





**Software
      Development Costs:**





The
      Company capitalizes certain software costs after technological feasibility
      of
      the product has been established. Generally, an original estimated economic
      life
      of three years is assigned to capitalized software costs, once the product
      is
      available for general release to customers. Costs incurred prior to the
      establishment of technological feasibility are charged to research and
      development expense.





Additionally,
      the Company has recorded software development costs for its purchases of
      developed technology through acquisitions. (See Note 3.)


F-10


Capitalized
      software costs are amortized over related sales on a product-by-product basis
      using the straight-line method over the remaining estimated economic life of
      the
      product. (See Note 6.)





The
      establishment of technological feasibility and the ongoing assessment of
      recoverability of capitalized software development costs require considerable
      judgment by management with respect to certain external factors, including,
      but
      not limited to, technological feasibility, anticipated future gross revenue,
      estimated economic life and changes in software and hardware technologies.





**Long-Lived
      Assets:**





The
      Company reviews the recoverability of long-lived intangible assets when
      circumstances indicate that the carrying amount of assets may not be
      recoverable. This evaluation is based on various analyses including undiscounted
      cash flow projections. In the event undiscounted cash flow projections indicate
      impairment, the Company would record an impairment based on the fair value
      of
      the assets at the date of the impairment. The Company accounts for impairments
      under the Financial Accounting Standards Board ("FASB") Statement of Financial
      Accounting Standards ("SFAS") No. 144, “Accounting for the Impairment or
      Disposal of Long-Lived Assets”. During 2004 the Company recorded impairments
      associated with its Cicero® technology and for its Ensuredmail technology
      acquired in 2004.





**Revenue
      Recognition:**





The
      Company recognizes license revenue from end-users and third party resellers
      in
      accordance with the American Institute of Certified Public Accountants ("AICPA")
      Statement of Position ("SOP") 97-2, “Software Revenue Recognition”, as amended
      by SOP 98-9, ''Modification of SOP 97-2, 'Software Revenue Recognition,' with
      Respect to Certain Transactions''. The Company reviews each contract to identify
      elements included in the software arrangement. SOP 97-2 and SOP 98-9 require
      that an entity recognize revenue for multiple element arrangements by means
      of
      the ''residual method'' when (1) there is vendor-specific objective evidence
      (''VSOE'') of the fair values of all of the undelivered elements that are not
      accounted for by means of long-term contract accounting, (2) VSOE of fair value
      does not exist for one or more of the delivered elements, and (3) all revenue
      recognition criteria of SOP 97-2 (other than the requirement for VSOE of the
      fair value of each delivered element) are satisfied. VSOE of the fair value
      of
      undelivered elements is established on the price charged for that element when
      sold separately. Software customers are given no rights of return and a
      short-term warranty that the products will comply with the written
      documentation. The Company has not experienced any product warranty
      returns.





Revenue
      from recurring maintenance contracts is recognized ratably over the maintenance
      contract period, which is typically twelve months. Maintenance revenue that
      is
      not yet earned is included in deferred revenue.


Revenue
      from consulting and training services is recognized as services are performed.
      Any unearned receipts from service contracts result in deferred revenue.





**Cost
      of Revenue:**





The
      primary components of the Company's cost of revenue for its software products
      are software amortization on internally developed and acquired technology,
      royalties on certain products, and packaging and distribution costs. The primary
      component of the Company's cost of revenue for maintenance and services is
      compensation expense.





**Advertising
      Expenses:**





The
      Company expenses advertising costs as incurred. Advertising expenses were
      approximately $88,000, $16,000, and $7,000 for the years ended December 31,
      2006, 2005 and 2004, respectively.





**Research
      and Product Development:**





Research
      and product development costs are expensed as incurred.





**Income
      Taxes:**





The
      Company uses SFAS No. 109, ''Accounting for Income Taxes'', to account for
      income taxes. This statement requires an asset and liability approach that
      recognizes deferred tax assets and liabilities for the expected future tax
      consequences of events that have been recognized in the Company's financial
      statements or tax returns. In estimating future tax consequences,


F-11


all
      expected future events, other than enactments of changes in the tax law or
      rates, are generally considered. A valuation allowance is recorded when it
      is
      ''more likely than not'' that recorded deferred tax assets will not be realized.
      (See Note 8.)





**Stock
      Split:**





As
      discussed in Note 2, the Company’s stockholders approved a 100 to 1 reverse
      stock split in November 2006. The Company retained the current par value of
      $.001 per share for all common shares. All references in the financial
      statements and notes to the number of shares outstanding, per share amounts,
      and
      stock option data of the Company’s common shares have been restated to reflect
      the effect of the reverse stock split for the periods presented.








**Loss
      Per Share:**





Basic
      loss per share is computed based upon the weighted average number of common
      shares outstanding. Diluted loss per share is computed based upon the weighted
      average number of common shares outstanding and any potentially dilutive
      securities. During 2006, 2005, and 2004, potentially dilutive securities
      included stock options, warrants to purchase common stock, and preferred stock.





The
      following table sets forth the potential shares that are not included in the
      diluted net loss per share calculation because to do so would be anti-dilutive
      for the periods presented. The amounts have been restated in accordance with
      SAB
      Topic 4 (c ) to reflect the adjustment to the Company’s capitalization as a
      result of the 100:1 reverse stock split which was approved by the Company in
      November 2006:





**2006**
            
            **2005**
            
            **2004**Stock
                options
            
            
            45,315
            
            
            59,009
            
            
            74,886Warrants
            
            
            323,623
            
            
            193,761
            
            
            199,534Preferred
                stock
            
            
            1,763,478
            
            
            85,046
            
            
            98,5572,132,416
            
            
            337,816
            
            
            372,977





In
      2006, 2005 and 2004, no dividends were declared on preferred stock.








**Stock-Based
      Compensation:**





During
      2006, the Company adopted SFAS No. 123 (revised 2004) (SFAS No. 123R”),
“Share-Based Payment”, which addresses the accounting for stock-based payment
      transactions in which an enterprise receives employee services in exchange
      for
      (a) equity instruments of the enterprise or (b) liabilities that are based
      on
      the fair value of the enterprise’s equity instruments or that may be settled by
      the issuance of such equity instruments. In January 2005, the SEC issued SAB
      No.
      107, which provides supplemental implementation guidance for SFAS No. 123R.
      SFAS
      No. 123R eliminates the ability to account for stock-based compensation
      transactions using the intrinsic value method under Accounting Principles Board
      (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and instead
      generally requires that such transactions be accounted for using a
      fair-value-based method. The Company uses the Black-Scholes option-pricing
      model
      to determine the fair-value of stock-based awards under SFAS No. 123R,
      consistent with that used for pro forma disclosures under SFAS No. 123,
“Accounting for Stock-Based Compensation”. The Company has elected to use the
      modified prospective transition method as permitted by SFAS No. 123R and,
      accordingly, prior periods have not been restated to reflect the impact of
      SFAS
      No. 123R. The modified prospective transition method requires that stock-based
      compensation expense be recorded for all new and unvested stock options that
      are
      ultimately expected to vest as the requisite service is rendered beginning
      on
      the first day of the Company’s year ended December 31, 2006. Stock-based
      compensation expense for awards granted prior to 2006 is based on the grant-date
      fair-value as determined under the pro forma provisions of SFAS No. 123. The
      Company did not grant options during 2006, therefore there were no diluted
      earnings per common share due to the adoption of SFAS No. 123R.





Prior
      to the adoption of SFAS No. 123R, the Company measured compensation expense
      for
      its employee stock-based compensation plans using the intrinsic value method
      prescribed by APB Opinion No. 25. The Company applied the disclosure provisions
      of SFAS No. 123 as amended by SFAS No. 148, “Accounting for Stock-Based
      Compensation - Transition and Disclosure”, as if the fair-value-based method had
      been applied in measuring compensation expense. Under APB Opinion No. 25, when
      the exercise price of the Company’s employee stock options was equal to the
      market price of the underlying stock on the date of the grant, no compensation
      expense was recognized.


F-12





The
      following table illustrates the effect on net loss and net loss per common
      share
      as if the Company had applied the fair value recognition provisions of SFAS
      No.
      123 to stock-based compensation during 2005 and 2004 (in
      thousands):





**Years
                Ended December 31,****2005**
            
            **2004**Net
                loss applicable to common stockholders, as reported
            
            $
            (3,681
            )
            $
            (9,761
            )Less:
                Total stock-based employee compensation expense under
              fair
                value based method for all awards, net of related tax
                effects
            
            
            (180
            )
            
            (777
            )Pro
                forma loss applicable to common stockholders
            
            $
            (3,861
            )
            $
            (10,538
            )Loss
                per share:Basic
                and diluted, as reported
            
            $
            (8.27
            )
            $
            (27.11
            )Basic
                and diluted, pro forma
            
            $
            (8.68
            )
            $
            (29.27
            )





The
      fair value of the Company's stock-based awards to employees was estimated as
      of
      the date of the grant using the Black-Scholes option-pricing model, using the
      following weighted-average assumptions:





**2006**
            
            **2005**
            
            **2004**Expected
                life (in years)
            
            
            3.6
                years
            
            
            6.0
                years
            
            
            4.19
                yearsExpected
                volatility
            
            
            140
            %
            
            149
            %
            
            138
            %Risk
                free interest rate
            
            
            4.93
            %
            
            4.48
            %
            
            4.75
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %








**Warrants
      Liability** :





The
      Company had issued warrants to Series A3 and Series B3 preferred stockholders
      which contain provisions that allow the warrant holders to force a cash
      redemption for events outside the control of the Company. The fair value of
      the
      warrants are accounted for as a liability and are re-measured through the
      Consolidated Statements of Operations at each balance sheet date. As of December
      31, 2006 and 2005, the fair value of these warrants was $0.






**Reclassifications:**





Certain
      prior year amounts in the accompanying financial statements have been
      reclassified to conform to the 2006 presentation. Such reclassifications had
      no
      effect on previously reported net loss or stockholders’ deficit.








**Recent
      Accounting Pronouncements:**





In
      July 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income
      Taxes - An Interpretation of SFAS No. 109”. FIN No. 48 clarifies the accounting
      for uncertainty in income taxes recognized in an enterprise’s financial
      statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN
      No. 48 also prescribes a recognition threshold and measurement attribute for
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. In addition, FIN No. 48 provides guidance
      on derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure and transition. The provisions of FIN No. 48 are to be
      applied to all tax positions upon initial adoption of this standard. Only tax
      positions that meet the more-likely-than-not recognition threshold at the
      effective date may be recognized or continue to be recognized as an adjustment
      to the opening balance of accumulated deficit (or other appropriate components
      of equity) for that fiscal year. The provisions of FIN No. 48 are effective
      for
      fiscal years beginning after December 15, 2006. The Company is evaluating the
      impact of the adoption of FIN 48 but does not currently expect the adoption
      of
      this new standard to have a material impact on our financial position, results
      of operations, or cash flows.





In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulleting (“SAB”) 108, to address diversity in practice in
      quantifying financial statement misstatements. SAB 108 requires that the Company
      quantify


F-13


misstatements
      based on their impact on each of its financial statements and related
      disclosures. SAB 108 is effective for fiscal years ending after November 15,
      2006. The Company has adopted SAB 108 effective as of December 31, 2006. The
      adoption of this bulletin did not have a material impact on our financial
      position, results of operations, or cash flows.





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS
      No. 157 provides guidance for using fair value to measure assets and
      liabilities. It also responds to investors’ requests for expanded information
      about the extent to which companies measure assets and liabilities at fair
      value, the information used to measure fair value, and the effect of fair value
      measurements on earnings. SFAS No. 157 applies whenever other standards require
      (or permit) assets or liabilities to be measured at fair value, and does not
      expand the use of fair value in any new circumstances. SFAS No. 157 is effective
      for financial statements issued for fiscal years beginning after November 15,
      2007 and is required to be adopted by the Company in the first quarter of 2008.
      The Company is currently evaluating the effect that the adoption of SFAS No.
      157
      will have on our financial position, results of operations, or cash
      flows.





In
      December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based
      Payment, (“SFAS 123R”).  SFAS 123R addresses the accounting for share-based
      payments to employees, including grants of employee stock options.  Under
      the new standard, companies will no longer be able to account for share-based
      compensation transactions using the intrinsic method in accordance with APB
      Opinion No. 25, “Accounting for Stock Issued to Employees”.  Instead,
      companies will be required to account for such transactions using a fair-value
      method and recognize the expense in the consolidated statements of
      operations.  SFAS 123R is effective for periods beginning after
      June 15, 2005 and allows, but does not require, companies to restate the
      full fiscal year of 2005 to reflect the impact of expensing share-based payments
      under SFAS 123R.  The Company uses the Black-Scholes option-pricing model
      to determine the fair-value of stock-based awards under SFAS No. 123R,
      consistent with that used for pro forma disclosures under SFAS No. 123,
“Accounting for Stock-Based Compensation”. The Company has elected to use the
      modified prospective transition method as permitted by SFAS No. 123R and,
      accordingly, prior periods have not been restated to reflect the impact of
      SFAS
      No. 123R. The modified prospective transition method requires that stock-based
      compensation expense be recorded for all new and unvested stock options that
      are
      ultimately expected to vest as the requisite service is rendered beginning
      on
      the first day of the Company’s year ended December 31, 2006. Stock-based
      compensation expense for awards granted prior to 2006 is based on the grant-date
      fair-value as determined under the pro forma provisions of SFAS No. 123. The
      Company recognized incremental stock-based compensation expense of $14,000
      during 2006 as a result of the adoption of SFAS No. 123R.








**NOTE
      2.**  **RECAPITALIZATION**





In
      November 2006, the Company’s stockholders approved an amendment to the
      Certificate of Incorporation to provide the Company’s Board of Directors with
      discretionary authority to effect a reverse stock split ratio from 20:1 to
      100:1
      and on November 20, 2006, the Board of Directors set that reverse stock ratio
      to
      be 100:1. In addition, the Company’s stockholders approved an amendment to
      change the name of the Company from Level 8 Systems, Inc. to Cicero Inc., to
      increase the authorized common stock of the Company from 85 million shares
      to
      215 million shares and to convert existing preferred shares into a new Series
      A-1 preferred stock of Cicero Inc. The proposals at the Special Meeting of
      Stockholders of Level 8 comprised a proposed recapitalization of Level 8 which
      was also subject to the receipt of amendments to outstanding convertible
      promissory notes, senior reorganization notes and the convertible bridge notes.





As
      part of the plan of recapitalization, Senior Reorganization Notes in the
      aggregate principal amount of $2,559,000 to Senior Reorganization Noteholders
      who had loaned funds to the Company in exchange for Senior Reorganization Notes
      and Additional Warrants at a special one-time exercise price of $0.10 per share,
      (i) will receive and have automatically exercised Additional Warrants
      exercisable into shares of Common Stock, by applying the accrued interest on
      their Senior Reorganization Notes and by cashless exercise to the extent of
      the
      balance of the exercise price, (ii) if a holder of existing warrants who
      advanced the exercise price of their warrants to the Company, will have their
      existing warrants automatically exercised and (iii) those Senior Reorganization
      Noteholders who loaned the Company the first $1,000,000 in respect of the
      exercise price of their existing warrants will receive Early Adopter Warrants
      of
      the Company at a ratio of 2:1 for shares issuable upon exercise of each existing
      warrant exercised at the special exercise price of $10.00 per share. At the
      time
      of issuance of the Senior Reorganization Notes, the trigger for conversion
      into
      exercisable warrants was an anticipated recapitalization merger. Since the
      recapitalization plan was amended, the Company solicited Senior Noteholders
      for
      their consent to convert upon approval of the plan of recapitalization by
      stockholders. Approximately $2,309,000 of the Senior Reorganization Noteholders
      have consented to the change in the “trigger” and have cancelled their notes and
      converted into 3,438,473 shares of the Company’s common stock.


F-14


In
      accordance with EITF 98-5, “Accounting for Convertible Securities with
      Beneficial Conversion Features or Contingently Adjustable Conversion Ratios”,
      the Company has allocated the proceeds received from the Note and Warrant
      Offering between the warrants exercised and the future warrants granted and
      has
      employed the Black-Scholes valuation method to determine the fair value of
      the
      warrants exercised and the additional warrants issued. The Senior Reorganization
      Noteholders who have consented to convert their debt amounted to approximately
      $2,309,000. Of that amount, approximately $979,000 represents the exercise
      price
      of existing warrants that was loaned to the Company for which the warrant
      holders will receive both additional warrants and early adopter warrants. Using
      the Black-Scholes formula, the Company has determined that the fair value of
      the
      warrants granted to this tranche is approximately $440,000. The difference
      between the fair value of the additional warrants and the total invested in
      this
      tranche, or $539,000, is treated as a beneficial conversion and fully
      amortizable. The second tranche of investment that consisted of those warrant
      holders who loaned the exercise price of their existing warrants, and will
      receive additional warrants but no early adopter warrants, amounted to
      approximately $107,000. Using Black-Scholes, the Company has determined that
      the
      fair value of the warrants granted to this tranche is approximately $32,000
      and
      the beneficial conversion amount is $75,000. The third tranche consisted of
      investors who had no existing warrants and will only receive additional warrants
      upon consummation of the Recapitalization. The total investment in this tranche
      is $1,223,000. Using Black-Scholes, the Company has determined that the fair
      value of the warrants granted to this tranche is approximately $570,000 and
      the
      beneficial conversion amount is $653,000. Since this beneficial conversion
      feature is immediately convertible upon issuance, the Company has fully
      amortized this beneficial conversion feature in the Statement of Operations
      for
      the year ended December 31, 2006.





Also
      as part of the recapitalization plan, Convertible Bridge Notes in the principal
      amount of $3,915,000 are automatically cancelled and converted into 30,508,448
      shares of the Company’s common stock. Also in accordance with EITF 98-5, using
      the Black-Scholes formula, the Company has calculated the fair value of the
      common stock resulting from conversion of the Convertible Bridge Notes. Based
      upon that calculation, the fair value of the stock received was $195,000. The
      difference between the total of the Convertible Bridge Notes and the fair value
      of the stock ($3,720,000) is treated as a beneficial conversion. Since this
      beneficial conversion feature is immediately convertible upon issuance, the
      Company has fully amortized this beneficial conversion feature in the Statement
      of Operations for the year ended December 31, 2006.





The
      Company had issued $992,000 aggregate principal amount of Convertible Promissory
      Notes. As part of the recapitalization plan, these Noteholders were offered
      reduced conversion prices to convert their notes into shares of the Company’s
      new series A-1 preferred stock. All Noteholders have agreed to convert their
      notes into shares of Series A-1 preferred stock. The Company has cancelled
      these
      notes and issued 1,591 shares of its Series A-1 preferred stock. In accordance
      with EITF 98-5 and specifically paragraph 8, the Company has utilized the
      Black-Scholes formula to determine the fair value of the stock received. The
      Company has calculated the fair value of the stock received to be $484,000
      resulting in a beneficial conversion of $508,000. Since this beneficial
      conversion is immediately recognizable by the holders, the Company has fully
      amortized this conversion and recorded an accretion to preferred stock in the
      Statement of Operations for the year ended December 31, 2006.





Holders
      of the Company’s Series A-3, B-3, C and D preferred stock were offered reduced
      conversion rates on their existing preferred stock in exchange for shares in
      a
      new Series A-1 preferred stock for Cicero Inc. as part of the recapitalization
      plan. As a result of stockholder approval, the Company affected an exchange
      of
      existing preferred shares into 172.15 Series A-1 preferred shares. In exchange
      for the reduced conversion prices, holders of the series A-3, B-3 and D shares
      forfeited their anti-dilution protection along with certain other rights, ranks
      and privileges. The Company’s Series D preferred stock contained a redemption
      feature which required that the Company account for same as a liability. The
      Company’s Series A-1 preferred stock contains no redemption features and
      accordingly, upon exchange, the fair value of these shares were converted to
      equity. The Company employed the Black-Scholes formula to value the shares
      exchanged and have determined that the reduced conversion prices and exchange
      has created a beneficial conversion of $21,000. As the new Series A-1 preferred
      shares are immediately convertible, the Company has recorded this beneficial
      conversion as a deemed dividend in the Statement of Operations for the year
      ended December 31, 2006.








**NOTE
      3.**  **ACQUISITIONS**





In
      January 2004, the Company acquired substantially all of the assets and certain
      liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally
      certified encryption software company. Under the terms of the purchase
      agreement, the Company issued 2,027,027 shares of common stock at a price of
      $0.37. The total purchase price of the assets being acquired plus certain
      liabilities assumed was $750,000, and has been accounted for by the purchase
      method of accounting. The Company agreed to register the common stock for resale
      under the Securities Act of 1933, as amended.


F-15





The
      purchase price was allocated to the assets acquired and liabilities assumed
      based on the Company’s estimates of fair value at the acquisition date. The
      Company assessed the net realizable value of the Ensuredmail software technology
      acquired and determined the purchase price exceeded the amounts allocated to
      the
      software technology acquired less liabilities assumed by approximately $587,000.
      This excess of the purchase price over the fair values of the assets acquired
      less liabilities assumed was allocated to goodwill, and, because it was deemed
      impaired, charged to the Statements of Operations for the year ended December
      31, 2004. (See Note 6.)








**NOTE
      4.**  **ACCOUNTS
      RECEIVABLE**





Trade
      accounts receivable was composed of the following at December 31 (in
      thousands):





**2006**
            
            **2005**Current
                trade accounts receivable
            
            $
            230
            
            $
            18Less:
                allowance for doubtful accounts
            
            
            60
            
            
            --$
            170
            
            $
            18








The
      (credit) provision for uncollectible amounts was $60,000, ($12,000), and
      ($4,000) for the years ended December 31, 2006, 2005, and 2004,
      respectively. Write-offs (net of recoveries) of accounts receivable were ($0)
      for the years ended December 31, 2006, 2005 and 2004.








**NOTE
      5.**  **PROPERTY
      AND EQUIPMENT**





Property
      and equipment was composed of the following at December 31 (in thousands):





**2006**
            
            **2005**Computer
                equipment
            
            $
            252
            
            $
            246Furniture
                and fixtures
            
            
            8
            
            
            8Office
                equipment
            
            
            149
            
            
            140409
            
            
            394Less:
                accumulated depreciation and amortization
            
            
            (394
            )
            
            (384
            )$
            15
            
            $
            10





Depreciation
      and amortization expense of property and equipment was $12,000, $11,000, and
      $11,000 for the years ended December 31, 2006, 2005, and 2004, respectively.








**NOTE
      6.**  **SOFTWARE
      PRODUCT TECHNOLOGY**





In
      accordance with SFAS 86, "Accounting for the Costs of Computer Software to
      Be
      Sold, Leased, or Otherwise Marketed", ** the
      Company periodically completed an assessment of the recoverability of the
      Cicero® product technology. This assessment was performed during 2004, due to
      the Company’s continued operating losses and the limited software revenue
      generated by the Cicero® technology over the previous twelve to eighteen months.
      The Company was in negotiations with customers to purchase licenses, which
      would
      have a significant impact on the cash flows from the Cicero® technology and the
      Company. Since the negotiations had been in process for several months and
      expected completion of the transactions had been delayed, the Company had
      reduced its cash flow projections. Historical cash flows generated by the
      Cicero® technology do not support the long-lived asset and accordingly the
      Company impaired the excess of the unamortized book value of the technology
      in
      excess of the expected net realizable value for the year ended December 31,
      2004. This charge, in the amount of $2,844,000 was recorded as software
      amortization for the year ended December 31, 2004. As of December 31, 2006
      and
      2005, the Company has no capitalized costs for the Cicero®
technology.


F-16


Also
      in accordance with SFAS 86, ** the
      Company completed an assessment of the recoverability of the Ensuredmail product
      technology. This assessment was also completed during 2004, due to the Company’s
      revised cash flow projections from software revenue. These revised cash flow
      projections do not support the long-lived asset and accordingly the Company
      has
      impaired the excess of the unamortized book value of the technology in excess
      of
      the expected net realizable value. This charge, in the amount of $154,000,
      was
      recorded as software amortization for the year ended December 31, 2004. As
      of
      December 31, 2005, the Company has no capitalized costs for the Ensuredmail
      software technology.








**NOTE
      7.**  **SHORT-TERM
      DEBT AND CONVERTIBLE NOTES**





Notes
      payable, long-term debt, and notes payable to related party consist of the
      following at December 31(in thousands):




**2006**
            
            **2005**Term
                loan (a)
            
            $
            1,971
            
            $
            1,971Note
                payable; related party (b)
            
            
            9
            
            
            9Notes
                payable (c)
            
            
            950
            
            
            509Short
                term convertible note (d)
            
            
            --
            
            
            265Short
                term convertible notes, related party (e)
            
            
            --
            
            
            727$
            2,930
            
            $
            3,481








(a)
            The
                Company has a $1,971 term loan bearing interest at LIBOR plus 1.5%
                (approximately 6.38% at December 31, 2006). Interest is payable quarterly.
                There are no financial covenants and the term loan is guaranteed
                by Liraz
                Systems Ltd., the Company’s former principal stockholder. The loan matures
                on October 31, 2007. (See Note 14.)





(b)
            From
                time to time the Company borrowed money from the Company's Chief
                Information Officer. The notes bear interest at 12% per annum. As
                of
                December 31, 2006, the Company is indebted to Anthony Pizi, the Company’s
                former Chairman and CEO and current Chief Information Officer, in
                the
                amount of $9,000.





(c)
            The
                Company does not have a revolving credit facility and from time to
                time
                has issued a series of short term promissory notes with private lenders,
                which provide for short term borrowings both secured and unsecured
                by
                accounts receivable. In addition, the Company has settled certain
                litigation and agreed to a series of promissory notes to support
                the
                obligations. The notes bear interest between 10% and 12% per annum.




(d)
              The
                  Company entered into convertible notes with private lenders. The
                  notes
                  bear interest between 12% and 18% per annum and allow for the conversion
                  of the principal amount due into common stock of the Company. In
                  April
                  2005, the Company entered into a convertible loan in the amount
                  of $30,000
                  with a member of the Company’s Board of Directors. Under the term of this
                  agreement, the loan bears interest at 1% per month and was convertible
                  upon the option of the note holder into 428,571 shares of our common
                  stock
                  at a conversion price of $0.07 per share. As part of the recapitalization
                  plan, the Company has offered to lower that conversion rate and
                  exchange
                  the note for 60 shares of Series A-1 preferred stock. In November
                  2006,
                  the Noteholder consented to the amended conversion rate and the
                  Note has
                  been cancelled. In May 2004, the Company entered into convertible
                  loans
                  aggregating $185,000 from several investors including a member
                  of the
                  Company’s Board of Directors. Under the terms of these agreements, the
                  loans bear interest between 1% and 1.5% per month and are convertible
                  upon
                  the option of the Noteholder into an aggregate of 578,125 shares
                  of our
                  common stock and warrants to purchase an aggregate of 578,125 shares
                  of
                  our common stock exercisable at $0.32. The warrants expire three
                  years
                  from grant. As part of the recapitalization plan, the Company has
                  offered
                  to lower that conversion rate and exchange the note for 80.94 shares
                  of
                  Series A-1 preferred stock. In November 2006, the Noteholders consented
                  to
                  the amended conversion rate and the Notes have been cancelled.
                  Also in
                  March 2004, the Company entered into a convertible loan in the
                  amount of
                  $50,000. Under the terms of this agreement, the loan bears interest
                  at 1%
                  per month and is convertible upon the option of the note holder
                  into
                  135,135 shares of our common stock and warrants to purchase 135,135
                  shares
                  of our common stock at an exercisable price of $0.37 per share.
                  All such
                  warrants expire three years from the date of grant. As part of
                  the
                  recapitalization plan, the Company has offered to lower that conversion
                  rate and exchange the note for 19.23 shares of Series A-1 preferred
                  stock.
                  In November 2006, the Noteholder consented to the amended conversion
                  rate
                  and the Note has been
                  cancelled.
  F-17
  (e)
              The
                  Company entered into convertible promissory notes with Anthony
                  Pizi, the
                  Company’s Chief Information Officer and Mark and Carolyn Landis, who are
                  related by marriage to Anthony Pizi, and Mr. Landis is the Company’s
                  Chairman of the Board of Directors.


In
      June 2004, the Company entered into a convertible loan agreement with Mr. Pizi
      in the amount of $100,000. Under the terms of the agreement, the loan bears
      interest at 1% per month and is convertible upon the option of the note holder
      into 270,270 shares of our common stock and warrants to purchase 270,270 shares
      of our common stock exercisable at $0.37. The warrants expire in three years
      from the date of grant. As part of the recapitalization plan, the Company has
      offered to lower that conversion rate and exchange the note for 14 shares of
      Series A-1 preferred stock. In November 2006, the Noteholder consented to the
      amended conversion rate and the Note has been cancelled. In July 2004, the
      Company entered into a convertible promissory note with Mr. Pizi in the face
      amount of $112,000. Under the terms of the agreement, the loan bears interest
      at
      1% per month and is convertible upon the option of the note holder into 560,000
      shares of our common stock and warrants to purchase 560,000 shares of our common
      stock at $0.20 per share. As part of the recapitalization plan, the Company
      has
      offered to lower that conversion rate and exchange the note for 78.4 shares
      of
      Series A-1 preferred stock. In November 2006, the Noteholder consented to the
      amended conversion rate and the Note has been cancelled. Also in July 2004,
      Mr.
      Pizi entered into a second convertible promissory note in the face amount of
      $15,000 which bears interest at 1% per month and is convertible into 90,118
      shares of our common stock and warrants to purchase 90,118 shares of our common
      stock at $0.17 per share. All such warrants expire three years from the date
      of
      grant. As part of the recapitalization plan, the Company has offered to lower
      that conversion rate and exchange the note for 12.62 shares of Series A-1
      preferred stock. In November 2006, the Noteholder consented to the amended
      conversion rate and the Note has been cancelled.





In
      March 2004, the Company entered into a convertible loan agreement with Mark
      and
      Carolyn Landis, in the principal amount of $125,000. Under the terms of the
      agreement, the loan bears interest at 1% per month and is convertible upon
      the
      option of the note holder into 446,429 shares of our common stock and warrants
      to purchase 446,429 shares of our common stock exercisable at $0.28. The
      warrants expire in three years from the date of grant. As part of the
      recapitalization plan, the Company has offered to lower that conversion rate
      and
      exchange the note for 62.5 shares of Series A-1 preferred stock. In November
      2006, the Noteholder consented to the amended conversion rate and the Note
      has
      been cancelled. In June 2004, we entered into a convertible loan agreement
      with
      Mark and Carolyn Landis, in the amount of $125,000. Under the terms of the
      agreement, the loan bears interest at 1% per month and also is convertible
      upon
      the option of the note holder into 781,250 shares of our common stock and
      warrants to purchase 781,250 shares of our common stock exercisable at $0.16.
      The warrants expire in three years from the date of grant. As part of the
      recapitalization plan, the Company has offered to lower that conversion rate
      and
      exchange the note for 113.64 shares of Series A-1 preferred stock. In November
      2006, the Noteholder consented to the amended conversion rate and the Note
      has
      been cancelled. In October 2004, the Company entered into a convertible loan
      agreement with Mark and Carolyn Landis in the amount of $100,000. Under the
      terms of the agreement, the loan bears interest at 1% per month and is
      convertible upon the option of the note holder into 1,000,000 shares of our
      common stock and warrants to purchase 2,000,000 shares of the Company’s common
      stock exercisable at $0.10. The warrants expire in three years. As part of
      the
      recapitalization plan, the Company has offered to lower that conversion rate
      and
      exchange the note for 400 shares of Series A-1 preferred stock. In November
      2006, the Noteholder consented to the amended conversion rate and the Note
      has
      been cancelled. In November 2004, the Company entered into a convertible loan
      agreement with Mark and Carolyn Landis in the amount of $150,000. Under the
      terms of the agreement, the loan bears interest at 1% per month and is
      convertible upon the option of the note holder into 1,875,000 shares of our
      common stock and warrants to purchase 1,875,000 shares of the Company’s common
      stock exercisable at $0.08. All such warrants expire three years from the date
      of grant. As part of the recapitalization plan, the Company has offered to
      lower
      that conversion rate and exchange the note for 750 shares of Series A-1
      preferred stock. In November 2006, the Noteholder consented to the amended
      conversion rate and the Note has been cancelled.


F-18





**NOTE****8.** **INCOME TAXES**





A
      reconciliation of expected income tax at the statutory federal rate with the
      actual income tax provision is as follows for the years ended December 31 (in
      thousands) :





**2006**
            
            **2005**
            
            **2004**Expected
                income tax benefit at statutory rate (34%)
            
            $
            (1,019
            )
            $
            (1,251
            )
            $
            (3,319
            )State
                taxes, net of federal tax benefit.
            
            
            (180
            )
            
            (308
            )
            
            (219
            )Effect
                of foreign operations including withholding taxes
            
            
            --
            
            
            --
            
            
            12Effect
                of change in valuation allowance
            
            
            1,073
            
            
            1,537
            
            
            3,357Non-deductible
                expenses
            
            
            126
            
            
            22
            
            
            169Total
            
            $
            --
            
            $
            --
            
            $
            --





Significant
      components of the net deferred tax asset (liability) at December 31 were as
      follows:





**2006**
            
            **2005**Current
                assets:Allowance
                for doubtful accounts
            
            $
            34
            
            $
            4Accrued
                expenses, non-tax deductible
            
            
            279
            
            
            145Deferred
                revenue
            
            
            15
            
            
            31Noncurrent
                assets:Loss
                carryforwards
            
            
            91,016
            
            
            89,528Depreciation
                and amortization
            
            
            5,931
            
            
            6,74697,275
            
            
            96,454Less:
                valuation allowance
            
            
            (97,275
            )
            
            (96,454
            )$
            --
            
            $
            --





At
      December 31, 2006, the Company had net operating loss carryforwards of
      approximately $227,539,000, which may be applied against future taxable income.
      These carryforwards will expire at various times between 2006 and 2025. A
      substantial portion of these carryforwards are restricted to future taxable
      income of certain of the Company's subsidiaries or limited by Internal Revenue
      Code Section 382. Thus, the utilization of these carryforwards cannot be
      assured. Net operating loss carryforwards include tax deductions for the
      disqualifying dispositions of incentive stock options. When the Company utilizes
      the net operating loss related to these deductions, the tax benefit will be
      reflected in additional paid-in capital and not as a reduction of tax expense.
      The total amount of these deductions included in the net operating loss
      carryforwards is $21,177,000.





The
      undistributed earnings of certain foreign subsidiaries are not subject to
      additional foreign income taxes nor considered to be subject to U.S. income
      taxes unless remitted as dividends. The Company intends to reinvest such
      undistributed earnings indefinitely; accordingly, no provision has been made
      for
      U.S. taxes on those earnings. The determination of the amount of the
      unrecognized deferred tax liability related to the undistributed earnings is
      not
      practicable.





The
      Company provided a full valuation allowance on the total amount of its deferred
      tax assets at December 31, 2006 and 2005 since management does not believe
      that it is more likely than not that these assets will be realized.








**NOTE****9.** **STOCKHOLDERS’
EQUITY**





**Common
      Stock** :





As
      part
      of the recapitalization plan described in Note 2, the Company converted
      outstanding convertible promissory notes, senior reorganization notes and
      convertible bridge notes. Senior reorganization debt amounting to $2,309,000
      was
      cancelled and converted into 3,438,473 shares of the Company’s common stock. The
      Company also converted $3,915,000 of Convertible Bridge Notes into 30,508,448
      shares of Cicero common stock. These shares were issued in reliance upon the


F-19


exemption
      from registration under Rule 506 of Regulation D and on the exemption from
      registration provided by Section 4(2) of the Securities Act of 1933 for
      transactions by an issuer not involving a public offering.





In
      January 2004, the Company completed a common stock financing round wherein
      it
      raised $1,247,000 of capital from several new investors as well as certain
      investors of Critical Mass Mail, Inc. The Company sold 3,369,192 shares of
      common stock at a price of $0.37 per share. As part of the financing, the
      Company has also issued warrants to purchase 3,369,192 shares of the Company’s
      common stock at an exercise price of $0.37. The warrants expire three years
      from
      the date of grant. These shares were issued in reliance upon the exemption
      from
      registration under Rule 506 of Regulation D and on the exemption from
      registration provided by Section 4(2) of the Securities Act of 1933 for
      transactions by an issuer not involving a public offering.





**Stock
      Grants** :





During
      2006 and 2005, no stock awards were made to employees.








**Stock
      Options** :





The
      Company maintains two stock option plans, the 1995 and 1997 Stock Incentive
      Plans, which permit the issuance of incentive and nonstatutory stock options,
      stock appreciation rights, performance shares, and restricted and unrestricted
      stock to employees, officers, directors, consultants, and advisors. In July
      2003, stockholders approved a proposal to increase the number of shares reserved
      within these plans to a combined total of 109,000 shares of common stock for
      issuance upon the exercise of awards and provide that the term of each award
      be
      determined by the Board of Directors. In December 2005, the remaining options
      under the 1995 Stock Incentive Plan expired. The Company also has a stock
      incentive plan for outside directors and the Company has set aside 1,200 shares
      of common stock for issuance under this plan.





Under
      the terms of the Plans, the exercise price of the incentive stock options may
      not be less than the fair market value of the stock on the date of the award
      and
      the options are exercisable for a period not to exceed ten years from date
      of
      grant. Stock appreciation rights entitle the recipients to receive the excess
      of
      the fair market value of the Company's stock on the exercise date, as determined
      by the Board of Directors, over the fair market value on the date of grant.
      Performance shares entitle recipients to acquire Company stock upon the
      attainment of specific performance goals set by the Board of Directors.
      Restricted stock entitles recipients to acquire Company stock subject to the
      right of the Company to repurchase the shares in the event conditions specified
      by the Board are not satisfied prior to the end of the restriction period.
      The
      Board may also grant unrestricted stock to participants at a cost not less
      than
      85% of fair market value on the date of sale. Options granted vest at varying
      periods up to five years and expire in ten years.


F-20





Activity
      for stock options issued under these plans for the fiscal years ending December
      31, 2006, 2005 and 2004 was as follows:


**Plan
                  Activity**
              
              **Option
                  Price**
                **Per
                  Share**
              
              **Weighted
                  Average**
                **Exercise
                  Price**Balance
                  at December 31, 2003
              
              
              56,259
              
              
              20.00-3,931.00
              
              
              243.00Granted
              
              
              31,392
              
              
              12.00
                  -39.00
              
              
              26.00Exercised
              
              
              (5,192
              )
              
              8.00
                  -37.00
              
              
              17.00Forfeited
              
              
              (7,572
              )
              
              22.00-3,788.00
              
              
              812.00Balance
                  at December 31, 2004
              
              
              74,887
              
              
              12.00-3,931.00
              
              
              111.00Granted
              
              
              2,529
              
              
              7.00
                  - 12.00
              
              
              9.00Exercised
              
              
              (2,529
              )
              
              7.00
                  - 12.00
              
              
              9.00Forfeited
              
              
              (15,877
              )
              
              22.00-3,931.00
              
              
              75.00Balance
                  at December 31, 2005
              
              
              59,010
              
              
              12.00-3,931.00
              
              
              124.00Forfeited
              
              
              (13,695
              )
              
              22.00-3,931.00
              
              
              137.14Balance
                  at December 31, 2006
              
              
              45,315
              
              
              12.00-3,931.00
              
              
              120.61




There
      were no option grants issued during 2006. The weighted average grant date fair
      value of options issued during the years ended December 31, 2005, and 2004
      was
      equal to $9.00 and $26.00 per share, respectively. There were no option grants
      issued below fair market value during 2005 and 2004.





At
      December 31, 2006, 2005, and 2004, options to purchase approximately 45,315,
      5,237, and 4,775 shares of common stock were exercisable, respectively, pursuant
      to the plans at prices ranging from $12.00 to $3,931.25. The following table
      summarizes information about stock options outstanding at December 31, 2006:





**EXERCISE
                PRICE**
            
            **NUMBER**
              **OUTSTANDING/**
              **EXERCISABLE**
            
            **REMAINING
                CONTRACTUAL**
              **LIFE
                FOR OPTIONS**
              **OUTSTANDING**
            
            **WEIGHTED****AVERAGE**
              **EXERCISE****PRICE**$
                12.00 - 393.12
            
            
            39,680
            
            
            6.4
            
            $
            48.03393.13
                -786.25
            
            
            5,350
            
            
            4.1
            
            
            586.35786.26-1,179.37
            
            
            165
            
            
            3.0
            
            
            944.411,179.38-1,572.50
            
            
            50
            
            
            1.0
            
            
            1,473.001,572.60-1,965.62
            
            
            40
            
            
            3.6
            
            
            1,881.251,965.62-3,538.12
            
            
            0
            
            
            0.0
            
            
            0.003,538.13-3,931.25
            
            
            30
            
            
            3.2
            
            
            3,931.2545,315
            
            
            6.1
            
            $
            120.61








**Preferred
      Stock** :





As
      part
      of the recapitalization plan approved by shareholders in November 2006, the
      Company offered to exchange its existing Series A-3, B-3, C and D preferred
      shares at reduced conversion rates in exchange for shares of a new Series A-1
      preferred stock in Cicero Inc. This proposal also required approved by existing
      preferred shareholders as a class. The new conversion prices with respect to
      the
      Series A-3, B-3 and D preferred stock were negotiated with the holders of each
      series based upon such factors as the current conversion price in relation
      to
      the market, the dollar amount represented by such series and, waiver of
      anti-dilution, liquidation preferences, seniority and other senior rights.
      The
      conversion price for the Series C preferred stock was determined in relation
      to
      the conversion price for the Series D preferred stock. The Board of Directors
      determined the new conversion price of each series of Level 8 preferred stock
      after discussion and review of those rights,


F-21


ranks
      and privileges that were being waived by the present holders of preferred stock.
      Among those rights being waived are anti-dilution protection, liquidation
      preferences and seniority.





The
      holders of the Series A-1 preferred stock shall have the rights and preferences
      set forth in the Certificate of Designations filed with the Secretary of State
      of the State of Delaware upon the approval of the Recapitalization. The rights
      and interests of the Series A-1 preferred stock of the Company will be
      substantially similar to the rights interests of each of the series of Level
      8
      preferred stock other than for (i) anti-dilution protections that have been
      permanently waived and (ii) certain voting, redemption and other rights that
      holders of Series A-1 preferred stock will not be entitled to. All shares of
      Series A-1 preferred stock will have a liquidation preference *pari
      passu* with all other Series A-1 preferred stock.





The
      Series A-1 preferred stock is convertible at any time at the option of the
      holder into an initial conversion ratio of 1,000 shares of Common Stock for
      each
      share of Series A-1 preferred stock. The initial conversion ratio shall be
      adjusted in the event of any stock splits, stock dividends and other
      recapitalizations. The Series A-1 preferred stock is also convertible on a
      automatic basis in the event that (i) the Company closes on an additional
      $5,000,000 equity financing from strategic or institutional investors, or (ii)
      the Company has four consecutive quarters of positive cash flow as reflected
      on
      the Company’s financial statements prepared in accordance with generally
      accepted accounting principals (“GAAP”) and filed with the Commission. The
      holders of Series A-1 preferred stock are entitled to receive equivalent
      dividends on an as-converted basis whenever the Company declares a dividend
      on
      its Common Stock, other than dividends payable in shares of Common Stock. The
      holders of the Series A-1 preferred stock are entitled to a liquidation
      preference of $500 per share of Series A-1 preferred stock upon the liquidation
      of the Company. The Series A-1 preferred stock is not redeemable.





The
      holders of Series A-1 preferred stock also possess the following voting rights.
      Each share of Series A-1 preferred stock shall represent that number of votes
      equal to the number of shares of Common Stock issuable upon conversion of a
      share of Series A-1 preferred stock. The holders of Series A-1 preferred stock
      and the holders of Common Stock shall vote together as a class on all matters
      except: (i) regarding the election of the Board of Directors of the Company
      (as set forth below); (ii) as required by law; or (iii) regarding certain
      corporate actions to be taken by the Company (as set forth below).





The
      approval of at least two-thirds of the holders of Series A-1 preferred stock
      voting together as a class, shall be required in order for the Company to:
      (i)
      merge or sell all or substantially all of its assets or to recapitalize or
      reorganize; (ii) authorize the issuance of any equity security having any right,
      preference or priority superior to or on parity with the Series A-1 preferred
      stock; (iii) redeem, repurchase or acquire indirectly or directly any of its
      equity securities, or to pay any dividends on the Company’s equity securities;
      (iv) amend or repeal any provisions of its certificate of incorporation or
      bylaws that would adversely affect the rights, preferences or privileges of
      the
      Series A-1 preferred stock; (v) effectuate a significant change in the principal
      business of the Company as conducted at the effective time of the
      Recapitalization; (vi) make any loan or advance to any entity other than in
      the
      ordinary course of business unless such entity is wholly owned by the Company;
      (vii) make any loan or advance to any person, including any employees or
      directors of the Company or any subsidiary, except in the ordinary course of
      business or pursuant to an approved employee stock or option plan; and (viii)
      guarantee, directly or indirectly any indebtedness or obligations, except for
      trade accounts of any subsidiary arising in the ordinary course of business.
      In
      addition, the unanimous vote of the board of directors is required for any
      liquidation, dissolution, recapitalization or reorganization of the Company.
      The
      voting rights of the holders of Series A-1 preferred stock set forth in this
      paragraph shall be terminated immediately upon the closing by the Company of
      at
      least an additional $5,000,000 equity financing from strategic or institutional
      investors.





In
      addition to the voting rights described above, the holders of a majority of
      the
      shares of Series A-1 preferred stock are entitled to appoint two observers
      to
      the Company’s Board of Directors who shall be entitled to receive all
      information received by members of the Board of Directors, and shall attend
      and
      participate without a vote at all meetings of the Company’s Board of Directors
      and any committees thereof. At the option of a majority of the holders of Series
      A-1 preferred stock, such holders may elect to temporarily or permanently
      exchange their board observer rights for two seats on the Company’s Board of
      Directors, each having all voting and other rights attendant to any member
      of
      the Company’s Board of Directors. As part of the Recapitalization, the right of
      the holders of Series A-1 preferred stock to elect a majority of the voting
      members of the Company’s Board of Directors shall be terminated.





As
      a result of the reduced conversion prices the Company exchanged all of the
      Series A-3, B-3, C and D preferred stock into 172 shares of Series A-1 preferred
      stock and using Black-Scholes, we calculated a beneficial conversion in the
      exchange of the Series A-3, B-3, C and D shares for Series A-1 preferred stock.
      The beneficial conversion of $21,000 is treated as a deemed dividend in the
      Statement of Operations for the year ended December 31, 2006.


F-22


As
      part of the recapitalization plan, Noteholders of $992,000 of Convertible
      Promissory Notes were offered reduced conversion prices to convert their notes
      into shares of the Company’s new series A-1 preferred stock. All Noteholders
      have agreed to convert their notes into shares of Series A-1 preferred stock.
      The Company has cancelled these notes and issued 1,591 shares of its Series
      A-1
      preferred stock. In accordance with EITF 98-5 and specifically paragraph 8,
      the
      Company has utilized the Black-Scholes formula to determine the fair value
      of
      the stock received. The Company has calculated the fair value of the stock
      received to be $484,000 resulting in a beneficial conversion of $508,000. Since
      this beneficial conversion is immediately recognizable by the holders, the
      Company has fully amortized this conversion and recorded an accretion to
      preferred stock in the Statement of Operations for the year ended December
      31,
      2006.





During
      2005 and 2004, there were 456 shares of preferred stock converted into 1,351,112
      shares of the Company's common stock and 4,686 shares of preferred stock
      converted into 7,037,451 shares of the Company’s common stock, respectively.
      There were 1,571 shares of the Series A3 Preferred Stock and 30,000 shares
      of
      Series B3 Preferred Stock, 991 shares of Series C Preferred Stock, and 1,061
      shares of Series D Preferred Stock outstanding at December 31,
      2005.








**Stock
      Warrants:**





The
      Company values warrants based on the Black-Scholes pricing model. Warrants
      granted in 2006, 2005, and 2004 were valued using the following
      assumptions:





**Expected**
              **Life
                in****Years**
            
            **Expected****Volatility**
            
            **Risk
                Free**
              **Interest****Rate**
            
            **Expected**
              **Dividend**
            
            **Fair
                Value of**
              **Common****Stock**2002-2003
                Financing Warrants
            
            
            5
            
            
            97
            %
            
            2
            %
            
            None
            
            $
            0.40Preferred
                Series C Warrants
            
            
            5
            
            
            117
            %
            
            3
            %
            
            None
            
            $
            0.38Preferred
                Series D-1 Warrants
            
            
            5
            
            
            117
            %
            
            3
            %
            
            None
            
            $
            0.07Preferred
                Series D-2 Warrants
            
            
            5
            
            
            102
            %
            
            3
            %
            
            None
            
            $
            0.20Private
                Placement - January 2004
            
            
            3
            
            
            101
            %
            
            3
            %
            
            None
            
            $
            0.36Early
                Adopter Warrants
            
            
            4
            
            
            104
            %
            
            4
            %
            
            None
            
            $
            1.50





**Increase
      in Capital Stock:**





In
      November 2006, the stockholders approved a proposal to amend the Amended and
      Restated Certificate of Incorporation to increase the aggregate number of shares
      of Common Stock that the Company is authorized to issue from 85,000,000 to
      215,000,000.








**NOTE
      10.**  **EMPLOYEE
      BENEFIT PLANS**





The
      Company sponsors one defined contribution plan for its U.S. employees - the
      Level 8 Systems 401(k). Under the terms of the Plan, the Company provides a
      50%
      matching contribution up to 6% of an employee’s salary. Participants must be
      eligible Company plan participants and employed at December 31 of each calendar
      year to be eligible for employer matching contributions. Matching contributions
      to the Plan included in the Consolidated Statement of Operations totaled $0,
      $30,000 and $54,000, for the years ended December 31, 2006, 2005, and 2004,
      respectively. On December 1, 2005 the company suspended further contributions
      to
      the defined contribution plan.





The
      Company also had employee benefit plans for each of its foreign subsidiaries,
      as
      mandated by each country's laws and regulations. The Company no longer maintains
      foreign subsidiaries.








F-23


**NOTE
      11.** **SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT
      RISK**





In
      2006, four customers accounted for 50.0%, 18.7%, 13.3% and 10.0% of operating
      revenue. In 2005, two customers accounted for 52.4% and 13.0% of operating
      revenues. In 2004, five customers accounted for 24.6%, 22.4%, 13.5%, 11.8%
      and
      11.4% of operating revenues.








**NOTE
      12.**  **FOREIGN
      CURRENCIES**





The
      Company’s net foreign currency transaction losses/ (gains) were $14,000,
      $(23,000), and $13,000 for the years ended 2006, 2005, and 2004,
      respectively.








**NOTE
      13.**  **SEGMENT
      INFORMATION AND GEOGRAPHIC INFORMATION**





The
      Company makes operating decisions and assesses performance of the Company’s
      operations based on the following reportable segments: (1) Desktop Integration
      segment, and (2) Messaging and Application Engineering segment. The Company
      previously had three reportable segments but the Company has reported the
      Systems Integration segment as discontinued operations.





The
      principal product in the Desktop Integration segment is Cicero®. Cicero® is a
      business integration software product that maximizes end-user productivity,
      streamlines business operations and integrates disparate systems and
      applications.





The
      products that comprise the Messaging and Application Engineering segment are
      Ensuredmail, Geneva Integration Broker, CTRC and Star/SQL.





Segment
      data includes a charge allocating all corporate headquarters costs to each
      of
      its operating segments based on each segment's proportionate share of expenses.
      The Company evaluates the performance of its segments and allocates resources
      to
      them based on earnings (loss) before interest and other income/(expense), taxes,
      in-process research and development, and restructuring.





The
      table below presents information about reported segments for the twelve months
      ended December 31, 2006, 2005 and 2004 (in thousands):





**For
                the year ended December 31,****2006**
            
            **2005**
            
            **2004**Desktop
                Integration
            
            Messaging
                and Application Engineering
            
            Total
            
            Desktop
                Integration
            
            Messaging
                and Application Engineering
            
            Total
            
            Desktop
                Integration
            
            Messaging
                and Application Engineering
            
            TotalTotal
                revenue
            
            $
            965
            
            $
            7
            
            $
            972
            
            $
            760
            
            $
            25
            
            $
            785
            
            $
            707
            
            $
            68
            
            $
            775Total
                cost of revenue
            
            
            767
            
            
            --
            
            
            767
            
            
            1,188
            
            
            --
            
            
            1,188
            
            
            5,662
            
            
            213
            
            
            5,875Gross
                margin (loss)
            
            
            198
            
            
            7
            
            
            205
            
            
            (428
            )
            
            25
            
            
            (403
            )
            
            (4,955
            )
            
            (145
            )
            
            (5,100
            )Total
                operating expenses
            
            
            1,964
            
            
            121
            
            
            2,085
            
            
            2,536
            
            
            119
            
            
            2,655
            
            
            3,348
            
            
            373
            
            
            3,721Segment
                profitability (loss)
            
            $
            (1,766
            )
            $
            (114
            )
            $
            (1,880
            )
            $
            (2,964
            )
            $
            (94
            )
            $
            (3,058
            )
            $
            (8,303
            )
            $
            (518
            )
            $
            (8,821
            )


F-24




A
      reconciliation of segment operating expenses to total operating expense follows
      (numbers are in thousands):





**2006**
            
            **2005**
            
            **2004**Segment
                operating expenses
            
            $
            2,085
            
            $
            2,655
            
            $
            3,721Write-off
                of intangible assets
            
            
            --
            
            
            --
            
            
            587(Gain)
                on disposal of assets
            
            
            (24
            )
            
            --
            
            
            (5
            )Total
                operating expenses
            
            $
            2,061
            
            $
            2,655
            
            $
            4,303





A
      reconciliation of total segment profitability to net loss for the fiscal years
      ended December 31(in thousands):





**2006**
            
            **2005**
            
            **2004**Total
                segment profitability (loss)
            
            $
            (1,880
            )
            $
            (3,058
            )
            $
            (8,821
            )Write-off
                of intangible assets
            
            
            --
            
            
            --
            
            
            (587
            )Gain/
                on disposal of assets
            
            
            24
            
            
            --
            
            
            5Interest
                and other income/(expense), net
            
            
            (1,141
            )
            
            (623
            )
            
            (328
            )Net
                loss before provision for income taxes
            
            $
            (2,997
            )
            $
            (3,681
            )
            $
            (9,731
            )








The
      following table presents a summary of long-lived assets by segment as of
      December 31 (in thousands):





**2006**
            
            **2005**Desktop
                Integration
            
            $
            15
            
            $
            10Messaging/Application
                Engineering
            
            
            -
            
            
            -Total
                assets
            
            $
            15
            
            $
            10





The
      following table presents a summary of revenue by geographic region for the
      years
      ended December 31(in thousands):





**2006**
            
            **2005**
            
            **2004**Denmark
            
            $
            -
            
            $
            -
            
            $
            7Italy
            
            
            -
            
            
            2
            
            
            4United
                Kingdom
            
            
            -
            
            
            -
            
            
            1USA
            
            
            972
            
            
            783
            
            
            762Other
            
            
            -
            
            
            -
            
            
            1$
            972
            
            $
            785
            
            $
            775





Presentation
      of revenue by region is based on the country in which the customer is domiciled.
      As of December 31, 2006, 2005 and 2004, all of the long-lived assets of the
      Company are located in the United States.








**NOTE
      1****4.** **RELATED PARTY INFORMATION**





Liraz
      Systems Ltd., the Company’s former principal stockholder guarantees certain debt
      obligations of the Company. In November 2006, the Company and Liraz agreed
      to
      extend the guarantee and with the approval of the lender, agreed to extend
      the
      maturity of the debt obligation until October 31, 2007. The Company issued
      6,000,000 shares of common stock (pre reverse stock split) to Liraz in exchange
      for this debt extension. In November 2005, the Company and Liraz agreed to
      extend the guarantee and with the approval of the lender, agreed to extend
      the
      maturity of the debt obligation until October 30, 2006. The Company issued
      2,400,000 shares of common stock and granted a warrant to purchase an additional
      3,600,000 shares of our common stock at an exercise price of $0.002 per share
      to
      Liraz in exchange for this debt extension. In 2004, the Company


F-25


and
      Liraz also agreed to extend the guarantee and maturity of the debt obligation
      until November 2005. The Company agreed to issue Liraz 3,942,000 shares of
      stock
      for that extension.





During
      2006, under an existing reseller agreement, the Company recognized $100,000
      of
      software revenue with Pilar Services, Inc. Pilar Services is presently owned
      and
      managed by Charles Porciello who is a member of our Board of Directors. As
      of
      December 31, 2006, the receivable was still outstanding and the Company has
      reserved for possible doubtful accounts.





From
      time to time during 2005 and 2004, the Company entered into short term notes
      payable with Anthony Pizi, the Company’s former Chief Executive Officer and
      current Chief Information Officer. The Notes bear interest at 1% per month
      and
      are unsecured. At December 31, 2006, the Company was indebted to Mr. Pizi in
      the
      amount of $9,000.





*Convertible
      Promissory Notes:* Directors and executive officers made the following loans
      to the Company for convertible promissory notes: In June 2004, the Company
      entered into a convertible loan agreement with Mr. Pizi in the amount of
      $100,000. Under the terms of the agreement, the loan bears interest at 1% per
      month and is convertible upon the option of the note holder into 270,270 shares
      of our common stock and warrants to purchase 270,270 shares of our common stock
      exercisable at $0.37. The warrants expire in three years from the date of grant.
      As part of the recapitalization plan, the Company has offered to lower that
      conversion rate and exchange the note for 14 shares of Series A-1 preferred
      stock.****In November 2006, the Noteholder consented to the
      amended conversion rate and the Note has been cancelled.





In
      July
      2004, the Company entered into a convertible promissory note with Mr. Pizi
      in
      the face amount of $112,000. Under the terms of the agreement, the loan bears
      interest at 1% per month and is convertible upon the option of the note holder
      into 560,000 shares of our common stock and warrants to purchase 560,000 shares
      of our common stock at $0.20 per share. As part of the recapitalization plan,
      the Company has offered to lower that conversion rate and exchange the note
      for
      78.4 shares of Series A-1 preferred stock.****In November
      2006, the Noteholder consented to the amended conversion rate and the Note
      has
      been cancelled. Also in July 2004, Mr. Pizi entered into a second convertible
      promissory note in the face amount of $15,000 which bears interest at 1% per
      month and is convertible into 90,118 shares of our common stock and warrants
      to
      purchase 90,118 shares of our common stock at $0.17 per share. All such warrants
      expire three years from the date of grant. As part of the recapitalization
      plan,
      the Company has offered to lower that conversion rate and exchange the note
      for
      12.62 shares of Series A-1 preferred stock**.** In November 2006,
      the Noteholder consented to the amended conversion rate and the Note has been
      cancelled.





In
      March
      2004, the Company entered into a convertible promissory note with Mr. and Mrs.
      Mark Landis in the amount of $125,000. Mr. Landis is the Company’s Chairman of
      the Board and Mr. and Mrs. Landis are parents-in-law to Mr. Pizi, the Company’s
      Chief Information Officer.****Under the terms of the
      agreement, the loan bears interest at 1% per month and is convertible upon
      the
      option of the note holder into 446,429 shares of our common stock and warrants
      to purchase 446,429 shares of our common stock exercisable at $0.28. The
      warrants expire in three years from the date of grant. As part of the
      recapitalization plan, the Company has offered to lower that conversion rate
      and
      exchange the note for 62.5 shares of Series A-1 preferred
      stock.****In November 2006, the Noteholder consented to the
      amended conversion rate and the Note has been cancelled.





In
      June
      2004, the Company entered into a convertible promissory note with Mr. and Mrs.
      Landis in the amount of $125,000. Under the terms of the note, the loan bears
      interest at 1% per month and is convertible into 781,250 shares of the Company’s
      common stock and warrants to purchase 781,250 shares of Level 8 common stock
      exercisable at $0.16 per share. The warrants expire in three years from the
      date
      of grant. As part of the recapitalization plan, the Company has offered to
      lower
      that conversion rate and exchange the note for 113.64 shares of Series A-1
      preferred stock. In November 2006, the Noteholder consented to the amended
      conversion rate and the Note has been cancelled.





In
      October 2004, the Company entered into a convertible promissory note with Mr.
      and Mrs. Landis in the amount of $100,000. Under the terms of the agreement,
      the
      loan bears interest at 1% per month and is convertible into 1,000,000 shares
      of
      our common stock and warrants to purchase 2,000,000 shares of the Company’s
      common stock exercisable at $0.10 per share. The warrants expire in three years.
      As part of the recapitalization plan, the Company has offered to lower that
      conversion rate and exchange the note for 400 shares of Series A-1 preferred
      stock**.**In November 2006, the Noteholder consented to the
      amended conversion rate and the Note has been cancelled.





In
      November 2004, the Company entered into a convertible promissory note with
      Mark
      and Carolyn Landis, in the amount of $150,000. Under the terms of the agreement,
      the loan bears interest at 1% per month and is convertible into 1,875,000 shares


F-26


of
      our
      common stock and warrants to purchase 1,875,000 shares of the Company’s common
      stock exercisable at $0.08 per share. All such warrants expire three years
      from
      the date of grant. As part of the recapitalization plan, the Company has offered
      to lower that conversion rate and exchange the note for 750 shares of Series
      A-1
      preferred stock. In November 2006, the Noteholder consented to the amended
      conversion rate and the Note has been cancelled.





In
      June
      2004, the Company entered into a convertible promissory note with Fredric Mack,
      a former director of the Company, in the amount of $125,000. Under the terms
      of
      the note, the loan bears interest at 1% per month, and is convertible into
      390,625 shares of the Company’s common stock and warrants to purchase 390,625
      shares of the Company’s common stock exercisable at $0.32 per share. As part of
      the recapitalization plan, the Company has offered to lower that conversion
      rate
      and exchange the note for 54.69 shares of Series A-1 preferred stock. In
      November 2006, the Noteholder consented to the amended conversion rate and
      the
      Note has been cancelled.





In
      April
      2005, the Company entered into a convertible promissory note with Bruce Miller,
      a director of the Company, in the amount of $30,000. Under the terms of the
      note, the loan bears interest at 1% per month and is convertible into 428,571
      shares of the Company’s common stock. As part of the recapitalization plan, the
      Company has offered to lower that conversion rate and exchange the note for
      60
      shares of Series A-1 preferred stock.****In November 2006,
      the Noteholder consented to the amended conversion rate and the Note has been
      cancelled.





In
      July
      2004, the Company entered into a convertible promissory note with Nicholas
      Hatalski, who until July 22, 2005 (during the period when the terms of the
      recapitalization merger were being negotiated and at the time of approval of
      the
      recapitalization merger by our board of directors), was a director of the
      Company, in the amount of $25,000. Under the terms of the note, the loan bears
      interest at 1% per month and is convertible into 78,125 shares of the Company’s
      common stock and warrants to purchase 78,125 shares of the Company’s common
      stock exercisable at $0.32 per share. As part of the recapitalization plan,
      the
      Company has offered to lower that conversion rate and exchange the note for
      10.94 shares of Series A-1 preferred stock.****In November
      2006, the Noteholder consented to the amended conversion rate and the Note
      has
      been cancelled.





All
      of
      such warrants expire three years from date of grant.





*Senior
      Reorganization*Notes. From March 2004 to April 2005, directors and
      executive officers made the following loans to us for Senior Reorganization
      Notes: Mr. Pizi held $423,333 of Senior Reorganization Notes, which were
      converted into warrants to purchase an additional 571,659 shares of Cicero
      common stock at a purchase price of $0.20 per
      share.****





Mr.
      Landis held $327,860 of Senior Reorganization Notes, which were converted into
      warrants to purchase an additional 442,345 shares of Cicero common stock at
      an
      exercise price of $0.20 per share.





Mr.
      Mack
      held, together with his affiliates, $88,122 of Senior Reorganization Notes,
      which were converted into warrants to purchase an additional 112,205 shares
      of
      Cicero common stock at a purchase price of $0.20 per share.





Mr.
      Miller held, together with his affiliates, $77,706 of Senior Reorganization
      Notes, which were converted into warrants to purchase an additional 114,597
      shares of Cicero common stock at a purchase price of $0.20.





Mr.
      Atherton held, together with his affiliates, $20,000 of Senior Reorganization
      Notes which were converted into warrants to purchase an additional 289,856
      shares of Cicero common stock at a purchase price of $0.20.





Mr.
      Broderick, Chief Executive Officer and Chief Financial Officer of the Company,
      held $2,300 of Senior Reorganization Notes, which were converted into warrants
      to purchase 3,222 shares of the Cicero Inc. common stock at a purchase price
      of
      $0.20 per share, and options to purchase 12,609 shares of common stock under
      the
      Company’s stock option plan that will convert into options to purchase Cicero
      common stock.





Such
      warrants are only issuable upon approval of the recapitalization merger, and
      were automatically exercised in connection with the consummation of the
      recapitalization plan.





*Convertible
      Bridge Notes*. From July 2005 to December 2006, directors and executive
      officers made the following loans to the Company for Convertible Bridge Notes:


F-27





Mr.
      Pizi
      held $85,000 of Convertible Bridge Notes which bore interest at 10% and matured
      on September 15, 2005. These notes automatically converted into 680,000 shares
      of Cicero common stock upon approval of the recapitalization plan by
      stockholders.





Mr.
      Landis held $395,000 of Convertible Bridge Notes which bore interest at 10%
      and
      matured on various dates in 2005 and 2006. These notes automatically converted
      into 3,160,000 shares of Cicero common stock upon approval of the
      recapitalization plan by stockholders.





Mr.
      Mack
      held, together with his affiliates, $114,000 of Convertible Bridge Notes which
      bear interest at 10% and matured on various dates in 2005 and 2006. These notes
      automatically converted into 897,564 shares of Cicero common stock upon approval
      of the recapitalization plan by stockholders.





Mr.
      Miller held, together with his affiliates, $120,000 of Convertible Bridge Notes
      which bear interest at 10% and matured on various dates in 2005 and 2006. These
      notes automatically converted into 947,273 shares of Cicero common stock upon
      approval of the recapitalization plan by stockholders.





Mr.
      Bruce
      Hasenyager, a member of our Board of Directors, held $4,061 of Convertible
      Bridge Notes which bear interest at 10% and matured on September 15, 2005.
      These
      notes automatically converted into 32,485 shares of Cicero common stock upon
      approval of the recapitalization plan by stockholders.





Mr.
      Bruce
      Percelay, a member of our Board of Directors, held $130,000 of Convertible
      Bridge Notes which bear interest at 10% and matured on various dates in 2005
      and
      2006. These notes automatically converted into 1,027,273 shares of Cicero common
      stock upon approval of the recapitalization plan by stockholders.





Mr.
      John W. Atherton, a member of our Board of Directors, held $15,000 of
      convertible Bridge Notes which bear interest at 10% and matured during 2006.
      These notes automatically converted into 120,000 shares of Cicero common stock
      upon approval of the recapitalization plan by stockholders.





Mr.
      Charles Porciello, a member of our Board of Directors, held $10,000 of
      Convertible Bridge Notes which bear interest at 10% and matured during 2006.
      These notes automatically converted into 80,000 shares of Cicero common stock
      upon approval of the recapitalization plan by stockholders.





**NOTE
      15.**  **LEASE
      COMMITMENTS**





The
      Company leases certain facilities and equipment under various operating leases.
      Future minimum lease commitments on operating leases that have initial or
      remaining non-cancelable lease terms in excess of one year as of December 31,
      2006 consisted of only one lease as follows (in thousands):


Lease
              Commitments2007
            
            $
            592008
            
            
            6$
            65





Rent
      expense for the years ended December 31, 2006, 2005 and 2004 was $60,000,
      $122,000, and $197,000, respectively. As of December 31, 2006, 2005 and
      2004, the Company had no sublease arrangements.





**NOTE
      16.**  **CONTINGENCIES**





Various
      lawsuits and claims have been brought against us in the normal course of our
      business. In January 2003, an action was brought against us in the Circuit
      Court
      of Loudon County, Virginia, for a breach of a real estate lease. The case was
      settled in August 2003. Under the terms of the settlement agreement, we agreed
      to assign a note receivable with recourse equal to the unpaid portion of the
      note should the note obligor default on future payments. The unpaid balance
      of
      the note was $545,000, of which the current unpaid principal portion is
      approximately $123,000 and it matures in December 2007. At the maturity of
      the
      Note, the Company will be liable for approximately $31,000 which we have
      recognized in our non current debt.


F-28





In
      October 2003, we were served with a summons and complaint in Superior Court
      of
      North Carolina regarding unpaid invoices for services rendered by one of our
      subcontractors. The amount in dispute was approximately $200,000 and is included
      in accounts payable. Subsequent to March 31, 2004, we settled this litigation.
      Under the terms of the settlement agreement, we agreed to pay a total of
      $189,000 plus interest over a 19-month period ending November 15, 2005. The
      Company is in the process of negotiating a series of payments for the remaining
      liability of approximately $80,000.





In
      March 2004, we were served with a summons and complaint in Superior Court of
      North Carolina regarding a security deposit for a sublease in Virginia. The
      amount in dispute is approximately $247,000. In October 2004, we reached a
      settlement agreement wherein we agreed to pay $160,000 over a 36-month period
      ending October 2007.





In
      August 2004, we were notified that we were in default under an existing lease
      agreement for office facilities in Princeton, New Jersey. The amount of the
      default is approximately $65,000. Under the terms of the lease agreement, we
      may
      be liable for future rents should the space remain vacant. We have reached
      a
      settlement agreement with the landlord which calls for a total payment of
      $200,000 over a 36-month period ending October 2007.





In
      October 2005, we were notified that Critical Mass Mail, Inc. had filed a claim
      against us in the amount of $45,000 for failure to pay certain liabilities
      under
      an Asset Purchase Agreement dated January 9, 2004. We in turn filed a counter
      claim that Critical Mass Mail, Inc. failed to deliver certain assets and other
      documents under the same Asset Purchase Agreement. We had already reserved
      the
      potential liability under this action as part of the asset purchase accounting.
      In February, 2006, Critical Mass Mail amended their complaint and is seeking
      damages of approximately $600,000 for our failure to timely register the
      underlying securities issued in the Asset Purchase Agreement. In November 2006,
      we negotiated a settlement with Critical Mass Mail that provides for monthly
      payments of the amounts already accrued. In December 2006 we settled the amended
      complaint and agreed to issue $50,000 worth of the Company’s common stock. The
      Company has recorded stock compensation expense as of December 31, 2006 in
      this
      amount.





Under
      the indemnification clause of the Company’s standard reseller agreements and
      software license agreements, the Company agrees to defend the reseller/licensee
      against third party claims asserting infringement by the Company’s products of
      certain intellectual property rights, which may include patents, copyrights,
      trademarks or trade secrets, and to pay any judgments entered on such claims
      against the reseller/licensee.








**NOTE****17.** **SELECTED QUARTERLY FINANCIAL DATA
      (UNAUDITED)**


**First**
                **Quarter**
              
              **Second**
                **Quarter**
              
              **Third**
                **Quarter**
              
              **Fourth**
                **Quarter****(In
                  thousands, except per share data)**2006:Net
                  revenues
              
              $
              281
              
              $
              320
              
              $
              248
              
              $
              123Gross
                  margin/(loss)
              
              
              75
              
              
              114
              
              
              60
              
              
              (44
              )Net
                  loss
              
              
              (576
              )
              
              (515
              )
              
              (647
              )
              
              (1,259
              )Net
                  loss/share -basic and diluted
              
              $
              (1.20
              )
              $
              (1.07
              )
              $
              (1.35
              )
              $
              (0.25
              )2005:Net
                  revenues
              
              $
              153
              
              $
              461
              
              $
              84
              
              $
              87Gross
                  margin/(loss)
              
              
              (179
              )
              
              106
              
              
              (201
              )
              
              (129
              )Net
                  loss
              
              
              (1,031
              )
              
              (738
              )
              
              (943
              )
              
              (969
              )Net
                  loss/share -basic and diluted
              
              $
              (2.37
              )
              $
              (1.70
              )
              $
              (2.12
              )
              $
              (2.08
              )






**NOTE****18.** **SUBSEQUENT
      EVENTS**





In
      February 2007, the Company raised a total of $500,000 from a private sale of
      its
      common stock. Under the terms of the sale, the Company issued 3,723,008 shares
      of common stock to a consortium of investors. **** These
      securities were issued under the exemption offered by Rule 506 of Regulation
      D
      under Section 4(2) of the Securities Act of 1933.





F-29