UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549











FORM 10-Q





QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934





For the Quarter Ended March 31, 2011





Commission File Number 001-33888











American Defense Systems, Inc.


(Exact Name of Registrant as Specified in Its Charter)





Delaware

83-0357690(State or Other Jurisdiction of Incorporation or

Organization)

(I.R.S. Employer Identification No.)





230 Duffy Avenue


Hicksville, NY 11801


(516) 390-5300


(Address including zip code, and telephone number, including area code, of principal executive offices)





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





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o  No  o





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





Large Accelerated Filer   o

Accelerated Filer   oNon-Accelerated Filer   o

Smaller Reporting Company   x





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





As of May 16, 2011, 54,341,685 shares of common stock, par value $0.001 per share, of the registrant were outstanding.








TABLE OF CONTENTS





PART I — FINANCIAL INFORMATIONItem 1.
Condensed Consolidated Financial Statements
3Condensed Consolidated Balance Sheets as of March 31, 2011 (Unaudited) and December 31, 2010
3Condensed Consolidated Statements of Operations for the three months ended March 31, 2011 and 2010 (Unaudited)
5Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2011 and 2010 (Unaudited)
6Notes to Condensed Consolidated Financial Statements
7Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
19Item 3.
Quantitative and Qualitative Disclosure About Market Risk
25Item 4.
Controls and Procedures
25PART II — OTHER INFORMATIONItem 1.
Legal Proceedings
26Item 1A.
Risk Factors
26Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
37Item 3.
Defaults Upon Senior Securities
37Item 4.
(Removed and Reserved)
37Item 5.
Other Information
38Item 6.
Exhibits
38SIGNATURES
39





2




PART I





Item 1.     Condensed Consolidated Financial Statements





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS





March 31, 2011

(Unaudited)


December 31,

2010 *ASSETSCURRENT ASSETSCash

$
745,689


$
249,855Accounts receivable, net of allowance for doubtful accounts of $383,561 and $380,756 as of March 31, 2011 and December 31, 2010, respectively


1,063,491



1,041,491Accounts receivable factoring


2,959



84,463Tax receivable


101,641



101,641Costs in excess of billings on uncompleted contracts, net


1,500,999



1,472,606Prepaid expenses and other current assets


285,328



395,845Deferred tax assets


1,928



1,928Assets of discontinued operations


-



1,903,276TOTAL CURRENT ASSETS


3,702,035



5,251,105Property and equipment, net


1,287,404



1,961,610Deferred financing costs, net


-



454,741Goodwill


-



812,500Deposits


604,138



639,138Assets of discontinued operations


-



652,376TOTAL ASSETS

$
5,593,577


$
9,771,470





* Condensed from audited financial statements





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





3





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS





March 31, 2011

(Unaudited)


December 31,

2010 *LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIENCY)CURRENT LIABILITIESAccounts payable

$
3,011,001


$
3,178,119Accrued expenses


115,727



450,035Warrant liability


5,697



8,822Mandatorily redeemable Series A convertible preferred stock (cumulative), 15,000 shares authorized issued and outstanding


-



14,010,000Liabilities of discontinued operations


-



1,671,350TOTAL CURRENT LIABILITIES


3,132,425



19,318,326LONG TERM LIABILITIESDeferred rent


225,807



211,963Deferred tax liability


1,928



1,928TOTAL LIABILITIES


3,360,160



19,532,217COMMITMENTS AND CONTINGENCIESSHAREHOLDERS' EQUITY (DEFICIENCY)Common stock, $0.001 par value, 100,000,000 shares authorized, 54,341,685 shares issued and outstanding as of March 31, 2011 and December 31, 2010


54,341



54,341Additional paid-in capital


16,539,987



16,506,708Accumulated deficit


(14,360,911
)


(26,321,796
)TOTAL SHAREHOLDERS' EQUITY (DEFICIENCY)


2,233,417



(9,760,747
)TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIENCY)

$
5,593,577


$
9,771,470





* Condensed from audited financial statements





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





4





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)


For the Three Months EndedMarch 31,


March 31,2011


2010CONTRACT REVENUES EARNED

$
2,536,152


$
11,308,964COST OF REVENUES EARNED (exclusive of depreciationshown separately below)


1,386,543



6,583,438GROSS PROFIT


1,149,609



4,725,526OPERATING EXPENSESGeneral and administrative expenses


817,018



1,430,230General and administrative salaries


703,895



884,218Sales and marketing


171,403



562,809T2 expenses


102,361



218,848Research and development


115,159



121,717Depreciation


269,754



287,196Professional fees


238,864



573,370TOTAL OPERATING EXPENSES


2,418,454



4,078,388OPERATING (LOSS) INCOME


(1,268,845
)


647,138OTHER INCOME (EXPENSE)Unrealized loss on adjustment of fair value Series A convertible preferred stock classified as a liability


(2,395,592
)


(646,100
)Unrealized gain (loss) on warrant liability


3,125



(24,429
)Gain on sale of fixed asset


54,475



-Gain on redemption of mandatorily redeemable preferred stock


12,786,969



-Interest expense


(236,118
)


(644,729
)Interest expense - mandatorily redeemable preferred stock dividends


-



(375,000
)Finance charge


(20,212
)


(79,781
)TOTAL OTHER INCOME (EXPENSE)


10,192,647



(1,770,039
)INCOME (LOSS) BEFORE INCOME TAXES FROM CONTINUING OPERATIONS


8,923,802



(1,122,901
)INCOME TAX PROVISION


-



-INCOME (LOSS) FROM CONTINUING OPERATIONS


8,923,802



(1,122,901
)DISCONTINUED OPERATIONS (Note 6):INCOME FROM DISCONTINED OPERATIONS, (including gain on disposal of $2,910,565), NET OF TAX of $0


3,037,083



298,496NET INCOME (LOSS)

$
11,960,885


$
(824,405
)Weighted Average Shares Outstanding (Basic and Diluted)


54,341,685



46,798,263Income (Loss) per Share (Basic and Diluted)INCOME (LOSS) FROM CONTINUING OPERATIONS

$
0.16


$
(0.02
)INCOME FROM DISCONTINED OPERATIONS, NET OF TAX

$
0.06


$
0.01NET INCOME (LOSS)

$
0.22


$
(0.02
)





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




5





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)





Three Months Ended March 31,2011


2010CASH FLOWS FROM OPERATING ACTIVITIES:NET INCOME (LOSS)

$
11,960,885


$
(824,405
)Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:Gain on redemption of preferred stock


(12,786,969
)


-Gain on disposal of subsidiary


(2,910,565
)


-Gain on sale of fixed asset


(54,475
)


-Change in costs in excess of billings reserve


-



30,000Change in fair value associated with preferred stock and warrants liabilities


2,392,467



670,529Stock based compensation expense


33,279



118,007Amortization of deferred financing costs


141,710



386,889Amortization of discount on Series A preferred stock


94,408



254,257Depreciation and amortization


269,754



288,830Bad debt expense


2,805



45,000Deferred rent


13,844



204,309Stock issued for payment of dividends on preferred stock


-



375,000Changes in operating assets and liabilities:Accounts receivable


(605,653
)


(2,041,284
)Accounts receivable factoring


81,504



(146,219
)Deposits and other assets


14,255



88,001Cost in excess of billing on uncompleted contracts


60,330



1,684,392Prepaid expenses and other current assets


(44,954
)


(61,349
)Accounts payable and accrued expenses


256,308



(957,567
)NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES


(1,081,067
)


114,390CASH FLOWS FROM INVESTING ACTIVITIES:Proceeds from sale of fixed asset


429,697



-Proceeds from disposal of subsidiary/redemption of preferred stock


1,000,000



-Purchase of equipment


(6,273
)


(50,706
)NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES


1,423,424



(50,706
)CASH FLOWS FROM FINANCING ACTIVITIES:Cash overdraft


-



24,287NET CASH PROVIDED BY FINANCING ACTIVITIES


-



24,287NET INCREASE IN CASH


342,357



87,971CHANGE IN CASH OF DISCONTINUED OPERATIONS, INCLUDINGCASH DISPOSED OF AT THE TRANSACTION DATE


153,477



-CASH AT BEGINNING OF YEAR


249,855



-CASH AT THE END OF PERIOD

$
745,689


$
87,971Supplemental disclosure of cash flow information:Cash paid during the period for interest

$
-


$
-Cash paid during the period for taxes

$
-


$
-Non cash investing and financing activities:Redemption of mandatorily redeemable preferred stock

$
16,500,000


$
-





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




6





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





1.
NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Organization





American Defense Systems, Inc. (the “Company” or “ADSI”) was incorporated under the laws of the State of Delaware on December 6, 2002.





On May 1, 2003, the stockholder of A. J. Piscitelli & Associates, Inc. (“AJP”) exchanged all of his issued and outstanding shares for shares of American Defense Systems, Inc. The exchange was accounted for as a recapitalization of the Company, wherein the stockholder retained all the outstanding stock of American Defense Systems, Inc. At the time of the acquisition American Defense Systems, Inc. was substantially inactive.





In January 2008, American Physical Security Group, LLC (“APSG”) was established as a wholly owned subsidiary of the Company for the purposes of acquiring the assets of American Anti-Ram, Inc., a manufacturer of crash tested vehicle barricades. APSG is located in North Carolina. On March 22, 2011, the Company entered into a Securities Redemption Agreement, as more fully discussed in Note 6, with the holders of its Series A convertible preferred stock (the “Series A Holders”), pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG. As such the results of APSG have been reflected in discontinued operations for all periods presented.





Interim Review Reporting





The accompanying interim unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. For further information, refer to the financial statements and footnotes thereto included in the Company’s Form 10-K annual report for the year ended December 31, 2010 filed on April 15, 2011.





Nature of Business





The Company designs and supplies transparent and opaque armor solutions for both military and commercial applications. Its primary customers are United States government agencies and general contractors who have contracts with governmental entities. These products, sold under Vista trademarks, are used in transport and fighting vehicles, construction equipment, sea craft and various fixed structures which require ballistic and blast attenuation.





The Company also provides engineering and consulting services, develops and installs detention and security hardware, entry control and monitoring systems, intrusion detection systems, and security glass.





Principles of Consolidation





The consolidated financial statements include the accounts of American Defense Systems, Inc. and its wholly-owned subsidiaries, AJP and American Institute for Defense and Tactical Studies, Inc. (“T2”). All significant intercompany accounts and transactions have been eliminated in consolidation.




7





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Management Liquidity Plans





As of March 31, 2011, the Company had working capital of $569,610, an accumulated deficit of $14,360,911, shareholders’ equity of $2,233,417 and cash on hand of $745,689. The Company had an operating loss of $(1,268,845) and operating income of $647,138 for the three months ended March 31, 2011 and 2010, respectively. The Company had income from continuing operations for the three months ended March 31, 2011 of $8,923,802, including a gain of $12,786,969 on the redemption of mandatorily redeemable preferred stock, and losses from continuing operations for the three months ended March 31, 2010 of $(1,122,901). The Company had net income (losses) of $11,960,885 and $(824,405) for the three months ended March 31, 2011 and 2010, respectively. The Company had net cash used in operations of $(1,081,067) and net cash provided by operations of $114,390 for the three months ended March 31, 2011, and 2010, respectively. The Company entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series A convertible preferred stock (the “Series A Preferred”), as more fully discussed in Note 6. In addition, the Company is currently seeking to raise capital or obtain access to capital sufficient to permit the Company to meet its future cash flow needs though there can be no assurance that the Company will be able to obtain additional financing on commercially reasonable terms or at all. The Company also continues to explore all sources of increasing revenue. If the Company is unable in the near term to raise capital or increase revenue, it will not have sufficient cash to sustain its operations for the next twelve months. As a result the Company may be forced to further reduce or even curtail its operations. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.





Reclassifications





Certain amounts in the prior year financial statements have been reclassified for comparative purposes to conform to the presentation in the current year financial statements. These reclassifications had no effect on previously reported income.





Use of Estimates





The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.





Significant estimates for all periods presented include cost in excess of billings, allowance for doubtful accounts, liabilities associated with the Series A Preferred and warrants, and valuation of deferred tax assets.





Subsequent Events





The Company has evaluated events that occurred subsequent to March 31, 2011 through the date these financial statements were issued. Management concluded that no subsequent events required disclosure in these financial statements except as noted below.




On May 16, 2011, the Company received notice from the staff of the NYSE Amex LLC (the “Exchange”) that, based on their review of the Company’s Form 10-K for the period ended December 31, 2010, the Company is not in compliance with certain of the Exchange’s continued listing standards as set forth in Part 10 of the Exchange’s Company Guide. Specifically, the Exchange noted that the Company is not in compliance with (a) Section 1003(a)(i) of the Company Guide because it reported stockholders’ equity of less than $2,000,000 as of December 31, 2010 and losses from continuing operations and net losses in two of its three most recent fiscal years ended December 31, 2010, (b) Section 1003(a)(ii) of the Company Guide because it reported stockholders’ equity of less than $4,000,000 as of December 31, 2010 and losses from continuing operations and net losses in three of its four most recent fiscal years ended December 31, 2010 and (c) Section 1003(a)(iv) of the Company Guide because the Company has sustained losses which are so substantial in relation to the Company’s overall operations or the Company’s existing financial resources, or the Company’s financial condition has become so impaired that it appears questionable, in the opinion of the Exchange, as to whether the Company will be able to continue operations and/or meet its obligations as they mature.




In order to maintain listing of the Company’s common stock on Exchange, the Company must submit a plan by June 15, 2011, addressing how the Company intends to regain compliance with Section 1003(a)(iv) by August 16, 2011 and Sections 1003(a)(i) and 1003(a)(ii) by November 16, 2012. The Company expects to submit such a plan by the June 15, 2011 deadline. If the Exchange accepts the plan, then the Company may be able to continue its listing during the plan period, up to November 16, 2012, during which time the Company will be subject to periodic reviews to determine whether it is making progress consistent with the plan. If the Company fails to submit a plan acceptable to the Exchange or, if the plan is accepted but the Exchange determines that the Company is not making progress consistent with the plan or that the Company is not in compliance with all continued listing standards of the Company Guide by November 16, 2012, then the Company expects the Exchange will initiate delisting proceedings.




8





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




The Company’s common stock continues to trade on the Exchange under the symbol “EAG,” however, the Exchange has advised the Company that the Exchange is utilizing the financial status indicator fields in the Consolidated Tape Association’s Consolidated Tape System and Consolidated Quote Systems Low Speed and High Speed Tapes to identify companies that are in noncompliance with the Exchange’s continued listing standards. Accordingly, the Company will become subject to the trading symbol extension “.BC” to denote its noncompliance.




In addition, the Exchange staff notified the Company, in accordance with Section 1003(f)(v) of the Company Guide, that it deems it appropriate for the Company to effect a reverse stock split to address the low selling price per share of its common stock and that if a reverse stock split is not completed by November 16, 2011, the Exchange may consider suspending dealings in, or removing from the list, the Company’s common stock.





Revenue and Cost Recognition





The Company recognizes revenue in accordance with the provisions of Accounting Standards Codification (“ASC”) 605, “Revenue Recognition”, which states that revenue is realized and earned when all of the following criteria are met:


(a) persuasive evidence of the arrangement exists,


(b) delivery has occurred or services have been rendered,


(c) the seller’s price to the buyer is fixed and determinable, and


(d) collectibility is reasonably assured.





The Company recognizes revenue and reports profits from purchase orders filled under master contracts when an order is complete. Purchase orders received under master contracts may extend for periods in excess of one year. However, no revenues, costs or profits are recognized in operations until the period of completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of March 31, 2011 and December 31, 2010, there were no such provisions made.





Contract Revenue





Cost in Excess of Billing





All costs associated with uncompleted customer purchase orders under contract are recorded on the balance sheet as a current asset called “Costs in Excess of Billings on Uncompleted Contracts, net.” Such costs include direct material, direct labor, and project-related overhead. Upon completion of a purchase order, costs are then reclassified from the balance sheet to the statement of operations as costs of revenue. A customer purchase order is considered complete when a satisfactory inspection has occurred, resulting in customer acceptance and delivery.





Concentrations





The Company’s bank accounts are maintained in financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and therefore bear minimal risk.





The Company has one supplier that provided 10% of its supply needs during the quarter ended March 31, 2011. Additionally, the Company relies on a limited number of contract manufacturers and suppliers to provide manufacturing services for its products. The inability of any contract manufacturer or supplier to fulfill supply requirements of the Company could materially impact future operating results.





For the three months ended March 31, 2011, the Company derived 16% and 64%, respectively, of its revenues from various U.S. government entities, and two other customers. For the three months ended March 31, 2010, the Company derived 93% of its revenues from various U.S. government entities.




9





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Allowance for Doubtful Accounts





The allowance for doubtful accounts reflects management’s best estimate of probable losses inherent in the account receivable balance. Management determines the allowance based on known troubled accounts, historical experience, and other currently available evidence. Management performs on-going credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by the review of their current credit information. Collections and payments from customers are continuously monitored. While such bad debt expenses have historically been within expectations and allowances established, the Company cannot guarantee that it will continue to experience the same credit loss rates that it has in the past. At March 31, 2011 and December 31, 2010, the allowance for doubtful accounts was $383,561 and $380,756, respectively.





Segment Reporting





As a result of the sale of APSG on March 22, 2011 (see Note 6) the Company currently classifies its business operations into one reportable segment.





Income (Loss) per Share





Basic income (loss) per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive. Dilutive potential common shares would primarily consist of employee stock options, warrants and convertible preferred stock.





Securities that could potentially dilute basic EPS in the future that were not included in the computation of the diluted EPS because to do so would be anti-dilutive consist of the following:





March 31,In Thousands

2011


2010Warrants to purchase Common Stock


675,001



1,448,681Options to purchase Common Stock


2,479,000



2,330,000Series A Convertible Preferred Stock *


-



7,500,000Total potential Common Stock


3,154,001



11,278,681





* The Company entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series Preferred as more fully discussed in Note 6. On April 9, 2010, pursuant to the amendment of the Company’s certificate of incorporation, the conversion price of the Series A Preferred was reduced to $0.50 and all of the outstanding shares of the Series A Preferred were convertible into 30,000,000 shares of common stock.





Fair Value of Financial Instruments





Fair value of certain of the Company’s financial instruments including cash, accounts receivable, note receivable, accrued compensation, and other accrued liabilities approximate cost because of their short maturities. The Company measures and reports fair value in accordance with ASC 820, “Fair Value Measurements and Disclosure” which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value investments.





Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, principal (or most advantageous) markets, and an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the Company’s credit risk.





10





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques may require significant judgment and are primarily dependent upon the characteristics of the asset or liability, and the quality and availability of inputs. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and resulting measurement as follows:





Level 1





Quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities;





Level 2





Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities; and





Level 3





Unobservable inputs for the asset or liability that are supported by little or no market activity and that are significant to the fair values.





Fair value measurements are required to be disclosed by the Level within the fair value hierarchy in which the fair value measurements in their entirety fall. Fair value measurements using significant unobservable inputs (in Level 3 measurements) are subject to expanded disclosure requirements including a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to total gains or losses for the period (realized and unrealized), segregating those gains or losses included in earnings, and a description of where those gains or losses included in earning are reported in the statement of operations.





The Company did not have any assets or liabilities categorized as Level 1 or Level 2 as of March 31, 2011 or December 31, 2010. There were no transfers into or out of Level 1 or Level 2 during the quarters ended March 31, 2011 or 2010.





The following summarizes the Company’s assets and liabilities measured at fair value as of March 31, 2011 and December 31, 2010:





Fair Value Measurements at Reporting Date UsingQuoted Prices in

Active Markets for

Identical


Significant Other

Observable


Significant

UnobservableBalance as of


Assets


Inputs


InputsDescription

March 31, 2011


(Level 1)


(Level 2)


(Level 3)LiabilitiesPlacement Agent Warrants (1)

$
5,697


$
-


$
-


$
5,697Total Liabilities

$
5,697


$
-


$
-


$
5,697





11





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Fair Value Measurements at Reporting Date UsingQuoted Prices in

Active Markets for

Identical


Significant Other

Observable


Significant

UnobservableBalance as of


Assets


Inputs


InputsDescription

December 31, 2010


(Level 1)


(Level 2)


(Level 3)LiabilitiesSeries A Preferred (1)

$
14,010,000


$
-


$
-


$
14,010,000Placement Agent Warrants (1)


8,822



-



-



8,822Total Liabilities

$
14,018,822


$
-


$
-


$
14,018,822





(1)       Methods and significant inputs and assumptions are discussed in Note 5 below.





The following is a reconciliation of the beginning and ending balances for the Company’s liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2011 and 2010:





Series A

Preferred


2005

Warrants


2006

Warrants


Placement

Agent

Warrants


TotalBalance – January 1, 2011

$
14,010,000


$
-


$
-


$
8,822


$
14,018,822Amortization of debt discount


94,408



-



-



-



94,408Change in fair value


2,395,592



-



-



(3,125
)


2,392,467Redemption


(16,500,000
)


-



-



-



(16,500,000
)Balance – March 31, 2011

$
-


$
-


$
-


$
5,697


$
5,697





Series A

Preferred


2005

Warrants


2006

Warrants


Placement

Agent

Warrants


TotalBalance – January 1, 2010

$
12,429,832


$
4,372


$
1,494


$
29,547


$
12,465,245Amortization of debt discount


254,257



-



-



-



254,257Change in fair value


646,100



(4,290
)


(1,466
)


30,185



670,529Balance – March 31, 2010

$
13,330,189


$
82


$
28


$
59,732


$
13,390,031





The change in fair value recorded for Level 3 liabilities for the periods above are reported in other income (expense) on the condensed consolidated statement of operations.




12





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Recent Accounting Pronouncements





In October 2009, the FASB issued new accounting guidance, under ASC Topic 605, on revenue recognition which addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. Specifically, this guidance amends the criteria for Subtopic 605-25, Revenue Recognition-Multiple Element Arrangements, for separating consideration in multiple-deliverable arrangements. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence, (b) third-party evidence, or (c) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangements to all deliverables using the relative selling price method and also requires expanded disclosures. This guidance is effective for the Company for all new or materially modified arrangements entered into on or after January 1, 2011 with earlier application permitted as of the beginning of a fiscal year. Full retrospective application of the new guidance is optional. The adoption of this standard will have an impact on the Company’s consolidated financial position and results of operations for all multiple deliverable arrangements entered into or materially modified in 2011.





In January 2010, the FASB issued new accounting guidance, under ASC Topic 820, on Fair Value Measurements and Disclosures, which requires new disclosures and clarifies some existing disclosure requirements about fair value measurement. Under the new guidance, a reporting entity should (a) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers, and (b) present separately information about purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs. This guidance was effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements which are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of the guidance effective for interim and annual reporting periods beginning after December 15, 2010 and 2009 did not have a material impact on the Company’s consolidated financial position or results of operations.





In July 2010, the FASB issued ASU 2010-20, Receivables (Topic 310): Disclosure about the Credit Quality of Financial Receivables and the Allowance for Credit Losses, which amends ASC Topic 310 by requiring additional disclosures about the credit quality of an entity’s financing receivables and its allowance for credit losses on a disaggregated basis. The objective of enhancing these disclosures is to improve financial statement users’ understanding of (1) the nature of an entity’s credit risk associated with its financing receivables and (2) the entity’s assessment of that risk in estimating its allowance for credit losses as well as changes in the allowance and the reasons for those changes. The guidance is effective for the first reporting period ending on or after December 15, 2010. The adoption of this standard did not have a material impact on the Company’s consolidated financial position and results of operations.





2.
COSTS IN EXCESS OF BILLINGS (BILLINGS IN EXCESS OF COSTS) ON UNCOMPLETED CONTRACTS AND ACCOUNTS RECEIVABLE





Costs in Excess of Billings and Billing in Excess of Costs


The cost in excess of billings on uncompleted purchase orders issued pursuant to contracts reflects the accumulated costs incurred on purchase orders in production but not completed.  Upon completion, inspection and acceptance by the customer, the purchase order is invoiced and the accumulated costs are charged to the statement of operations as costs of revenues earned.  During the production cycle of the purchase order, should any progress billings occur or any interim cash payments or advances be received, such billings and/or receipts on uncompleted contracts are accumulated as billings in excess of costs. The Company fully expects to collect net costs incurred in excess of billing within twelve months and periodically evaluates each purchase order and contract for potential disputes related to overruns and uncollectable amounts.





Costs in excess of billing on uncompleted contracts were $1,500,999 and $1,472,606 as of March 31, 2011 and December 31, 2010, respectively.





Backlog


The estimated gross revenue on work to be performed on backlog was approximately $10 million and $28 million as of March 31, 2011 and 2010, respectively.





13





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Accounts Receivable


The Company records accounts receivable related to its long-term contracts, based on billings or on amounts due under the contractual terms. Accounts receivable consist primarily of receivables from completed purchase orders and progress billings on uncompleted contracts. Allowance for doubtful accounts is based upon a review of outstanding receivables, historical collection information, and existing economic conditions. Any amounts considered recoverable under the customer’s surety bonds are treated as contingent gains and recognized only when received.





Accounts receivable throughout the year may decrease based on payments received, credits for change orders, or back charges incurred. At March 31, 2011 and December 31, 2010, the Company had accounts receivable of $1,063,491 and $1,041,491, respectively and an allowance for doubtful accounts of $383,561 and $380,756, respectively. The Company recorded bad debt expense of $2,805 and $45,000 for the three months ended March 31, 2011 and 2010, respectively.





3.      COMMITMENTS AND CONTINGENCIES





Legal Proceedings





The Company is subject to various claims and contingencies in the ordinary course of its business, including those related to litigation, business transactions, employee-related matters, and others. When the Company is aware of a claim or potential claim, it assesses the likelihood of any loss or exposure. If it is probable that a loss will result and the amount of the loss can be reasonably estimated, the Company will record a liability for the loss. If the loss is not probable or the amount of the loss cannot be reasonably estimated, the Company discloses the claim if the likelihood of a potential loss is reasonably possible and the amount involved could be material. While there can be no assurances, the Company does not expect that any of its pending legal proceedings will have a material financial impact on the Company’s results.





On February 29, 2008, Roy Elfers, a former employee commenced an action against the Company for breach of contract arising from his termination of employment in the Supreme Court of the State of New York, Nassau County. The Complaint seeks damages of approximately $87,000. The Company filed an answer to the complaint. The parties have completed discovery and have completed taking depositions. Trial is scheduled for June 2011. The Company intends to vigorously defend this action.





On March 4, 2008, Thomas Cusack, the Company’s former General Counsel, commenced an action with the United States Department of Labor, Occupational Safety and Health and Safety Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act. On April 2, 2008, the Company filed a response to the charges. The Company intends to vigorously defend against the action. On March 7, 2008, Mr. Cusack also commenced a second action against the Company for breach of contract and related issues arising from his termination of employment in New York State Supreme Court, Nassau County. On May 7, 2008, the Company served a motion to dismiss the complaint, and on or about September 26, 2008, the Court dismissed several claims (tortious interference with a contract, tortious interference with economic opportunity, fraudulent inducement to enter into a contract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack's breach of contract claims, stock conversion claim, as well one claim for conversion of his personal property which Mr. Cusack has also asserted against the Company’s executive officers.  On October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining claims, and on November 5, 2008, the Company filed an answer to the complaint and filed counterclaims against Mr. Cusack for fraud. The parties have completed the discovery and depositions. The parties submitted motions for summary judgment and on August 19, 2010, the Court granted Mr. Cusack’s motion as to his stock conversion claim and narrowed certain issues as to his breach of contract claims. On September 13, 2010, the Company appealed this decision. On January 14, 2011, the Court stayed the trial pending the appeal of the summary judgment decision. Mr. Cusack seeks damages in excess of $3,000,000. The Company intends to vigorously defend this action.





On January 7, 2011, Action Group, Inc. commenced an action in the United States District Court for the Eastern District of New York. The complaint seeks $1,187,510 for goods allegedly sold to American Defense Systems, Inc., for which payment was not received. This amount is included in accounts payable in the condensed consolidated balance sheet as of March 31, 2011. While the parties were engaged in settlement discussions, plaintiff sought and was granted entry of a default on February 8, 2011. Plaintiff then filed a motion with the Court, dated March 7, 2011, seeking entry of a default judgment in the amount of $1,246,542, representing the original demand set forth in the complaint, plus interest, costs and disbursements. On March 16, 2011, the Court issued an Order, directing Defendants to respond to the Court in writing within seven days as to why default judgment should not be entered. On March 28, 2011, counsel for American Defense Systems, Inc. sought and obtained an Order from the Court extending its time to respond to the Court’s March 16, 2011 Order up to and including April 11, 2011. On April 11, 2011, Defendants served and filed a motion to set aside the default entered against them, and in opposition to plaintiff’s motion for entry of a default judgment. The motion is not yet fully submitted to the Court for its review and, accordingly, the Court has not yet made any determination as to the Defendants’ request to set aside the default.





14





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





4.      SHAREHOLDERS’ EQUITY (DEFICIENCY)





The following table summarizes the changes in shareholders' equity (deficiency) for the three months ended March 31, 2011:





Balance - January 1, 2011

$
(9,760,747
)Stock based compensation


33,279Net income


11,960,885Balance - March 31, 2011

$
2,233,417





Warrants





The following is a summary of stock warrants outstanding at March 31, 2011:





Warrants


Weighted Average

Exercise Price


WeightedAverage

Remaining

ContractualLives

(in years)Balance – January 1, 2011


675,001


$
2.00



2.18Granted


-



n/a



-Exercised


-



n/a



-Cancelled, Forfeited or expired


-



n/a



-Balance – March 31, 2011


675,001


$
2.00



1.94Exercisable – March 31, 2011


675,001





Stock Option Plan





The Company accounts for all stock based compensation as an expense in the financial statements and associated costs are measured at the fair value of the award. The Company also recognizes the excess tax benefit related to stock option exercises as financing cash inflows instead of operating inflows. As a result, the Company’s net income (loss) before taxes for the three months ended March 31, 2011 and 2010 included $33,279 and $118,007 of stock based compensation, respectively. The stock based compensation expense is included in general and administrative expense in the condensed consolidated statements of operations. The Company has selected a “with-and-without” approach regarding the accounting for the tax effects of share-based compensation awards.





15





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The following is a summary of stock options outstanding at March 31, 2011:




Weighted-





Weighted AverageAverage Exercise


Aggregate


Remaining ContractualStock Options


Price


Intrinsic Value


Life (In years)Outstanding, January 1, 2011


2,505,000


$
1.65



-



4.38Granted


-



n/a



n/a



n/aExercised


-



n/a



n/a



n/aCancelled/forfeited


(26,000
)


2.00



n/a



n/aOutstanding, March 31, 2011


2,479,000


$
1.65



-



4.14Exercisable, March 31, 2011


1,313,000


$
1.84







3.84





As of March 31, 2011, there was a total of $295,551 of unrecognized compensation arrangements granted under the Company’s 2007 Incentive Compensation Plan (the “2007 Plan”). The cost is expected to be recognized through 2015.





The Company did not issue any options during the three months ended March 31, 2011.





5.
MANDATORILY REDEEMABLE SERIES A CONVERTIBLE PREFERRED STOCK AND WARRANT LIABILITIES





Series A Preferred





The Series A Preferred was redeemable on October 1, 2011 and convertible into shares of common stock at a rate of 2,000 shares of common stock for each share of Series A Preferred. On March 22, 2011, the Company entered into a Securities Redemption Agreement (the "Redemption Agreement") with the Series A Holders, pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG, the Company’s wholly-owned subsidiary.  The Series A Holders owned an aggregate of 15,000 shares of the Series A Preferred.  In exchange for the sale of the APSG interests to the Series A Holders, the Series A Holders (i) paid the Company $1,000,000 in cash at the closing of the transactions and (ii) tendered to the Company the Series A Preferred, which had an aggregate redemption price of $16,500,000. Upon the closing of the transactions, the Series A Holders own 100% of the APSG interests and APSG is no longer be a subsidiary of the Company.





In connection with the Redemption Agreement, the Company and the Series A Holders entered into a Membership Interest Option Agreement (the "Option Agreement") pursuant to which the Series A Holders granted the Company an option (the “Option”) to repurchase the APSG interests within six months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option. An analysis of the Option was performed and its value was deemed to be immaterial.





The total consideration the Company received in connection with the Redemption Agreement was $1.0 million in cash and the return and extinguishment of the mandatorily redeemable Series A Preferred which had a redemption value of $16.5 million. The Company prepared a preliminary estimate of the fair value of APSG and allocated $4.4 million of the consideration to the sale of APSG and the residual amount of the consideration was allocated to the redemption of the Series A Preferred. The Company recorded a gain on the redemption of the Series A Preferred, which had been previously accounted for as a liability, of approximately $13 million, net of the write off of the unamortized deferred financing costs, for the three months ended March 31, 2011.




16





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





2005 Warrants, 2006 Warrants, and Placement Agent Warrants





Upon issuance, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants met the requirements for equity classification set forth in Emerging Issues Task Force (“EITF”) Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock, and Statement of Financial Accounting Standards (“SFAS”) No. 133, as codified in ASC 815. However, effective January 1, 2009, the Company was required to analyze its then outstanding financial instruments in accordance with EITF 07-5 as codified in ASC 815-40. Based on the Company’s analysis, its 2005 Warrants, 2006 Warrants, and Placement Agent Warrants, include price protection provisions whereby the exercise price could be adjusted upon certain financing transactions at a lower price per share and could no longer be viewed as indexed to the Company’s common stock. As a result, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants are accounted for as “derivatives” under ASC 815 and recorded as liabilities at fair value as of January 1, 2009 with changes in subsequent period fair value recorded in the statement of operations. The 2005 and 2006 Warrants expired in June 2010.





Fair values for the Company’s derivatives and financial instruments are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, market interest rates, forward yield curves and discount rates. Such amounts and the recognition of such amounts are subject to significant estimates which may change in the future. The methods and significant inputs and assumptions utilized in estimating the fair value of the Placement Agent Warrants are discussed below. Each of the measurements is considered a Level 3 measurement as a result of at least one unobservable input.





Placement Agent Warrants





The Company estimated the fair value of the Placement Agent Warrants as of March 31, 2011. The model used is subject to the significant assumptions discussed below and requires the following key inputs with respect to the Company and/or instrument:





Quoted Stock Price

$
0.16Exercise Price

$
2.00Expected Life (in years)


1.94Stock Volatility


98.16
%Risk-Free Rate


1.29
%Dividend Rate


0
%





6.      DISCONTINUED OPERATIONS





On March 22, 2011, the Company entered into a Securities Redemption Agreement (the "Redemption Agreement") with the Series A Holders, pursuant to which the Company sold to the Series A Holders all of the issued and outstanding membership interests in APSG, the Company’s wholly-owned subsidiary.  The Series A Holders owned an aggregate of 15,000 shares of the Series A Preferred.  In exchange for the sale of the APSG interests to the Series A Holders, the Series A Holders (i) paid the Company $1,000,000 in cash at the closing of the transactions and (ii) tendered to the Company the Series A Preferred, which had an aggregate redemption price of $16,500,000.  Upon the closing of the transactions, the Series A Holders own 100% of the APSG interests and APSG is no longer be a subsidiary of the Company.





In connection with the Redemption Agreement, the Company and the Series A Holders entered into a Membership Interest Option Agreement (the "Option Agreement") pursuant to which the Series A Holders granted the Company an option (the “Option”) to repurchase the APSG interests within six months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option. An analysis of the Option was performed and its value was deemed to be immaterial.




17





AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The lease for the facility in North Carolina that APSG occupies is in the Company’s name, however, APSG pays the rent directly to the landlord.





The presentation herein of the results of continuing operations excludes APSG for all periods presented. The following amounts have been segregated from continuing operations and are reflected as discontinued operations in the condensed consolidated statement of operations for the three months ended March 31, 2011 and 2010:





2011


2010Revenues

$
969,291


$
4,136,580Income from discontinued operations before income taxes


126,518



298,496Gain on disposal of APSG


2,910,565



-Income tax expense


-



-Income from discontinued operations, net of tax

$
3,037,083


$
298,496





The following amounts have been segregated from continuing operations and are reflected as discontinued operations in the condensed consolidated balance sheet at December 31, 2010:





Current Assets:Cash

$
178,304Accounts receivable, net


1,417,240Inventory


307,7321,903,276Long-term Assets:Property and equipment, net


17,926Intangibles


634,450652,376LiabilitiesAccounts payable and accrued expenses

$
1,671,350





Cash flows from discontinued operations were not reported separately for the three months ended March 31, 2011 and 2010.





The total consideration the Company received in connection with the Redemption Agreement was $1.0 million in cash and the return and extinguishment of the mandatorily redeemable Series A Preferred which had a redemption value of $16.5 million. The Company allocated $4.4 million of the consideration to the sale of APSG based on a preliminary calculation of the fair value of APSG with the residual amount of the consideration allocated to the redemption of the Series A Preferred. The Company recorded a gain on the sale of APSG of approximately $3 million for the three months ended March 31, 2011 based on the difference between the allocated consideration and the net book value of APSG, including goodwill.





7.      INCOME TAXES




In its interim financial statements the Company follows the guidance in ASC 270, “Interim Reporting” (“ASC 270”) and ASC 740, “Income Taxes” (“ASC 740”) whereby the Company utilizes the expected annual effective tax rate in determining its income tax provisions for the interim period’s income or loss. That rate differs from the U.S. statutory rate primarily as a result of certain net operating loss carryforwards and permanent differences between book and tax reporting. Based on its preliminary assessment, the Company believes the transactions entered into on March 22, 2011 (See Notes 5 and 6) will not result in significant tax as a result of differences in book and tax reporting and the availability of net operating losses to offset taxable income.





The Company does not expect that its unrecognized tax benefits will significantly change within the next twelve months. The Company files a consolidated U.S. income tax return and tax returns in certain state and local jurisdictions. There are no current tax examinations in progress. As of March 31, 2011, the Company remains subject to examination in applicable tax jurisdictions for the relevant statute of limitations periods.





18





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





The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this report and in our annual report on Form 10-K for the year ended December 31, 2010.





Except for statements of historical fact, certain information described in this report contains “forward-looking statements” that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “project,” “will,” “would” or similar words. The statements that contain these or similar words should be read carefully because these statements discuss our future expectations, contain projections of our future results of operations or of our financial position, or state other “forward-looking” information. We believe that it is important to communicate our future expectations to our investors. However, there may be events in the future that we are not able accurately to predict or control. Further, we urge you to be cautious of the forward-looking statements which are contained in this report because they involve risks, uncertainties and other factors affecting our operations, market growth, service and products.  You should not place undue reliance on any forward-looking statement, which speaks only as of the date made. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in “Risk Factors” in Item 1A of Part II.





Overview





We are a defense and security products company engaged in three business areas: customized transparent and opaque armor solutions for construction equipment and tactical and non-tactical transport vehicles used by the military; architectural hardening and perimeter defense, such as bullet and blast resistant transparent armor, walls and doors; and tactical training products and services consisting of our live-fire interactive T2 Tactical Training System and our American Institute for Defense and Tactical Studies. The portion of our business related to vehicle anti-ram barriers such as bollards, steel gates and steel wedges that deploy out of the ground was sold as of March 22, 2011.





We primarily serve the defense market and our sales are highly concentrated within the U.S. government. Our customers include various branches of the U.S. military through the U.S. Department of Defense and to a much lesser extent other U.S. government, law enforcement and correctional agencies as well as private sector customers.





Our recent historical revenues have been generated primarily from a limited number of large contracts and a series of purchase orders from a single customer. To continue expanding our business, we are seeking to broaden our customer base and to diversify our product and service offerings. Our strategy to increase our revenue, grow our company and increase shareholder value involves the following key elements:




·
increase exposure to military platforms in the U.S. and internationally;




·
develop strategic alliances and form strategic partnerships with original equipment manufacturers (OEMs); and




·
focus on an advanced research and development program to capitalize on increased demand for new armor materials.





We are pursuing each of these growth strategies simultaneously.





Sources of Revenues





We derive our revenues by fulfilling orders under master contracts awarded by branches of the United States military, law enforcement and corrections agencies and private companies involved in the defense market and other customer purchase orders. Under these contracts and purchase orders, we provide customized transparent and opaque armor products for transport and construction vehicles used by the military, group protection kits and spare parts. We also derive revenues from sales of our architectural hardening and perimeter defense products, which we sometimes refer to as physical security products. To date, we have generated nominal revenues from our T2 and other training solutions and we are evaluating the continued offering of such training products and services and expect to continue that process over the next several months.





Our contract backlog as of March 31, 2011 was $10 million. We estimate that it will all be filled during the remainder of 2011.Accordingly, in order to maintain our current revenue levels and to generate revenue growth, we will need to win more contracts with the U.S. government and other commercial entities, achieve significant penetration into critical infrastructure and public safety protection markets, and successfully further develop our relationships with OEM's and strategic partners. Notwithstanding the possible significant troop reductions in Afghanistan and Iraq, we expect that demand in those countries for armored military construction vehicles will continue in order to repair significant war damage and for nation-building purposes. In addition, we are exploring interest in armored construction equipment in other countries with mine-infested regions.





19





We continue to aggressively bid on projects and are in preliminary talks with a number of international firms to pursue long-term government and commercial contracts, including with respect to Homeland Security. While no assurances can be given that we will obtain a sufficient number of contracts or that any contracts we do obtain will be of significant value or duration, we are confident that we will continue to have the opportunity to bid and win contracts as we have in 2010.





Cost of Revenues and Operating Expenses




Cost of Revenues.           Cost of revenues consists of parts, direct labor and overhead expenses incurred for the fulfillment of orders under contract. These costs are charged to expense upon completion and acceptance of an order. Costs of revenue also includes the costs of prototyping and engineering, which are expensed upon completion of an order as well. These costs are included as costs of revenue because they are incurred to modify products based upon government specifications and are reimbursable costs within the contract. These costs for the production of goods under contract are expensed when they are complete. We allocate overhead expenses such as employee benefits, computer supplies, depreciation for computer equipment and office supplies based on personnel assigned to the job. As a result, indirect overhead expenses are included in cost of revenues and each operating expense category.




Sales and Marketing.         Expenses related to sales and marketing consist primarily of compensation for our sales and marketing personnel, sales commissions and incentives, trade shows and related travel.  Sales and marketing costs are charged to expense as incurred. As we have implemented various cost cutting measures, we expect that in 2011, sales and marketing expenses will decrease.




Research and Development.       Research and development expenses are incurred as we perform ongoing evaluations of materials and processes for existing products, as well as the development of new products and processes. We expect that in 2011, research and development expenses will remain consistent with or decrease from 2010 levels. Research and development costs are charged to expense as incurred.




General and Administrative.        General and administrative expenses consist of compensation and related expenses for finance, accounting, administrative, legal, professional fees, other corporate expenses and allocated overhead.  We expect that in 2011, general and administrative expenses will decrease in absolute dollars and decrease as a percentage of revenues due to cost cutting measures implemented in 2010 and in the first quarter of 2011.




General and Administrative Salaries.         General and administrative salaries expenses consist of compensation for the officers, and IT, design and engineering personnel.  We expect that in 2011, general and administrative salaries expenses will decrease in absolute dollars and decrease as a percentage of revenues due to the cost cutting measures, which include reduction in labor costs, implemented in 2010 and the first quarter of 2011.





Critical Accounting Policies





Our condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions.





We believe that of our significant accounting policies, which are described in Note 1 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2010, involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.





Revenue and Cost Recognition.         We recognize revenue in accordance with Accounting Standards Codification (ASC) 605, "Revenue Recognition", which states that revenue is realized and earned when all of the following criteria are met: (a) persuasive evidence of the arrangement exists, (b) delivery has occurred or services have been rendered, (c) the seller's price to the buyer is fixed and determinable and (d) collectability is reasonably assured. Under this provision, revenue is recognized upon delivery and acceptance of the order.





We recognize revenue and report profits from purchases orders filled under master contracts when an order is complete, as defined below. Purchase orders received under master contracts may extend for periods in excess of one year. Purchase order costs are accumulated as deferred assets and billings and/or cash received are charged to a deferred revenue account during the periods of construction.  However, no revenues, costs or profits are recognized in operations until the period upon completion of the order. An order is considered complete when all costs, except insignificant items, have been incurred and, the installation or product is operating according to specification or the shipment has been accepted by the customer. Provisions for estimated contract losses are made in the period that such losses are determined. As of March 31, 2011, there were no such provisions made.




20





All costs associated with uncompleted purchase orders under contract are recorded on the balance sheet as a deferred asset called "Costs in Excess of Billings on Uncompleted Contracts." Upon completion of a purchase order, such associated costs are then reclassified from the balance sheet to the statement of operations as costs of revenue.





Stock-Based Compensation.      Stock based compensation consists of stock or options issued to employees, directors, consultants and contractors for services rendered. We account for the stock issued using the estimated current market price per share at the date of issuance. Such cost is recorded as compensation in our statement of operations at the date of issuance.





In December 2007, we adopted our 2007 Incentive Compensation Plan pursuant to which we have issued and intend to issue stock-based compensation from time to time, in the form of stock, stock options and other equity based awards. Our policy for accounting for such compensation in the form of stock options is as follows:





In accordance with ASC 718 “Compensation–Stock Compensation” we record stock based compensation at fair value. We use the Black-Scholes option pricing model to measure the fair value of our option awards. The Black-Scholes model requires the input of highly subjective assumptions including volatility, expected term, risk-free interest rate and dividend yield. In 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, as codified in ASC 718-10-599, which provides supplemental implementation guidance for ASC 718.





Stock-based compensation expense recognized will be based on the estimated portion of the awards that are expected to vest. We will apply estimated forfeiture rates based on analyses of historical data, including termination patterns and other factors.





We recognized $33,279 and $118,007 in stock compensation expense for the three months ended March 31, 2011 and 2010, respectively.





Fair Value Measurements.     We follow the provisions of ASC 820, “Fair Value Measurements and Disclosures” (ASC 820). ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value investments.





Fair value, as defined in ASC 820, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, whether using an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the company’s credit risk.





Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques requires significant judgment and are primarily dependent upon the characteristics of the asset or liability, the principal (or most advantageous) market in which participants would transact for the asset or liability and the quality and availability of inputs. Inputs to valuation techniques are classified as either observable or unobservable within the following hierarchy:





Level 1 Inputs:  These inputs come from quoted prices (unadjusted) in active markets for identical assets or liabilities.





Level 2 Inputs:  These inputs are other than quoted prices that are observable, for an asset or liability. This includes: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.





Level 3 Inputs:  These are unobservable inputs for the asset or liability which require the company’s own assumptions.




21





Series A Convertible Preferred Stock.        The Series A Convertible Preferred Stock (or Series A Preferred) was mandatorily redeemable on October 1, 2011 and was convertible into shares of common stock at $0.50 per share subject to adjustment should we issue future common stock at a lesser price. As a result we elected to record the hybrid instrument, preferred stock and conversion option together, at fair value. Subsequent reporting period changes in fair value are to be reported in the statement of operations. Pursuant to the Redemption Agreement, all outstanding shares of Series A Convertible Preferred Stock were redeemed on March 22, 2011.





The proceeds from the issuance of the Series A Preferred and accompanying common stock warrants, net of direct costs including the fair value of warrants issued to the Placement Agent in connection with the transaction, must be allocated to the instruments based upon relative fair value upon issuance as they must be measured initially at fair value. Therefore, after the initial recording of the Series A Preferred based upon net proceeds received, the carrying value of the Series A Preferred must be adjusted to the fair value at the date of issuance, with the difference recorded as a gain or loss. On March 7, 2008, the date of initial issuance, we recorded a derivative liability of $9.8 million. On April 4, 2008, the date of the second issuance, we recorded a derivative liability of $3.6 million. These liabilities were subsequently adjusted to fair value as of March 22, 2011 (date of redemption) and March 31, 2010, which resulted in a loss of $2.4 million and $0.6 million for the period from January 1, 2011 through March 22, 2011 and the three months ended March 31, 2010, respectively.





Consolidated Results of Operations





The following discussion should be read in conjunction with the information set forth in the condensed consolidated financial statements and the related notes thereto appearing elsewhere in this report. The following discussion excludes results of discontinued operations.





Comparison of the Three Months Ended March 31, 2011 and 2010





Revenues.    Revenues for the three months ended March 31, 2011 were $2.5 million, a decrease of $8.8 million, or 77.9%, as compared to revenues of $11.3 million in the comparable period in 2010. This decrease was due primarily to a slow-down in government orders.





Cost of Revenues.     Cost of revenues for the three months ended March 31, 2011 was $1.4 million, a decrease of $5.2 million, or 78.8%, over cost of revenues of $6.6 million in the comparable period in 2010. This decrease resulted primarily from the decline in revenue.





Gross Profit.    Gross profits for the three months ended March 31, 2011 and 2010 were $1.1 million and $4.7 million, respectively. Gross profit margin was 45.3% and 41.8% for three months ended March 31, 2011 and 2010, respectively. The increase in gross profit margin resulted primarily from a better product mix in 2011 from spare parts and field service representatives.





Sales and Marketing Expenses.    Sales and marketing expenses for the three months ended March 31, 2011 and 2010 were $171,403 and $562,809, respectively, representing a decrease of $391,406, or 69.5%. The decrease was due primarily to a decrease in trade show expenses and related expenses from selling and marketing, and a reduction in headcount of 4 employees.





T2 Expenses.    T2 expenses for the three months ended March 31, 2011 and 2010 were $102,361 and $218,848, respectively, representing a decrease of $116,487, or 53.2%. The decrease was due primarily to a decrease in T2 salary expense resulting from the decrease in the number of T2 employees.





Research and Development Expenses.    Research and development expenses for the three months ended March 31, 2011 and 2010 were $115,159 and $121,717, respectively, a decrease of $6,558 or 5.4%.





General and Administrative Expenses.    General and administrative expenses for the three months ended March 31, 2011 and 2010 were $817,018 and $1,430,230 respectively. The decrease of $613,212 or 42.9% was due primarily to lower general liability insurance due to decreased sales and a reduction in travel expenses.





General and Administrative Salaries Expense.    General and administrative salaries expenses for the three months ended March 31, 2011 and 2010 were $703,895 and $884,218, respectively. The decrease of $180,323 or 20.4% was due primarily to a reduction in headcount of 5 employees.





Depreciation Expense.    Depreciation expense was $269,754 and $287,196 for the three months ended March 31, 2011 and 2010, respectively, a decrease of $17,442, or 6.1%.





Professional Fees.     Professional fees for the three months ended March 31, 2011 and 2010 were $238,864 and $573,370, respectively. The decrease of $334,506 or 58.3% was due primarily to a decrease in legal and outside consulting fees.





22





Other (Income) and Expense.     Our Series A Preferred was recorded at fair value through March 22, 2011 with changes in fair value recorded in the statement of operations. We experienced a loss on adjustment of fair value with respect to our Series A Preferred of $2,395,592 and $646,100 for the three months ended March 31, 2011 and 2010, respectively. In addition, we incurred interest expense associated with the amortization of the deferred financing costs and discount on the Series A Preferred of $236,118 and $641,146 for the three months ended March 31, 2011 and 2010, respectively. We also recorded a gain on the redemption of the Series A Preferred of $12,786,969 for the three months ended March 31, 2011 (see Note 5 of the accompanying condensed consolidated financial statements).





Income from Discontinued Operation.     We recorded income from discontinued operation of $3,037,083 which included a gain on the sale of APSG of $2,910,565 for the three months ended March 31, 2011 (see Note 6 of the accompanying condensed consolidated financial statements).





Liquidity and Capital Resources





The primary sources of our liquidity during the three months ended March 31, 2011 were proceeds from the sale of APSG and the redemption of the Series A Preferred, as well as proceeds from the sale of a fixed asset. As of March 31, 2011, our principal sources of liquidity are net accounts receivable of $1.1 million and costs in excess of billings of $1.5 million as well as our ability to sell future accounts receivable under an accounts receivable purchase agreement with Republic Capital Access (RCA).





As of March 31, 2011, we had working capital of $569,610, an accumulated deficit of $14,360,911, shareholders’ equity of $2,233,417 and cash on hand of $745,689. We had an operating loss of $(1,268,845) and operating income of $647,138 for the three months ended March 31, 2011 and 2010, respectively.  We had income from continuing operations for the three months ended March 31, 2011 of $8,923,802, including a gain of $12,786,969 on the redemption of preferred stock, and losses from continuing operations for the three months ended March 31, 2010 of $(1,122,901). We had net income (losses) of $11,960,885 and $(824,405) for the three months ended March 31, 2011 and 2010, respectively. We had net cash used in operations of $(1,081,067) and net cash provided by operations of $114,390 for the three months ended March 31, 2011, and 2010, respectively.  We entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series A convertible preferred stock (the “Series A Preferred”), as more fully discussed in Note 6 of the accompanying condensed consolidated financial statements. In addition, we are currently seeking to raise capital or obtain access to capital sufficient to permit us to meet our future cash flow needs though there can be no assurance that we will be able to obtain additional financing on commercially reasonable terms or at all. We also continue to explore all sources of increasing revenue. If we are unable in the near term to raise capital or increase revenue, we will not have sufficient cash to sustain our operations for the next twelve months. As a result we may be forced to further reduce or even curtail our operations. These factors raise substantial doubt about our ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.





Net Cash (Used In) Provided By Operating Activities.Net cash used in operating activities was $1,081,067 for the three months ended March 31, 2011 compared to net cash provided by operating activities of $114,390 for the three months ended March 31, 2010. Net cash used in operating activities during the three months ended March 31, 2011 consisted primarily of changes in our operating assets and liabilities of $(238,210), including changes in accounts receivable, cost in excess of billing, prepaid expenses and other current assets, and accounts payable and accrued expenses. Net cash provided by operating activities during the three months ended March 31, 2010 consisted primarily of changes in our operating assets and liabilities including accounts receivable, cost in excess of billing, prepaid expenses and other current assets, and accounts payable and accrued expenses. The changes in accounts receivable and costs in excess of billing of $2.0 million and $1.7 million, respectively, reflect the increases in receivables from completed projects and a decrease in costs incurred on projects in process as of March 31, 2010.





Net Cash Provided By (Used In) Investing Activities. Net cash provided by investing activities for the three months ended March 31, 2011 was $1,423,424 and consisted of $1,000,000 of proceeds from the sale of APSG and the redemption of the Series A Preferred, as well as proceeds from the sale of a fixed asset of 429,697, partially offset by leasehold improvements and purchases of computer equipment. Net cash used in investing activities for the three months ended March 31, 2010 was $50,706 and consisted of purchases of general and computer equipment, and leasehold improvements.





Net Cash Provided By Financing Activities. Net cash provided by financing activities for the three months ended March 31, 2011 and 2010 was $0 and $24,287, respectively.





23





Accounts Receivable Purchase Agreement





In July 2009, we entered into an accounts receivable purchase agreement with Republic Capital Access, LLC (RCA), which was amended in October 2009. Under the purchase agreement, we can sell eligible accounts receivables to RCA. Eligible accounts receivable, subject to the full definition of such term in the purchase agreement, generally are our receivables under prime government contracts.





Under the terms of the purchase agreement, we may offer eligible accounts receivable to RCA and if RCA purchases such receivables, we will receive an initial upfront payment equal to 90% of the receivable. Following RCA’s receipt of payment from our customer for such receivable, they will pay to us the remaining 10% of the receivable less its fees. In addition to a discount factor fee and an initial enrollment fee, we are required to pay RCA a program access fee equal to a stated percentage of the sold receivable, a quarterly program access fee if the average daily amount of the sold receivables is less than $2.25 million and RCA’s initial expenses in negotiating the purchase agreement and other expenses in certain specified situations. The purchase agreement also provides that in the event, but only to the extent, that the conveyance of receivables by us is characterized by a court or other governmental authority as a loan rather than a sale, we shall be deemed to have granted RCA effective as of the date of the first purchase under the purchase agreement, a security interest in all of our right, title and interest in, to and under all of the receivables sold by us to RCA, whether now or hereafter owned, existing or arising.





The initial term of the purchase agreement ended on December 31, 2009 and will renew annually after the initial term, unless earlier terminated by either of the parties. Pursuant to an amendment to the purchase agreement in October 2009, the term during which we may offer and sell eligible accounts receivable to RCA (Availability Period) was extended from December 31, 2009 to October 15, 2010, and the discount factor rate was reduced from 0.524% to 0.4075%. On November 12, 2010, we signed an amendment to the purchase agreement which extended the term to October 15, 2011. As of March 31, 2011, RCA held approximately $3,000 of accounts receivable for which RCA has not received payment from our customers.





Series A Convertible Preferred Stock





In March and April 2008, we sold shares of our Series A Convertible Preferred Stock (or Series A Preferred) and warrants to purchase our common stock (or Investor Warrants). We received aggregate gross proceeds of $15.0 million, before fees and expenses of the placement agent in the transaction and other expenses. The Series A Preferred had a mandatory redemption date of October 1, 2011.





On March 22, 2011, the Company entered into a Securities Redemption Agreement (the “Redemption Agreement”) with the holders of our Series A Convertible Preferred Stock, pursuant to which we sold all of the issued and outstanding membership interests in American Physical Security Group, LLC (“APSG”), the Company’s wholly-owned subsidiary, to the holders of our Series A Convertible Preferred Stock.  In exchange for the sale of the APSG interests, the holders of our Series A Convertible Preferred Stock (i) paid $1,000,000 in cash to us at the closing of the transactions and (ii) tendered to the Series A Convertible Preferred Stock, which had an aggregate redemption price of $16,500,000.  Upon the closing of the transactions, APSG is no longer a subsidiary of our company.  In connection with the Redemption Agreement, the Company and the holders of our Series A Convertible Preferred Stock entered into that certain Membership Interest Option Agreement (the "Option Agreement") pursuant to the Company was granted an option (the “Option”) to repurchase APSG within six (6) months following the closing of the transactions contemplated by the Redemption Agreement at a cash purchase price equal to the sum of (i) $15,525,000, plus (ii) the amount of any net investment made in APSG concurrently with and following the closing of the Redemption Agreement and prior to the closing of the purchase of the APSG membership interests pursuant to exercise of the Option. An analysis of the Option was performed and its value was deemed to be immaterial.




24





Item 3.     Quantitative and Qualitative Disclosure About Market Risk





We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 (or Exchange Act) and are not required to provide the information required under this Item 3.





Item 4.     Controls and Procedures





Evaluation of Disclosure Controls and Procedures





Disclosure controls and procedures, as defined in Rules 13(a)-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934 (or Exchange Act), are controls and other procedures that are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified by the rules and forms promulgated by the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. As a result of this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of March 31, 2011 because of the material weakness set forth below.





The following is a summary of the material weakness we identified as of December 31, 2010 which remains as of March 31, 2011:





Due to a lack of adequate systems, processes, and resources we did not maintain effective controls over the period-end financial close and reporting processes as of March 31, 2011. Due to the actual and potential effect on financial statement balances and disclosures, and the importance of the financial closing and reporting processes, we concluded that, in the aggregate, these deficiencies in internal controls over the period-end financial close and reporting process constituted a material weakness in internal control over financial reporting. The specific deficiencies contributing to this material weakness were as follows:





·
Inadequate documentation of review process. We did not maintain procedures for a formalized timely documented review process to ensure significant, complex, and non-routine transactions are recorded correctly in the financial statements.


·
Inadequate policies and procedures for inventory. We did not design, establish, and maintain effective documented financial accounting policies and procedures related to inventory counting, pricing and valuation.





Our efforts to improve our internal controls are ongoing and focused on expanding our organizational capabilities to improve our control environment and on implementing process changes to strengthen our internal control and monitoring activities.





Changes in Internal Controls





There were no changes in our internal controls over financial reporting during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to affect, our internal control over financial reporting.





Limitations on the Effectiveness of Controls





Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, with our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls.





The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, a control may become inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.





25




PART II
 
 Item 1.
Legal Proceedings
 
 On February 29, 2008, Roy Elfers, a former employee commenced an action against us for breach of contract arising from his termination of employment in the Supreme Court of the State of New York, Nassau County. The Complaint seeks damages of approximately $87,000. The Company filed an answer to the complaint. The parties have completed discovery and have completed taking depositions. Trial is scheduled for June 2011. We believe meritorious defenses to the claims exist and we intend to vigorously defend this action.
 
 On March 4, 2008, Thomas Cusack, our former General Counsel, commenced an action with the United States Department of Labor, Occupational Safety and Health and Safety Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act. On April 2, 2008, we filed a response to the charges. We believe the allegations to be without merit and intend to vigorously defend against the action. On March 7, 2008, Mr. Cusack also commenced a second action against us for breach of contract and related issues arising from his termination of employment in New York State Supreme Court, Nassau County. On May 7, 2008, we served a motion to dismiss the complaint, and on or about September 26, 2008, the Court dismissed several claims (tortious interference with a contract, tortious interference with economic opportunity, fraudulent inducement to enter into a contract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack's breach of contract claims, stock conversion claim, as well as one claim for conversion of his personal property which Mr. Cusack has also asserted against our executive officers. On October 13, 2008, Mr. Cusack filed an amended complaint as to the remaining claims, and on November 5, 2008, we filed an answer to the amended complaint and filed counterclaims against Mr. Cusack for fraud. The parties have completed discovery and have scheduled depositions. The parties submitted motions for summary judgment, and on August 19, 2010, the Court granted Mr. Cusack’s motion as to his stock conversion claim and narrowed certain issues as to his breach of contract claims. On September 13, 2010, the Company appealed this decision. On January 14, 2011, the Court stayed the trial pending the appeal of the summary judgment decision. Mr. Cusack seeks damages in excess of $3,000,000. We believe meritorious defenses to the claims exist and we intend to vigorously defend this action.
 
 On January 7, 2011, Action Group, Inc. commenced an action in the United States District Court for the Eastern District of New York. The complaint seeks $1,187,510 for goods allegedly sold to the Company, for which payment was not received. While the parties were engaged in settlement discussions, plaintiff sought and was granted entry of a default on February 8, 2011. Plaintiff then filed a motion with the Court, dated March 7, 2011, seeking entry of a default judgment in the amount of $1,246,542, representing the original demand set forth in the complaint, plus interest, costs and disbursements. On March 16, 2011, the Court issued an Order, directing Defendants to respond to the Court in writing within seven days as to why default judgment should not be entered. On March 28, 2011, counsel for the Company sought and obtained an Order from the Court extending its time to respond to the Court’s March 16, 2011 Order up to and including April 11, 2011. On April 11, 2011, Defendants served and filed a motion to set aside the default entered against them, and in opposition to plaintiff’s motion for entry of a default judgment. The motion is not yet fully submitted to the Court for its review and, accordingly, the Court has not yet made any determination as to the Defendants’ request to set aside the default.
 
 Item 1A.
Risk Factors
  Our business, industry and common stock are subject to numerous risks and uncertainties. The discussion below sets forth all of such risks and uncertainties that we have identified as material, but are not the only risks and uncertainties facing us. Any of the following risks, if realized, could materially and adversely affect our revenues, operating results, profitability, financial condition, prospects for future growth and overall business, as well as the value of our common stock.Our business is also subject to general risks and uncertainties that affect many other companies, such as overall U.S. and non-U.S. economic and industry conditions, including a global economic slowdown, geopolitical events, changes in laws or accounting rules, fluctuations in interest and exchange rates, terrorism, international conflicts, major health concerns, natural disasters or other disruptions of expected economic and business conditions. Additional risks and uncertainties not currently known to us or that we currently believe are immaterial also may impair our business operations and liquidity.
  26
  Risks Relating to Our Company
  We have a history of operating losses and anticipate future operating losses until such time as we can generate additional sales.
 
 We have a history of operating losses and there is a substantial doubt about our ability to continue as a going concern. As of March 31, 2011, the Company had working capital of $569,610, an accumulated deficit of $14,360,911, shareholders’ equity of $2,233,417 and cash on hand of $745,689. We had an operating loss of $(1,268,845) and operating income of $647,138 for the three months ended March 31, 2011 and 2010, respectively. We had income from continuing operations for the three months ended March 31, 2011 of $8,923,802, including a gain of $12,786,969 on the redemption of preferred stock, and losses from continuing operations for the three months ended March 31, 2010 of $(1,122,901). We had net income (losses) of $11,960,885 and $(824,405) for the three months ended March 31, 2011 and 2010, respectively. We had net cash used in operations of $(1,081,067) and net cash provided by operations of $114,390 for the three months ended March 31, 2011, and 2010, respectively. We entered into an agreement with the Series A Holders on March 22, 2011 to redeem the Series A convertible preferred stock (the “Series A Preferred”), as more fully discussed in Note 6 of the accompanying condensed consolidated financial statements. In addition, we are currently seeking to raise capital or obtain access to capital sufficient to permit us to meet our future cash flow needs though there can be no assurance that we will be able to obtain additional financing on commercially reasonable terms or at all. We also continue to explore all sources of increasing revenue. If we are unable in the near term to raise capital or increase revenue, we will not have sufficient cash to sustain our operations for the next twelve months. As a result we may be forced to further reduce or even curtail our operations. These factors raise substantial doubt about our ability to continue as a going concern.
 
 We depend on the U.S. Government for a substantial amount of our sales and if we do not continue to experience demand for our products within the U.S. Government, our business may fail. Moreover, our growth in the last few years has been attributable in large part to U.S. wartime spending in support of troop deployments in Iraq and Afghanistan. If such troop levels are reduced, our business may be harmed.
 
 We primarily serve the defense market and our sales are highly concentrated within the U.S. government. Customers for our products include the U.S. Department of Defense, including the U.S. Marine Corps and U.S. Army Tank Automotive and Armaments Command (TACOM), and the U.S. Department of Homeland Security. Government tax revenues and budgetary constraints, which fluctuate from time to time, can affect budgetary allocations for these customers. Many government agencies have in the past experienced budget deficits that have led to decreased spending in defense, law enforcement and other military and security areas. Our results of operations may be subject to substantial period-to-period fluctuations because of these and other factors affecting military, law enforcement and other governmental spending.
 
 U.S. defense spending historically has been cyclical. Defense budgets have received their strongest support when perceived threats to national security raise the level of concern over the country’s safety, such as in Iraq and Afghanistan. As these threats subside, spending on the military tends to decrease. Accordingly, while U.S. Department of Defense funding has grown rapidly over the past few years, there is no assurance that this trend will continue. Rising budget deficits, the cost of the war on terror and increasing costs for domestic programs continue to put pressure on all areas of discretionary spending, and the new administration has signaled that this pressure will most likely impact the defense budget. A decrease in U.S. government defense spending, including as a result of planned significant U.S. troop level reductions in Iraq or Afghanistan, or changes in spending allocation could result in our government contracts being reduced, delayed or terminated. Reductions in our government contracts, unless offset by other military and commercial opportunities, could adversely affect our ability to sustain and grow our future sales and earnings.
 
 We entered into a redemption agreement with holders of our Series A Convertible Preferred Stock in which we transferred our interest in our subsidiary, American Physical Security Group, LLC.
 
 On March 22, 2011, the Company entered into the Redemption Agreement with the holders of our Series A Convertible Preferred Stock, pursuant to which we sold all of the issued and outstanding membership interests in APSG, the Company’s wholly-owned subsidiary, to the holders of our Series A Convertible Preferred Stock.  In exchange for the sale of the APSG interests, the holders of our Series A Convertible Preferred Stock (i) paid $1,000,000 in cash to us at the closing of the transactions and (ii) tendered to the Series A Convertible Preferred Stock, which had an aggregate redemption price of $16,500,000.  Upon the closing of the transactions, APSG will no longer be a subsidiary of our company.  APSG accounted for $8.1 million, or 20.4% of our revenues in fiscal year 2010 and generated operating income of $74,735 compared to an operating loss of approximately $4.5 million in fiscal year 2010 for the company as a whole. APSG generated operating income of $126,518 and $298,496 for the quarters ended March 31, 2011 and 2010, respectively. The loss of revenues from APSG could materially adversely affect our business, results from operations and financial condition.
  27
  Our revenues historically have been concentrated in a small number of contracts obtained through the U.S. Department of Defense and the loss of, or reduction in estimated revenue under, any of these contracts, or the inability to contract further with the U.S. Department of Defense could significantly reduce our revenues and harm our business.
 
 Our revenues historically have been generated by a small number of contracts. During the first quarter of 2011 three contracts with the U.S. Department of Defense organizations represented approximately 16% of our revenue. During the first quarter of 2010 four contracts with the U.S. Department of Defense organizations represented approximately 93% of our revenue. While we believe we have satisfied and continue to satisfy the terms of these contracts, there can be no assurance that we will continue to receive orders under such contracts. Our government customers generally have the right to cancel any contract, or ongoing or planned orders under any contract, at any time. If any of our significant contracts were canceled, or our customers reduce their orders under any of these contracts, or we were unable to contract further with the U.S. Department of Defense, our revenues could significantly decrease and our business could be severely harmed.
 
 We are required to comply with complex laws and regulations relating to the procurement, administration and performance of U.S. government contracts, and the cost of compliance with these laws and regulations, and penalties and sanctions for any non-compliance could adversely affect our business.
 
 We are required to comply with laws and regulations relating to the administration and performance of U.S. government contracts, which affect how we do business with our customers and impose added costs on our business. Among the more significant laws and regulations affecting our business are the following:
  ·
The Federal Acquisition Regulations: Along with agency regulations supplemental to the Federal Acquisition Regulations, comprehensively regulate the formation, administration and performance of federal government contracts;
  ·
The Truth in Negotiations Act: Requires certification and disclosure of all cost and pricing data in connection with contract negotiations;
  ·
The Cost Accounting Standards and Cost Principles: Imposes accounting requirements that govern our right to reimbursement under certain cost-based federal government contracts; and
  ·
Laws, regulations and executive orders restricting the use and dissemination of information classified for national security purposes and the export of certain products and technical data. We engage in international work falling under the jurisdiction of U.S. export control laws. Failure to comply with these control regimes can lead to severe penalties, both civil and criminal, and can include debarment from contracting with the U.S. government.
  Our contracting agency customers periodically review our performance under and compliance with the terms of our federal government contracts. We also routinely perform internal reviews. As a result of these reviews, we may learn that we are not in compliance with all of the terms of our contracts. If a government review or investigation uncovers improper or illegal activities, we may be subject to civil or criminal penalties or administrative sanctions, including:
  ·
Termination of contracts;
  ·
Forfeiture of profits;
  ·
Cost associated with triggering of price reduction clauses;
  ·
Suspension of payments;
  ·
Fines; and
  ·
Suspension or debarment from doing business with federal government agencies.
  If we fail to comply with these laws and regulations, we may also suffer harm to our reputation, which could impair our ability to win awards of contracts in the future or receive renewals of existing contracts. If we are subject to civil and criminal penalties and administrative sanctions or suffer harm to our reputation, our current business, future prospects, financial condition, and/or operating results could be materially harmed. In addition, we are subject to the industrial security regulations, protocols, and procedures of the U.S. Government as set forth in the National Industrial Security Program Operating Manual (NISPOM), which are designed to protect and safeguard classified information from unauthorized release to individuals and organizations not possessing a security clearance or the requisite level of clearance necessary to access that information. Accordingly, any failure to adhere to the requirements of the NISPOM could expose us to severe legal and administrative consequences, including, but not limited to, our suspension or debarment from government contracts, the revocation of our clearance, and the termination of our government contracts, the occurrence of any of which could substantially harm our existing business and preclude us from competing for or receiving future government contracts.
  28
  Government contracts are usually awarded through a competitive bidding process that entails risks not present in the acquisition of commercial contracts.
 
 A significant portion of our contracts and task orders with the U.S. government is awarded through a competitive bidding process. We expect that much of the business we seek in the foreseeable future will continue to be awarded through competitive bidding. Budgetary pressures and changes in the procurement process have caused many government customers to increasingly purchase goods and services through indefinite delivery/indefinite quantity (IDIQ) contracts, General Services Administration (GSA) schedule contracts and other government-wide acquisition contracts (GWACs). These contracts, some of which are awarded to multiple contractors, have increased competition and pricing pressure, requiring us to make sustained post- award efforts to realize revenue under each such contract. Competitive bidding presents a number of risks, including without limitation:
  ·
the need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and cost overruns;
  ·
the substantial cost and managerial time and effort that we may spend to prepare bids and proposals for contracts that may not be awarded to us;
  ·
the need to estimate accurately the resources and cost structure that will be required to service any contract we are awarded; and
  ·
the expense and delay that may arise if our or our partners’ competitors protest or challenge contract awards made to us or our partners pursuant to competitive bidding, and the risk that any such protest or challenge could result in the resubmission of bids on modified specifications, or in the termination, reduction or modification of the awarded contract.
  If we are unable to consistently win new contract awards over any extended period, our business and prospects will be adversely affected, and that could cause our actual results to be adversely affected. In addition, upon the expiration of a contract, if the customer requires further services of the type provided by the contract, there is frequently a competitive rebidding process. There can be no assurance that we will win any particular bid, or that we will be able to replace business lost upon expiration or completion of a contract, and the termination or non-renewal of any of our significant contracts would cause our actual results to be adversely affected.
 
 The U.S. government may reform its procurement or other practices in a manner adverse to us.
 
 Because we derive a significant portion of our revenues from contracts with the U.S. government or its agencies, we believe that the success and development of our business will depend on our continued successful participation in federal contracting programs. The current administration has signed a Memorandum for the Heads of Executive Departments and Agencies on Government Contracting, which orders significant changes to government contracting, including the review of existing federal contracts to eliminate waste and the issuance of government-wide guidance to implement reforms aimed at cutting wasteful spending and fraud. The federal procurement reform called for in the Memorandum requires the heads of several federal agencies to develop and issue guidance on review of existing government contracts and authorizes that any contracts identified as wasteful or otherwise inefficient be modified or cancelled. If any of our contracts were to be modified or cancelled, our actual results could be adversely affected and we can give no assurance that we would be able to procure new U.S. Government contracts to offset the revenues lost as a result of any modification or cancellation of our contracts. In addition, there may be substantial costs or management time required to respond to government review of any of our current contracts, which could delay or otherwise adversely affect our ability to compete for or perform contracts. Further, if the ordered reform of the U.S. Government’s procurement practices involves the adoption of new cost-accounting standards or the requirement that competitors submit bids or perform work through teaming arrangements, that could be costly to satisfy or could impair our ability to obtain new contracts. The reform may also involve the adoption of new contracting methods to GSA or other government-wide contracts, or new standards for contract awards intended to achieve certain socio-economic or other policy objectives, such as establishing new set-aside programs for small or minority-owned businesses. In addition, the U.S. government may face restrictions from other new legislation or regulations, as well as pressure from government employees and their unions, on the nature and amount of services the U.S. government may obtain from private contractors. These changes could impair our ability to obtain new contracts. Any new contracting methods could be costly or administratively difficult for us to implement and, as a result, could harm our operating results.
  29
  Our contracts with the U.S. government and its agencies are subject to audits and cost adjustments. Unfavorable government audits could force us to adjust previously reported operating results, could affect future operating results and could subject us to a variety of penalties and sanctions.
 
 U.S. government agencies, including the Defense Contract Audit Agency (DCAA), routinely audit and investigate government contracts and government contractors’ incurred costs, administrative processes and systems. Certain of these agencies, including the DCAA, review our performance on contracts, pricing practices, cost structure and compliance with applicable laws, regulations and standards. They also review the adequacy of our internal control systems and policies, including our purchase, property, estimation, compensation and management information systems. Any costs found to be improperly allocated to a specific contract will not be reimbursed, and any such costs already reimbursed must be refunded. Moreover, if any of the administrative processes and systems are found not to comply with government requirements, we may be subjected to increased government scrutiny and approval that could delay or otherwise adversely affect our ability to compete for or perform contracts. Therefore, an unfavorable outcome of an audit by the DCAA or another government agency could cause actual results to be adversely affected and differ materially from those anticipated. If a government investigation uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeitures of profits, suspension of payments, fines and suspension or debarment from doing business with the U.S. government. In addition, we could suffer serious reputational harm if allegations of impropriety were made against us. Each of these events could cause our actual results to be adversely affected.
 
 A portion of our business depends upon obtaining and maintaining required security clearances, and our failure to do so could result in termination of certain of our contracts or cause us to be unable to bid or re-bid on certain contracts.
 
 Obtaining and maintaining personal security clearances (PCLs) for employees involves a lengthy process, and it can be difficult to identify, recruit and retain employees who already hold security clearances. If our employees are unable to obtain or retain security clearances, or if such employees who hold security clearances terminate their employment with us, the customer whose work requires cleared employees could terminate their contract with us or decide not to exercise available options, or to not renew it. To the extent we are not able to engage employees with the required security clearances for a particular contract, we may not be able to bid on or win new contracts, or effectively re-bid on expiring contracts, which could adversely affect our business.
 
 A facility security clearance (FCL) is an administrative determination by the Defense Security Service (DSS), a U.S. Department of Defense component, that a particular contractor facility has the requisite level of security, procedures, and safeguards to handle classified information requirements for access to classified information. Our ability to obtain and maintain FCLs has a direct impact on our ability to compete for and perform U.S. government contracts, the performance of which requires access to classified information. Our inability to so obtain or maintain any facility security clearance level could result in the termination, non-renewal or our inability to obtain certain U.S. government contracts, which would reduce our revenues and harm our business.
 
 We may not realize the full amount of revenues reflected in our backlog, which could harm our operations and significantly reduce our future revenues.
 
 There can be no assurances that our backlog estimates will result in actual revenues in any particular fiscal period because our customers may modify or terminate projects and contracts and may decide not to exercise contract options. We define backlog as the future revenue we expect to receive from our contracts. We include potential orders expected to be awarded under IDIQ contracts. Our revenue estimates for a particular contract are based, to a large extent, on the amount of revenue we have recently recognized on that contract, our experience in utilizing capacity on similar types of contracts, and our professional judgment. Our revenue estimate for a contract included in backlog can be lower than the revenue that would result from our customers utilizing all remaining contract capacity. Our backlog includes estimates of revenues the receipt of which require future government appropriation, option exercise by our clients and/or is subject to contract modification or termination. At March 31, 2011, our backlog was approximately $10 million, all of which is estimated to be realized in 2011. These estimates are based on our experience under such contracts and similar contracts, and we believe such estimates to be reasonable. However, we believe that the receipt of revenues reflected in our backlog estimate for the following twelve months will generally be more certain than our backlog estimate for periods thereafter. If we do not realize a substantial amount of our backlog, our operations could be harmed and our future revenues could be significantly reduced.
  30
  U.S. government contracts often contain provisions that are typically not found in commercial contracts and that are unfavorable to us, which could adversely affect our business.
 
 U.S. government contracts contain provisions and are subject to laws and regulations that give the U.S. government rights and remedies not typically found in commercial contracts, including without limitation, allowing the U.S. government to:
  ·
terminate existing contracts for convenience, as well as for default;
  ·
establish limitations on future services that can be offered to prospective customers based on conflict of interest regulations;
  ·
reduce or modify contracts or subcontracts;
  ·
decline to make orders under existing contracts;
  ·
cancel multi-year contracts and related orders if funds for contract performance for any subsequent year become unavailable;
  ·
decline to exercise an option to renew a multi-year contract; and
  ·
claim intellectual property rights in products provided by us.
  The ownership, control or influence of our company by foreigners could result in the termination, non-renewal of or our inability to obtain certain U.S. government contracts, which would reduce our revenues and harm our business.
 
 We are subject to industrial security regulations of the U.S. Department of Defense and other federal agencies that are designed to safeguard against unauthorized access by foreigners and others to classified and other sensitive information. If we were to come under foreign ownership, control or influence, our clearances could be revoked and our U.S. government customers could terminate, or decide not to renew, our contracts, and such a situation could also impair our ability to obtain new contracts and subcontracts. Any such actions would reduce our revenues and harm our business.
 
 We depend on our suppliers and one, in particular, provided us with approximately 10% of our supply needs during the quarter ended March 31, 2011. If we cannot obtain certain components for our products or we lose any of our key suppliers, we would have to develop alternative designs that could increase our costs or delay our operations.
 
 We depend upon a number of suppliers for components of our products. Of these suppliers, Lapeer Industries, Inc. supplied approximately 10% of our overall supply needs during the quarter ended March 31, 2011. In particular, Lapeer Industries, Inc. supplied our steel pieces and hardware. There is an inherent risk that certain components of our products will be unavailable for prompt delivery or, in some cases, discontinued. We have only limited control over any third-party manufacturer as to quality controls, timeliness of production, deliveries and various other factors. Should the availability of certain components be compromised through the loss of, or impairment of the relationship with, any of our three key suppliers or otherwise, it could force us to develop alternative designs using other components, which could add to the cost of goods sold and compromise delivery commitments. If we are unable to obtain components in a timely manner, at an acceptable cost, or at all, we would need to select new suppliers, redesign or reconstruct processes we use to build our transparent and opaque armored products. We may not be able to manufacture one or more of our products for a period of time, which could materially adversely affect our business, results from operations and financial condition.
 
 If we fail to keep pace with the ever-changing market of security-related defense products, our revenues and financial condition will be negatively affected.
 
 The security-related defense product market is rapidly changing, with evolving industry standards. Our future success will depend in part upon our ability to introduce new products, designs, technologies and features to meet changing customer requirements and emerging industry standards; however, there can be no assurance that we will successfully introduce new products or features to our existing products or develop new products that will achieve market acceptance. Any delay or failure of these products to achieve market acceptance would adversely affect our business. In addition, there can be no assurance that products or technologies developed by others will not render our products or technologies non-competitive or obsolete. Should we fail to keep pace with the ever-changing nature of the security-related defense product market, our revenues and financial condition will be negatively affected.
  31
  We believe that, in order to remain competitive in the future, we will need to continue to invest financial resources to develop new and adapt or modify our existing offerings and technologies, including through internal research and development, acquisitions and joint ventures or other teaming arrangements. These expenditures could divert our attention and resources from other projects, and we cannot be sure that these expenditures will ultimately lead to the timely development of new offerings and technologies. Due to the design complexity of our products, we may in the future experience delays in completing the development and introduction of new products. Any delays could result in increased costs of development or deflect resources from other projects. In addition, there can be no assurance that the market for our offerings will develop or continue to expand as we currently anticipate. The failure of our technology to gain market acceptance could significantly reduce our revenues and harm our business. Furthermore, we cannot be sure that our competitors will not develop competing technologies which gain market acceptance in advance of our products.
 
 We may be subject to personal liability claims for our products and if our insurance is not sufficient to cover such claims, our expenses may increase substantially.
 
 Our products are used in applications where the failure to use our products properly or their malfunction could result in bodily injury or death, and we may be subject to personal liability claims. Although we currently maintain general liability insurance which includes $1 million of product liability coverage, our insurance may not be adequate to cover such claims. As a result, a significant lawsuit could adversely affect our business. We may be exposed to liability for personal injury or property damage claims relating to the use of our products. Any future claim against us for personal injury or property damage could materially adversely affect our business, financial condition, and results of operations and result in negative publicity. We currently maintain insurance for this type of liability as well as seek Support Antiterrorism by Fostering Effective Technologies Act of 2002 (also known as the SAFETY Act) certification for our products where we deem appropriate. However, although we maintain insurance coverage, we may experience legal claims outside of our insurance coverage, or in excess of our insurance coverage, or that insurance will not cover. Even if we are not found liable, the costs of defending a lawsuit can be high.
 
 We are subject to substantial competition.
 
 We are subject to significant competition that could harm our ability to win business and increase the price pressure on our products. We face strong competition from a wide variety of firms, including large, multinational, defense and aerospace firms. Most of our competitors have considerably greater financial, marketing and technological resources than we do, which may make it difficult to win new contracts and we may not be able to compete successfully. Certain competitors operate larger facilities and have longer operating histories and presence in key markets, greater name recognition and larger customer bases. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the promotion and sale of their products. Moreover, we may not have sufficient resources to undertake the continuing research and development necessary to remain competitive.
 
 We must comply with environmental regulations or we may have to pay expensive penalties or clean up costs.
 
 We are subject to federal, state, local and foreign laws, and regulations regarding protection of the environment, including air, water, and soil. Our manufacturing business involves the use, handling, storage, discharge and disposal of, hazardous or toxic substances or wastes to manufacture our products. We must comply with certain requirements for the use, management, handling, and disposal of these materials. If we are found responsible for any hazardous contamination, we may have to pay expensive fines or penalties or perform costly clean-up. Even if we are charged, and later found not responsible, for such contamination or clean up, the cost of defending the charges could be high. Authorities may also force us to suspend production, alter our manufacturing processes, or stop operations if we do not comply with these laws and regulations.
 
 We may not be able to adequately safeguard our intellectual property rights and trade secrets from unauthorized use, and we may become subject to claims that we infringe on others’ intellectual property rights.
 
 We rely on a combination of trade secrets, trademarks, and other intellectual property laws, nondisclosure agreements and other protective measures to preserve our proprietary rights to our products and production processes.
 
 We currently have five utility and one provisional U.S. pending patent applications. We do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims. We have not emphasized, and do not presently intend to emphasize, patents as a source of significant competitive advantage, however, if we are issued patents we intend to seek to enforce them as commercially appropriate.
 
 These measures afford only limited protection and may not preclude competitors from developing products or processes similar or superior to ours. Moreover, the laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States, and we may face other obstacles to enforcing our intellectual property rights outside the United States including the ability to enforce judgments, the possibility of conflicting judgments among courts and tribunals in different jurisdictions and locating, hiring and supervising local counsel in such other countries.
  32
  Although we implement protective measures and intend to defend our proprietary rights, these efforts may not be successful. From time to time, we may litigate within the United States or abroad to enforce our licensed patents, to protect our trade secrets and know-how or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. Enforcing or defending our proprietary rights could be expensive, require management’s attention and might not bring us timely or effective relief.
 
 Furthermore, third parties may assert that our products or processes infringe their patent or other intellectual property rights. Our patents, if granted, may be challenged, invalidated or circumvented. Although there are no pending or threatened intellectual property lawsuits against us, we may face litigation or infringement claims in the future. Infringement claims could result in substantial costs and diversion of our resources even if we ultimately prevail. A third party claiming infringement may also obtain an injunction or other equitable relief, which could effectively block the distribution or sale of allegedly infringing products. Although we may seek licenses from third parties covering intellectual property that we are allegedly infringing, we may not be able to obtain any such licenses on acceptable terms, if at all.
 
 We depend on management and other key personnel and we may not be able to execute our business plan without their services.
 
 Our success and our business strategy depend in large part on our ability to attract and retain key management and operating personnel. Such individuals are in high demand and are often subject to competing employment offers. We depend to a large extent on the abilities and continued participation of our executive officers and other key employees. We presently maintain “key man” insurance on Anthony Piscitelli, our President and Chief Executive Officer. We believe that, as our activities increase and change in character, additional experienced personnel will be required to implement our business plan. Competition for such personnel is intense and we may not be able to hire them when required, or have the ability to retain them.
 
 We may partner with foreign entities, and domestic entities with foreign contacts, which may affect our business plans by increasing our costs.
 
 We recognize that there may be opportunities for increased product sales in both the domestic and global defense markets. We have recently initiated plans to strategically team with foreign entities as well as domestic entities with foreign business contacts in order to better compete for both domestic and foreign military contracts. In order to implement these plans, we may incur substantial costs which may include additional research and development, prototyping, hiring personnel with specialized skills, implementing and maintaining technology control plans, technical data export licenses, production, product integration, marketing, warehousing, finance charges, licensing, tariffs, transportation and other costs. In the event that working with foreign entities and/or domestic entities with foreign business contacts proves to be unsuccessful, this strategy may ineffectively use our resources which may affect our profitability and the costs associated with such work may preclude us from pursuing alternative opportunities.
 
 We are presently classified as a small business and the loss of our small business status may adversely affect our ability to compete for government contracts.
 
 We are presently classified as a small business as determined by the Small Business Administration based upon the North American Industry Classification Systems (NAICS) industry and product specific codes which are regulated in the United States by the Small Business Administration. While we do not presently derive a substantial portion of our business from contracts which are set-aside for small businesses, we are able to bid on small business set-aside contracts as well as contracts which are open to non-small business entities. It is also possible that we may become more reliant upon small business set-aside contracts. Our continuing growth may cause us to lose our designation as a small business, and additionally, as the NAICS codes are periodically revised, it is possible that we may lose our status as a small business and may sustain an adverse impact on our current competitive advantage. The loss of small business status could adversely impact our ability to compete for government contracts, maintain eligibility for special small business programs and limit our ability to partner with other business entities which are seeking to team with small business entities as may be required under a specific contract.
 
 We intend to pursue international sales opportunities which may require export licenses and controls and result in the commitment of significant resources and capital.
 
 In order to pursue international sales opportunities, we have initiated a program to obtain product classifications, commodity jurisdictions, licenses, technology control plans, technical data export licenses and export related programs. Due to our diverse products, it is possible that some products may be subject to classification under the United States State Department International Traffic in Arms Regulations (ITAR). In the event that a product is classified as an ITAR-controlled item, we will be required to obtain an ITAR export license. While we believe that we will be able to obtain such licenses, the denial of required licenses and/or the delay in obtaining such licenses may have a significant adverse impact on our ability to sell products internationally. Alternatively, our products may be subject to classification under the United States Commerce Department’s Export Administration Regulations (EAR). We also anticipate that we may be required to comply with international regulations, tariffs and controls and we intend to work closely with experienced freight forwarders and advisors. We anticipate that an internal compliance program for international sales will require the commitment of significant resources and capital.
  33
  Increases in our international sales may expose us to unique and potentially greater risks than are presented in our domestic business, which could negatively impact our results of operations and financial condition.
 
 If our international sales grow, we may be exposed to certain unique and potentially greater risks than are presented in our domestic business. International business is sensitive to changes in the budgets and priorities of international customers, which may be driven by potentially volatile worldwide economic conditions, regional and local economic and political factors, as well as U.S. foreign policy. International sales will also expose us to local government laws, regulations and procurement regimes which may differ from U.S. Government regulation, including import-export control, exchange control, investment and repatriation of earnings, as well as to varying currency and other economic risks. International contracts may also require the use of foreign representatives and consultants or may require us to commit to financial support obligations, known as offsets, and provide for penalties if we fail to meet such requirements. As a result of these and other factors, we could experience award and funding delays on international projects or could incur losses on such projects, which could negatively impact our results of operations and financial condition.
 
 The outcome of litigation in which we have been named as a defendant is unpredictable and an adverse decision in any such matter could have a material adverse effect on our financial position or results of operations.
 
 We are defendants in a number of litigation matters. These matters may divert financial and management resources that would otherwise be used to benefit our operations. Although we believe that we have meritorious defenses to the claims made in the litigation matters to which we have been named a party and intend to contest each lawsuit vigorously, no assurances can be given that the results of these matters will be favorable to us. An adverse resolution or outcome of any of these lawsuits, claims, demands or investigations could have a negative impact on our financial condition, results of operations and liquidity. See Item 1 “Legal Proceedings”.
 
 Unanticipated changes in our tax provisions or exposure to additional income tax liabilities could affect our profitability.
 
 We are subject to income taxes in the United States. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. Furthermore, changes in domestic or foreign income tax laws and regulations, or their interpretation, could result in higher or lower income tax rates assessed or changes in the taxability of certain sales or the deductibility of certain expenses, thereby affecting our income tax expense and profitability. Although we believe our tax estimates are reasonable, the final determination of tax audits could be materially different from our historical income tax provisions and accruals. Additionally, changes in the geographic mix of our sales could also impact our tax liabilities and affect our income tax expense and profitability.
  Risks Relating to Our Common Stock
  We have identified a material weakness in our internal control over financial reporting for the period ended March 31, 2011. If we are unable to remediate the material weakness in our internal control over financial reporting, we may not be able to report accurately our financial results. This could have a material adverse effect on our share price.
 
 Effective internal controls are necessary for us to provide accurate financial reports. We completed documenting and testing our internal control procedures to satisfy the requirements of Section 404 of the Sarbanes Oxley Act of 2002 and the related rules of the SEC, which require, among other things, our management to assess annually the effectiveness of our internal control over financial reporting.
 
 As a result of management’s assessment of internal controls, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information required to be disclosed is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
  34
  Due to a lack of adequate systems, processes, and resources we did not maintain effective controls over the period-end financial close and reporting processes as of March 31, 2011. Due to the actual and potential effect on financial statement balances and disclosures, and the importance of the financial closing and reporting processes, we concluded that, in the aggregate, these deficiencies in internal controls over the period-end financial close and reporting process constituted a material weakness in internal control over financial reporting. The specific deficiencies contributing to this material weakness were as follows:
  ·     Inadequate documentation of review process. We did not maintain procedures for a formalized timely documented review process to ensure significant, complex, and non-routine transactions are recorded correctly in the financial statements.
  ·     Inadequate policies and procedures for inventory. We did not design, establish, and maintain effective documented financial accounting policies and procedures related to inventory counting, pricing and valuation.
  We cannot assure you if or when we will be able to remedy these deficiencies, that additional material weaknesses or significant deficiencies in our internal control over financial reporting will not be identified in the future or that our internal control over financial reporting will be adequate in all cases to uncover inaccurate or misleading financial information that could be reported by members of management. If our controls failed to identify any misreporting of financial information or our management or independent registered public accounting firm were to conclude in their reports that our internal control over financial reporting was not effective, investors could lose confidence in our reported financial information and the trading price of our shares could drop significantly. In addition, we could be subject to sanctions or investigations by the stock exchange upon which our common stock may be listed, the SEC or other regulatory authorities, which would require additional financial and management resources.
  Volatility of our stock price could adversely affect stockholders.
  The market price of our common stock could fluctuate significantly as a result of:
  ·     quarterly variations in our operating results;
  ·     cyclical nature of defense spending;
  ·     interest rate changes;
  ·     changes in the market's expectations about our operating results;
  ·     our operating results failing to meet the expectation of securities analysts or investors in a particular period;
  ·     changes in financial estimates and recommendations by securities analysts concerning our company or the defense industry in general;
  ·     operating and stock price performance of other companies that investors deem comparable to us;
  ·     news reports relating to trends in our markets;
  ·     changes in laws and regulations affecting our business;
  ·     material announcements by us or our competitors;
  ·     sales of substantial amounts of common stock by our directors, executive officers or significant stockholders or the perception that such sales could occur;
  ·     general economic and political conditions such as recessions and acts of war or terrorism; and
  ·     other matters discussed in Risk Factors.
  Fluctuations in the price of our common stock could contribute to the loss of all or part of an investor's investment in our company.
 
 We currently do not intend to pay dividends on our common stock and consequently your only opportunity to achieve a return on your investment is if the price of common stock appreciates.
 
 We currently do not plan to declare dividends on our common stock in the foreseeable future. Any payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our board of directors. Agreements governing future indebtedness will likely contain similar restrictions on our ability to pay cash dividends. Consequently, your only opportunity to achieve a return on your investment in the common stock of our company will be if the market price of our common stock appreciates and you sell your common stock at a profit.
  35
 
 Provisions in our certificate of incorporation and bylaws or Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our stock.
 
 Our amended and restated certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:
  ·     establish a classified board of directors so that not all members of our board of directors are elected at one time;
  ·     provide that directors may only be removed "for cause" and only with the approval of 66 2/3 percent of our stockholders;
  ·     provide that only our board of directors can fill vacancies on the board of directors;
  ·     require super-majority voting to amend our bylaws or specified provisions in our certificate of incorporation;
  ·     authorize the issuance of "blank check" preferred stock that our board of directors could issue to increase the number of outstanding shares and to discourage a takeover attempt;
  ·     limit the ability of our stockholders to call special meetings of stockholders;
  ·     prohibit common stockholder action by written consent, which requires all common stockholder actions to be taken at a meeting of our stockholders;
  ·     provide that the board of directors is expressly authorized to adopt, amend, or repeal our bylaws, subject to the rights of our stockholders to do the same by super-majority vote of stockholders; and
  ·     establish advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.
  In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control of our company.
 
 These and other provisions contained in our amended and restated certificate of incorporation and bylaws could delay or discourage transactions involving an actual or potential change in control of us or our management, including transactions in which our stockholders might otherwise receive a premium for their shares over then current prices, and may limit the ability of stockholders to remove our current management or approve transactions that our shareholders may deem to be in their best interests and, therefore, could adversely affect the price of our common stock.
 
 Shares of stock issuable pursuant to our stock options and warrants may adversely affect the market price of our common stock.
 
 As of May 16, 2011, we had outstanding stock options to purchase an aggregate of 2,479,000 shares of common stock under our 2007 Incentive Compensation Plan and warrants to purchase an aggregate of 675,001 shares of common stock. In addition, we have 2,495,000 shares of common stock reserved for issuance under our 2007 Incentive Compensation Plan. Our outstanding warrants also contain provisions that increase, subject to limited exceptions, the number of shares of common stock that may be acquired upon the conversion or exercise of such securities in the event we issue (or are deemed to have issued) shares of our common stock at a per share price that is less than their then existing exercise price in the case of the warrants. The exercise of the stock options and warrants would further reduce a stockholder’s percentage voting and ownership interest. Further, the stock options and warrants are likely to be exercised when our common stock is trading at a price that is higher than the exercise price of these options and warrants, and we would be able to obtain a higher price for our common stock than we will receive under such options and warrants. The exercise, or potential exercise, of these options and warrants could adversely affect the market price of our common stock and adversely affect the terms on which we could obtain additional financing.
 
 The continued listing of our common stock on the NYSE Amex is subject to compliance with their continued listing requirements. While we have not received any notice of intent to delist our common stock, we have received notice that the price of our common stock would need to increase in order to be in compliance with NYSE Amex listing standards. If our common stock were to be delisted, the ability of investors in our common stock to make transactions in such stock would be limited.
 
 Our common stock is listed on the NYSE Amex, a national securities exchange. Continued listing of our common stock on the NYSE Amex requires us to meet continued listing requirements set forth in the NYSE Amex’s Company Guide. These requirements include both quantitative and qualitative standards. While we have not received any notice of intent to delist our common stock, investors should be aware that if the NYSE Amex were to delist our common stock from quotation on its exchange, this would limit investors’ ability to make transactions in our common stock.
  36
  In October 2010 we received a notice from the NYSE Amex advising us that the price of our common stock would need to increase in order to be in compliance with continued listing standards. The NYSE Amex requested that we either affect a reverse stock split or advise them of other pending or planned action to address our stock price within a reasonable amount of time. We have responded to the NYSE Amex with an action plan.
 
 In November 2010 we received a follow-up notice from the NYSE Amex indicating that we were nearing the exchange’s financial threshold for continued listing. The NYSE Amex indicated at that time that it would continue to monitor our performance, but that no action was required by us.
 
 On May 16, 2011, we received notice from the staff of the NYSE Amex LLC (the “Exchange”) that, based on their review of the Company’s Form 10-K for the period ended December 31, 2010, the Company is not in compliance with certain of the Exchange’s continued listing standards as set forth in Part 10 of the Exchange’s Company Guide. Specifically, the Exchange noted that we are not in compliance with (a) Section 1003(a)(i) of the Company Guide because of reported stockholders’ equity of less than $2,000,000 as of December 31, 2010 and losses from continuing operations and net losses in two of our three most recent fiscal years ended December 31, 2010, (b) Section 1003(a)(ii) of the Company Guide because of our reported stockholders’ equity of less than $4,000,000 as of December 31, 2010 and losses from continuing operations and net losses in three of our four most recent fiscal years ended December 31, 2010 and (c) Section 1003(a)(iv) of the Company Guide because we have sustained losses which are so substantial in relation to our overall operations or our existing financial resources, or our financial condition has become so impaired that it appears questionable, in the opinion of the Exchange, as to whether we will be able to continue operations and/or meet our obligations as they mature.
  In order to maintain listing of our common stock on Exchange, we must submit a plan by June 15, 2011, addressing how we intend to regain compliance with Section 1003(a)(iv) by August 16, 2011 and Sections 1003(a)(i) and 1003(a)(ii) by November 16, 2012. We expect to submit such a plan by the June 15, 2011 deadline. If the Exchange accepts the plan, then we may be able to continue our listing during the plan period, up to November 16, 2012, during which time we will be subject to periodic reviews to determine whether we are making progress consistent with the plan. If we fail to submit a plan acceptable to the Exchange or, if the plan is accepted but the Exchange determines that we are not making progress consistent with the plan or that we are not in compliance with all continued listing standards of the Company Guide by November 16, 2012, then we expect the Exchange will initiate delisting proceedings.
  Our common stock continues to trade on the Exchange under the symbol “EAG,” however, the Exchange has advised us that the Exchange is utilizing the financial status indicator fields in the Consolidated Tape Association’s Consolidated Tape System and Consolidated Quote Systems Low Speed and High Speed Tapes to identify companies that are in noncompliance with the Exchange’s continued listing standards. Accordingly, we will become subject to the trading symbol extension “.BC” to denote its noncompliance.
  In addition, the Exchange staff notified us, in accordance with Section 1003(f)(v) of the Company Guide, that it deems it appropriate for the us to effect a reverse stock split to address the low selling price per share of our common stock and that if a reverse stock split is not completed by November 16, 2011, the Exchange may consider suspending dealings in, or removing from the list, our common stock.
 
 Item 2.        Unregistered Sales of Equity Securities and Use of Proceeds
 
 None.
 
 Item 3.        Defaults Upon Senior Securities
 
 None.
 
 Item 4.        (Removed and Reserved)
  37
  Item 5.        Other Information
  Date of Annual Meeting of Stockholders
 
 The date of the 2011 Annual Meeting is scheduled for October 14, 2011, which will be more than thirty days after the anniversary date of the 2010 annual meeting of stockholders. Therefore, in accordance with Rule 14a-5(f) under the Exchange Act and other applicable rules of the Securities and Exchange Commission, we are hereby notifying our stockholders that August 15, 2011 will be the deadline for submitting stockholder proposals for inclusion in our proxy statement for the 2011 Annual Meeting pursuant to Rule 14a-8 of the Exchange Act, which we believe is a reasonable time before we will begin the printing and mailing of our proxy materials for the 2011 Annual Meeting. All stockholder proposals must be in compliance with applicable laws and regulations and our bylaws in order to be considered for inclusion in the proxy statement and form of proxy for the 2011 Annual Meeting. Stockholders are advised to review our bylaws, which contain additional procedural and substantive requirements. In addition, if we are not notified by such deadline of an intent to present a proposal at our 2011 Annual Meeting, management will have the right conferred by the proxies to exercise its discretionary voting authority with respect to such proposal, if presented at the meeting.
 
 In order for a stockholder proposal regarding the nomination of a director or other business to be brought at the Annual Meeting outside of Rule 14a-8 to be considered timely under our bylaws, notice of the proposal must have been received by the Secretary at the Company’s principal headquarters between June 16, 2011 and July 16, 2011. In order for either type of proposal to be considered, such notice must also contain certain information specified in our bylaws.
 
 Item 6.        Exhibits
 
 ExhibitNumber
Exhibit
 
 2.1(1)  Securities Redemption Agreement, dated March 22, 2011, by and among American Defense Systems, Inc.; West Coast Opportunity Fund, LLC; and Centaur Value Fund, L.P.
 
 2.2(1)  Membership Interest Option Agreement, dated March 22, 2011, by and among American Defense Systems, Inc.; West Coast Opportunity Fund, LLC; and Centaur Value Fund, L.P.
 
 31.1*  Certification of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
 
 31.2*  Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Act of 1934, as amended.
 
 32.1*  Certification of Chairman and Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 *     Filed herewith.
 
 (1) Previously filed as an Exhibit to the Current Report on Form 8-K filed March 28, 2011.
  38
  SIGNATURES
 
 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 AMERICAN DEFENSE SYSTEMS, INC.Date: May 23, 2011
By:
/s/ Gary SidorskyChief Financial Officer
  39
  Index to Exhibits
 
 ExhibitNumber

Exhibit31.1

Certification of Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.31.2

Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Act of 1934, as amended.32.1

Certification of Chairman and Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
  40