**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, 2005.





[_]
      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





**LEVEL
      8 SYSTEMS, INC.**


(Exact
      name of registrant as specified in its character)





**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
      [ ]
      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
      [ ]
      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
      [_]





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. [ **X** ]







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  [_]    Accelerated
      filer  [_]    Non-accelerated
      filer  [ **X** ]





Aggregate
      market value of the outstanding voting stock held by non-affiliates of the
      Registrant as of June 30, 2005 was approximately $2,153,345.





There
      were 48,039,947 shares of Common Stock outstanding as of March 28, 2006.








**LEVEL
      8 SYSTEMS, INC.**





Annual
      Report on Form 10-K


For
      the
      Fiscal Year Ended December 31, 2005





Item
              Number
            
            Page
              NumberPART
                I1.
            Business
            12.
            Properties
            103.
            Legal
                Proceedings
            104.
            Submission
                of Matters to a Vote of Security Holders
            11PART
                II5.
            Market
                for Level 8 Common Stock and Related Shareholder Matters
            126.
            Selected
                Financial Data
            137.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            137A.
            Quantitative
                and Qualitative Disclosures About Market Risk
            258.
            Financial
                Statements and Supplementary Data
            259.
            Changes
                in Accountants
            259A.
            Controls
                and Procedures
            259B.
            Other
                Information
            25PART
                III10.
            Directors
                and Executive Officers of Level 8
            2611.
            Executive
                Compensation
            3012.
            Security
                Ownership of Certain Beneficial Owners and Management
            3113.
            Certain
                Relationships and Related Transactions
            3414.
            Principal
                Accountant Fees and Services
            37PART
                IV15.
            Index
                Exhibits, Financial Statement Schedules, and Reports on Form
                8-K
            39SIGNATURES
            45INDEX
                TO FINANCIAL STATEMENTS
            F-1














**PART
      I**





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





**Overview**





*Level
      8 Systems, Inc. (the “Company” or “Level 8”) is a provide* r
      of
      business integration software, known as Cicero, which enables organizations
      to
      integrate new and existing information and processes at the desktop. Our Cicero
      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, Level 8 also provides technical support, training
      and consulting services as part of its commitment to providing its customers
      with industry-leading integration solutions. Level 8’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.





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 composite interface that works the
      way
      people think.





By
      using
      Cicero software, companies can decrease their customer management costs,
      increase their customer service level 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
      of
      mission-critical applications and extend the productive life and functional
      reach of their application portfolio.





Cicero
      software is engineered to harness 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 Nationwide Financial Services, arvato services
      (a division of Bertelsmann A.G.), Science Applications International
      Corporation, IBM and N.E.W. Customer Service Companies. Since the beginning
      of
      2005, we have experienced interest from intelligence, security, law enforcement
      and other government users. The U.S. Department of Agriculture installed Cicero
      software in January 2005, and the West Windsor Township, New Jersey Police
      Department deployed Cicero software in spring 2005.





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, Small Business Email Encryption Server, and Email Encryption
      Desktop for individual use. All of the Ensuredmail products use 3-DES 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, Physicians Plus Insurance
      Company, 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.





Level
      8
      Systems, Inc. was incorporated in New York in 1988, and re-incorporated in
      Delaware in 1999. Our principal executive offices are located to 1433 State
      Highway 34, Building C, Farmingdale, New Jersey 07727 and our telephone number
      is (732) 919-3150. Our web site is located at www.level8.com.








**Strategic
      Realignment**





Historically,
      Level 8 Systems, Inc. has been a global provider of software solutions to help
      companies integrate new and existing applications as well as extends 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 hardware 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 call 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 Level 8) 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 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-implemented the Cicero software to provide increased functionality and much
      more powerful integration capabilities.





In
      April
      2001, management reassessed the methodology by which Level 8 would make
      operating decisions and allocate resources. Operating decisions and performance
      assessments were based on the following reportable segments: (1) Desktop
      Integration (Cicero), (2) System Integration (Geneva Enterprise Integrator
      and
      Geneva Business Process Automator) and (3) Messaging and Application
      Engineering (Geneva Integration Broker, Geneva Message Queuing, Geneva XIPC
      and
      Geneva AppBuilder). In connection with executing our strategic realignment
      and
      focusing on Cicero, we have restructured our business, reduced our number of
      employees and, in the fourth quarter of 2002, sold the remaining assets
      associated with Geneva Enterprise Integrator and Geneva Business Process
      Automator. We have sold most of the assets comprising the Messaging and
      Application Engineering Products segment and all of the assets in the Systems
      Integration Segment. Level 8 has recognized the Systems Integration segment
      as a
      discontinued business and accordingly, has reclassified those assets and
      liabilities on the accompanying balance sheets for 2002 and 2003 and segregated
      the results of operations under gain or loss from a discontinued business on
      the
      accompanying statement of operations. As such, the Systems Integration segment
      has been eliminated. Geneva Integration Broker is the only current software
      product represented in the Messaging and Application Engineering
      segment.


2


The
      Company’s future revenues are entirely dependent on acceptance of Cicero which
      has limited success in commercial markets to date. The Company has experienced
      negative cash flows from operations for the past three years and operating
      losses for those three years. At December 31, 2005, the Company had a working
      capital deficiency of approximately $13,894,000. 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 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
      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
      December 31, 2004, the Company completed a Note and Warrant Offering wherein
      it
      has raised a total of approximately $1,615,000, of which $67,000 was received
      in
      2005. Under the terms of the Offer, warrant holders of Level 8’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 merger plan. Those
      warrant holders who elected to convert, tendered their conversion price in
      cash
      and received a Note Payable in exchange. In early 2005, the Company announced
      an
      extension to the Note and Warrant offering of which the Company raised an
      additional $944,000, for a total of approximately $2,559,000. Upon approval
      of
      the recapitalization merger at a Shareholders meeting, these Notes would convert
      into common shares of Cicero, Inc., the surviving corporation in the merger.
      The
      Company also entered into several Convertible Bridge Notes with a consortium
      of
      investors. As of December 31, 2005, the Company had raised $1,760,000 of
      Convertible Bridge Notes of which $566,000 was from various members of the
      Company’s Board of Directors. Under the terms of these Notes, holders will
      convert their Notes into 62,490,887 shares of Cicero, Inc. common stock upon
      effectiveness of the proposed recapitalization merger.





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 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 rates of expense and assuming revenues for the next
      twelve months at an annualized rate of our revenue for the year ended 2005,
      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
      $1,900,000 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 Level 8 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 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.


3


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 tools to
      debug, view history and trace logs.







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 Windows NT, 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
      software 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 software’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


4


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 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.





*Geneva
      Integration Broker* *.* Geneva
      Integration Broker does not represent a significant portion of Level 8’s current
      business or prospects. Geneva Integration Broker is a transport independent
      message broker that enables an organization to rapidly integrate diverse
      business systems regardless of platform, transport, format or protocol. The
      key
      feature of Geneva Integration Broker is its support for XML and other standards
      for open data exchange on the Internet. The product provides a robust platform
      for building eBusiness applications that integrate with existing back-office
      systems. Geneva Integration Broker’s support for open data exchange and secure
      Internet transports is used for building Internet-based business-to-business
      solutions.





**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, telephone support and twenty-four hour, seven days
      a
      week access to support-related information via the Internet. 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.


5





**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 to provide in contact centers 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.
 
 ·  *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.
 
 More
        than
        4,000 Merrill Lynch personnel are currently using Cicero software. We licensed
        the Cicero technology from Merrill Lynch during 2000 and have enhanced it
        to
        license to contact centers and the financial services, insurance and
        telecommunications industries, as well as the intelligence, security, law
        enforcement and other governmental organizations. Our significant customers
        include Nationwide Financial Services, arvato services, a division of
        Bertelsmann A.G., Bank of America, IBM, Science Applications International
        Corporation, N.E.W. Customer Service Companies and the West Windsor Township,
        New Jersey Police Department.
 
 Bank
        of
        America, Nationwide Financial Services, and Gateway Electronic Medical
        Management Systems (GEMMS) each accounted for more than ten percent (10%)
        of our
        operating revenues in 2003. In 2004, Bank of America, Convergys, IBM, Nationwide
        Financial Services and SAIC each accounted for more than ten percent (10%)
        of
        our operating revenue. In 2005, NEW Customer Service Companies and Innovative
        System Solutions Corporation accounted for more than ten percent (10%) of
        our
        operating revenue.




**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 OEM relationships. We provide training and
      other support necessary to systems integrators and OEMs to aid in the promotion
      of our products. To date we have entered into strategic partnerships with the
      following OEMs, for integrated business solutions: Science Applications
      International Corporation, ThinkCentric, Hewlett Packard, House of Code and
      Titan Systems Corporation. In addition, we have entered into strategic
      partnerships with Silent Systems, Inc., ADPI LLC, arvato services, a division
      of
      Bertelsmann A.G, GEMMS, Genesis Technology Group Inc., Plan B Technologies
      Inc.,
      Pilar Services, Inc., and Gini Corporation. These organizations have
      relationships with existing customers and 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.


6


***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 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.








**Research
      and Product Development**




In
      connection with the narrowing of our strategic focus, and in light of the sale
      of our Systems Integration products, 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 $891,000, $1,111,000
      and $1,017,000 in 2005, 2004, and 2003, respectively. The decrease in costs
      in
      2005 reflects the reduction in headcount by two employees, plus associated
      overheads. The increase in research and development costs in 2004 as compared
      with 2003 is attributable to an allocation of certain costs primarily from
      General and Administrative costs.





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.




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.




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.


7





**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 Portal
                  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
                  Level 8’s technology. Siebel is a representative product in the CRM
                  software category.
 
 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.
 
 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.


**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


8


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
      “Level 8 Systems”, “Cicero”, “Ensuredmail”, and the trademarks “Level 8”, “Level
      8 Technologies”, and “Geneva Integration Broker”.





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.




There
      can
      be no assurance that the steps we have taken will prevent misappropriation
      of
      our technology, and such protections do not preclude competitors from developing
      products with functionality or features similar to our products. Furthermore,
      there can be no assurance that third parties will not independently develop
      competing technologies that are substantially equivalent or superior to our
      technologies. Additionally, with respect to the Cicero line of software
      products, there can be no assurance that Merrill Lynch will protect its patents
      or that we will have the resources to successfully pursue infringers.




Although
      we do not believe that our products infringe the proprietary rights of any
      third
      parties, there can be no assurance that infringement claims will not be asserted
      against our customers or us in the future. In addition, we may be required
      to
      indemnify our distribution partners and end users for similar claims made
      against them. Furthermore, we may initiate claims or litigation against third
      parties for infringement of our proprietary rights or to establish the validity
      of our proprietary rights. Litigation, either as a plaintiff or defendant,
      would
      cause us to incur substantial costs and divert management resources from
      productive tasks whether or not said litigation is resolved in our favor, which
      could have a material adverse effect on our business operating results and
      financial condition.





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.





**Employees**




As
      of
      December 31, 2005, we employed 20 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 Windows NT, 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.level8.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 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


9


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
      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 business is subject to a number of risks
      associated with doing business abroad including the effect of foreign currency
      exchange fluctuations on our results of operations; 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 its 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.





**Market
      Risk**





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.








**Item
      2.**  **Properties**





Our
      corporate headquarters are located in approximately 1,300 square feet of office
      space in Farmingdale, New Jersey, pursuant to a twelve-month sublease from
      one
      of our resellers that expired in August, 2005. We are continuing to occupy
      such
      premises on a month-to-month basis. 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 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 $247,000 and it matures in December 2007. We assessed the
      probability of liability under the recourse provisions using a weighted
      probability cash flow analysis and have recognized a long-term liability in
      the
      amount of $131,000.





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 24-month period ending
      October 2006.





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
      20-month period ending July 2006.


10


In
      April
      2005, we were notified that Critical Mass Mail, Inc. had filed a claim against
      us for failure to pay certain liabilities under an Asset Purchase Agreement
      dated January 9, 2004. We in turn filed 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 the Agreement
      as part of the asset purchase accounting. On March 1, 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. We believe that the probability of an unfavorable outcome is remote
      and accordingly, we have not reserved for this contingency.





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.








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





None.







11





**PART
      II**





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





Our
      common stock has 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. 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 for common stock in the foreseeable
      future. The chart below sets forth the high and low stock prices for the
      quarters of the fiscal years ended December 31, 2005 and 2004.





**2005**
            
            **2004****Quarter**
            
            
            **High**
            
            
            **Low**
            
            
            **High**
            
            
            **Low**First
            
            $
            0.16
            
            $
            0.07
            
            $
            0.45
            
            $
            0.35Second
            
            $
            0.09
            
            $
            0.04
            
            $
            0.39
            
            $
            0.12Third
            
            $
            0.05
            
            $
            0.02
            
            $
            0.17
            
            $
            0.09Fourth
            
            $
            0.05
            
            $
            0.01
            
            $
            0.14
            
            $
            0.05





The
      closing price of the common stock on December 31, 2005 was $0.02 per share.
      As
      of March 13, 2006 we had 205 registered shareholders of record.





**Recent
      Sales of Unregistered Securities**





In
      2004,
      the Company announced a Note and Warrant Offering in which warrant holders
      of
      Level 8’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
      merger plan. **** The
      senior secured notes issued in the aggregate principal amount of $2,559,000
      to
      holders of warrants of Level 8 who loaned to Level 8 the exercise price of
      their
      warrants and other investors who lent funds to Level 8 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
      Level 8, 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 Level 8 will issue Additional Warrants to
      Senior Reorganization Noteholders in connection with their loans to Level 8,
      such warrants exercisable at $0.002 per share in the event of the consummation
      of the merger agreement, these warrants will automatically be deemed
      exercised, by applying the accrued interest on their Senior Reorganization
      Notes
      and by cashless exercise to the extent of the balance of the exercise price,
      upon the consummation of the recapitalization merger. The shares issuable upon
      exercise of the Additional Warrants will convert into an aggregate of 19,360,959
      shares of Cicero common stock in the recapitalization merger (less the number
      of
      shares to be applied to the cashless exercise).





Senior
      Reorganization Noteholders who loaned Level 8 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 Level 8 (“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 merger exchange ratio) of
      $0.10
      per share, as part of the recapitalization merger. In the recapitalization
      merger, Early Adopter Warrants will convert into warrants of Cicero for an
      aggregate of 1,005,562 shares of Cicero, and the exercise price increased to
      $2.00 per share.





These
      securities were issued under the exemption offered by Rule 506 of Regulation
      D
      under Section 4(2) of the Securities Act of 1933.





In
      2005,
      the Company entered into several Convertible Bridge Notes with a consortium
      of
      investors. These notes bear interest at 10% and mature at various dates
      beginning on September 15, 2005. The Notes are convertible into shares of
      Cicero, Inc. common stock upon effectiveness of the proposed recapitalization
      merger at a conversion rate of $0.025. As of December 31, 2005, the Company
      has
      raised $1,760,000 of Convertible Bridge Notes of


12


which
      $566,000 was from various members of the Company’s Board of Directors. If the
      merger proposal is not approved, the Notes will immediately become due and
      payable. These securities were issued under the exemption offered by Rule 506
      of
      Regulation D of the Securities Act of 1933.





The
      Company has not repurchased any shares of its stock.





**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).





**Year
                Ended December 31,**
              **(in
                thousands, except per share data)****2001**
            
            **2002**
            
            **2003**
            
            **2004**
            
            **2005**SELECTED
                STATEMENT OF OPERATIONS DATARevenue
            
            $
            17,357
            
            $
            3,101
            
            $
            530
            
            $
            775
            
            $
            785Loss
                from continuing operations
            
            $
            (58,060
            )
            $
            (13,142
            )
            $
            (9,874
            )
            $
            (9,731
            )
            $
            (3,681
            )Loss
                from continuing operations per common share - basic and
                diluted
            
            $
            (3.70
            )
            $
            (0.75
            )
            $
            (0.54
            )
            $
            (0.28
            )
            $
            (0.08
            )Weighted
                average common and common equivalent shares outstanding- basic and
                diluted
            
            
            15,958
            
            
            18,877
            
            
            21,463
            
            
            35,982
            
            
            44,502











**At
                December 31,**
              **(in
                thousands)****2001**
            
            **2002**
            
            **2003**
            
            **2004**
            
            **2005**SELECTED
                BALANCE SHEET DATAWorking
                capital (deficiency)
            
            $
            (4,529
            )
            $
            (6,254
            )
            $
            (6,555
            )
            $
            (10,255
            )
            $
            (13,894
            )Total
                assets
            
            
            35,744
            
            
            11,852
            
            
            5,362
            
            
            530
            
            
            241Long-term
                debt, including current maturities
            
            
            4,845
            
            
            2,893
            
            
            2,756
            
            
            5,444
            
            
            7,931Senior
                convertible redeemable preferred stock
            
            
            --
            
            
            --
            
            
            3,355
            
            
            1,367
            
            
            1,061Stockholders'
                equity (deficiency)
            
            
            13,893
            
            
            1,653
            
            
            (6,103
            )
            
            (11,857
            )
            
            (15,076
            )








**Item
      7.**    **Management's
      Discussion and Analysis of Financial Condition and Results of Operations,
      (dollars in thousands, except share and per share amounts)** .





**General
      Information**





Level
      8
      Systems 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, Level 8 also provides technical support, training
      and consulting services as part of its commitment to providing its customers
      industry-leading integration solutions. Level 8’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. Level 8 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.''


13





**Business
      Strategy**





Management
      makes operating decisions and assesses performance of Level 8’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
      products that comprise the Messaging and Application Engineering segment are
      Geneva Integration Broker and Ensuredmail. Geneva Integration Broker is a
      transport independent message broker that enables an organization to rapidly
      integrate diverse business systems regardless of platform, transport, format
      or
      protocol. Ensuredmail is an encrypted email technology that can reside on either
      the server or the desktop.





**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 our three categories of revenue.





**Year
                Ended December 31,****2005**
            
            **2004**
            
            **2003**Revenue:Software
            
            
            51.9
            %
            
            30.8
            %
            
            19.3
            %Maintenance
            
            
            18.7
            %
            
            39.5
            %
            
            59.6
            %Services
            
            
            29.4
            %
            
            29.7
            %
            
            21.1
            %Total
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Cost
                of revenue:Software
            
            
            2.0
            %
            
            577.8
            %
            
            783.4
            %Maintenance
            
            
            44.6
            %
            
            49.3
            %
            
            70.4
            %Services
            
            
            104.7
            %
            
            131.0
            %
            
            171.3
            %Total
            
            
            151.3
            %
            
            758.1
            %
            
            1,025.1
            %Gross
                margin (loss)
            
            
            (51.3
            )%
            
            (658.1
            )%
            
            (925.1
            )%Operating
                expenses:Sales
                and marketing
            
            
            79.9
            %
            
            140.4
            %
            
            317.0
            %Research
                and product development
            
            
            113.5
            %
            
            143.3
            %
            
            191.9
            %General
                and administrative
            
            
            144.8
            %
            
            196.4
            %
            
            482.6
            %Impairment
                of intangible assets
            
            
            0.0
            %
            
            75.7
            %
            
            0.0
            %(Gain)/loss
                on disposal of assets
            
            
            0.0
            %
            
            (0.6
            )%
            
            78.3
            %Restructuring,
                net
            
            
            0.0
            %
            
            0.0
            %
            
            (157.4
            )%Total
            
            
            338.2
            %
            
            555.2
            %
            
            912.4
            %Loss
                from operations
            
            
            (389.5
            )%
            
            (1,213.3
            )%
            
            (1,837.5
            )%Other
                income (expense), net
            
            
            (79.4
            )%
            
            (42.3
            )%
            
            (25.5
            )%Loss
                before taxes
            
            
            (468.9
            )%
            
            (1,255.6
            )%
            
            (1,863.0
            )%Income
                tax provision (benefit)
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %Loss
                from continuing operations
            
            
            (468.9
            )%
            
            (1,255.6
            )%
            
            (1,863.0
            )%Loss
                from discontinued operations
            
            
            0.0
            %
            
            (3.9
            )%
            
            (24.9
            )%Net
                loss
            
            
            (468.9
            )%
            
            (1,259.5
            )%
            
            (1,887.9
            )%





14





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:





**2005**
            
            **2004**
            
            **2003**United
                States
            
            
            100
            %
            
            98
            %
            
            90
            %Europe
            
            
            --
            
            
            2
            %
            
            9
            %Other
            
            
            --
            
            
            --
            
            
            1
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %





The
      table
      below present’s information about reported segments for the twelve months ended
      December 31, 2005, 2004, and 2003 (in thousands):








**For
                the year ended December 31,****2005**
            
            **2004**
            
            **2003**Desktop
                Integration
            
            
            Messaging
                and Application Engineering
            
            
            Total
            
            
            Desktop
                Integration
            
            
            Messaging
                and Application Engineering
            
            
            Total
            
            
            Desktop
                Integration
            
            
            Messaging
                and Application Engineering
            
            
            TotalTotal
                revenue
            
            $
            760
            
            $
            25
            
            $
            785
            
            $
            707
            
            $
            68
            
            $
            775
            
            $
            466
            
            $
            64
            
            $
            530Total
                cost of revenue
            
            
            1,188
            
            
            --
            
            
            1,188
            
            
            5,662
            
            
            213
            
            
            5,875
            
            
            5,371
            
            
            62
            
            
            5,433Gross
                margin (loss)
            
            
            (428
            )
            
            25
            
            
            (403
            )
            
            (4,955
            )
            
            (145
            )
            
            (5,100
            )
            
            (4,905
            )
            
            2
            
            
            (4,903
            )Total
                operating expenses
            
            
            2,536
            
            
            119
            
            
            2,655
            
            
            3,348
            
            
            373
            
            
            3,721
            
            
            4,999
            
            
            256
            
            
            5,255Segment
                profitability (loss)
            
            $
            (2,964
            )
            $
            (94
            )
            $
            (3,058
            )
            $
            (8,303
            )
            
            (518
            )
            
            (8,821
            )
            $
            (9,904
            )
            $
            (254
            )
            $
            (10,158
            )








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





**2005**
            
            **2004**
            
            **2003**Segment
                operating expenses
            
            $
            2,655
            
            $
            3,721
            
            $
            5,255Write-off
                of intangible assets
            
            
            --
            
            
            587
            
            
            --(Gain)Loss
                on disposal of assets
            
            
            --
            
            
            (5
            )
            
            415Restructuring,
                net
            
            
            --
            
            
            --
            
            
            (834
            )Total
                operating expenses
            
            $
            2,655
            
            $
            4,303
            
            $
            4,836





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





**2005**
            
            **2004**
            
            **2003**Total
                segment profitability (loss)
            
            $
            (3,058
            )
            $
            (8,821
            )
            $
            (10,158
            )Write-off
                of intangible assets
            
            
            --
            
            
            (587
            )
            
            --Gain/(loss)
                on disposal of assets
            
            
            --
            
            
            5
            
            
            (415
            )Restructuring
            
            
            --
            
            
            --
            
            
            834Interest
                and other income/(expense), net
            
            
            (623
            )
            
            (328
            )
            
            (135
            )Net
                loss before provision for income taxes
            
            $
            (3,681
            )
            $
            (9,731
            )
            $
            (9,874
            )








**Years
      Ended December 31, 2005, 2004, and 2003**





*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


15


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.





Total
      revenues increased slightly, or 1% from $775,000 in 2004 to $785,000 in 2005.
      Revenues increased 46% from $530,000 in 2003 to $775,000 in 2004. During 2003,
      2004, and 2005 the Company was unable to secure significant large scale
      contracts but did secure several smaller installations from several different
      companies. Gross profit margin (loss) was (51)%, (658)%, and (925)% for 2005,
      2004, and 2003, respectively.





The
      Desktop Integration segment had a gross margin (loss) of (56)% for the year
      ended December 31, 2005, (701)% for the year ended December 31, 2004 and a
      gross
      margin (loss) of (1,053)% for the year ended December 31, 2003. At each balance
      sheet date, the Company reassesses the recoverability of the Cicero technology
      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 continued operating losses and the
      limited software revenue generated by the Cicero technology over the prior
      periods. The Company had been in negotiations with numerous 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 reduced its cash flow projections. Historical cash flows
      generated by the Cicero technology 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,
      September 30, 2003 and at December 31, 2003. These charges, in the amount of
      $2,844,000, $745,000 and $248,000 respectively, have been recorded as cost
      of
      software revenue.





The
      Messaging and Application Engineering segment gross margin for the year ended
      December 31, 2005 was 100%, and the gross margin (loss) was (213%) for the
      year
      ended December 31, 2004. For the year ended December 31, 2003, the Messaging
      and
      Application Engineering segment had a gross margin 3%. 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. 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. 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 increased approximately 70% in 2005 from those results
      achieved in 2004 and increased 134% in 2004 as compared to 2003. The increase
      in
      software revenues in 2005 and 2004 is attributed to the successful deployment
      of
      a few small integration engagements, which were non-existent in 2003.





The
      gross
      margin (loss) on software products was 96%, (1,773)%, and (3,971)% for the
      2005,
      2004 and 2003 years ended, respectively. 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 Level 8 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


16


amended
      to extend Level 8’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 Level 8) and to grant ownership
      rights in the Cicero trademark. Level 8 is indemnified by Merrill Lynch with
      regard to the rights granted to Level 8 by them. It is a condition to
      consummation of the recapitalization merger that the license agreement be
      amended so that the recapitalization merger would not give rise to a right
      of
      Merrill Lynch to terminate the license. Consideration for the original Cicero
      license consisted of 1,000,000 shares of Level 8 common stock. In exchange
      for
      the amendment, Level 8 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, Level 8 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%
      in 2005, (1,950)% in 2004, and (3,971)% in 2003. The software product gross
      margin (loss) on the Messaging and Application Engineering segment was 100%
      for
      2005, (587)% for 2004, and 0 for 2003.





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, 2005 **** decreased
      by approximately 52% or $159,000 from 2004. The decline in maintenance revenues
      in 2005 as compared to 2004 is primarily due to the non-renewal of one
      maintenance contract for the Cicero product within the Desktop Integration
      segment. Maintenance revenues for the year ended December 31, 2004 **** decreased
      by approximately 3% or $10,000 from 2003. The decline in maintenance revenues
      in
      2004 as compared to 2003 is the result of one maintenance contract not being
      renewed.





The
      Desktop Integration segment accounted for approximately 88% of total maintenance
      revenue and the Messaging and Application Engineering segment accounted for
      approximately 12% of total maintenance revenues in 2005.





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 (138)% for 2005. Gross margin (loss) on maintenance products for 2004 and
      2003 were (25)% and (18)% 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, 2005 were approximately the same as
      in
      2004. Services revenue for the year ended December 31, 2004 increased by
      approximately 105% or $118,000 over the same period in 2003. The increase in
      service revenues as compared to 2003 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 (256)%, (341)%, and (711)% for
      the
      years ended 2005, 2004 and 2003, 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 42% or
      approximately $461,000 in 2005 and decreased by 35% or approximately $592,000
      in
      2004 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. ****


17


Sales
      and
      marketing expenses are expected to increase slightly 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 20% or $220,000 in 2005 as compared to 2004.
      The decrease in costs in 2005 reflects the reduction in headcount by two
      employees, plus associated overheads. Research and development expense increased
      by 9% or $94,000 in 2004 as compared to 2003. The increase in research and
      development spending is attributable to an allocation of certain costs primarily
      from general and administrative costs.





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, IT and administrative staff, related overhead,
      and
      all non-allocable corporate costs of operating the Company. General and
      administrative expenses for the year ended December 31, 2005 decreased by 25%
      or
      $385,000 over the prior year. In fiscal 2004, general and administrative
      expenses decreased by 41% or $1,036,000 as compared to 2003. The sharp decline
      in general and administrative costs in 2005 and 2004 reflects the general
      downsizing conducted by the Company in both years.





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, 2005 and 2003, and $587,000
      for the year ended December 31, 2004. During 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.
      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,
      2005, 2004 and 2003, there was no remaining goodwill on the Company’s balance
      sheet.





**Restructuring.** As
      of
      December 31, 2002, the Company’s accrual for restructuring was $772,000, which
      was primarily comprised of excess facility costs. As more fully discussed in
      Note 21 Contingencies, in 2003 the Company settled litigation relating to these
      excess facilities. Accordingly, the Company has reversed the restructuring
      balance. Under the terms of the settlement agreement, the Company agreed to
      assign the note receivable from the sale of Geneva to EM Software Solutions,
      Inc., with recourse equal to the unpaid portion of the note receivable should
      the note obligor, EM Software Solutions, Inc., default on future payments.
      The
      current unpaid principal portion of the note receivable assigned is
      approximately $247,000 and matures in December 2007. The Company assessed the
      probability of liability under the recourse provisions using a probability
      weighted cash flow analysis and has recognized a long-term liability in the
      amount of $131,000.





**Warrants
      Liability.** The
      Company has 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 is accounted for as a liability and is re-measured at each balance
      sheet date. As of December 31, 2005, the warrant liability had a fair value
      of
      $0 and the Company had recorded the change in the fair value of the warrant
      liability of $198,000 for the year ended December 31, 2004 in the consolidated
      statements of operations.





**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 2005, 2004 or 2003. 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.


18





**Liquidity
      and Capital Resources**





***Operating
      and Investing Activities***





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 its amount owing its creditors. The Company had a
      decrease of $29,000 in assets and liabilities of discontinued operations, a
      decrease in $12,000 for credit of 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.





By
      comparison, the Company generated cash of $88,000 for the year ended December
      31, 2004.





Operating
      activities utilized approximately $3,365,000 in cash, which was primarily
      comprised of the loss from operations of $9,761,000, offset by non-cash charges
      for depreciation and amortization of approximately $4,287,000, an impairment
      of
      intangible assets of $587,000, stock compensation expense of $635,000, offset
      by
      a non-cash decrease in the fair value of its warrant liability of $198,000.
      In
      addition, the Company utilized cash through an increase in accounts receivable
      of $143,000 as well as through a reduction of prepaid expenses and other assets
      of $216,000 and generated approximately $884,000 in cash through an increase
      in
      its amount owing its creditors, and an increase in assets and liabilities of
      discontinued operations of $86,000.





The
      Company generated approximately $3,455,000 of cash during the year from
      financing activities as a result of proceeds from a private placement of common
      stock and warrants in the amount of $1,250,000 and cash proceeds from warrant
      exercises of $112,000. In addition, the Company generated approximately
      $1,483,000 as a result of its Note and Warrant Offering which expired on
      December 31, 2004. In addition, the Company incurred gross borrowings of
      $1,057,000 and repaid $447,000 against those borrowings.





***Financing
      Activities***





The
      Company funded its cash needs during the year ended December 31, 2005 with
      cash
      on hand from December 31, 2004, through the use of proceeds from borrowings
      under convertible debt agreements as well as the proceeds from a Note and
      Warrant Offering.





The
      Company has a $1,971,000 term loan bearing interest at LIBOR plus 1.5%
      (approximately 5.26% at December 31, 2005), 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. During 2000, the loan and
      guaranty were amended to extend the due date from May 31, 2001 to November
      30,
      2003 and to provide the Company with additional borrowings. In exchange for
      the
      initial and amended guarantees, the Company issued Liraz a total of 170,000
      shares of the Company’s common stock. Based upon fair market value at the time
      of issuance, the Company recorded total deferred costs of $4,013,000 related
      to
      the guaranty. These costs were amortized in the statement of operations as
      a
      component of interest expense over the term of the guaranty. In November 2003,
      the Company and Liraz Systems Ltd. agreed to extend its guaranty on the
      Company’s term loan and with Bank Hapoalim, the note holder, to extend the
      maturity date on the loan to November 8, 2004. Under the terms of the agreement
      with Liraz, the Company agreed to issue 300,000 shares of its common stock.
      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


19


$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 recapitalization merger see
      Note 13), the Company has not recognized any value to these warrants until
      the
      contingency is removed.




In
      2004,
      the Company announced a Note and Warrant Offering in which warrant holders
      of
      Level 8’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
      merger plan. Under the terms of the Offer, which expired on December 31, 2004,
      warrant holders who elect 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 recapitalization merger at a
      Shareholders meeting, these Notes would convert into common shares of Cicero,
      Inc., the surviving corporation in the merger. 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 $0.10 per share. In addition, upon approval of the
      recapitalization merger, 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.





From
      July
      through December 2005, the Company entered into several Convertible Bridge
      Notes
      with a consortium of investors. As of December 31, 2005, the Company had raised
      $1,760,000 of Convertible Bridge Notes of which $566,000 was from various
      members of the Company’s Board of Directors. Under the terms of these Notes,
      holders will convert their Notes into 62,490,887 shares of Cicero, Inc. common
      stock upon effectiveness of the proposed recapitalization merger. If the merger
      proposal is not approved, the Notes will immediately become due and
      payable.





The
      Company believes that the recapitalization merger 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 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 2005, 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 $1.9 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 Level 8 be unable to continue as
      a
      going concern.





In
      April
      2005, the Company borrowed $30,000 from a member of the Company’s Board of
      Directors 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 note holder into 428,571 shares of our common stock at a
      conversion price of $0.07 per share.





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.





On
      March
      19, 2003, the Company completed a $3.5 million private placement of Series
      D
      Convertible Redeemable Preferred Stock (“Series D Preferred Stock”), convertible
      at a conversion ratio of $0.32 per share of common stock into an aggregate
      of
      11,031,250 shares of common stock. As part of the financing, the Company has
      also issued warrants to purchase an aggregate of 4,158,780 shares of common
      stock at an exercise price of $0.07 per share (“Series D-1 Warrants”). On
      October 10, 2003, the Company, consistent with its obligations, also issued
      warrants to purchase an aggregate of 1,665,720 shares of common stock at an
      exercise price the lesser of $0.20 per share or market price at the time of
      exercise (“Series D-2 Warrants”). The Series D-2 Warrants became exercisable on
      November 1, 2003, because the Company failed to report $6 million in gross
      revenues for the nine-month period ended September 30, 2003. Both existing
      and
      new investors participated in the financing. The Company also agreed to register
      the common stock issuable upon conversion of the Series D Preferred Stock and
      exercise of the warrants for resale under the Securities Act of 1933, as
      amended. Under the terms of the financing agreement, a redemption


20


event
      may
      occur if any one person, entity or group shall control more than 35% of the
      voting power of the Company’s capital stock. The Company allocated the proceeds
      received from the sale of the Series D Preferred Stock and warrants to the
      preferred stock and detachable warrants on a relative fair value basis,
      resulting in the allocation of $2,890,000 to the Series D Preferred Stock and
      $640,000 to the detachable warrants. Based upon the allocation of the proceeds,
      the Company determined that the effective conversion price of the Series D
      Preferred Stock was less than the fair value of the Company’s common stock on
      the date of issuance. The beneficial conversion feature was recorded as a
      discount on the value of the Series D Preferred Stock and an increase in
      additional paid-in capital. Because the Series D Preferred Stock was convertible
      immediately upon issuance, the Company fully amortized such beneficial
      conversion feature on the date of issuance.





As
      part
      of the financing, the Company and the lead investors agreed to form a joint
      venture to exploit the Cicero technology in the Asian market. The terms of
      the
      agreement required that the Company deposit $1 million of the gross proceeds
      from the financing into escrow to fund the joint venture. The escrow agreement
      allowed for the immediate release of funds to cover organizational costs of
      the
      joint venture. During the quarter ended March 31, 2003, $225,000 of escrowed
      funds was released. Since the joint venture was not formed and operational
      on or
      by July 17, 2003, the lead investors had the right, but not the obligation,
      to
      require the Company to purchase $1 million in liquidation value of the Series
      D
      Preferred Stock at a 5% per annum premium, less their pro-rata share of
      expenses. On October 21, 2004, the Company received notification from the lead
      investors of their intent to redeem the escrow balance and surrender the
      equivalent amount of Series D preferred shares. This redemption was completed
      in
      November 2004.





Another
      condition of the financing required the Company to place an additional $1
      million of the gross proceeds into escrow, pending the execution of a definitive
      agreement with Merrill Lynch providing for the sale of all right, title and
      interest to the Cicero technology. Since a transaction with Merrill Lynch for
      the sale of Cicero was not consummated by May 18, 2003, the lead investors
      had
      the right, but not the obligation, to require the Company to purchase $1 million
      in liquidation value of the Series D Preferred Stock at a 5% per annum premium.
      In addition, the Company and the lead investor agreed to extend the escrow
      release provisions until the end of July 2003 when all remaining escrow monies
      were released to the Company.





In
      connection with the sale of Series D Preferred Stock, the holders of the
      Company’s Series A3 Preferred Stock and Series B3 Preferred Stock (collectively,
      the “Existing Preferred Stockholders”), entered into an agreement whereby the
      Existing Preferred Stockholders have agreed to waive certain applicable price
      protection anti-dilution provisions. Under the terms of the waiver agreement,
      the Company is also permitted to issue equity securities representing aggregate
      proceeds of up to an additional $4.9 million following the sale of the Series
      D
      Preferred Stock. Additionally, the Existing Preferred Stockholders have also
      agreed to a limited lock-up restricting their ability to sell common stock
      issuable upon conversion of their preferred stock and warrants and to waive
      the
      accrual of any dividends that may otherwise be payable as a result of the
      Company’s delisting from Nasdaq. As consideration for the waiver agreement, the
      Company has agreed to issue on a pro rata basis up to 1,000,000 warrants to
      all
      the Existing Preferred Stockholders on a pro rata basis at such time and from
      time to time as the Company closes financing transactions that represent
      proceeds in excess of $2.9 million, excluding the proceeds from the Series
      D
      Preferred Stock transaction and any investments made by a strategic investor
      in
      the software business. Such warrants will have an exercise price that is the
      greater of $0.40 or the same exercise price as the exercise price of the
      warrant, or equity security, that the Company issues in connection with the
      Company’s financing or loan transaction that exceeds the $2.9 million
      threshold.





In
      October 2003, the Company completed a common stock financing round wherein
      it
      raised $853,000 of capital. The offering closed on October 15, 2003. The Company
      sold 1,894,444 shares of common stock at a price of $0.45 per share for a total
      of $853,000 in proceeds and issued warrants to purchase 473,611 shares of the
      Company’s common stock at an exercise price of $0.45. The warrants expire three
      years from the date of grant. As part of an agreement with Liraz Systems Ltd,
      the guarantor of the Company’s term loan, the Company used $200,000 of the
      proceeds to reduce the principal outstanding on the term loan to
      $1,971,000.





The
      Company incurred loss of approximately $3,681,000 for the year ended December
      31, 2005 in addition to losses from continuing operations of approximately
      $19,605,000 for the previous two fiscal years. The Company has experienced
      negative cash flows from operations for the past three years. At December 31,
      2005, the Company had a working capital deficiency of approximately $13,894,000.
      The Company’s future revenues are entirely dependent on acceptance of Cicero,
      which has 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 who
      have
      demonstrated interest in the Cicero software technology.  The
      Company is experiencing difficulty increasing sales revenue largely because
      of
      the unique nature of the product as well as customer concerns about


21


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, 2005 are as follows (in thousands):





**2006**
            
            **2007**
            
            **2008**
            
            **2009**
            
            **Total**Short
                and long-term debt, including interest payments
            
            $
            8,390
            
            $
            131
            
            $
            --
            
            $
            --
            
            $
            8,521Service
                purchase commitments
            
            
            300
            
            
            --
            
            
            --
            
            
            --
            
            
            300Operating
                leases
            
            
            56
            
            
            56
            
            
            --
            
            
            --
            
            
            112Total
            
            $
            8,746
            
            $
            187
            
            $
            --
            
            $
            --
            
            $
            8,933





Short
      and
      long-term debt, including interest payments includes approximately $992,000
      of
      convertible notes and $2,559,000 of short term debt related to the Note and
      Warrant Offering and $1,760,000 of Convertible Bridge Notes. Upon approval
      of
      the recapitalization merger, these amounts will convert into equity in the
      surviving company.





Under
      the
      employment agreement between the Company and Mr. Pizi effective January 1,
      2005,
      the Company is to pay Mr. Pizi an annual base salary of $200,000, and a
      performance bonus in cash of up to $400,000 per annum based upon certain revenue
      goals, as determined by the Compensation Committee of the Board of Directors
      of
      the Company, in its discretion. In August 2005, Mr. Pizi voluntarily reduced
      his
      annual salary to $150,000 for the year. 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 base salary within thirty
      (30) days of termination, (b) all then outstanding but unvested stock options
      shall vest one hundred percent (100%), and (c) two hundred thousand (200,000)
      shares of the Company's common stock.





Under
      the
      employment agreement between the Company and Mr. Broderick effective January
      1,
      2005, the Company pays Mr. Broderick a base salary of $200,000 and a performance
      bonus of cash up to 50% of Mr. Broderick’s base salary. In August 2005, Mr.
      Broderick voluntarily reduced his annual salary to $150,000 for the year. Upon
      termination of Mr. Broderick's employment by the Company without cause, the
      Company has agreed to provide Mr. Broderick with salary continuation of six
      months of Mr. Broderick's then base salary beginning on the first payday after
      the date of termination.





**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.


22


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 collect ability 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.





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,
      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, 2005, we had a valuation allowance of $96,454,000
      against $96,454,000 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.




23


At
      December 31, 2005, the Company has net operating loss carryforwards of
      approximately $230,926,000, 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.





**Restructuring
      Reserves.** At
      December 31, 2002, the Company’s restructuring liabilities totaled $772,000
      which represented estimated excess facilities costs. In August 2003, the Company
      settled litigation relating to these excess facilities. Accordingly, the Company
      has reversed the restructuring balance. Under the terms of the settlement
      agreement, the Company agreed to assign the note receivable from the sale of
      Geneva to EM Software Solutions, Inc., with recourse equal to the unpaid portion
      of the note receivable should the note obligor, EM Software Solutions, Inc.,
      default on future payments. The current unpaid principal portion of the note
      receivable at assignment is approximately $247,000 and matures December 2007.
      The Company assessed the probability of liability under the recourse provisions
      using a probability weighted cash flow analysis and has recognized a long-term
      liability in the amount of $131,000.





**Recent
      Accounting Pronouncements:**





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 will be 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 has not yet determined which fair-value method and transitional
      provision it will follow.  However, the Company expects that the adoption
      of SFAS 123R will have a significant impact on its results of operations. 
The Company does not expect the adoption of SFAS 123R will impact its overall
      financial position.  See Stock-Based Compensation in Note 1 for the pro
      forma impact on net income and net income per share from calculating stock-based
      compensation costs under the fair value alternative of SFAS 123.  However,
      the calculation of compensation cost for share-based payment transactions after
      the effective date of SFAS 123R may be different from the calculation of
      compensation cost under SFAS 123, but such differences have not yet been
      quantified.





In
      January 2003, the FASB issued Interpretation No. 46 or FIN 46 “Consolidation of
      Variable Interest Entities”, an interpretation of Accounting Research Bulletin
      No. 51, “Consolidated Financial Statements”. In
      October 2003, the FASB issued FASB Staff Position FIN 46-6, “Effective Date of
      FASB Interpretation No. 46, Consolidation of Variable Interest Entities”
deferring the effective date for applying the provisions of FIN 46 for public
      entities’ interests in variable interest entities or
      potential variable interest entities created before February 1, 2003 for
      financial statements of interim or annual periods that end after December 15,
      2003. **** FIN
      46
      establishes accounting guidance for consolidation of variable interest entities
      that function to support the activities of the primary beneficiary. In
      December 2003, the FASB issued FIN 46 (revised December 2003), “Consolidation of
      Variable Interest Entities.” This revised interpretation is effective for all
      entities no later than the end of the first reporting period that ends after
      March 15, 2004. The
      Company has no investment in or contractual relationship or other business
      relationship with a variable interest entity and therefore the adoption of
      this
      interpretation did not have any impact on its consolidated financial position
      or
      results of operations. However, if the Company enters into any such arrangement
      with a variable interest entity in the future or an entity with which we have
      a
      relationship is reconsidered based on guidance in FIN 46 to be a variable
      interest entity, the Company’s consolidated financial position or results of
      operations might be materially impacted.





In
      May
      2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial
      Instruments with Characteristics of Both Liabilities and Equity”. SFAS No. 150
      establishes standards for how an issuer classifies and measures certain
      financial instruments with characteristics of both liabilities and equity.
      It
      requires that an issuer classify a financial instrument that is within its
      scope
      as a liability (or an asset in some circumstances). Many of those instruments
      were previously classified as equity. Some of the provisions of this Statement
      are consistent with the current definition of liabilities in FASB Concepts
      Statement No. 6, “Elements of Financial Statements”. The adoption of this
      statement did not have a material impact on the Company’s results of operations
      and financial **** condition.


24





**Item
      7a.**  **Quantitative
      and Qualitative Disclosures about Market Risk**





As
      the
      Company has sold most of its European based business and has closed several
      European sales offices, 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.








**Item
      9.**  **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.








**Item
      9A.**  **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 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
      March
      10, 2005, Level 8 Systems reported 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 reported the resignation of Mr. Ralph Martino as Chairman
      of the Board of Directors.





On
      June
      6, 2005 the Company reported the election of Mr. Charles B. Porciello to the
      Board of Directors.





On
      July
      27, 2005, the Company reported the resignations of Nicholas Hatalski and Kenneth
      Nielsen as members of the Board of Directors and the appointments of Mark
      Landis, Bruce Miller, Fredric Mack and John Broderick as members to the
      Company’s Board of Directors.


25








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.


26


**PART
      III**





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





As
      of
      December 31, 2005, the Board of Directors of the Company consisted Mark Landis,
      Fredric Mack, Bruce Miller, John Broderick, Charles B. Porciello, Anthony Pizi,
      Bruce Hasenyager and Jay Kingley. On January 10, 2006 Bruce Percelay was elected
      to the Board of Directors by vote of existing Directors. Messrs. Pizi, Kingley,
      and Hasenyager were elected at the 2003 Special Meeting of Stockholders and
      Messrs. Landis, Mack, 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. On March
      7, 2005 the board of directors elected by unanimous vote Mr. Ralph Martino
      to
      serve on the board until the next special meeting of stockholders. On May 31,
      2005, Mr. Martino resigned from the board. Mr. Nicholas Hatalski and Mr. Kenneth
      Nielsen resigned from the board in July 2005. On March 7, 2006 Mr. Fredric
      Mack
      resigned from the Board of Directors. Messrs. Martino’s, Hatalski’s, Nielsen’s,
      and Mack’s resignations were not the result of a disagreement with Level 8 or
      its management.





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: 64





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: 46





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: 63





Mr.
      Hasenyager has been a director of Level 8 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: 44





Mr.
      Kingley has been a director of Level 8 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.


27





***Charles
      B. Porciello***


Director
      since June 2005. Age: 70




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. Porciello is the Chief Executive Officer of Pilar Services, Inc. Prior
        to
        that, Mr. Porciello served as Chief Operating Officer for Enterprise Integration
        Corporation until 2003. Mr. Porciello was Vice President of Capstone Corporation
        from 1998 to 2000. Mr. Porciello retired from the U.S. Air Force in 1982
        after
        serving his country for twenty five years.





***Bruce
      Miller***


Director
      since July 2005. Age: 55




Mr.
      Bruce
      Miller is a General Partner of Delphi Partners, Ltd. a privately-owned
      investment partnership since 1989. He is a director of American Season
      Corporation. Mr. Miller has served as a consultant for various entities
      including a long-standing association with Cape Air/Nantucket Airlines, Inc.
      Mr.
      Miller sits on the board of the Nantucket Historical Association 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: 50





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: 56





Mr.
      Broderick is currently the Chief Executive Officer and Chief Financial Officer
      of Level 8. Mr. Broderick has served as the Chief Operating Officer of Level
      8
      since June 2002, as the Chief Financial Officer of Level 8 since April 2001,
      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 for Programmer's Paradise, a publicly held
      (NASDAQ: PROG) international software marketer. Mr. Broderick received his
      B.S.
      in accounting from Villanova University.





**Compensation
      Committee Interlocks and Insider Participation**





The
      Compensation Committee for 2005 was comprised of Messrs. Kingley and Porciello.
      Messrs. Neilsen and Hatalski served on the Committee until their resignation
      from the Board in July 2005. 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 not recognized any revenues
      with Pilar to date. 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
      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


28


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 are being issued
      out of the Level 8 Systems, Inc. 1997 Employee Stock Plan.





**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:
      46





Mr.
      Pizi
      currently serves as the Chief Information Officer of Level 8. He served as
      the
      Chief Executive Officer and Chief Technology Officer of Level 8 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:
      56





Mr.
      Broderick serves as the Chief Executive Officer since July 22, 2005 and as
      the
      Chief Financial Officer of Level 8 since April 2001. He has served as the Chief
      Operating Officer of Level 8 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 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. Frank Artale was designated the
“audit committee financial expert” as defined in Item 401(h) of Regulation S-K.
      Following the resignation of Mr. Artale in January 2004, the Company has not
      appointed a replacement “audit committee financial expert” and continues to look
      for a candidate to fill this role on the board or directors and the Audit
      Committee.





**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 Level 8 Systems, 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.level 8.com.





**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”)


29


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.








**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
      2005, **** serving
      or having served at the end of fiscal 2004 whose salary and bonus exceeded
      $100,000 for services rendered to the Company during the fiscal year 2005.
      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 2005, see “Option Grants in
      Fiscal 2005.”





**Summary
      Compensation Table**


**Name
                and**
              **Principal**
              **Position**
            
            **Fiscal**
              **Year**
            
            **Salary**
            
            **Bonus**
            
            **Securities**
              **Underlying**
              **Options**
            
            **All
                Other**
              **Annual****Compensation**Anthony
                C. Pizi
              ChiefInformation
                Officer (1)
            
            
            2005
                2004
                  2003
            
            $
              $
              $
            150,000(1
              200,000(2
              200,000(3
            )
              )
              )
            $
              $
              $
            --
              --
              100,000
            
            
            --
              500,000
              500,000
            
            $
              $
              $
            --
              --
              --John
                P. Broderick
              Chief
                Executive Officer ,Chief Financial Officer, Corporate
                Secretary
            
            
            2005
                    2004
                      2003
            
            $
              $
              $
            150,000(4
              200,000(5
              200,000(6
            )
              )
              )
            $
              $
            --
              60,000
            
            
            --
              500,000
              500,000
            
            $
              $
              $
            --
              --
              --










(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. As of December 31, 2005, Mr. Pizi is owed approximately $94,935
                of
                deferred salary and all of his earned bonus from
                2003





(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.
                Pizi’s base salary for fiscal 2003 was $200,000. Mr. Pizi had voluntarily
                elected to defer $31,250 of salary from 2003 and all of his 2003
                earned
                bonus.




(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. As
                of
                December 31, 2005, Mr. Broderick is owed approximately $112,500 of
                deferred salary and $47,000 of earned 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 of his earned
                bonus
                ($60,000) from 2003.




(6)
            Mr.
                Broderick’s base salary for 2003 was $200,000. Mr. Broderick voluntarily
                elected to defer $31,250 of salary from 2003 and all of his earned
                bonus.


30





The
      Company did not award any grants of stock options to the Named Executives during
      fiscal 2005. The Company did not award any stock appreciation rights (“SARs”)
      during fiscal 2005.





The
      following table sets forth information concerning the options exercised during
      fiscal 2005 and held at December 31, 2005 by the Named Executives.





**Fiscal
      2005 Year-End Option Holdings and Values**


**Number
                of Securities**
              **Underlying
                Unexercised**
              **Options
                at December 31, 2005**
            
            **Value
                of Unexercised In-the-Money**
              **Options
                at December 31, 2005(1)****Name**
            
            
            **Shares
                Acquired****on
                Exercise**
            
            
            **Value**
              **Realized**
            
            
            **Exercisable**
            
            
            **Unexercisable**
            
            
            **Exercisable**
            
            
            **Unexercisable**Anthony
                C.
                Pizi
            
            
            -0-
            
            
            -0-
            
            
            1,833,300
            
            
            166,700
            
            
            -0-
            
            
            -0-John
                P.
                Broderick
            
            
            -0-
            
            
            -0-
            
            
            1,099,200
            
            
            166,700
            
            
            -0-
            
            
            -0-





(1)
            Based
                on $0.02 per share, the December 31, 2005, 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,
      2005,
      the Company is to pay Mr. Pizi an annual base salary of $200,000 and a
      performance bonus in cash of up to $400,000 per annum based upon certain revenue
      goals, 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 base salary within thirty (30) days of
      termination and (b) two hundred thousand (200,000) shares of the Company’s
      common stock. 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 grant Mr. Pizi five hundred thousand
      (500,000) shares of the Company’s common stock. 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,
      2005, the Company pays Mr. Broderick a base salary of $200,000 and a performance
      bonus of cash up to $100,000 per annum based upon certain revenue goals, 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
      salary continuation of six months of Mr. Broderick’s then base salary beginning
      on the first payday after the date of termination. 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) a lump sum payment of one year of Mr. Broderick’s then
      base salary within thirty (30) days of termination and (b) two hundred fifty
      thousand (250,000) shares of the Company’s common stock and immediately vest all
      unvested stock options held by Mr. Broderick. 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.





31





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




The following table
      sets forth information as of December 31, 2005 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 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
      Level 8 Systems, 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, 2005 upon the exercise of stock
      options as well as exercise of warrants. The chart is based on 48,039,947 common
      shares outstanding as of December 31, 2005. 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**Brown
                Simpson Partners I, Ltd. (1)
            
            
            5,936,921
                (2
            )
            
            11.1
            %Liraz
                Systems, Ltd.(3)
            
            
            6.426,869
                (4
            )
            
            13.4
            %Mark
                and Carolyn P. Landis (5)
            
            
            9,904,575
                (6
            )
            
            17.3
            %Fredric
                H. Mack and Trust(s) (7)
            
            
            1,669,710
                (8
            )
            
            3.4
            %Anthony
                C. Pizi
            
            
            4,207,497
                (9
            )
            
            8.1
            %John
                P. Broderick
            
            
            1,099,200
                (10
            )
            
            2.2
            %Bruce
                W. Hasenyager
            
            
            100,000
                (11
            )
            
            *Jay
                R. Kingley
            
            
            100,000
                (11
            )
            
            *Charles
                Porciello
            
            
            0
            
            
            *Bruce
                Percelay
            
            
            0
            
            
            *Bruce
                Miller
            
            
            705,629
                (12
            )
            
            *All
                current directors and executive officers as a group (9
                persons)
            
            
            17,786,611
                (13
            )
            
            27.4
            %




·
            Represents
                less than one percent of the outstanding
                shares.





1.
            The
                address of Brown Simpson Partners I, Ltd. is c/o Xmark Asset Mgmt.
                LLC,
                152 West 57thSt., 1stFloor, New York, New York 10019.





2.
            Includes
                1,197,032 shares of common stock issuable upon conversion of Series
                B-3
                preferred stock, 460,526 shares of common stock issuable upon conversion
                of Series C preferred stock and 4,009,093 shares issuable upon the
                exercise of warrants and 270,270 shares of common stock. The exercise
                prices of the warrants are as follows: 115,132 at $0.38 per share,
                270,270
                at $0.37 per share and 3,623,691 at $0.40 per share. Brown Simpson
                Partners I, Ltd. disclaims beneficial ownership of 4,009,093 warrant
                shares because they are
                anti-dilutive.





3.
            The
                address of Liraz Systems, Ltd. is 5 Hazoref St., Holon 58856,
                Israel.





4.
            Includes
                2,632 shares of common stock issuable upon the conversion of Series
                C
                preferred stock, 82,237 shares of common issuable upon the exercise
                of
                warrants at an exercise price of $0.38 per share of common stock,
                3,600,000 shares of common issuable upon the exercise of warrants
                at an
                exercise price of $0.002, and 6,342,000 shares of common stock.




5.
            The
                address of Mark and Carolyn P. Landis is 251 Crandon Blvd., Key Biscayne,
                Fl. 33149


32





6.
            Includes
                5,220,273 shares of common stock issuable upon the exercise of warrants
                issuable in connection with convertible promissory notes as follows:
                (i)
                1,875,000 shares with an exercise price of is $0.08 per share; (ii),
                2,000,000 shares with an exercise price of $0.10 per share; (iii)
                781,250
                shares with an exercise price of $0.16 per share; (iv) 446,429 shares
                with
                an exercise price of $0.28 per share; and (v) 117,594 shares with
                an
                exercise price of $0.37 per share. Also includes: (ii) 446,429 shares
                of
                common stock issuable upon conversion of $125,000 principal amount
                of
                convertible promissory notes issued on February 1, 2004 at a conversion
                price of $0.28; (ii) 781,250 shares of common stock issuable upon
                conversion of $125,000 principal amount of convertible promissory
                notes
                issued on June 30, 2004 at a conversion price of $0.16 (iii) 1,000,000
                shares of common stock issuable upon conversion of $100,000 principal
                amount of convertible promissory notes issued October 12, 2004; and
                (iv)
                1,875,000 shares of common stock issuable upon conversion of $150,000
                principal amount of convertible promissory notes issued November
                11, 2004.
                Also includes 581,623 shares of common stock. Disclaims beneficial
                ownership of 5,220,273 shares because they are anti-dilutive.





7.
            The
                address of Fredric H. Mack is 2115 Linwood Avenue, Fort Lee, New
                Jersey
                07024.Fredric
                H. Mack, trustee of 4-30-92 Trust, Fred Mack Trust - Hailey Mack,
                and Fred
                Mack Trust - Jason Mack, exercises sole or shared voting or dispositive
                power with respect to the securities held by 4-30-92 Trust, Fred
                Mack
                Trust - Hailey Mack, and Fred Mack Trust-
                Jason Mack.





8.
            Includes
                394,737 shares of common stock issuable upon conversion of Series
                C
                preferred stock and 632,883 shares of common stock issuable upon
                the
                exercise of warrants. The exercise price of warrants is as follows:
                390,625 shares at $0.32 per share of common stock; 202,703 shares
                at $0.37
                per share of common stock; 22,222 shares at $0.45 per share of common
                stock; and 17,333 shares $0.60 per share. Also includes 390,625 shares
                of
                common stock issuable upon conversion of $125,000 principal amount
                of
                convertible promissory notes issued on May 10, 2004 at a conversion
                price
                of $0.32. Also includes, in the Fredric Mack 4-30-92 Trust, 203,125
                shares
                of common stock issuable upon conversion of Series D preferred stock,
                30,672 shares of common stock issuable upon exercise of Series D-2
                Warrants at an exercise price the lower of $0.20 or the trading price
                of
                Level 8’s common stock at the time of exercise and 9,334 shares of common
                stock issuable upon exercise of warrants at an exercise price of
                $0.60 per
                share. Also includes, in the trust for Hailey Mack and the trust
                for Jason
                Mack, 4,167 each shares of common stock issuable upon exercise of
                warrants
                at an exercise price of $0.45 per share.




9.
            Includes
                1,833,300 shares subject to stock options exercisable within sixty
                (60)
                days, 394,737 shares of common stock issuable upon conversion of
                Series C
                preferred stock and 835,742 shares of common stock issuable upon
                the
                exercise of warrants. The exercise price of warrants is as follows:
                90,118
                shares at $0.17 per share of common stock; 560,000 shares at $0.20
                per
                share of common stock; and 185,624 shares at $0.32 per share of common
                stock. Also includes 270,270 shares of common stock issuable upon
                conversion of $100,000 principal amount of convertible promissory
                notes
                issued on April 12, 2004 at a conversion price of $0.37, 560,000
                shares of
                common stock issuable upon conversion of $112,000 principal amount
                of
                convertible promissory note issued on June 11, 2004 at a conversion
                price
                of $0.20 and 90,118 shares of common stock issuable upon conversion
                of
                $15,320 principal amount of convertible promissory note issued on
                June 14,
                2004 at a conversion price of $0.17. Disclaims beneficial ownership
                of
                223,330 shares of common stock because they are anti-dilutive.





10.
            Consists
                of 1,099,200 shares subject to stock options exercisable within sixty
                (60)
                days.





11.
            Consists
                of 100,000 shares subject to stock options exercisable within sixty
                (60)
                days.





12.
            Consists
                of 101,372 shares of Level 8 common stock issuable upon the exercise
                warrants. The exercise price of the warrants range from $0.37 to
                the lower
                of $0.20 or the trading price of Level 8’s common stock at the time of
                exercise. Includes 300,000 shares of common stock upon the conversion
                of
                $21,000 principal amount of convertible promissory note issued on
                April
                25, 2005 at a conversion price of $0.07 per share. Mr. Miller has
                sole or
                shared voting or dispositive power with respect to the securities
                held by
                Delphi Partners, Ltd., which holds a senior promissory note in the
                amount
                of $10,203.49 which bears interest at 10% per annum. Delphi Partners,
                Ltd.
                also owns 128,571 shares of common stock issuable upon conversion
                of
                $9,000 principal amount of convertible promissory note issued on
                April 25,
                2005 at a conversion price of $0.07. Delphi Partners owns 175,686
                shares
                of common stock issuable upon the exercise of warrants. The exercise
                price
                of the warrants range from $0.45 to the lower of $0.20 or the trading
                price of Level 8’s common stock at the time of exercise.





13.
            Includes
                shares issuable upon exercise of options and warrants exercisable
                within
                sixty (60) days as described in Notes 5-12 to our financial
                statements.


33


**EQUITY
      COMPENSATION PLAN INFORMATION**





The
      following table sets forth certain information as of December 31, 2005, 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
            
            
            5,900,897
            
            $
            1.30
            
            
            2,413,010Equity
                compensation plans not approved by stockholders (1)
            
            
            --
            
            
            --
            
            
            --Total
            
            
            5,900,897
            
            $
            1.30
            
            
            2,413,010





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








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




**Loan
      from Related Parties**





During
      200 5,
      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, 2005, 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 us for convertible
      promissory notes: In June 2004, the Company entered into a convertible
      promissory note with Mr. Pizi. The
      note,
      in the face amount of $112,000, bears interest at 1% per month and is
      convertible into 560,000 shares of the Company’s common stock and warrants to
      purchase 560,000 shares of our common stock at $0.20 per share. Also in June
      2004, Mr. Pizi entered into a second convertible promissory note in the face
      amount of $15,000 which is convertible into 90,118 shares of the Company’s
      common stock and warrants to purchase 90,118 shares of the Company’s common
      stock at $0.17 per share.





On
      April
      12, 2004, the Company entered into a convertible promissory note with Mr. Pizi.
      The note, in the face amount of $100,000, bears interest at 1% per month and
      is
      convertible into common stock of the Company at a conversion rate of $0.37
      per
      share. In addition, Mr. Pizi was granted 270,270 warrants to purchase the
      Company’s common stock at $0.37 per share.





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 .





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 Level 8 common stock and warrants to purchase
      781,250 shares of Level 8 common stock exercisable at $0.16 per
      share .





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 bears
      interest at 1% per month, and is convertible into


34


446,429
      shares of Level 8 common stock and warrants to purchase 446,429 shares of Level
      8 common stock exercisable at $0.28 per share.





In
      June
      2004, the Company entered into a convertible promissory note with Fredric Mack,
      a former director of Level 8, 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 Level 8 common stock and warrants to purchase 390,625 shares of Level
      8 common stock exercisable at $0.32 per share.





In
      April
      2005, the Company entered into a convertible promissory note with Bruce Miller,
      a director of Level 8, 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 Level 8 common 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 merger were being negotiated and at the time of approval of
      the
      recapitalization merger by our board of directors), was a director of Level
      8,
      in the amount of $25,000. Under the terms of the note, the loan bears interest
      at 1.5% per month and is convertible into 78,125 shares of Level 8 common stock
      and warrants to purchase 78,125 shares of Level 8 common stock exercisable
      at
      $0.32 per share.





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 holds $423,333
      of Senior Reorganization Notes, which may be converted into warrants to purchase
      an additional 57,165,993 shares of Level 8 common stock at a purchase price
      of
      $0.002 per share. ****





Mr.
      Landis holds $327,860 of Senior Reorganization Notes, which may be converted
      into warrants to purchase an additional 44,234,523 shares of Level 8 common
      stock at an exercise price of $0.002 per share.





Mr.
      Mack
      holds, together with his affiliates, $88,122 of Senior Reorganization Notes,
      which may be converted into warrants to purchase an additional 44,234,523 shares
      of Level 8 common stock at a purchase price of $0.002 per share.





Mr.
      Miller holds, together with his affiliates, $77,706 of Senior Reorganization
      Notes, which may be converted into warrants to purchase an additional 11,459,727
      shares of Level 8 common stock at a purchase price of $0.002.





John
      Broderick, Chief Executive Officer and Chief Financial Officer of Level 8,
      holds
      $2,300 of Senior Reorganization Notes, which may be converted into warrants
      to
      purchase 333,333 shares of Level 8 common stock at a purchase price of $0.002
      per share, and options to purchase 1,099,200 shares of common stock under the
      Level 8 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
      are
      to be automatically exercised in connection with the consummation of the
      recapitalization merger.





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





Mr.
      Pizi
      holds $85,000 of Convertible Bridge Notes which bear interest at 10% and mature
      on September 15, 2005. Upon consummation of the recapitalization merger, these
      notes will automatically convert into 3,400,000 shares of Cicero common stock.





Mr.
      Landis holds $213,000 of Convertible Bridge Notes which bear interest at 10%
      and
      mature on September 15, 2005. Upon consummation of the recapitalization merger,
      these notes will automatically convert into 8,520,000 shares of Cicero common
      stock.





Mr.
      Mack
      holds, together with his affiliates, $74,000 of Convertible Bridge Notes which
      bear interest at 10% and mature on September 15, 2005. Upon consummation of
      the
      recapitalization merger, these notes will automatically convert into 2,960,000
      shares of Cicero common stock.





Mr.
      Miller holds, together with his affiliates, $90,000 of Convertible Bridge Notes
      which bear interest at 10% and mature on September 15, 2005. Upon consummation
      of the recapitalization merger, these notes will automatically convert into
      3,600,000 shares of Cicero common stock.


35


Bruce
      Hasenyager, a member of our Board of Directors, holds $4,061 of Convertible
      Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon
      consummation of the recapitalization merger, these notes will automatically
      convert into 162,425 shares of Cicero common stock.





Bruce
      Percelay, a member of our Board of Directors, holds $100,000 of Convertible
      Bridge Notes which bear interest at 10% and mature on December 15, 2005. Upon
      consummation of the recapitalization merger, these notes will automatically
      convert into 4,000,000 shares of Cicero common stock.





**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.





**Preferred
      Stock and Warrant Exchange**





On
      March
      19, 2003, Level 8 Systems, Inc. completed a $3.5 million private placement
      of
      Series D Convertible Preferred Stock (“Series D Preferred Stock”), convertible
      at a conversion ratio of $0.32 per share of common stock into an aggregate
      of
      11,031,250 shares of common stock. As part of the financing, the Company has
      also issued warrants to purchase an aggregate of 4,158,780 shares of common
      stock at an exercise price of $0.07 per share (“Series D-1 Warrants”). On
      October 10, 2003, the Company, consistent with its obligations, also issued
      warrants to purchase an aggregate of 1,665,720 shares of common stock at an
      exercise price the lesser of $0.20 per share or market price at the time of
      exercise (“Series D-2 Warrants”). The Series D-2 Warrants became exercisable on
      November 1, 2003, because the Company failed to report $6 million in gross
      revenues for the nine-month period ended September 30, 2003. Both existing
      and
      new investors participated in the financing. The Company also agreed to register
      the common stock issuable upon conversion of the Series D Preferred Stock and
      exercise of the warrants for resale under the Securities Act of 1933, as
      amended. Under the terms of the financing agreement, a redemption event may
      occur if any one person, entity or group shall control more than 35% of the
      voting power of the Company’s capital stock. The Company allocated the proceeds
      received from the sale of the Series D Preferred Stock and warrants to the
      preferred stock and detachable warrants on a relative fair value basis,
      resulting in an allocation of $2,890,000 to the Series D Preferred Stock and
      $640,000 to the detachable warrants. Based upon the allocation of the proceeds,
      the Company determined that the effective conversion price of the Series D
      Preferred Stock was less than the fair value of the Company’s common stock on
      the date of issuance. The beneficial conversion feature was recorded as a
      discount on the value of the Series D Preferred Stock and an increase in
      additional paid-in capital. Because Series D Preferred Stock was convertible
      immediately upon issuance, the Company fully amortized such beneficial
      conversion feature on the date of issuance.





On
      October 25, 2002, we effected an exchange of all of our outstanding shares
      of
      Series A2 Convertible Redeemable Preferred Stock (“Series A2 Preferred Stock”)
      and Series B2 Convertible Redeemable Preferred Stock (“Series B2 Preferred
      Stock”) and related warrants for an equal number of shares of newly created
      Series A3 Convertible Redeemable Preferred Stock (“Series A3 Preferred Stock”)
      and Series B3 Convertible Redeemable Preferred Stock (“Series B3 Preferred
      Stock”) and related warrants. This exchange was made to correct a deficiency in
      potential conversion price adjustments from the prior exchange of Series A1
      and
      B1 Preferred Stock and related warrants for Series A2 and B2 Preferred Stock
      and
      related warrants on August 29, 2002. The conversion price for the Series A3
      Preferred Stock and the conversion price for the Series B3 Preferred Stock
      remain the same as the previously issued Series A1 and A2 Preferred Stock and
      Series B1 and B2 Preferred Stock, at $8.333 and $12.531, respectively. The
      exercise price for the aggregate 753,640 warrants relating to the Series A3
      Preferred Stock was increased from $0.38 to $0.40 per share which is a reduction
      from the $1.77 exercise price of the warrants relating to the Series A1
      Preferred Stock. The exercise price for the aggregate 1,047,382 warrants
      relating to the Series B3 Preferred Stock was increased from $0.38 to $0.40
      per
      share which is a reduction from the $1.77 exercise price of the warrants
      relating to the Series B1 Preferred Stock. The adjusted exercise price was
      based
      on the closing price of the Company’s Series C Convertible Redeemable Preferred
      Stock and warrants on August 14, 2002, plus $0.02, to reflect accurate current
      market value according to relevant Nasdaq rules. This adjustment was made as
      part of the agreement under which the holders of the Company’s Preferred Stock
      agreed to waive their price-protection anti-


36


dilution
      protections to allow the Company to issue the Series C Preferred Stock and
      warrants without triggering the price-protection anti-dilution provisions and
      excessively diluting its Common Stock.





Under
      the
      terms of the agreement, we are authorized to issue equity securities in a single
      or series of financing transactions representing aggregate gross proceeds to
      the
      Company of approximately $5 million, or up to an aggregate 17,500 shares of
      common stock, whichever occurs first, without triggering the price-protection
      anti-dilution provisions in the Series A3 Preferred Stock and B3 Preferred
      Stock
      and related warrants. In exchange for the waiver of these price-protection
      anti-dilution provisions, we repriced the warrants as described above and have
      agreed to issue on a pro rata basis up to 4,600 warrants to the holders of
      Series A3 Preferred Stock and Series B3 Preferred Stock at such time and from
      time to time as the Company closes subsequent financing transactions up to
      the
      $5 million issuance cap or the 17,500 share issuance cap. As a result of the
      Series C Preferred Stock financing which represented approximately $1.6 million
      of the Company’s $5 million in allowable equity issuances, the Company is
      obligated to issue an aggregate of 1,462,801 warrants at an exercise price
      of
      $0.40 per share to the existing Preferred Stockholders. Additionally, the
      Company has agreed to issue a warrant to purchase common stock to the existing
      Preferred Stockholders on a pro rata basis for each warrant to purchase common
      stock that the Company issues to a third-party lender in connection with the
      closing of a qualified loan transaction. The above referenced warrants will
      have
      the same exercise price as the exercise price of the warrant, or equity
      security, that the Company issues in connection with the Company’s subsequent
      financing or loan transaction or $0.40 per share (adjusted for
      recapitalizations, stock splits and the like), whichever is
      greater.





As
      a
      result of the Series D preferred Stock financing which represented approximately
      $3.5 million against the allowable equity issuances, the Company was obligated
      to issue an aggregate of 3,048,782 warrants at an exercise price of $0.40 per
      share to the existing Series A3 and Series B3 Preferred shareholders. The
      warrants were issued on October 8, 2003 and had a fair value of $1,062,000
      which
      was recorded as a deemed dividend to preferred stockholders. Additionally,
      the
      Company has agreed to issue a warrant to purchase common stock to the existing
      Preferred Stockholders on a pro rata basis for each warrant to purchase common
      stock that the Company issues to a third-party lender in connection with the
      closing of a qualified loan transaction. The above referenced warrants will
      have
      the same exercise price as the exercise price of the warrant, or equity
      security, that the Company issues in connection with the Company’s subsequent
      financing or loan transaction or $0.40, whichever is greater. These warrants
      are
      not classified as a liability under EITF 00-19.




**Borrowings
      and Commitments from Liraz**





Liraz
      Systems Ltd. guarantees certain debt obligations of the Company. In September
      2004, 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
      November 3, 2005. The Company issued 3,942,000 shares of common stock to Liraz
      in exchange for this debt extension. In 2003, the Company and Liraz also agreed
      to extend the guarantee and maturity of the debt obligation until November
      2004.
      The Company agreed to issue Liraz 300,000 shares of stock for that extension.
      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.








**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, 2005 and 2004.





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 2005 (and reviews of quarterly
      financial statements on form 10-Q), 2005 and 2004 was $36,000 for each year.


37





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 2005 and 2004.





TAX
      FEES





Tax
      fees
      include fees for tax compliance, tax advice and tax planning. There were no
      fees
      billed by Margolis & Company P.C. for these services in 2005 and 2004.





OTHER
      FEES





All
      other
      fees include fees for all services except those described above. 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.




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 preapproved by the Audit Committee. It is the Company’s
      policy that all such services be preapproved prior to commencement of the
      engagement. The Audit Committee is also required to preapprove the estimated
      fees for such services, as well as any subsequent changes to the terms of the
      engagement.





38





**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, 2005 and 2004




Consolidated
      Statements of Operations for the years ended December 31, 2005, 2004 and
      2003




Consolidated
      Statements of Stockholders' Equity for the years ended December 31, 2005, 2004
      and 2003




Consolidated
      Statements of Comprehensive Loss for the years ended December 31, 2005, 2004
      and
      2003





Consolidated
      Statements of Cash Flows for the years ended December 31, 2005, 2004 and
      2003




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
      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.


39


On
      February 6, 2004, Level 8 Systems filed a Form 8-K reporting the appointment
      of
      Margolis & Company P.C. as the Company’s new Independent Registered Public
      Accounting Firm.





On
      November 26, 2003, Level 8 Systems filed a Form 8 K reporting the resignation
      of
      Deloitte & Touche LLP as the Company’s Independent Registered Public
      Accounting Firm.





(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 August 4, 2003 (incorporated by reference to exhibit 3.1
                to Level
                8’s Form 10-K filed March 31, 2004).3.2
            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).3.3
            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).3.4
            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).3.5
            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).3.6
            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
            Form
                of term sheet dated December 15, 2005, with extension of term sheet
                dated
                February 27, 2006(filed
                herewith).4.2
            Form
                of term sheet dated October 6, 2004 (incorporated by reference to
                exhibit
                4.1 to Cicero, Inc. Report on Form S-4, filed May 13,
                2005).4.3
            Form
                of term sheet dated March 2, 2005 (incorporated by reference to exhibit
                4.2 to Cicero, Inc. Report on Form S-4, filed May 13,
                2005).4.4
            Form
                of Promissory Note (incorporated by reference to exhibit 4.3 to Cicero,
                Inc. Report on Form S-4, filed May 13, 2005).4.5
            Form
                of Extended Promissory Note (incorporated by reference to exhibit
                4.4 to
                Cicero, Inc. Report on Form S-4, filed May 13, 2005).4.6
            Form
                of Note Purchase Agreement (incorporated by reference to exhibit
                4.5 to
                Cicero, Inc. Report on Form S-4, filed May 13, 2005).4.7
            Form
                of Extended Note Purchase Agreement (incorporated by reference to
                exhibit
                4.5 to Cicero, Inc. Report on Form S-4, filed May 13,
                2005).4.8
            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).


40





4.9
            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).4.10
            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).4.11
            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).4.12
            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).4.13
            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).4.13A
            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).4.14
            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).4.14A
            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).4.15
            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).4.16
            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).4.17
            Form
                of Stock Purchase Warrant issued to Liraz Systems, LTD. for the November
                3, 2005 extension of the Bank Hapoalim loan guaranty (filed
                herewith).4.18
            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).4.19
            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).4.20
            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).4.20A
            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).4.21
            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 March 31, 2004).


41





4.22
            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).4.23
            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).4.24
            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).4.25
            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 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).10.2
            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).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).


42





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).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. 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, 2005
                (filed herewith).*10.16
            Employment
                Agreement between John P. Broderick and the Company effective January
                1,
                2005 (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).


43





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).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 LLP (filed herewith).31.1
            Certification
                of Chief Executive Officer pursuant to Rule 13a-14(a) (filed
                herewith).31.2
            Certification
                of Chief Financial Officer pursuant to Rule 13a-14(a) (filed
                herewith).32.1
            Certification
                of John P. Broderick, Chief Executive Officer and Chief Financial
                Officer
                pursuant to 18 USC § 1350, as adopted pursuant to §906 of the
                Sarbanes-Oxley Act of 2002 (filed
                herewith).





*
      Management contract or compensatory agreement.


44





***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.




LEVEL
      8
      SYSTEMS, INC.







By: /s/
      John P. Broderick


John
      P.
      Broderick


Chief
      Executive Officer


Date:
      March 31, 2006




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
              Mark
                Landis
            Chairman
                of the Board
            March
                31, 2006/s/
                John P. Broderick
              John
                P. Broderick
            Chief
                Executive Officer/Chief Financial Officer
              (Principal
                Executive Officer)
            March
                31, 2006/s/
                Anthony C. Pizi
              Anthony
                C.
                Pizi
            Chief
                Information Officer
            March
                31, 2006/s/
                Bruce
                Hasenyager
              Bruce
                Hasenyager
            Director
            March
                31, 2006/s/
                Jay
                Kingley
              Jay
                Kingley
            Director
            March
                31, 2006/s/
                Bruce Miller
              Bruce
                Miller
            Director
            March
                31, 2006/s/
                Charles Porciello
              Charles
                Porciello
            Director
            March
                31, 2006/s/
                Bruce Percelay
              Bruce
                Percelay
            Director
            March
                31, 2006





45











**INDEX
      TO FINANCIAL STATEMENTS**

















Report
                    of Independent Registered Public Accounting Firm
                
                F-2**Financial
                    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-10





F
          -1





REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








To
      the
      Board of Directors and Stockholders of


Level
      8
      Systems, Inc.


Farmingdale,
      New Jersey





We
      have
      audited the accompanying consolidated balance sheet of Level 8 Systems, Inc.
      and
      subsidiaries (the "Company") as of December 31, 2005 and 2004, and the related
      consolidated statements of operations, stockholders' equity (deficit), cash
      flows, and comprehensive loss for each of the three years in the period ended
      December 31, 2005. 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 Level 8 Systems, Inc. and
      subsidiaries as of December 31, 2005 and 2004, and the results of their
      operations and their cash flows for each of the three years in the period ended
      December 31, 2005, 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
      23,
      2006









































F
          -2


**LEVEL
      8 SYSTEMS, INC.**


**CONSOLIDATED
      BALANCE SHEETS**


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


**December
                31, 2005**
            
            **December
                31, 2004****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            29
            
            $
            107Assets
                of operations to be abandoned
            
            
            131
            
            
            148Trade
                accounts receivable, net
            
            
            18
            
            
            152Prepaid
                expenses and other current assets
            
            
            53
            
            
            108Total
                current assets
            
            
            231
            
            
            515Property
                and equipment, net
            
            
            10
            
            
            15Total
                assets
            
            $
            241
            
            $
            530**LIABILITIES
                AND STOCKHOLDERS' DEFICIT**Current
                liabilities:Senior
                reorganization debt
            
            $
            2,559
            
            $
            1,548Convertible
                bridge notes
            
            
            1,760
            
            
            --Short-term
                debt
            
            
            3,481
            
            
            3,646Accounts
                payable
            
            
            2,528
            
            
            2,351Accrued
                expenses:Salaries,
                wages, and related items
            
            
            1,036
            
            
            879Other
            
            
            2,193
            
            
            1,725Liabilities
                of operations to be abandoned
            
            
            490
            
            
            536Deferred
                revenue
            
            
            78
            
            
            85Total
                current liabilities
            
            
            14,125
            
            
            10,770Long-term
                debt
            
            
            131
            
            
            250Senior
                convertible redeemable preferred stock
            
            
            1,061
            
            
            1,367Total
                liabilities
            
            
            15,317
            
            
            12,387Commitments
                and contingencies (Notes 20 and 21)Stockholders'
                equity (deficit):Convertible
                preferred
                stock, $0.001 par value, 10,000,000 shares authorized.
              Series
                A3 - 10,070 shares issued and 1,571 shares outstanding at December
                31,
                2005 and 2004, $1,000 per share
                liquidation preference (aggregate liquidation value of
                $1,571)
              Series
                B3 - 30,000 shares issued and outstanding, $1,000 per share liquidation
                preference (aggregate liquidation value of $30,000)
              Series
                C - 1,590 shares issued and 991 and 1,141 outstanding at December
                31, 2005
                and 2004, respectively, $1,000 per share liquidation preference (aggregate
                liquidation value of $991)
            
            
            --
              
              --
              
              --
            
            
            --
              
              --
              
              --Common
                stock, $0.001 par value, 85,000,000 shares authorized at December
                31, 2005
                and 2004; 48,016,338 and 43,304,022 issued and outstanding at December
                31,
                2005 and 2004, respectively
            
            
            48
            
            
            43Additional
                paid-in-capital
            
            
            210,594
            
            
            210,142Accumulated
                deficit
            
            
            (225,715
            )
            
            (222,034
            )Accumulated
                other comprehensive loss
            
            
            (3
            )
            
            (8
            )Total
                stockholders' (deficit)
            
            
            (15,076
            )
            
            (11,857
            )Total
                liabilities and stockholders' deficit
            
            $
            241
            
            $
            530





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


F
          -3


**LEVEL
      8 SYSTEMS, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


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


**Years
                Ended December 31,****2005**
            
            
            **2004**
            
            
            **2003**Revenue:Software
            
            $
            407
            
            $
            239
            
            $
            102Maintenance
            
            
            147
            
            
            306
            
            
            316Services
            
            
            231
            
            
            230
            
            
            112Total operating revenue
            
            
            785
            
            
            775
            
            
            530Cost
                of revenue:Software
            
            
            16
            
            
            4,478
            
            
            4,152Maintenance
            
            
            350
            
            
            382
            
            
            373Services
            
            
            822
            
            
            1,015
            
            
            908Total
                cost of revenue
            
            
            1,188
            
            
            5,875
            
            
            5,433Gross
                margin (loss)
            
            
            (403
            )
            
            (5,100
            )
            
            (4,903
            )Operating
                expenses:Sales
                and marketing
            
            
            627
            
            
            1,088
            
            
            1,680Research
                and product development
            
            
            891
            
            
            1,111
            
            
            1,017General
                and administrative
            
            
            1,137
            
            
            1,522
            
            
            2,558Write-off
                of intangible assets
            
            
            -
            
            
            587
            
            
            -(Gain)/loss
                on disposal of assets
            
            
            -
            
            
            (5
            )
            
            415Restructuring,
                net
            
            
            -
            
            
            -
            
            
            (834
            )Total
                operating expenses
            
            
            2,655
            
            
            4,303
            
            
            4,836Loss
                from operations
            
            
            (3,058
            )
            
            (9,403
            )
            
            (9,739
            )Other
                income (charges):Interest
                income
            
            
            -
            
            
            -
            
            
            33Interest
                expense
            
            
            (593
            )
            
            (264
            )
            
            (119
            )Change
                in fair value of warrant liability
            
            
            -
            
            
            198
            
            
            133Other
                expense
            
            
            (30
            )
            
            (262
            )
            
            (182
            )(623
            )
            
            (328
            )
            
            (135
            )Loss
                from continuing operations
            
            
            (3,681
            )
            
            (9,731
            )
            
            (9,874
            )Loss
                from discontinued operations
            
            
            -
            
            
            (30
            )
            
            (132
            )Net
                loss
            
            
            ($3,681
            )
            
            ($9,761
            )
            
            ($10,006
            )Accretion
                of preferred stock and deemed dividends
            
            
            -
            
            
            -
            
            
            1,702Net
                loss applicable to common stockholders
            
            
            ($3,681
            )
            
            ($9,761
            )
            
            ($11,708
            )Loss
                per share:Loss
                from continuing operations - basic and diluted
            
            
            ($0.08
            )
            
            ($0.28
            )
            
            ($0.54
            )Loss
                from discontinued operations - basic and diluted
            
            
            -
            
            
            -
            
            
            -Net
                loss applicable to common stockholders - basic and diluted
            
            
            ($0.08
            )
            
            ($0.28
            )
            
            ($0.54
            )Weighted
                average common shares outstanding - basic and diluted
            
            
            44,502
            
            
            35,982
            
            
            21,463





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





F
          -4


**LEVEL
      8 SYSTEMS, INC.**


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


**(in
      thousands)**


**Common
                Stock**
              **Shares********Amount**
            
            **Preferred
                Stock**
              **Shares********Amount**
            
            **Additional**
              **Paid-in**
              **Capital**
            
            **Accumulated**
              **(Deficit)******
            
            **Accumulated**
              **Other**
              **Comprehensive**
              **Income
                (Loss)**
            
            **Total**Balance
                at December 31, 2002
            
            
            19,203
            
            $
            19
            
            
            42
            
            
            --
            
            $
            202,916
            
            $
            (200,565
            )
            $
            (717
            )
            $
            1,653Conversion
                of preferred shares to common
            
            
            1,378
            
            
            1
            
            
            (6
            )
            
            
            
            
            --
            
            
            
            
            
            
            
            
            1Shares
                issued as compensation
            
            
            95
            
            
            --
            
            
            
            
            
            
            
            
            48
            
            
            
            
            
            
            
            
            48Shares
                issued for bank guarantee
            
            
            150
            
            
            --
            
            
            
            
            
            
            
            
            51
            
            
            
            
            
            
            
            
            51Exercises
                of stock options
            
            
            27
            
            
            --
            
            
            
            
            
            
            
            
            6
            
            
            
            
            
            
            
            
            6Conversion
                of warrants
            
            
            3,352
            
            
            4
            
            
            
            
            
            
            
            
            402
            
            
            
            
            
            
            
            
            406Conversion
                of senior convertible redeemable preferred stock
            
            
            546
            
            
            1
            
            
            
            
            
            
            
            
            174
            
            
            
            
            
            
            
            
            175Accretion
                of preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            640
            
            
            (640
            )
            
            
            
            
            --Shares
                issued in private placement of common stock
            
            
            1,894
            
            
            2
            
            
            
            
            
            
            
            
            850
            
            
            
            
            
            
            
            
            852Deemed
                dividend
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,062
            
            
            (1,062
            )
            
            
            
            
            --Foreign
                currency translation adjustment.
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (6
            )
            
            (6
            )Reclassification
                of unrealized loss included in income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            717
            
            
            717Net
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (10,006
            )
            
            
            
            
            (10,006
            )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
            )


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





F
          -5


**LEVEL
      8 SYSTEMS, INC.**


**CONSOLIDATED
      STATEMENTS OF COMPREHENSIVE LOSS**


**(in
      thousands)**





**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**Net
                loss
            
            
            ($3,681
            )
            
            ($9,761
            )
            
            ($
                10,006
            )Other
                comprehensive income (loss), net of tax:Foreign
                currency translation adjustment
            
            
            5
            
            
            (2
            )
            
            (6
            )Reclassification
                of unrealized loss included in income - other than temporary
                decline
            
            
            -
            
            
            -
            
            
            717Comprehensive
                loss
            
            
            ($3,676
            )
            
            ($9,763
            )
            
            ($
                9,295
            )














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





F
          -6


**LEVEL
      8 SYSTEMS, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(in
      thousands)**


**Years
                Ended December 31,****2005**
            
            
            **2004**
            
            
            **2003**Cash
                flows from operating activities:Net
                loss
            
            
            ($3,681
            )
            
            ($9,761
            )
            
            ($10,006
            )Adjustments
                to reconcile net loss to net cash (used in) operating
                activities:Depreciation
                and amortization
            
            
            11
            
            
            4,287
            
            
            3,116Change
                in fair value of warrant liability
            
            
            --
            
            
            (198
            )
            
            (133
            )Stock
                compensation expense
            
            
            149
            
            
            635
            
            
            48Impairment
                of intangible assets and software product technology
            
            
            --
            
            
            587
            
            
            993(Credit)
                for doubtful accounts
            
            
            (12
            )
            
            (4
            )
            
            (52
            )(Gain)
                loss on disposal of assets
            
            
            --
            
            
            --
            
            
            (23
            )Changes
                in assets and liabilities, net of assets acquired and liabilities
                assumed:Trade
                accounts receivable and related party receivables
            
            
            146
            
            
            (143
            )
            
            1,404Assets
                and liabilities of operations to be abandoned
            
            
            (29
            )
            
            86
            
            
            101Prepaid
                expenses and other assets
            
            
            55
            
            
            216
            
            
            420Accounts
                payable and accrued expenses
            
            
            804
            
            
            884
            
            
            (351
            )Deferred
                revenue
            
            
            (7
            )
            
            46
            
            
            (273
            )Net
                cash (used in) operating activities
            
            
            (2,564
            )
            
            (3,365
            )
            
            (4,756
            )Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (6
            )
            
            --
            
            
            (36
            )Repayment
                of note receivable
            
            
            --
            
            
            --
            
            
            867Net
                cash provided by (used in) investing activities
            
            
            (6
            )
            
            --
            
            
            831Cash
                flows from financing activities:Proceeds
                from issuance of common shares, net of issuance costs
            
            
            --
            
            
            1,250
            
            
            859Proceeds
                from issuance of convertible redeemable stock, less escrow of
                $776
            
            
            --
            
            
            --
            
            
            2,754Proceeds
                from exercise of warrants
            
            
            --
            
            
            112
            
            
            406Borrowings
                under credit facility, term loans and notes payable
            
            
            2,542
            
            
            2,540
            
            
            980Repayments
                of term loans, credit facility and notes payable
            
            
            (55
            )
            
            (447
            )
            
            (1,248
            )Net
                cash provided by financing activities
            
            
            2,487
            
            
            3,455
            
            
            3,751Effect
                of exchange rate changes on cash
            
            
            5
            
            
            (2
            )
            
            (6
            )Net
                increase (decrease) in cash and cash equivalents
            
            
            (78
            )
            
            88
            
            
            (180
            )Cash
                and cash equivalents at beginning of year
            
            
            107
            
            
            19
            
            
            199Cash
                and cash equivalents at end of year
            
            $
            29
            
            $
            107
            
            $
            19SUPPLEMENTAL
                DISCLOSURES OF CASH FLOW INFORMATIONCash
                paid (refunds) during the year for:Income
                taxes
            
            $
            1
            
            $
            2
            
            
            ($18
            )Interest
            
            $
            645
            
            $
            749
            
            $
            218





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


F
          -7


**LEVEL
      8 SYSTEMS, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS - CONTINUED**





Non-Cash
      Investing and Financing Activities





**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 956,250 shares of Level 8 Systems common stock upon
      conversion of 306 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.





**2003**





During
      2003, the Company issued 161,438 shares of common stock to vendors for
      outstanding liabilities valued at $73,000. Of this total, 66,667 shares or
      $25,000, were issued as part of the 1,894,444 shares issued in the October
      2003
      private placement.





In
      November 2003, the Company issued 150,000 shares of common stock to a designated
      subsidiary of Liraz Systems Ltd. as compensation for extension of a bank debt
      guarantee valued at $51,000.





During
      2003, the Company issued 546,875 shares of Level 8 Systems common stock upon
      conversion of 175 shares of Series D Convertible Redeemable Preferred
      Stock.





In
      October 2003, the Company issued 3,048,782 warrants to holders of the Series
      A3
      Convertible Redeemable Preferred Stock and Series B3 Convertible Redeemable
      Preferred Stock under an existing agreement and in consideration for the waiver
      of certain price protection anti-dilution provisions of the Series A3 Preferred
      Stock and Series B3 Preferred Stock agreements. The warrants have a strike
      price
      of $0.40 valued at $1,062,000. (See Note 12.)


F
          -8


In
      April
      2003, the Company agreed to exchange the warrants issued in the January 2002
      private placement priced at $2.50 each for new warrants priced at $0.60 each
      and
      has extended the expiration date to until March 2007. This exchange was made
      as
      a result of a waiver by such warrant holders of certain terms and conditions
      that would trigger payments by the Company if the Company did not keep such
      shares registered under the Securities Act of 1933, as amended.





F
          -9


**LEVEL
      8 SYSTEMS, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





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





Level
      8
      Systems, Inc. (''Level 8'' or the ''Company'') is a global provider of business
      integration software that 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 a loss of $3,681,000
      for the year ended December 31, 2005 and has experienced negative cash flows
      from operations for each of the years ended December 31, 2005, 2004 and 2003.
      At
      December 31, 2005, the Company had a working capital deficiency of approximately
      $13,894,000. 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 Level 8 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.
      Level 8 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 Level 8’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
      merger 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 merger at a Shareholders
      meeting, these Notes would convert into common shares of Cicero, Inc., the
      surviving corporation in the merger. As of December 31, 2005, the Company raised
      a total of $2,559,000 from the Note and Warrant Offering. During 2005, the
      Company also entered into several Convertible Bridge Notes with a consortium
      of
      investors. As of December 31, 2005, the Company had raised $1,760,000 of
      Convertible Bridge Notes. The Convertible Bridge Notes convert into common
      stock
      of Cicero, Inc. upon approval of the recapitalization merger. Management expects
      that it will be able to raise additional capital, post merger, 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
          -10


**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 institutions in both the United States and several foreign
      countries. At times, such cash and cash equivalents in the United States 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.





F
          -11


**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 2.)





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 7.)





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. Effective January 1, 2002, 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 and 2003, 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. Any unearned receipts from
      service contracts result 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.


F
          -12


**Advertising
      Expenses:**





The
      Company expenses advertising costs as incurred. Advertising expenses were
      approximately $16,000, $7,000, and $9,000 for the years ended December 31,
      2005,
      2004 and 2003, 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, 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
      11.)








**Discontinued
      Operations:**





During
      the third quarter of 2002, the Company made a decision to dispose of the Systems
      Integration segment and entered into negotiations with potential buyers. The
      Systems Integration segment qualified for treatment as a discontinued operation
      in accordance with SFAS 144, “Accounting for the Impairment or Disposal of
      Long-Lived Assets”, and the Company reclassified the results of operations for
      the Systems Integration segment in 2002 to "loss from discontinued operations"
      in the Consolidated Statements of Operations. The sale of the Systems
      Integration segment was completed in December 2002.








**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 2005, 2004, and 2003, 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:





**2005**
            
            **2004**
            
            **2003**Stock
                options
            
            
            5,900,897
            
            
            7,488,639
            
            
            5,625,878Warrants
            
            
            19,376,075
            
            
            19,953,406
            
            
            10,926,706Preferred
                stock
            
            
            8,504,611
            
            
            9,855,723
            
            
            16,893,17433,781,583
            
            
            37,297,768
            
            
            33,445,758





In
      2005,
      2004 and 2003, no dividends were declared on preferred stock.








**Stock-Based
      Compensation:**





The
      Company has adopted the disclosure provisions of SFAS 123, “Accounting for
      Stock-Based Compensation”, and has applied Accounting Principles Board (“APB”)
      Opinion No. 25, “Accounting for Stock Issued to Employees”, and related
      Interpretations in accounting for its stock-based compensation plans. Had
      compensation cost for the Company’s stock option plans been determined based on
      the fair value at the grant dates for awards under the plans, consistent with
      the method required by SFAS No. 123, the Company’s net loss and diluted net loss
      per common share would have been the pro forma amounts indicated below (in
      thousands).


F
          -13





Years
                ended December 31,**2005**
            
            
            **2004**
            
            
            **2003**Net
                loss applicable to common stockholders, as reported
            
            
            ($3,681
            )
            
            ($9,761
            )
            
            ($11,708
            )Less:
                Total stock-based employee compensation expense underfair
                value based method for all awards, net of related tax
                effects
            
            
            (180
            )
            
            (777
            )
            
            (1,016
            )Pro
                forma loss applicable to common stockholders
            
            
            ($3,861
            )
            
            ($10,538
            )
            
            ($12,724
            )Loss
                per share:Basic
                and diluted, as reported
            
            $
            (0.08
            )
            $
            (0.28
            )
            $
            (0.54
            )Basic
                and diluted, pro forma
            
            $
            (0.09
            )
            $
            (0.29
            )
            $
            (0.59
            )





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:





**2005**
            
            **2004**
            
            **2003**Expected
                life (in years)
            
            6.00
            
            
            4.19
            
            
            8.33Expected
                volatility
            
            149
            %
            
            138
            %
            
            126
            %Risk
                free interest rate
            
            4.48
            %
            
            4.75
            %
            
            4.00
            %Expected
                dividend yield
            
            0
            %
            
            0
            %
            
            0
            %








**Warrants
      Liability** :





The
      Company has 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.








**Reclassifications:**





Certain
      prior year amounts in the accompanying financial statements have been
      reclassified to conform to the 2005 presentation. Such reclassifications had
      no
      effect on previously reported net income or stockholders’ equity.








**Recent
      Accounting Pronouncements:**




In
      May
      2005, the FASB issued SFAS No. 154, “Accounting Changes and Error
      Corrections”, which changes the requirements for the accounting and reporting of
      a change in accounting principle. SFAS No. 154 applies to all voluntary
      changes in accounting principle as well as to changes required by an accounting
      pronouncement that does not include specific transition provisions. SFAS
      No. 154 requires that changes in accounting principle be retrospectively
      applied. SFAS No. 154 is effective for accounting changes and corrections
      of errors made in fiscal years beginning after December 15, 2005. The
      Company does not believe adoption of this statement will have a material impact
      on the Company’s financial statements.





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 will be 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 has not yet determined which fair-value
      method and transitional provision it will follow.  However, the Company
      expects that the adoption of SFAS 123R will have a significant impact on its
      results of operations.  The Company does not expect the adoption of SFAS
      123R will impact its overall financial position.  See Stock-Based
      Compensation above for the pro forma impact on net loss and net loss per share
      from calculating stock-based compensation costs under the fair


F
          -14


value
      alternative of SFAS 123.  However, the calculation of compensation cost for
      share-based payment transactions after the effective date of SFAS 123R may
      be
      different from the calculation of compensation cost under SFAS 123, but such
      differences have not yet been quantified.








**NOTE
      2.**  **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.





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 7.)








**NOTE
      3.**  **DISPOSITIONS**





In
      March
      2003, the Company received notification of the finalization of the bankruptcy
      proceeding in the United Kingdom and recorded a gain on the closure of the
      subsidiary of $216,000 in gain (loss) on disposal of assets.





In
      December 2003, the Company received notification of the liquidation of the
      Denmark subsidiary and the Company recorded a gain on the closure of the
      subsidiary of $62,000 in gain (loss) on disposal of assets.








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





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





**2005**
            
            **2004**Current
                trade accounts receivable
            
            $
            18
            
            $
            164Less:
                allowance for doubtful accounts
            
            
            --
            
            
            (12
            )$
            18
            
            $
            152




The
      (credit) provision for uncollectible amounts was ($12,000), ($4,000), and
      ($52,000) for the years ended December 31, 2005, 2004, and 2003,
      respectively. Write-offs (net of recoveries) of accounts receivable were ($0)
      for the years ended December 31, 2005 and 2004, and ($488,000) for the year
      ended December 31, 2003.








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





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


**2005**
            
            **2004**Computer
                equipment
            
            $
            246
            
            $
            242Furniture
                and fixtures
            
            
            8
            
            
            8Office
                equipment
            
            
            140
            
            
            138394
            
            
            388Less:
                accumulated depreciation and amortization
            
            
            (384
            )
            
            (373
            )$
            10
            
            $
            15




Depreciation
      and amortization expense of property and equipment was $11,000, $11,000 and
      $167,000 for the years ended December 31, 2005, 2004, and 2003,
      respectively.


F
          -15


**NOTE
      6.**  **NOTES
      RECEIVABLE**





In
      2002,
      the Company disposed of the remaining assets of the Systems Integration segment
      through a sale to EM Software Solutions, Inc. As part of the proceeds, the
      Company received two notes receivable from the purchaser. The first note was
      due
      on February 13, 2003 in the amount of $744,000 and bore interest at prime plus
      2.25%. This note was repaid in February 2003. The second note was in the
      principal amount of $617,000 and bears interest at prime plus 1%. Principal
      and
      interest is payable monthly and the note matures in 2007. Due to the uncertainty
      of the collection of the note at the time, the Company recorded the note net
      of
      an allowance of $494,000.





As
      more
      fully discussed in Note 21, the Company had been party to litigation for breach
      of a real estate lease. That case was settled in August 2003. Under the terms
      of
      the settlement agreement, the Company agreed to assign the note receivable
      due
      from EM Software Solutions, with recourse equal to the unpaid portion of the
      Note should the Note obligor default on future payments. The principal balance
      outstanding on the Note at the time of assignment was $545,000. The Company
      assessed the probability of liability under the recourse provisions using a
      weighted probability cash flow analysis and has recognized a long-term liability
      in the amount of $131,000. In addition, the Company wrote off the unreserved
      portion of the Note, or $51,000.








**NOTE
      7.**  **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, 2005, the Company has
      no
      capitalized costs for the Cicero technology.





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.





Effective
      July 2002, the Company determined that the estimated asset life of the Cicero
      technology has been extended as a result of the January 2002 amended license
      agreement with Merrill Lynch, Pierce, Fenner & Smith Incorporated (“Merrill
      Lynch”) wherein the exclusive right to modify, commercialize, and distribute the
      technology was extended in perpetuity. Accordingly, the Company reassessed
      the
      estimated life of the technology and extended it from three years to five years.
      The effect of the change in the estimated life resulted in a reduction of
      $4,608,000 of amortization expense for the year ended December 31, 2003.
      The impact on the net loss applicable to common stockholders - basic and diluted
      was $(0.21) per share for December 31, 2003.





During
      the years ended December 31, 2004 and 2003, the Company recognized $4,276,000
      of
      which $3,585,000 is an impairment charge, and $3,933,000 of which $993,000
      is an
      impairment charge, respectively, of expense related to the amortization of
      these
      costs, which is recorded as cost of software revenue in the consolidated
      statements of operations. Accumulated amortization of capitalized software
      costs
      was $24,712,000 and $20,436,000 at December 31, 2004 and 2003,
      respectively.





F
          -16


**NOTE
      8.**   **SENIOR
      REORGANIZATION DEBT**





In
      2004,
      the Company announced a Note and Warrant Offering in which warrant holders
      of
      Level 8’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
      merger plan. Under the terms of the Offer, which expired on December 31, 2004,
      warrant holders who elect to convert, would tender their conversion price in
      cash and receive a Note Payable in exchange. As of December 31, 2005 the company
      had raised $2,559,000. Upon approval of the recapitalization merger at a
      Shareholders meeting in mid 2006, these Notes would convert into common shares
      of Cicero, Inc., the surviving corporation in the merger. 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 $0.10 per share. In addition, upon approval
      of
      the recapitalization merger, each warrant holder would be entitled to additional
      warrants to purchase common stock in Cicero, Inc. If the merger proposal is
      not
      approved, the Notes will immediately become due and payable.








**NOTE
      9. CONVERTIBLE BRIDGE DEBT**





From
      July
      through December 2005, the Company entered into several Convertible Bridge
      Notes
      with a consortium of investors. These notes bear interest at 10% and mature
      at
      various dates beginning on September 15, 2005. The Notes are convertible into
      shares of Cicero, Inc. common stock upon effectiveness of the proposed
      recapitalization merger. Since the Company has not effected the recapitalization
      merger by December 31, 2005, the conversion rates on the Notes is $0.025. As
      of
      December 31, 2005, the Company has raised $1,760,000 of Convertible Bridge
      Notes
      of which $566,000 was from various members of the Company’s Board of Directors.
      If the merger proposal is not approved, the Notes will immediately become due
      and payable.








**NOTE
      10.**  **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):




**2005**
            
            **2004**Term
                loan (a)
            
            $
            1,971
            
            $
            1,971Note
                payable; related party (b)
            
            
            9
            
            
            69Notes
                payable (c)
            
            
            509
            
            
            644Short
                term convertible note (d)
            
            
            265
            
            
            235Short
                term convertible notes, related party (e)
            
            
            727
            
            
            727$
            3,481
            
            $
            3,646








(a)
            The
                Company has a $1,971 term loan bearing interest at LIBOR plus 1.5%
                (approximately 5.26% at December 31, 2005). Interest is payable quarterly.
                There are no financial covenants and the term loan is guaranteed
                by Liraz
                Systems Ltd., the Company’s former principal shareholder. The loan matures
                on October 30, 2006. (See Note 18.)





(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, 2005, 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 is 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. In May 2004, the Company entered into convertible loans aggregating
      $185,000 from several investors including a member of the Company’s


F
          -17


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 note holder
      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. 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.





(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
      April
      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. In June 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. Also in June 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.





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. 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. 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. 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.








**NOTE
      1** **1.**  **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) :





**2005**
            
            **2004**
            
            **2003**Expected
                income tax benefit at statutory rate (34%)
            
            $
            (1,251
            )
            $
            (3,319
            )
            $
            (3,402
            )State
                taxes, net of federal tax benefit.
            
            
            (308
            )
            
            (219
            )
            
            (405
            )Effect
                of foreign operations including withholding taxes
            
            
            --
            
            
            12
            
            
            (31
            )Effect
                of change in valuation allowance
            
            
            1,537
            
            
            3,357
            
            
            3,769Non-deductible
                expenses
            
            
            22
            
            
            169
            
            
            69Total
            
            $
            --
            
            $
            --
            
            $
            --





F
          -18


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





**2005**
            
            **2004**Current
                assets:Allowance
                for doubtful accounts
            $
            4
            
            $
            4Accrued
                expenses, non-tax deductible
            
            145
            
            
            522Deferred
                revenue
            
            31
            
            
            34Noncurrent
                assets:Loss
                carryforwards
            
            89,528
            
            
            76,229Depreciation
                and amortization
            
            6,746
            
            
            7,58196,454
            
            
            84,370Less:
                valuation allowance
            
            (96,454
            )
            
            (84,370
            )$
            --
            
            $
            --





At
      December 31, 2005, the Company had net operating loss carryforwards of
      approximately $230,926,000, 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, 2005 and 2004 since management does not believe
      that it is more likely than not that these assets will be realized.








**NOTE
      12. SENIOR CONVERTIBLE REDEEMABLE PREFERRED STOCK**





On
      March
      19, 2003, the Company completed a $3.5 million private placement of Series
      D
      Convertible Preferred Stock (“Series D Preferred Stock”), convertible at a
      conversion ratio of $0.32 per share of common stock into an aggregate of
      11,031,250 shares of common stock. As part of the financing, the Company has
      also issued warrants to purchase an aggregate of 4,158,780 shares of common
      stock at an exercise price of $0.07 per share (“Series D-1 Warrants”). On
      October 10, 2003, the Company, consistent with its obligations, also issued
      warrants to purchase an aggregate of 1,665,720 shares of common stock at an
      exercise price the lesser of $0.20 per share or market price at the time of
      exercise (“Series D-2 Warrants”). The Series D-2 Warrants became exercisable on
      November 1, 2003, because the Company failed to report $6 million in gross
      revenues for the nine month period ended September 30, 2003. Both existing
      and
      new investors participated in the financing. The Company also agreed to register
      the common stock issuable upon conversion of the Series D Preferred Stock and
      exercise of the warrants for resale under the Securities Act of 1933, as
      amended. Under the terms of the financing agreement, a redemption event may
      occur if any one person, entity or group shall control more than 35% of the
      voting power of the Company’s capital stock. The Company allocated the proceeds
      received from the sale of the Series D Preferred Stock and warrants to the
      preferred stock and detachable warrants on a relative fair value basis,
      resulting in an allocation of $2,890,000 to the Series D Preferred Stock and
      $640,000 to the detachable warrants. Based upon the allocation of the proceeds,
      the Company determined that the effective conversion price of the Series D
      Preferred Stock was less than the fair value of the Company’s common stock on
      the date of issuance. The beneficial conversion feature was recorded as a
      discount on the value of the Series D Preferred Stock and an increase in
      additional paid-in capital. Because Series D Preferred Stock was convertible
      immediately upon issuance, the Company fully amortized such beneficial
      conversion feature on the date of issuance.


F
          -19


As
      part
      of the financing, the Company and the lead investors have agreed to form a
      joint
      venture to exploit the Cicero technology in the Asian market. The terms of
      the
      agreement require that the Company place $1 million of the gross proceeds from
      the financing into escrow to fund the joint venture. The escrow agreement allows
      for the immediate release of funds to cover organizational costs of the joint
      venture. During the quarter ended March 31, 2003, $225,000 of escrowed funds
      was
      released. Since the joint venture was not formed and operational on or by July
      17, 2003, the lead investors have the right, but not the obligation, to require
      the Company to purchase $1 million in liquidation value of the Series D
      Preferred Stock at a 5% per annum premium, less their pro-rata share of
      expenses. On October 21, 2004, the Company received notification from the lead
      investors of their intent to redeem the escrow balance and surrender the
      equivalent amount of Series D preferred shares. This redemption was completed
      in
      November 2004.





Another
      condition of the financing requires the Company to place an additional $1
      million of the gross proceeds into escrow, pending the execution of a definitive
      agreement with Merrill Lynch, providing for the sale of all right, title and
      interest to the Cicero technology. Since a transaction with Merrill Lynch for
      the sale of Cicero was not consummated by May 18, 2003, the lead investors
      have
      the right, but not the obligation, to require the Company to purchase $1 million
      in liquidation value of the Series D Preferred Stock at a 5% per annum premium.
      In addition, the Company and the lead investor agreed to extend the escrow
      release provisions until the end of July 2003 when all remaining escrow monies
      were released to the Company.








**NOTE
      1** **3.**  **STOCKHOLDERS’
      EQUITY**





**Common
      Stock** :





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.




In
      October 2003, the Company entered into a Securities Purchase Agreement with
      several investors wherein the Company agreed to sell 1,894,444 shares of its
      common stock and issue 473,611 warrants to purchase the Company’s common stock
      at a price of $0.45 per share for a total of $853,000 in proceeds. This offering
      closed on October 15, 2003. The warrants expire in 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.





In
      January 2002, the Company entered into a Securities Purchase Agreement with
      several investors wherein the Company agreed to sell up to 3,000,000 shares
      of
      its common stock and warrants. The common stock was valued at $1.50 per share
      and warrants to purchase additional shares were issued with an exercise price
      of
      $2.75 per share. This offering closed on January 16, 2002. Of the 3,000,000
      shares, the Company sold 2,381,952 shares of common stock for a total of
      $3,574,000 and granted 476,396 warrants to purchase the Company’s common stock
      at an exercise price of $2.75 per share. The warrants expire in three years
      from
      the date of grant and have a call feature that forces exercise if the Company’s
      common stock exceeds $5.50 per share. 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. Under this
      Private Placement, the Company had agreed to certain terms and conditions that
      would trigger payments by the Company if the Company did not keep such shares
      registered under the Securities Act of 1933, as amended. In April 2003, in
      exchange for a waiver of such provisions the Company agreed to exchange the
      warrants from the January 2002 Private Placement priced at $2.50 for new
      warrants priced at $0.60 and has extended the expiration date until March 2007.
      Each participant is required to execute a waiver prior to receiving the repriced
      warrants.








**Stock
      Grants** :





During
      2005 and 2004, no stock awards were made to employees.


F
          -20


**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 10,900,000 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, 509,250 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 120,000
      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.





Activity
      for stock options issued under these plans for the fiscal years ending December
      31, 2005, 2004 and 2003 was as follows:


**Plan
                Activity**
            
            **Option
                Price**
              **Per
                Share**
            
            **Weighted
                Average**
              **Exercise
                Price**Balance
                at December 31, 2002
            
            
            3,834,379
            
            
            0.34-39.32
            
            
            3.81Granted
            
            
            2,566,126
            
            
            0.22
                - 0.57
            
            
            0.24Exercised
            
            
            (121,434
            )
            
            0.22
                - 0.22
            
            
            0.22Forfeited
            
            
            (653,193
            )
            
            0.22-
                39.32
            
            
            2.60Balance
                at December 31, 2003
            
            
            5,625,878
            
            
            0.20-39.32
            
            
            2.43Granted
            
            
            3,139,232
            
            
            0.12
                - 0.39
            
            
            0.26Exercised
            
            
            (519,232
            )
            
            0.08
                - 0.37
            
            
            0.17Forfeited
            
            
            (757,239
            )
            
            0.22-37.88
            
            
            8.12Balance
                at December 31, 2004
            
            
            7,488,639
            
            
            0.12-39.32
            
            
            1.11Granted
            
            
            252,929
            
            
            0.07
                - 0.12
            
            
            0.09Exercised
            
            
            (252,929
            )
            
            0.07
                - 0.12
            
            
            0.09Forfeited
            
            
            (1,587,742
            )
            
            0.22-39.32
            
            
            0.75Balance
                at December 31, 2005
            
            
            5,900,897
            
            
            0.12-39.32
            
            
            1.24








The
      weighted average grant date fair value of options issued during the years ended
      December 31, 2005, 2004, and 2003 was equal to $0.09, $0.26, and $0.24 per
      share, respectively. There were no option grants issued below fair market value
      during 2005, 2004 or 2003.





At
      December 31, 2005, 2004, and 2003, options to purchase approximately 5,237,432,
      4,775,040, and 2,770,126 shares of common stock were exercisable, respectively,
      pursuant to the plans at prices ranging from $0.12 to $39.32. The following
      table summarizes information about stock options outstanding at December 31,
      2005:


F
          -21





**EXERCISE
                PRICE**
            
            **NUMBER**
              **OUTSTANDING**
            
            **REMAINING
                CONTRACTUAL**
              **LIFE
                FOR OPTIONS**
              **OUTSTANDING**
            
            **NUMBER**
              **EXERCISABLE**
            
            **WEIGHTED**
              **AVERAGE**
              **EXERCISE**
              **PRICE**$
                0.12 - 3.93
            
            
            5,212,947
            
            
            6.9
            
            
            4,549,482
            
            $
            0.473.94
                -7.86
            
            
            597,000
            
            
            5.1
            
            
            597,000
            
            
            5.837.87-11.79
            
            
            61,750
            
            
            2.5
            
            
            61,750
            
            
            8.9511.80-15.72
            
            
            5,000
            
            
            1.7
            
            
            5,000
            
            
            14.7315.73-19.66
            
            
            5,500
            
            
            4.6
            
            
            5,500
            
            
            18.8119.67-23.59
            
            
            3,000
            
            
            0.2
            
            
            3,000
            
            
            20.0023.60-27.52
            
            
            0
            
            
            0.0
            
            
            0
            
            
            0.0027.53-31.45
            
            
            3,000
            
            
            4.0
            
            
            3,000
            
            
            30.2531.46-35.38
            
            
            0
            
            
            0.0
            
            
            0
            
            
            0.0035.39-39.32
            
            
            12,700
            
            
            2.0
            
            
            12,700
            
            
            39.145,900,897
            
            
            6.7
            
            
            5,237,432
            
            $
            1.24








**Preferred
      Stock** :





In
      connection with the sale of Series D Preferred Stock, the holders of the
      Company’s Series A3 Preferred Stock and Series B3 Preferred Stock (collectively,
      the “Existing Preferred Stockholders”), entered into an agreement whereby the
      Existing Preferred Stockholders have agreed to waive certain applicable price
      protection anti-dilution provisions. Under the terms of the waiver agreement,
      the Company is also permitted to issue equity securities representing aggregate
      proceeds of up to an additional $4.9 million following the sale of the Series
      D
      Preferred Stock. Additionally, the Existing Preferred Stockholders have also
      agreed to a limited lock-up restricting their ability to sell common stock
      issuable upon conversion of their preferred stock and warrants and to waive
      the
      accrual of any dividends that may otherwise be payable as a result of the
      Company’s delisting from Nasdaq. As consideration for the waiver agreement, the
      Company has agreed to issue on a pro rata basis up to 1,000 warrants to all
      the
      Existing Preferred Stockholders on a pro rata basis at such time and from time
      to time as the Company closes financing transactions that represent proceeds
      in
      excess of $2.9 million, excluding the proceeds from the Series D Preferred
      Stock
      transaction. Such warrants will have an exercise price that is the greater
      of
      $0.40 or the same exercise price as the exercise price of the warrant, or equity
      security, that the Company issues in connection with the Company’s financing or
      loan transaction that exceeds the $2.9 million threshold.





On
      August
      14, 2002, the Company completed a $1.6 million private placement of Series
      C
      Convertible Preferred Stock (“Series C Preferred Stock”), convertible at a
      conversion ratio of $0.38 per share of common stock into an aggregate of
      4,184,211 shares of common stock. As part of the financing, the Company has
      also
      issued warrants to purchase an aggregate of 1,046,053 shares of common stock
      at
      an exercise price of $0.38 per share. As consideration for the $1.6 million
      private placement, the Company received approximately $1.4 million in cash
      and
      allowed certain debt holders to convert approximately $150,000 of debt and
      $50,000 accounts payable to equity. The Chief Information Officer of the
      Company, Anthony Pizi, converted $150,000 of debt owed to him into shares of
      Series C Preferred Stock and warrants. Both existing and new investors
      participated in the financing. The Company also agreed to register the common
      stock issuable upon conversion of the Series C Preferred Stock and exercise
      of
      the warrants for resale under the Securities Act of 1933, as amended. The
      Company allocated the proceeds received from the sale of the Series C Preferred
      Stock and warrants to the preferred stock and the detachable warrants on a
      relative fair value basis, resulting in the allocation $1,271,000 to the Series
      C Preferred Stock and $329,000 to the detachable warrants. Based on the
      allocation of the proceeds, the Company determined that the effective conversion
      price of the Series C Preferred Stock was less than the fair value of the
      Company’s common stock on the date of issuance. As a result, the Company
      recorded a beneficial conversion feature in the amount of $329,000 based on
      the
      difference between the fair market value of the Company’s common stock on the
      closing date of the transaction and the effective conversion price of the Series
      C Preferred Stock. The beneficial conversion feature was recorded as a discount
      on the value of the Series C Preferred Stock and an increase in additional
      paid-in capital. Because the Series C Preferred Stock was convertible
      immediately upon issuance, the Company fully amortized such beneficial
      conversion feature on the date of issuance **.**


F
          -22


In
      connection with the sale of Series C Preferred Stock, the Company agreed with
      the existing holders of its Series A1 Convertible Preferred Stock (the “Series
      A1 Preferred Stock”) and the Series B1 Convertible Preferred Stock (the “Series
      B1 Preferred Stock”), in exchange for their waiver of certain anti-dilution
      provisions, to reprice an aggregate of 1,801,022 warrants to purchase common
      stock from an exercise price of $1.77 to $0.38. The Company entered into an
      Exchange Agreement with such holders providing for the issuance of 11,570 shares
      of Series A2 Convertible Preferred Stock (“Series A2 Preferred Stock”) and
      30,000 Series B2 Convertible Preferred Stock (“Series B2 Preferred Stock”),
      respectively. Series A2 Preferred Stock and Series B2 Preferred Stock are
      convertible into an aggregate of 1,388,456 and 2,394,063 shares of the Company’s
      common stock at $8.33 and $12.53 per share, respectively. The exchange is being
      undertaken in consideration of the temporary release of the anti-dilution
      provisions of the Series A1 Preferred Stockholders and Series B1 Preferred
      Stockholders. Based on a valuation performed by an independent valuation firm,
      the Company recorded a deemed dividend of $293,000, to reflect the increase
      in
      the fair value of the preferred stock and warrants as a result of the exchange.
      (See “Stock Warrants” for fair value assumptions.) The dividend increased the
      fair value of the warrant liability. As of December 31, 2005, no warrants had
      been exercised.





On
      October 25, 2002, the Company effected an exchange of all of our outstanding
      shares of Series A2 Convertible Redeemable Preferred Stock (“Series A2 Preferred
      Stock”) and Series B2 Convertible Redeemable Preferred Stock (“Series B2
      Preferred Stock”) and related warrants for an equal number of shares of newly
      created Series A3 Convertible Redeemable Preferred Stock (“Series A3 Preferred
      Stock”) and Series B3 Convertible Redeemable Preferred Stock (“Series B3
      Preferred Stock”) and related warrants. This exchange was made to correct a
      deficiency in the conversion price from the prior exchange of Series A1 and
      B1
      Preferred Stock and related warrants for Series A2 and B2 Preferred Stock and
      related warrants on August 29, 2002. The conversion price for the Series A3
      Preferred Stock and the conversion price for the Series B3 Preferred Stock
      remain the same as the previously issued Series A1 and A2 Preferred Stock and
      Series B1 and B2 Preferred Stock, at $8.33 and $12.53, respectively. The
      exercise price for the aggregate 753,640 warrants relating to the Series A3
      Preferred Stock (“Series A3 Warrants”) was increased from $0.38 to $0.40 per
      share which is a reduction from the $1.77 exercise price of the warrants
      relating to the Series A1 Preferred Stock. The exercise price for the aggregate
      1,047,382 warrants relating to the Series B3 Preferred Stock (“Series B3
      Warrants”) was increased from $0.38 to $0.40 per share which is a reduction from
      the $1.77 exercise price of the warrants relating to the Series B1 Preferred
      Stock. The adjusted exercise price was based on the closing price of the
      Company’s Series C Convertible Redeemable Preferred Stock and warrants on August
      14, 2002, plus $0.02, to reflect accurate current market value according to
      relevant Nasdaq rules. This adjustment was made as part of the agreement under
      which the holders of the Company’s Preferred Stock agreed to waive their
      price-protection anti-dilution protections to allow the Company to issue the
      Series C Preferred Stock and warrants without triggering the price-protection
      anti-dilution provisions and excessively diluting its common stock. The Company
      may cause the redemption of the Series A3 Preferred Stock warrants and the
      Series B3 Preferred Stock warrants for $.0001 at any time if the closing price
      of the Company’s common stock over 20 consecutive trading days is greater than
      $5.00 and $7.50 per share, respectively. The holders of the Series A3 and Series
      B3 Warrants may cause the warrants to be redeemed for cash at the difference
      between the exercise price and the fair market value immediately preceding
      a
      redemption event as defined in the contract. As such, the fair value of the
      warrants at issuance has been classified as a warrant liability in accordance
      with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to,
      and Potentially Settled in a Company’s Own Stock”. As of December 31, 2005, no
      warrants have been exercised and the fair value of the liability is
      $0.





Under
      the
      terms of the agreement, the Company is authorized to issue equity securities
      in
      a single or series of financing transactions representing aggregate gross
      proceeds to the Company of approximately $5 million, or up to an aggregate
      17,500 shares of common stock, without triggering the price-protection
      anti-dilution provisions in the Series A3 Preferred Stock and B3 Preferred
      Stock
      and related warrants. In exchange for the waiver of these price-protection
      anti-dilution provisions, the Company repriced the warrants as described above
      and have agreed to issue on a pro rata basis up to 4,600 warrants to the holders
      of Series A3 Preferred Stock and Series B3 Preferred Stock at such time and
      from
      time to time as the Company closes subsequent financing transactions up to
      the
      $5 million issuance cap or the 17,500 share issuance cap. As a result of the
      Series C Preferred Stock financing, which represented approximately $1.6 million
      of the Company’s $5 million in allowable equity issuances, the Company is
      obligated to issue an aggregate of 1,462,801 warrants at an exercise price
      of
      $0.40 per share to the existing preferred stockholders. The warrants were issued
      on December 31, 2002 and had a fair value of $373,000, which was recorded as
      a
      dividend to, Preferred stockholders. As a result of the Series D preferred
      Stock
      financing which represented approximately $3.5 million against the allowable
      equity issuances, the Company was obligated to issue an aggregate of 3,048,782
      warrants at an exercise price of $0.40 per share to the existing Series A3
      and
      Series B3 preferred shareholders. The warrants were issued on October 8, 2003
      and had a fair value of $1,062,000, which was recorded as a deemed dividend
      to
      preferred stockholders. Additionally, the Company has agreed to issue a warrant
      to purchase common stock to the existing preferred stockholders on a pro rata
      basis for each warrant to purchase common stock that the Company issues to
      a
      third-party lender in connection with the closing of a qualified loan
      transaction. The above referenced warrants will have the same


F
          -23


exercise
      price as the exercise price of the warrant, or equity security, that the Company
      issues in connection with the Company’s subsequent financing or loan transaction
      or $0.40, whichever is greater. These warrants are not classified as a liability
      under EITF 00-19.





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 2004, 2003, and 2002 were valued using the following
      assumptions:





**Expected
                Life in****Years**
            
            **Expected****Volatility**
            
            **Risk
                Free Interest****Rate**
            
            **Expected**
              **Dividend**
            
            **Fair
                Value of Common****Stock**Preferred
                Series A3 and B3 Warrants
            
            
            4
            
            
            107.5
            %
            
            4
            %
            
            None
            
            $
            1.892002-2003
                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 - October 2003
            
            
            3
            
            
            102
            %
            
            3
            %
            
            None
            
            $
            0.45Private
                Placement - January 2004
            
            
            3
            
            
            101
            %
            
            3
            %
            
            None
            
            $
            0.36





During
      December 2000, the Company issued a commercial lender rights to purchase up
      to
      172,751 shares of the Company's common stock at an exercise price of $4.34
      in
      connection with a new credit facility. The warrants were valued at $775,000
      or
      $4.49 per share and were exercisable until December 28, 2004. As of the date
      of
      expiration, no warrants were exercised.





**Increase
      in Capital Stock:**





In
      July
      2003, 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 60,000,000 to
      85,000,000.








**NOTE
      1** **4.**  **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 Level 8 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
      $30,000, $54,000, and $14,000 for the years ended December 31, 2005, 2004,
      and 2003, 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
          -24





**NOTE
      1** **5.**  **SIGNIFICANT
      CUSTOMERS AND CONCENTRATION OF CREDIT RISK**





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. In 2003, three customers accounted for 42.1%, 19.5% and 12.7% of
      operating revenues.





**NOTE
      16.**  **FOREIGN
      CURRENCIES**





As
      of
      December 31, 2005, the Company had $0 of U.S. dollar equivalent cash and trade
      receivable balances denominated in foreign currencies.





The
      Company’s net foreign currency transaction losses/ (gains) were $(23,000),
      $13,000, and $31,000 for the years ended 2005, 2004, and 2003,
      respectively.








**NOTE
      17.**  **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, 2005, 2004 and 2003 (in thousands):


**For
                the year ended December 31,**2005
            
            2004
            
            2003Desktop
                Integration
            
            
            Messaging
                and Application Engineering
            
            
            Total
            
            
            Desktop
                Integration
            
            
            Messaging
                and Application Engineering
            
            
            Total
            
            
            Desktop
                Integration
            
            
            Messaging
                and Application Engineering
            
            
            TotalTotal
                revenue
            
            $
            760
            
            $
            25
            
            $
            785
            
            $
            707
            
            $
            68
            
            $
            775
            
            $
            466
            
            $
            64
            
            $
            530Total
                cost of revenue
            
            
            1,188
            
            
            --
            
            
            1,188
            
            
            5,662
            
            
            213
            
            
            5,875
            
            
            5,371
            
            
            62
            
            
            5,433Gross
                margin (loss)
            
            
            (428
            )
            
            25
            
            
            (403
            )
            
            (4,955
            )
            
            (145
            )
            
            (5,100
            )
            
            (4,905
            )
            
            2
            
            
            (4,903
            )Total
                operating expenses
            
            
            2,536
            
            
            119
            
            
            2,655
            
            
            3,348
            
            
            373
            
            
            3,721
            
            
            4,999
            
            
            256
            
            
            5,255Segment
                profitability (loss)
            
            $
            (2,964
            )
            $
            (94
            )
            $
            (3,058
            )
            $
            (8,303
            )
            
            (518
            )
            
            (8,821
            )
            $
            (9,904
            )
            $
            (254
            )
            $
            (10,158
            )





F
          -25





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





**2005**
            
            **2004**
            
            **2003**Segment
                operating expenses
            
            $
            2,655
            
            $
            3,721
            
            $
            5,255Write-off
                of intangible assets
            
            
            --
            
            
            587
            
            
            --(Gain)Loss
                on disposal of assets
            
            
            --
            
            
            (5
            )
            
            415Restructuring,
                net
            
            
            --
            
            
            --
            
            
            (834
            )Total
                operating expenses
            
            $
            2,655
            
            $
            4,303
            
            $
            4,836





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





**2005**
            
            **2004**
            
            **2003**Total
                segment profitability (loss)
            
            $
            (3,058
            )
            $
            (8,821
            )
            $
            (10,158
            )Write-off
                of intangible assets
            
            
            --
            
            
            (587
            )
            
            --Gain/(loss)
                on disposal of assets
            
            
            --
            
            
            5
            
            
            (415
            )Restructuring
            
            
            --
            
            
            --
            
            
            834Interest
                and other income/(expense), net
            
            
            (623
            )
            
            (328
            )
            
            (135
            )Net
                loss before provision for income taxes
            
            $
            (3,681
            )
            $
            (9,731
            )
            $
            (9,874
            )





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





**2005**
            
            **2004**Desktop
                Integration
            
            $
            10
            
            $
            15Messaging/Application
                Engineering
            
            
            -
            
            
            -Total
                assets
            
            $
            10
            
            $
            15





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





**2005**
            
            **2004**
            
            **2003**Denmark
            
            $
            -
            
            $
            7
            
            $
            32Italy
            
            
            2
            
            
            4
            
            
            18United
                Kingdom
            
            
            -
            
            
            1
            
            
            -USA
            
            
            783
            
            
            762
            
            
            476Other
            
            
            -
            
            
            1
            
            
            4$
            785
            
            $
            775
            
            $
            530





Presentation
      of revenue by region is based on the country in which the customer is domiciled.
      As of December 31, 2005, 2004 and 2003, all of the long-lived assets of the
      Company are located in the United States. The Company reimburses the Company’s
      foreign subsidiaries for their costs plus an appropriate mark-up for profit.
      Intercompany profits and losses are eliminated in consolidation.








**NOTE
      1** **8.**  **RELATED
      PARTY INFORMATION**





Liraz
      Systems Ltd. guarantees certain debt obligations of the Company. 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


F
          -26


Company
      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. (See Note 10.)





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, 2005, 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: On
      April
      12, 2004, the Company entered into a convertible promissory note with Mr. Pizi.
      The note, in the face amount of $100,000, bears interest at 1% per month and
      is
      convertible into common stock of the Company at a conversion rate of $0.37
      per
      share. In addition, Mr. Pizi was granted 270,270 warrants to purchase the
      Company’s common stock at $0.37 per share.





In
      June
      2004, the Company entered into a convertible promissory note with Mr. Pizi. The
      note,
      in the face amount of $112,000, bears interest at 1% per month and is
      convertible into 560,000 shares of the Company’s common stock and warrants to
      purchase 560,000 shares of our common stock at $0.20 per share. Also in June
      2004, Mr. Pizi entered into a second convertible promissory note in the face
      amount of $15,000 which is convertible into 90,118 shares of the Company’s
      common stock and warrants to purchase 90,118 shares of the Company’s common
      stock at $0.17 per share.





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 note, the loan bears interest at 1% per month, and is convertible
      into 446,429 shares of Level 8 common stock and warrants to purchase 446,429
      shares of Level 8 common stock exercisable at $0.28 per share.





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 Level 8 common stock and warrants to purchase
      781,250 shares of Level 8 common stock exercisable at $0.16 per
      share .





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 .





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 of our common stock and warrants to purchase
      1,875,000 shares of the Company’s common stock exercisable at $0.08 per
      share .





In
      June
      2004, the Company entered into a convertible promissory note with Fredric Mack,
      a former director of Level 8, 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 Level 8 common stock and warrants to purchase 390,625 shares of Level
      8 common stock exercisable at $0.32 per share.





In
      April
      2005, the Company entered into a convertible promissory note with Bruce Miller,
      a director of Level 8, 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 Level 8 common 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 merger were being negotiated and at the time of approval of
      the
      recapitalization merger by our board of directors), was a director of Level
      8,
      in the amount of $25,000. Under the terms of the note, the loan bears interest
      at 1.5% per month and is convertible into 78,125 shares of Level 8 common stock
      and warrants to purchase 78,125 shares of Level 8 common stock exercisable
      at
      $0.32 per share.





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


F
          -27


*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 holds $423,333
      of Senior Reorganization Notes, which may be converted into warrants to purchase
      an additional 57,165,993 shares of Level 8 common stock at a purchase price
      of
      $0.002 per share. ****





Mr.
      Landis holds $327,860 of Senior Reorganization Notes, which may be converted
      into warrants to purchase an additional 44,234,523 shares of Level 8 common
      stock at an exercise price of $0.002 per share.





Mr.
      Mack
      holds, together with his affiliates, $88,122 of Senior Reorganization Notes,
      which may be converted into warrants to purchase an additional 44,234,523 shares
      of Level 8 common stock at a purchase price of $0.002 per share.





Mr.
      Miller holds, together with his affiliates, $77,706 of Senior Reorganization
      Notes, which may be converted into warrants to purchase an additional 11,459,727
      shares of Level 8 common stock at a purchase price of $0.002.





John
      Broderick, Chief Executive Officer and Chief Financial Officer of Level 8,
      holds
      $2,300 of Senior Reorganization Notes, which may be converted into warrants
      to
      purchase 333,333 shares of Level 8 common stock at a purchase price of $0.002
      per share, and options to purchase 1,099,200 shares of common stock under the
      Level 8 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
      are
      to be automatically exercised in connection with the consummation of the
      recapitalization merger.





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





Mr.
      Pizi
      holds $85,000 of Convertible Bridge Notes which bear interest at 10% and mature
      on September 15, 2005. Upon consummation of the recapitalization merger, these
      notes will automatically convert into 3,400,000 shares of Cicero common stock.





Mr.
      Landis holds $213,000 of Convertible Bridge Notes as of December 31, 2005,
      which
      bear interest at 10% and mature on September 15, 2005. Upon consummation of
      the
      recapitalization merger, these notes will automatically convert into 8,520,000
      shares of Cicero common stock.





Mr.
      Mack
      holds, together with his affiliates, $74,000 of Convertible Bridge Notes which
      bear interest at 10% and mature on September 15, 2005. Upon consummation of
      the
      recapitalization merger, these notes will automatically convert into 2,960,000
      shares of Cicero common stock.





Mr.
      Miller holds, together with his affiliates, $90,000 of Convertible Bridge Notes
      which bear interest at 10% and mature on September 15, 2005. Upon consummation
      of the recapitalization merger, these notes will automatically convert into
      3,600,000 shares of Cicero common stock.





Bruce
      Hasenyager, a member of our Board of Directors, holds $4,061 of Convertible
      Bridge Notes which bear interest at 10% and mature on September 15, 2005. Upon
      consummation of the recapitalization merger, these notes will automatically
      convert into 162,425 shares of Cicero common stock.





Bruce
      Percelay, a member of our Board of Directors, holds $100,000 of Convertible
      Bridge Notes which bear interest at 10% and mature on December 15, 2005. Upon
      consummation of the recapitalization merger, these notes will automatically
      convert into 4,000,000 shares of Cicero common stock.








**NOTE
      19.**  **RESTRUCTURING
      CHARGES**





As
      part
      of the Company’s plan to focus on the emerging desktop integration marketplace
      with its new Cicero product, the Company completed substantial restructurings
      in
      2002. At December 31, 2002, the Company’s accrual for restructuring was
      $772,000, which was primarily comprised of excess facility costs. As more fully
      discussed in Note 21 Contingencies, subsequent to September 30, 2003, the
      Company settled litigation relating to these excess facilities. Accordingly,
      the
      Company has reversed the restructuring balance, as of September 30, 2003. Under
      the terms of the settlement agreement, the Company agreed to assign the note
      receivable from the sale of Geneva to EM Software Solutions, Inc., with recourse
      equal to


F
          -28


the
      unpaid portion of the note receivable should the note obligor, EM Software
      Solutions, Inc., default on future payments. The current unpaid principal
      portion of the note receivable assigned is approximately $247,000 and matures
      December 2007. The Company assessed the probability of liability under the
      recourse provisions using a probability weighted cash flow analysis and has
      recognized a long-term liability in the amount of $131,000.








**NOTE
      20.**  **COMMITMENTS**





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, 2005 were as follows (in thousands):


Lease
              Commitments2006
            
            $
            562007
            
            
            56$
            112





Rent
      expense for the years ended December 31, 2005, 2004 and 2003 was $122,000,
      $197,000, and $586,000, respectively. As of December 31, 2005 and 2004, the
      Company had no sublease arrangements. Sublease income for the year ended
      December 31, 2003 was $241,000.





Royalty
      Commitments: The Company is obligated under a royalty sharing agreement with
      Merrill Lynch to 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.








**NOTE
      21.**  **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 and it matures in December 2007. We assessed the
      probability of liability under the recourse provisions using a weighted
      probability cash flow analysis and have recognized a long-term liability in
      the
      amount of $131,000.





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 24-month period ending
      October 2006.





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, in
      accounts payable, over a 20-month period ending July 2006.





In
      April
      2005, we were notified that Critical Mass Mail, Inc had filed a claim against
      us
      for failure to pay certain liabilities under an Asset Purchase Agreement dated
      January 9, 2004. We in turn filed 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 the Agreement
      as part of the asset purchase accounting. On March 1, 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. We believe that the probability of an unfavorable outcome is remote
      and accordingly, we have not reserved for this contingency.


F
          -29


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
      22.**  **SELECTED
      QUARTERLY FINANCIAL DATA (UNAUDITED)**





**First**
              **Quarter**
            
            **Second**
              **Quarter**
            
            **Third**
              **Quarter**
            
            **Fourth**
              **Quarter****(In
                thousands, except per share data)**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
            
            $
            (0.02
            )
            $
            (0.02
            )
            $
            (0.02
            )
            $
            (0.02
            )2004:Net
                revenues
            
            $
            83
            
            $
            250
            
            $
            173
            
            $
            269Gross
                margin/(loss)
            
            
            (1,020
            )
            
            (3,819
            )
            
            (217
            )
            
            (44
            )Loss
                from continuing operations
            
            
            (2,627
            )
            
            (4,787
            )
            
            (1,204
            )
            
            (1,113
            )Loss
                discontinued operations
            
            
            (9
            )
            
            (7
            )
            
            (7
            )
            
            (7
            )Net
                loss .
            
            
            (2,636
            )
            
            (4,794
            )
            
            (1,211
            )
            
            (1,120
            )Net
                loss/share continuing operations - basic and diluted
            
            $
            (0.09
            )
            $
            (0.14
            )
            $
            (0.03
            )
            $
            (0.02
            )Net
                loss/share discontinued operations -- basic and diluted
            
            
            --
            
            
            --
            
            
            --
            
            
            --Net
                loss/share -basic and diluted
            
            $
            (0.09
            )
            $
            (0.14
            )
            $
            (0.03
            )
            $
            (0.02
            )








**NOTE
      23.**  **SUBSEQUENT
      EVENTS**





As
      of
      December 31, 2005, the Company has raised a total of $1,760,000 from the
      Convertible Bridge Notes. Since then, the Company has raised an additional
      $275,000. If the merger proposal is not approved, the Notes will immediately
      become due and payable. The Company filed its preliminary Form S-4 with the
      Securities and Exchange Commission on February 15, 2005 and its amendment to
      the
      Form on December 5, 2005. The Company will file an additional amendment to
      the
      Forms S-4 in March 2006.





On
      March
      7, 2006, Mr. Fredric Mack resigned from the Company’s Board of Directors. Mr.
      Mack’s resignation did not involve a disagreement with Level 8 Systems, Inc. on
      any matter relating to the Company’s operations, policies, or
      practices.