**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom                to**

**Commission file number 000-29335**

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**WITNESS SYSTEMS, INC.**

(Exact Name of Registrantas Specified in Its Charter)

| **Delaware**                                                     |   | **23-2518693**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction  of Incorporation or Organization) |   | (I.R.S. Employer  Identification No.) |
| ** **                                                       |   | ** **                            |
| **300  Colonial Center Parkway  Roswell, Georgia**               |   | **30076**                             |
| (Address of  Principal Executive Offices)                        |   | (Zip Code)                            |

 

Registrant’s telephonenumber, including area code **770-754-1900**

Securities registeredpursuant to Section 12(b) of the Act:

| **Title of each class**                 |   | **Name of  each exchange on which registered** |
|-----------------------------------------|--------|------------------------------------------------|
| Common Stock, par  value $.01 per share |   | Nasdaq                                         |

 

Securities registeredpursuant to Section 12(g) of the Act: **None**

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

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

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon- accelerated filer (as defined in Exchange Act Rule 12b-2).
| Large accelerated filer o |   | Accelerated filer x |   | Non-accelerated  filer o |
|--------------------------------|--------|---------------------|--------|--------------------------|

 

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

Theaggregate market value of the voting stock held by non-affiliates of theregistrant as of June 30, 2006 was $680.1 million. The number of shares ofthe registrant’s common stock outstanding on March 8, 2007 was 34,640,764.

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**DOCUMENTS INCORPORATED BYREFERENCE**

Portionsof the registrant’s definitive proxy statement for its annual meeting ofstockholders, currently scheduled for June 15, 2007, are incorporated byreference in Part III of this report.

 

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**IMPORTANTNOTE**

On February 11, 2007,we entered into an Agreement and Plan of Merger with Verint Systems Inc. (“Verint”),which provides for us to be acquired by Verint and will no longer be a publiccompany. If the merger contemplated by that agreement is completed, we willbecome a wholly-owned subsidiary of Verint. Except as otherwise expresslynoted, all statements and information in this filing presume our continuationas a going concern and as an independent company, which will not be the case ifwe are acquired by Verint.

**PART I**

This Annual Report on Form 10-Kincludes “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the SecuritiesAct and Section 21E of the Securities Exchange Act. Typically, thesestatements contain the words “believes,” “anticipates,” “intends,” “expects” orsimilar words. Examples of forward-looking statements include, but are notlimited to, the impact of the February 2007 restatement of our historical ConsolidatedFinancial Statements on our future reported results. In any event, anyinformation or statements made that are not statements of historical fact areforward-looking statements. These forward-looking statements are based on anumber of assumptions and involve numerous risks and uncertainties. There are anumber of important factors that could cause our actual results to differmaterially from those indicated by these forward-looking statements, includingthe factors referred to in Item 1A of Part 1 of this report “RiskFactors” beginning on page 10.

On February 11, 2007,we entered into a definitive agreement under which Verint will acquire Witnessfor $27.50 per share in cash, less any applicable withholding taxes, withoutinterest. Verint currently expects to fund the Merger through up to $650million in senior secured debt financing from Lehman Brothers, Deutsche Bank,Credit Suisse and certain of its affiliates. Comverse Technology, the 57%majority stockholder in Verint, has committed to finance up to $293 million ofthe purchase price through the purchase of additional equity in Verint in theform of preferred stock. The remainder will be paid for with existing cash fromthe combined company. The Merger is expected to close in the second quarter of2007, pending approvals from regulators and Witness stockholders.

**Item1.   Business**

You should read theBusiness section in conjunction with Management’s Discussion and Analysisof Financial Condition and Results of Operations and the Consolidated FinancialStatements and Notes thereto included elsewhere in this report and with theunderstanding that our actual future results may differ materially fromexpectations. All forward-looking statements made in this report are qualifiedby these cautionary statements. You are cautioned that forward-lookingstatements are not guarantees of future performance and are made only as of thedate of this report, and we undertake no obligation, other than as may berequired by law, to update or revise these statements for any reason, includingto reflect changes in assumptions, the occurrence of unanticipated events orchanges in future operating results over time.

**Overview**

***Witness*********Systems, Inc.(“Witness”) is a publicly traded company that provides workforce optimizationsoftware and services that help businesses capture customer intelligence andoptimize their work performance. We were incorporated in Delaware in 1997 andhad 834 employees as of December 31, 2006. Our Impact 360TM solution is an integrated offering of softwareproducts that provide comprehensive workforce optimization functionality,including quality monitoring, high volume compliance and IP recording,workforce management, performance management and electronic learning (“e-learning”).Our quality monitoring products record multimedia interactions, includingtraditional voice, Web chat and email, based on user-defined business rules toenable our customers to evaluate the performance of their customer servicerepresentatives, or CSRs, wherever they may be located in the enterprise.Our full-time 

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complianceapplications are designed to record high volume voice conversations betweenCSRs and customers for purposes such as compliance recording and salesverification. Our workforce management products enable our customers to developstrategic staffing plans, deploy skilled resources and evaluate productivity ofCSRs in a contact center, branch bank or back office operations. Ourperformance management applications provide comprehensive analytics, includingperformance scorecards, and reports of customer interaction and CSR performance.Our e-learning applications deliver ongoing training tailored to CSR needs andcompetencies. We also provide consulting and implementation services, trainingand support to customers that use our software products. Primarily deployed incontact centers—as well as the remote, branch and back offices of globalorganizations, the workforce optimization solution captures, analyzes andenables users to share and act on cross-functional information across theenterprise. With Impact 360, organizations can improve interactions and theunderlying back-office processes that enhance the customer experience and buildcustomer loyalty.

We have more than 3,000customers, including more than 60 Fortune 100 companies. Our solutions are usedin a wide variety of industries worldwide, including financial services,communications services, manufacturing, utilities, retail, transportation,travel and outsourcing. No individual customer accounted for 10% or more of ourrevenue in 2006, 2005 or 2004. We market and sell our products through both ourdirect sales force and through indirect channels. Our indirect sales channelincludes reseller, distributor, original equipment manufacturer, or “OEM”, andsimilar arrangements with key vendors in the contact center workforceoptimization market.

**Pending Acquisition of Witness by Verint Systems Inc.**

On February 11, 2007,we entered into an Agreement and Plan of Merger (the “Merger Agreement”) withVerint, a Delaware corporation pursuant to which Witness expects to merge witha wholly-owned subsidiary of Verint, and thereby becoming a wholly-ownedsubsidiary of Verint (“the Merger”). At the effective time of the Merger, eachoutstanding share of our common stock will be converted into the right toreceive $27.50 in cash, less any applicable withholding taxes and withoutinterest. Under the Merger Agreement, each outstanding stock option of Witnessthat is vested at the effective time of the merger and has an exercise pricebelow $27.50 will be cancelled and exchanged for a cash payment by Verint in anamount equal to the excess (if any) of $27.50 over the exercise price peroption share multiplied by the number of shares of Witness common stock subjectto such vested option. Witness stock options that are vested at the effectivetime of the merger and have an exercise price above $27.50 will be cancelledwithout payment. Each outstanding stock option of Witness that is unvested atthe effective time of the merger will be assumed by Verint and will become anoption to purchase shares of Verint common stock on the same terms andconditions as were applicable to the stock option immediately prior to theeffective time of the merger. The number of shares of Verint common stocksubject to each assumed option will be determined by multiplying the number ofshares of Witness common stock that were subject to the unvested optionimmediately prior to the effective time of the merger by the conversion ratioset forth in the Merger Agreement, and rounding that result down to the nearestwhole number of shares of Verint common stock. The per share exercise price forthe assumed option will be determined by dividing the per share exercise priceof the Witness common stock subject to the unvested option as in effectimmediately prior to the effective time of the Merger by the conversion ratio,and rounding that result up to the nearest whole cent. The conversion ratio isthe ratio obtained by dividing $27.50 by the average of the closing salesprices of a share of Verint common stock for the twenty consecutive tradingdays immediately before the closing of the Merger (subject to adjustment forstock splits and dividends).

We have filed apreliminary proxy statement with the Securities and Exchange Commission (“SEC”),and we plan to mail to our stockholders a definitive proxy statement inconnection with the Merger once we obtain approval from the SEC. The definitiveproxy statement will contain important information about the Merger and relatedmatters. Investors and security holders are urged to read the definitive proxystatement carefully when it is available.

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Except as otherwiseexpressly noted, all statements and information in this filing presume ourcontinuation as a going concern and as an independent public company, whichwill not be the case if the Merger is completed.

**Industry Background and Trends**

The workforce optimizationsolutions market has evolved in recent years to address the increasingchallenges faced by enterprises in managing their customer service and salesactivities effectively. The overall goal of workforce optimization in thecustomer service function is to enable companies to balance the competingobjectives of maximizing customer satisfaction and increasing revenue, while atthe same time controlling customer service costs. Customer contact centers,branch banks, help desks, and billing and order fulfillment departmentsregularly represent the key focal points for personal interaction between abusiness and its customers, making the effectiveness of the CSRs and otherstaff critical to the overall success of the business.

We believe several keytrends are driving the workforce optimization market, including:

*Voice over InternetProtocol (“VoIP”) technologies.**  *The convergence of voice and datacommunications technologies, most notably through the rapid adoption of VoIP,is changing the landscape of telecommunications infrastructure. VoIP, or IPtelephony, is a software-based technology that enables the conversion of voicecommunications into data packets that can be routed over any IP-based network,as opposed to traditional circuit-switched voice transmission lines. Manycompanies are replacing legacy analog voice infrastructures in their contactcenters with VoIP telephony infrastructure to realize the many benefits ofIP-based communications, including reduced costs and enablement of advancedbusiness communication applications. These equipment upgrades typically requirenew deployments of workforce optimization solutions designed to support IPenvironments. VoIP applications also permit the customer service function toextend beyond traditional contact centers by facilitating easier access tocustomer interaction information.

*Software solutions runningon open systems.**  *Organizationsare increasingly seeking to deploy information technology and business softwareapplications based on open standards that run on commercially available,non-proprietary hardware. The use of open systems, as opposed to applicationsthat run on proprietary hardware systems offered by a single vendor, generallyprovides for lower cost of ownership and greater flexibility in theirinformation technology infrastructures.

*Integration of workforceoptimization applications.**  *Increasingly, companies worldwide are seeking anintegrated offering of workforce optimization applications, including qualitymonitoring and high-volume compliance recording, workforce management,performance management and e-learning. By integrating these applications, anenterprise can reduce costs by eliminating duplicative hardware, streamliningimplementation and reducing administration requirements. Integration also makesthe applications easier to use through a single unified graphical userinterface. Most important, by integrating these applications under oneframework, enterprises gain the ability to manage their workforce performancein a closed loop, including evaluating and analyzing complete customerinteractions through multiple media, identifying opportunities and performancegaps, scheduling personnel based on strengths and weaknesses, applying targetedinstruction for continuous improvement, integrating instruction into aworkforce schedule, and compensating employees based on actual performance.

*Increasing complexity ofcustomer service operations.**  *Customer service operations at many organizationshave become increasingly complex, driven by the demand for highly available andeffective customer service. For example, contact centers have become theprimary points of customer contact for organizations, as the contact centershave evolved from providing solely inbound customer support to handlingsupport, service, sales, bill payment and numerous other customer interactions.Organizations are facilitating customer service interactions across multiplemedia, including traditional voice, Web chat, instant messaging, guided browsersessions and e-mail, and are therefore challenged to maintain a 

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consistently highlevel of customer service across all media channels. Moreover, as a result ofrecent trends toward offshore and outsourced contact center operations,managing and optimizing the quality of customer interactions has become moreimportant, and more difficult, than ever.

**Impact 360**

Impact 360, our integratedworkforce optimization solution, enables organizations to capture, analyze andact on cross-functional information concerning workforce performance, customerinteractions and customer service processes. Impact 360 offers a unifiedframework for workforce optimization that provides organizations a holisticview of performance and enables them to leverage this information to providemore effective and efficient customer service. Our new solutions frameworksupports both traditional time division multiplexing, or TDM, switchenvironments and IP telephony environments and executes on standard operatingsystems and hardware platforms.

The integrated componentsof our workforce optimization solution encompass quality monitoring andhigh-volume compliance recording, workforce management, performance managementand e-learning. Impact 360 is available as a fully integrated solution, inspecific packages or as separate applications. Impact 360 provides numerousbenefits to our customers, including reduced infrastructure costs, rapidimplementation and central administration. More importantly, shared access toinformation across all functions in the customer service value chain enablesour customers to make informed decisions that can generate cost savings,improve decision making and increase competitive advantages. We also offerrelated consulting and implementation services, training and support.

The components of oursolution include:

*Quality monitoring andhigh-volume compliance recording.**  *Our recording solutions enable therecording of a CSR’s multimedia interactions with a customer throughtraditional voice, Web chat, instant messaging, guided browser sessions ande-mail. The CSR’s voice interaction with a customer can be synchronized withthe CSR’s corresponding computer desktop activities, such as data entry, screennavigation and data retrieval, for review and analysis by supervisors. Qualitymonitoring selectively records interactions based on user-defined businessrules, while high-volume compliance recording stores all interactions betweenan organization’s CSRs and its customers for purposes such as legal orregulatory compliance and sales verification. Our solutions enable companies toevaluate the performance of CSRs, analyze the effectiveness of supportingsystems and enhance the quality of service being delivered.

*Workforce management.**  *Our workforce management solutionssimplify the task of forecasting and scheduling, enabling contact centers tobalance cost, service level and agent preferences. Users can analyze historicaldata to forecast future interaction volumes and service handle times in orderto schedule the optimal number of agents, with the required skill sets, at thenecessary times. As a result, organizations can reduce costs by staffingappropriately to meet workload demands, drive business growth, and improveemployee effectiveness and retention.

*Performance management.**  *Our performance managementsolutions provide comprehensive analysis of customer interaction and CSRperformance. Leveraging performance scorecards with industry-accepted anduser-defined key performance indicators, these solutions combine data derivedfrom our evaluation application with data from other business systems, such ascustomer relationship management software, enterprise resource planningsoftware and integrated telephony applications. Our solution also offers datavisualization, search capabilities and speech analytics. Using our solutions,supervisors can obtain a quick, streamlined view of performance relative tostrategic organizational objectives. The reporting, dynamic analysis andperformance scorecard capabilities of these solutions provide organizationswith business intelligence that can lead to increased revenue, heightenedservice quality and improved operational efficiencies.

*E-learning.**  *Our e-learning solutions deliverongoing training tailored to CSR competencies in order to achieve continuousperformance improvement. The e-learning management software tracks training 

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completion andcompiles transcripts to enhance CSR skills. When the e-learning applicationsare integrated with other Impact 360 components, a supervisor can review a recordedcustomer interaction, evaluate the CSR’s performance and prioritize customizedtraining and lesson plans for the CSR. Our solution enables targeted learningcontent to be delivered directly to a CSR’s desktop through a series ofstandardized lessons or customized lessons created from recorded interactions.E-learning can enable companies to reduce employee turnover and to buildcustomer loyalty through a more highly skilled and motivated workforce.

*Customer Feedback.*   Ourcustomer feedback solution surveys customers immediately after theirinteractions with agents over the IVR, Web, and e-mail with short, dynamicsurveys that are delivered based on user-defined business rules. Because thesesurveys are dynamic and intelligent, context-based, and timely, they impactcustomers in a measurably positive manner and deliver response rates greaterthan those obtained through traditional questionnaires. As a result,organizations can move beyond mere sampling to capture data—even with largenumbers of customers and multiples sites.

**Witness Service Network**

The Witness ServiceNetwork is our approach to consulting, training and support services thataccompany our Impact 360 solutions. Our service and support offerings aredesigned to enable our customers to achieve a rapid return on investment andrealize the maximum benefit our solutions provide by enabling organizations tooptimize their contact center operations. Our services consist ofimplementation services, training, business consulting and customer support.

The initial implementationengagement for our Impact 360 solutions is typically completed within 30 to 60days from the start date of the implementation phase. Training services providethe skills and knowledge necessary to enable business and technical users toutilize the Impact 360 solutions. Training is provided at our global trainingcenters, on-site at the customers’ location or via our web-based education andtraining management system. In addition, we offer customized training programstailored to the specific needs of our customers.

Ourbusiness consulting services are designed to help customers gain the most valuefrom the Impact 360 solution to optimize the people, processes and technologydeployed throughout their contact center operations. Witness Systems StrategicConsulting Services include:

·       AdviceLine—Providesguidance on operational or business practice questions through ten one-hour,one-on-one sessions with a Witness Systems contact center expert delivered overthe phone or web;

·       BusinessDiscovery—Identifies and quantifies how Witness Systems solutions can improveperformance within the contact center or back office operations;

·       BusinessImplementation Accelerator—Addresses the broader issues of large-scaleworkforce optimization software deployments, such as changes to staffing,policies and procedures, that are often overlooked during systemimplementation;

·       CalibratingQuality for Consistency—Provides the insight needed to develop and performconsistent quality monitoring evaluations for contact center agents andcustomer service representatives;

·       Communicatingin a Changing Environment—Develops a plan for communicating the guidelines,expectations, and objectives of an Impact 360 deployment to multiple levels ofthe organization;

·       CustomReport Enablement—Shows how to use Impact 360’s reporting tools and databaseschema to create and run custom reports;

·       HighImpact Coaching—Teaches best practices for deploying a successful program tocoach contact and service center staff effectively;

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·       LeveragingContact Editing—Shows how the contact editing functionality within Impact 360Workforce Optimization and Quality Monitoring can be used effectively as partof an eLearning program;

·       Measuringfor ROI Success—Defines key metrics that enable users to quantify the return oninvestment (ROI) provided by their Impact 360 solution;

·       QualityEvaluation Optimization—Creates meaningful quality monitoring evaluation formsthat tie quality initiatives to specific corporate, contact center, agent, andcustomer objectives;

·       QualityMonitoring Configuration Consulting—Provides an in-depth understanding ofImpact 360 Quality Monitoring’s different configurable options to supportcurrent and future customization;

·       WorkforceManagement Model Validation—Identifies areas within the contact center that cancause the Impact 360 Workforce Management data model to become obsolete (suchas attrition, new queues, and additional skill sets); and

·       WorkforceOptimization Assessment—Evaluates the people, processes, and technologieswithin the contact center to determine their efficiency and effectiveness.

The support operationprovides customer support services including access to major and minorreleases, service packs and hot fixes, remote diagnostics and installation.Customer support is offered in two distinct plans with services that range from12 hour phone access Monday through Friday to 24 hours, 7 days a week. Weprovide support services via the telephone, e-mail and via an on-lineknowledgebase of product-related information.

**Our Strategy**

Our objective is to be aleading provider of workforce optimization software and services to help globalenterprises improve all aspects of customer service, from contact centercustomer interactions to remote and branch offices and underlying back officeprocesses. Key elements of our strategy include the following:

*Extend the breadth anddepth of the Impact 360 solution.*   We believeImpact 360 provides today’s most comprehensive, integrated offering ofworkforce optimization products designed to manage, analyze and improve thecustomer service function. We intend to continue investing in research anddevelopment to enhance the functionality, effectiveness and ease of use of ourImpact 360 solution, as well as to expand the number of third-partyapplications with which our software can readily integrate.

*Maximize sales to existingcustomers.**  *Wehave a large installed base of customers, many of which currently utilize onlya subset of our workforce optimization products or have not deployed ourproducts in all of their contact centers or elsewhere throughout their customerservice operations. We believe these customers represent a significantopportunity for us to generate additional sales of complementary products andservices. Impact 360 has been designed to enable cross-selling and upselling ofadditional products to customers already utilizing our software. During 2006, wegenerated approximately 82% of our license revenue through sales to existingcustomers.

*Capitalize on the growingadoption of VoIP.**  *OurImpact 360 solution fully supports VoIP telephony infrastructure. As companiesupgrade to VoIP telephony infrastructure in their customer service operations,they will typically need to upgrade their workforce optimization solutions.This dynamic provides us with a unique opportunity to displace competitivesolutions with Impact 360, and we intend to aggressively pursue companiesengaging in telephony infrastructure upgrades. In addition, because VoIPprovides small and medium-sized businesses with a new opportunity to deployworkforce optimization solutions at a more reasonable price, we have theopportunity to sell Impact 360 to a segment of the market that has historicallybeen unable to afford these solutions. In order to address this opportunity, wehave created a version of Impact 360 specifically designed to meet the needs ofsmall and medium-sized businesses.

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*Expandour indirect sales channel.**  *Historically, the majority of our sales have beendriven by our direct sales force. In recent years, we have significantlybolstered our indirect sales channel through reseller, distributor and OEMarrangements with key hardware and service providers in the contact centermarket. For example, Avaya, an OEM provider, bundles our workforce optimizationsoftware products with sales of its converged communications (TDM and IP)infrastructure hardware solutions. We have also announced a similar OEMagreement with Nortel and BT (Trading Room Systems). We are also seekingto expand our relationships with and among systems integrators. In addition tobroadening our overall sales leverage, we believe these channel partnershipsprovide an efficient means to enable us to penetrate one of the fastest growingsegments in the contact center industry, the small and medium-sized businesssegment.

*Expand our businessthrough strategic acquisitions.**  *We intend to pursue acquisitions ofbusinesses, technologies and products that we believe will complement ourexisting operations and enhance our position in the workforce optimizationmarket. In 2003 we acquired Eyretel Plc, which strengthened our market presenceinternationally and expanded our capabilities in the compliance recordingmarket, and in 2005 we acquired Blue Pumpkin Software, Inc., a leadingprovider of workforce management products. In 2006 we acquired Demos SolutionsConsulting Group Ltd. also known as Demos Solutions (“Demos”) and Exametric, Inc.(“Exametric”), two leaders in supplying enterprise productivity and resourceplanning solutions to the financial services industry.

**Research andDevelopment**

We believe our software development capabilities areessential to our strategy of enhancing our core technology, developingadditional applications, incorporating that technology and maintaining thecompetitiveness of our software. We devote a substantial portion of ourresources to developing new software and features, extending and improving oursoftware technology, debugging and quality testing our products and researchingnew technological initiatives in our market. We believe that our future successdepends in part upon our ability to continue to enhance existing software,respond to changing customer requirements and develop and introduce new orenhanced software that incorporates new technological developments and emergingindustry standards.

As of December 31,2006, we had 301 associates (including 93 contractors) engaged in research anddevelopment activities. Research and development expenditures, exclusive ofacquired in-process research and development, for the years ended December 31,2006, 2005 and 2004 were $33.3 million, $26.7 million and $20.8 million,respectively. We anticipate our research and development costs will increase in2007.

**Competition**

Our software andservices compete in the emerging market for products that record and analyzecustomer interactions and provide electronic learning applications. This marketis intensely competitive and experiences rapid changes in technology. Webelieve that we compete effectively and that we enjoy a competitive advantagebased upon:

·       thefunctionality and quality of our products,

·       theease of use and ability of our products to operate with a variety of hardwareand software products,

·       ourability as a single vendor to offer a full suite of applications,

·       ourability to implement our products quickly,

·       theresponsiveness of our customer support, and

·       ourreputation in the marketplace.

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Our competitorsinclude:

·                    traditionalcall-logging vendors;

·                    qualitymonitoring suppliers to the contact center industry;

·                    workforcemanagement, forecasting and scheduling vendors to the call center, branchbanking and back office operations industries;

·                    electroniclearning vendors;

·                    businessanalytics vendors;

·                    largetelecom solution providers;

·                    enterprisesoftware vendors;

·                    systemsintegrators and consulting firms; and

·                    new,larger and more established entities that may acquire, invest in or form jointventures with providers of recording or performance enhancing softwaresolutions.

In addition, we have developed, and intend to continueto develop, relationships with companies that resell our software, companiesthat integrate the software with their technology and products and companiesthat provide us with customer referrals or leads. Some of these companies havesimilar, and often more established, relationships with our competitors, andmay recommend the products and services of competitors to customers instead ofour software and services. In addition, through their relationships with us,these companies could learn about our software and the market for our softwareand services and could develop and sell competing products and services.

The principalcompetitive factors in our market include:

·       product performance, reliability andfeatures;

·       ability to effectively integrate productsinto customers’ environments;

·       user scalability and open architecture;

·       third-party integration;

·       quality and speed of productimplementation;

·       ease-of-use for customers;

·       analytic capabilities of the product;

·       how quickly new products and productenhancements can be brought to market;

·       customer support; and

·       pricing of products and services.

Our success will depend onour ability to compete effectively based on these factors. Further, we expectthat competition will increase as other established and emerging companiesenter our market and as new products, services and technologies are introduced.Increased competition may result in price reductions, lower gross margins andloss of market share. This could materially and adversely affect our business,financial condition and results of operations.

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**Proprietary Rights**

*General.**  *Our success depends to a significantdegree on the legal protection of our software and other proprietary technologyrights. We rely on a combination of patent, trade secret, copyright andtrademark laws and confidentiality and non-disclosure agreements with employeesand third parties to establish and protect our proprietary rights. Thesemeasures may not be sufficient to protect proprietary rights, and we cannot becertain that third parties will not misappropriate our technology and use itfor their own benefit. Also, most of these protections do not preclude ourcompetitors from independently developing products with functionality orfeatures substantially equivalent or superior to our software. Any failure toprotect our intellectual property could have a material adverse effect on ourbusiness.

*Licenses.**  *Our licenses are designed toprohibit unauthorized use, copying and disclosure of our software technology.When we license our software to customers, we require license agreementscontaining confidentiality terms customary in the industry in order to protectour proprietary rights in the software. These agreements generally warrant thatthe software will materially comply with written documentation. We assert thatwe own or have sufficient rights in the software we distribute and have notviolated the intellectual property rights of others. We license our products ina format that does not permit the users to change the software code. Inaddition, because we treat the source code for our products as a trade secret,all employees and third parties who require access to the source code are firstrequired to sign non-disclosure agreements.

*Patents.**  *As of December 31, 2006, wehad 13****U.S. and 3 non-U.S patents. We cannotassure you that we will file new patent, trademark or copyright applications,that any future applications will be approved, that any existing or futurepatents, trademarks or copyrights will adequately protect our intellectualproperty or that any existing or future patents, trademarks or copyrights willnot be challenged by third parties.

*Trademarks and servicemarks.**  *Asof December 31, 2006, we had 11 registered trademarks in the U.S and 7trademarks registered internationally. We also claim common law protections forother marks we use in our business. Competitors and other companies could adoptsimilar marks, or try to prevent us from using our marks, consequently impedingour ability to build brand identity and possibly leading to customer confusion.We are aware of certain uses, U.S. trademark registrations, and U.S. trademarkapplications for our “eQuality” trademark and its variations that predate ouruse and the April 30, 2002 issuance of the U.S. registration for ourtrademark eQuality®. Itis possible that the owner of legal rights resulting from one or more of theseprior uses, U.S. trademark registrations, or U.S. trademark applications willbring legal action to challenge our registration of and/or our continued use ofthe trademark eQuality®, andmay also seek compensation for damages resulting from our use of our registeredtrademark if such challenging party prevails on such a claim. As a result, wecannot assure you that our registration of this trademark will be undisturbed,or that this use will not result in liability for trademark infringement,trademark dilution, and/or unfair competition.

**Availability ofReports and Other Information.**

Our corporate Web site is *http://www.witness.com*. We make availableon this Web site, free of charge, access to our Annual Reports on Forms 10-K,Quarterly Reports on Forms 10-Q, Current Reports on Form 8-K,Proxy Statement on Schedule 14A and amendments to those materials filed orfurnished pursuant to Section 13(a) or 15(d) of the Securitiesand Exchange Act of 1934 as soon as reasonably practicable after weelectronically submit such materials to the Securities and Exchange Commission.In addition, the Commission’s Web site is *http://www.sec.gov.*The Commission makes available on its Web site, free of charge, reports, proxyand information statements, and other information regarding issuers, such asus, that file electronically with the Commission. Information provided on ourWeb site or on the Commission’s Web site is not part of this Annual Report on Form 10-K.

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**Item 1A.   RiskFactors**

Our future operatingresults may vary substantially from period to period. The price of our commonstock will fluctuate in the future, and an investment in our common stock issubject to a variety of risks, including, but not limited to, the specificrisks identified below. Inevitably, some investors in our securities willexperience gains while others will experience losses depending on the prices atwhich they purchase and sell our securities. Prospective and existing investorsshould consider the following factors in evaluating our business or aninvestment in our securities. If any of the following or other risks actuallyoccurs, our business, financial condition and results of operations could beadversely affected. In that case, the trading price of our common stock coulddecline.

*Our business and operatingresults may be adversely affected by our proposed acquisition by Verint.*

On February 11, 2007, we signed an Agreement andPlan of Merger with Verint. Pursuant to the Merger Agreement, a wholly ownedsubsidiary of Verint will merge with and into Witness Systems, Witness Systemswill become a wholly owned subsidiary of Verint, and each outstanding share ofour common stock will be exchanged for the right to receive $27.50 in cash,less any applicable withholding taxes and without interest.

The Merger is subject to several conditions, includingapproval by our stockholders, the expiration of applicable waiting periodsunder antitrust laws and certain other regulatory approvals and other customaryclosing conditions. We have made customary representations and warranties andcovenants in the Merger Agreement, including covenants relating to obtainingthe requisite approval of the Company’s stockholders and the conduct of ourbusiness between the date of the signing of the Merger Agreement and theclosing of the Merger. We anticipate that the Merger will be consummated in thesecond quarter of 2007.

The announcement of theMerger could have an adverse effect on our revenue if customers delay, defer orcancel purchases pending consummation of the planned Merger. Current andprospective customers could be reluctant to purchase our products and servicesdue to potential uncertainty about the combined company’s product offerings andits support and servicing of our existing products. If our announcement of theMerger causes our customers to delay purchase decisions pending consummation ofthe planned Merger, our business and operating results could be materiallyadversely affected. The uncertainty surrounding the proposed Merger may alsocause employee turnover or impair our ability to add new employees to thecompany. Any significant employee turnover or delays in hiring forecastedpositions could have an adverse effect on our business and operating results.

*If our planned acquisition by Verint is not completed,our business, operating results and stock price may be adversely affected.*

If the plannedMerger with Verint is not completed, we could suffer a number of consequencesthat could adversely affect our business, operating results and stock price,including the following:

·       themarket price of our common stock could decline following an announcement thatthe Merger has been abandoned, to the extent that the current market pricereflects a market assumption that the Merger will be completed;

·       wecould, under certain circumstances, be required to pay Verint a termination feeof approximately $35.5 million;

·       wewould remain liable for our costs related to the transaction, such as legal,accounting and certain investment banking fees, and we expect these costs to besignificant; and

·       activities relating to theMerger may divert our management’s attention from our business and causedisruptions among our employees and our relationships with customers andbusiness partners, 

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thus detractingfrom our ability to grow revenue and minimize costs and possibly leading to aloss of revenue and market position that we may not be able to regain if thetransaction does not occur.

*Our operating results for 2001 to 2004 have beenadversely impacted by the results of the voluntary review of our stock optionpractices and grants.*

In connection with our recent stock options review, werestated our Consolidated Financial Statements for each of the years ended December 31,2001 through December 31, 2005, and for the first quarter of 2006.Accordingly, you should not rely on financial information included in thereports on Form 10-K, Form 10-Q and Form 8-Kpreviously filed by us, the related opinions of our independent registeredpublic accounting firm, earnings press releases and similar communicationsissued by us, for periods ended on or before March 31, 2006, all of whichhave been superseded in their entirety by the information contained in our 2005Form 10-K/A and our amended Quarterly Report on Form 10-Q/Afor the three months ended March 31, 2006, each filed on February 8,2007.

Based on the results of the stock option review, weconcluded that, pursuant to Accounting Principles Board (“APB”) No. 25, *Accounting for Stock Issued to Employees*, and relatedinterpretations, the accounting measurement dates for certain stock optiongrants, covering options to purchase approximately 4.6 million shares of ourcommon stock, differed from the measurement dates previously used for suchawards. As a result, revised measurement dates were applied to the affectedoption grants, and we recorded a total of $9.5 million in additionalstock-based compensation expense for the years 2000 through 2005. Theadditional stock-based compensation expense was amortized over the serviceperiod relating to each option, typically four years, with approximately 90% ofthe total expense recorded in years prior to 2004.

These expenses had theeffect of decreasing income from operations, net income, and net income pershare (basic and diluted) in affected periods in which we reported income, andincreasing loss from operations, net loss, and net loss per share in affectedperiods in which we reported a loss. Further information regarding the effectof the restatement on our Consolidated Financial Statements for various periodsis provided in “Management’s Discussion and Analysis of Financial Condition andResults of Operations” included in Part II, Item 7 of this Report.

*An SEC inquiry and litigation relating to certain ofour stock option grants remain pending and could have an adverse effect on ourbusiness, operating results and stock price and may divert the attention of ourmanagement and other key employees.*

An informal inquiry by the SEC relating to our stockoption granting practices remains pending, as does derivative and class actionlitigation against the Company and certain of our Board of Directors andofficers. Although we believe that we have made appropriate corrections to ourConsolidated Financial Statements for matters relating to stock options, wecannot rule out the possibility that these proceedings may require furtheradjustments to the Financial Statements and other disclosures set forth in thisAnnual Report on Form 10-K. In addition, these proceedings arelikely to result in additional legal expense that may affect our results infuture periods, and may also result in diversion of management attention andother resources, as well as fines, penalties, damages and other sanctions. The U.S.Attorney’s Office for the Northern District of Georgia has also been givenaccess to the documents and information provided by us to the SEC. Action bythe SEC, the U.S. Attorney’s Office or other governmental agencies could resultin civil or criminal actions against us and/or certain of our former officers,directors and/or employees and might result in monetary and other sanctions.

As discussed in Note 14 ofNotes to Consolidated Financial Statements, included in Part IV, Item 15of this Report, civil litigation described in the preceeding paragraph includesallegations, among other, that certain of our current and former directors andofficers improperly dated stock option grants to enhance 

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theirown profits on the exercise of such options or for other improper purposes.Although we and the other defendants intend to defend these claims vigorously,there are many uncertainties associated with any litigation, and we cannotassure you that these actions will be resolved without substantial costs and/orsettlement charges. We have entered into indemnification agreements with eachof our present and former directors and officers. Under those agreements, weare (with certain exceptions) required to indemnify each such director orofficer against expenses, including attorneys’ fees, judgments, fines andsettlements, paid by such individual in connection with the pending litigation.

The resolution of thepending investigations by the SEC and U.S. Attorney’s Office, the defense ofour pending civil litigation, and the defense of any additional litigationrelating to our past stock option practices or the February 2007restatement of our prior Consolidated Financial Statements could result insignificant costs and diversion of the attention of management and other keyemployees.

*The implementation of newaccounting rules related to the expensing of stock-based awards negativelyimpacted our operating results in 2006 and is expected to continue to do so in2007 and thereafter. Any subsequent changes in accounting rules may alsohave an adverse effect on our results of operations.*

We adopted Statement ofFinancial Accounting Standards (“SFAS”) No. 123(R), *Share-BasedPayment*, effective January 1, 2006. SFAS No. 123(R) requiresall share-based payment awards to employees, including grants of stock options,restricted stock units and employee stock purchase rights, to be recognized inour Consolidated Financial Statements based on their respective grant date fairvalues and does not allow the previously permitted pro forma disclosure-onlymethod as an alternative to Financial Statements recognition. The adoption ofSFAS No. 123(R) may have a significant adverse impact on our reportedresults of operations because the stock-based compensation expense is chargeddirectly against our reported earnings. Stock-based compensation expense andunvested stock-based compensation will increase to the extent that we increaseour work force, grant additional equity awards to employees or assume unvestedequity awards in connection with acquisitions.

*If we fail to protect ourintellectual property, third parties may use our technology for their ownbenefit.*

Our success and ability tocompete depends to a significant degree upon our proprietary technology. Werely on a combination of patent, trade secret, copyright and trademark laws andconfidentiality agreements with employees and third parties to establish andprotect our proprietary rights. These measures may not be sufficient toprotect our proprietary rights, and we cannot be certain that third partieswill not misappropriate our technology and use it for their own benefit. Also,most of these protections do not preclude our competitors from independentlydeveloping products with functionality or features substantially equivalent orsuperior to our software. Any infringement of our proprietary rights couldnegatively affect our future operating results.

As of December 31,2006, we had 11 registered trademarks in the U.S. and 13 U.S. and 3 non-U.Spatents. We cannot assure you that we will file new patent or trademarkapplications, that any future applications will be approved, that any existingor future patents, trademarks or copyrights will adequately protect ourintellectual property or that any existing or future patents, trademarks orcopyrights will not be challenged by third parties.

We are aware of certainuses, U.S. trademark registrations, and U.S. trademark applications for our “eQuality”trademark and its variations that predate our use, and the April 2002issuance of the U.S. registration for our trademark eQuality®. It is possible that an ownerof legal rights resulting from prior use, registrations, or applications willbring legal action to challenge our registration of and/or our use of thetrademark eQuality®, andmay also seek compensation for damages resulting from our use thistrademark. As a result, we cannot assure you that our registration of thistrademark will be undisturbed, or that this use will not result in liabilityfor trademark infringement, trademark dilution, and/or unfair competition.

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Moreover, the laws ofcertain foreign countries do not protect our intellectual property rights tothe same extent as do the laws of the United States. Furthermore, policing theunauthorized use of our products is difficult, and litigation may benecessary in the future to enforce our intellectual property rights, to protectour trade secrets or to determine the validity and scope of the proprietaryrights of others. Litigation could result in substantial costs and diversion ofresources and could negatively affect our future operating results.

*Claims by other companiesthat our software infringes their intellectual property could require us toincur substantial costs or prevent us from selling our software or services.*

Third parties have in thepast claimed, and it is possible that third parties will in the future claim,that we have infringed their current or future intellectual property. We expectthat we and other participants in our industry will be increasingly subject toinfringement claims as the number of competitors and products grows. Anyclaims, with or without merit, which are generally uninsurable, could betime-consuming, result in costly litigation, require us to reengineer orredevelop our software, cause product shipment delays or require us to enterinto royalty or licensing agreements, any of which could negatively affect ouroperating results. Any efforts to reengineer our software or obtain licensesfrom third parties may not be successful, could be extremely costly andwould likely divert valuable management and product development resources.

For example, claims havebeen asserted against us in lawsuits involving Knowlagent, STS and NICE (asdescribed in Item 3, “Legal Proceedings”, of Part I). We cannot assure youthat we will be successful in defending against the claims that have beenasserted or any other claims that may be asserted. We also cannot assureyou that such claims will not have a material adverse effect on our business,financial condition, or operations. Defending infringement claims or otherclaims involves substantial costs and diversion of management resources. Inaddition, to the extent we are not successful in defending such claims, wemay be subject to injunctions with respect to the use or sale of certainof our products or to liabilities for damages to the claimants or to customersto whom we have indemnification commitments, and we may be required toobtain licenses which may not be available on reasonable terms. Inaddition, we cannot assure you that legal action claiming patent infringement willnot be commenced against us, or that we would prevail in litigation given thecomplex technical issues and inherent uncertainties in patent litigation. Inaddition, users of our software may become subject to claims if oursoftware is alleged to infringe the intellectual property rights of others.These software users could attempt to hold us responsible for these claims andany resulting harm they suffer. If a patent claim against us were to besuccessful and we could not obtain a license on acceptable terms or license asubstitute technology or redesign to avoid infringement, we may beprevented from distributing our software or required to incur significantexpense and delay in developing non-infringing software. Such a result couldhave a material adverse effect on our business, financial condition and resultsof operations.

*Becauseour products have a long sales cycle, it is more difficult to plan our expensesand forecast our results; and our operating results may fail to meetinvestor expectations and may fluctuate materially from period to period,which may adversely affect our stock price.*

It typically takes three to nine months from the timewe qualify a sales lead until we sign a sales contract with the customer. As aresult, it is difficult for us to predict the quarter in which a particularsale will occur. If our sales cycle unexpectedly lengthens for one or morelarge orders or a significant number of small orders, it would delay the timingof our revenue, but not the timing of most of our corresponding expenses.Lengthening of our sales cycle could also increase the total cost of a sale dueto additional employee time and costs associated with the sale. Materialchanges in our sales cycle could cause our quarterly revenue or operatingresults to be below the expectations of investors, and the price of our commonstock could fall substantially.

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Our customers’decision process regarding their purchase of our products and services isrelatively long due to several factors, including:

·       thecomplex nature of our products, requiring our need to educate potentialcustomers about the uses and benefits of our products;

·       competitionfor the corporate resources necessary to finance the purchase andimplementation of our products;

·       customers’budgeting and purchasing cycles;

·       generaleconomic conditions;

·       theextent of customers’ evaluation and internal approval process often requiredbefore purchasing our products and services; and

·       delayedpurchases due to announcements of new products or enhancements by ourcompetitors or us.

*If our products and services are not used and acceptedby existing and prospective customers, our business and results of operationswill be adversely affected.*

The market forworkforce optimization software, including software that records and analyzescustomer interactions and that forecast and schedules employees, is still developing.Our success depends on the use and acceptance of our software and services byexisting and prospective customers. In addition, demand for our softwareremains uncertain because our existing and potential customers may:

·       notunderstand the benefits of using workforce optimization software generally or,more specifically, software which records and analyzes the interactions betweena business and its customers or which optimizes the forecasting and schedulingof employees;

·       notachieve favorable results using our software;

·       experiencetechnical difficulty in implementing our software;

·       usealternative methods such as online self-help to solve the same businessproblems our software is intended to address; or

·       closecontact centers.

*Our quarterly results are difficult to predict andadverse fluctuations in operating results could cause our stock price to fall.*

Our quarterlyrevenue and operating results are difficult to predict and could fluctuatesignificantly from period to period. In particular, we typically derive asignificant portion of our software product revenue toward the end of eachquarter and from a small number of relatively large orders. The delay orfailure to close anticipated sales in a particular quarter could reduce ourrevenue in that quarter and subsequent quarters over which revenue for the salecould be recognized. In addition, because our revenue from installation andtraining services largely correlates with our product revenue, a decline inproduct revenue could also cause a decline in our professional services revenuein the same quarter or in subsequent quarters. Our quarterly revenue isdifficult to forecast for several reasons, including the following:

·       changesin demand for our products and services;

·       thetendency of customers to delay software purchases until the end of the fiscalquarter;

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·       lengtheningof our customers’ budgeting and purchasing cycles;

·       timingof any acquisitions and related costs;

·       delaysin installations of our software;

·       varyingsales and implementation cycles for our products and services from customer tocustomer;

·       thefailure of our customers to renew their maintenance service agreements;

·       thetiming of hiring new services employees and the rate at which these employeesbecome productive; and

·       thedevelopment and performance of our distribution channels.

As a result of these andother factors, we believe that quarter-to-quarter comparisons of our operatingresults may not be a good indicator of our future performance, and youshould not rely on them to predict our future performance or the performance ofour stock price. If our revenue or operating results fall below theexpectations of investors or securities analysts, the price of our common stockwould likely decline.

*We may be unable to manage and expand ourinternational operations, which may adversely affect our business andoperating results.*

We derived revenues of $97.2 million,$84.6 million and $68.1 million in 2006, 2005 and 2004, respectively, fromcustomers located outside the United States. Our operations outside of theUnited States at December 31, 2006, consisted of operations located inAustralia, Brazil, Canada, China, Germany, India, Japan, Mexico, theNetherlands, Singapore, South Africa and the United Kingdom. We have alsoestablished relationships with a number of international resellers.

We intend to expandour international operations through acquisitions, internal business expansionand strategic business relationships. These efforts require significantmanagement attention and financial resources. We may not be able tosuccessfully penetrate international markets or, if we do, we may not beable to grow or to maintain adequate profit margins in these markets. Becauseof the complex nature of our international expansion, it may adverselyaffect our business and operating results. International expansion and salesare subject to many risks, including the following:

·       limiteddevelopment of an international market for our software and services;

·       expandingand training our international sales force and support operations;

·       highercosts of employment in certain international locations;

·       difficultiesin producing localized versions of our products;

·       politicaland economic instability;

·       potentiallyadverse tax consequences of operating in foreign countries;

·       internationallaws and regulations, including trade restrictions, local labor ordinances,changes in tariff rates and import and export licensing requirements;

·       longerpayment cycles and difficulties in collecting accounts receivable;

·       currencyfluctuations;

·       culturaldifferences which may affect workforce performance and sales processes;

·       difficultiesand expenses associated with complying with a variety of foreign laws; and

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·       unexpectedchanges in regulatory requirements.

As we further expand ouroperations outside the United States, we will also face new competitors andcompetitive environments. In addition to the risks associated with our domesticcompetitors, foreign competitors may pose an even greater risk, becausethey may possess a better understanding of their local markets and havebetter working relationships with local infrastructure providers and others. Inparticular, because telephone protocols and standards are unique to eachcountry, local competitors will have more experience with, and may have acompetitive advantage in, these markets. We may not be able to obtainsimilar levels of knowledge, which could place us at a significant competitivedisadvantage. In addition, we have limited experience in developing locallanguage versions of our products or in marketing our products to internationalcustomers. We may not be able to successfully translate, market, sell anddeliver our products internationally.

*If we are unable to maintain a productive direct salesforce, our business and operating results could be adversely affected.*

We believe that our futuresuccess will depend on maintaining a productive direct sales force.Historically, it has taken us up to six months to train new sales personnelbefore they reach an acceptable level of productivity. We have also experienceddifficulty in recruiting sales personnel with experience in computer andtelephone integration technologies. We cannot assure you that we will be ableto continue to manage turnover and hire new sales personnel to meet our needs.If the personnel we hire are less qualified than we expect, it may take usmore time to train them before they reach an acceptable level of productivity,which could increase our costs and reduce our revenue.

*If we are unable to expand the distribution of ourproducts through indirect sales channels, our business and operating resultscould be materially adversely affected.*

Our strategy is to continue to increase the proportionof customers served through indirect sales channels, such as select resellersand a variety of strategic marketing alliances. Product revenue, excludinghardware revenue, from our indirect sales channel represented approximately 44%and 41% of total product revenue in 2006 and 2005, respectively. We expectrevenue from our indirect sales channel and, accordingly, our dependence ondistribution partners, to increase as we establish relationships with companiesto resell our software worldwide. We cannot assure you that we will be able tomaintain productive relationships with our current partners, or that we will beable to establish similar relationships with additional resellers on a timelybasis, if at all.

Some resellers with whichwe do business have similar, and often more established, relationships with ourcompetitors, and may recommend the products and services of ourcompetitors to customers instead of our software and services. We cannotprovide assurance that these distribution partners will devote adequateresources to selling our software and services or that our resellersmay not learn about our products and the market for our software andservices and develop and sell competing products and services. As a result, ourrelationships with resellers could lead to increased competition for us.

*Competition in our business could adversely affect ourrevenue, profitability and market share.*

The market forproducts that record customer interactions, forecast andschedule employees, analyze performance and/or provide electronic learningis intensely competitive, evolving and is subject to rapid changes intechnology. We believe our principal competitors include, but are not limitedto:

·       traditionalcall-logging vendors;

·       qualitymonitoring suppliers to the contact center industry;

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·       workforcemanagement, forecasting and scheduling vendors to the call center, branchbanking and back office operations industries;

·       electroniclearning vendors;

·       businessanalytics vendors;

·       largetelecom solution providers;

·       enterprisesoftware vendors;

·       systemsintegrators and consulting firms; and

·       new,larger and more established entities that may acquire, invest in orform joint ventures with providers of recording or performance enhancingsoftware solutions.

Many of our current and potential competitors havelonger operating histories, more established business relationships, largercustomer bases, a broader range of products and services, greater namerecognition and substantially greater financial, technical, marketing,personnel, management, service, support and other resources than we do. As aresult, our current and potential competitors may be able to respond morequickly to new or emerging technologies and changes in customer requirements,take better advantage of acquisitions and other opportunities, devote greaterresources to marketing and selling their products and services and adopt moreaggressive pricing policies. We cannot assure you that our current or potentialcompetitors will not develop products comparable or superior in terms of priceand performance features to those developed by us.

In addition, many of our competitors market theirproducts through resellers and companies that integrate their technology andproducts with those of the competitor. These resellers and technology partnersoften have strong business relationships with our customers and potentialcustomers. For example, some of our competitors have better and more longstanding relationships than we do with telephone switch vendors. Ourcompetitors may use these business relationships to market and sell theirproducts and compete for potential customers. It is also possible thatresellers or technology partners may acquire or be acquired by one or moreof our competitors, which would further solidify their business relationships.

We expect that competitionwill increase as other established and emerging companies enter our market andas new products, services and technologies are introduced. Increasedcompetition may result in price reductions, lower gross margins and loss ofmarket share, any of which could materially and adversely affect our business,financial condition and results of operations.

*Our heavy reliance on sales of our recording, qualitymonitoring and workforce management software exposes us to risks of obsolescencedue to changes in competitive product offerings.*

We have derived asubstantial portion of our product revenues from sales of our recording,quality monitoring and workforce management software products. We expectrevenue from these products to continue to account for a significant portion ofour revenue for the foreseeable future. As a result, any factors affecting themarkets for these products could materially and adversely affect our business,financial condition and results of operations. We cannot assure you that themarket will continue to demand our current products or those we will besuccessful in marketing any new or enhanced products. If our competitorsrelease new products that are superior to our products in performance or price,demand for our products may decline. A decline in demand for our productsas a result of competition, technological change or other factors would reduceour total revenues and adversely affect profitability.

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*If we fail to develop new software or improve ourexisting software, we may not remain competitive.*

The markets for ourproducts are characterized by rapidly changing technology, frequent new productintroductions and enhancements, changes in customer demands and evolvingindustry standards. Our existing products could be rendered obsolete if we failto continue to advance our technology. We have also found that thetechnological life cycles of our products are difficult to estimate, partiallybecause of changing demands of our customers. We believe that our futuresuccess will depend on our ability to continue to enhance our current productline while we concurrently develop and introduce new products that keep pacewith competitive and technological developments. These developments require usto anticipate customers’ future needs and to continue to make substantialproduct development investments. Although we are presently developing a numberof product enhancements to our product suites, we cannot assure you that theseenhancements will be completed on a timely basis or gain customer acceptance.In addition, failure to develop new software or improve existing softwareproducts may adversely affect our ability to maintain our maintenancerenewal rate which could adversely affect our revenue.

*Our liability to customers may be substantial ifour products fail to perform properly.*

Our software is used in acomplex operating environment that requires its integration with computer andtelephone networks and other business software applications. If our productsfail to function as required, we may be subject to claims for substantialdamages. Courts may not enforce provisions in our contracts that wouldlimit our liability or otherwise protect us from liability for damages.Although we maintain general liability insurance coverage, including coveragefor errors or omissions, this coverage may not continue to be available onreasonable terms or in sufficient amounts to cover claims against us. Inaddition, our insurer may disclaim coverage as to any future claim. Ifclaims exceeding the available insurance coverage are successfully assertedagainst us, or our insurer imposes premium increases, large deductibles orco-insurance requirements on us, our business, financial position, and resultsof operations could be adversely affected.

*If an original equipment manufacturer that ispart of our indirect sales channel experiences technical difficulties, ourproduct sales through that channel may be adversely affected.*

When we sell our softwarethrough an original equipment manufacturer, or OEM, our software is embedded inthe OEM’s product, which we sometimes refer to as the “environment” for oursoftware. When the OEM’s product uses our software, there is a risk that the “environment”will fail or that it will not achieve the compatibility with our product thatwe and the OEM seek. If this happens, our software might not function properly,or the OEM might sell less of it, or both, which could have a material adverseeffect on our revenues, operating cash flows and the growth of ourbusiness.

*Our software may contain undetected errors or “bugs,”resulting in harm to our reputation and operating results.*

Software products ascomplex as those offered by us might contain undetected errors or failures whenfirst introduced or when new versions are released. We cannot assure you,despite testing by us and by current and prospective customers that errors willnot be found in new products or product enhancements after commercial release.Any errors found may cause substantial harm to our reputation and resultin a loss in revenue and additional unplanned expenses to remedy any defects.

*If our advanced compliance recording applications failto record our customers’ interactions, we may be subject to liability andour reputation may be harmed.*

Many of our customers useour advanced compliance recording applications to record and store interactionswith customers to provide back-up and verification of transactions and to guardagainst risks posed by lost or misinterpreted voice communications. Thesecustomers rely on our applications to record, 

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storeand retrieve voice data in a timely, reliable and efficient manner. If ourapplications fail to record our customers’ interactions or our customers areunable to retrieve the recordings when necessary, we may be subject toliability and our reputation may be harmed.

*If weare unable to maintain the security of our systems, our business, financialcondition and operating results could be harmed.*

The occurrence orperception of security breaches in the operation of our business or suffered bythird parties using our products could harm our business, financial conditionand operating results. Our customers use our products to compile and analyzehighly sensitive or confidential information. We may come into contactwith such information or data when we perform support or maintenancefunctions for our customers. While we have internal policies and procedures foremployees performing these functions, the perception that we have improperlyhandled sensitive, confidential information could have a negative effect on ourbusiness. If, in handling this information, we fail to comply with privacy orsecurity laws, we could incur civil liability to government agencies, customersand individuals whose privacy is compromised. If personal information isreceived or used from sources outside the U.S., we could be subject to civil,administrative or criminal liability under the laws of other countries. Inaddition, while we implement sophisticated security measures, third partiesmay attempt to breach our security or inappropriately use our productsthrough computer viruses, electronic break-ins and other disruptions. Ifsuccessful, confidential information may be improperly obtained and wemay be subject to lawsuits and other liability. Any internal or externalsecurity breaches could harm our reputation, and even the perception ofsecurity risks, whether or not valid, could inhibit market acceptance of ourproducts.

*Fluctuationsin foreign currency exchange rates could affect our financial results.*

We may experiencegains and losses resulting from fluctuations in currency exchange rates.Moreover, in locations where we price our products in U.S. dollars, our salescould be affected adversely by declines in foreign currencies relative to thedollar, thereby making our products more expensive in local currencies. Inlocations where we sell our products in local currencies, we could becompetitively unable to increase our prices to reflect fluctuations in exchangerates. We do not use derivative instruments to manage our foreign exchangerisk, and we cannot predict the impact that future exchange rate fluctuationsmay have on our results.

*Certainprovisions in agreements that we have entered into may expose us toliability for breach that is not limited in amount by the terms of thecontract.*

Certain contractprovisions, principally confidentiality and indemnification obligations incertain of our license agreements, could expose us to risks of loss that, insome cases, are not limited by contract to a specified maximum amount. If wefail to perform to the standards required by these contracts, we could besubject to additional liability and our business, financial condition andresults of operations could be materially and adversely affected.

*If weare unable to maintain the compatibility of our software with certain otherproducts and technologies, our future business would be adversely affected.*

Our software mustintegrate with software and hardware solutions provided by a number of ourexisting and potential competitors. For example, our products must integratewith phone switches made by the telephone switch vendors and computer telephonysoftware applications offered by other software providers. These competitors ortheir business partners could alter their products so that our software nolonger integrates well with them, or they could delay or deny our access tosoftware releases that allow us to timely adapt our software to integrate withtheir products. If we cannot adapt our software to changes in necessarytechnology, it may significantly impair our ability to competeeffectively, particularly if our software must integrate with the software andhardware solutions of our competitors.

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*If our professional services employees do not provideinstallation services effectively and efficiently, our customers may notuse our installation services or may stop using our software.*

Our customers ordinarilypurchase installation, training and maintenance services together with ourproducts. The functionality of our products is not dependent on ourinstallation and training services. We believe that the speed and quality ofinstallation services are competitive factors in our industry. If our installationservices are not satisfactory to our customers, the customers may choosenot to use our installation services or they may not license our softwarein the future. As a result, we would lose licensing and services revenue, andit could harm our reputation. In addition, our revenues realized from theperformance of maintenance services are material to our operating results,and a failure to provide adequate maintenance support to our customers wouldresult in reduced maintenance revenues and have an adverse effect on ouroperating results.

*We may make acquisitions or investments that arenot successful and that adversely affect our ongoing operations.*

We may acquireor make investments in companies, products, services and technologies that webelieve complement our business and assist us in quickly bringing new productsto market. We have limited experience in making acquisitions and investments.As a result, our ability to identify and evaluate prospects, completeacquisitions and properly manage the integration of businesses is relativelyunproven. If we fail to properly evaluate and execute acquisitions orinvestments, it may have a material adverse effect on our business andoperating results. In making or attempting to make acquisitions or investments,we face a number of risks, including:

·       identifyingsuitable candidates, performing appropriate due diligence, identifyingpotential liabilities and negotiating acceptable terms;

·       reducingour working capital and hindering our ability to expand or maintain ourbusiness, if we make acquisitions using cash;

·       thepotential distraction of our management, diversion of our resources anddisruption of our business;

·       retainingand motivating key employees of the acquired companies;

·       managingoperations that are distant from our current headquarters and operations;

·       enteringinto geographic markets in which we have little or no prior experience;

·       competingfor acquisition opportunities with competitors that are larger than we are orhave greater financial and other resources than we have;

·       accuratelyforecasting the financial impact of a transaction;

·       assumingliabilities of acquired companies, including litigation related to theoperation of the business prior to the acquisition;

·       maintaininggood relations with the customers and suppliers of the acquired company;

·       potentiallydilutive issuances of securities as consideration for an acquisition;

·       effectivelyintegrating acquired companies and achieving expected synergies; and

·       theimpairment of the value of the assets acquired in any corporate acquisition.

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*If we need additional financing to maintain or expandour business, it may not be available on favorable terms, if at all.*

Although we believeour current cash and borrowing capacity will be sufficient to meet ouranticipated cash needs for at least the next 12 months and the foreseeablefuture, we may need additional funds to expand or meet all of ouroperating needs. If we need additional financing, we cannot be certain that itwill be available to us on favorable terms, or at all. If we raise additionalfunds by issuing equity securities or convertible debt, the ownership interestof our stockholders could be significantly diluted, and any additional equitysecurities we issue may have rights, preferences or privileges senior tothe rights of our stockholders. Also, the terms of any additional financing weobtain may significantly limit our future financing and operatingactivities. If we need funds and cannot obtain them on acceptable terms, we may beunable to:

·       developand enhance our software to remain competitive;

·       takeadvantage of future opportunities, such as acquisitions;

·       respondto changing customer needs and our competitors’ innovations; or

·       attractand retain qualified key personnel.

Any of these events couldsignificantly harm our business and financial condition and limit our growth.

*Our inability to source hardware could harm ourbusiness.*

A number ofcustomers expect us to source hardware to support the implementation of oursoftware. We seek to reduce the amount of hardware sales in the future and havetransferred the fulfillment of hardware orders to third-party distributors.Thus, we are largely dependent on third parties for the supply of hardwarecomponents to our customers. If these hardware distributors experiencefinancial, operational or quality assurance difficulties, or if there is anyother disruption in our relationships, we may be required to locatealternative hardware sources. We are subject to the following risks due to ourhardware distribution system:

·       cancellationsof orders due to unavailability of hardware;

·       increasedhardware prices, which may make our products less attractive; and

·       additionaldevelopment expense to modify our products to work with new hardware configurations.

Even if we and/or ourdistributors are successful in locating alternative sources of supply,alternative suppliers could increase prices significantly. In addition,alternative components may malfunction or interact with existingcomponents in unexpected ways. The use of new suppliers and the modification ofour products to function with new systems would require testing andmay require further modifications, which may result in additionalexpense, diversion of management attention and other resources, inability tofulfill customer orders or delay in fulfillment, reduction in quality andreliability, customer dissatisfaction, and other adverse effects on ourreputation, business and operating results.

*We have reported material weaknesses in internalcontrols over financial reporting and cannot assure you that additionalmaterial weaknesses will not be identified in the future. If our internalcontrols over financial reporting or disclosure controls and procedures are noteffective, there may be errors in our Consolidated Financials Statements thatcould require a restatement or our filings may not be timely and investors maylose confidence in our reported financial information, which could lead to adecline in our stock price.*

The Sarbanes-Oxley Act of2002 imposes certain duties on us and our executives, Board of Directors andattorneys. Our efforts to comply with the requirements of Section 404 haveresulted in increased general and administrative expense and a diversion ofmanagement time and attention from revenue-

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generatingactivities to compliance activities, and we expect these efforts to require thecontinued commitment of significant resources. We have reported materialweaknesses in internal control over financial reporting which we found inconnection with our evaluation of controls and procedures as of December 31,2006. If we fail to maintain the adequacy of our internal controls, wemay not be able to ensure that we can conclude on an ongoing basis that wehave effective internal controls over financial reporting. Failure to maintaineffective internal controls over financial reporting could result ininvestigation and/or sanctions by regulatory authorities, and could have amaterial adverse effect on our business and operating results, investorconfidence in our reported financial information, and the market price of ourcommon stock.

*Our stock price has been volatile.*

The market price of ourcommon stock has been subject to significant fluctuations in response tovariations in quarterly operating results and other factors. In addition, thestock market has experienced significant volatility that has particularlyaffected the market prices of equity securities of many technology companiesand that often has been unrelated or disproportionate to the operatingperformance of these companies. Any announcement with respect to any adversevariance in revenue or earnings from levels generally expected by securitiesanalysts or investors could have a significant adverse effect on the tradingprice of our common stock. In addition, factors such as announcements oftechnological innovations or new products by us, our competitors or thirdparties, changing conditions in the customer relationship management softwaremarket, changes in the market valuations of similar companies, loss of a majorcustomer, additions or departures of key personnel, changes in estimates bysecurities analysts, announcements of extraordinary events, such asacquisitions or litigation, or general economic conditions may have anadverse effect on the market price of our common stock. With the announcementof our pending Merger with Verint pursuant to which our stockholders wouldreceive a fixed cash price of $27.50 per share of our common stock (less anyapplicable withholding taxes and without interest), the market price of ourcommon stock may depend more on developments and expectations relating to theprobability and timing of completion of the Merger and may be less subject tofluctuation resulting from other changes.

*Government regulation of telephone and Internetmonitoring could cause a decline in the use of our software, result inincreased expenses for us or subject our customers and us to liability.*

As the telecommunicationsindustry continues to evolve, state, federal and foreign governments (includingsupranational governmental organizations such as the European Union) andindustry associations may increasingly regulate the monitoring oftelecommunications and telephone and Internet monitoring and recordingproducts, such as our software. We believe that increases in regulation couldcome in a number of different forms, including regulations regarding privacy,protection of personal information such as Social Security numbers, credit cardinformation and employment. For example, the State of California enacted theDatabase Security Breach Act, which requires any business that suffers acomputer security breach to immediately notify customers in California ifpersonal information has been compromised, and the payment card industry hasadopted regulations that require additional security regarding the storage ofconsumers’ credit card numbers. The adoption of any new regulations or changesto existing regulations could cause a decline in the use of our software andcould result in increased expense for us as we modify our software toaccommodate these regulations. Moreover, these regulations could subject ourcustomers or us to liability. Whether or not these regulations are adopted, ifwe do not adequately address the privacy concerns of consumers, companiesmay be hesitant to use our software. If any of these events occur, itcould materially and adversely affect our business.

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*If we are unable to attract and retain key personnel,our ability to effectively manage and grow our business would suffer.*

Our success greatly depends on our ability to hire,train, retain and motivate qualified personnel, particularly in sales,marketing, research and development, service and support. We face significant competitionfor individuals with the skills required to perform the services we offer.If we are unable to attract and retain qualified personnel or if we experiencehigh personnel turnover, it could prevent us from effectively managing andexpanding our business.

Our success also dependsupon the continued service of our executive officers. Any of our executiveofficers and other employees could terminate his or her relationship with us atany time. The loss of the services of our executive officers or other keypersonnel, particularly if lost to competitors, could materially and adverselyaffect our business.

*Our certificate of incorporation and bylaws, as wellas Delaware law, may inhibit a takeover of our company, which could limitthe price investors might be willing to pay for our securities.*

Should our proposed Merger with Verint not beconsummated our amended and restated certificate of incorporation and bylaws,as well as Delaware law, contain provisions that might enable our management toresist a takeover of our company by some other person or entity. For example,our stockholders cannot take action by written consent or call a specialmeeting to remove our Board of Directors. In addition, our directors serve forstaggered terms, which makes it difficult to remove all our directors at once.Further, in October 2002, our Board of Directors approved, and weimplemented, a stockholder rights plan which has the effect of causingsubstantial dilution to a person or group that attempts to acquire us on termsnot approved by the Board of Directors.

These anti-takeoverprovisions might discourage, delay or prevent a change in the control of ourcompany or a change in our management. These provisions could also discourageproxy contests and make it more difficult for you and other shareholders toelect directors and take other corporate actions. The existence of theseprovisions could also limit the price that investors might be willing to pay inthe future for our securities.

**Item 1B.**               UnresolvedStaff Comments

We have not received anywritten comments regarding our periodic or current reports from the staff ofthe Securities and Exchange Commission that were issued 180 days or more beforethe end of our fiscal year ended December 31, 2006, and therefore no issuesremain unresolved.

**Item 2.**                        Properties

Our principaladministrative, marketing, product development, training and support facilitiesare located in Roswell, Georgia, a suburb of Atlanta, where we leaseapproximately 96,400 square feet under a lease that expires in 2007. We occupyapproximately 26,000 square feet in Leatherhead, United Kingdom under a leasethat expires in 2014, which includes administrative, marketing, productdevelopment and support facilities. In addition, we lease offices in the UnitedStates, Australia, Brazil, Canada, China, India, Japan, Mexico, Singapore, andthe United Kingdom. We believe our facilities are in good operating conditions,suitable and adequate for our current and expected near-term requirements.

**Item 3.**                        LegalProceedings

On December 11, 2002, we filed in the UnitedStates District Court for the Northern District of Georgia, Atlanta Division, alawsuit against Knowlagent, Inc. (“Knowlagent”), which is the assignee ofUnited States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagenthas accused our eQuality 

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Now software of infringingthe above patents. We filed suit seeking a declaration that we did not and donot infringe either of the two patents listed above, as well as a declarationthat the above patents are invalid and unenforceable. We also filed a claimrequesting that if the patents are found to be valid, that one of our ownemployees be named the rightful inventor of the patents. We also requestedmonetary damages in an amount equal to the amount that Knowlagent has receivedfrom its use of the above patents. On December 31, 2002, Knowlagent filedits answer to our complaint as well as two counterclaims, alleging that weinfringe and contribute to the infringement by others of the above patents;Knowlagent seeks both monetary damages and an injunction in connection with itscounterclaim. On June 6, 2005, the Court held a claim construction hearingand issued a claim construction order on June 8, 2005. The case is nowproceeding to expert discovery and summary judgment phases.

On July 20, 2004, STS Software Systems Ltd. (“STSSoftware”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICE Ltd.”),filed a patent infringement suit in the U.S. District Court for the SouthernDistrict of New York against us (“New York Action”). The New York Actionasserts that our products, including eQuality ContactStore for IP, infringeUnited States (“U.S.”). Patent No. 6,122,665 (“the ‘665 patent”) and seeksonly injunctive, not monetary, relief. On the same day, we filed a declaratoryjudgment action against STS Software in the U.S. District Court for theNorthern District Georgia (“Georgia Action”). We seek a declaration from thecourt that we have not infringed any valid claim of the ‘665 patent. By Orderentered December 16, 2004, Judge Koeltl of the U.S. District Court for theSouthern District of New York granted our motion to transfer the New YorkAction to the Northern District of Georgia, which has now consolidated theformer New York Action with the Georgia Action. On July 7, 2005, the Courtalso granted STS leave to amend its complaint to add three patents to thedispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and 6,880,004(respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004 patent”; collectively,“the STS patents”), again seeking solely injunctive relief. We answered thefirst amended complaint and asserted counterclaims on July 29, 2005,collectively, through which we deny infringement of any valid claim of the STSpatents and seek a declaration to that effect. The Court entered its claimconstruction ruling on January 16, 2007, and the case is progressingthrough its remaining discovery phases.

On August 30, 2004, we filed in the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. (“NICE Inc.”), a wholly-ownedsubsidiary of NICE Ltd., alleging patent infringement. Specifically, wehave alleged that NICE products, including the NiceUniverse products thatinclude screen capture and synchronized screen and voice capture technologies,infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220(“the ‘220 Patent”), both entitled “Method and Apparatus for SimultaneouslyMonitoring Computer User Screen and Telephone Activity from a Remote Location.”We have sought an injunction and money damages for NICE’s infringement of thesetwo patents. NICE Inc. has answered and counterclaimed for declaratoryjudgments of non-infringement and invalidity. Since then, on February 24,2005, we filed suit against NICE Ltd. because of its infringing activitiesin violation of the ‘798 and ‘220 patents, including importation of the accusedNICE products. By order dated April 5, 2005, the court has consolidatedthe NICE Inc. and NICE Ltd. actions. The Court entered its claim constructionruling on January 5, 2007, and the case is progressing through itsremaining discovery phases.

On January 19, 2006, we filed in the UnitedStates District Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. and NICE Systems, Ltd. (collectively “NICE”),alleging patent infringement. Specifically, we have alleged that NICE products,including NicePerform and related products that include the ability tomonitor communications to detect the presence of at least one predeterminedparameter, infringe claims of U.S. Patent No. 6,404,857 B1 (“the ‘857Patent”), entitled “Signal Monitoring Apparatus for Analyzing Communications.”We have sought an injunction and money damages for NICE’s infringement of the ‘857patent. On March 6, 2006, NICE answered and 

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counterclaimed, allegingthat the ‘857 patent is not infringed and is invalid. The case has been set ona discovery calendar and is at a preliminary stage.

On May 10, 2006, NICE Systems, Inc. and NICESystems Ltd. (collectively “NICE”), filed a patent infringement suit seekingmonetary damages and injunctive relief in the U.S. District Court for theDistrict of Delaware against us (“Delaware Action”). The Delaware Actionasserts that our products, including ContactStore, ContactStore for IP,ContactStore for Communications Manager, Quality for Communications Manager,and eQuality Balance, infringe one or more claims of ten U.S. Patents:  U.S. Patent Nos. 5,274,738; 5,396,371;5,819,005; 6,249,570; 6,728,345; 6,775,372; 6,785,370; 6,870,920; 6,959,079;and 7,010,109 (“the Delaware Patents”). We answered NICE’s complaint on June 30,2006, through which we deny infringement of any valid claim of any of theDelaware Patents. The case has been set on a discovery calendar and is at apreliminary stage.

On December 27, 2006, NICE Systems, Inc. andNICE Systems Ltd. (collectively, “NICE”), filed a declaratory judgment actionagainst us in the U.S. District Court for the Northern District Georgia,relating to U.S. Patent No. 6,757,361 (“the ‘361 Patent”), entitled “SignalMonitoring Apparatus Analyzing Voice Communication Content.”  NICE seeks a declaration from the court thatthe claims of the ‘361 Patent are invalid, and that NICE has not infringed anyvalid claim of the ‘361 Patent. The Company has moved to dismiss or stay thecase while a previously filed reissue proceeding remains pending in the PatentOffice. The motion remains pending.

On August 29, 2006, A. Edward Miller filed ashareholder derivative lawsuit in the United States District Court for theNorthern District of Georgia (Atlanta Division) naming Witness Systems, Inc.(the “Company”) as a nominal defendant and naming all of our current Board ofDirectors and a number of our current officers as defendants. Miller v. Gould,et al., Civil Action No. 1:06-CV-2039 (N.D. Ga.). Thecomplaint alleges purported violations of federal and state law, includingbreaches of fiduciary duty, abuse of control, constructive fraud, corporatewaste, unjust enrichment, gross mismanagement and violations of certainantifraud provisions of the federal securities laws (including Sections 10(b) and14(a) of the Securities Exchange Act of 1934 and Rules 10b-5and 14a-9 thereunder) in connection with certain stock option grants madeby the Company. The complaint seeks monetary damages in unspecified amounts,disgorgement of profits, an accounting, rescission of stock option grants,imposition of a constructive trust over the defendants’ stock options andproceeds derived therefrom, punitive damages, reimbursement of attorneys’ feesand other costs and expenses, an order directing the Company to adopt or put toa stockholder vote various proposals relating to corporate governance, andother relief as determined by the court. On November 15, 2006, the Companyand the other defendants filed a motion to dismiss the complaint in itsentirety on a variety of grounds, including plaintiffs’ failure to allegedemand futility. Rather than respond to that Motion, plaintiffs on January 9,2007 filed an Amended Complaint. On March 9, 2007, the Company and theother defendants filed a motion to stay or dismiss the amended complaint.

A class action securities lawsuit has been filedby an individual on August 14, 2006 claiming tobe a stockholder of the Company naming the Company and certain of itsBoard of Directors and officers as defendants in connection with certain stockoption grants made by the Company. Rosenberg v. Gould, et al., Civil Action No. 1:06-CV-1894(N.D. Ga.). The complaint, filed in the United States District Court for theNorthern District of Georgia, alleges violations of Section 10(b) ofthe Securities Exchange Act of 1934 and Rule 10b-5 thereunder andseeks unspecified damages, attorneys’ fees and other costs and expenses,unspecified extraordinary, equitable and injunctive relief, and other relief asdetermined by the court. A lead plaintiff has been designated, and the AmendedComplaint is due on March 26, 2007. The Company and the other defendantswill respond to the complaint when appropriate.

On October 27, 2006, the Company received anotice of informal nonpublic inquiry from the Securities and ExchangeCommission requesting certain documents and information relating to the 

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company’s stock optiongrant practices from February 2000 to the present. We intend to cooperatefully with all matters related to this request.

On March 14, 2007, the Company was served with acomplaint by Doron Aspitz, the former chief executive officer of Blue PumpkinSoftware, Inc., in California Superior Court for the County of Santa Clara(Case No. 107CV078480). The complaint names the Company as defendant andpurports to assert eight causes of action, for promissory estoppel, promissoryfraud, negligent misrepresentation, breach of fiduciary duty, vote buying,violation of Section 17200 of the California Business and ProfessionsCode, violation of Section 1101 of the California general Corporation Law,and unjust enrichment. The complaint purports to seek over $5.0 million incompensatory damages as well as other unquantified punitive and exemplarydamages, disgorgement, and attorneys’ fees and costs. The complaint was filedon or about January 19, 2007 but no effort was made to serve the complaintuntil approximately mid-March 2007, and no response is presently due. TheCompany will respond to the complaint at an appropriate time and intends tocontest the complaint vigorously.

From time to time we maybe involved in other legal proceedings and/or litigation arising in theordinary course of our business that might impact on our financial position,our results of operations, or our cash flows.

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

No matters were submitted to a vote of securityholders during the fourth quarter ended December 31, 2006.

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**PART II**

**Item5.**                        Market forOur Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities

**Common Stock—Listingon the Nasdaq Stock Market**

Our common stock trades on the Nasdaq Stock Marketunder the symbol “WITS”. As of December 31, 2006, due to our delay infiling our quarterly reports on Form 10-Q for the quarters ended June 30,2006 and September 30, 2006, we were not in compliance with the NasdaqStock Market filing requirements for continued listing as set forth in MarketplaceRule 4310(c)(14). We have since filed our quarterly reports on Form 10-Qfor the quarters ended June 30, 2006 and September 30, 2006 and byletter dated February 15, 2007, the Nasdaq Listing Hearing and ReviewCouncil notified us of its determination that we have demonstrated compliancewith all Nasdaq Marketplace Rules. The letter further states that thepreviously reported delisting proceedings with respect to our securities arenow closed and that our securities will continue to be listed on the NasdaqStock Market.

Thefollowing table sets forth, the high and low sale price per share of the commonstock on the Nasdaq Stock Market in each of the last eight quarters:

| ** **                          | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------|------------|----------|------------|---------|------------|
| Year Ended  December 31, 2006: |       |     |       |    |       |
| Fourth quarter                      |       | $        | 20.01      |    | $          | 15.17 |   |
| Third quarter                       |       | $        | 20.37      |    | $          | 12.76 |   |
| Second quarter                      |       | $        | 25.33      |    | $          | 18.07 |   |
| First quarter                       |       | $        | 25.48      |    | $          | 18.61 |   |
| Year Ended  December 31, 2005: |       |     |       |    |       |
| Fourth quarter                      |       | $        | 22.12      |    | $          | 18.28 |   |
| Third quarter                       |       | $        | 21.10      |    | $          | 16.90 |   |
| Second quarter                      |       | $        | 18.58      |    | $          | 15.68 |   |
| First quarter                       |       | $        | 20.00      |    | $          | 16.11 |   |

 

The closing sale price of our common stock as reportedby the Nasdaq Stock Market on March 8, 2007 was $26.51.

*DividendPolicy.**  *Wehave not paid any cash dividends on our common stock to date. Our Board ofDirectors determines whether or not we will pay dividends. The Board ofDirectors considers a number of factors in deciding whether or not to paydividends, including our earnings, our capital requirements and our financialcondition. Currently, the Board of Directors intends to retain all earnings, ifany, for use in our business operations and, accordingly, does not expect todeclare or pay any dividends in the foreseeable future.

*Rule 10b5-1—TradingPlans.**  *OurBoard of Directors approved an amendment to our insider trading policy topermit our officers, directors and other insiders to enter into trading plansor arrangements to sell shares of our common stock complying with Rule 10b5-1of the Securities Exchange Act of 1934, as amended. Trading plans provide forsales, subject to price restrictions, daily limits and other contingencies, ofshares of our common stock.

*Holders.**  *As of March 8, 2007, we had118 holders of record of our common stock. We believe that we have more than5,000 beneficial owners.

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**Issuer Purchases ofEquity Securities**

In 2002, our Board ofDirectors authorized a stock repurchase program to spend up to$10.0 million to repurchase our common stock. As of December 31,2006, we had repurchased 1.0 million shares of our common stock for$3.1 million, which were retired. As at December 31, 2006, 6.9million shares are available for repurchase, however, we have not repurchasedour common stock since 2003 and do not presently plan to repurchase additionalcommon stock.

**Performance Graph**

The performance graphbelow compares the cumulative total shareholder return on the Company’s commonstock with the cumulative total return on the equity securities of companiesincluded in the Nasdaq composite index and Research Data Group (“RDG”) Softwarecomposite index. The RDG Software composite index is comprised of over 80publicly traded software companies including Adobe Systems, Citrix Systems,Comverse Techlology, Microsoft Corp., Oracle Corp. and SAP AG. The graphassumes an investment of $100 on December 31, 2001. We have not declaredany dividends in the period represented in this performance graph. Theperformance graph represents past performance and is not necessarily indicativeof future price performance of our common stock.

**COMPARISON OF 5YEAR CUMULATIVE TOTAL RETURN*Among Witness Systems, Inc., The NASDAQ Composite IndexAnd The RDG Software Composite Index**

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*                    $100invested on 12/31/01 in stock or index—including reinvestment of dividends.Fiscal year ending December 31.

| ** **                      | ** ** | **12/01**  | ** ** | **12/02** | ** ** | **12/03** | ** ** | **12/04**  | ** ** | **12/05**  | ** ** | **12/06**  | ** ** |
|---------------------------------|------------|------------|------------|-----------|------------|-----------|------------|------------|------------|------------|------------|------------|------------|
| **Witness  Systems, Inc.** | ** ** | **100.00** | ** ** | **25.83** | ** ** | **69.59** | ** ** | **131.08** | ** ** | **147.67** | ** ** | **131.61** | ** ** |
| **NASDAQ  Composite**           | ** ** | **100.00** | ** ** | **69.66** | ** ** | **99.71** | ** ** | **113.79** | ** ** | **114.47** | ** ** | **124.20** | ** ** |
| **RDG Software Composite**      | ** ** | **100.00** | ** ** | **69.77** | ** ** | **86.91** | ** ** | **97.48**  | ** ** | **97.30**  | ** ** | **107.31** | ** ** |

 

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**Item 6.**                        SelectedFinancial Data

Thefollowing selected consolidated financial data should be read in conjunctionwith the Consolidated Financial Statements and Notes thereto and with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this report (in thousands, except for per share data):

| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2006(a)**                                | ** ** | **2005(b)** | ** ** | **2004** | ** ** | **2003(c)** | ** ** | **2002** | ** ** |
| **Statement of Operations Data:**               |       |                                       |       |   |   |   |   |   |   |   |   |
| Revenue:                                        |       |                                       |       |   |   |   |   |   |   |   |   |
| Product                                         |       | $                                          | 85,850     |   | $ | 74,186 |   | $ | 57,620 |   | $ | 46,238 |   | $ | 33,383 |   |
| Services                                        |       | 135,933                                    |       | 111,142 |   | 83,715 |   | 61,799 |   | 34,303 |   |
| Total revenue                                   |       | 221,783                                    |       | 185,328 |   | 141,335 |   | 108,037 |   | 67,686 |   |
| Cost of revenue:                                |       |                                       |       |   |   |   |   |   |   |   |   |
| Product                                         |       | 18,875                                     |       | 19,130 |   | 13,784 |   | 11,580 |   | 1,132 |   |
| Services                                        |       | 52,662                                     |       | 42,361 |   | 32,645 |   | 24,413 |   | 12,615 |   |
| Total cost of revenue                           |       | 71,537                                     |       | 61,491 |   | 46,429 |   | 35,993 |   | 13,747 |   |
| Gross profit                                    |       | 150,246                                    |       | 123,837 |   | 94,906 |   | 72,044 |   | 53,939 |   |
| Operating expenses:                             |       |                                       |       |   |   |   |   |   |   |   |   |
| Selling, general and administrative             |       | 114,951                                    |       | 85,995 |   | 65,808 |   | 60,823 |   | 41,624 |   |
| Research and development                        |       | 33,307                                     |       | 26,717 |   | 20,816 |   | 18,267 |   | 15,460 |   |
| Merger-related and integration costs            |       | 2,702                                      |       | 4,532 |   | 498 |   | 7,865 |   | — |   |
| Acquired in-process research and development    |       | 760                                        |       | 9,000 |   | — |   | 7,840 |   | — |   |
| Operating (loss) income                         |       | (1,474                                     | )          | (2,407 | ) | 7,784 |   | (22,751 | ) | (3,145 | ) |
| Interest and  other income, net                 |       | 5,180                                      |       | 860 |   | 1,206 |   | 1,303 |   | 1,570 |   |
| Income (loss) before provision for income taxes |       | 3,706                                      |       | (1,547 | ) | 8,990 |   | (21,448 | ) | (1,575 | ) |
| (Benefit)  provision for income taxes           |       | (3,752                                     | )          | 3,024 |   | 312 |   | 307 |   | 261 |   |
| Net income (loss)                               |       | $                                          | 7,458      |   | $ | (4,571 | ) | $ | 8,678 |   | $ | (21,755 | ) | $ | (1,836 | ) |
| Net income (loss) per  share:                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic                                           |       | $                                          | 0.22       |   | $ | (0.17 | ) | $ | 0.37 |   | $ | (0.99 | ) | $ | (0.08 | ) |
| Net income (loss) per  share:                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Diluted                                         |       | $                                          | 0.20       |   | $ | (0.17 | ) | $ | 0.33 |   | $ | (0.99 | ) | $ | (0.08 | ) |
| Weighted-average common  shares outstanding:    |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic                                           |       | 33,687                                     |       | 27,221 |   | 23,361 |   | 21,991 |   | 22,626 |   |
| Diluted                                         |       | 36,533                                     |       | 27,221 |   | 26,084 |   | 21,991 |   | 22,626 |   |
| **Balance Sheet Data:**                         |       |                                       |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                      |       | $                                          | 73,888     |   | $ | 111,751 |   | $ | 42,641 |   | $ | 21,517 |   | $ | 30,089 |   |
| Working capital                                 |       | 125,497                                    |       | 119,115 |   | 60,114 |   | 28,697 |   | 59,435 |   |
| Total assets                                    |       | 324,593                                    |       | 264,394 |   | 124,499 |   | 104,035 |   | 87,141 |   |
| Total stockholders’  equity                |       | 245,477                                    |       | 202,284 |   | 74,374 |   | 49,995 |   | 65,074 |   |

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(a)           We commenced theconsolidation of Demos and Exametric, Inc. on October 2, 2006.

(b)          We commenced theconsolidation of Blue Pumpkin Software, Inc. and Optimis Group Limited onJanuary 25, 2005 and May 24, 2005, respectively.

(c)           We commenced theconsolidation of Eyretel plc on March 22, 2003.

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

The followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations is intended to provide investors with an understanding of the Company’spast performance, its financial condition and its prospects and should be readin conjunction with the Consolidated Financial Statements and Notes theretoincluded elsewhere in this report. Investors should carefully review theinformation contained in this report under Item1A “Risk Factors” beginning on page 10.****The following will be discussed and analyzed:

·       StockOption Practices and Restatement of Consolidated Financial Statements

·       Overview

·       CriticalAccounting Policies and Estimates

·       RecentAccounting Pronouncements

·       Resultsof Operations

·       Liquidity and CapitalResources

**Stock OptionPractices and Restatement of Consolidated Financial Statements**

Beginning in late May 2006, the Company’smanagement initiated a preliminary internal review of the Company’s historicalstock option practices and related accounting treatment in response to generalmedia attention concerning stock option grants at various public companies andshareholder interest with respect to this particular issue. On August 8,2006, in response to the results of management’s preliminary internal review,our Board of Directors voluntarily formed a Special Committee of independentdirectors to review our stock option practices and grants during the periodbetween the date of the Company’s initial public offering on February 10,2000 and August 31, 2002. The Special Committee undertook itsinvestigation with the assistance of independent counsel and accounting expertsretained by its counsel. The Special Committee reviewed all 5.7 million stockoptions granted throughout the period covered by its investigation. In December 2006,the Special Committee completed its review and reported its findings andrecommendations to our full Board of Directors. The Special Committee did notfind fraud or intentional misrepresentation in the financial reporting of theoption grants that it analyzed but found inaccuracies in the determination ofmeasurement dates for certain stock option grants affecting the Company’saccounting and disclosures. For a number of these grants, the Special Committeefound that it was likely that the stated grant date was selected in hindsightbased on price given the lack of supporting documentation and that the optionprice was the low price in a given month or quarter. Such grants were found tobe present during 2000 and through approximately mid-year 2001. The SpecialCommittee concluded that it was not necessary to expand the investigation tocover periods after August 31, 2002. Among the various key considerationsin reaching this conclusion were: 1) as noted above, the Special Committee didnot find fraud or intentional misrepresentation in the financial reporting ofthe option grants that it analyzed; 2) the Special Committee’s investigationfound that the last instance of likely grant date selection based on stockprice occurred in mid-2001; and 3) the Special Committee observed thatthe option granting practices of the Company became more formal and regularizedduring the latter phase of the period subject to its review.

In addition to the Special Committee investigation,the Company, with the assistance of outside legal counsel, reviewed the Company’sstock option practices and grants for the periods subsequent to August 31,2002. This review evaluated 90 percent of the 11.1 million options grantedafter August 31, 2002. The review was designed not only to provide a highdegree of grant review coverage, but also to appropriately assess the proprietyof measurement dates for each of the various types of options granted duringthis period. Among others, option grant types covered included: 1) new employeegrants in 

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connection with theacquisition of businesses; 2) semi-annual employee ranking grants; 3) routinenon-officer grants for such events as new hires, promotions, sales achievement,etc; and 4) officer grants, including grants to the Company’s then ChiefExecutive Officer (“CEO”). This review did not find fraud or intentionalmisrepresentation in the financial reporting relating to option grants butidentified errors in the determination of measurement dates. However, sucherrors were relatively immaterial and did not exhibit evidence of selection ofa favorable grant date and price in hindsight.

In those instances during the two review periods wherethe fair market value of our common stock at the originally stated grant datewas lower than the fair market value on the redetermined measurement date, inaccordance with APB No. 25 and related interpretations, we concluded thatwe should have recorded stock-based compensation expense which was notaccounted for in our previously issued Consolidated Financial Statements.

As a result of the findings described above, ourrestated Consolidated Financial Statements as of December 31, 2005reflected a cumulative decrease in net income of approximately $9.5 million forthe years 2000 to 2005 due to non-cash adjustments to stock-based compensationexpense. The stock-based compensation expense is primarily based on APB No. 25which are intrinsic value based charges that are amortized over the vestingterms of the stock options. In connection with the restatement, we identifiedadditional adjustments that needed to be recorded to our historicalConsolidated Financial Statements. These adjustments consisted primarily ofpurchase accounting relating to acquisition of Blue Pumpkin, income taxes andmiscellaneous other items. The cumulative effect of the restatement adjustmentson our Consolidated Balance Sheet as of December 31, 2005 resulted in anincrease in the accumulated deficit of $10.5 million, an increase in additionalpaid-in capital of $5.8 million and increases in assets and liabilities of $2.8million and $7.5 million, respectively. Although there were no optionmeasurement dating issues, our 2006 Consolidated Financial Statements areimpacted by option grants in prior years where the measurement dates have beenadjusted.

As a result of the SpecialCommittee’s review, we restated our Consolidated Financial Statements for eachof the years ended December 31, 2001 through December 31, 2005, andfor the first quarter of 2006. Accordingly, you should not rely on financialinformation included in the reports on Form 10-K, Form 10-Qand Form 8-K previously filed by us, the related opinions of ourindependent registered public accounting firm, earnings press releases andsimilar communications issued by us, for periods ended on or before March 31,2006, all of which have been superseded in their entirety by the informationcontained in our 2005 Form 10-K/A and our amended Quarterly Reporton Form 10-Q/A for the three months ended March 31, 2006, eachfiled February 8, 2007.

**Overview**

We are a leading provider of workforce optimizationsoftware and services that help businesses capture customer intelligence andoptimize their work performance. Our Impact 360 solution features qualitymonitoring, compliance and IP recording, workforce management, performancemanagement and e-learning. Our quality monitoring products record multimediainteractions, including traditional voice, Web chat and email, based onuser-defined business rules to enable our customers to evaluate theperformance of their customer service representatives (“CSRs”) wherever theymay be located in the enterprise. Our full-time compliance applicationsare designed to record high volume voice conversations between CSRs andcustomers for purposes such as compliance recording and sales verification. Ourworkforce management products enable our customers to develop strategicstaffing plans, deploy skilled resources and evaluate productivity of CSRs in acontact center, branch bank or back office operations. Our performancemanagement applications provide comprehensive analytics, including performancescorecards, and reports of customer interaction and CSR performance. Our e-learningapplications deliver ongoing training tailored to CSR needs and competencies.We also provide consulting and implementation services, training and support tocustomers that use our software products. Primarily deployed in contact 

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centers—as well as theremote, branch and back offices of global organizations, the workforceoptimization solution captures, analyzes and enables users to share and act oncross-functional information across the enterprise. With Impact 360,organizations can improve interactions and the underlying back-office processesthat enhance the customer experience and build customer loyalty.

Our Impact 360 solution is an integrated offering ofsoftware products that provide comprehensive workforce optimizationfunctionality, including quality monitoring and high-volume compliancerecording, workforce management, performance management and electroniclearning, or e-learning. Our quality monitoring products record multimediainteractions, including traditional voice, Web chat and email, based onuser-defined business rules to enable our customers to evaluate theperformance of their CSRs wherever they may be located in the enterprise. Ourhigh-volume compliance applications are designed to record high volume,full-time performance of the voice conversations between CSRs and customers forpurposes such as compliance recording and sales verification. Our workforcemanagement products enable our customers to develop strategic staffing plans,deploy skilled resources and evaluate productivity of CSRs. Our performancemanagement applications provide comprehensive analytics, including performancescorecards, and reports of customer interaction and CSR performance. Oure-learning applications deliver ongoing training tailored to CSR needs and competencies.We also provide consulting and implementation services, training and support tocustomers that use our software products.

We derive product revenue by licensing software andderive services revenue by providing related installation, training, consulting,and maintenance services. We also derive a relatively small portion of productrevenue by selling hardware to customers. The majority of our product revenueis derived from recording, quality monitoring (“QM”) and workforce management (“WFM”)software. We sell our products through our direct sales force and through ourindirect sales channels. Our indirect sales channels consist of distributors,resellers, systems integrators and Original Equipment Manufacturers (“OEM”).Distributors and resellers purchase product from us at a discount and thenresell our products to end-users (or, in the case of distributors, to otherresellers) and referral partners are paid a fee for referring sales leads to usor for assisting us in a sales order. Systems integrators are informationtechnology (“IT”) consulting service companies who recommend our productsduring client engagements. Through OEM agreements, we co-develop products,which are sold by the OEM as part of their portfolio of products.

We intend to continue to expand our global saleschannels by entering into new reseller, distributor, OEM and similararrangements with key vendors in the contact center workforce optimizationmarket. In 2006, 2005 and 2004, approximately 44%, 41% and 32%, respectively**,**of our license revenue has been derived from the indirectsales channel.

We plan to grow our product revenue and maintain ourcompetitive position from a technology perspective through the timelyintroduction of new products, such as pre-packaged solutions, which addcapabilities such as performance analysis and e-learning management to our corequality monitoring and workforce management solutions. We also believe themarket shift from traditional hardware based recording to VoIP represents asignificant growth opportunity and our software solutions support both of theserecording environments. In addition, we believe our product offerings can bemarketed toward branch-office and back-office initiatives for business processmonitoring, which represents a new market for us. Factors that may impact ourability to grow our product revenue, however, include our ability to remaincompetitive from a technology perspective; market acceptance of our newproducts; our ability to maintain our product pricing integrity; and ourability to expand our global sales channels.

We also plan to grow ourservices revenue in concert with our product revenue. When our customerslicense our products, they generally purchase installation, training and oneyear of support services. Therefore, as we generate product revenue, we alsogenerate related services revenue. In addition, our customers generally renewtheir maintenance contracts with us each year. Therefore, our maintenancerevenue increases as our customer base increases. Factors that may influenceour ability to grow our 

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servicesrevenue, however, include our ability to continue to increase product revenues,provide services that enable and enhance our customers’ ability to improve theefficiency and effectiveness of their call center operations and our ability tomaintain a high level of customer success and satisfaction.

On January 24, 2005,we acquired Blue Pumpkin Software, Inc. (“Blue Pumpkin”), a privately heldCalifornia corporation. With this acquisition, we expanded our workforceoptimization solution to include advanced workforce management software andservices solutions including forecasting, scheduling, adherence and planningapplications. Pursuant to the Merger Agreement and Plan of Reorganization,dated December 16, 2004 (the “Blue Pumpkin Merger Agreement”), we paid $36million in cash which was funded from our existing cash and investments andissued 1.9 million shares of Witness’ common stock valued at $33.5 million(measured based on the date the stock consideration became fixed pursuant tothe application of a formula specified in the Blue Pumpkin Merger Agreement).On May 24, 2005, the shares issued in connection with the acquisition wereregistered for resale with the Securities and Exchange Commission. Pursuant tothe Blue Pumpkin Merger Agreement, cash of $4 million and 210,000 shares ofcommon stock valued at approximately $3.7 million on the date of acquisitionwere placed into escrow and was released to Witness during the month of March 2006in satisfaction and settlement of claims that Witness brought against theescrow fund, including claims from the settlement of IEX Corporations’s (“IEX”)litigation. See Note 5 of the Consolidated Financial Statements includedelsewhere in this report for discussion of the Blue Pumpkin acquisition.

On May 23, 2005, weacquired Optimis Group Limited (“Optimis”), a UK-based provider of workforceoptimization software solutions. Blue Pumpkin owned a minority interest in anoperating subsidiary of Optimis, the balance of which was acquired through theOptimis acquisition. We paid $5.0 million in cash and other considerationthat was financed from our existing cash and investments. Ten percent ofthe aggregate acquisition consideration was held in escrow and was released in August 2006.

On October 2, 2006,we acquired Exametric, a leading software solutions company specializing inworkforce management and optimization for the financial services industry. Thetotal consideration paid for Exametric was cash of approximately $23 million.Approximately $2.4 million of the aggregate consideration will be held inescrow until October 2, 2007, or longer, if claims are brought against theescrow fund and remain pending on that date. The escrow fund will be availableto indemnify Witness for losses resulting from, among other things, breaches ofrepresentations, warranties, covenants and certain transaction costs.

On October 2, 2006,we acquired Demos, a leading productivity solution provider for the financialservices industry. The total purchase consideration in 2006 for Demos was cashof approximately $6.3 million, including $0.3 million earned in 2006 as part ofthe potential for an earn-out of approximately $18.0 million based on thegrowth of the business over the next several years. Ten percent (10%) of theinitial consideration plus ten percent (10%) of any earn-out earned will beheld in escrow until October 2, 2007, or longer, if claims are broughtagainst the escrow fund and remain pending on that date. The escrow fund willbe available to indemnify Witness for losses resulting from, among otherthings, breaches of representations, warranties and covenants.

During 2006, 2005 and2004, 44%, 46% and 48%, respectively, of our revenue was derived from customersoutside the United States. We had 838** **full-timeemployees, excluding approximately 93 contractors located in the Asia-Pacificregion, at December 31, 2006, compared to 619 at December 31, 2005and 485 at December 31, 2004. As of December 31, 2006**,** 316 full**-**time employeeswere located outside the United States.

**Critical Accounting Policies and Estimates**

The discussion andanalysis of our financial condition and results of operations is based upon ourConsolidated Financial Statements, which have been prepared in accordance withaccounting principles 

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generallyaccepted in the United States of America. The preparation of these ConsolidatedFinancial Statements requires us to make certain estimates and judgments thataffect our reported assets, liabilities, revenue and expenses, and our relateddisclosure of contingent assets and liabilities. On an on-going basis, were-evaluate our estimates, accounting policies and judgments including thoserelated to revenue recognition, the collectibility of receivables, accountingfor acquisitions, impairment of long-lived assets, income taxes and stock-basedcompensation to ensure that our Consolidated Financial Statements are presentedfairly and in accordance with generally accepted accounting Principles. We baseour estimates on historical experience and on various assumptions that webelieve to be reasonable under the circumstances. However, because futureevents and their effects cannot be determined with certainty, actual resultsmay differ from these estimates under different assumptions or conditions andsuch differences could be material. Management believes that the followingaccounting policies and estimates are critical to understanding and evaluatingour reported financial results. Management has reviewed these criticalaccounting policies and estimates with the Audit Committee of our Board ofDirectors.

*Revenue Recognition.**  *We recognize revenue in accordancewith the American Institute of Certified Public Accountants’ Statement ofPosition (“SOP”) No. 97-2,*Software Revenue Recognition,* and SOP No. 98-9*, Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions**and* Emerging Issues Task Force (“EITF”) No. 00-21,*Revenue Arrangements with Multiple Deliverables*.Revenue is primarily derived from licensing software and providing relatedservices including maintenance. We also derive a relatively small portion ofproduct revenue by selling hardware to customers. Product revenue, whichincludes software and hardware, is recognized when persuasive evidence of anarrangement exists, delivery of the product has occurred, the fee is fixed ordeterminable, collection is probable and vendor specific objective evidence offair value (“VSOE”) exists to allocate revenue to the undelivered elements ofthe arrangement. We report hardware revenue gross in accordance with EITF No. 99-19,*Reporting Revenue Gross as a Principal versus Net asan Agent,* because the factors indicating gross reporting outweighthe factors indicating net reporting. We recognize revenue using the residualmethod of accounting since we generally have VSOE for maintenance andprofessional services, but not for the software and hardware elements of theorder. Under the residual method, services revenue, including maintenance andprofessional services, is deferred at an amount equal to its fair value untilthose elements are delivered. Consequently, product revenue for the softwareand hardware is recognized (i) upon delivery of those products when wehave VSOE for the related maintenance and professional services sold and (ii) atan amount representing the difference between the total order amount and theamount deferred. For customer orders that include hardware, hardware revenue isaccounted for as a separate unit of accounting in accordance with guidanceprovided in EITF 00-21.

Services revenue includesinstallation, training, consulting, maintenance and reimbursable travelexpenses. Revenue from installation, training and consulting services isrecognized upon performance of the related services and is offered and billedas separate elements of contracts. Reimbursable travel expenses revenue isrecognized upon incurrence of the related expenses. The functionality of thesoftware and any hardware sold is not dependent on installation and trainingservices and customization is not required to enable our customers to use ourproducts. Maintenance is offered as a separate element and the majority ofcontracts include the right to unspecified upgrades on a when-and-if availablebasis. Maintenance revenue is deferred and recognized ratably over the term ofthe related contract.

*Allowance for DoubtfulAccounts.**  *Weperform ongoing evaluations of our customers and continuously monitorcollections and payments and estimate an allowance for doubtful accounts basedon the aging of the underlying receivables, our historical experience withwrite-offs and any specific customer collection issues that we have identified.While such credit losses have historically been within our expectations and webelieve appropriate reserves have been established, we cannot assure that wewill continue to experience the same credit loss rates that we have experiencedin the past or adequately predict future credit losses. If the financialcondition of our customers were to deteriorate and resulted in 

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an impairment oftheir ability to make payments, additional allowances may be required whichwould result in an additional selling, general and administrative expense inthe period such determination is made.

Our revenue recognitionpolicy is significant because our revenues are a key component of our resultsof operations. We follow very specific and detailed guidelines, discussedabove, in measuring revenues; however, certain judgments and estimates affectthe application of our revenue policy described above. Further, assessment ofcollectibility is particularly critical in determining whether or not revenuesshould be recognized. We also record provisions for estimated sales allowanceson product and service related revenues at the time the related revenues arerecorded. These estimates are based on historical sales and servicesallowances, analysis of customer credits and other known factors. If futuresales credits prove to be greater than the historical data and the estimates weused to calculate these provisions, our revenues could be overstated.

*Accounting forAcquisitions.**  *Accountingfor acquisitions requires management to make judgments and estimates indetermining the purchase price, the fair value of the assets and liabilitiesacquired and merger-related and integration costs. In recording the BluePumpkin and Optimis acquisitions in 2005 and the Demos and Exametricacquisitions in 2006, significant judgment was required in estimating:

·       valuationof deferred revenue,

·       valuationof intangible assets and acquired in-process research and development, and

·       otherliabilities existing at the time of acquisition.

Changes to purchase priceestimates, including contingent purchase price earn-outs, are reflected asadjustments to goodwill and/or other acquired assets to the extent informationwas requested but not received at the date of acquisition. Other adjustmentsare reflected in our results of operations. In accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 142,*Goodwill and Other Intangible Assets*, goodwill andintangible assets with indefinite useful lives are not amortized, but aretested for impairment annually or more frequently if circumstances indicatetheir value may no longer be recoverable.

*Impairment of Long-LivedAssets.**  *Long-livedassets, such as property and equipment and intangible assets, are accounted forin accordance with SFAS No. 144*,Accounting for Impairment or Disposal of Long-lived Assets* and arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. All of ouridentifiable intangible assets are amortized using the straight-line method.Useful lives of amortizable intangible assets are reviewed annually with anychanges in estimated useful lives being accounted for prospectively over therevised remaining useful life. Recoverability of assets to be held and usedwould be measured by a comparison of the carrying amount of an asset to theestimated undiscounted future cash flows expected to be generated by the asset.If the carrying amount of an asset exceeds its estimated undiscounted futurecash flows, an impairment charge is recognized in the amount by which thecarrying amount of the asset exceeds the fair value of the asset. Thedetermination of estimated future cash flows, however, requires management tomake estimates. Future events and changes in circumstances may require us torecord a significant impairment charge in the period in which such events orchanges occur. Impairment testing requires considerable analysis and judgmentin determining the results. If other assumptions and estimates were used in ourevaluations, the results could differ significantly.

*Accounting for IncomeTaxes.**  *Weaccount for income taxes in accordance with SFAS No. 109,*Accounting for Income Taxes*, whichrequires recognition of deferred income tax assets and liabilities fortemporary differences between the financial reporting and tax bases of recordedassets and liabilities and the expected benefits of net operating loss andcredit carry forwards. SFAS No. 109 requires that deferred income taxassets be reduced by a valuation allowance if it is more likely than not thatsome portion or all 

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of the deferredincome tax assets will not be realized. Historically, we have provided acomplete valuation allowance against the deferred income tax asset. We evaluatethe realizability of our deferred income tax assets, primarily resulting fromnet operating loss and credit carry forwards, and adjust our valuationallowance, if necessary.

As of December 31,2006, we eliminated $7.3 million of the valuation allowance related to deferredincome tax assets in the UK. The utilization of deferred tax assets, primarilynet operating loss carry forwards arising from acquisitions, results in areduction in goodwill and the recognition of tax expense associated with thepurchased deferred tax assets.

The utilization of netoperating loss carry forwards generated by the tax deduction for stock optionexercises results in an increase to additional-paid-in-capital and therecognition of tax expense. Under SFAS No. 123(R), *Share-BasedPayment*, the realization of tax benefits resulting from stock optionexercises results in an increase to additional-paid-in-capital and therecognition of tax expense. Under SFAS No. 123(R), we will continue to followthe with-and-without approach and consider the impact of excess stock optiondeductions last when computing our income tax provision. Due to the existenceof net operating loss carry forwards, $5.0 million of income tax benefitsoriginating from stock option deductions have not reduced taxes payable and,therefore, have not been realized or recorded in 2006.

Estimates and judgmentsare required in determining our worldwide income tax provision. In the ordinarycourse of conducting business globally, there are many transactions andcalculations whose ultimate tax outcome cannot be certain. Although we believeour estimates and judgments are reasonable, no assurance can be given that thefinal tax outcome of these matters will not be different from what is reflectedin our historical income tax provisions and accruals. Such differences couldhave a material impact on our income tax provision and operating results in theperiod in which such a determination is made.

*Stock-Based Compensation.**  *On January 1, 2006, we adoptedSFAS No.123(R), which requires the measurement and recognition of compensationexpense for all share-based payment awards made to employees including employeestock options and shares made available through the employee stock purchaseplan based on the grant date fair value of those awards. We determine the fairvalue of share-based payment awards on the date of grant using Black-Scholesoption-pricing model. The fair value of share-based awards is affected by stockprice as well as assumptions regarding a number of highly complex andsubjective variables. These variables include, but are not limited to, ourexpected stock price volatility over the term of the awards, and actual andprojected employee stock option exercise behavior. SFAS No. 123(R) alsorequires that forfeitures be estimated over the vesting period of an award,rather than being recognized as a reduction of compensation expense when theforfeiture actually occurs. We adopted SFAS No. 123(R) using the modifiedprospective transition method. Our Consolidated Financial Statements as of andfor the year ended December 31, 2006 reflect the impact of SFASNo. 123(R).

In accordance with the modified prospective transitionmethod, our Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS No. 123(R).This statement requires us to estimate the fair value of share-based paymentawards on the date of grant using an option-pricing model. The value of the portionof the award that is ultimately expected to vest is recognized as expense overthe requisite service periods in our Consolidated Statement of Operations.Stock-based compensation expense recognized under SFAS No. 123(R) forthe year ended December 31, 2006 was $13.8 million. Prior to the adoptionof SFAS No. 123(R), we accounted for stock-based awards to employees usingthe intrinsic value method in accordance with Accounting Principles Board(“APB”) No. 25, *Accounting for StockIssued to Employees*, as allowed under SFAS No. 123, *Accounting for Stock-Based Compensation*.

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On November 10, 2005,the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FSP123(R)-3,*Transition Election Related to Accounting for TaxEffects of Share-Based Payment Awards.* We elected to adopt thealternative transition method provided in the FSP for calculating the taxeffects of stock-based compensation pursuant to SFAS No. 123(R). Thealternative transition method includes simplified methods to establish thebeginning balance of the additional-paid-in capital pool (“APIC pool”) relatedto the tax effects of employee stock-based compensation, and to determine thesubsequent impact on the APIC pool and the Consolidated Statement of Cash Flowsof the tax effects of employee stock-based compensation awards that wereoutstanding upon adoption of SFAS No. 123(R).

**Recent AccountingPronouncements**

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108(“SAB 108”) Financial Statements*—Considering the Effectsof Prior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*, effective for fiscal years ending after November 15,2006. SAB 108 requires the utilization of a dual-approach to assessing thequantitative effects of financial misstatements. This dual-approach includesboth an income statement assessment and a balance sheet assessment. Upon ouradoption of SAB 108 as of December 31, 2006, we determined that we neededto record a $1.4 million cumulative adjustment, net of tax of $0.5 million, todecrease our opening accumulated deficit balance for the year 2006. Thisadjustment was to correct certain prior year differences that had previouslybeen considered immaterial to the 2005 and 2004 Consolidated FinancialStatements. See Note 1, “Summaryof Significant Accounting Policies,” of the Notes to the Consolidated FinancialStatements included elsewhere in this report for discussion of RecentAccounting Pronouncements.

**Results ofOperations**

Thetable below shows operating data as a percentage of total revenue for theperiods indicated:

| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Product                                      |       |                                       | 39         | % |   |   | 40 | % |   |   | 41 | % |   |
| Services                                     |       |                                       | 61         |   |   |   | 60 |   |   |   | 59 |   |   |
| Total revenue                                |       |                                       | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Product                                      |       |                                       | 8          |   |   |   | 10 |   |   |   | 10 |   |   |
| Services                                     |       |                                       | 24         |   |   |   | 23 |   |   |   | 23 |   |   |
| Total cost of revenue                        |       |                                       | 32         |   |   |   | 33 |   |   |   | 33 |   |   |
| Gross profit                                 |       |                                       | 68         |   |   |   | 67 |   |   |   | 67 |   |   |
| Operating  expenses:                         |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative          |       |                                       | 52         |   |   |   | 46 |   |   |   | 47 |   |   |
| Research and development                     |       |                                       | 15         |   |   |   | 15 |   |   |   | 15 |   |   |
| Merger-related and integration costs         |       |                                       | 1          |   |   |   | 2 |   |   |   | 0 |   |   |
| Acquired in-process research and development |       |                                       | 0          |   |   |   | 5 |   |   |   | 0 |   |   |
| Operating income (loss)                      |       |                                       | 0          |   |   |   | (1 | ) |   |   | 5 |   |   |
| Interest and  other income, net              |       |                                       | 2          |   |   |   | 1 |   |   |   | 1 |   |   |
| Income before provision for income taxes     |       |                                       | 2          |   |   |   | 0 |   |   |   | 6 |   |   |
| (Benefit)  provision for income taxes        |       |                                       | (1         | ) |   |   | 2 |   |   |   | 0 |   |   |
| Net income (loss)                            |       |                                       | 3          | % |   |   | (2 | )% |   |   | 6 | % |   |

 

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*Impact of Demos,Exametric, Blue Pumpkin and Optimis Acquisitions*

The acquisition of Demos and Exametric in 2006increased our reported revenues in 2006 by an estimated $4.5 million. Operatingexpenses, expressed as a percentage of total revenue, increased in 2006compared to the same period in 2005 due to a charge of $0.8 million in acquiredin-process research and development costs, an increase of $0.5 million inmerger-related and integration costs and additional intangible assetamortization of $0.9 million, all related to these 2006 acquisitions.

The acquisition of BluePumpkin and Optimis in 2005 increased our reported revenues in 2005 by anestimated $25 million. Operating expenses increased in 2005 compared to thesame period in 2004 due to a charge of $9.0 million in acquired in-processresearch and development costs, an increase of $3.7 million inmerger-related and integration costs and additional intangible assetamortization of $9.3 million, all related to these 2005 acquisitions.

*Total revenue*

Total revenue increased by20% to $221.8 million in 2006 compared to 2005 and 31% to $185.3 millionin 2005 compared to 2004. The increase in total revenue can be attributed toacquisitions and the continued growth of our business. Effective April 1,2006, we began recognizing revenue from one OEM partner upon receipt of validpurchase orders versus royalty reports because it was determined, based on theCompany’s historical experience with this particular partner, that fixed anddeterminable pricing exists at the time the order is placed by the partner. Thenumber of installed customer sites grew to 4,700 sites at the end of 2006 from4,209 sites at the end of 2005 and 2,799 sites at the end of 2004.International revenue increased 15% in 2006 compared to 2005 and 24% in 2005compared to 2004.

*Product revenue*

Product revenue includes hardware and softwarerevenue. Although hardware sales are incidental to our business, we expect thatwe will continue to sell hardware to our existing customers as well as to newcustomers whose preference is to make joint purchases of hardware and software.It is difficult to estimate future hardware revenue due to its incidentalnature.

Product revenue, excluding hardware revenue of $8.0million in 2006, $5.7 million in 2005 and $7.6 million in 2004,increased 14% and 37% in 2006 and 2005, respectively, compared to prior years.The increase in software revenue growth in 2006 is largely attributed to ourexpanded product line, particularly Impact 360, as wellas additional revenue recognized from the indirect saleschannel. Our Impact 360 solution consists of software products and servicesdesigned to optimize the workforce, processes and technology involved in thecustomer service function. We periodically review our revenue recognitionpolicy with regard to our indirect sales channel in order to accountfor current trends surrounding collectability.

Product revenue as a percentage of total revenue hasdecreased slightly over the past three years due to increased services revenue,as discussed below. Our product pricing has remained relatively consistent overthe past three years. The percentage of product revenue, excluding hardwarerevenue, derived from our indirect sales channel increased to 44% in 2006 from41% in 2005 and 32% in 2004. This increase results from our strategy to expandour indirect sales channels.

New customers accountedfor 18%, 25% and 22%, respectively, of product revenue, excluding hardwarerevenue, in 2006, 2005 and 2004, with the balance of revenue representingfollow-on revenue from our existing customer base. We receive follow-on revenuefrom our customers when they purchase additional user licenses or licenseadditional applications at existing sites and when they license our products atnew sites. We expect to generate the majority of our product revenue fromexisting customers during 2007.

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*Services revenue*

Services revenue,consisting of installation, training, consulting, maintenance support andreimbursable travel expenses, increased 22% to $135.9 million in 2006 comparedto 2005 and 33% to $111.1 million in 2005 compared to 2004. The increaseswere due to installation and training services related to new product sales andto customers renewing their maintenance contracts with us thereby increasingour recurring maintenance revenue stream. The percentage of Witness customersthat have renewed their maintenance contracts with us has historically exceeded90%. We believe that maintenance contracts will be renewed at a comparable rateduring 2007. Our services pricing has remained consistent over the past threeyears. We expect services revenue, in absolute dollars, to increase over timedue to the compounding effect of renewals of annual maintenance contracts fromexisting customer sites and to remain relatively constant as a percentage oftotal revenue, excluding hardware revenue, in 2007.

*Total cost ofrevenue*

Total cost of revenueincreased 16% to $71.5 million in 2006 compared to 2005 and 32% to$61.5 million in 2005 compared to 2004. Expressed as a percent of revenue,gross profit margins were 68% in 2006 and 67% in 2005 and 2004. The increase ingross profit margin in 2006 resulted primarily from productivity gains achievedin the professional services organization, offset by an inclusion ofstock-based compensation expense of $2.2 million. Excluding hardware,stock-based compensation and the amortization of intangible assets resultingfrom acquisitions, gross profit margins have remained consistent at 74% in2006, 2005 and 2004. We expect our gross profit margin, excluding hardware andamortization of intangible assets, to remain relatively constant in 2007.

*Cost of productrevenue*

Cost of product revenue consists of amortization ofacquired technology, hardware costs, royalties due to third parties forsoftware components that are embedded in our software applications,amortization of capitalized software development costs and packaging costs.Amortization of acquired technology was $7.4 million in 2006 and$9.2 million in 2005 and $4.4 million in 2004. The decrease inamortization in 2006 was attributable to a portion of the technology acquiredin the 2003 Eyretel acquisition becoming fully amortized during the year. Theincrease in the amortization of acquired technology in 2005 was largely due tothe acquisition of Blue Pumpkin.

Cost of hardware revenuewas $8.1 million $5.8 million and $7.3 million in 2006, 2005 and2004, respectively. The increase in cost of hardware revenue in 2006corresponds to the increase in hardware product revenue in 2006. Cost ofsoftware revenue, decreased 19% in 2006 compared to 2005 and increased 24% in 2005compared to 2004. The year-over-year cost of software revenue fluctuationresults from the royalties due to third parties for software included in ourproduct offerings which vary period-over-period in proportion to the sales ofcertain software products. Expressed as a percentage of software revenue, thecost of software revenue was 4%, 6% and 4% in 2006, 2005 and 2004,respectively. As we develop upgrades of our existing products and add newofferings to our product suite, we may add additional third-party technologyinto our products, which would increase the cost of software revenue in thefuture.

*Cost of servicesrevenue*

Cost of services revenuefor installation, training, consulting and maintenance services includepersonnel costs and related expenses and allocated overhead. Personnel costsinclude salaries, bonuses, stock-based compensation and benefits. Cost ofservices revenue increased 24% to $52.7 million in 2006 compared to 2005. Theincrease in 2006 is consistent with the increase in services revenue and is dueprimarily to an increase in the number of employees engaged in customer supportservices and the 

39

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inclusionof $2.2 million stock-based compensation expense. Cost of services revenueincreased 30% to $42.4 million in 2005 compared to 2004 due primarily toan increase in the number of employees and contractors engaged in customersupport services mainly as a result of the Blue Pumpkin and Optimisacquisitions. Cost of services revenue as a percentage of services revenue was39%, 38% and 39% in 2006, 2005 and 2004, respectively. We anticipate that ourservices margins will remain relatively constant in 2007. We expect ourcustomer service organization to continue to grow over time and, therefore, weanticipate that our cost of services revenue, in absolute dollars, willincrease as we grow our customer base.

*Operating Expenses*

*Selling,General and Administrative.*   Selling, general andadministrative (“SG&A”) expense consists primarily of personnel costs,sales commissions, marketing programs, professional fees, the amortization ofcertain intangibles, stock-based compensation expense and provisions for baddebt expense. SG&A expense increased 34% to $115.0 million in 2006 comparedto 2005 due to the inclusion of $9.2 million stock-based compensation expense,an increase in legal and professional fees, accrued expense associated withseverance to be paid to the former CEO and higher staffing levels. Legal andprofessional fees in 2006 include $5.5 million related to the stock optionreview matter. We have Directors and Officers insurance coverage that isprovided for defense fees and costs incurred in connection with the classaction and derivative action (the “litigation”) made against Witness as aresult of the stock option review matter. However, in accordance with SFASNo. 5, *Accounting for Contingencies,*we have concluded that an insurancereimbursement receivable cannot be recorded at this time due to uncertaintiesrelating to the recovery that is neither probable nor estimatable as ofDecember 31, 2006. SG&A expense increased 31% to$86.0 million in 2005 compared to 2004 due primarily to higheramortization expenses and the increased size of our Company after theacquisitions of Blue Pumpkin and Optimis.

*Researchand Development.*   Researchand development (“R&D”) expense consists primarily of personnel andconsulting costs to support product development, and allocated overhead.R&D costs are generally expensed as incurred and include softwaredevelopment costs incurred prior to the establishment of technologicalfeasibility. Costs incurred subsequent to establishing technologicalfeasibility are capitalized and amortized over their estimated useful lives tocost of product revenue. As of December 31, 2006 and 2005, $0.7 millionand $0.5 million, respectively, in software development costs were capitalizedof which $0.6 million and $0.5 million****were amortizedto cost of product revenue in 2006 and 2005, respectively. R&D expenseincreased 25% to $33.3 million in 2006 compared to 2005, primarily due to theincreased number of employees engaged in research and development activitiesand the inclusion of $2.4 million stock-based compensation expense in 2006.R&D expense increased 28% to $26.7 million in 2005 compared to 2004 primarilydue to the increased number of employees engaged in research and developmentactivities as a result of the Blue Pumpkin acquisition. We expect total R&Dexpense to increase in absolute dollars but decrease as a percentage of totalrevenue during 2007 as compared to 2006.

*Merger-Relatedand Integration Costs.**   We incurred merger-related and integrationcosts of $2.7 million in 2006, primarily due to the Blue Pumpkin, Demos andExametric acquisitions. We incurred merger-related and integration costs of$4.5 million in 2005 due to the Blue Pumpkin and Optimis acquisitions, and$0.5 million during 2004 due to the Eyretel acquisition. The 2006 and 2005merger-related and integration costs are comprised primarily of costs oftransitional employees and other contractors, travel, legal and advertisingcosts.*

*Acquired In-ProcessResearch and Development.**  **During 2006 and 2005, we estimated that$0.8 million and $9.0 million of the purchase price of Exametric and BluePumpkin, respectively, represented acquired in-process research and development(“IPR&D”) that had not yet reached technological feasibility as defined bySFAS No. 86,*Accounting for the Cost of Computer Software to BeSold, Leased or Otherwise Marketed,*and had no alternative future use. Accordingly,these amounts were immediately charged to expense upon consummation of theacquisition. The value of the IPR&D was determined with*

40

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*the assistance of an independent third-party appraiser byutilizing a discounted cash flow methodology, focusing on the income-producingcapabilities of the in-process technologies and taking into consideration:stage of completion; complexity of work to date and to complete; anticipatedproduct development and introduction schedules; forecasted product salescycles; internal and external risk factors; revenue and operating expenseestimates; contributory asset charges, and costs already incurred and theexpected costs to complete.*

*Interest and OtherIncome, Net*

Interestand other income, net for year 2006, 2005 and 2004, respectively is as follows(in thousands):

| ** **                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest income               |       | $        | 6,405      |     | $          | 1,137    |       | $ | 1,010 |   |
| Foreign currency  (loss) gain |       | (966     | )          | (173     | )          | 256      |       |
| Other expense                 |       | (259     | )          | (104     | )          | (60      | )          |
|                          |       | $        | 5,180      |     | $          | 860      |       | $ | 1,206 |   |

 

The increase in interestincome in 2006 is due to higher cash and investment balances resulting from oursale of additional common stock in December 2005. Higher foreign currencylosses in 2006 resulted from a weakening U.S dollar against other currencies,particularly the British pound sterling.

*Provision forIncome Taxes*

We recorded a provision for federal alternativeminimum tax, deferred taxes and foreign income tax in 2006, a provision forfederal alternative minimum tax and foreign income tax in 2005, and a provisionfor foreign income tax in 2004, net of federal tax benefits. Of the ($3.8)million provision benefit for the year ended December 31, 2006, ($4.7)million relates to the provision for foreign deferred taxes. Specifically,($4.4) million relates to the release of the valuation allowance for deferredtax assets of the Company’s primary U.K. subsidiary, Witness Systems Ltd. Theremaining $0.6 million of the tax provision relates primarily to currentfederal alternative minimum tax, current foreign taxes, and customerwithholding tax.

The provision for incometaxes in 2006, 2005 and 2004 benefited from the utilization of net operatingloss carryforwards from prior years. We have net operating loss carry forwardsaggregating $78.1 million for U.S. income tax purposes and $31.0 millionfor foreign income tax purposes remaining as of December 31, 2006. Weexpect that the provision for income taxes in 2007 will benefit from theutilization of these net operating loss carry forwards. However, theutilization of certain net operating loss carry forwards arising fromacquisitions may result in the recognition of deferred income tax expense.

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**Quarterly Resultsof Operations**

Thefollowing tables present unaudited quarterly statements of operations data foreach of the last eight quarters in the two-year period ended December 31,2006, as well as the percentage of total revenue represented by each item. Theinformation has been derived from our unaudited Consolidated FinancialStatements, which have been prepared on substantially the same basis as theaudited Consolidated Financial Statements contained in this report. Theunaudited Consolidated Financial Statements contain all adjustments, consistingonly of normal recurring adjustments that we consider to be necessary to presentfairly this information when read in conjunction with the ConsolidatedFinancial Statements and Notes thereto appearing elsewhere in this report. Theresults of operations for any quarter are not necessarily indicative of theresults to be expected for any future period.

| ** **                                                     | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                     | ** ** | **Dec. 31,   2006(a)** | ** ** | **Sept. 30,  2006** | ** ** | **Jun. 30,  2006** | ** ** | **Mar. 31,  2006** | ** ** | **Dec. 31,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005(b)** | ** ** | **Mar. 31,  2005(b)** | ** ** |
| ** **                                                     | ** ** | **(in thousands)**          | ** ** |
| Revenue:                                                       |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                                        |       | $                                | 26,614     |   | $ | 17,334 |   | $ | 22,063 |   | $ | 19,839 |   | $ | 20,594 |   | $ | 18,306 |   | $ | 18,918 |   | $ | 16,368 |   |
| Services                                                       |       | 37,749                           |       | 33,792 |   | 32,765 |   | 31,627 |   | 30,255 |   | 28,843 |   | 27,253 |   | 24,791 |   |
| Total revenue                                                  |       | 64,363                           |       | 51,126 |   | 54,828 |   | 51,466 |   | 50,849 |   | 47,149 |   | 46,171 |   | 41,159 |   |
| Cost of revenue:                                               |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                                        |       | 5,510                            |       | 3,578 |   | 5,209 |   | 4,578 |   | 5,327 |   | 4,543 |   | 4,928 |   | 4,332 |   |
| Services                                                       |       | 15,157                           |       | 12,951 |   | 12,799 |   | 11,755 |   | 11,223 |   | 10,810 |   | 10,793 |   | 9,535 |   |
| Total cost of revenue                                          |       | 20,667                           |       | 16,529 |   | 18,008 |   | 16,333 |   | 16,550 |   | 15,353 |   | 15,721 |   | 13,867 |   |
| Gross profit                                                   |       | 43,696                           |       | 34,597 |   | 36,820 |   | 35,133 |   | 34,299 |   | 31,796 |   | 30,450 |   | 27,292 |   |
| Operating  expenses:                                           |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative                            |       | 37,407                           |       | 26,461 |   | 25,874 |   | 25,209 |   | 22,753 |   | 21,667 |   | 21,577 |   | 19,998 |   |
| Research and development                                       |       | 9,107                            |       | 8,142 |   | 8,080 |   | 7,978 |   | 6,679 |   | 6,945 |   | 6,895 |   | 6,198 |   |
| Merger-related and integration costs                           |       | 511                              |       | (31 | ) | 131 |   | 2,091 |   | 889 |   | 1,059 |   | 925 |   | 1,659 |   |
| Acquired in-process research and development                   |       | 760                              |       | — |   | — |   | — |   | — |   | — |   | — |   | 9,000 |   |
| Operating (loss) income                                        |       | (4,089                           | )          | 25 |   | 2,735 |   | (145 | ) | 3,978 |   | 2,125 |   | 1,053 |   | (9,563 | ) |
| Interest and other income, net                                 |       | 887                              |       | 1,550 |   | 1,472 |   | 1,271 |   | 421 |   | 245 |   | 56 |   | 138 |   |
| (Loss) income before provision for income taxes |       | (3,202                           | )          | 1,575 |   | 4,207 |   | 1,126 |   | 4,399 |   | 2,370 |   | 1,109 |   | (9,425 | ) |
| (Benefit)  provision for income taxes                     |       | (2,691                           | )          | (1,020 | ) | (218 | ) | 177 |   | 552 |   | 1,822 |   | 617 |   | 33 |   |
| Net (loss) income                                              |       | $                                | (511       | ) | $ | 2,595 |   | $ | 4,425 |   | $ | 949 |   | $ | 3,847 |   | $ | 548 |   | $ | 492 |   | $ | (9,458 | ) |

----

(a)           We commenced theconsolidation of Demos and Exametric on October 2, 2006.

(b)          Wecommenced the consolidation of Blue Pumpkin Software, Inc and Optimis onJanuary 25, 2005 and May 23, 2005, respectively.

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| ** **                                      | ** ** | **Three Months Ended**                                | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                      | ** ** | **Dec. 31,  2006(a)**                                      | ** ** | **Sept. 30,  2006** | ** ** | **Jun. 30,  2006** | ** ** | **Mar. 31,  2006** | ** ** | **Dec. 31,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005(b)** | ** ** | **Mar. 31,  2005(b)** | ** ** |
| ** **                                      | ** ** | **(as a percentage of total revenue)** | ** ** |
| Revenue:                                        |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       |                                                            | 41         | % |   |   | 34 | % |   |   | 40 | % |   |   | 39 | % |   |   | 40 | % |   |   | 39 | % |   |   | 41 | % |   |   | 40 | % |   |
| Services                                        |       |                                                            | 59         |   |   |   | 66 |   |   |   | 60 |   |   |   | 61 |   |   |   | 60 |   |   |   | 61 |   |   |   | 59 |   |   |   | 60 |   |   |
| Total revenue                                   |       |                                                            | 100        |   |   |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue:                                |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       |                                                            | 9          |   |   |   | 7 |   |   |   | 10 |   |   |   | 9 |   |   |   | 10 |   |   |   | 10 |   |   |   | 11 |   |   |   | 11 |   |   |
| Services                                        |       |                                                            | 23         |   |   |   | 25 |   |   |   | 23 |   |   |   | 23 |   |   |   | 22 |   |   |   | 23 |   |   |   | 23 |   |   |   | 23 |   |   |
| Total cost of revenue                           |       |                                                            | 32         |   |   |   | 32 |   |   |   | 33 |   |   |   | 32 |   |   |   | 32 |   |   |   | 33 |   |   |   | 34 |   |   |   | 34 |   |   |
| Gross profit                                    |       |                                                            | 68         |   |   |   | 68 |   |   |   | 67 |   |   |   | 68 |   |   |   | 68 |   |   |   | 67 |   |   |   | 66 |   |   |   | 66 |   |   |
| Operating expenses:                             |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative             |       |                                                            | 58         |   |   |   | 52 |   |   |   | 47 |   |   |   | 49 |   |   |   | 45 |   |   |   | 46 |   |   |   | 47 |   |   |   | 48 |   |   |
| Research and development                        |       |                                                            | 14         |   |   |   | 16 |   |   |   | 15 |   |   |   | 15 |   |   |   | 13 |   |   |   | 15 |   |   |   | 15 |   |   |   | 15 |   |   |
| Merger-related and integration costs            |       |                                                            | 1          |   |   |   | — |   |   |   | — |   |   |   | 4 |   |   |   | 2 |   |   |   | 2 |   |   |   | 2 |   |   |   | 4 |   |   |
| Acquired in-process research and development    |       |                                                            | 1          |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 22 |   |   |
| Operating (loss) income                         |       |                                                            | (6         | ) |   |   | 0 |   |   |   | 5 |   |   |   | 0 |   |   |   | 8 |   |   |   | 4 |   |   |   | 2 |   |   |   | (23 | ) |   |
| Interest and  other income, net                 |       |                                                            | 1          |   |   |   | 3 |   |   |   | 3 |   |   |   | 2 |   |   |   | 1 |   |   |   | 1 |   |   |   | 0 |   |   |   | 0 |   |   |
| (Loss) income before provision for income taxes |       |                                                            | (5         | ) |   |   | 3 |   |   |   | 8 |   |   |   | 2 |   |   |   | 9 |   |   |   | 5 |   |   |   | 2 |   |   |   | (23 | ) |   |
| (Benefit)  provision for income taxes           |       |                                                            | (4         | ) |   |   | (2 | ) |   |   | 0 |   |   |   | 0 |   |   |   | 1 |   |   |   | 4 |   |   |   | 1 |   |   |   | 0 |   |   |
| Net (loss) income                               |       |                                                            | (1         | )% |   |   | 5 | % |   |   | 8 | % |   |   | 2 | % |   |   | 8 | % |   |   | 1 | % |   |   | 1 | % |   |   | (23 | )% |   |

----

(a)           We commenced theconsolidation of Demos and Exametric on October 2, 2006.

(b)          We commenced theconsolidation of Blue Pumpkin Software, Inc and Optimis on January 25,2005 and May 23, 2005, respectively.

The increase in total revenue in the fourth quarter of2006 reflects the consolidation of Demos and Exametric, which were acquired in October 2006.The increase in total revenue, beginning in the first and second quarters of2005, reflects the consolidation of Blue Pumpkin and Optimis, which wereacquired in January and May 2005, respectively. Our second and fourthquarters generally have higher product revenue than the first and thirdquarters due to our customers’ budgeting and spending patterns.

Our quarterly operatingresults, particularly product revenues, have experienced significantfluctuations in the past, and we expect that this pattern will continue in thefuture. For instance, quarterly results may fluctuate based on the timing ofsales due to customer calendar-year budgeting cycles, slow summer purchasingpatterns and compensation policies that tend to compensate sales personnel,typically in the latter half of the year, for achieving annual quotas. As aresult of the foregoing and other factors, we believe that quarter-to-quartercomparisons of results are not necessarily meaningful, and such comparisonsshould not be relied upon as indications of future performance.

**Liquidity andCapital Resources**

In March 2007, we reduced our line of credit from$15.0 million to $2.0 million and extended the maturity date on the $2.0million line of credit to March 2008. At our election, borrowings underthe line of credit bear interest at the bank’s prime rate, which was 8.25% on December 31,2006, or LIBOR plus 

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300 basis points.Borrowings under the revolving line of credit are limited to 85% of eligibleaccounts receivable, as defined by the agreement. The revolving line of creditis secured by all of our assets and requires compliance with various covenants,including liquidity ratios and EBITDA requirements, among others. As of December 31,2006, we were in compliance with all bank covenants.

As of December 31, 2006, we had no amountsoutstanding under the line of credit and the amount available for borrowing was$14.0 million, which was net of outstanding letters of credit of $1.0million. The letters of credit secure the lease on our corporate headquartersfacility and have decreasing schedules that ultimately expire in 2007. In addition,we have a £0.3 million ($0.6 million) letter of****creditsecuring our premises leased in the United Kingdom.

We anticipate spending at least $8.0 million incapital expenditures in 2007 primarily for computer equipment and software. Webelieve that our capital expenditures may increase over the next several yearsas we expand our facilities and acquire equipment to support the expansion ofour research and development activities and internal management and informationsystems. We believe that our existing cash and investment balances, togetherwith our anticipated cash flows from operations, will be sufficient to meet ourworking capital and capital expenditures for at least the nexttwelve months.

On February 11, 2007, we entered into adefinitive agreement under which Verint will acquire Witness for $27.50 pershare in cash, less any applicable withholding taxes, without interest. Verintcurrently expects to fund the Merger through up to $650 million in seniorsecured debt financing from Lehman Brothers, Deutsche Bank, Credit Suisse andcertain of its affiliates. Comverse Technology, the 57% majority stockholder inVerint, has committed to finance up to $293 million of the purchase pricethrough the purchase of additional equity in Verint in the form of preferredstock. The remainder will be paid for with existing cash from the combined company.The Merger is expected to close in the second quarter of 2007, pendingapprovals from regulators and Witness stockholders.

The restatement of ourConsolidated Financial Statements, as a result of the findings of our stockoption review and certain other matters, did not materially or adversely affectour liquidity or capital resources.

*Market Risk*

Our market risk exposure primarily relates tofluctuations in foreign exchange rates and interest rates. As of December 31,2006, we have not entered into derivative or hedging transactions to managerisk in connection with such fluctuations. Due to the relative strength offoreign currencies compared to the U.S. dollar during 2006 and 2004, foreigncurrency translations contributed $2.5 million and $3.4 million to ourcash balances at December 31, 2006 and 2004, respectively. Due to therelative weakness of foreign currencies compared to the U.S. dollar, thetranslation of our subsidiaries cash denominated in foreign currencies reducedour 2005 cash balances by $2.3 million. Within our foreign-based operations,where transactions may be denominated in foreign currencies, we are subject tomarket risk with respect to fluctuations in the relative value of currencies.Currently, we have foreign-based operations in Australia, Brazil, Canada, China,Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africa and theUnited Kingdom that conduct transactions in either the local currency of thelocation or U.S. dollars. We are exposed to adverse movements in foreigncurrency exchange rates because we translate foreign currencies into U.S.dollars for reporting purposes. Cumulative translation adjustment changesresulted in an increase of $3.4 million and a decrease of $1.9 million instockholders’ equity in 2006 and 2005, respectively. Net foreign exchange(losses) gains reflected in our operating results were ($1.0) million,($0.2) million and $0.3 million in 2006, 2005 and 2004, respectively.

Exposure to market raterisk for changes in interest rates relates to our investment portfolio and anypotential borrowing. Our investments are made with capital preservation andliquidity as our primary objectives. We generally hold only high-gradeinvestments such as commercial paper, corporate bonds, 

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auctionrate securities and U.S. government agency securities. To reduce our BalanceSheet exposure to variations in asset values, our investment policy guidelinesspecify that we invest in the highest investment grade securities and maintaina weighted average maturity of nine months or less for our entire portfolio.Our investment portfolio may contain securities with maturities of up to threeyears. While this minimizes our interest rate risk to asset values, our resultsare exposed to fluctuations in interest income due to changes in market rates.

*ContractualObligations and Off Balance Sheet Arrangements*

As of December 31,2006, our contractual cash obligations associated with lease obligations is asfollows (in thousands):

| ** **                   | ** ** | **Payments Due by Period** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **Total**                                 | ** ** | **Less than 1  Year** | ** ** | **2 - 3  Years** | ** ** | **4 - 5  Years** | ** ** | **After 5 Years** | ** ** |
| Operating lease  obligations |       | $                                         | 18,465     |   |   | $ | 5,762 |   |   | $ | 5,783 |   | $ | 3,745 |   |   | $ | 3,175 |   |   |
|                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We entered into a software licensing agreement in 2005which requires us to pay an additional $1.3 million in 2007 for the rightto distribute a vendor’s software as part of our workforce optimizationsolution. This amount has been recorded as an accrued liability as of December 31,2006. Imputed interest expense associated with the payment is not significant.

On April 6, 2006, Blue Pumpkin and IEX reached anagreement to settle all claims asserted between the two companies. As part ofthe final settlement, Witness paid $8.25 million to IEX’s parent companyin April 2006 and agreed to make six annual payments of $0.5 million($3.0 million in total) from April 2007 through 2012.

On October 2, 2006, we acquired Demos, a leadingproductivity solution provider for the financial services industry. The totalpurchase consideration in 2006 for Demos was cash of approximately $6.3million, including $0.3 million earned in 2006 as part of the potential for anearn-out of approximately $18 million based on the growth of the business overthe next several years.

As of December 31,2006, we did not have any other material contractual commitments or anyoff-balance sheet arrangements.

**Item 7A.**                Qualitativeand Quantitative Disclosures About Market Risk

See Management’sDiscussion and Analysis of Financial Condition and Results of Operations, Item7 of Part II of this Annual Report for a discussion of market risk.

**Item 8.**                        FinancialStatements and Supplementary Data

Our Consolidated FinancialStatements, together with related notes and the reports of KPMG LLP, ourindependent registered public accounting firm, are set forth on the pages indicatedin Item 15.

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosures

None.

**Item 9A.**                Controlsand Procedures.

*Evaluationof Disclosure Controls and Procedures.**  *We maintain disclosure controls andprocedures designed to provide reasonable assurance that information requiredto be disclosed in the periodic reports we file with the SEC is recorded,processed, summarized and reported accurately and within the time periodsspecified in the rules of the SEC. We carried out an evaluation as of December 31,2006, under the 

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supervision and theparticipation of our management, including our Chief Executive Officer (“CEO”)and Chief Financial Officer (“CFO”), of the design and operation of thesedisclosure controls and procedures pursuant to Exchange Act Rule 13a-15(c).Based upon that evaluation, our CEO and CFO concluded that our disclosurecontrols and procedures were not effective due to material weaknesses discussedin Management’s Report on Internal Control Over Financial Reporting on page F-2hereof.

*Changesin Internal Control.**  *Therewas no change in internal control over financial reporting that occurred duringthe three months ended December 31, 2006 that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

We are currently inthe process of implementing the following remediation steps to address thematerial weaknesses referenced above:

·       Createa detailed acquisition accounting checklist in order to ensure purchase priceconsideration is properly measured and recorded;

·       Reviseour policies and procedures related to our review of the tax provision toprovide for sufficient analysis of the accounting for valuation allowancesestablished in a business combination. Specifically, revise the review procedures performed by our taxprofessionals and outside consultants to ensure applicable issues areappropriately considered;

·       Formalizeour review procedures over the allowance for uncollectible accounts to ensureaged receivables and specific customer collection issues are appropriatelyconsidered when estimating and recording the allowance for uncollectibleaccounts; and 

·       Formalizeour policies and procedures related to the recognition of deferred revenue,including enhanced monitoring of aged deferred revenues associated with certainservice projects, as well as certain accounting policies related to maintenancecontracts.  

*Management’s Report onInternal Control over Financial Reporting.*   See Part IV,Item 15 page F-2 for Management’s Report on Internal ControlOver Financial Reporting.

**Item 9B.**               OtherInformation

Effective December 6, 2006, Mr. David Gouldvoluntarily agreed to step down as the Chairman of the Company’s Board ofDirectors and was replaced by Mr. Dan Lautenbach, a member of the Company’sBoard of Directors since 2002. Effective January 3, 2007, Mr. DavidGould voluntarily resigned from his position as Chief Executive Officer of theCompany and as a member of the Company’s Board of Directors and was replaced by Mr. Nicholas Discombe, whohas served as the Company’s President and Chief Operating Officer since April 2003.Pursuant to an agreement dated January 3, 2007 and later amended on February 2,2007, Mr. Gould will continue as an employee until April 30, 2007.Upon termination of employment, Mr. Gould will be entitled to separationpayments of $29,333 per month for 12 months. In return, Mr. Gould agreedto the termination of his employment agreement and change in control agreement.

46

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**PART III**

Certain informationrequired by Part III is omitted from this Report in that the Company willfile a definitive proxy statement within 120 days after the end ofthis fiscal year pursuant to Regulation 14A (the “Proxy Statement”) forits 2007 Annual Meeting of Stockholders proposed to be held on June 15,2007, and the information included therein is incorporated herein by reference.

**Item 10.**                 Directors,Executive Officers andCorporate Governance

*Code of Ethics*

We have adopted a Code ofEthics within the meaning of Item 406(b) of Regulation S-K. ThisCode of Ethics applies to our principal executive officer, principal financialofficer and principal accounting officer. This Code of Ethics is publiclyavailable on our website at *http://www.witness.com*.If we make substantive amendments to this Code of Ethics or grant any waiver,including any implicit waiver, we will disclose the nature of such amendment orwaiver on our website or in a report on Form 8-K within fourbusiness days of such amendment or waiver.

*Audit CommitteeFinancial Expert*

Our Board of Directors has determined that at leastone person serving on the Audit Committee is an “audit committee financialexpert” as defined under Item 401(h) of Regulation S-K. JoelKatz, the Chairman of the Audit Committee, is an “audit committee financialexpert” and is independent as defined under applicable SEC and Nasdaq StockMarket rules.

The other informationrequired by this Item is incorporated by reference from the ProxyStatement under the headings “Election of Directors” and “ExecutiveCompensation.”

**Item 11.**                 ExecutiveCompensation

The information requiredby this Item is incorporated by reference from the Proxy Statement underthe heading “Executive Compensation.”

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

The information requiredby this Item is incorporated by reference from the Proxy Statement underthe heading “Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters.”

**Item 13.**                 CertainRelationships and Related Transactions, and Director Independence

The information requiredby this Item is incorporated by reference from the Proxy Statement underthe heading “Executive Compensation.”

**Item 14.**                 PrincipalAccountant Fees and Services

The information required by this Item isincorporated by reference from the Proxy Statement under the heading “AuditFees and Services.”

47

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**PART IV**

**Item 15. Exhibitsand Financial Statement Schedules**

(a)           Thefollowing documents are filed as part of this report:
| 1.     |   | Financial  Statements                                                                                                                            |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | Management’s  Report on Internal Control Over Financial Reporting                                                                           |
|   |   | Report of  Independent Registered Public Accounting Firm on Internal Control Over  Financial Reporting                                           |
|   |   | Report of  Independent Registered Public Accounting Firm on Consolidated Financial  Statements                                                   |
|   |   | Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                                               |
|   |   | Consolidated  Statements of Operations for the years ended December 31, 2006, 2005 and  2004                                                |
|   |   | Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the  years ended December 31, 2006, 2005 and 2004 |
|   |   | Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and  2004                                                |
|   |   | Notes to  Consolidated Financial Statements                                                                                                      |
| 2.     |   | Financial  Statement Schedule                                                                                                                    |
|   |   | Schedule  II—Valuation and Qualifying Accounts                                                                                              |
| 3.     |   | Signatures                                                                                                                                       |

 

(b)          Exhibits
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                     |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(12)         |       | Merger Agreement and Plan of Reorganization by and  among Witness Systems, Inc., Baron Acquisition Corporation, Blue Pumpkin  Software, Inc., and, solely with respect to Article VIII and  Article IX, Laurence R. Hootnick as Shareholder Agent and The U.S. Stock  Transfer Corporation as Depository Agent dated December 16, 2004     |
| 2.2(18)         |       | Agreement and Plan of  Merger among Verint Systems Inc., White Acquisition Corporation and the  Company dated February 11, 2007                                                                                                                                                                                                                                |
| 3.1(2)          |       | Fifth Amended and  Restated Certificate of Incorporation of the Company                                                                                                                                                                                                                                                                                             |
| 3.2(1)          |       | Amended and Restated  Bylaws of the Company                                                                                                                                                                                                                                                                                                                         |
| 3.3(7)          |       | Form of Certificate  of Designation for Series A Junior Participating Preferred Stock                                                                                                                                                                                                                                                                     |
| 4.1(2)          |       | See Exhibit 3.1 for  provisions of the Fifth Amended and Restated Certificate of Incorporation of  the Company defining rights of the holders of Common Stock of the Company.                                                                                                                                                                                  |
| 4.2(4)          |       | See Exhibit 3.2 for  provisions of the Amended and Restated Bylaws of the Company defining rights  of the holders of Common Stock of the Company                                                                                                                                                                                                               |
| 4.3(1)          |       | Specimen Stock  Certificate                                                                                                                                                                                                                                                                                                                                         |
| 4.4(7)          |       | Form of Rights  Agreement, dated October 25, 2002, between the Company and SunTrust Bank  which includes the form of Certificate of Designation for the Series A  Junior Participating Preferred Stock as Exhibit A, the form of Rights  Certificate as Exhibit B and the Summary of Rights to Purchase Preferred  Stock as Exhibit C |
| 4.5(17)         |       | Amendment to Rights  Agreement entered into as of February 11, 2007 between the Company and  Computershare Trust Company, N.A                                                                                                                                                                                                                                  |

 

48

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| Exhibit  Number | ** ** | **Description**                                                                                                                          |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(3)         |       | Lease Agreement between the Company and Colonial  Center at Mansell Overlook/Colonial Business Center dated July 28, 2000           |
| 10.2(9)         |       | Lease Agreement between Eyretel plc and Cornhill  Insurance plc at Kings Court dated December 24, 1999                              |
| 10.3(13)        |       | Lease Agreement between the Company and Mission  Towers, LLC at Freedom Circle Drive dated February 18, 2005                        |
| 10.4(1)         |       | Amended and Restated Stock Incentive Plan of the  Company                                                                                |
| 10.5(2)         |       | Amendment No. 1 to the Company’s Amended and  Restated Stock Incentive Plan                                                    |
| 10.6(9)         |       | Amendment No. 2 to the Company’s Amended and  Restated Stock Incentive Plan                                                    |
| 10.7(5)         |       | Form of Stock Option Grant Certificate                                                                                              |
| 10.8(4)         |       | Employee Stock Purchase Plan of the Company                                                                                              |
| 10.11(9)        |       | Director and Key Executive Stock Ownership Incentive  Policy                                                                             |
| 10.12(13)       |       | Form of Inducement Grant for Employees of Blue  Pumpkin                                                                             |
| 10.13(1)        |       | Employment Agreement entered into between  David B. Gould and the Company effective February 2, 1999                           |
| 10.14(1)        |       | Amendment No. 1 to Employment Agreement entered  into between David B. Gould and the Company, dated as of August 2,  1999 |
| 10.15(1)        |       | Restricted Stock Award Agreement dated  March 31, 1999, between the Company and David Gould                                    |
| 10.16(8)        |       | Employment Agreement entered into between  Nicholas S. Discombe and the Company, dated as of June 29, 2003                     |
| 10.17(9)        |       | 2003 Broad Based Option Plan                                                                                                             |
| 10.18(9)        |       | 2003 Non-Employee Director Stock Option Plan                                                                                             |
| 10.19(1)        |       | Form of Indemnification Agreement for executive  officers and directors of the Company                                              |
| 10.20(11)       |       | Form of Change of Control Agreement entered  into with certain senior officers of the company                                       |
| 10.21(1)        |       | Subsidiary License and Distribution Agreement                                                                                            |
| 10.22(6)        |       | Loan and Security Agreement between the Company and  Silicon Valley Bank dated April 3, 2002                                   |
| 10.23(6)        |       | Loan Modification Agreement between the Company and  Silicon Valley Bank dated November 12, 2002                                    |
| 10.24(6)        |       | Revolving Promissory Note between the Company and  Silicon Valley Bank dated November 12, 2002                                      |
| 10.25(9)        |       | Second Loan Modification Agreement between the  Company and Silicon Valley Bank dated May 14, 2003                                  |

 

49

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| Exhibit  Number | ** ** | **Description**                                                                                                                    |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------|
| 10.26(9)        |       | Third Loan Modification Agreement between the  Company and Silicon Valley Bank dated November 13, 2003                        |
| 10.27(10)       |       | Fourth Loan Modification Agreement between the  Company and Silicon Valley Bank dated January 8, 2004                         |
| 10.28(10)       |       | Fifth Loan Modification  Agreement between the Company and Silicon Valley Bank dated March 10,  2004                          |
| 10.29(13)       |       | Sixth Loan Modification  Agreement between the Company and Silicon Valley Bank dated January 12,  2005                        |
| 10.30(14)       |       | Seventh Loan Modification  Agreement between the Company and Silicon Valley Bank dated March 10,  2005                        |
| 10.31(14)       |       | Amended and Restated  Stock Incentive Plan                                                                                         |
| 10.32(14)       |       | Amended and Restated  Stock Incentive Plan                                                                                         |
| 10.33(15)       |       | Eight Loan Modification  Agreement between the Company and Silicon Valley Bank dated March 31,  2005                          |
| 10.34(15)       |       | Amended and Restated  Stock Incentive Plan                                                                                         |
| 10.35(15)       |       | Amended and Restated  Stock Incentive Plan                                                                                         |
| 10.36(16)       |       | Amendment No.1 to the  Witness Systems, Inc. Amended and restated Stock Incentive plan                                        |
| 10.37(16)       |       | Amended &  Restated Employee Stock Purchase Plan.                                                                         |
| 10.38(16)       |       | Form of Inducement  Grant for Contractors who will become employee of Witness Systems Software  India PVT Ltd                 |
| 10.39(17)       |       | Separation and Release  Agreement entered into as of January 3, 2007 between the Company and  David Gould                     |
| 10.40(18)       |       | First Amendment to  Separation and Release Agreement entered into as of February 2, 2007  between the Company and David Gould |
| 10.41*          |       | Tenth Loan Modification  Agreement between the Company and Silicon Valley Bank dated March 8,  2007                           |
| 21.1*           |       | List of subsidiaries                                                                                                               |
| 23.1*           |       | Report of Independent  Registered Public Accounting Firm on Consolidated Financial Statements  Schedule                            |
| 23.2*           |       | Consent of Independent  Registered Public Accounting Firm                                                                          |
| 23.3*           |       | Consent of Independent  Business Valuation Experts                                                                                 |
| 31.1*           |       | Certificate of the Chief  Executive Officer                                                                                        |
| 31.2*           |       | Certificate of the Chief  Financial Officer                                                                                        |
| 32.1*           |       | Certifications Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002                                                     |

 

----

                 * Filed herewith

50

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       (1) Incorporated by reference to exhibits previously filed with theCompany’s Registration Statement on Form S-1 (File No. 333-91383)

       (2) Incorporated by reference to exhibits previously filed with theCompany’s Registration Statement on Form S-8 (File No. 333-67416)

       (3) Incorporated by reference to exhibits previously filed with theCompany’s Quarterly Report on Form 10-Q for the period endedJune 30, 2000

       (4) Incorporated by reference to exhibits previously filed with theCompany’s Annual Report on Form 10-K for the year endedDecember 31, 1999

       (5) Incorporated by reference to exhibits previously filed with theCompany’s Annual Report on Form 10-K for the year endedDecember 31, 2000

       (6) Incorporated by reference to exhibits previously filed with theCompany’s Quarterly Report on Form 10-Q for the period endedSeptember 30, 2002

       (7) Incorporated by reference to exhibits previously filed with theCompany’s Current Report on Form 8-K on November 4, 2002

       (8) Incorporated by reference to exhibits previously filed with theCompany’s Quarterly Report on Form 10-Q for the period endedJune 30, 2003

       (9) Incorporated by reference to exhibits previously filed with theCompany’s Annual Report on Form 10-K for the year endedDecember 31, 2003

(10) Incorporated by reference to exhibits previously filed with theCompany’s Quarterly Report on Form 10-Q for the period endedMarch 31, 2004

(11) Incorporated by reference to exhibits previously filed with theCompany’s Quarterly Report on Form 10-Q for the period endedSeptember 30, 2004

(12) Incorporated by reference to exhibits previously filed with theCompany’s Current Report on Form 8-K on January 27, 2005

(13) Incorporated by reference to exhibits previously filed with theCompany’s Annual Report on Form 10-K for the year endedDecember 31, 2004

(14) Incorporated by reference to exhibits previously filed with theCompany’s Quarterly Report on Form 10-Q for the period endedMarch 31, 2005

(15) Incorporated by reference to exhibits previously filed with theCompany’s Quarterly Report on Form 10-Q for the period endedJune 30, 2005

(16) Incorporated by reference to exhibits previously filed with theCompany’s Annual Report on Form 10-K for the year endedDecember 31, 2005

(17) Incorporated by reference to exhibits previously filed with theCompany’s Current Report on Form 8-K on January 9, 2007

(18) Incorporated by reference to exhibits previously filed with theCompany’s Current Report on Form 8-K on February 15, 2007

51

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**WITNESS SYSTEMS,INC. AND SUBSIDIARIES**

**Indexto Consolidated Financial Statements**
| Management’s Report on  Internal Control Over Financial Reporting                                                                                 |   | F-2  |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------|--------|
| Report of Independent Registered Public Accounting  Firm on Internal Control Over Financial Reporting               |   | F-4  |   |
| Report of Independent Registered Public Accounting  Firm on Consolidated Financial Statements                                                          |   | F-6  |   |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                                                     |   | F-7  |   |
| Consolidated Statements of Operations for the years  ended December 31, 2006, 2005, and 2004                                                      |   | F-8  |   |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income (Loss) for the years ended December 31, 2006,  2005, and 2004 |   | F-9  |   |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005, and 2004                                                      |   | F-10 |   |
| Notes to Consolidated Financial Statements                                                                                                             |   | F-11 |   |
| Schedule  II—Valuation and Qualifying Accounts                                                                                                    |   | F-39 |   |
| Signatures                                                                                                                                             |   | F-40 |   |

 

F-1

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**Management’s Reporton Internal Control Over Financial Reporting**

The management of the Company is responsible forestablishing and maintaining adequate internal control over financial reportingas defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. TheCompany maintains accounting and internal control systems which are intended toprovide reasonable assurance that assets are safeguarded against loss fromunauthorized use or disposition, transactions are executed in accordance withmanagement’s authorization and accounting records are reliable for preparingfinancial statements in accordance with accounting principles generallyaccepted in the United States. 

Internal control over financial reporting cannotprovide absolute assurance of achieving financial reporting objectives becauseof its inherent limitations. Internal control over financial reporting is aprocess that involves human diligence and compliance and is subject to lapsesin judgment and breakdowns resulting from human failures. Internal control overfinancial reporting also can be circumvented by collusion or impropermanagement override. Because of such limitations, there is a risk that materialmisstatements may not be prevented or detected on a timely basis by internal controlover financial reporting. However, these inherent limitations are knownfeatures of the financial reporting process. Therefore, it is possible todesign into the process safeguards to reduce, though not eliminate, this risk.

A material weakness in internal control over financialreporting is defined by Public Company Accounting Oversight Board (“PCAOB”)Auditing Standard No. 2 as a significant deficiency, or combination ofsignificant deficiencies, that results in more than remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected.

As of December 31,2006, management conducted an assessment of the effectiveness of our internalcontrol over financial reporting based upon the framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (“COSO”),Internal Control-Integrated Framework. Based on this assessment, managementconcluded that as of December 31, 2006, we did not maintain effective controlover financial reporting, due to the following material weaknesses:

(1)         We did not have effectivepolicies and procedures to provide for appropriate consideration of allpayments made to the selling shareholders in a business combination. Thisdeficiency resulted in a material error in our preliminary 2006 ConsolidatedFinancial Statements.

(2)         We did not have policiesand procedures sufficiently detailed to ensure appropriate accounting for thereduction of deferred income tax asset valuation allowances established as partof a business combination. As a result, there were material errors in goodwilland income tax expense in our preliminary 2006 Consolidated FinancialStatements.

(3)         Our evaluation and reviewof the allowance for uncollectible accounts receivable was not sufficientlythorough and objective to ensure accounts receivable were recorded at their netrealizable value. Specifically, our evaluation and review of the allowance foruncollectible accounts receivable did not adequately consider the aging ofcertain receivables and specific customer collection issues that existed atDecember 31, 2006. As a result, there were errors in accounts receivable andoperating expenses in our preliminary 2006 Consolidated Financial Statements.

(4)         Our policies andprocedures over the recognition of deferred revenue from maintenance and otherservice contracts were not sufficient to ensure that revenue was recognized inthe appropriate period in accordance with U.S. generally accepted accountingprinciples. Specifically, our policies and procedures did not provide forsufficient analysis of contracts included in deferred revenue to determine thetiming of recognition. This deficiency resulted in errors in revenue anddeferred revenue in our preliminary 2006 Consolidated Financial Statements.

F-2

----

These material weaknesses result in more than a remotelikelihood that a material misstatement in the annual or interim financialstatements would not be prevented or detected.

Management’s assessment of the effectiveness ofinternal control over financial reporting as of December 31, 2006 has beenaudited by KPMG LLP, an independent registered public accounting firm. Theirreport appears immediately after this report.

Witness Systems, Inc.March 30, 2007

F-3

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**Report of Independent Registered Public AccountingFirmon Internal Control Over Financial Reporting**

The Board of DirectorsWitness Systems, Inc.:

We have audited management’sassessment, included in the accompanying Management’s Report on InternalControl over Financial Reporting (page F-2), that Witness Systems, Inc. did notmaintain effective internal control over financial reporting as of December 31,2006, because of the effect of the material weaknesses identified inmanagement’s assessment, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Witness Systems, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management's assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management's assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.  Acompany's internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (2) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements. 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

Amaterial weakness is a control deficiency, or combination of control deficiencies,that results in more than a remote likelihood that a material misstatement ofthe annual or interim financial statements will not be prevented or detected.The following material weaknesses have been identified and included inmanagement’s assessment:  

(1)         The Company did not haveeffective policies and procedures to provide for appropriate consideration ofall payments made to the selling shareholders in a business combination. Thisdeficiency resulted in a material error in the Company’s preliminary 2006consolidated financial statements.

(2)         The Company did not havepolicies and procedures sufficiently detailed to ensure appropriate accountingfor the reduction of deferred income tax asset valuation allowances establishedas part 

F-4

----

of a business combination.  As a result, there were material errors ingoodwill and income tax expense in the Company’s preliminary 2006 consolidatedfinancial statements.

(3)         Management’s evaluationand review of the allowance for uncollectible accounts receivable was notsufficiently thorough and objective to ensure accounts receivable were recordedat their net realizable value. Specifically, management’s evaluation and review of the allowance foruncollectible accounts receivable did not adequately consider the aging ofcertain receivables and specific customer collection issues that existed atDecember 31, 2006.  As a result, therewere errors in accounts receivable and operating expenses in the Company’spreliminary 2006 consolidated financial statements.

(4)         The Company’s policiesand procedures over the recognition of deferred revenue from maintenance andother service contracts were not sufficient to ensure that revenue wasrecognized in the appropriate period in accordance with U.S. generally acceptedaccounting principles.  Specifically, theCompany’s policies and procedures did not provide for sufficient analysis ofcontracts included in deferred revenue to determine the timing of recognition.  This deficiency resulted in errors in revenueand deferred revenue in the Company’s preliminary 2006 consolidated financialstatements.

Each of the aforementionedmaterial weaknesses in internal control over financial reporting individuallyresulted in more than a remote likelihood that a material misstatement of theCompany’s interim or annual financial statements would not have been preventedor detected.

In our opinion, management’sassessment that Witness Systems, Inc. did not maintain effective internalcontrol over financial reporting as of December 31, 2006, is fairly stated, inall material respects, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also, in our opinion, becauseof the effect of the material weaknesses described above on the achievement ofthe objectives of the control criteria, Witness Systems, Inc. has notmaintained effective internal control over financial reporting as of December31, 2006, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO).

We alsohave audited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated balance sheet of WitnessSystems, Inc. and subsidiaries as of December 31, 2006, and the relatedconsolidated statements of operations, stockholders’ equity and comprehensiveincome (loss), and cash flows for the year ended December 31, 2006. Thesematerial weaknesses were considered in determining the nature, timing, andextent of audit tests applied in our audit of the 2006 consolidated financialstatements, and this report does not affect our report dated March 30,2007, which expressed an unqualified opinion on those consolidated financialstatements.

/s/ KPMG LLP

Atlanta, GeorgiaMarch 30, 2007

F-5

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**Reportof Independent Registered Public Accounting Firm on Consolidated FinancialStatements**

The Board of DirectorsWitness Systems, Inc.:

Wehave audited the accompanying consolidated balance sheets of Witness Systems, Inc.and subsidiaries as of December 31, 2006 and 2005, and the related consolidatedstatements of operations, stockholders’ equity and comprehensive income (loss),and cash flows for each of the years in the three-year period ended December 31,2006. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

Weconducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Witness Systems, Inc.and subsidiaries as of December 31, 2006 and 2005, and the results oftheir operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2006, in conformity with U.S. generally acceptedaccounting principles.

Asdiscussed in Notes 1 and 11 to the consolidated financial statements,effective January 1, 2006, the Company changed its method of accountingfor share-based compensation by adopting Statement of Financial AccountingStandards No. 123(R), *Share-Based Payment*.

Also,as discussed in Note 1 to the Consolidated Financial Statements, effectiveDecember 31, 2006, the Company changed its method of quantifying errors byadopting Staff Accounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements.*

We alsohave audited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the effectiveness of Witness Systems, Inc.’s internal control over financialreporting as of December 31, 2006, based on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), and our report dated March 30,2007, expressed an unqualified opinion on management’s assessment of, and anadverse opinion on the effective operation of, internal control over financialreporting.

/s/ KPMG LLP

Atlanta, GeorgiaMarch 30, 2007

F-6

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands, except share data)**

| ** **                                                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                                            |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                       |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                             |       | $                     | 73,888     |   | $ | 111,751 |   |
| Investments                                                                                                                                                                                           |       | 57,640                |       | 14,886 |   |
| Restricted cash held in escrow                                                                                                                                                                        |       | —                |       | 4,000 |   |
| Accounts receivable, net of allowance of $2,990 at  December 31, 2006 and $3,283 at December 31, 2005                                                                                  |       | 59,668                |       | 40,218 |   |
| Prepaid and other current assets                                                                                                                                                                      |       | 7,361                 |       | 5,462 |   |
| Total current assets                                                                                                                                                                                  |       | 198,557               |       | 176,317 |   |
| Intangible  assets, net                                                                                                                                                                               |       | 41,282                |       | 36,389 |   |
| Goodwill                                                                                                                                                                                              |       | 59,130                |       | 40,319 |   |
| Property and  equipment, net                                                                                                                                                                          |       | 10,207                |       | 7,796 |   |
| Deferred income tax  assets                                                                                                                                                                           |       | 5,233                 |       | — |   |
| Other assets                                                                                                                                                                                          |       | 10,184                |       | 3,573 |   |
|                                                                                                                                                                                                  |       | $                     | 324,593    |   | $ | 264,394 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                                  |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                      |       | $                     | 10,005     |   | $ | 3,795 |   |
| Accrued expenses                                                                                                                                                                                      |       | 24,256                |       | 29,651 |   |
| Deferred revenue                                                                                                                                                                                      |       | 38,799                |       | 23,756 |   |
| Total current liabilities                                                                                                                                                                             |       | 73,060                |       | 57,202 |   |
| Other long-term  liabilities                                                                                                                                                                          |       | 5,418                 |       | 4,165 |   |
| Deferred income  tax liabilities                                                                                                                                                                      |       | 638                   |       | 743 |   |
| Total liabilities                                                                                                                                                                                     |       | 79,116                |       | 62,110 |   |
| Commitments and  contingencies                                                                                                                                                                        |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                                            |       |                  |       |   |   |
| Preferred stock, $.01 par value; 10,000,000 shares  authorized; (50,000 shares of which have been designated as Series A  Junior Participating Preferred Stock), no shares issued or outstanding |       | —                |       | — |   |
| Common stock, $.01 par value; 50,000,000 shares  authorized; 34,122,704 and 32,612,193 shares issued and outstanding at  December 31, 2006 and 2005, respectively                           |       | 341                   |       | 326 |   |
| Additional paid-in capital                                                                                                                                                                            |       | 282,594               |       | 251,712 |   |
| Accumulated deficit                                                                                                                                                                                   |       | (43,971               | )          | (52,830 | ) |
| Accumulated other comprehensive income                                                                                                                                                                |       | 6,513                 |       | 3,076 |   |
| Total stockholders’ equity                                                                                                                                                                       |       | 245,477               |       | 202,284 |   |
|                                                                                                                                                                                                  |       | $                     | 324,593    |   | $ | 264,394 |   |

 

See accompanying Notes to Consolidated Financial Statements.

F-7

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)**

| ** **                                      | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                        |       |                                        |       |   |   |   |   |
| Product                                         |       | $                                           | 85,850     |   | $ | 74,186 |   | $ | 57,620 |   |
| Services                                        |       | 135,933                                     |       | 111,142 |   | 83,715 |   |
| Total revenue                                   |       | 221,783                                     |       | 185,328 |   | 141,335 |   |
| Cost of revenue:                                |       |                                        |       |   |   |   |   |
| Product                                         |       | 18,875                                      |       | 19,130 |   | 13,784 |   |
| Services                                        |       | 52,662                                      |       | 42,361 |   | 32,645 |   |
| Total cost of revenue                           |       | 71,537                                      |       | 61,491 |   | 46,429 |   |
| Gross profit                                    |       | 150,246                                     |       | 123,837 |   | 94,906 |   |
| Operating expenses:                             |       |                                        |       |   |   |   |   |
| Selling, general and administrative             |       | 114,951                                     |       | 85,995 |   | 65,808 |   |
| Research and development                        |       | 33,307                                      |       | 26,717 |   | 20,816 |   |
| Merger-related and integration costs            |       | 2,702                                       |       | 4,532 |   | 498 |   |
| Acquired in-process research and development    |       | 760                                         |       | 9,000 |   | — |   |
| Operating (loss) income                         |       | (1,474                                      | )          | (2,407 | ) | 7,784 |   |
| Interest and  other income, net                 |       | 5,180                                       |       | 860 |   | 1,206 |   |
| Income (loss) before provision for income taxes |       | 3,706                                       |       | (1,547 | ) | 8,990 |   |
| (Benefit)  provision for income taxes           |       | (3,752                                      | )          | 3,024 |   | 312 |   |
| Net income (loss)                               |       | $                                           | 7,458      |   | $ | (4,571 | ) | $ | 8,678 |   |
| Net income (loss) per  share:                   |       |                                        |       |   |   |   |   |
| Basic                                           |       | $                                           | 0.22       |   | $ | (0.17 | ) | $ | 0.37 |   |
| Diluted                                         |       | $                                           | 0.20       |   | $ | (0.17 | ) | $ | 0.33 |   |
| Weighted-average common  shares outstanding:    |       |                                        |       |   |   |   |   |
| Basic                                           |       | 33,687                                      |       | 27,221 |   | 23,361 |   |
| Diluted                                         |       | 36,533                                      |       | 27,221 |   | 26,084 |   |

 

See accompanying Notes to Consolidated Financial Statements.

F-8

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY AND**

**COMPREHENSIVE INCOME (LOSS)**

**YearsEnded December 31, 2006, 2005 and 2004(In thousands)**

| ** **                                                             | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                             | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **        | ** ** | **Other**              | ** ** | **Total**  | ** ** |
| ** **                                                             | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                             | ** ** | **Number**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**       | ** ** | **Income**             | ** ** | **Equity** | ** ** |
| Balances at  December 31, 2003                                    |       |                  | 22,170     |        |       |            | $          | 222               |       |                   |       | $          | 102,724    |   |   |   | $ | (56,937 | ) |   |   | $ | 3,986 |   |   |   | $ | 49,995 |   |   |
| Exercise of stock  options                                             |       |                  | 2,224      |        |       |            | 22         |              |       |                   | 12,993     |       |       |   | — |   |   |   | — |   |   |   | 13,015 |   |   |
| Tax benefit on  exercised stock options                                |       |                  | —     |        |       |            | —     |              |       |                   | 214        |       |       |   | — |   |   |   | — |   |   |   | 214 |   |   |
| Shares issued  under employee stock purchase plan                      |       |                  | 82         |        |       |            | 1          |              |       |                   | 688        |       |       |   | — |   |   |   | — |   |   |   | 689 |   |   |
| Stock-based  compensation expense                                      |       |                  | —     |        |       |            | —     |              |       |                   | 827        |       |       |   | — |   |   |   | — |   |   |   | 827 |   |   |
| Comprehensive income:                                                  |       |                  |       |        |       |            |       |              |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Change in  cumulative foreign currency translation adjustment          |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | — |   |   |   | 959 |   |   |   | 959 |   |   |
| Change in  unrealized losses on investments, net                       |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | — |   |   |   | (3 | ) |   |   | (3 | ) |   |
| Net income                                                             |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | 8,678 |   |   |   | — |   |   |   | 8,678 |   |   |
| Total  comprehensive income                                            |       |                  |       |        |       |            |       |              |       |                   |       |       |       |   |   |   |   |   |   |   |   |   | 9,634 |   |   |
| Balances at  December 31, 2004                                    |       |                  | 24,476     |        |       |            | 245        |              |       |                   | 117,446    |       |       |   | (48,259 | ) |   |   | 4,942 |   |   |   | 74,374 |   |   |
| Exercise of stock  options                                             |       |                  | 1,462      |        |       |            | 14         |              |       |                   | 10,434     |       |       |   | — |   |   |   | — |   |   |   | 10,448 |   |   |
| Tax benefit on  exercised stock options                                |       |                  | —     |        |       |            | —     |              |       |                   | 222        |       |       |   | — |   |   |   | — |   |   |   | 222 |   |   |
| Shares issued  under employee stock purchase plan                 |       |                  | 69         |        |       |            | 1          |              |       |                   | 1,034      |       |       |   | — |   |   |   | — |   |   |   | 1,035 |   |   |
| Stock  issuance—Blue Pumpkin                                      |       |                  | 1,890      |        |       |            | 19         |              |       |                   | 33,509     |       |       |   | — |   |   |   | — |   |   |   | 33,528 |   |   |
| Sale of common  stock                                                  |       |                  | 4,715      |        |       |            | 47         |              |       |                   | 88,686     |       |       |   |   |   |   |   |   |   |   |   | 88,733 |   |   |
| Stock-based  compensation expense                                      |       |                  | —     |        |       |            | —     |              |       |                   | 381        |       |       |   | — |   |   |   | — |   |   |   | 381 |   |   |
| Comprehensive loss:                                                    |       |                  |       |        |       |            |       |              |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Change in  cumulative foreign currency translation adjustment          |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | — |   |   |   | (1,875 | ) |   |   | (1,875 | ) |   |
| Change in  unrealized gains on investments, net                        |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | — |   |   |   | 9 |   |   |   | 9 |   |   |
| Net loss                                                               |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | (4,571 | ) |   |   | — |   |   |   | (4,571 | ) |   |
| Total  comprehensive loss                                              |       |                  |       |        |       |            |       |              |       |                   |       |       |       |   |   |   |   |   |   |   |   |   | (6,437 | ) |   |
| Balances at  December 31, 2005                                    |       |                  | 32,612     |        |       |            | 326        |              |       |                   | 251,712    |       |       |   | (52,830 | ) |   |   | 3,076 |   |   |   | 202,284 |   |   |
| Cumulative  adjustment to accumulated deficit upon adoption of SAB 108 |       |                  | —     |        |       |            | —     |              |       |                   | 31         |       |       |   | 1,401 |   |   |   | — |   |   |   | 1,432 |   |   |
| Exercise of stock  options                                             |       |                  | 1,335      |        |       |            | 14         |              |       |                   | 12,004     |       |       |   | — |   |   |   | — |   |   |   | 12,018 |   |   |
| Tax benefit on  exercised stock options                                |       |                  | —     |        |       |            | —     |              |       |                   | 210        |       |       |   | — |   |   |   | — |   |   |   | 210 |   |   |
| Stock issuance—Blue  Pumpkin                                      |       |                  | 183        |        |       |            | 1          |              |       |                   | 3,720      |       |       |   | — |   |   |   | — |   |   |   | 3,721 |   |   |
| Fair value of escrow  shares                                           |       |                  | —     |        |       |            | —     |              |       |                   | 1,351      |       |       |   | — |   |   |   | — |   |   |   | 1,351 |   |   |
| Shares issued  under employee stock purchase plan                 |       |                  | 19         |        |       |            | —     |              |       |                   | 396        |       |       |   | — |   |   |   | — |   |   |   | 396 |   |   |
| Cost of sale of  common stock                                          |       |                  | —     |        |       |            | —     |              |       |                   | 13         |       |       |   | — |   |   |   | — |   |   |   | 13 |   |   |
| Retired treasury  stock (shares held in  escrow)                       |       |                  | (27        | )           |       |            | —     |              |       |                   | (653       | )          |       |   | — |   |   |   | — |   |   |   | (653 | ) |   |
| Stock-based  compensation expense                                      |       |                  | —     |        |       |            | —     |              |       |                   | 13,810     |       |       |   | — |   |   |   | — |   |   |   | 13,810 |   |   |
| Comprehensive income:                                                  |       |                  |       |        |       |            |       |              |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Change in  cumulative foreign currency translation adjustment          |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | — |   |   |   | 3,446 |   |   |   | 3,446 |   |   |
| Change in  unrealized losses on investments, net                       |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | — |   |   |   | (9 | ) |   |   | (9 | ) |   |
| Net income                                                             |       |                  | —     |        |       |            | —     |              |       |                   | —     |       |       |   | 7,458 |   |   |   | — |   |   |   | 7,458 |   |   |
| Total  comprehensive income                                            |       |                  |       |        |       |            |       |              |       |                   |       |       |       |   |   |   |   |   |   |   |   |   | 10,895 |   |   |
|                                                                   |       |                  |       |        |       |            |       |              |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Balances at  December 31, 2006                                    |       |                  | 34,122     |        |       |            | $          | 341               |       |                   |       | $          | 282,594    |   |   |   | $ | (43,971 | ) |   |   | $ | 6,513 |   |   |   | $ | 245,477 |   |   |

 

See accompanying Notes to Consolidated Financial Statements.

F-9

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**

| ** **                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from operating  activities:                                                               |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                                    |       | $                                           | 7,458      |   | $ | (4,571 | ) | $ | 8,678 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                        |       |   |   |   |   |
| In-process research and development                                                                  |       | 760                                         |       | 9,000 |   | — |   |
| Amortization of intangible assets                                                                    |       | 16,204                                      |       | 15,201 |   | 5,911 |   |
| Depreciation and amortization of property and equipment                                              |       | 5,798                                       |       | 4,394 |   | 3,175 |   |
| Provision for accounts receivable                                                                    |       | 3,291                                       |       | 3,224 |   | 1,908 |   |
| Deferred income taxes                                                                                |       | (4,700                                      | )          | 2,253 |   | — |   |
| Stock-based compensation expense                                                                     |       | 13,810                                      |       | 381 |   | 827 |   |
| Other non-cash items, net                                                                            |       | 919                                         |       | 233 |   | 842 |   |
| Excess tax benefits from stock-based compensation                                                    |       | (145                                        | )          | — |   | — |   |
| Changes  in operating assets and liabilities:                                                        |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                  |       | (18,336                                     | )          | (14,281 | ) | 5,068 |   |
| Prepaid and other assets                                                                             |       | (5,755                                      | )          | 1,511 |   | (3,043 | ) |
| Accounts payable                                                                                     |       | 5,476                                       |       | (2,565 | ) | (92 | ) |
| Accrued expenses                                                                                     |       | 430                                         |       | (1,633 | ) | 626 |   |
| Deferred revenue                                                                                     |       | 13,819                                      |       | (4,132 | ) | 3,978 |   |
| Accrued restructuring and integration costs                                                          |       | (243                                        | )          | (2,815 | ) | (5,085 | ) |
| Net cash provided by operating activities                                                            |       | 38,786                                      |       | 6,200 |   | 22,793 |   |
| Cash flows from investing  activities:                                                               |       |                                        |       |   |   |   |   |
| Capital expenditures                                                                                 |       | (7,606                                      | )          | (5,746 | ) | (3,204 | ) |
| Purchases of investments                                                                             |       | (133,575                                    | )          | (14,553 | ) | (40,076 | ) |
| Proceeds from maturities of investments                                                              |       | 89,223                                      |       | — |   | 4,500 |   |
| Proceeds from sales of investments                                                                   |       | 2,768                                       |       | 33,625 |   | 20,440 |   |
| Acquisition of Blue Pumpkin Software, Inc, net of  cash acquired of $3,917                           |       | (8,250                                      | )          | (37,477 | ) | — |   |
| Acquisition of Exametric, Inc, net of cash acquired  of $330                                         |       | (23,101                                     | )          | — |   | — |   |
| Acquisition of Demos Solutions, net of cash acquired  of $355                                        |       | (5,718                                      | )          | — |   | — |   |
| Other acquisitions, net of cash acquired of $1,300                                                   |       | (13,030                                     | )          | (4,256 | ) | — |   |
| Changes in restricted cash held in escrow                                                            |       | 4,000                                       |       | (4,000 | ) | — |   |
| Purchase of other business assets                                                                    |       | (459                                        | )          | (2,514 | ) | — |   |
| Net cash used in investing activities                                                                |       | (95,748                                     | )          | (34,921 | ) | (18,340 | ) |
| Cash flows from financing  activities:                                                               |       |                                        |       |   |   |   |   |
| Proceeds from exercise of stock options                                                              |       | 12,398                                      |       | 10,448 |   | 13,015 |   |
| Proceeds from employee stock purchase plan                                                           |       | 396                                         |       | 1,035 |   | 689 |   |
| Proceeds from sale of common stock                                                                   |       | 3,620                                       |       | 88,733 |   | — |   |
| Excess tax benefits from stock-based compensation                                                    |       | 145                                         |       | — |   | — |   |
| Other                                                                                                |       | (7                                          | )          | (105 | ) | (401 | ) |
| Net cash provided by financing activities                                                            |       | 16,552                                      |       | 100,111 |   | 13,303 |   |
| Effect of exchange rate changes on cash                                                              |       | 2,547                                       |       | (2,280 | ) | 3,368 |   |
| Net (decrease) increase in cash and cash equivalents                                                 |       | (37,863                                     | )          | 69,110 |   | 21,124 |   |
| Cash and cash equivalents at beginning of year                                                       |       | 111,751                                     |       | 42,641 |   | 21,517 |   |
| Cash and cash equivalents at end of year                                                             |       | $                                           | 73,888     |   | $ | 111,751 |   | $ | 42,641 |   |
| Supplemental cash flow  information:                                                                 |       |                                        |       |   |   |   |   |
| Cash paid for interest                                                                               |       | $                                           | 5          |   | $ | 14 |   | $ | — |   |
| Cash paid for  income taxes                                                                          |       | $                                           | 412        |   | $ | 488 |   | $ | 245 |   |

 

See accompanying Notes to Consolidated Financial Statements.

F-10

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2006, 2005 and 2004**

**1.**   Summaryof Significant Accounting Policies

***Business***—WitnessSystems, Inc. (“Witness”) is a publicly traded company that providesworkforce optimization software and services that help businesses capturecustomer intelligence and optimize their work performance. Our Impact 360solution features quality monitoring, compliance and IP recording, workforcemanagement, performance management and e-learning. Our quality monitoringproducts record multimedia interactions, including traditional voice, Web chatand email, based on user-defined business rules to enable our customers toevaluate the performance of their customer service representatives (“CSRs”),wherever they may be located in the enterprise. Our complianceapplications are designed to record high volume voice conversations betweenCSRs and customers for purposes such as compliance recording and salesverification. Our workforce management products enable our customers to developstrategic staffing plans, deploy skilled resources and evaluate productivity ofCSRs in a contact center, branch bank or back office operations. Ourperformance management applications provide comprehensive analytics, includingperformance scorecards, and reports of customer interaction and CSRperformance. Our e-learning applications deliver ongoing training tailored toCSR needs and competencies. We also provide consulting and implementationservices, training and support to customers that use our software products.Primarily deployed in contact centers - as well as the remote, branch and backoffices of global organizations, the workforce optimization solution captures,analyzes and enables users to share and act on cross-functional informationacross the enterprise. With Impact 360, organizations can improve interactionsand the underlying back-office processes that enhance the customer experienceand build customer loyalty.

We are headquartered in Roswell, Georgia withoperations in the United States, Australia, Brazil, Canada, China, Germany,India, Japan, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom. We were originally incorporated in 1988 in Georgia and werereincorporated in Delaware in 1997.

***Principles ofConsolidation and Reclassifications***—The ConsolidatedFinancial Statements include the Financial Statements of Witness Systems, Inc.and its wholly-owned subsidiaries. All significant intercompany balances andtransactions have been eliminated in consolidation. Certain prior year amountshave been reclassified to conform to the current year presentation.

***Use of Estimates***—TheConsolidated Financial Statements have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof these Consolidated Financial Statements requires us to make certainestimates and judgments that affect our reported assets, liabilities, revenuesand expenses, and our related disclosure of contingent assets and liabilities.We base our estimates on historical experience and on various assumptions thatwe believe to be reasonable under the circumstances. Actual results may differfrom these estimates under different assumptions or conditions.

***Cash and CashEquivalents and Investments***—Cash and cashequivalents consist of cash on deposit, money market accounts, commercial paperand U.S. Government agency securities. All highly liquid investments withoriginal maturities of three months or less at the time of purchase areclassified as cash equivalents.

Investments are classified as available for sale andare carried at fair market value. Unrealized holding gains and losses on suchinvestments are reported as a separate component of accumulated other 

F-11

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comprehensive income untilrealized. If a decline in fair value is determined to be other than temporary,the cost basis of the individual security is written down to fair value as anew cost basis resulting in a realized loss. Realized gains and losses fromsales are based on the specific identification method. Our investments arepresented as current assets as they represent the investment of cash availableto be used in current operations within the next year.

***Restricted CashHeld in Escrow***—Pursuant to the Blue Pumpkin MergerAgreement discussed in Note 5, “Blue Pumpkin and Optimis Acquisitions,”cash of $4.0 million was placed in escrow on the date of acquisition. Theescrow fund was established to compensate Witness, subject to certainlimitations, for potential losses that could result from, among other things,the IEX litigation and other specified litigation. The escrow fund is reflectedas restricted cash held in escrow on our Consolidated Balance Sheet as of December 31,2005 and was released to Witness in 2006.

***Allowance forDoubtful Accounts***—We perform ongoing evaluationsof our customers and continuously monitor collections and payments and estimatean allowance for doubtful accounts based on the aging of the underlyingreceivables, our historical experience with write-offs and any specificcustomer collection issues that we have identified. While such credit losseshave historically been within our expectations and we believe appropriatereserves have been established, we cannot assure that we will continue to experiencethe same credit loss rates that we have experienced in the past or adequatelypredict future credit losses. If the financial condition of our customers wereto deteriorate and resulted in an impairment of their ability to make payments,additional allowances may be required which would result in additional selling,general and administrative expense in the period such determination is made.

***Property and Equipment***—Propertyand equipment are stated at cost, less accumulated depreciation and amortization.Property and equipment are depreciated and amortized using the straight-linemethod over the estimated useful lives of the assets. Leasehold improvementsare amortized using the straight-line method over the shorter of the estimatedlife of the asset or the remaining term of the lease. Property and equipmentgenerally has the following estimated useful lives and is comprised of thefollowing amounts (in thousands):

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Computer  equipment (2 years)                   |       | $                     | 12,450     |   | $ | 9,038 |   |
| Software (2 -  3 years)                    |       | 6,154                 |       | 4,187 |   |
| Other equipment  (5 years)                      |       | 5,427                 |       | 4,221 |   |
| Furniture and  fixtures (5 years)               |       | 1,846                 |       | 711 |   |
| Leasehold  improvements                         |       | 4,048                 |       | 3,354 |   |
|                                            |       | 29,925                |       | 21,511 |   |
| Less accumulated  depreciation and amortization |       | 19,718                |       | 13,715 |   |
|                                            |       | $                     | 10,207     |   | $ | 7,796 |   |

 

Depreciation and amortization on property andequipment was $5.8 million**,** $4.4 millionand $3.2 million in 2006, 2005 and 2004, respectively.

***Long-Lived Assets***—***As*** requiredby Statement of Financial Accounting Standards (“SFAS”) No. 144*, Accounting for Impairment or Disposal of Long-livedAssets*, long-lived assets are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and usedwould be measured by a comparison of the carrying amount of an asset to theestimated undiscounted future cash flows expected to be generated by the asset.If the carrying amount of an asset exceeds its undiscounted estimated futurecash flows, an impairment charge is recognized in the amount by which thecarrying amount of the asset exceeds the fair 

F-12

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value of the asset. Todate, no events or changes in circumstances have occurred that would require usto test long-lived assets for recoverability.

***Goodwill andIntangible Assets***—Goodwill and intangible assetsare accounted for in accordance with SFAS No.142, *Goodwill and Intangible Assets*. This statement requires thatgoodwill and intangible assets with indefinite lives should not be amortized,but should be tested for impairment on an annual basis, or more often if anevent occurs or circumstances change that indicate that the fair value of areporting unit or indefinite-lived intangible asset might have fallen below itscarrying amount.

***Revenue Recognitionand Deferred Revenue***—We recognize revenue inaccordance with the American Institute of Certified Public Accountants’Statement of Position (“SOP”) 97-2, *SoftwareRevenue Recognition*, and SOP 98-9, *Modification of* SOP 97-2, *Software Revenue Recognition, With Respect to Certain**Transactions and*Emerging Issues Task Force (“EITF”)**No. 00-21*, Revenue Arrangementswith Multiple Deliverables.* Revenue is primarily derived fromlicensing software and providing related services including maintenance.Product revenue, which can include software and hardware, is recognized whenpersuasive evidence of an agreement exists, delivery of the product hasoccurred, the fee is fixed or determinable, collection is probable and vendorspecific objective evidence of fair value (“VSOE”) exists to allocate revenueto the undelivered elements of the arrangement. The Company reports hardwarerevenue gross in accordance with EITF No. 99-19, *Reporting Revenue Gross as a Principal versus Net asan Agent,* because the factors indicating gross reporting outweighthe factors indicating net reporting. We recognize revenue using the residualmethod of accounting when customer orders contain multiple elements, includingthe sale of licensed software, hardware, maintenance, and professional services.We generally have VSOE for maintenance and professional services, but not forthe software and hardware elements of the order. Under the residual method,services revenue, including maintenance and professional services, is deferredat an amount equal to VSOE until those elements are delivered. Consequently,product revenue for the software and hardware is recognized (i) upondelivery of those products when we have VSOE for the related maintenance andprofessional services sold and (ii) at an amount representing thedifference between the total order amount and the amount deferred. For customerorders that include hardware, hardware revenue is accounted for as a separateunit of accounting in accordance with guidance provided in EITF No. 00-21.

Services revenue includes installation, training,consulting, maintenance and reimbursable travel expenses. Revenue frominstallation, training and consulting services is recognized upon performanceof the related services and is offered and billed as separate elements ofcontracts. Reimbursable travel expenses revenue is recognized upon incurrenceof the related expenses. The functionality of the software and any hardwaresold is not dependent on installation and training services and customizationis not required to enable our customers to use our products. Maintenance isoffered as a separate element and the majority of contracts include the rightto unspecified upgrades on a when-and-if available basis. Maintenance revenueis deferred and recognized ratably over the term of the related maintenancecontract.

Our revenue recognition policy is significant becauseour revenues are a key component of our results of operations. We follow veryspecific and detailed guidelines in measuring revenues; however, certainjudgments and estimates affect the application of our revenue policy describedabove. Further, assessment of collectibility is particularly critical indetermining whether or not revenues should be recognized. We also recordprovisions for estimated sales allowances on product and service relatedrevenues at the time the related revenues are recorded. These estimates arebased on historical sales and services allowances, analysis of customer creditsand other known factors. If future sales credits prove to be greater than thehistorical data and the estimates we used to calculate these provisions, ourrevenues could be overstated.

Deferred revenue consists primarily of amountscollected from customers for products and services that have not met thecriteria for revenue recognition.

F-13

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***Advertising Costs***—Advertisingcosts are expensed as incurred. Advertising expenses were $0.4 million, $0.5million and $0.3 million in 2006, 2005 and 2004, respectively.

***Research andDevelopment Costs***—Research and development costsconsist primarily of personnel and consulting costs involved with productdevelopment and allocated overhead. These costs are expensed as incurred andinclude software development costs incurred prior to the establishment oftechnological feasibility and stock-based compensation expense (in 2006).

***SoftwareDevelopment Costs***—In accordance with SFAS No. 86,*Accounting for the Costs of ComputerSoftware to be sold, leased, or Otherwise Marketed,*softwaredevelopment costs are expensed until technological feasibility of the producthas been established and are capitalized commencing upon the establishment oftechnological feasibility through the time of general release to customers.Amortization of software development costs begins when the product is availablefor general release and is amortized using the greater of: (1) thestraight-line method over the expected life of the product or (2) theratio of current product revenue to the total of current and future productrevenue. At each balance sheet date, the unamortized software development costsare compared to the net realizable value of the underlying product and to theextent any unamortized capitalized costs exceed the net realizable value of theasset, those costs are written off. As of December 31, 2006, and 2005,unamortized software development costs were $1.3 million and $1.2 million,respectively, and are included in other assets on the accompanying ConsolidatedBalance Sheets. During 2006, 2005 and 2004, $0.7 million, $0.5 million and $0.4 millionin software development costs were amortized to cost of product revenue.

***Merger-RelatedCosts and Purchase Price Contingencies******—***Inaccounting for acquisitions, we accrue for certain loss contingencies thatexist at the date of acquisition. We reduce such liabilities as thosecontingencies are resolved or if we determine that the contingency no longerrepresents a probable loss. Any adjustments to these liabilities are reflectedas adjustments to goodwill and/or other acquired assets to the extentinformation was requested but not received at the date of acquisition. Otheradjustments are reflected in our results of operations, except as prescribed byEITF No. 95-3, *Recognition ofLiabilities in Connection with a Purchase Business Combination*.

***Stock-Based Compensation***—OnJanuary 1, 2006, we adopted SFAS No.123(R), *Share-BasedPayment*, which requires the measurement and recognition ofcompensation expense for all share-based payment awards made to employeesincluding employee stock options and shares made available through the employeestock purchase plan based on the grant date fair value of those awards. Wedetermine the fair value of share-based payment awards on the date of grantusing Black-Scholes option-pricing model. The fair value of share-based awards isaffected by stock price as well as assumptions regarding a number of highlycomplex and subjective variables. These variables include, but are not limitedto, our expected stock price volatility over the term of the awards, and actualand projected employee stock option exercise behavior. SFAS No. 123(R) alsorequires that forfeitures be estimated over the vesting period of an award,rather than being recognized as a reduction of compensation expense when theforfeiture actually occurs. We adopted SFAS No. 123(R) using themodified prospective transition method. Our Consolidated Financial Statementsas of December 31, 2006 reflect the impact of SFAS No. 123(R).

In accordance with the modified prospective transitionmethod, our Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS No. 123(R).This statement requires us to estimate the fair value of share-based paymentawards on the date of grant using an option-pricing model. The value of theportion of the award that is ultimately expected to vest is recognized asexpense over the requisite service periods in our Consolidated Statement ofOperations. Stock-based compensation expense recognized under SFAS No. 123(R) forthe year ended December 31, 2006 was $13.8 million. Prior to the adoptionof SFAS No. 123(R), we accounted for stock-based awards to employees usingthe intrinsic value method in accordance with Accounting Principles 

F-14

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Board (“APB”) No. 25,*Accounting for Stock Issued to Employees* as allowed underSFAS No. 123, *Accounting for Stock-BasedCompensation*.

Thefollowing table illustrates the effect on net (loss) income and net (loss)income per share if we had applied the fair value method as prescribed by SFAS No. 123(in thousands, except per share data):

| ** **                                                                                               | ** ** | **Years Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Reported net  (loss) income                                                                              |       | $                                       | (4,571     | ) | $ | 8,678 |   |
| Add: Stock-based  employee compensation expense included in reported net (loss) income, net of  tax      |       | 381                                     |       | 827 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards |       | (13,597                                 | )          | (9,282 | ) |
| Pro forma net  (loss) income                                                                             |       | $                                       | (17,787    | ) | $ | 223 |   |
| Net (loss) income  per share:                                                                            |       |                                    |       |   |   |
| Reported basic                                                                                           |       | $                                       | (0.17      | ) | $ | 0.37 |   |
| Pro forma basic                                                                                          |       | $                                       | (0.65      | ) | $ | 0.01 |   |
| Reported diluted                                                                                         |       | $                                       | (0.17      | ) | $ | 0.33 |   |
| Pro forma diluted                                                                                        |       | $                                       | (0.65      | ) | $ | 0.01 |   |

*** ***

***Income Taxes***—Weaccount for income taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*, whichrequires companies to recognize deferred income tax assets and liabilitiesusing enacted tax rates for the effect of temporary differences between thebook and tax bases of recorded assets and liabilities. The effect on deferredincome tax assets and liabilities of a change in tax rates is recognized inincome in the period that includes the enactment date. SFAS No. 109 alsorequires that deferred income tax assets be reduced by a valuation allowance ifit is more likely than not that some portion or all of the deferred income taxasset will not be realized. We evaluate the realizability of our deferredincome tax assets and establish a valuation allowance to reduce our deferredincome tax assets based on an assessment of the likelihood of theirrealization. We consider certain relevant criteria including deferred income taxliabilities that can be used to offset deferred income tax assets, estimates offuture taxable income of appropriate character within the carry forward periodavailable, and tax planning strategies.

***Net Income (Loss)Per Share***—We calculate net income (loss) per sharepursuant to SFAS No. 128, *Earnings PerShare*. Basic net income (loss) per share is calculated by dividingour net income (loss) by the weighted average number of shares outstandingduring the period. When the effects are not anti-dilutive, diluted net income(loss) per share is computed by dividing our net income (loss) by the weightedaverage number of shares outstanding and the dilutive impact of all dilutivestock options. The dilutive impact of stock options is determined by applyingthe treasury stock method. (See Note 2 for further information.)

***Fair Value ofFinancial Instruments***—At December 31, 2006and 2005, our financial instruments included cash and cash equivalents,investments, accounts receivable and accounts payable. We believe the carryingvalues of cash and cash equivalents, accounts receivable and accounts payableapproximate fair values because of the short-term maturities of theseinstruments. Our investments are carried at fair value.

***Foreign Currency—******Generally,*********the functional currency has beendetermined to be the local currency for our foreign subsidiaries. As a result,those subsidiaries’ assets and liabilities are translated at year-end exchangerates and income statement items are translated at average exchange rates prevailingduring the year. Such translation adjustments are recorded as a component ofstockholders’ equity and other comprehensive income (loss).

F-15

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Net gains (losses) from foreign currency denominatedtransactions are included in interest and other income, net and were ($1.0)million, ($0.2) million and $0.3 million in 2006, 2005 and 2004,respectively.

***Recent AccountingPronouncements—******In***June 2006,the Financial Accounting Standard Board (“FASB”) issued Interpretation (“FIN”) No. 48,*“Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109.”* This Interpretationprescribes a recognition threshold and measurement attribute for the FinancialStatement recognition and measurement of a tax position taken or expected to betaken in a tax return, and provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, and transition.This Interpretation is effective for us as of January 1, 2007. We arecurrently evaluating the impact of adopting FIN No. 48 on our financialposition, cash flows, and results of operations.

In June 2006, the FASB issued EITF No. 06-3,“How Taxes Collected from Customers and Remitted to Governmental AuthoritiesShould Be Presented in the Income Statement (That is, Gross versus NetPresentation)”. This EITF requires disclosure of the accounting policy of anytax assessed by a governmental authority that is directly imposed on arevenue-producing transaction (i.e., sales, use, value added) on a gross(included in revenue and costs) or net (excluded from revenue) basis. This EITFis effective for us as of January 1, 2007. We are currently assessing theimpact of the EITF on our results of operations.

In September 2006, the FASB issued SFAS No. 157,*“Fair Value Measurements”*, which becomeseffective beginning on January 1, 2008. SFAS No. 157 addresses thedefinition of fair value, the methods used to measure fair value and theexpanded disclosures about fair value measurement of a company’s assets andliabilities. SFAS No. 157 requires that the fair value measurement shouldbe determined based on the assumptions that market participants would use inpricing the asset or liability. We are currently assessing the impact of theSFAS No. 157 on our results of operations and financial position.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 108 (“SAB 108”) FinancialStatements*—Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements*, effective for fiscal years ending after November 15,2006. SAB 108 requires the utilization of a dual-approach to assessing thequantitative effects of financial misstatements. This dual approach includesboth an income statement method and a balance sheet method.

F-16

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Upon our adoption of SAB108 as of December 31, 2006, we determined that we needed to record a $1.4million cumulative adjustment, net of tax of $0.5 million, to decrease ouropening accumulated deficit balance for year 2006. This adjustment was tocorrect certain prior year differences that had previously been consideredimmaterial under the Company’s method of evaluating uncorrected misstatementsto the 2005 and 2004 Consolidated Financial Statements, but were consideredmaterial under the dual approach. The following table reflects the mattersincluded in this cumulative adjustment (in thousands):

| **Description**                  | ** ** | ** ** | ** ** | **Cumulative  adjustment** | ** ** | **Nature and timing of the differences**                                                                                                                                                                                      | ** **                                                                                                                                                        |
|----------------------------------|------------|------------|------------|----------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Property and equipment |       |       | $          | 835                        |       |                                                                                                                                                                                                                                                   | The adjustment resulted  from our capitalization policy, which was to expense fixed assets under a  $2,500 threshold, consistently applied over previous periods. |   |
| Prepaid assets                   |       |       | 93         |                       |       | The adjustment resulted  from our accounting policy, which was to expense immaterial prepaid expenses,  consistently applied over previous periods.                                                                                                    |                                                                                                                                                              |
| Accrued expenses                 |       |       | 405        |                       |       | The adjustment resulted  from our accrual policy, which was to accrue each year’s audit fees on a  pro-rata basis throughout the year, consistently applied over previous  periods.                                                               |                                                                                                                                                              |
| Deferred revenue                 |       |       | 518        |                       |       | The adjustment resulted  from our maintenance revenue recognition policy, which was to defer the  initial recognition of maintenance revenue on new orders with start dates  after the first of the month, consistently applied over previous periods. |                                                                                                                                                              |
|                             |       |       | 1,851      |                       |       | The above adjustments  include $0.2 million relating to 2004 and the remainder relates to 2005.                                                                                                                                                   |                                                                                                                                                              |
| Tax effect                       |       |       | (450       | )                          |       |                                                                                                                                                                                                                                                   |                                                                                                                                                              |
| Net effect                       |       |       | $          | 1,401                      |       |                                                                                                                                                                                                                                                   |                                                                                                                                                              |   |

 

**2.**   NetIncome (Loss) Per Share

Thefollowing is a reconciliation of the numerator and denominator used in thecalculation of basic and diluted net income (loss) per share (in thousands,except per share data):

| ** **                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss)                                                                   |       | $                                          | 7,458      |   | $ | (4,571 | ) | $ | 8,678 |   |
| Weighted average shares  of common stock and common stock  equivalents outstanding: |       |                                       |       |   |   |   |   |
| Basic                                                                               |       | 33,687                                     |       | 27,221 |   | 23,361 |   |
| Dilutive effect of stock options computed using the  treasury stock method          |       | 2,846                                      |       | — |   | 2,723 |   |
| Diluted common shares and share equivalents  outstanding                            |       | 36,533                                     |       | 27,221 |   | 26,084 |   |
| Net income (loss) per  share:                                                       |       |                                       |       |   |   |   |   |
| Basic                                                                               |       | $                                          | 0.22       |   | $ | (0.17 | ) | $ | 0.37 |   |
| Diluted                                                                             |       | $                                          | 0.20       |   | $ | (0.17 | ) | $ | 0.33 |   |

 

F-17

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The total number of shareequivalents excluded from the calculations of historical diluted net loss percommon share for 2005 was 2,695,822 calculated using the treasury stock method.(See Note 11 for further information on stock options.) We have excludedall outstanding stock options from the calculation of diluted net loss percommon share for 2005 because we reported a loss in 2005 and all suchsecurities are anti-dilutive. In 2006, 2005 and 2004, 2,634,888, 348,467 and461,087 stock options, respectively, were excluded from the computation ofdiluted earnings per share because they had an anti-dilutive effect.

**3.**   Cashand Cash Equivalents and Investments

Theamortized cost, gross unrealized gain (loss) and fair market value of cash andcash equivalents and investments available for sale as of December 31,2006 and 2005 were as follows (in thousands):

| ** **                        | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|----------------|------------|------------|------------|
| **December 31, 2006**   | ** ** | ** ** | ** ** | **Cost**       | ** ** | **Gain**   | ** ** | **Loss** | ** ** | **Market** | ** ** |
| Cash and cash  equivalents:       |       |       |       |           |       |       |       |   |   |   |   |
| Cash                              |       | $          | 47,735     |           |       | —     |       |   | — |   | $ | 47,735 |   |
| Money market funds                |       | 11,777     |       |           | —     |       |       | — |   | 11,777 |   |
| Commercial paper                  |       | 14,376     |       |           | —     |       |       | — |   | 14,376 |   |
| Total cash and cash equivalents   |       | $          | 73,888     |           |       | —     |       |   | — |   | $ | 73,888 |   |
| Investments:                      |       |       |       |           |       |       |       |   |   |   |   |
| Corporate debt securities         |       | $          | 16,504     |           |       | $          | 6          |   |   | $ | (5 | ) | $ | 16,505 |   |
| U.S. Government agency securities |       | 8,984      |       |           | —     |       |       | (12 | ) | 8,972 |   |
| Commercial paper                  |       | 13,145     |       |           |       |       |       | — |   | 13,145 |   |
| Certificates of deposit           |       | 2,243      |       |           | —     |       |       | — |   | 2,243 |   |
| Auction rate securities           |       | 16,775     |       |           | —     |       |       | — |   | 16,775 |   |
| Total investments                 |       | $          | 57,651     |           |       | $          | 6          |   |   | $ | (17 | ) | $ | 57,640 |   |
|                                   |            |            |            |                |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

| ** **                        | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|----------------|------------|------------|------------|
| **December 31, 2005**   | ** ** | ** ** | ** ** | **Cost**       | ** ** | **Gain**   | ** ** | **Loss** | ** ** | **Market** | ** ** |
| Cash and cash  equivalents:       |       |       |       |           |       |       |       |   |   |   |   |   |   |
| Cash                              |       | $          | 17,115     |           |       | —     |       |   |   | — |   |   | $ | 17,115 |   |
| Money market funds                |       | 68,833     |       |           | —     |       |       |   | — |   |   | 68,833 |   |
| Commercial paper                  |       | 25,803     |       |           | —     |       |       |   | — |   |   | 25,803 |   |
| Total cash and cash equivalents   |       | $          | 111,751    |           |       | —     |       |   |   | — |   |   | $ | 111,751 |   |
| Investments:                      |       |       |       |           |       |       |       |   |   |   |   |   |   |
| Corporate debt securities         |       | $          | 1,433      |           |       | —     |       |   |   | $ | (2 | ) |   | $ | 1,431 |   |
| U.S. Government agency securities |       | 2,326      |       |           | —     |       |       |   | — |   |   | 2,326 |   |
| Commercial paper                  |       | 6,881      |       |           | —     |       |       |   | — |   |   | 6,881 |   |
| Certificates of deposit           |       | 4,248      |       |           | —     |       |       |   | — |   |   | 4,248 |   |
| Total investments                 |       | $          | 14,888     |           |       | —     |       |   |   | $ | (2 | ) |   | $ | 14,886 |   |
|                                   |            |            |            |                |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2006, the fair market value ofinvestments with maturity dates ranging from 91 days to one year totaled$53.6 million and an investment with a maturity date of greater than 1 yeartotaled $4.0 million. The unrealized holding losses of $17,000 at December 31,2006 relates to corporate debt securities with an A plus rating and U.S.Government agency securities with fair market values of $16.5 million and$9.0 million, respectively. As of December 31, 2006, the corporate debtand U.S. Government agency have not been in a loss position for more than12 months, and we believe this impairment to be temporary. At December 31,2005, the fair market value of investments with remaining maturity datesranging from 91 days to one year totaled $13.5 million and aninvestment with a maturity 

F-18

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date of 13 months totaled$1.4 million. The unrealized holding losses of $2,000 at December 31,2005 relates mainly to one corporate debt security with an A plus rating with afair market value of $1.4 million.

We recorded interestincome of $6.4 million, $1.1 million and $1.0 million during 2006,2005 and 2004, respectively.

**4.**   IntangibleAssets

Thefollowing tables present the components of intangible assets (in thousands):

| ** **                 | ** ** | **December 31, 2006** | ** ** |
|----------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**               | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Acquired  technology       |       | $                               | 44,975     |   |   | $ | 26,746 |   |   | $ | 18,229 |   |
| Customer  relationships    |       | 30,929                          |       |   | 11,486 |   |   | 19,443 |   |
| Distribution  arrangements |       | 4,360                           |       |   | 3,287 |   |   | 1,073 |   |
| Other intangible  assets   |       | 4,197                           |       |   | 1,660 |   |   | 2,537 |   |
|                       |       | $                               | 84,461     |   |   | $ | 43,179 |   |   | $ | 41,282 |   |

 

| ** **                 | ** ** | **December 31, 2005** | ** ** |
|----------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**               | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Acquired  technology       |       | $                               | 35,979     |   |   | $ | 17,762 |   |   | $ | 18,217 |   |
| Customer  relationships    |       | 21,506                          |       |   | 5,558 |   |   | 15,948 |   |
| Distribution  arrangements |       | 4,263                           |       |   | 2,369 |   |   | 1,894 |   |
| Other intangible  assets   |       | 1,515                           |       |   | 1,185 |   |   | 330 |   |
|                       |       | $                               | 63,263     |   |   | $ | 26,874 |   |   | $ | 36,389 |   |

 

Theincrease in the intangible assets balances in 2006 is primarily due toacquisitions discussed in Note 6. The increase in the intangible assetsbalances in 2005 is due to the acquisition of Blue Pumpkin and Optimis asdiscussed in Note 5. The acquired technology, distribution arrangementsand customer lists are being amortized using the straight-line method over oneto seven years, and the other intangibles assets, which include trademarks,patents and non-compete agreements, are being amortized using the straight-linemethod over two to five years. The intangible assets and related amortizationexpenses are subject to foreign currency translation and deferred income taxadjustments. Foreign currency translation resulted in approximately $2.1 million increase in accumulatedamortization during 2006. Amortization of intangible assets included in theaccompanying Consolidated Statements of Operations is as follows (inthousands):

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Included in:                                |       |                                       |       |   |   |   |   |
| Cost of product revenue                     |       | $                                          | 7,402      |   | $ | 9,154 |   | $ | 4,441 |   |
| Selling, general and administrative expense |       | 6,738                                      |       | 6,047 |   | 1,470 |   |
|                                        |       | $                                          | 14,140     |   | $ | 15,201 |   | $ | 5,911 |   |

 

F-19

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Theestimated future amortization expense of the intangible assets as of December 31,2006 is as follows (in thousands):

| 2007   |   | $      | 16,829 |   |
|--------|--------|--------|--------|--------|
| 2008   |   | 14,583 |   |
| 2009   |   | 4,266  |   |
| 2010   |   | 1,831  |   |
| 2011   |   | 1,588  |   |
|   |   | $      | 39,097 |   |

 

**5.**   BluePumpkin and Optimis Acquisitions

On January 24, 2005, we acquired Blue PumpkinSoftware, Inc. (“Blue Pumpkin”), a privately held California corporation.With this acquisition, we expanded our workforce optimization solution toinclude advanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications. Pursuant to ourMerger Agreement and Plan of Reorganization, dated December 16, 2004, withBlue Pumpkin (the “Blue Pumpkin Merger Agreement”), we paid $36 million in cashwhich was funded from our existing cash and investments and issued 1.9 millionshares of Witness’ common stock valued at $33.5 million (measured based onthe date the stock consideration became fixed pursuant to the application of aformula specified in the Blue Pumpkin Merger Agreement). On May 24, 2005,the shares issued in connection with the acquisition were registered for resalewith the Securities and Exchange Commission. Pursuant to the Blue PumpkinMerger Agreement, cash of $4.0 million and 210,000 shares of common stockvalued at approximately $3.7 million on the date of acquisition were placedinto an escrow fund to compensate Witness, subject to certain limitations, forpotential losses that could result from, among other things, the IEX litigationand other specified litigations, and breaches of Blue Pumpkin’srepresentations, warranties or covenants in the Blue Pumpkin Merger Agreement.

On December 15, 2005, Tekelec, IEX’s parentcompany, and Witness reached a tentative agreement to settle all claimsasserted between them. As part of the final settlement entered into in April 2006,Witness made payment of $8.25 million to Tekelec, and agreed to make six annualpayments of $0.5 million ($3.0 million in total) from April 2007 through2012. In accordance with APB No. 21, *Intereston Receivables and Payables,* we recorded a $0.7 million discount representing the difference betweenthe face value and the present value of the $3.0 million. The escrow fund wasreleased to Witness during March 2006 in satisfaction and settlement ofclaims that Witness brought against the escrow fund, including claims forlosses resulting from the settlement of the IEX litigation. As part of theagreement to release the escrow, Witness issued shares of common stock forproceeds of approximately $3.1 million. These shares were issued at a discountof approximately $1.35 million, which was recorded as a charge to earnings inour Consolidated Statement of Operations for the year ended December 31,2006.

Wecommenced consolidation of Blue Pumpkin on January 25, 2005 and theacquisition was accounted for using the purchase method of accounting inaccordance with SFAS No. 141,*BusinessCombinations*. The following summarizes the total purchase price forBlue Pumpkin (in thousands):

| Value of Witness  Systems, Inc. common stock issued |   | $      | 33,500 |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Cash  consideration                                      |   | 36,000 |   |
| Direct  acquisition costs                                |   | 5,400  |   |
|                                                     |   | $      | 74,900 |   |

 

F-20

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Underthe purchase method of accounting, the total purchase price is allocated toBlue Pumpkin’s net tangible and intangible assets based upon their estimatedfair value as of the date of the acquisition with any amount paid in excess ofthe fair value of the net assets recorded as goodwill. Based upon the purchaseprice and review of the net assets acquired and liabilities assumed, thepurchase price allocation, is as follows (in thousands):

| Cash and  investments                |   | $       | 3,900  |   |
|--------------------------------------|--------|---------|--------|--------|
| Other current  assets                |   | 6,400   |   |
| Property and  equipment, net         |   | 700     |   |
| Acquired  technology                 |   | 21,000  |   |
| Customer  relationships              |   | 17,000  |   |
| Goodwill                             |   | 34,400  |   |
| In-process  research and development |   | 9,000   |   |
| Other long term  assets              |   | 400     |   |
| Total assets acquired                |   | 92,800  |   |
| Current  liabilities                 |   | (3,600  | )      |
| Litigation  accrual                  |   | (11,200 | )      |
| Deferred revenue                     |   | (1,700  | )      |
| Restructuring  accruals              |   | (1,400  | )      |
| Total liabilities assumed            |   | (17,900 | )      |
|                                 |   | $       | 74,900 |   |

 

The fair values of identifiable intangible assets weredetermined with the assistance of Taylor Consulting Group, Inc., anindependent third-party appraiser using both an income and a cost approachtaking into consideration the nature, risks, historical patterns, economiccharacteristics, and future considerations of the assets. As of the closingdate of the merger, technological feasibility of the in-process research anddevelopment (“IPR&D”) had not been established and the technology had noalternative future use. Accordingly, we charged the value of the IPR&D atthe date of the acquisition to expense. The amount of the purchase priceallocated to IPR&D was based on established valuation techniques used inthe software industry. The fair value assigned to the acquired IPR&D wasdetermined using a discounted cash flow methodology, which discounts expectedfuture cash flows to present value.

The key assumptions used in the valuation include,among others, expected completion date of the in-process projects identified asof the acquisition date, estimated cost to complete the projects, revenuecontributions and expense projections assuming the resulting product hasentered the market, and discount rates based on the risks associated with thedevelopment life cycle of the in-process technology acquired. The discountrates used in the present value calculations are obtained from aweighted-average cost of capital analysis, adjusted upward to account for theinherent uncertainties surrounding the successful development of the IPR&D,the expected profitability levels of such technology, and the uncertainty oftechnological advances that could potentially impact the estimates. We assumethe pricing model for the resulting product of the acquired IPR&D to bestandard within its industry. We did not take into consideration anyconsequential amount of expense reductions from integrating the acquiredIPR&D with other existing in process or completed technology.

The key considerations underlying the valuation ofacquired in-process research and development from Blue Pumpkin are as follows:a) guidance from SFAS No. 2,*Accountingfor Research and Development Costs* and FASB Interpretation No. 4,*Applicability of FASB Statement No. 2 toBusiness Combinations Accounted for by the Purchase Method*; b)percent completed as of the acquisition date; c) estimated costs to date,as well as costs to complete the technology; and d) the numerous technical,cost, market, and timing risks we face before the technology becomestechnologically feasible.

F-21

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Unauditedpro forma information reflecting the acquisition of Blue Pumpkin as if it occurredon January 1, 2004 is as follows (in thousands, except per share amounts):

| ** **                                | ** ** | **Year ended  December 31,** | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Total revenues                            |       | $                                      | 186,403    |   | $ | 175,213 |   |
| Net income (loss)                         |       | $                                      | 2,039      |   | $ | (4,508 | ) |
| Net income (loss)  per share—basic   |       | $                                      | 0.07       |   | $ | (0.18 | ) |
| Net income (loss)  per share—diluted |       | $                                      | 0.07       |   | $ | (0.18 | ) |
| Weighted average  shares—basic       |       | 27,396                                 |       | 25,251 |   |
| Weighted average  shares—diluted     |       | 29,943                                 |       | 25,251 |   |

 

The pro forma results include adjustments for theamortization expense of intangible assets arising from the acquisition and thereversal of interest income assuming the cash portion of the purchase was paidfrom available cash. In addition, the pro forma results do not reflect anyadjustments for IPR&D charges, because of their non-recurring nature, andcost savings and synergies that we believe would have resulted had theacquisition occurred on January 1, 2005.

On May 23, 2005, weacquired Optimis Group Limited (“Optimis”), a UK-based provider of workforceoptimization software solutions. Blue Pumpkin owned a minority interest in anoperating subsidiary of Optimis, the balance of which was acquired through theOptimis acquisition. We paid $5.0 million in cash and other consideration,which was financed from our existing cash and investments. Ten percent of theaggregate merger consideration was held in escrow and was released in August 2006to Optimis shareholders. Acquisition of Optimis resulted in $5.3 million inadditional goodwill.

**6.**   OtherAcquisitions

*Acquisition ofDemos*

On October 2, 2006, we acquired Demos, a leadingproductivity solution provider for the financial services industry. The totalpurchase consideration in 2006 for Demos was cash of approximately $6.3million, including $0.3 million earned in 2006 as part of the potential for anearn-out of approximately $18.0 million based on the growth of the businessover the next several years. Ten percent (10%) of the initial considerationplus ten percent (10%) of any earn-out earned will be held in escrow until October 2,2007, or longer, if claims are brought against the escrow fund and remainpending on that date. The escrow fund will be available to indemnify Witnessfor losses resulting from, among other things, breaches of representations,warranties and covenants.

Wecommenced the consolidation of Demos on October 2, 2006 and theacquisition was accounted for using the purchase method of accounting inaccordance with SFAS No. 141. The following summarizes the total preliminarypurchase price for Demos (in thousands):

| Cash  consideration       |   | $   | 6,330  |   |
|---------------------------|--------|-----|--------|--------|
| Direct  acquisition costs |   | 386 |   |
|                      |   | $   | 6,716  |   |

 

F-22

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Underthe purchase method of accounting, the total purchase price is allocated toDemos’ net tangible and intangible assets based upon their estimated fair valueas of the date of the acquisition with any amount paid in excess of the fairvalue of the net assets recorded as goodwill. Based upon the purchase price andreview of the net assets acquired and liabilities assumed, the purchase priceallocation, is as follows (in thousands):

| Cash and  investments        |   | $     | 355    |   |
|------------------------------|--------|-------|--------|--------|
| Other current  assets        |   | 817   |   |
| Property and  equipment, net |   | 100   |   |
| Acquired  technology         |   | 1,400 |   |
| Customer  relationships      |   | 3,300 |   |
| Other intangible  assets     |   | 700   |   |
| Goodwill                     |   | 822   |   |
| Total assets acquired        |   | 7,494 |   |
| Current liabilities          |   | (778  | )      |
| Total liabilities assumed    |   | (778  | )      |
|                         |   | $     | 6,716  |   |

 

*Acquisition ofExametric*

On October 2, 2006, we acquired Exametric, aleading software solutions company specializing in workforce management andoptimization for the financial services industry. The total consideration paidfor Exametric was cash of approximately $23 million. Approximately $2.4 millionof the aggregate consideration will be held in escrow until October 2, 2007,or longer, if claims are brought against the escrow fund and remain pending onthat date. The escrow fund will be available to indemnify Witness for lossesresulting from, among other things, breaches of representations, warranties,covenants and certain transaction costs.

Wecommenced the consolidation of Exametric on October 2, 2006 and theacquisition was accounted for using the purchase method of accounting inaccordance with SFAS No. 141. The following summarizes the totalpreliminary purchase price for Exametric (in thousands):

| Cash  consideration       |   | $   | 23,000 |   |
|---------------------------|--------|-----|--------|--------|
| Direct  acquisition costs |   | 431 |   |
|                      |   | $   | 23,431 |   |

 

F-23

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Underthe purchase method of accounting, the total purchase price is allocated toExametric’s net tangible and intangible assets based upon their estimated fairvalue as of the date of the acquisition with any amount paid in excess of thefair value of the net assets recorded as goodwill. Based upon the purchaseprice and review of the net assets acquired and liabilities assumed, thepurchase price allocation, is as follows (in thousands):

| Cash and  investments                |   | $      | 330    |   |
|--------------------------------------|--------|--------|--------|--------|
| Other current  assets                |   | 1,166  |   |
| Acquired  technology                 |   | 2,000  |   |
| Customer  relationships              |   | 5,300  |   |
| Other intangible  assets             |   | 500    |   |
| Goodwill                             |   | 14,848 |   |
| In-process  research and development |   | 760    |   |
| Other assets                         |   | 94     |   |
| Total assets acquired                |   | 24,998 |   |
| Current liabilities                  |   | (1,239 | )      |
| Deferred revenue                     |   | (328   | )      |
| Total liabilities assumed            |   | (1,567 | )      |
|                                 |   | $      | 23,431 |   |

 

The fair values ofExametric and Demos identifiable intangible assets were determined using bothan income and a cost approach taking into consideration the nature, risks,historical patterns, economic characteristics, and future considerations of theassets.

*Other Acquisitionand Investment*

In addition to the above, weacquired another company and made an investment in a technology-related companyduring 2006. The acquisition resulted in $4.6 million in additional goodwill.In accordance with APB No. 18, *“TheEquity Method of Accounting for Investments in Common Stock*”, theinvestment in the technology-related company was accounted for using the costmethod of accounting and is included in other assets on the ConsolidatedBalance Sheet as of December 31, 2006. The pro forma effect of the 2006acquisitions were not material to our Consolidated Financial Statements.

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**7.**   Acquisition-RelatedRestructuring Accruals and Merger-Related and Integration Costs

As aresult of the Demos and Exametric acquisitions in 2006, we recorded $0.2million in acquisition-related restructuring accruals related to personnelreductions. As a result of the Blue Pumpkin and Optimis acquisitions in 2005,we recorded $ 2.4 million in certain acquisition-related restructuringaccruals primarily related to personnel reductions. All such costs met thecriteria for accrual as outlined in EITF No. 95-3, *Recognition of Liabilities in Connection with aPurchase Business Combination,* and were included in the assetsacquired and liabilities assumed in the purchase of Demos, Exametric, BluePumpkin, Optimis and Eyretel. The following table summarizes the restructuringaccrual activity (in thousands):

| ** **                                 | ** ** | **Severance  and Benefits** | ** ** | **Facilities** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|----------------|------------|-----------|------------|
| Accrual at  December 31, 2004         |       |                             | $          | —         |       |      |       | $ | 2,044 |   |   | $ | 2,044 |   |
| Acquisition-related restructuring accruals |       |                             | 1,972      |           |       |      | 462        |   |   | 2,434 |   |
| Cash payments                              |       |                             | (1,976     | )              |       |      | —     |   |   | (1,976 | ) |
| Amounts credited to rent expenses          |       |                             | —     |           |       |      | (223       | ) |   | (223 | ) |
| Foreign exchange translation               |       |                             | 4          |           |       |      | (210       | ) |   | (206 | ) |
| Accrual at  December 31, 2005         |       |                             | —     |           |       |      | 2,073      |   |   | 2,073 |   |
| Acquisition-related restructuring accruals |       |                             | 153        |           |       |      |       |   |   | 153 |   |
| Cash payments                              |       |                             | (81        | )              |       |      |       |   |   | (81 | ) |
| Amounts credited to rent expenses          |       |                             |       |           |       |      | (518       | ) |   | (518 | ) |
| Foreign exchange translation               |       |                             |       |           |       |      | 216        |   |   | 216 |   |
| Accrual at  December 31, 2006         |       |                             | 72         |           |       |      | 1,771      |   |   | 1,843 |   |
| Less: Long-term portion                    |       |                             | —     |           |       |      | 1,469      |   |   | 1,469 |   |
| Current portion at  December 31, 2006 |       |                             | $          | 72             |       |      |       | $ | 302 |   |   | $ | 374 |   |

 

Thefollowing table summarizes all merger-related and integration costs that werecharged to expense during the years ended December 31, 2006, 2005 and 2004(in thousands):

| ** **                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Exametric and  Demos:                |       |     |       |     |       |     |       |
| Merger-related and integration costs |       | $        | 510        |     | $          | —   |       | $ | — |   |
| Blue Pumpkin and  Optimis:           |       |     |       |     |       |     |       |
| Merger-related and integration costs |       | 2,192    |       | 4,433    |       | 203      |       |
| Eyretel:                             |       |     |       |     |       |     |       |
| Merger-related and integration costs |       | —   |       | —   |       | (543     | )          |
| Retention bonus expense              |       | —   |       | 99       |       | 838      |       |
|                                 |       | $        | 2,702      |     | $          | 4,532    |       | $ | 498 |   |

 

During 2006, we incurred merger-related andintegration costs in the amount of $2.2 million pertaining to the acquisitionsof Blue Pumpkin and Optimis. These expenses were primarily associated with legal and professional fees and a discount onshares sold to the Blue Pumpkin shareholders in connection with the IEXsettlement. We also incurred merger-related and integration costs in theamount of $0.5 million pertaining to the acquisitions of Demos and Exametric.During 2005, we incurred merger-related and integration costs pertaining to theacquisitions of Blue Pumpkin and Optimis comprised primarily of legal costs,transitional employees and other contractors, and travel and advertising costs.Merger-related and integration costs incurred in 2004 totaled $0.5 million andrelated to the acquisition of Eyretel.

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**8.**   AccruedExpenses

Accruedexpenses consisted of the following (in thousands):

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Accrued  commissions, compensation and benefits |       | $                     | 10,661     |   | $ | 8,322 |   |
| Other accrued  acquisition liabilities          |       | 1,702                 |       | 936 |   |
| Legal accruals                                  |       | 3,172                 |       | 11,759 |   |
| Other accrued  expenses                         |       | 8,721                 |       | 8,634 |   |
|                                            |       | $                     | 24,256     |   | $ | 29,651 |   |

 

**9.**   Lineof Credit

In March 2007, we reduced our line of credit from$15.0 million to $2.0 million and extended the maturity date on the $2.0million line of credit to March 2008. At our election, borrowings underthe line of credit bear interest at the bank’s prime rate, which was 8.25% on December 31,2006, or LIBOR plus 300 basis points. Borrowings under the revolving lineof credit are limited to 85% of eligible accounts receivable, as defined by theagreement. The revolving line of credit is secured by all of our assets andrequires compliance with various covenants, including liquidity ratios andEBITDA requirements, among others. As of December 31, 2006, we were incompliance with all bank covenants.

As of December 31,2006, we had no amounts outstanding under the line of credit and the amountavailable for borrowing was $14.0 million, which was net of outstandingletters of credit of $1.0 million. The letters of credit secure the lease onour corporate headquarters facility and have decreasing schedules thatultimately expire in 2007. In addition, we have a £0.3 million ($0.6 million)letter of****credit securing our leased premises inthe United Kingdom.

**10.**   Stockholders’Equity

***Accumulated Comprehensive Income******—******Accumulated***othercomprehensive income consisted of the following (in thousands):

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cumulative  foreign currency translation adjustments |       | $                     | 6,524      |   | $ | 3,078 |   | $ | 4,953 |   |
| Unrealized loss  on investments                      |       | (11                   | )          | (2 | ) | (11 | ) |
|                                                 |       | $                     | 6,513      |   | $ | 3,076 |   | $ | 4,942 |   |

 

***Stock Repurchases******—In*** 2002,our Board of Directors authorized a stock repurchase program to spend up to$10.0 million to repurchase our common stock. As of December 31,2006, we had repurchased 1.0 million shares of our common stock for$3.1 million, which were retired. The Company has not repurchased itscommon stock since 2003 and does not presently plan to repurchase additionalcommon stock.

***Sale of Additional Shares of Common Stock******—In*** December 2005,we issued 4.7 million additional shares of common stock resulting in $88.8million in net proceeds.

**11.**   Stock-Based Compensation and Employee Benefit Plans

Effective January 1, 2006, we adopted SFAS No. 123(R) usingthe modified prospective application transition method. SFAS No. 123(R) requiresus to estimate the fair value of share-based payment awards on the date ofgrant using an option-pricing model. The value of the portion of the award thatis ultimately expected to vest is recognized as expense over the requisiteservice period. We recognize stock-based 

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compensation expense overthe awards’ vesting periods using the accelerated method as provided for by FINNo. 28, *Accounting for Stock Appreciation Rights andOther Variable Stock Option or Award Plans*. Prior to the adoption ofSFAS No. 123(R), we accounted for stock-based awards to employees usingthe intrinsic value method in accordance with APB No. 25 as allowed underSFAS No. 123.

Our net income (loss) for the years ended December 31,2006, 2005 and 2004 includes $13.8 million, $0.4 million and $0.8 million,respectively, of stock-based compensation expense and $0.2 million in 2006,2005 and 2004, of related income tax benefits recorded to additionalpaid-in-capital. Cash received from stock option exercises for the years ended December 31,2006, 2005 and 2004 was $12.4 million, $10.5 million and $13.0 million,respectively.

As of December 31, 2006, there was $14.7 millionof total unrecognized stock-based compensation expense related to unvestedshare-based compensation arrangements granted under all stock option plans.That cost is expected to be recognized over a weighted-average period of 1.2years.

Asummary of all stock option plans activity as of December 31, 2006 is asfollows:

| ** **                                                  | ** ** | **Number  of Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value (a)  000’s** | ** ** |
|-------------------------------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|-----------------------------------------------------|------------|------------------------------------------------------|------------|
| Outstanding as of  December 31, 2005                   |       | 8,570,696                  |       |                                    | 10.98      |                                                |       |                                                 | 5.5 years  |   |   |   | $ | 74,667 |   |   |
| Granted                                                     |       | 2,970,250                  |       |                                    | 18.94      |                                                |       |                                                 |       |   |   |   |   |   |   |
| Exercised                                                   |       | (1,334,921                 | )          |                                    | 8.73       |                                                |       |                                                 |       |   |   |   |   |   |   |
| Forfeited                                                   |       | (709,831                   | )          |                                    | 16.08      |                                                |       |                                                 |       |   |   |   |   |   |   |
| Expired                                                     |       | (60,707                    | )          |                                    | 14.61      |                                                |       |                                                 |       |   |   |   |   |   |   |
| Outstanding as of  December 31, 2006                   |       | 9,435,487                  |       |                                    | 13.39      |                                                |       |                                                 | 4.4 years  |   |   |   | $ | 46,046 |   |   |
| Vested + Expected to vest as of December 31,  2006 (b) |       | 8,458,536                  |       |                                    | $          | 12.91                                               |       |                                                 |       | 4.5 years |   |   |   | $ | 44,957 |   |   |
| Exercisable as of  December 31, 2006                   |       | 4,083,122                  |       |                                    | $          | 9.76                                                |       |                                                 |       | 4.7 years |   |   |   | $ | 32,879 |   |   |

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(a)           The aggregate intrinsicvalues were computed by applying the following formula = (market value of anoption as of December 31, 2006 - the exercise price at which the optionwas granted) x the number of common stock options.

(b)          The number of sharesvested + expected to vest as of December 31, 2006 is computed by applyingthe following formula = Number of shares vested as of December 31, 2006 +(shares not vested as of December 31, 2006*[100%-forfeiture rate])

F-27

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Thefollowing table summarizes information about stock options outstanding andexercisable as of December 31, 2006:

| **Outstanding**                             | ** ** | **Exercisable** | ** ** |
|---------------------------------------------|------------|-----------------|------------|
| **Range of Exercise Prices** | ** ** | ** **      | ** ** | **Number  of shares** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
| $1.42 - $6.00                               |       | 1,994,921       |       |   | 5.3 years |   |   |   | $ | 4.16 |   |   | 1,360,567 |   |   | $ | 3.60 |   |   |
| $6.25 - $11.95                              |       | 1,733,172       |       |   | 4.8 years |   |   |   | 9.35 |   |   | 1,274,319 |   |   | 8.98 |   |   |
| $12.15 - $16.97                             |       | 2,700,310       |       |   | 4.0 years |   |   |   | 16.05 |   |   | 1,048,754 |   |   | 15.26 |   |   |
| $17.25 - $34.00                             |       | 3,007,084       |       |   | 4.1 years |   |   |   | 19.45 |   |   | 399,482 |   |   | 18.85 |   |   |
|                                        |       | 9,435,487       |       |   | 4.4 years |   |   |   | $ | 13.39 |   |   | 4,083,122 |   |   | $ | 9.76 |   |   |

 

Thetotal intrinsic value of stock options exercised in 2006, 2005 and 2004 is asfollows (in thousands):

| ** **                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Total intrinsic  value of stock options exercised |       | $        | 17,297     |     | $          | 17,105   |       | $ | 17,421 |   |
|                                                   |            |          |            |          |            |          |            |  |  |  |

 

The weighted-averagegrant date fair value of stock options granted during 2006, 2005 and 2004 was$7.47, $7.52 and $5.77 per share, respectively. The weighted-average grant datefair values were determined using the Black-Scholes option-pricing model withthe following weighted-average assumptions:

| ** **                  | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-----------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Expected term of  option(1) |       | 3.3 years |       | 3.5 years |       | 2.5 years |       |
| Volatility(2)               |       | 52        | %          | 53        | %          | 88        | %          |
| Forfeiture(3)               |       | 16.2      | %          | —    | %          | —    | %          |
| Risk-free  interest rate(4) |       | 4.6       | %          | 3.9       | %          | 3.1       | %          |
| Expected dividend yield     |       | 0         | %          | 0         | %          | 0         | %          |

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(1)          Theexpected term of employee stock options represents the weighted-average periodthe stock options are expected to remain outstanding. The following factorswere considered in estimating the expected term using the Black-Scholes model:

·       Thevesting period of the awards

·       Employees’past exercise and post-vesting employment departure behavior

·       Expectedvolatility of the price of the underlying share

(2)          We used 3.3 yearhistorical stock-price volatility as the expected volatility assumption whichaligns with the expected term of the options granted during the year ended December 31,2006. We believe that historical volatility reflects our current assessment ofexpected volatility. Prior to 2006, we used historical stock price volatilityin accordance with SFAS No. 123 for purposes of our pro forma disclosure.

(3)          The forfeiture rates aredetermined taking into consideration historical forfeiture rates. SFAS No. 123(R) requiresforfeitures be estimated at the time of option grants and revised, asnecessary, in subsequent periods if actual forfeitures differ from thoseestimates. Prior to adoption of SFAS No. 123(R), our pro forma disclosuresaccounted for actual forfeitures as they occurred.

(4)          The risk-free interestrate assumptions are based on the rate currently available on zero-coupon U.S.Treasury instruments with a remaining term equal to the expected term of theshare option.

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***Stock Incentive Plans******—We***havethree stock incentive plans: (i) the 1999 Stock Incentive Plan (the “1999Plan”); (ii) the 2003 Broad Based Option Plan (the “2003 Plan”); and (iii) the2003 Non-employee Director Stock Option Global Plan (the “Director Plan”).

*1999 Plan—**Under*the 1999 Plan,we may grant shares of common stock in the form of stock options, restrictedstock awards, or stock appreciation rights to employees and key personsaffiliated with Witness, as defined. In 2001, our stockholders modified aprovision to increase, without further approval required, the number of sharesauthorized each year beginning on January 1, 2002 by a number equal to thelesser of 10% of the total number of shares of common stock then outstanding or3,000,000 shares. As of December 31, 2006, we had 1,213,942 sharesavailable for future grant.

In 2003, we adopted theDirector and Key Executive Stock Ownership Incentive Policy (the “Policy”)under the 1999 Plan. The Policy intended to promote the interests of Witnessand its stockholders by encouraging members of the Board of Directors and keyexecutives to purchase shares of our common stock. Under the Policy, aneligible person who purchased at least 500 shares and up to 3,000 shares of ourcommon stock in the open market was automatically and immediately granted fiveoptions from our 1999 Plan for each share purchased, with an exercise priceequal to the closing price of our common stock on the date of purchase.One-half of the options vested on the first anniversary of the grant date, andthe remaining options vested in 12 equal monthly installments thereafter. ThePolicy expired on June 15, 2004 and 122,500 options were granted underthis Policy.

During 2005, 603,500 stockoptions were granted to certain Blue Pumpkin and Optimis employees as aninducement to join Witness. During 2006, 469,000 stock options were granted to certainDemos and Exametric employees as an inducement to join Witness. The inducementoptions are exercisable for five years from the date of grant and will firstbecome exercisable, as to 25 percent of the total amount, after one year fromthe date of grant, and commencing 13 months after grant and until the end ofthe 47th month following grant, the options will become exercisable as to anadditional two percent per month and the balance upon the 48th month followinggrant.

*2003 Plan—**In*connection with theEyretel acquisition, we established the 2003 Plan for former Eyretel employees.The 2003 Plan became effective in June 2003, allowing us to grant sharesof common stock in the form of stock options. As of December 31, 2006, wehad 414,333 shares available for future grant. We do not anticipate increasingthe number of shares available for issuance under the 2003 Plan.

*Director Plan—**The*Director Planbecame effective in 2003, allowing us to grant non-employee members of our Boardof Directors non-qualified options to purchase shares of our common stockpursuant to a formula award. As of December 31, 2006, we had 352,000shares available for future grant.

Each plan remains ineffect until the earlier of the tenth anniversary of its effective date or thedate on which all reserved shares have been issued or are no longer availablefor use. Option vesting terms typically range from two to four years. Optionsgranted since July 1, 2004, have five-year terms from the date of grant.Options granted prior to July 1, 2004 have ten-year terms from the date ofthe grant. The 1999 Plan and the 2003 Plan provide for accelerated vesting inthe event that an employee is terminated without cause or for good reasonfollowing a change in control. The Director Plan provides for acceleratedvesting upon a change of control. To the extent that accelerated vesting of optionsoccurs, we may have a future charge. Our policy is to issue new shares uponshare option exercise.

***Employee Stock Purchase Plan—****The*Employee StockPurchase Plan (“ESPP”) allows our employees to elect up to 15% of their pay to purchasethrough payroll deductions shares of common stock at a price per share of 95%of the fair market value at the end of each quarterly option period. The ESPPincludes a provision to increase, without further approval required, the numberof shares authorized each year on January 1 by a number equal to thelesser of 2% of the total number of shares of common stock then outstanding or900,000 shares. As of December 31, 2006, 510,952 shares of common stockhave been issued under the ESPP.

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***Retirement Plans—******We*********have a U.S. tax-qualifieddefined contribution plan under Section 401(k) of the InternalRevenue Code (the “401(k) Plan”). Employees are eligible to participatethe first of the month following their date of hire. The 401(k) Planallows participants to contribute up to 100% of eligible compensation, subjectto U.S. Internal Revenue Service limitations. The 401(k) Plan alsoprovides for discretionary employer matching contributions. We also have apersonal savings plan (“Savings Plan”) for our United Kingdom employees. Inaccordance with the Inland Revenue limitations, employees are eligible toinvest of up to 35% of base salary in the Savings Plan, which includes employercontributions ranging from 5% to 7% of employee compensation. We contributed$0.6 million, $0.5 million and $0.8 million to the 401(k) Planand Savings Plan in 2006, 2005 and 2004, respectively.

***Stockholder’sRights Plan—******We*****have a stockholder rights plan (the “Rights Plan”) whichhas the effect of causing substantial dilution to a person or group thatattempts to acquire Witness on terms not approved by the Board of Directors.Under the Rights Plan, we issued a dividend of one right for each share of ourcommon stock, par value of $0.01 per share, held by stockholders of record asof the close of business on November 4, 2002. Each right will entitlestockholders to purchase one unit of a share of our Series A JuniorParticipating Preferred Stock for $25.00. The rights generally will beexercisable only upon the occurrence of certain events, and will expire on November 4,2012 unless earlier terminated.

Prior to entering into the Merger Agreement, on February 11,2007, our Board of Directors adopted and approved an amendment to the RightsPlan, which amends certain sections and definitions of the Rights Plan therebyrendering the Rights Plan inapplicable to the acquisition by Verint or itsaffiliates of shares of Witness common stock in connection with the merger.

As a result of the amendment, (1) the preferredstock purchase rights issued under the Rights Plan will be inapplicable to themerger, the Merger Agreement and the other transactions contemplated by theMerger Agreement, (2) the merger will not cause the rights to separatefrom the shares of our common stock or permit the our stockholders to exercisethe rights, and (3) the preferred stock purchase rights issued under theRights Plan will expire immediately prior to the effective time of the merger.

The Rights Plan has no present dilutive effect on ourcapital structure, nor does it affect reported earnings per share or change theway our shares of common stock are traded. Neither the adoption of the RightsPlan, nor the dividend distribution of the rights, was taxable to ourshareholders or Witness.

***Change of Control—******Our*****senior officers, including our named executive officers,have change of control agreements, which in general, provide the officers withseverance benefits in the event of a change in control as defined. Theagreements provide for Witness to pay the officer a multiple of his, or her,base salary and target bonus, in a lump sum, as well as a minimum pro ratabonus for the year in which the change of control occurs, and payment of COBRAcontinuation coverage (for all but two officers), life insurance premiums andlong-term disability insurance premiums for a fixed period of time. Inaddition, most of the agreements provide for a gross-up payment for U.S.federal “golden parachute” excise taxes that might result from the receipt ofthe severance payments. The severance payments vary by seniority, and involvemultiples of 1.0 or 1.5 times the sum of base salary and bonus. In the changeof control agreements other than those for our Chief Executive Officer (“CEO”)and Chief Financial Officer (“CFO”), payments are made only if there is both achange of control of Witness and a termination of employment of the officerwithout cause (or a constructive termination) as determined by the terms of therespective agreements.

**12.**   IncomeTaxes

Income (losses) before income taxes from U.S.operations were ($6.5) million, ($1.3) million and $10.2 million in2006, 2005 and 2004, respectively. Income (losses) before income taxes fromforeign operations were $10.2 million, ($0.2) million and ($1.2) million in2006, 2005 and 2004, respectively.

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We recorded a provision for income tax benefit of($3.8) million during the year ended December 31, 2006, of which ($4.7)million relates to the provision for foreign deferred taxes. Specifically,($4.4) million relates to the release of the valuation allowance againstdeferred tax assets for Witness Systems Ltd. The remaining provision consistsof $0.2 million for the U.S. federal alternative minimum income tax(“AMT”), $0.2 million for foreign withholding income taxes, and $0.2 millionfor other taxes. For the same periods during 2005 and 2004, the tax expense of$3.0 million and $0.3 million, respectively, was primarily related to deferredtax expense resulting from the release of the valuation allowance associatedwith the acquired deferred income tax assets of Blue Pumpkin, and foreignincome tax.

Thecomponents of the provision for income tax expense for 2006, 2005 and 2004 areas follows (in thousands):

| ** **       | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal          |       | $        | 209        |     | $          | 235      |       | $ | 213 |   |
| State            |       | 112      |       | —   |       | —   |       |
| Foreign          |       | 627      |       | 535      |       | 186      |       |
| Total current    |       | 948      |       | 770      |       | 399      |       |
| Federal deferred |       | —   |       | 2,454    |       | —   |       |
| Foreign deferred |       | (4,700   | )          | (200     | )          | (87      | )          |
| Total deferred   |       | (4,700   | )          | 2,254    |       | (87      | )          |
| Total            |       | $        | (3,752     | )        | $          | 3,024    |       | $ | 312 |   |

 

Incometax expense (benefit) differed from the amounts computed by applying thestatutory U.S. federal income tax rate of 35% to income (loss) before provisionfor income taxes as a result of the following (in thousands):

| ** **                                                                                              | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Computed  “expected” tax expense (benefit)                                                    |       | $                                          | 1,297      |   | $ | (525 | ) | $ | 3,056 |   |
| Increase (decrease) in  income taxes resulting from:                                                    |       |                                       |       |   |   |   |   |
| State income taxes, net of federal income taxes                                                         |       | (147                                       | )          | (468 | ) | 256 |   |
| In-process research & development                                                              |       | 297                                        |       | 3,060 |   | — |   |
| Distribution from foreign subsidiary                                                                    |       | —                                     |       | 539 |   | — |   |
| (Decrease) increase in valuation allowance for  deferred income tax assets                              |       | (7,023                                     | )          | 467 |   | (2,793 | ) |
| Foreign tax credits                                                                                     |       | (108                                       | )          | (588 | ) | — |   |
| Research and experimentation credits                                                                    |       | —                                     |       | (500 | ) | (665 | ) |
| Nondeductible meals & entertainment                                                            |       | 517                                        |       | 264 |   | 225 |   |
| Nondeductible shareholder payment                                                                       |       | 528                                        |       | — |   | — |   |
| Income tax effect attributable to foreign operations  at different rates, including foreign withholding |       | (36                                        | )          | 525 |   | 162 |   |
| Impact of tax rate changes                                                                              |       | 720                                        |       | — |   | — |   |
| Other, net                                                                                              |       | 203                                        |       | 250 |   | 71 |   |
|                                                                                                    |       | $                                          | (3,752     | ) | $ | 3,024 |   | $ | 312 |   |

 

F-31

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Theincome tax effects of temporary differences that give rise to significantportions of our deferred income tax assets and liabilities are presented below(in thousands):

| ** **                                                                       | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred income  tax assets:                                                     |       |                  |       |   |   |
| Allowance for  doubtful accounts                                                 |       | $                     | 1,311      |   | $ | 1,498 |   |
| Accrued expenses  and other                                                      |       | 3,427                 |       | 617 |   |
| Property and  equipment depreciation                                             |       | 1,882                 |       | 1,477 |   |
| Identifiable  intangible assets amortization                                     |       | 4,731                 |       | 10,467 |   |
| Stock-based  compensation                                                        |       | 4,956                 |       | 1,697 |   |
| Net operating  losses, research and experimentation and foreign tax credits |       | 33,499                |       | 39,884 |   |
| Foreign deferred  income tax assets, principally net operating losses            |       | 10,995                |       | 13,404 |   |
| Gross deferred income tax assets                                                 |       | 60,801                |       | 69,044 |   |
| Valuation  allowance for deferred income tax assets                              |       | (46,048               | )          | (56,092 | ) |
| Net deferred income tax assets                                                   |       | 14,753                |       | 12,952 |   |
| Deferred income  tax liabilities:                                                |       |                  |       |   |   |
| Intangible assets                                                                |       | (10,158               | )          | (13,695 | ) |
| Net deferred  income tax asset (liabilities)                                     |       | $                     | 4,595      |   | $ | (743 | ) |

 

The net change in the valuation allowance for deferredincome tax assets for 2006 was a decrease of ($10.0) million, and an increasein 2005 and 2004 of $23.3 million and $4.6 million, respectively. Thevaluation allowance decrease in 2006 is comprised of $1.2 million for currentactivity, ($7.4) for the release of the valuation allowance for Witness SystemsLtd., ($2.7) million of deferred tax liabilities reducing the valuationallowance as a result of the Exametric acquisition, ($0.5) million for theadjustment under SAB 108, and other miscellaneous adjustments of ($0.5)million. Included in the valuation allowance for deferred income tax assets asof December 31, 2006 is $21.8 million from the Blue Pumpkin acquisitionand $2.1 million from the Eyretel acquisition in 2003 which, when reversed,will result in the reduction of goodwill or intangible assets prior to beingreflected as an income tax provision benefit. For 2006, Witness Systems Ltd.recorded a credit to other identified intangible assets in the amount of $0.8million related to the release of a portion of its valuation allowance.

At December 31, 2006, we had federal netoperating loss, federal research and experimentation credit, and foreign taxcredit carryforwards for U.S. federal income tax purposes of$78.1 million, $6.3 million and $0.8 million, respectively, whichexpire in varying amounts beginning in the year 2011 and which, in part, may besubject to various limitations. We also have incurred net foreign losses in theamount of $30.5 million as of December 31, 2006 which are availableto offset future taxable income in their respective foreign jurisdictions.These foreign losses expire in varying amounts beginning in 2006.

As of December 31, 2006, the U.S. and U.K. netoperating loss carryforwards include tax deductions of approximately $42.2 millionand $9.8 million, respectively, resulting from the exercise of stockoptions. In accordance with APB No. 25, any income tax benefit derivedfrom these tax deductions is reflected as additional paid-in capital at thetime we recognize any such income tax benefit. Under SFAS No. 123(R), anyexcess tax benefits not realized in 2006 (i.e. reduction to taxable income)cannot be recorded as a tax benefit (i.e cannot be reported as a deferred taxasset) until such benefits reduce the tax payable. As a result, the aboveexcess tax benefits are being tracked separately and will be recorded whenrealized under the “with and without” approach.

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During 2006, we also recognized as income tax expenseapproximately $0.2 million of AMT that would have been payable had there beenno stock option deductions under the “with and without” approach as it relatesto the ordering of its excess stock option deductions. Actual stock optiondeductions incurred for income tax purposes results in no actual payment ofAMT. A “hypothetical” deferred income tax asset is created by the “hypothetical”AMT expense incurred.

Undistributed accumulatedand current earnings of our foreign subsidiaries totaled approximately ($47.3)million and $10 million, respectively, at December 31, 2006. We considerthose earnings reinvested indefinitely and, accordingly, provide no provisionfor U.S. federal and state income taxes. Upon distribution of those earnings inthe form of dividends or otherwise, we may be subject to withholding taxespayable to various foreign countries, however, no U.S. income taxes will begenerally incurred due to net operating loss carryovers available to offset theincome from the dividend payment. Determination of the amount of unrecognizeddeferred U.S. income tax liability is not practicable because of thecomplexities associated with its hypothetical calculation.

**13.**   Segmentand Geographic Information

We consider ourselves to be in a single industrysegment, specifically licensing and servicing of software applications to thecustomer interaction recording and analysis market. Our chief operatingdecision maker receives financial information by geographic region; however,our operating segments are aggregated into one reportable segment based uponsimilar economic characteristics, products, services and delivery methods.

World-wideannual revenue based on customer location is as follows (in thousands):

| ** **     | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States  |       | $                                          | 124,497    |   | $ | 100,817 |   | $ | 73,268 |   |
| United Kingdom |       | 56,543                                     |       | 48,804 |   | 39,166 |   |
| Rest of world  |       | 40,743                                     |       | 35,707 |   | 28,901 |   |
| Total          |       | $                                          | 221,783    |   | $ | 185,328 |   | $ | 141,335 |   |

 

The rest of world revenue was derived primarily fromcustomers located in Australia, Canada, China, India and Japan. No individualcustomer accounted for more than 10% of consolidated revenue during 2006, 2005or 2004, or accounts receivable at December 31, 2006 or 2005.

Long-livedassets, including goodwill and intangible assets, by geography are as follows(in thousands):

| ** **     | ** ** | **December 31,** | ** ** |
|----------------|------------|-----------------------|------------|
| ** **     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| United States  |       | $                     | 99,028     |   | $ | 71,430 |   |
| United Kingdom |       | 9,386                 |       | 10,824 |   |
| Rest of world  |       | 2,205                 |       | 2,250 |   |
| Total          |       | $                     | 110,619    |   | $ | 84,504 |   |

 

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**14.**   Commitmentsand Contingencies

***Operating Commitments—******We*********lease office facilities, includingour corporate headquarters, and certain office furniture and equipment undervarious noncancelable operating lease agreements. Future minimum payments underleases with remaining terms greater than one year at December 31, 2006,and for the next five years and in the aggregate are as follows (in thousands):

| **December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|------------|------------|
| 2007                  |       | $          | 5,762      |       |
| 2008                  |       | 2,992      |       |
| 2009                  |       | 2,791      |       |
| 2010                  |       | 2,159      |       |
| 2011                  |       | 1,586      |       |
| Thereafter            |       | 3,175      |       |
|                  |       | $          | 18,465     |       |

 

Lease expense for the years ended December 31,2006, 2005, and 2004 was $5.2 million, $5.7 million and $5.7 million,respectively.

We entered into a software licensing agreement in 2005which requires us to pay an additional $1.3 million in 2007 for the rightto distribute a vendor’s software as part of our workforce optimizationsolution. This amount has been recorded as accrued liabilities as of December 31,2006. Imputed interest expense associated with the payment is not significant.

On April 6, 2006, Blue Pumpkin and IEX reached anagreement to settle all claims asserted between the parties. As part of thefinal settlement, Witness paid $8.25 million to IEX’s parent company, in April 2006and agreed to make six annual payments of $0.5 million ($3.0 millionin total) from April 2007 through 2012.

On October 2, 2006, we acquired Demos, a leadingproductivity solution provider for the financial services industry. The totalpurchase consideration in 2006 for Demos was cash of approximately $6.3million, including $0.3 million earned in 2006 as part of the potential for anearn-out of approximately $18 million based on the growth of the business overthe next several years. A portion of such potential earn-out is subject to accelerationin the event there is a change in control of the Company.

***Legal Proceedings—******On*********December 11, 2002, we filed inthe United States District Court for the Northern District of Georgia, AtlantaDivision, a lawsuit against Knowlagent, Inc. (“Knowlagent”), which is theassignee of United States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2.Knowlagent has accused our eQuality Now software of infringing the abovepatents. We filed suit seeking a declaration that we did not and do notinfringe either of the two patents listed above, as well as a declaration thatthe above patents are invalid and unenforceable. We also filed a claimrequesting that if the patents are found to be valid, that one of our own employeesbe named the rightful inventor of the patents. We also requested monetarydamages in an amount equal to the amount that Knowlagent has received from itsuse of the above patents. On December 31, 2002, Knowlagent filed itsanswer to our complaint as well as two counterclaims, alleging that we infringeand contribute to the infringement by others of the above patents; Knowlagentseeks both monetary damages and an injunction in connection with itscounterclaim. On June 6, 2005, the Court held a claim construction hearingand issued a claim construction order on June 8, 2005. The case is nowproceeding to expert discovery and summary judgment phases.

On July 20, 2004, STS Software Systems Ltd. (“STSSoftware”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICE Ltd.”),filed a patent infringement suit in the U.S. District Court for the SouthernDistrict of New York against us (“New York Action”). The New York Actionasserts that our products, including eQuality ContactStore for IP, infringeUnited States (“U.S.”). Patent No. 6,122,665 

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(“the ‘665 patent”) andseeks only injunctive, not monetary, relief. On the same day, we filed adeclaratory judgment action against STS Software in the U.S. District Court forthe Northern District Georgia (“Georgia Action”). We seek a declaration fromthe court that we have not infringed any valid claim of the ‘665 patent. ByOrder entered December 16, 2004, Judge Koeltl of the U.S. District Courtfor the Southern District of New York granted our motion to transfer the New YorkAction to the Northern District of Georgia, which has now consolidated theformer New York Action with the Georgia Action. On July 7, 2005, the Courtalso granted STS leave to amend its complaint to add three patents to thedispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and 6,880,004(respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004 patent”;collectively, “the STS patents”), again seeking solely injunctive relief. Weanswered the first amended complaint and asserted counterclaims on July 29,2005, collectively, through which we deny infringement of any valid claim ofthe STS patents and seek a declaration to that effect. The Court entered itsclaim construction ruling on January 16, 2007, and the case is progressingthrough its remaining discovery phases.

On August 30, 2004, we filed in the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. (“NICE Inc.”), a wholly-ownedsubsidiary of NICE Ltd., alleging patent infringement. Specifically, wehave alleged that NICE products, including the NiceUniverse products thatinclude screen capture and synchronized screen and voice capture technologies,infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220(“the ‘220 Patent”), both entitled “Method and Apparatus for SimultaneouslyMonitoring Computer User Screen and Telephone Activity from a Remote Location.”We have sought an injunction and money damages for NICE’s infringement of thesetwo patents. NICE Inc. has answered and counterclaimed for declaratoryjudgments of non-infringement and invalidity. Since then, on February 24,2005, we filed suit against NICE Ltd. because of its infringing activitiesin violation of the ‘798 and ‘220 patents, including importation of the accusedNICE products. By order dated April 5, 2005, the court has consolidatedthe NICE Inc. and NICE Ltd. actions. The Court entered its claim constructionruling on January 5, 2007, and the case is progressing through its remainingdiscovery phases.

On January 19, 2006, we filed in the UnitedStates District Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. and NICE Systems, Ltd. (collectively “NICE”),alleging patent infringement. Specifically, we have alleged that NICE products,including NicePerform and related products that include the ability tomonitor communications to detect the presence of at least one predeterminedparameter, infringe claims of U.S. Patent No. 6,404,857 B1 (“the ‘857Patent”), entitled “Signal Monitoring Apparatus for Analyzing Communications.”We have sought an injunction and money damages for NICE’s infringement of the ‘857patent. On March 6, 2006, NICE answered and counterclaimed, alleging thatthe ‘857 patent is not infringed and is invalid. The case has been set on adiscovery calendar and is at a preliminary stage.

On May 10, 2006, NICE Systems, Inc. and NICESystems Ltd. (collectively “NICE”), filed a patent infringement suit seekingmonetary damages and injunctive relief in the U.S. District Court for theDistrict of Delaware against us (“Delaware Action”). The Delaware Actionasserts that our products, including ContactStore, ContactStore for IP,ContactStore for Communications Manager, Quality for Communications Manager,and eQuality Balance, infringe one or more claims of ten U.S. Patents:  U.S. Patent Nos. 5,274,738; 5,396,371;5,819,005; 6,249,570; 6,728,345; 6,775,372; 6,785,370; 6,870,920; 6,959,079;and 7,010,109 (“the Delaware Patents”). We answered NICE’s complaint on June 30,2006, through which we deny infringement of any valid claim of any of theDelaware Patents. The case has been set on a discovery calendar and is at apreliminary stage.

On December 27, 2006, NICE Systems, Inc. andNICE Systems Ltd. (collectively, “NICE”), filed a declaratory judgment actionagainst us in the U.S. District Court for the Northern District Georgia,relating to U.S. Patent No. 6,757,361 (“the ‘361 Patent”), entitled “SignalMonitoring Apparatus Analyzing Voice Communication Content.”  NICE seeks a declaration from the court thatthe claims of the ‘361 

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Patent are invalid, andthat NICE has not infringed any valid claim of the ‘361 Patent. The company hasmoved to dismiss or stay the case while a previously filed reissue proceedingremains pending in the Patent Office. The motion remains pending.

On August 29, 2006, A. Edward Miller filed ashareholder derivative lawsuit in the United States District Court for theNorthern District of Georgia (Atlanta Division) naming Witness Systems, Inc.(the “Company”) as a nominal defendant and naming all of our current Board ofDirectors and a number of our current officers as defendants. Miller v. Gould,et al., Civil Action No. 1:06-CV-2039 (N.D. Ga.). Thecomplaint alleges purported violations of federal and state law, includingbreaches of fiduciary duty, abuse of control, constructive fraud, corporatewaste, unjust enrichment, gross mismanagement and violations of certainantifraud provisions of the federal securities laws (including Sections 10(b) and14(a) of the Securities Exchange Act of 1934 and Rules 10b-5and 14a-9 thereunder) in connection with certain stock option grants madeby the Company. The complaint seeks monetary damages in unspecified amounts,disgorgement of profits, an accounting, rescission of stock option grants,imposition of a constructive trust over the defendants’ stock options andproceeds derived therefrom, punitive damages, reimbursement of attorneys’ feesand other costs and expenses, an order directing the Company to adopt or put toa stockholder vote various proposals relating to corporate governance, andother relief as determined by the court. On November 15, 2006, the Companyand the other defendants filed a motion to dismiss the complaint in itsentirety on a variety of grounds, including plaintiffs’ failure to allegedemand futility. Rather than respond to that Motion, plaintiffs on January 9,2007 filed an Amended Complaint. On March 9, 2007, the Company and theother defendants filed a motion to stay or dismiss the amended complaint.

A class action securities lawsuit has been filedby an individual on August 14, 2006 claiming tobe a stockholder of the Company naming the Company and certain of itsBoard of Directors and officers as defendants in connection with certain stockoption grants made by the Company. Rosenberg v. Gould, et al., Civil Action No. 1:06-CV-1894(N.D. Ga.). The complaint, filed in the United States District Court for theNorthern District of Georgia, alleges violations of Section 10(b) ofthe Securities Exchange Act of 1934 and Rule 10b-5 thereunder andseeks unspecified damages, attorneys’ fees and other costs and expenses,unspecified extraordinary, equitable and injunctive relief, and other relief asdetermined by the court. A lead plaintiff has been designated, and the AmendedComplaint is due on March 26, 2007. The Company and the other defendantswill respond to the complaint when appropriate.

On October 27, 2006, the Company received anotice of informal nonpublic inquiry from the Securities and ExchangeCommission requesting certain documents and information relating to the company’sstock option grant practices from February 2000 to the present. We intendto cooperate fully with all matters related to this request.

On March 14, 2007, the Company was served with acomplaint by Doron Aspitz, the former chief executive officer of Blue PumpkinSoftware, Inc., in California Superior Court for the County of Santa Clara(Case No. 107CV078480). The complaint names the Company as defendant andpurports to assert eight causes of action, for promissory estoppel, promissoryfraud, negligent misrepresentation, breach of fiduciary duty, vote buying,violation of Section 17200 of the California Business and ProfessionsCode, violation of Section 1101 of the California general Corporation Law,and unjust enrichment. The complaint purports to seek over $5.0 million incompensatory damages as well as other unquantified punitive and exemplarydamages, disgorgement, and attorneys’ fees and costs. The complaint was filedon or about January 19, 2007 but no effort was made to serve the complaintuntil approximately mid-March 2007, and no response is presently due. TheCompany will respond to the complaint at an appropriate time and intends tocontest the complaint vigorously.

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From time to time we may be involved in other legalproceedings and/or litigation arising in the ordinary course of our businessthat might impact on our financial position, our results of operations, or ourcash flows.

***Indemnificationsand Warranties—******We***moreoften than not indemnify our customers against damages and costs resulting fromclaims of patent, copyright, or trademark infringement associated with use ofour software in its software licensing agreements. We have historically notmade any payments under such indemnifications. However, we continue to monitorthe conditions that are subject to the indemnifications to identify whether itis probable that a loss has occurred, and would recognize any such losses underthe indemnifications when those losses are probable and estimable. In addition,we warrant to customers that our software products operate substantially inaccordance with the software product’s specifications. Historically, nomaterial costs have been incurred related to software product warranties and nosignificant costs are expected in the future.

We have entered intoindemnification agreements with each of our present and former directors andofficers. Under those agreements, we are (with certain exceptions) required toindemnify each such director or officer against expenses, including attorneys’fees, judgments, fines and settlements, paid by such individual in connectionwith the pending litigation relating to our stock option granting practices.

**15.**   SubsequentEvents

On February 11, 2007, we entered into anAgreement and Plan of Merger (the “Merger”) with Verint Systems Inc., aDelaware corporation. At the effective time of the Merger, each outstandingshare of Witness’ common stock will be converted into the right to receive$27.50 in cash, less any applicable withholding taxes and without interest.Under the Merger Agreement, each outstanding stock option of Witness that is vestedat the effective time of the merger and has an exercise price below $27.50 willbe cancelled and exchanged for a cash payment by Verint in an amount equal tothe excess (if any) of $27.50 over the exercise price per option sharemultiplied by the number of shares of Witness common stock subject to suchvested option. Witness stock options that are vested at the effective time ofthe merger and have an exercise price above $27.50 will be cancelled withoutpayment. Each outstanding stock option of Witness that is unvested at theeffective time of the merger will be assumed by Verint and will become anoption to purchase shares of Verint common stock on the same terms andconditions as were applicable to the stock option immediately prior to theeffective time of the merger. The number of shares of Verint common stocksubject to each assumed option will be determined by multiplying the number ofshares of Witness common stock that were subject to the unvested optionimmediately prior to the effective time of the merger by the conversion ratioset forth in the Merger Agreement, and rounding that result down to the nearestwhole number of shares of Verint common stock. The per share exercise price forthe assumed option will be determined by dividing the per share exercise priceof the Witness common stock subject to the unvested option as in effectimmediately prior to the effective time of the merger by the conversion ratio,and rounding that result up to the nearest whole cent. The conversion ratio isthe ratio obtained by dividing $27.50 by the average of the closing salesprices of a share of Verint common stock as reported for the twenty consecutivetrading days immediately before the closing of the merger (subject toadjustment for stock splits and dividends). The Merger Agreement does notprohibit Verint from making necessary adjustments to the conversion ratio bymodifying the exercise price per share and taking such other actions as may benecessary or appropriate to comply with Section 409A of the InternalRevenue Code of 1986, as amended and preserve the intended tax treatment ofeach outstanding unvested option. We have agreed to freeze our employee stockpurchase plan effective April 1, 2007 and to prohibit participants in theplan from increasing their payroll deductions or commencing purchase electionsfrom those in effect on February 11, 2007. We have also agreed toterminate our employee stock purchase plan immediately as of or prior to theeffective time of the merger.

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Effective January 3, 2007, Mr. David Gouldvoluntarily resigned from his position as Chief Executive Officer of theCompany and as a member of the Company’s Board of Directors and was replaced by Mr. Nicholas Discombe, whohas served as the Company’s President and Chief Operating Officer since April 2003.Pursuant to an agreement dated January 3, 2007 and later amended on February 2,2007, Mr. Gould will continue as an employee until April 30, 2007.Upon termination of employment, Mr. Gould will be entitled to separationpayments of $29,333 per month for 12 months. The amount was accrued for as of December 31,2006. In return, Mr. Gould agreed to the termination of his employmentagreement and change in control agreement. In accordance with the originalterms of the standard employee option agreement, stock options held by Mr. Gouldof approximately 620,000 shares continue to vest throughout his employmentperiod. While his option agreement was not amended, in accordance with SFAS No. 123(R),we recorded $1.9 million in stock-based compensation expense in the firstquarter of 2007 to reflect a defacto modification of those options.

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**Schedule II**

**Valuation and Qualifying Accounts(In thousands)**

| ** **                         | ** ** | **Balance at  Beginning of  Year** | ** ** | **Charged  against  Revenue** | ** ** | **Charged  to  Expense** | ** ** | **Deductions** | ** ** | **Balance at  End of  Year** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|-------------------------------|------------|--------------------------|------------|----------------|------------|----------------------------------------|------------|
| Allowance for Doubtful  Accounts:  |       |                                         |       |                          |       |                     |       |           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Year ended December 31, 2006  |       |                                         | $          | 3,283                         |       |                     |       | $              | 2,045      |                                   |       |   | $ | 1,246 |   |   |   | $ | (3,584 | ) |   |   | $ | 2,990 |   |   |
| Year ended December 31, 2005  |       |                                         | $          | 3,250                         |       |                     |       | $              | 2,849      |                                   |       |   | $ | 587 |   |   |   | $ | (3,403 | ) |   |   | $ | 3,283 |   |   |
| Year ended  December 31, 2004 |       |                                         | 2,840      |                          |       |                     | 1,395      |           |       |                                   | 513        |   |   |   | (1,498 | ) |   |   | 3,250 |   |   |

 

F-39

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**SIGNATURES**

Pursuantto the requirements of Section 13 of 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| Dated:  March 30, 2007 | WITNESS SYSTEMS, INC. |
|-----------------------------|-----------------------|
|                        | By:                   | /s/  WILLIAM F. EVANS |
|                        |                  | William F. Evans |
| * *                    | * *              | *Executive  Vice President and Chief Financial Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons in the capacities and on the dateindicated
| /s/  NICK DISCOMBE    | * * | *Chief Executive Officer and Director* |   | March 30, 2007 |
|---------------------------------|----------|----------------------------------------|--------|---------------------|
| Nick Discombe                   | * * | * *                               |   |                |
| /s/  WILLIAM F. EVANS | * * | *Executive Vice President and  Chief*  |   | March 30, 2007 |
| William F. Evans                | * * | *Financial  Officer*                   |   |                |
| /s/  TOM BISHOP       | * * | *Director*                             |   | March 30, 2007 |
| Tom Bishop                      | * * | * *                               |   |                |
| /s/  THOMAS J. CROTTY | * * | *Director*                             |   | March 30, 2007 |
| Thomas J. Crotty                | * * | * *                               |   |                |
| /s/  JOEL G. KATZ     | * * | *Director*                             |   | March 30, 2007 |
| Joel G. Katz                    | * * | * *                               |   |                |
| /s/  DAN LAUTENBACH   | * * | *Chairman of the Board*                |   | March 30, 2007 |
| Dan Lautenbach                  | * * | * *                               |   |                |
| /s/  PETER SINISGALLI | * * | *Director*                             |   | March 30, 2007 |
| Peter Sinisgalli                | * * | * *                               |   |                |

 

F-40

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