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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q/A**

** **

**(AmendmentNo. 1)**

** **

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

 

**For the Quarter Ended June 30, 2009**

 

**Commission File Number 001-33888**

 

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**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, ofprincipal executiveoffices)

 

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

 

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

 

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

 

| Large Accelerated Filer  o |   | Accelerated Filer  o         |
|--------------------------------------|--------|----------------------------------------|
|                                 |   |                                   |
| Non-Accelerated Filer  o   |   | Smaller Reporting Company  x |

 

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

 

As of August 13, 2009, 45,506,457 shares of commonstock, par value $0.001 per share, of the registrant were outstanding.

 

 

 

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**EXPLANATORY NOTE**

 

This Amendment No. 1on Form 10-Q/A (“Amendment No. 1”) to our Quarterly Report on Form 10-Qfor the quarter ended June 30, 2009, initially filed with the Securitiesand Exchange Commission on August 14, 2009 (the “Original Filing”), isbeing filed to restate our consolidated financial statements at, and for thethree and six month periods ended, June 30, 2009 and the notes related theretoand the related sections of the Management’s Discussion and Analysis ofFinancial Condition and Results of Operations. Management, with the concurrence of the Audit Committee of our Board ofDirectors, has concluded that the financial statements included in the OriginalFiling should be restated and no longer be relied upon due to (i) incorrectbalance sheet classifications of our Series A Convertible Preferred Stockand warrants to purchase our common stock, and related incorrect recording ofthe changes in fair value of such reclassified warrants, (ii) incorrectrecording of the modification to the investor warrants related to the Series AConvertible Preferred Stock as a change in fair value rather than a constructivedebt extinguishment, (iii) incorrect recording of the dividends on our Series AConvertible Preferred Stock as dividends rather than as interest expense on ourstatement of operations, (iv) the capitalization of certain legal expenditureson our balance sheet that should have been expensed on our statement ofoperations, (v) certain costs relating to the registration and exchange listingof our common stock originally included in additional paid in capital on ourbalance sheet that should have been expensed on our statement of operations,(vi) incorrect balance sheet classification of our Assets from DiscontinuedOperations and Liabilities from Discontinued Operations, (vii) stock-basedcompensation expense with respect to stock option and common stock grants madeto an employee and certain directors that should have been added to ourstatement of operations, and (viii) incorrect balance sheet classification ofan asset from a prior asset acquisition. See Note 2 in the Notes to Consolidated Financial Statements included inthis Amendment No. 1 for a discussion of the corrections and areconciliation of amounts previously reported to those shown herein. 

 

This Amendment No. 1also reflects the restatement of our consolidated financial statements at, andfor the year ended, December 31, 2008 (the “2008 FinancialStatements”).  The restatement of the2008 Financial Statements was made to correct the accounting for (i) incorrectbalance sheet classification of our Series A Convertible Preferred Stockand related investor warrants, (ii) incorrect balance sheet classificationof our Assets from Discontinued Operations and Liabilities from DiscontinuedOperations, (iii) incorrect recording of the dividends on our Series AConvertible Preferred Stock as dividends rather than as interest expense on ourstatement of operations, (iv) the capitalization of certain legal expenditureson our balance sheet that should have been expensed on our statement ofoperations, (v) certain costs relating to the registration and exchange listingof our common stock originally included in additional paid in capital on ourbalance sheet that should have been expensed on our statement of operations, and(vi) incorrect balance sheet classification of an asset from a prior assetacquisition. The restatement of the 2008 Financial Statements has been made inan amendment to our Annual Report on Form 10-K for the year ended December 31,2008 filed with the SEC on April 15, 2010 (“Form 10-K/A”).  For more information of the restatement ofour 2008 Financial Statements, see Note 2 in the Notes to ConsolidatedFinancial Statements included in this Amendment No. 1 and Note 2 in theNotes to Consolidated Financial Statements included in our Form 10-K/A. 

 

Although this Amendment No. 1sets forth the Original Filing in its entirety, this Amendment No. 1 onlyamends and restates Items 1 and 2 of Part I of the Original Filing, ineach case, solely as a result of, and to reflect the restatement, and to updateour assessment of our internal controls and procedures at June 30, 2009 asset forth in Part I, Item 4 to reflect the effects of the restatement, andPart II, Item 6 to reflect the filing of currently dated certifications ofour chief executive officer and chief financial officer.  No other information in the Original Filingis amended hereby. 

 

Except for the foregoing amended and restatedinformation, this Amendment No. 1 continues to describe conditions as ofthe date of the Original Filing, and we have not updated the disclosurescontained herein to reflect events that occurred at a later date. 

 

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TABLE OF CONTENTS

 
| **PART I — FINANCIAL INFORMATION** |
|----------------------------------------------|
|                                         |   |
| Item 1.                                      | Condensed  Financial Statements |
|                                         | Consolidated Balance Sheets as of December 31,  2008 and June 30, 2009 (unaudited) |
|                                         | Consolidated  Statements of Operations for the three and six months ended June 30,  2008 and 2009 (unaudited) |
|                                         | Consolidated  Statements of Cash Flows for the six months ended June 30, 2008 and 2009  (unaudited) |
|                                         | Notes to  Consolidated Financial Statements |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item 3.                                      | Quantitative  and Qualitative Disclosure About Market Risk |
| Item 4.                                      | Controls and  Procedures |
|                                         |   |
| **PART II — OTHER INFORMATION**    |
|                                         |   |
| Item 1.                                      | Legal Proceedings |
| Item 1A.                                     | Risk Factors |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds |
| Item 3.                                      | Defaults  Upon Senior Securities |
| Item 4.                                      | Submission  of Matters to a Vote of Security Holders |
| Item 5.                                      | Other Information |
| Item 6.                                      | Exhibits |
|                                         |   |
| **SIGNATURES**                               |

 

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**PART I**

** **

**Item1.    Consolidated Financial Statements**

 

 AMERICAN DEFENSE SYSTEMS, INC. andSUBSIDIARIES

 CONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                                                                                                                                        | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                        | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                                                                                        | ** ** | **(Unaudited)**   | ** ** | **(Audited)**         | ** ** |
| ** **                                                                                                                                                                                                        | ** ** | **(Restated)**    | ** ** | **(Restated)**        | ** ** |
| ASSETS                                                                                                                                                                                                            |       |              |       |                  |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| CURRENT  ASSETS                                                                                                                                                                                                   |       |              |       |                  |       |
| Cash                                                                                                                                                                                                              |       | $                 | 348,662    |                  | $          | 374,457 |   |
| Accounts receivable, net                                                                                                                                                                                          |       | 8,610,578         |       | 4,981,150             |       |
| Inventory                                                                                                                                                                                                         |       | 837,597           |       | 621,048               |       |
| Prepaid expenses and other  current assets                                                                                                                                                                        |       | 2,666,102         |       | 2,088,801             |       |
| Costs in excess of  billings on uncompleted contracts                                                                                                                                                             |       | 8,292,995         |       | 7,143,089             |       |
| Deposits                                                                                                                                                                                                          |       | 309,685           |       | 437,496               |       |
| Assets of discontinued  operations                                                                                                                                                                                |       | —            |       | 736,613               |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL  CURRENT ASSETS                                                                                                                                                                                             |       | 21,065,619        |       | 16,382,654            |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| PROPERTY and EQUIPMENT, net                                                                                                                                                                                       |       | 3,524,693         |       | 3,743,936             |       |
| DEFERRED FINANCING COSTS,  net                                                                                                                                                                                    |       | 2,081,006         |       | 1,500,533             |       |
| NOTES RECEIVABLE                                                                                                                                                                                                  |       | 925,000           |       | 925,000               |       |
| INTANGIBLE ASSETS                                                                                                                                                                                                 |       | 606,000           |       | 606,000               |       |
| GOODWILL                                                                                                                                                                                                          |       | 450,000           |       | 450,000               |       |
| DEFERRED TAX ASSET                                                                                                                                                                                                |       | 1,167,832         |       | 1,167,832             |       |
| OTHER ASSETS                                                                                                                                                                                                      |       | 159,560           |       | 159,560               |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                                      |       | $                 | 29,979,710 |                  | $          | 24,935,515 |   |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                         |       |              |       |                  |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| CURRENT LIABILITIES                                                                                                                                                                                               |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                                  |       | $                 | 6,520,627  |                  | $          | 2,480,652 |   |
| Accrued expenses                                                                                                                                                                                                  |       | 396,163           |       | 755,615               |       |
| Loan payable                                                                                                                                                                                                      |       | 55,490            |       | —                |       |
| Line of credit                                                                                                                                                                                                    |       | 1,429,789         |       | 76,832                |       |
| Preferred stock, $.001 par  value, 5,000,000 shares authorized, 15,000 shares designated as mandatorily  redeemable Series A Convertible Preferred Stock (cumulative), 15,000  shares issued and outstanding |       | 7,500,000         |       | 10,981,577            |       |
| Warrant liabilities                                                                                                                                                                                               |       | 97,435            |       | 90,409                |       |
| Liabilities of  discontinued operations                                                                                                                                                                           |       | —            |       | 736,613               |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                                                                         |       | 15,999,504        |       | 15,121,698            |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| LONG  TERM LIABILITIES                                                                                                                                                                                            |       |              |       |                  |       |
| Preferred stock, $.001 par  value, 5,000,000 shares authorized, 15,000 shares designated as mandatorily  redeemable Series A Convertible Preferred Stock (cumulative), 15,000  shares issued and outstanding |       | 4,723,642         |       | —                |       |
| Warrant liabilities                                                                                                                                                                                               |       | —            |       | —                |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL LIABILITIES                                                                                                                                                                                                 |       | 20,723,146        |       | 15,121,698            |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                     |       |              |       |                  |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| SHAREHOLDERS’ EQUITY                                                                                                                                                                                         |       |              |       |                  |       |
| Common Stock, $.001 par  value: 100,000,000 shares authorized,45,506,000 and 39,585,960 shares issued and  outstanding as of June 30, 2009 and December 31, 2008, respectively                          |       | 45,506            |       | 39,586                |       |
| Additional paid in capital                                                                                                                                                                                        |       | 14,184,752        |       | 11,096,031            |       |
| Accumulated deficit                                                                                                                                                                                               |       | (4,973,694        | )          | (1,321,800            | )          |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                                                                                                                   |       | 9,256,564         |       | 9,813,817             |       |
|                                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                   |       | $                 | 29,979,710 |                  | $          | 24,935,515 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements 

 

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AMERICAN DEFENSE SYSTEMS,INC. and SUBSIDIARIES 

CONSOLIDATEDSTATEMENTS OF OPERATIONS

 
| ** **                                                                                                              | ** ** | **Three  Months Ended** | ** ** | **Six  Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                                                                                              | ** ** | **June 30,**       | ** ** | **June 30,**     | ** ** |
| ** **                                                                                                              | ** ** | **2009**                | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                                                              | ** ** | **(Restated)**          | ** ** | **(Restated)**        | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| CONTRACT  REVENUES EARNED                                                                                               |       | $                       | 14,033,575 |                  | $          | 9,224,451 |   | $ | 23,523,277 |   | $ | 17,959,361 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| COST  OF REVENUES EARNED                                                                                                |       | 8,659,865               |       | 6,009,447             |       | 14,112,974 |   | 11,344,483 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| GROSS  PROFIT                                                                                                           |       | 5,373,710               |       | 3,215,004             |       | 9,410,303 |   | 6,614,878 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| OPERATING  EXPENSES                                                                                                     |       |                    |       |                  |       |   |   |   |   |
| General and administrative  expenses                                                                                    |       | 2,223,336               |       | 993,429               |       | 4,297,331 |   | 2,367,680 |   |
| General and administrative  salaries                                                                                    |       | 1,022,366               |       | 1,097,243             |       | 2,095,403 |   | 2,254,651 |   |
| Marketing                                                                                                               |       | 723,779                 |       | 727,260               |       | 1,457,573 |   | 1,359,567 |   |
| T2 expenses                                                                                                             |       | 124,070                 |       | —                |       | 237,672 |   | — |   |
| Research and development                                                                                                |       | 16,841                  |       | 203,956               |       | 203,227 |   | 369,152 |   |
| Settlement of litigation                                                                                                |       | 63,441                  |       | —                |       | 63,441 |   | 57,377 |   |
| Depreciation                                                                                                            |       | 278,083                 |       | 147,666               |       | 519,412 |   | 282,435 |   |
| Total operating expenses                                                                                                |       | 4,451,916               |       | 3,169,544             |       | 8,874,059 |   | 6,690,862 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| INCOME (LOSS) FROM OPERATIONS                                                                                           |       | 921,794                 |       | 45,450                |       | 536,244 |   | (75,984 | ) |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| OTHER INCOME (EXPENSE)                                                                                                  |       |                    |       |                  |       |   |   |   |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| Unrealized gain (loss) on adjustment of fair value Series A  convertible preferred stock classified as a liability |       | 9,142                   |       | 2,605,159             |       | (685,312 | ) | 1,176,494 |   |
| Unrealized gain (loss) on  warrant liabilities                                                                          |       | (107,022                | )          | 1,421,432             |       | (26,350 | ) | 1,313,843 |   |
| Loss on deemed  extinguishment of debt                                                                                  |       | (2,613,630              | )          | —                |       | (2,613,630 | ) | — |   |
| Other income (expense)                                                                                                  |       | (12,730                 | )          | 10,159                |       | (12,730 | ) | (3,423 | ) |
| Interest expense                                                                                                        |       | (438,421                | )          | (244,264              | )          | (781,151 | ) | (310,651 | ) |
| Interest expense - mandatory  redeemable preferred stock                                                                |       | (374,380                | )          | (401,252              | )          | (749,380 | ) | (401,252 | ) |
| Interest income                                                                                                         |       | 10                      |       | 48,305                |       | 8,856 |   | 90,081 |   |
| Total other income  (expense)                                                                                           |       | (3,537,031              | )          | 3,439,539             |       | (4,859,697 | ) | 1,865,092 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| INCOME  (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES                                                           |       | (2,615,237              | )          | 3,484,989             |       | (4,323,453 | ) | 1,789,108 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| INCOME  TAX PROVISION (BENEFIT)                                                                                         |       |                    |       | —                |       |   |   | — |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| LOSS FROM CONTINUING OPERATIONS                                                                                         |       | (2,615,237              | )          | 3,484,989             |       | (4,323,453 | ) | 1,789,108 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| LOSS  FROM DISCONTINUED OPERATIONS, NET OF TAXES                                                                        |       |                    |       |                  |       |   |   |   |   |
| Loss from operations of  discontinued division                                                                          |       | —                  |       | (115,007              | )          | — |   | (115,496 | ) |
| Loss from disposal of  discontinued division                                                                            |       | —                  |       | —                |       | — |   | — |   |
|                                                                                                                    |       | —                  |       | (115,007              | )          | — |   | (115,496 | ) |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| NET  INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS                                                                  |       | $                       | (2,615,237 | )                     | $          | 3,369,982 |   | $ | (4,323,453 | ) | $ | 1,673,612 |   |
|                                                                                                                    |       |                    |       |                  |       |   |   |   |   |
| Weighted Average Shares Outstanding - Basic and Diluted                                                                 |       | 41,484,307              |       | 39,204,753            |       | 41,484,307 |   | 39,069,337 |   |
|                                                                                                                    | ** ** |                    |       |                  |       |   |   |   |   |
| EARNINGS PER SHARE - Basic and Diluted Income from continuing  operations                                               |       | $                       | (0.06      | )                     | $          | 0.09 |   | $ | (0.10 | ) | $ | 0.03 |   |
| (Loss) from discontinued  operations                                                                                    |       | $                       | —     |                  | $          | — |   | $ | — |   | $ | — |   |
| Net income (loss)                                                                                                       |       | $                       | (0.06      | )                     | $          | 0.09 |   | $ | (0.10 | ) | $ | 0.03 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements 

 

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AMERICANDEFENSE SYSTEMS, INC. 

ANDSUBSIDIARIES 

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the six months ended June 30,2009 and 2008 

 
| ** **                                                                              | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                              | ** ** | **2009**                      | ** ** | **2008** | ** ** |
| ** **                                                                              | ** ** | **(Restated)**                | ** ** | ** ** | ** ** |
|                                                                                    |       |                          |       |   |   |
| Cash  flows from operating activities:                                                  |       |                          |       |   |   |
| Net income (loss)                                                                       |       | $                             | (4,323,453 | ) | $ | 1,210,721 |   |
|                                                                                    |       |                          |       |   |   |
| Adjustments  to reconcile net loss to net cash used in continuing operating activities: |       |                          |       |   |   |
| Change in fair value  associated with preferred stock and warrants                      |       | 711,662                       |       | (2,490,337 | ) |
| Loss on deemed  extinguishment of debt                                                  |       | 2,613,630                     |       | — |   |
| Stock based compensation  expense                                                       |       | 221,692                       |       | 54,297 |   |
| Amortization of deferred  financing costs                                               |       | 297,916                       |       | 147,747 |   |
| Discount on Series A  preferred stock                                              |       | 269,104                       |       | 154,604 |   |
| Depreciation and  amortization                                                          |       | 519,412                       |       | 282,435 |   |
| Issuance of stock toward  payment of accrued interest                                   |       | 1,199,380                     |       |   |   |
| Changes in operating assets  and liabilities:                                           |       |                          |       |   |   |
| Accounts receivable                                                                     |       | (3,629,428                    | )          | 1,219,538 |   |
| Inventories                                                                             |       | (216,549                      | )          | (533,907 | ) |
| Deposits and other assets                                                               |       | 127,811                       |       | (48,410 | ) |
| Cost in excess of billing  on uncompleted contracts                                     |       | (1,149,906                    | )          | (3,450,334 | ) |
| Prepaid expenses and other  assets                                                      |       | (577,039                      | )          | (621,405 | ) |
| Accounts payable and  accrued expenses                                                  |       | 3,603,243                     |       | (435,184 | ) |
| Due to related party                                                                    |       | —                        |       | 262,741 |   |
|                                                                                    |       |                          |       |   |   |
| Net cash used in continuing operating activities                                        |       | (332,525                      | )          | (4,247,494 | ) |
|                                                                                    |       |                          |       |   |   |
| Cash flows from continuing investing activities:                                        |       |                          |       |   |   |
| Purchase of equipment                                                                   |       | (300,169                      | )          | (2,239,575 | ) |
| Investment in affiliate                                                                 |       | —                        |       | (1,669,350 | ) |
| Advances for future  acquisitions                                                       |       | —                        |       | (387,350 | ) |
| Cash paid for acquisition  in excess of cash received                                   |       | —                        |       | (100,000 | ) |
|                                                                                    |       |                          |       |   |   |
| Net cash used in investing activities                                                   |       | (300,169                      | )          | (4,396,275 | ) |
|                                                                                    |       |                          |       |   |   |
| Cash flows from continuing financing activities:                                        |       |                          |       |   |   |
| Proceeds from notes  payable                                                            |       | —                        |       | 62,970 |   |
| Proceeds from line of  credit                                                           |       | 1,429,789                     |       | — |   |
| Proceeds from sale of  stock                                                            |       | —                        |       | 194,000 |   |
| Repayments of short term  financing                                                     |       | 55,490                        |       | (12,684 | ) |
| Proceeds from sale of  Series A Convertible                                        |       |                          |       |   |   |
| Preferred Shares                                                                        |       | —                        |       | 15,000,000 |   |
| Deferred financing costs                                                                |       | (878,380                      | )          | (1,466,886 | ) |
|                                                                                    |       |                          |       |   |   |
| Net cash provided by financing activities                                               |       | 606,899                       |       | 13,777,400 |   |
|                                                                                    |       |                          |       |   |   |
| NET INCREASE (DECREASE) IN CASH                                                         |       | (25,795                       | )          | 5,133,631 |   |
|                                                                                    |       |                          |       |   |   |
| CASH AT BEGINNING OF YEAR                                                               |       | 374,457                       |       | 1,479,886 |   |
|                                                                                    |       |                          |       |   |   |
| CASH AT END OF PERIOD                                                                   |       | $                             | 348,662    |   | $ | 6,613,517 |   |
|                                                                                    |       |                          |       |   |   |
| Supplemental disclosure of cash flow information:                                       |       |                          |       |   |   |
| Cash paid during the year  for interest                                                 |       | $                             | 25,157     |   | $ | — |   |
| Cash paid for taxes                                                                     |       | $                             | —     |   | $ | — |   |
|                                                                                    |       |                          |       |   |   |
| Supplemental disclosure of non-cash financing activities                                |       |                          |       |   |   |
| Stock options issued in  lieu of cash for compensation                                  |       | $                             | 214,131    |   | $ | 54,297 |   |
| Common stock issued in  lieu of cash                                                    |       | $                             | 156,847    |   | $ | — |   |
| Common stock issued as  payment toward accrued and future interest                      |       | $                             | 1,199,380  |   | $ | — |   |
| Common stock issued in  connection with investor warrants                               |       | $                             | 2,550,000  |   | $ | — |   |
|                                                                                    |       |                          |       |   |   |
| Assets and liabilities received in acquisition American  Anti-Ram, Inc.            |       |                          |       |   |   |
|                                                                                    |       |                          |       |   |   |
| Fixed assets                                                                            |       | $                             | —     |   | $ | 30,000 |   |
| Inventory                                                                               |       | $                             | —     |   | $ | 120,000 |   |
| Goodwill                                                                                |       | $                             | —     |   | $ | 280,000 |   |
| Accounts payable and  accrued expense                                                   |       | $                             | —     |   | $ | (30,000 | ) |
| Notes payable                                                                           |       | $                             | —     |   | $ | — |   |
| Shares issuable in  connection with acquisition                                         |       | $                             | —     |   | $ | (200,000 | ) |
| Cash paid in connection  with acquisition                                               |       | $                             | —     |   | $ | (100,000 | ) |
| Amounts due to American  Anti-Ram, Inc.                                            |       | $                             | —     |   | $ | (100,000 | ) |

 

The accompanying notes are an integral part of theseconsolidated financial statements 

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**JUNE 30, 2009**

 

**1.****             ****NATUREOF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Organization**

 

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

 

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

 

OnNovember 15, 2007, the Company entered into an Asset Purchase Agreementwith Tactical Applications Group (“TAG”), a North Carolina based soleproprietorship, and its owner.   TAG has a retail establishment located inJacksonville, North Carolina that supplies tactical equipment to military andsecurity personnel.  As discussed morefully in Note 7, the operations of TAG were discontinued on January 2,2009.

 

InJanuary 2008, American Physical Security Group, LLC (“APSG”) wasestablished as a wholly owned subsidiary of the Company for the purposes ofacquiring the assets of American Anti-Ram, Inc., a manufacturer of crashtested vehicle barricades. The acquisition represented a new product line forthe Company.  APSG is located in NorthCarolina.

 

**InterimReview Reporting**

 

The accompanying interim unaudited condensed financial statements havebeen prepared in accordance with generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q and Article 8of Regulation S-X. Accordingly, they do not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements. In our opinion, all adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation have beenincluded. Operating results for the three and six months period ended June 30,2009 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2009. For further information, refer to thefinancial statements and footnotes thereto included in the Company’s Form 10-K/Aannual report for the year ended December 31, 2008 filed on April 15, 2010.

 

**Natureof Business**

 

TheCompany designs and supplies transparent and opaque armor solutions for bothmilitary and commercial applications. Its primary customers are United Statesgovernment agencies and general contractors who have contracts withgovernmental entities. These products, sold under Vista trademarks, are used intransport and fighting vehicles, construction equipment, sea craft and variousfixed structures which require ballistic and blast attenuation.

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

TheCompany also provides engineering and consulting services, develops andinstalls detention and security hardware, entry control and monitoring systems,intrusion detection systems, and security glass. The Company also suppliesvehicle anti-ram barriers.  Its primarycustomer for these services and products are the detention and securityindustry.

 

**Principlesof Consolidation**

 

Theconsolidated financial statements include the accounts of American DefenseSystems, Inc. and its wholly-owned subsidiaries, A.J Piscitelli &Associates, Inc. and American Physical Security Group, LLC. The accountsof TAG have been presented as discontinued operations as discussed more fullyin Note 7.  All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

**Termsand Definitions**

 
| ADSI        | American Defense Systems, Inc. (the  “Company”)  |
|-------------|-----------------------------------------------------------------|
| AJP         | A.J. Piscitelli & Associates, Inc.,  a subsidiary |
| APB         | Accounting Principles Board                                     |
| ARB         | Accounting Review Board                                         |
| APSG        | American Physical Security Group, LLC, a  subsidiary            |
| EITF        | Emerging Issues Task Force                                      |
| FASB        | Financial Accounting Standards Board                            |
| FIN         | FASB Interpretation Number                                      |
| FSP         | FASB Staff Position                                             |
| GAAP        | Generally  Accepted Accounting Principles                       |
| PCAOB       | Public Companies Accounting Oversight Board                     |
| SAB         | Staff Accounting Bulletin                                       |
| SEC         | Securities Exchange Commission                                  |
| SFAS or FAS | Statement of Financial Accounting Standards                     |
| TAG         | Tactical  Applications Group                                    |

 

**Use ofEstimates**

 

Thepreparation of financial statements and related disclosures in conformity withaccounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the amounts reportedin the consolidated financial statements and accompanying notes. Estimates areused for revenue recognition, income taxes and accrued liabilities amongothers. Actual results could differ materially from those estimates.

 

Significantestimates for all periods presented include cost in excess of billings,liabilities associated with the Series A Convertible Preferred Stock andInvestor Warrants and valuation of deferred tax assets.

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

**Revenue and CostRecognition**

 

The Company recognizesrevenue in accordance with the provisions of SAB 104, “Revenue Recognition”,which states that revenue is realized and earned when all of the followingcriteria are met:

 

(a) persuasiveevidence of the arrangement exists,

(b) deliveryhas occurred or services have been rendered,

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

(d) collectibilityis reasonably assured.

 

Under this provision,revenue is recognized upon satisfactory completion of specified inspection,wherein by contract, customer acceptance and delivery occurs and title passesto the customer.

 

ContractRevenue

 

*Cost inExcess of Billing*

 

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

 

*Billingin Excess of Cost*

 

Allbillings associated with uncompleted purchase orders under contract arerecorded on the balance sheet as a current liability called “Billings in Excessof Costs on Uncompleted Contracts.”  Uponcompletion of the purchase order, all such billings are reclassified from thebalance sheet to the statement of operations as revenues.  Due to the structure of the Company’scontracts, billing is not done until the purchase order is complete, thereforethere are no amounts recorded as liabilities as of June 30, 2009 or2008.  Contract retentions are includedin accounts receivable.

 

**Cashand Cash Equivalents**

 

TheCompany considers all highly liquid investments with maturities of three monthsor less at the time of purchase to be cash equivalents.

 

**Concentrations**

 

Cashand cash equivalents are maintained in financial institutions. Deposits heldwith banks may exceed the amount of insurance provided on such deposits.Generally, these deposits may be redeemed upon demand and therefore bear minimalrisk.

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

TheCompany receives certain components from sole suppliers. Additionally, theCompany relies on a limited number of contract manufacturers and suppliers toprovide manufacturing services for its products. The inability of any contractmanufacturer or supplier to fulfill supply requirements of the Company couldmaterially impact future operating results.

 

Forthe six months ended June 30, 2009 and 2008, the Company derived 97% and99% of its revenues from various U.S. government entities.

 

**Inventories**

 

Inventoriesare stated at the lower of cost or market, with cost determined using thefirst-in, first-out method.

 

**Equipment**

 

Equipmentis stated at cost less accumulated depreciation. Depreciation is provided usinga straight-line method over an estimated useful life of three to five years.Expenditures for repairs and maintenance are charged to expense as incurred.

 

**Long-LivedAssets**

 

TheCompany reviews long-lived assets and certain identifiable assets related tothose assets for impairment whenever circumstances and situations change, suchthat there is an indication that the carrying amounts may not be recoverable.If the undiscounted cash flows of the long-lived assets are less than thecarrying amount, their carrying amounts are reduced to fair value, and animpairment loss is recognized.

 

**Goodwill and Indefinite-Lived Intangible Assets**

 

In accordance with SFAS 142, “Goodwill andOther Intangible Assets,” goodwill, represents the excess of thepurchase price over the fair value of net assets, including the amount assignedto identifiable intangible assets. The Company accounts for businesscombinations using the purchase method of accounting and accordingly, theassets and liabilities of the acquired entities are recorded at their estimatedfair values at the acquisition date. The primary driver that generates goodwillis the value of synergies between the acquired entities and the company, whichdoes not qualify as an identifiable intangible asset.  The Company does notamortize the goodwill balance.

 

The Company assesses goodwill andindefinite-lived intangible assets for impairment annually during the fourthquarter, or more frequently if events and circumstances indicate impairment mayhave occurred. If the carrying value of a reporting unit’s goodwill exceeds itsimplied fair value, the Company records an impairment loss equal to thedifference. SFAS 142 also requires that the fair value of indefinite-livedpurchased intangible assets be estimated and compared to the carrying value.The Company recognizes an impairment loss when the estimated fair value of theindefinite-lived purchased intangible assets is less than the carrying value.

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

**AdvertisingCosts**

 

The Company expenses all advertising costs asincurred.

 

**Earningsper Share**

 

Basicearnings (loss) per share is computed using the weighted-average number ofcommon shares outstanding during the period. Diluted net income per share iscomputed using the weighted-average number of common shares and dilutivepotential common shares outstanding during the period. Diluted net loss pershare is computed using the weighted-average number of common shares andexcludes dilutive potential common shares outstanding, as their effect isanti-dilutive. Dilutive potential common shares would primarily consist ofemployee stock options and restricted common stock.

 

**FairValue of Financial Instruments**

 

Fairvalue of certain of the Company’s financial instruments including cash and cashequivalents, accounts receivable, accrued compensation, and other accruedliabilities approximate cost because of their short maturities.

 

**Fair Value Measurements**

 

The Company adopted SFAS No. 157,“Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fairvalue, establishes a framework for measuring fair value in accordance with generallyaccepted accounting principles and expands disclosures about fair valueinvestments.

 

Fairvalue, as defined in SFAS 157, is the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. The fair value of an asset should reflectits highest and best use by market participants, whether using an in-use or anin-exchange valuation premise. The fair value of a liability should reflect therisk of nonperformance, which includes, among other things, the Company’scredit risk.

 

Valuationtechniques are generally classified into three categories: the market approach;the income approach; and the cost approach. The selection and application ofone or more of the techniques requires significant judgment and are primarilydependent upon the characteristics of the asset or liability, the principal (ormost advantageous) market in which participants would transact for the asset orliability and the quality and availability of inputs. Inputs to valuationtechniques are classified as either observable or unobservable within thefollowing hierarchy:

 

Level1 Inputs

 

Theseinputs come from quoted prices (unadjusted) in active markets for identicalassets or liabilities.

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

Level2 Inputs

 

Theseinputs are other than quoted prices that are observable, for an asset orliability. This includes: quoted prices for similar assets or liabilities inactive markets; quoted prices for identical or similar assets or liabilities inmarkets that are not active; inputs other than quoted prices that areobservable for the asset or liability; and inputs that are derived principallyfrom or corroborated by observable market data by correlation or other means.

 

Level3 Inputs

 

Theseare unobservable inputs for the asset or liability which require the Company’sown assumptions.

 

**Income Taxes**

 

The Company accounts for income taxes according to SFAS 109 “Accountingfor Income Taxes” which requires an asset and liability approach to financialaccounting for income taxes. Deferred income tax assets and liabilities arecomputed annually for the difference between the  the financial statement and tax bases ofassets and liabilities that will result in taxable or deductible amounts in thefuture, based on enacted tax laws and rates applicable to the periods in whichthe differences are expected to affect taxable income. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount expectedto be realized. Income tax expense is the tax payable or refundable for theperiod, plus or minus the change during the period in deferred tax assets andliabilities.

 

TheCompany adopted the provisions of FIN 48, “Accounting for Uncertainty in IncomeTaxes, an interpretation of FASB Statement 109,” effective January 1,2007. FIN 48 prescribes a recognition threshold and a measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. Benefits from tax positions should berecognized in the financial statements only when it is more likely than notthat the tax position will be sustained upon examination by the appropriatetaxing authority that would have full knowledge of all relevant information. Atax position that meets the more-likely-than-not recognition threshold ismeasured at the largest amount of benefit that is greater than fifty percentlikely of being realized upon ultimate settlement. Tax positions thatpreviously failed to meet the more-likely-than-not recognition threshold shouldbe recognized in the first subsequent financial reporting period in which thatthreshold is met. Previously recognized tax positions that no longer meet themore-likely-than-not recognition threshold should be derecognized in the firstsubsequent financial reporting period in which that threshold is no longer met.FIN 48 also provides guidance on the accounting for and disclosure ofunrecognized tax benefits, interest and penalties. Adoption of FIN 48 did nothave a significant impact on the Company’s financial statements.

 

TheCompany files income tax returns in the U.S. federal jurisdiction and variousstates. The Company has not been subject to U.S. federal income taxexaminations by tax authorities nor state authorities since its inception in2002.

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

**DebtExtinguishment**

 

TheCompany accounted for the effects of the May 22, 2009 settlementagreements (see Note 7) in accordance with the guidelines enumerated in EITFIssue No. 96-19 “ Debtor’s Accounting for a Modification of Exchange of DebtInstruments.”  EITF 96-19 provides that asubstantial modification of terms in an existing debt instrument should beaccounted for like, and reported in the same manner as, an extinguishment ofdebt.  EITF 96-19 further provides thatthe modification of a debt instrument by a debtor and a creditor in anon-troubled debt situation is deemed to have been accomplished with debtinstruments that are substantially different if the present value of cash flowsunder the terms of the new debt instrument is at least ten percent differentfrom the present value of the remaining cash flows under the terms of theoriginal instrument at the date of the modifications.

 

The Company evaluated the modification of the payment terms and therelated adjustment to financial instruments to determine whether thesemodifications resulted in the issuance of a substantially differentinstrument.  The Company determined aftergiving effect to the  changes in the duedates of payments and the consideration paid to the debt holders, in the formof reduced conversion and exercise prices, that the Company had issuedsubstantially different debt instruments, which resulted in a constructiveextinguishment of the original debt instrument. Accordingly, the Company recorded a loss on the extinguishment of debtin the amount of $2,613,630 which represented the difference in the carryingvalue of the old debt and fair value of the new debt.  The debt instrument charge is included in theaccompanying statement of operations for the three and six months ended June 30,2009.

 

**Recent accounting pronouncements**

 

*Accounting Standards Codification and the Hierarchy ofGenerally Accepted Accounting Principles*

 

InJune 2009, the FASB issued Statement No. 168, “The FASB Accounting Standards Codificationand the Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 168”).  SFASNo. 168 will become the single source of authoritative nongovernmentalU.S. generally accepted accounting principles (“GAAP”), superseding existingFASB, American Institute of Certified Public Accountants (“AICPA”), EmergingIssues Task Force (“EITF”), and related accounting literature.  SFAS No. 168reorganizes the thousands of GAAP pronouncements into roughly 90 accountingtopics and displays them using a consistent structure.  Also includedis relevant Securities and Exchange Commission guidance organized using thesame topical structure in separate sections.  SFAS No. 168 willbe effective for financial statements issued for reporting periods that endafter September 15, 2009.  This statement will have an impact onthe Company’s future consolidated financial statements since all futurereferences to authoritative accounting literature will be references inaccordance with SFAS No. 168.

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

*Subsequent Events*

 

InMay 2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS No. 165”) This Statementestablishes general standards of accounting for and disclosures of events thatoccur after the balance sheet date but before financial statements are issuedor are available to be issued.  It requires the disclosure of the datethrough which an entity has evaluated subsequent events and the basis for thatdate and is effective for interim and annual periods ending after June 15,2009.  Although additional disclosuresare required, the adoption of SFAS No. 165 is not expected to have amaterial impact on the Company’s consolidated financial statements.

 

*DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly*

 

In April 2009, the FASB issued FSP FAS No. 157-4,“Determining Fair Value When the Volume and Level of Activity for theAsset or Liability Have Significantly Decreased and Identifying TransactionsThat Are Not Orderly”. This FSP providesadditional guidance for estimating fair value in accordance with FASB StatementNo. 157, Fair Value Measurements,when the volume and level of activity for the asset or liability havesignificantly decreased. This FSP also includes guidance on identifyingcircumstances that indicate a transaction is not orderly. FSP FAS No. 157-4 is effectivefor interim and annual reporting periods ending after June 15, 2009, andshall be applied prospectively.  Theimplementation of FSP FAS No. 157-4 did not have a material on the Company’sconsolidated financial position and results of operations.

 

*Recognitionand Presentation of Other-Than-Temporary Impairments*

 

In April 2009, the FASB issued FSP FAS No. 115-2and FAS No. 124-2, “Recognition and Presentation ofOther-Than-Temporary Impairments ”. The objective of an other-than-temporaryimpairment analysis under existing U.S. generally accepted accountingprinciples (GAAP) is to determine whether the holder of an investment in a debtor equity security for which changes in fair value are not regularly recognizedin earnings (such as securities classified as held-to-maturity oravailable-for-sale) should recognize a loss in earnings when the investment isimpaired. An investment is impaired if the fair value of the investment is lessthan its amortized cost basis. FSP FASNo. 115-2 and FAS No. 124-2 is effective for interim andannual reporting periods ending after June 15, 2009, with early adoptionpermitted for periods ending after March 15, 2009. Earlier adoption forperiods ending before March 15, 2009, is not permitted.  Theimplementation of FSP FAS No. 115-2and FAS No. 124-2 did not have a material impact on the Company’sconsolidated financial position and results of operations.

 

*Interim Disclosures about Fair Value of Financial Instruments*

 

InApril 2009, the FASB issued FSP FAS No. 107-1 and APB No. 28-1, “InterimDisclosures about Fair Value of Financial Instruments”. This FSP amends SFAS No. 107,*Disclosures about Fair Value of FinancialInstruments,*to require disclosures about fair value of financial

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

instruments for interimreporting periods of publicly traded companies as well as in annual**financial statements. This FSP alsoamends APB Opinion No. 28, *InterimFinancial Reporting,*to require those disclosures in summarizedfinancial information at interim reporting periods. FSP FAS No. 107-1 is effective for interim reportingperiods ending after June 15, 2009, with early adoption permitted forperiods ending after March 15, 2009. The implementation of FSP FAS No. 107-1 did not have a materialimpact on the Company’s consolidated financial position and results ofoperations.

 

*Amendmentsto the Impairment Guidance of EITF Issue No. 99-20*

 

In January 2009, the FASB issued FSP EmergingIssues Task Force (“EITF”) Issue No. 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20”.This FSP amends the impairment guidance in EITF Issue No. 99-20, “Recognitionof Interest Income and Impairment on Purchased Beneficial Interests and BeneficialInterests That Continue to Be Held by a Transferor in Securitized FinancialAssets,” to achieve more consistent determination of whether another-than-temporary impairment has occurred. The FSP also retains andemphasizes the objective of an other than- temporary impairment assessment andthe related disclosure requirements in FASB Statement No. 115, *Accounting for Certain Investments in Debt and EquitySecurities,*and other related guidance. This Issue is effective for interim and annual reporting periodsending after December 15, 2008, and shall be applied prospectively.Retrospective application to a prior interim or annual reporting period is notpermitted. The adoption of FSP EITF 99-20-1 did not have a material effect onthe Company’s consolidated financial statements.

 

*Accountingfor Own-Share Lending Arrangements in Contemplation of Convertible DebtIssuance or Other Financing*

 

InJune 2009, the FASB issued FSP Emerging Issues Task Force (“EITF”) Issue No. 09-1,“Accounting for Own-Share Lending Arrangements in Contemplation of ConvertibleDebt Issuance or Other Financing”. This Issue is effective for fiscal yearsbeginning on or after December 15, 2009, and interim periods within thosefiscal years for arrangements outstanding as of the beginning of those fiscalyears. Share lending arrangements that have been terminated as a result ofcounterparty default prior to the effective date of this Issue but for whichthe entity has not reached a final settlement as of the effective date arewithin the scope of this Issue. ThisIssue requires retrospective application forall arrangements outstanding as of the beginning of fiscal years beginning onor after December 15, 2009. This Issue is effective for arrangementsentered into on or after the beginning of the first reporting period thatbegins on or after June 15, 2009. Early adoption is not permitted. TheCompany is currently assessing the impact of FSP EITF 09-1 on its consolidatedfinancial position and results of operations.

 

*Determining the Fair Value of a Financial Asset When theMarket for That Asset is Not Active*

 

In October 2008, the FASB issued FSP FAS No. 157-3,“Determining the Fair Value of a Financial Asset When the Market for That Assetis Not Active.”  This FSP clarifies the

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

application of SFAS No. 157, “Fair ValueMeasurements,” in a market that is not active. The FSP also provides examples for determining the fair value of afinancial asset when the market for that financial asset is not active.  FSP FAS No. 157-3 was effective uponissuance, including prior periods for which financial statements have not beenissued.  The impact of adoption wasnot material to the Company’s consolidated financial condition or results ofoperations.

 

*Determining Whether an Instrument (or Embedded Feature) IsIndexed to an Entity’s Own Stock*

 

InJune 2008, the FASB issued FSP EITF Issue No. 07-5 (FSP EITF 07-5), “DeterminingWhether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock”.  FSP EITF 07-5 provides guidance fordetermining whether and equity-linked financial instrument (or embeddedfeature) is indexed to an entity’s own stock. FSP EITF 07-5 applies to any freestanding financial instrument orembedded feature that has all the characteristics of a derivative.  This issue also applies to any freestandingfinancial instrument that is potentially settled in an entity’s own s tock,regardless of whether the instrument has all the characteristics of aderivative.  FSP EITF 07-5 is effectivefor financial statements issued for fiscal years beginning after December 15,2008, and interim periods within those fiscal years.  The adoption of FSP EITF 07-5 had a materialimpact on the Company’s consolidated financial statements.

 

*Disclosureand Derivative Instruments and Hedging Activities*

 

InMarch 2008, the FASB issued SFAS No. 161, *“*Disclosure about Derivative Instruments and HedgingActivities*,* an amendment of SFAS No. 133.”This statement requires that objectives for using derivative instruments bedisclosed in terms of underlying risk and accounting designation. The Companywas required to adopt SFAS No. 161 on January 1, 2009. The adoptionof SFAS No.161 changed the disclosures of derivative instruments held by theCompany’s consolidated financial statements.

 

**2.      Restatements**

 

On November 20, 2009,the Company’s management and the Audit Committee of its Board of Directorsconcluded that the Company’s consolidated financial statements as of and forthe year ended December 31, 2008 and the interim periods within the year,as of and for the three months ended March 31, 2009, and as of and for thethree and six months ended June 30, 2009 should be restated and should nolonger be relied upon as a result of certain errors discovered as describedbelow.

 

Series AConvertible Preferred Stock:

 

OnApril 14, 2009, the Company received a Notice of Triggering EventRedemption from the holder of 94% of the Series A Convertible PreferredStock. The notice demanded the full redemption of the holders’ shares of Series AConvertible Preferred Stock pursuant to a right to require the Company toredeem shares of Series A Convertible Preferred Stock provided under

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

the Certificate ofDesignation, Preferences and Rights of the Series A Convertible PreferredStock.  The redemption right purportedlywas triggered by the Company’s breach of certain covenants under a Consent andAgreement, dated May 23, 2008, between the Company and holders of the Series AConvertible Preferred Stock, which agreement and covenants are discussed inNote 7.  Although such redemption noticehad been received, the Series A Convertible Preferred Stock continued tobe reflected as a long term liability as of December 31, 2008 and June 30,2009 due to restrictions that precluded the Company from satisfying suchdemand.  These restrictions were imposedpursuant to the General Corporation Law of the State of Delaware (the “DGCL”),the Company’s state of incorporation, which would prohibit the Company fromsatisfying such redemption demand due to its lack of sufficient surplus, assuch term is defined under the DGCL.  Inaddition, the Company was restricted, under its revolving line of credit withTD Bank, from effecting such a redemption. Based on these external restrictions, management determined that theCompany could not have satisfied the redemption demand without violatingDelaware law and its contractual obligations under its credit facility with TDBank.  In May 2009, the Company and theholders of the Series A Convertible Preferred Stock entered into a Settlement Agreementin respect of the foregoing which provides that $7,500,000 in stated value ofDecember 31, 2009.  See Note 7 for adiscussion of the Settlement Agreement.

 

Management has reconsideredthe classification of the Series A Convertible Preferred Stock and determinedthat, notwithstanding the legal and contractual restrictions to satisfying thedemanded redemption, the obligation to redeem such preferred stock purportedlyremained outstanding.  Accordingly,management concluded that the Series A Convertible Preferred Stock shouldbe classified as a current liability as of December 31, 2008 and that$7,500,000 in stated value of such preferred stock should be classified as acurrent liability as of June 30, 2009 rather than a long term liability, inaccordance with paragraph 5 of Statement of Financial Accounting Standard 78,which indicates that liabilities due within one year should be presented withinthe financial statements as current liabilities.

 

InvestorWarrants:

 

The company has restatedits financial statements as of December 31, 2008 and June 30, 2009 toreclassify its derivative warrant liability associated with its warrants issuedto the investors in the Series A Convertible Preferred Stock (see Note 7).  The warrants contain features that allow theholder to request that the Company repurchase the warrant upon the occurrenceof certain events as defined in the warrant. The Company re-evaluated theclassification of this liability and determined that the warrant holders’ rightto “put” the warrant to the Company represented the ability to request cash ondemand and as such should be classified as a current liability. The Companypreviously recorded the warrant liability as a long term liability.  

 

Assetsfrom Discontinued Operations and Liabilities from Discontinued Operations:

 

In order to reflect the nature of the assets and liabilities associatedwith the Company’s discontinued operations, Management and its Audit Committeehave reclassified its balance sheet presentation from long term to short termat December 31, 2008.  This change was made to reflect that such assetsand liabilities would be realized within a period of less than one year.

 

Adoption of EITF 07-5

 

EffectiveJanuary 1, 2009, the Company was required to analyze its outstandingfinancial instruments following the guidance of EITF 07-5: and thatpronouncements effect in interpreting Statement of Financial AccountingStandards (“SFAS”) Statement No. 133 “Accounting for DerivativeInstruments and Hedging Activities” (“SFAS 133”). The Company determined that

 

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2009**

 

certainwarrants issued in 2005, 2006 and 2008 contained provisions whereby theexercise price could be adjusted upon certain financing transactions at a lowerprice per share could no longer be viewed as indexed to the Company’s commonstock. As such, the Company should have changed the accounting for this warrantto a “derivative” at fair value under SFAS 133. As a result the Companyrecorded the warrant liability at the fair value of the warrant of $166,775 asof January 1, 2009 and reclassified its issuance date fair value fromadditional paid-in-capital. The cumulative effect on adoption of EITF 07-5 asof January 1, 2009 is as follows:

 
| ** **                                             | ** ** | **Additional  Paid in  Capital** | ** ** | **Accumulated  Deficit** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|--------------------------|------------|
| Balance  December 31, 2008                        |       | $                                     | 11,096,031 |                     | $          | (1,321,800 | ) |
| Cumulative effect of a  change in accounting principle |       | (837, 954                             | )          | 672,179                  |       |
|                                                   |       |                                  |       |                     |       |
| Balance — January 1, 2009                    |       | $                                     | 10,258,077 |                     | $          | (649,621 | ) |

 

Thederivative warrant liability is recorded at fair value in each subsequentreporting period with changes in fair value recorded in the statement ofoperations.

 

Certain legalexpenses recorded as current assets:

The Company hasrestated its financial statements as of December 31, 2008 and for the yearthen ended and as of June 30, 2009 and for the three and six months thenended to reclassify and expense certain legal fees that were originallycapitalized in prepaid expenses and other current assets.  The legalexpenses pertained to fees incurred related to a lawsuit and certain costsincurred in connection with the Series A Redeemable Convertible PreferredStock.  The litigation fees of approximately $227,000, as of December 31,2008, should have been expensed as incurred and while the Series ARedeemable Convertible Preferred Stock fees of approximately $222,700, as of December 31,2008, should have been recorded as deferred financing costs rather than as acurrent asset. This revision was and continues to be immaterial to thestatement of operations for the year ended December 31, 2008, however upona SAB 99 and 108 analysis performed subsequently by management, it was deemednecessary to record this adjustment to keep the 2009 interim period financialstatements from being materially misstated.

 

For the three andsix months ended June 30, 2009, litigation fees of approximately $422,000and $774,000 should have been expensed as incurred.  The Company also incurred costs in connectionwith its Series A Redeemable Convertible Preferred Stock in the amount of$329,000 and $814,000 for the three and six months ended June 30,2009.  Such costs should have beenrecorded as deferred financing costs rather than as a current asset.  Additionally the amortization of thesedeferred financing costs should been recorded as interest expense during theyear ended 2008 and the interim periods in 2009. The company previouslyrecorded this amortization in general and administrative expense.

 

Dividends Paid:

The company has restated its financial statements forthe three and six months ended June 30, 2009 to reclassify on its Statement ofOperations its presentation of dividends accrued on its Series A Convertible Preferred Stock.  Under SFAS 150 “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity”, theCompany is required to present dividends paid to its Preferred Stockholders asinterest expense due to the mandatory redemption feature on its Series A Convertible Preferred Stock.  The Company re-evaluated its presentation ofPreferred Stock Dividends Accrued on its Statement of Operations andreclassified approximately $375,000 and $750,000 in dividends accrued tointerest expense for the three and six months ended June 30, 2009.

 

Registration Costs:

The Company has restated its financial statements asof December 31, 2008 to reclass approximately $1,561,000 of costs related to theregistration of the Company’s common stock with the SEC and listing on theAmerican Stock Exchange.  The $1,561,000costs were originally booked to the Company’s APIC account and reflectedaccordingly in the Company’s 2008 financial statements.  Based on additional analyses and research ofthe $1,561,000 costs, the Company has concluded that a more appropriate andconservative accounting treatment would have been to expense such costs whenincurred rather than charged directly to additional paid in capital.  Consequently, the Company has determined itshould restate its financial statements and expense the $1,561,000 costs whenincurred.  Management also notes there isno affect on total stockholders’ equity as a result of the restatement.  However, the restatement will increase thenet loss for the year ended December 31, 2008 and more accurately reflectretained earnings (accumulated deficit) and additional paid in capital and willresult in retained earnings being an accumulated deficit.

 

Deemed Extinguishment of Debt:

As disclosed inNote 1 the Company entered into a settlement agreement with its Series Apreferred stock holder on May 22, 2009 which resulted in a loss of$2,613,630 for the three months ended June 30, 2009 on the deemedextinguishment of the debt in accordance with the guidelines enumerated in EITFIssue No. 96-19 “ Debtor’s Accounting for a Modification of Exchange ofDebt Instruments.” Previously this loss had been reported as part of theunrealized gain (loss) on adjustment of fair value of the Series Apreferred stock and warrant liabilities.

 

Stock basedCompensation

The Company, inreviewing its stock based compensation expense, determined that it had notrecorded certain expenses totaling $125,442 for the three months ended March 31,2009 and $41,229 and $166,671 for the three and six months ended June 30,2009 related to the grant of common stock and stock options to an employee andcertain directors.

 

Management has conducted anadditional review of whether the matters discussed above were material underStaff Accounting Bulletin No. 99, “Materiality” and Staff AccountingBulletin No. 108, “Considering Effects of Prior Misstatements WhenQuantifying Misstatements in Current Year Financial Statements” for the 2008,2009 periods. Management determined that the above errors were material for theyear ended December 31, 2008 and the three and six months ended June 30,2009.  Accordingly, managementrecommended to the Audit Committee that a restatement was required.

 

The effect of the restatements on specific amounts provided in thecondensed consolidated financial statements is as follows:

 

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**AMERICAN DEFENSE SYSTEMS,INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**JUNE 30, 2009**

 

AMERICAN DEFENSE SYSTEMS,INC. and SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                                                                                                                                        | ** ** | **As of June 30, 2009** | ** ** | **As of December 31, 2008** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                        | ** ** | **As Previously  Recorded**  | ** ** | **As Restated**                  | ** ** | **As Previously  Recorded** | ** ** | **As Restated** | ** ** |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| ASSETS                                                                                                                                                                                                            |       |                         |       |                             |       |   |   |   |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| CURRENT ASSETS                                                                                                                                                                                                    |       |                         |       |                             |       |   |   |   |   |
| Prepaid expenses and other  current assets                                                                                                                                                                        |       | $                            | 4,933,040  |                             | $          | 2,666,102 |   | $ | 3,144,601 |   | $ | 2,088,801 |   |
| Assets of discontinued  operations                                                                                                                                                                                |       | —                       |       | —                           |       | — |   | 736,613 |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| TOTAL CURRENT ASSETS                                                                                                                                                                                              |       | 23,332,557                   |       | 21,065,619                       |       | 16,701,841 |   | 16,382,654 |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| DEFERRED FINANCING COSTS, net                                                                                                                                                                                     |       | 979,917                      |       | 2,081,006                        |       | 1,277,833 |   | 1,500,533 |   |
| INTANGIBLE ASSET                                                                                                                                                                                                  |       | —                       |       | 606,000                          |       | — |   | 606,000 |   |
| ASSETS OF DISCONTINUED  OPERATIONS                                                                                                                                                                                |       | —                       |       | —                           |       | 736,613 |   | — |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| TOTAL ASSETS                                                                                                                                                                                                      |       | $                            | 30,539,559 |                             | $          | 29,979,710 |   | $ | 25,162,615 |   | $ | 24,935,515 |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                                        |       |                         |       |                             |       |   |   |   |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| CURRENT LIABILITIES                                                                                                                                                                                               |       |                         |       |                             |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                  |       | 6,519,987                    |       | 6,520,627                        |       | — |   | — |   |
| Accrued  expenses                                                                                                                                                                                                 |       | 898,163                      |       | 396,163                          |       | — |   | — |   |
| Preferred stock, $.001 par  value, 5,000,000 shares authorized, 15,000 shares designated as mandatorily  redeemable Series A Convertible Preferred Stock (cumulative), 15,000  shares issued and outstanding |       | —                       |       | 7,500,000                        |       | — |   | 10,981,577 |   |
| Warrant liabilities                                                                                                                                                                                               |       | —                       |       | 97,435                           |       | — |   | 90,409 |   |
| Liabilities of  discontinued operations                                                                                                                                                                           |       | —                       |       | —                           |       | — |   | 736,613 |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| TOTAL CURRENT LIABILITIES                                                                                                                                                                                         |       | 8,903,429                    |       | 15,999,504                       |       | 3,313,099 |   | 15,121,698 |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| LONG TERM LIABILITIES                                                                                                                                                                                             |       |                         |       |                             |       |   |   |   |   |
| Preferred stock, $.001 par  value, 5,000,000 shares authorized, 15,000 shares designated as mandatorily  redeemable Series A Convertible Preferred Stock (cumulative), 15,000  shares issued and outstanding |       | 12,223,642                   |       | 4,723,642                        |       | 10,981,577 |   | — |   |
| Warrant liabilities                                                                                                                                                                                               |       | —                       |       | —                           |       | 90,409 |   | — |   |
| Liabilities of  discontinued operations                                                                                                                                                                           |       | —                       |       | —                           |       | 736,613 |   | — |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| TOTAL LIABILITIES                                                                                                                                                                                                 |       | 21,127,071                   |       | 20,723,146                       |       | 15,121,698 |   | 15,121,698 |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                     |       |                         |       |                             |       |   |   |   |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| SHAREHOLDERS’ EQUITY                                                                                                                                                                                         |       |                         |       |                             |       |   |   |   |   |
| Common stock                                                                                                                                                                                                      |       | 45,281                       |       | 45,506                           |       | — |   | — |   |
| Additional paid in capital                                                                                                                                                                                        |       | 12,844,845                   |       | 14,184,252                       |       | 9,534,616 |   | 11,096,031 |   |
| Retained earnings  (accumulated deficit)                                                                                                                                                                          |       | (3,477,638                   | )          | (4,973,694                       | )          | 466,715 |   | (1,321,800 | ) |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                                                                                                                   |       | 9,412,488                    |       | 9,256,564                        |       | 10,040,917 |   | 9,813,817 |   |
|                                                                                                                                                                                                              |       |                         |       |                             |       |   |   |   |   |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                   |       | $                            | 30,539,559 |                             | $          | 29,979,710 |   | $ | 25,162,615 |   | $ | 24,935,515 |   |

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

AMERICAN DEFENSE SYSTEMS,INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OFOPERATIONS

 
| ** **                                                                                                              | ** ** | **Three Months Ended**      | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| ** **                                                                                                              | ** ** | **June 30, 2009**      | ** ** | **June 30, 2009** | ** ** |
| ** **                                                                                                              | ** ** | **As Previously  Recorded** | ** ** | **As  Restated**       | ** ** | **As Previously  Recorded** | ** ** | **As  Restated** |   |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| OPERATING EXPENSES                                                                                                      |       |                        |       |                   |       |   |   |   |   |
| General and administrative  expenses                                                                                    |       | 1,889,767                   |       | 2,223,336              |       | 3,538,245 |   | 4,297,331 |   |
| Total operating expenses                                                                                                |       | 4,118,347                   |       | 4,451,916              |       | 8,114,973 |   | 8,874,059 |   |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                  |       | 1,255,363                   |       | 921,794                |       | 1,295,330 |   | 536,244 |   |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| OTHER INCOME (EXPENSE)                                                                                                  |       |                        |       |                   |       |   |   |   |   |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| Unrealized gain (loss) on adjustment of fair value Series A  convertible preferred stock classified as a liability |       | (278,507                    | )          | 9,142                  |       | (972,961 | ) | (685,312 | ) |
| Unrealized gain (loss) on  warrant liabilities                                                                          |       | (2,434,725                  | )          | (107,022               | )          | (2,420,671 | ) | (26,350 | ) |
| Loss on deemed  extinguishment of debt                                                                                  |       | —                      |       | (2,613,630             | )          | — |   | (2,613,630 | ) |
| Interest expense                                                                                                        |       | (301,857                    | )          | (438,421               | )          | (592,177 | ) | (781,151 | ) |
| Interest expense - mandatory  redeemable preferred stock                                                                |       | —                      |       | (374,480               | )          | — |   | (749,380 | ) |
| Total other income  (expense)                                                                                           |       | (3,027,809                  | )          | (3,537,031             | )          | (3,989,683 | ) | (4,859,697 | ) |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES                                                                     |       | (1,772,446                  | )          | (2,615,237             | )          | (2,694,353 | ) | (4,323,453 | ) |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| INCOME TAX PROVISION (BENEFIT)                                                                                          |       | 500,000                     |       | —                 |       | 500,000 |   | — |   |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| LOSS FROM CONTINUING OPERATIONS                                                                                         |       | (2,272,446                  | )          | (2,615,237             | )          | (3,194,353 | ) | (4,323,453 | ) |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| NET LOSS                                                                                                                |       | (2,272,446                  | )          | (2,615,237             | )          | (3,194,353 | ) | (4,323,453 | ) |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| PREFERRED STOCK DIVIDENDS ACCRUED                                                                                       |       | (375,000                    | )          | —                 |       | (749,380 | ) | — |   |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS                                                                   |       | $                           | (2,647,446 | )                      | $          | (2,615,237 | ) | $ | (3,943,733 | ) | $ | (4,323,453 | ) |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| Basic and Fully Diluted Net Income (Loss) Per Share Attributable to  Common Shareholders                                |       | $                           | (0.06      | )                      | $          | (0.06 | ) | $ | (0.10 | ) | $ | (0.10 | ) |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| Weighted Average Shares Outstanding                                                                                     |       | 41,484,307                  |       | 41,484,307             |       | 41,484,307 |   | 41,484,307 |   |
|                                                                                                                    |       |                        |       |                   |       |   |   |   |   |
| EARNINGS PER SHARE - Basic and diluted                                                                                  |       |                        |       |                   |       |   |   |   |   |
| Income from continuing  operations                                                                                      |       | $                           | (0.06      | )                      | $          | (0.06 | ) | $ | (0.10 | ) | $ | (0.10 | ) |
| (Loss) from discontinued  operations                                                                                    |       | $                           | —     |                   | $          | — |   | $ | — |   | $ | — |   |
| Net income (loss)                                                                                                       |       | $                           | (0.06      | )                      | $          | (0.06 | ) | $ | (0.10 | ) | $ | (0.10 | ) |

 

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**AMERICAN DEFENSE SYSTEMS, INC.AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**JUNE 30, 2009**

 

**3.****             ****COSTSIN EXCESS OF BILLINGS (BILLINGS IN EXCESS OF COSTS) ON UNCOMPLETED CONTRACTSAND ACCOUNTS RECEIVABLE**

 

Costsin Excess of Billings and Billing in Excess of Costs

Thecost in excess of billings on uncompleted contracts reflects the accumulatedcosts incurred on contracts in production but not completed.  Upon completion, inspection and acceptance bythe customer, the contract is invoiced and the accumulated costs are charged tostatement of operations as costs of revenues. During the production cycle of the contract, should any progressbillings occur or any interim cash payments or advances be received, suchbillings and/or receipts on uncompleted contracts are accumulated as billingsin excess of costs. The Company fully expects to collect net costs incurred in excessof billing and periodically evaluates each contract for potential disputesrelated to contract overruns and uncollectable amounts.  There was no bad debt expense recorded forthe six months ended June 30, 2009 and 2008.

 

Netcosts incurred in excess of billing consisted of the following as of June 30,2009, and December 31, 2008

 
| ** **                                                        | ** ** | **2009** | ** ** | **2008** | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                              |       |     |       |     |       |
| Cost in excess of billings on uncompleted  contracts              |       | $        | 8,292,995  |     | $          | 7,143,089 |   |
| Billings and/or receipts on uncompleted contracts                 |       | —   |       | —   |       |
| Net costs incurred in excess of billing on  uncompleted contracts |       | $        | 8,292,995  |     | $          | 7,143,089 |   |

 

AccountsReceivable

TheCompany records accounts receivable related to its long-term contracts, basedon billings or on amounts due under the contractual terms.  Accounts receivable consist primarily ofreceivables from completed contracts and progress billings on uncompletedcontracts.  Allowance for doubtfulaccounts is based upon a review of outstanding receivables, historical collectioninformation, and existing economic conditions. Any amounts consideredrecoverable under the customer’s surety bonds are treated as contingent gainsand recognized only when received.

 

Accountsreceivable throughout the year may decrease based on payments received, creditsfor change orders, or back charges incurred. At June 30, 2009 and December 31,2008, the Company had $8,610,578 and $4,981,150, respectively, of accountsreceivable, of which the Company considers all to be fully collectible.  There was no bad debt expense recorded forthe six months ended June 30, 2009 or 2008.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

**4.      PROPERTY AND EQUIPMENT**

 

Propertyand equipment at June 30, 2009 and December 31, 2008 consisted of thefollowing:

 
| ** **                                      | ** ** | **2009**  | ** ** | **2008**  | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|
| Leasehold improvements                          |       | $         | 1,771,402  |      | $          | 1,749,367 |   |
| General equipment                               |       | 742,227   |       | 666,120   |       |
| Light vehicles and trailers                     |       | 221,247   |       | 221,247   |       |
| T2 Demonstration range and firearms             |       | 744,454   |       | 744,454   |       |
| Office equipment                                |       | 1,056,666 |       | 855,294   |       |
| Furniture and fixtures                          |       | 190,044   |       | 163,658   |       |
| Aircraft                                        |       | 868,750   |       | 868,750   |       |
|                                            |       | 5,594,790 |       | 5,268,890 |       |
| Less: accumulated depreciation and amortization |       | 2,070,097 |       | 1,524,954 |       |
|                                            |       | $         | 3,524,693  |      | $          | 3,743,936 |   |

 

Forthe six months ended June 30, 2009 and 2008, the Company recorded $519,412and $282,435 in depreciation and amortization expense, respectively.

 

TheCompany maintains its firearms under the custodianship of an individual inaccordance with New York State law. The firearms are used for testing anddemonstrating the effectiveness of the Company’s bullet resistant and blastmitigation products.

 

**5.      COMMITMENTS AND CONTINGENCIES**

 

**LegalProceedings**

 

SouthernCalifornia Gold Products d/b/a Gypsy Rack

OnJuly 10, 2007, the Company filed a lawsuit against a former subcontractor,Southern California Gold Products d/b/a Gypsy Rack, the subcontractor’sPresident and owner, Glenn Harris, and a designer, James McAvoy in the UnitedStates District Court, Eastern District of New York. Defendants moved to changevenue to the Central District of California based upon insufficient contacts tothe State of New York and on October 12, 2007 the matter was transferredto the United States District Court for the Central District of California,Case Number 07-CV-02779. On February 21, 2008, pursuant to the court’sorder, the Company filed an amended complaint. The amended complaint names onlySouthern California Gold Products and James McAvoy as defendants and assertssix counts as follows: misappropriation of trade secrets and confidentialinformation; breach of contract; unfair competition; conversion; violation ofthe Lanham Act; and interference with prospective economic advantage. Theamended complaint seeks to enjoin the defendants from misappropriating, disclosing,or using our confidential

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

informationand trade secrets, and recall and surrender all products and trade secretswrongfully misappropriated or converted by the defendants. It also seekscompensatory damages in an amount to be established at trial together withprejudgment and post judgment interest, exemplary damages, disgorgement,restitution with interest, attorney’s fees and the costs of suit.  Defendants filed an answer to the amendedcomplaint on April 16, 2008. Shortly after the filing of the amended answer, defendants made a motionfor summary judgment on, among others, the grounds of collateral estoppel andres judicata. We filed opposition to the motion. The defendants motion and asubsequent application for an immediate interlocutory appeal were denied. Amediation settlement conference was held on October 31, 2008, which wasunsuccessful. The defendants made a second motion for summary judgment that wasdenied in May, 2009. Discovery has continued and expert discovery is in theprocess of being completed. A second mediation settlement conference was heldin July 2009. As a result of that conference, the parties believe they mayhave reached a settlement in principle. The parties have requested that theCourt stay discovery and the trial for a period of sixty (60) days. The partieshave proposed to the Court that they will report back to the Court on September 7,2009 to inform the Court of the results of these settlement discussions and tofurther discuss whether the parties and the case will proceed to trial.

 

Breachof Contract

OnFebruary 29, 2008, a former employee commenced an action against theCompany for breach of contract arising from his termination of employment inthe Supreme Court of the State of New York, Nassau County. The Complaint seeksdamages of approximately $87,000. The Company filed an answer to the complaintand will be commencing discovery.  The Company believes that meritoriousdefenses to the claims exist and the Company intends to vigorously defend thisaction.

 

Breachof Contract

OnMarch 4, 2008, the Company’s former General Counsel, commenced an actionwith the United States Department of Labor, Occupational Safety and Health andSafety Administration, alleging retaliation in contravention of theSarbanes-Oxley Act. The Complaint seeks damages in excess of $3,000,000. TheCompany believes the allegations to be without merit and intend to vigorously defendagainst the action. On March 7, 2008, a second action was commencedagainst the Company for breach of contract and related issues arising from histermination of employment in New York State Supreme Court, Nassau County.  On May, 7 2008, the Company served a motionto dismiss the complaint, which is fully submitted to the Court. No amountshave been accrued for damages as the Company believes meritorious defenses tothe claims exist.  The Company intends tovigorously defend this action. No further, significant actions have occurredand the matter is still pending resolution at June 30, 2009.

 

**Financing**

 

Asof June 30, 2009, the Company had access to a $2.5 million line of creditwith TD Bank, f/k/a Commerce Bank.  Thisline of credit allows the Company to borrow up to the amount specified above,limited to 80% — 85% of the total accounts receivable.  Under the line of credit, the 

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

Companyis charged interest at 1.75% over the libor rate.  The line of credit repayment terms are dueupon demand.  The balance as of June 30,2009 was $1,429,789.  See Note 9.

 

**6.      STOCKHOLDERS’ EQUITY**

 

**Warrants**

 

2005 Warrants

 

On June 30,2005, in connection with the closing of its 2005 private placement offering,the Company issued purchase warrants for up to 555,790 shares of common stockat the exercise price of $1.10 per share and with the expiration date of June 30,2010 (the “2005 Warrant”). Subsequent to the issuance of the 2005 Warrant, theCompany issued common stock at an effective price per share of $1.00 and, inaccordance with the terms of the 2005 Warrants agreement, the exercise pricewas adjusted to $1.00 per share and resulted in 611,369 warrants. The followingis a summary of the 2005 Warrants outstanding as of June 30, 2009:

 
| ** **                              | ** ** | **2005********Warrants** | ** ** | **Exercise********Price** | ** ** |
|-----------------------------------------|------------|--------------------------|------------|---------------------------|------------|
| Beginning balance, January 1, 2009 |       | 576,587                  |       | $                         | 1.00       |   |
| Add: Grants                             |       | —                   |       | n/a                       |       |
| Less: Exercised                         |       | —                   |       | n/a                       |       |
| Ending balance, June 30, 2009      |       | 576,587                  |       | $                         | 1.00       |   |

 

2006 Warrants

 

On October 24,2006, in accordance with the terms and conditions of the Company’s closing ofits 2005 private placement offering, the Company issued purchase warrants forup to 179,175 shares of common stock at the exercise price of $1.10 per shareand with the expiration date of June 30, 2010 (the “2006 Warrant”).Subsequent to the issuance of the 2006 Warrant, the Company issued common stockat an effective price per share of $1.00 and, in accordance with the terms ofthe 2006 Warrants agreement, the exercise price was adjusted to $1.00 per shareand resulted in 17,918 warrants. The following is a summary of the 2006Warrants outstanding as of June 30, 2009:

 
| ** **                              | ** ** | **2006********Warrants** | ** ** | **Exercise********Price** | ** ** |
|-----------------------------------------|------------|--------------------------|------------|---------------------------|------------|
| Beginning balance, January 1, 2009 |       | 197,093                  |       | $                         | 1.00       |   |
| Add: Grants                             |       | —                   |       | —                    |       |
| Less: Exercised                         |       | —                   |       | n/a                       |       |
| Ending balance, June 30, 2009      |       | 197,093                  |       | $                         | 1.00       |   |

 

** **

**Stock Option Plan**

 

Thefollowing is a summary of stock options outstanding at June 30, 2009:

 
| Beginning balance — December 31, 2008 |   | 1,995,000 |   |
|-------------------------------------------------|--------|-----------|--------|
| Options issued                                  |   | 200,000   |   |
| Exercised                                       |   | —    |   |
| Forfeited or expired                            |   | —    |   |
| Ending balance —  June 30, 2009       |   | 2,195,000 |   |

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

OnJanuary 12, 2009, the Company issued options to purchase an aggregate of100,000 shares of our common stock to our consultants for servicesrendered.  The exercise price for eachoption is $2.00 per share and each option vested immediately upon the issuance.

 

TheBlack-Scholes method option pricing model was used to estimate fair value as ofthe date of grant using the following assumptions:

 
| Risk-Free           |   | 2.99    | %      |
|---------------------|--------|---------|--------|
| Expected volatility |   | 45.00   | %      |
| Forfeiture rate     |   | 10.00   | %      |
| Expected life       |   | 5 Years |   |
| Expected dividends  |   | —  |   |

 

Based on the assumptions noted above, the fair market value of theoptions issued during 2009 was valued at $13,183 as of June 30, 2009.

 

**7.      SERIESA CONVERTIBLE PREFERRED STOCK, INVESTOR WARRANTS AND PLACEMENT WARRANTS**

 

TheCompany entered into a Securities Purchase Agreement (“Purchase Agreement”) on March 7,2008 to sell shares of its Series A Convertible Preferred Stock (“Series APreferred”) and warrants (“Investor Warrants”) to purchase shares of its commonstock, and to conditionally sell shares of the Company’s common stock, to threeinvestors (the “Series A Holders”). The investors purchased an aggregateof 15,000 shares of Series A Preferred and Investor Warrants to purchaseup to 3,750,000 shares of common stock and to conditionally purchase 100,000shares of common stock. The aggregate purchase price for the Series APreferred and Investor Warrants was $15,000,000 and the aggregate purchaseprice for the common stock was $500,000. The Company completed the sale of the Series A Preferred andInvestor Warrants in March and April 2008, and the Company andinvestors determined not to complete the conditional sale of the 100,000 sharesof common stock.

 

SettlementAgreements

 

Inconnection with a Notice of Triggering Event Redemption received by theCompany, on May 22, 2009 the Company entered into a Settlement Agreement,Waiver and Amendment with the Series A Holders (the “SettlementAgreement”) pursuant to which, among other things, (i) the Series AHolders waived any breach by the Company of certain financial covenants or itsobligation to timely pay dividends on the Series A Preferred for anyperiod through September 30, 2009, and waived any “Equity ConditionsFailure” and any “Triggering Event” under the Certificate of Designationotherwise arising from such breaches, (ii) the Warrants were amended toreduce the exercise price thereof from $2.40 per share to $0.01 per share, (iii) theCompany issued the Holders an aggregate of 2,000,000 shares of the Company’scommon stock (the “Dividend Shares”), in full satisfaction of theCompany’s obligation to pay dividends under the Certificate of Designations asof March 31, 2009, June 30, 2009 and

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

September 30, 2009, and(iv) the Company agreed to redeem $7,500,000 in stated value of the Series APreferred by December 31, 2009.  The Company agreed that, if it failsto so redeem $7,500,000 in stated value of the Series A Preferred by thatdate (a “Redemption Failure”), then, in lieu of any other remedies ordamages available to the Series A Holders (absent fraud), (i) theredemption price payable by the Company will increase by an amount equal to 10%of the stated value, (ii) the Company will use its best efforts to obtainstockholder approval to reduce the conversion price of the Series APreferred from $2.00 to $0.50 (which would increase the number of shares ofcommon stock into which the Series A Preferred is convertible), and (iii) theCompany will expand the size of its board of directors by two, will appoint twopersons designated by the Series A Holders to fill the two newly-createdvacancies, and will use its best efforts to amend the Company’s certificate ofincorporation to grant the Series A Holders the right to elect two personsto serve on the board. The Company recorded a loss of $2,613,630 as a result ofthe settlement agreement in accordance with EITF 96-19 (see Note 1).

 

Becausethe Settlement Agreement provides that $7,500,000 in stated value of the Series APreferred is to be redeemed at December 31, 2009, the Company continues torecord the $7,500,000 of such Series A Preferred as a current liabilityand reclassified the remaining fair value of the Series A Preferred of$4,723,642 to a long term liability at June 30, 2009.

 

Pursuantto the terms of the Settlement Agreement, on May 22, 2009, the Companyentered into a Registration Rights Agreement with the Series A Holderspursuant to which, among other things, the Company agreed to file with theSecurities and Exchange Commission, by June 1, 2009, a registrationstatement covering the resale of the Dividend Shares, and to use its bestefforts to have such registration statement declared effective as soon aspracticable thereafter.  The Companyfurther agreed with Series A Holders to include in such registrationstatement the shares of common stock issued upon the exercise of the InvestorWarrants in May and June 2009. A registration statement was filed, and subsequently declared effectiveon August 10, 2009.

 

Alsopursuant to the terms of the Settlement Agreement, each of the Company’sdirectors and executive officers has entered into a Lock-Up Agreement, pursuantto which each such person has agreed that, for so long as any shares of Series APreferred remain outstanding, he will not sell any shares of the Company’scommon stock owned by him as of May 22, 2009.

 

Alsopursuant to the terms of the Settlement Agreement, on May 22, 2009, theCompany’s Chief Executive Officer, President and Chairman, entered into anIrrevocable Proxy and Voting Agreement with the Series A Holders (the “VotingAgreement”), pursuant to which the Company’s CEO agreed, among otherthings, that if a Redemption Failure occurs he will vote all shares of theCompany’s voting stock owned by him in favor of (i) reducing theconversion price of the Series A Preferred from $2.00 to $0.50 and (ii) amendingthe Company’s certificate of incorporation to grant the Series A Holdersthe right to elect two persons to serve on the board of directors(collectively, the “Company Actions”).  The Company’s CEO alsoappointed WCOF as his proxy to vote his shares of the Company’s voting stock infavor of the Company Actions, and against approval of any opposing or competingproposal, at any stockholder meeting or written consent of the Company’sstockholders at which such matters are considered.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

*Accounting for the Series A Preferred*

 

TheSeries A Preferred Stock is redeemable with $7,500,000 due on December 31,2009 and $7,500,00 due on December 31, 2010 and convertible into shares ofcommon stock at $2.00 subject to adjustment should the Company issue futurecommon stock at a lesser price.  As aresult the Company elected to record the hybrid instrument, preferred stock andconversion option together, at fair value in accordance with SFAS 133.Subsequent reporting period changes in fair value are to be reported in thestatement of operations.

 

Theproceeds from the issuance of the Series A Preferred and accompanyingcommon stock warrants, net of direct costs including the fair value of warrantsissued to placement agent in connection with the transaction, must be allocatedto the instruments based upon relative fair value upon issuance and must bemeasured initially at fair value.”  Therefore, after the initial recording of the Series A Preferredbased upon net proceeds received, the carrying value of the Series APreferred was adjusted to the fair value at the date of issuance, with thedifference recorded as a loss.

 

For the six months ended June 30,2009, the Company has recorded a net loss on adjustment of the Series APreferred to fair value in the amount of $685,312.

 

*Presentation for the Series A Preferred*

 

TheCompany presents the Series A Preferred on the balance sheet at its fairvalue at each reporting period.  Fairvalue, as defined in SFAS 157, is theprice that would be received to sell an asset or paid to transfer a liabilityin an orderly transaction between market participants at the measurement date.

 

Thechange in fair value calculation between reporting periods is directly relatedto the price of the Company’s common stock. Therefore, an increase in the stockprice will result in an unrecognized loss, whereas a decrease in the stockprice will result in an unrecognized gain in the Company’s Statement of Operations.

 

Inorder to estimate the fair value at each reporting period, the Company uses theBinomial Lattice option pricing with the following assumptions:

 
| Risk-Free Rate                |   | .75       |   |
|-------------------------------|--------|-----------|--------|
| Expected volatility           |   | 80.00     | %      |
| Expected life                 |   | 1.5 years |   |
| Expected dividends            |   | 0.00      | %      |
| Strike price                  |   | $         | 2.00   |   |
| Stock price                   |   | $         | .48    |   |
| Effective discount rate       |   | 33.29     | %      |
| Debt feature applicable  rate |   | 35.00     | %      |

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

Basedon the above inputs, the Company calculated fair value for the Series APreferred as of June 30, 2009 was $12,223,642.  The per share price approximates $815 foreach of the 15,000 shares of Series A Preferred outstanding.

 

Investor Warrants

 

Inconnection with the closings under the Purchase Agreement, Investor Warrants topurchase up to 3,750,000 shares of Common Stock at $2.40 per share were issuedin addition to the 15,000 shares of Series A Preferred.  The warrant holder has a right based oncertain events to “put” the warrant back to the Company and receive cash.  As such the Company has recorded the warrantas a derivative liability at fair value with changes in fair value reported inthe statement of operations in accordance with SFAS 133.

 

Inconnection with the Settlement Agreement entered into on May 22, 2009, asnoted above, the warrants were amended to reduce the exercise price from $2.40to $.01.  As a result, the warrants wereconsidered exercised as of the date of the agreement.  The Company determined that the fair value ofthe warrants at the date of the Settlement Agreement was $2,550,683.  This loss from the increase in the fair valueof the warrants as of the date of the settlement has been recorded within theCompany’s Statement of Operations for the three and six months ended June 30,2009.  For the three and six months endedJune 30, 2009, as part of the loss on deemed extinguishment of debt (seeNote 1) the Company has recorded a net loss on adjustment of the investorwarrants to fair value in the amount of 107,022 and $26,350 respectively.

 

Placement Agent Warrants

 

Inconnection with the sale of the Series A Preferred and Investor Warrants,the placement agent was entitled to receive warrants (Placement Agent Warrants)to purchase a total of 6% of the number of common stock issued in the financingor 675,000 shares.   The Placement AgentWarrants were accounted for as a transaction cost associated with the issuanceof the Series A Preferred.  ThePlacement Agent Warrants recorded at fair value at the date of issuance.  Under EITF 00-19 “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock”, the Company satisfies the criteria for classification of the PlacementAgent Warrants as equity.  The fair valueassociated with the 675,000 Placement Agent Warrants was $511,742 at the dateof issuance.

 

DeferredFinancing Costs

 

Deferredfinancing costs include the corresponding amount associated with the PlacementAgent Warrants as indicated above, along with all other costs associated withobtaining the Series A Preferred financing.  Since the Series A Preferred andInvestor Warrants are classified as liabilities, the carrying value of thePlacement Agent Warrants has been recorded as Other Assets on the balance sheetand is amortized as additional financing costs over the term of the Series APreferred using the interest method.

 

Deferredfinancing costs included the following as of June 30, 2009:

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 
| Placement agent costs                         |   | $         | 900,000   |   |
|-----------------------------------------------|--------|-----------|-----------|--------|
| Investor expenses                             |   | 60,000    |      |
| Legal and other related costs                 |   | 1,336,437 |      |
| Fair market value of placement agent warrants |   | 511,742   |      |
| Less: amortization                            |   | (727,173  | )         |
| Deferred financing costs, net                 |   | $         | 2,081,006 |   |

 

FairValue Reporting

 

Asrequired by SFAS 157, financial assets and liabilities are classified based onthe lowest level of input that is significant to the fair value measurement.The Company’s assessment of the significance of a particular input to the fairvalue measurement requires judgment, and may affect the valuation of the fairvalue of assets and liabilities and their placement within the fair valuehierarchy levels.

 

The Company’s financialliabilities carried at fair value as of June 30, 2009 are the Series APreferred and derivative warrants.  Sincethe Series A Preferred valuation utilizes certain unobservable inputs thatare based upon estimate, including estimates on the initial stock prices,volatility based upon comparable companies and estimation of equity and debtpositions, the Company considers this to be a Level III input.  The Company’s derivative Warrants were alsocarried at fair value and were considered valued using a Level III input,through the date of settlement.

 

Thecarrying amounts and fair values of the Company’s financial instruments at June 30,2009, are as follows:

 
| ** **                      | ** ** | ** ** | ** ** | **Fair Value Measurements at June 30, 2009** | ** ** |
|---------------------------------|------------|------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **Total**  | ** ** | **Level 1**                                       | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| **Liabilitites:**               |       |       |       |                                              |       |   |   |   |   |
| Series A  Preferred Shares |       | $          | 12,223,642 |                                              | $          | — |   | $ | — |   | $ | 12,223,642 |   |
| Warrant  Derivatives            |       | $          | 97,435     |                                              | $          | — |   | $ | — |   | $ | 97,435 |   |
| **Total Liabilities:**          |       | $          | 12,321,077 |                                              | $          | — |   | $ | — |   | $ | 12,321,077 |   |

 
| ** **                      | ** ** | ** ** | ** ** | **Fair Value Measurements at December 31, 2008** | ** ** |
|---------------------------------|------------|------------|------------|-------------------------------------------------------|------------|
| ** **                      | ** ** | **Total**  | ** ** | **Level 1**                                           | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| **Liabilitites:**               |       |       |       |                                                  |       |   |   |   |   |
| Series A  Preferred Shares |       | $          | 10,981,577 |                                                  | $          | — |   | $ | — |   | $ | 10,981,577 |   |
| Warrant  Derivatives            |       | $          | 90,409     |                                                  | $          | — |   | $ | — |   | $ | 90,409 |   |
| **Total Liabilities:**          |       | $          | 11,071,986 |                                                  | $          | — |   | $ | — |   | $ | 11,071,986 |   |

 

Thefollowing is a reconciliation of the beginning and ending balances for theCompany’s assets measured at fair value on a recurring basis using significantunobservable inputs (Level 3):

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

**Fair Value Measurements UsingSignificant Unobservable Inputs (Level 3):**

 
| **Description**                                                                | ** ** | **(Level 3)** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------|------------|
| **Liabilities**                                                                |       |          |       |
| Balance at January 1, 2009                                                |       | $             | 11,071,986 |   |
| Cumulative effect of the change in accounting principal,  January 1, 2009 |       | 165,775       |       |
| Change in fair value included in operations                                    |       | 1,083,316     |       |
| Balance , June 30, 2009                                                   |       | $             | 12,321,077 |   |

 

**8.      DISCONTINUEDOPERATIONS**

 

On January 2, 2009, theCompany entered into an agreement with the prior owners of TAG to sell theassets and liabilities back to TAG.  TAGwas accounted for as a discontinued operation under GAAP, which requires theincome statement and cash flow information be reformatted to separate thedivested business from the Company’s continuing operations.

 

Thefollowing amounts represent TAG’s operations and have been segregated fromcontinuing operations and reported as discontinued operations for the sixmonths ended June 30, 2008.

 
| ** **                | ** ** | **2008** | ** ** |
|---------------------------|------------|----------|------------|
|                      |       |     |       |
| Contract  Revenues Earned |       | $        | 596,837    |   |
| Cost of Revenues Earned   |       | (424,090 | )          |
| Gross Profit              |       | 172,747  |       |
| Operating Expenses        |       | (288,727 | )          |
| Other Expenses            |       | 484      |       |
| Net Loss                  |       | $        | (115,496   | ) |

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

Thefollowing is a summary of assets and liabilities of TAG discontinued operationsas of December 31, 2008.

 
| ** **                  | ** ** | **2008** | ** ** |
|-----------------------------|------------|----------|------------|
|                        |       |     |       |
| Assets                      |       |     |       |
| Cash                        |       | $        | 75,103     |   |
| Inventory                   |       | 591,688  |       |
| Prepaid Expenses            |       | 174      |       |
| Property and Equipment, net |       | 69,648   |       |
| Deferred Financing Costs    |       | —   |       |
| Total Assets                |       | $        | 736,613    |   |
|                        |       |     |       |
| Liabilities                 |       |     |       |
| Accounts Payable            |       | $        | 700,287    |   |
| Short Term Notes            |       | 36,326   |       |
| Total Liabilities           |       | $        | 736,613    |   |

 

In accordance with the termsof the agreement, the original owners of TAG agreed to repay $1,000,000 of theoriginal $2,000,000 in consideration as follows:

 
| 2009  |   | $ | 75,000    |   |
|-------|--------|---|-----------|--------|
| 2010  |   | $ | 100,000   |   |
| 2011  |   | $ | 175,000   |   |
| 2012  |   | $ | 275,000   |   |
| 2013  |   | $ | 375,000   |   |
| Total |   | $ | 1,000,000 |   |

 

The Company has included the entire amount as notes receivable on itsbalance sheet, of which $75,000 is included within other current assets and$925,000 is recorded as a long term notes receivable.  The original owners of TAG havecollateralized the note receivable with their personal residence and the250,000 shares issued to them on the date of acquisition.  These shares are being held by the Company inescrow since January 2009 and will be returned upon final payment towardthe note receivable.

 

**9.      SUBSEQUENT EVENTS**

 

AccountsReceivable Purchase Agreement

 

OnJuly 27, 2009, the Company entered into an Accounts Receivable PurchaseAgreement with Republic Capital Access, LLC (“RCA”), as of July 23, 2009(the “RCA Purchase Agreement”).  Under the RCA Purchase Agreement, theCompany can sell eligible accounts receivables to

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE30, 2009**

 

RCA. Eligible accounts receivable, subject to the full definition of such term inthe RCA Purchase Agreement, generally are our receivables under prime governmentcontracts.

 

Underthe terms of the RCA Purchase Agreement, the Company may offer eligibleaccounts receivable to RCA and if RCA purchases such receivables, the Companywill receive an initial upfront payment equal to 90% of the receivable. Following RCA’s receipt of payment from customers for such receivables, RCAwill pay the remaining 10% of the receivable less its fees.  In additionto the Discount Factor fee and an initial enrollment fee, the Company isrequired to pay RCA a program access fee equal to a stated percentage of thesold receivable, a quarterly program access fee if the average daily amount ofthe sold receivables is less than $2,250,000 and RCA’s initial expenses innegotiating the RCA Purchase Agreement and other expenses in certain specifiedsituations.  The RCA Purchase Agreement also provides that in the event,but only to the extent, that the conveyance of receivables by the Company ischaracterized by a court or other governmental authority as a loan rather thana sale, the Company shall be deemed to have granted RCA effective as of thedate of the first purchase under the RCA Purchase Agreement, a securityinterest in all of the Company’s right, title and interest in, to and under allof the receivables sold by the Company to RCA, whether now or hereafter owned,existing or arising.  The initial term of the RCA Purchase Agreement endson December 31, 2009.  The Company has not yet sold any receivablesto RCA.

 

TDBank Loan Repayment

 

Asof July 24, 2009, the Company repaid in full the entire outstandingbalance under that certain Loan Agreement, dated as of May 2, 2007, amongthe Company, its wholly owned subsidiary A.J. Piscitelli & Associates, Inc.(“AJP”) and TD Bank, N.A. (formerly Commerce Bank, N.A., the “Bank”), asassumed by American Physical Security Group, LLC (a wholly owned subsidiary ofthe Company, “APSG” and together with the Company and AJP, the “BorrowingCompanies”), as amended (the “Loan Agreement”), and related agreements,including but not limited to the Revolving Credit Note and the Term Note, eachdated May 2, 2007 (collectively, the “Loan Documents”).  As of suchdate, (i) each of the Loan Documents have automatically terminated, (ii) theBank’s lien or security interest in the Borrowing Companies’ assets have beenterminated, and (iii) all obligations of the Borrowing Companies under theLoan Documents have been satisfied in full.

 

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**Item2.    Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

*The following discussion andanalysis of our financial condition and results of operations should be read inconjunction with our consolidated financial statements and related notes thatappear elsewhere in this report and in our annual report on Form 10-K forthe year ended December 31, 2008.*

 

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

 

**Overview**

 

We are a provider of customized transparent and opaque armor solutionsfor tactical and non-tactical transport vehicles and construction equipmentused by the military.

 

We also provide physical security products for architectural hardeningand perimeter defense, such as bullet and blast resistant transparent armor,walls and doors, as well as vehicle anti-ram barriers such as bollards, steelgates and steel wedges that deploy out of the ground.

 

In 2008, we launched our new live-fire interactive T2 Tactical TrainingSystem and have begun active marketing of the system. T2 provides lawenforcement officers, SWAT team members, tactical specialists and militaryoperators with the opportunity to hone their firearms and combat skills, withtheir own weapons and ammunition, in conjunction with realistic video scenariosbroadcast on a large screen, incorporating environmental factors such as heat,cold, sound and light effects. In addition to installation fees for T2 systems,we anticipate additional revenue opportunities for service and support of T2facilities once installed, and expect to offer training in the T2 as part of ourAmerican Institute for Defense and Tactical Studies.

 

Also in 2008, in conjunction with the T2, we began offering courses andseminars through our tactical training institute, the American Institute forDefense and Tactical Studies. Course offerings include training in the fieldsof Counterterrorism, Fundamentalist Islam and Middle Eastern Mindset, DignitaryProtection, IED Terrorist Tradecraft, Emergency Tactical Medicine, PostSuicide-Bombing Command and Incident Response, Forensics and Hand-to-Hand Combat.

 

We focus primarily on research and development, design and engineering,fabrication and providing component integration. Our armor solutions are usedin retrofit applications for equipment already in service, and we work withoriginal equipment manufacturers to provide armor solutions for new equipmentpurchased by the military. Similarly, our architectural hardening and otherphysical security products are incorporated in new construction, but are moreoften deployed in existing structures and facilities ranging from securecommercial buildings to military bases and other facilities.

 

Our technical expertise is in the development of lightweight compositeballistic, blast and bullet mitigating materials used to fortify and enhancecapabilities of existing and in-service equipment and structures. We serveprimarily the defense market and our sales are highly concentrated within theU.S. government. Our customers include various branches of the U.S. militarythrough the U.S. Department of Defense (or DoD) and to a much lesser extentother U.S. government, law enforcement and correctional agencies as well asprivate sector customers.

 

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Our recent historical revenues have been generated primarily from twolarge contracts and a series of purchase orders from a single customer.** **Tocontinue expanding our business, we are seeking to broaden our customer baseand to diversify our product and service offerings. Our strategy to increaseour revenue, grow our company and increase stockholder value involves thefollowing key elements:

 

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

·                  form strategic partnerships with originalequipment manufacturers (OEMs);

·                  develop strategic alliances;

·                  capitalize on increased homeland securityrequirements and non-military platforms;

·                  increase marketing efforts relating toour new tactical training products and services; and

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

 

We are pursuing each of these growth strategies simultaneously, andexpect one or more of them to result in additional revenue opportunities withinthe next 12 months.

 

**Sourcesof Revenues**

 

We derive our revenues by fulfilling orders under master contractsawarded by branches of the United States military, law enforcement andcorrections agencies and private companies involved in the defense market andother customer purchase orders. Under these contracts and purchase orders, weprovide customized transparent and opaque armor products for transport andconstruction vehicles used by the military, group protection kits and spareparts. We also derive revenues from sales of our physical security products.

 

Our contract backlog as of June 30, 2009 and June 30, 2008was $48.0 million and $45.0 million, respectively, and of our$48.0 million of contract backlog as of June 30, 2009, we estimatethat $28.0 million will be filled in 2009. Accordingly, in order to maintainour current revenue levels and to generate revenue growth, we will need to winmore contracts with the U.S. government and other commercial entities, achievesignificant penetration into critical infrastructure and public safetyprotection markets, and successfully further develop our relationships with OEM’sand strategic partners.  Notwithstanding the possible significanttroop reductions in Afghanistan and Iraq, we expect that demand in thosecountries for armored military construction vehicles will continue in order torepair significant war damage and for nation-building purposes. In addition, weare exploring interest in armored construction equipment in other countrieswith mine-infested regions.

 

We continue to aggressively bid on projects and are in preliminarytalks with a number of international firms to pursue long-term government andcommercial contracts, including with respect to Homeland Security. While no assurancescan be given that we will obtain a sufficient number of contracts or that anycontracts we do obtain will be of significant value or duration, we areconfident that we will continue to have the opportunity to bid and wincontracts as we have in 2007 and 2008.

 

**Costof Revenues and Operating Expenses**

 

*Cost of Revenues.*    Cost of revenuesconsists of parts, direct labor and overhead expense incurred for thefulfillment of orders under contract. These costs are charged to expense uponcompletion and acceptance of an order. Costs of revenue also includes the costsof protyping and engineering, which are expensed upon completion of an order aswell. These costs are included as costs of revenue because they are incurred tomodify products based upon government specifications and are reimbursable costswithin the contract. These costs for the production of goods under contract areexpensed when they are complete. We allocate overhead expenses such as employeebenefits, computer supplies, depreciation for computer equipment and officesupplies based on personnel assigned to the job. As a result, indirect overheadexpenses are included in cost of revenues and each operating expense category.

 

*Sales and Marketing.*    Expenses relatedto sales and marketing consist primarily of compensation for our sales andmarketing personnel, sales commissions and incentives, trade shows and relatedtravel.

 

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As our revenues increase, we plan to continue to invest heavily insales and marketing by increasing the number of direct sales personnel in orderto add new customers and increase sales to our existing customers. We also planto expand our marketing activities in order to build brand awareness andgenerate additional leads for our growing sales personnel.****Weexpect that in 2009, sales and marketing expenses will remain at the same or aslightly higher level in absolute dollars but will decrease as a percentage ofrevenues.

 

*Research and Development.*    Research anddevelopment expenses are incurred as we perform ongoing evaluations ofmaterials and processes for existing products, as well as the development ofnew products and processes. Such expenses typically include compensation andemployee benefits of engineering and testing personnel, materials, travel andcosts associated with design and required testing procedures associated withour product line. We expect that in 2009, research and development expenseswill increase in absolute dollars as we upgrade and extend our serviceofferings and develop new protections products, but will remain relativelyconsistent or decrease slightly as a percentage of revenues. Research and developmentcosts are charged to expense as incurred.

 

*General and Administrative.*    General andadministrative expenses consist of compensation and related expenses forexecutive, finance, accounting, administrative, legal, professional fees, othercorporate expenses and allocated overhead. We expect that in 2009, general andadministrative expenses will remain at the same or a slightly higher level inabsolute dollars but decrease as a percentage of revenues.

 

**CriticalAccounting Policies**

 

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

 

We believe that of our significant accounting policies, which aredescribed in Note 1 to the consolidated financial statements, thefollowing accounting policies involve a greater degree of judgment andcomplexity. Accordingly, these are the policies we believe are the most criticalto aid in fully understanding and evaluating our consolidated financialcondition and results of operations.

 

*Revenue and Cost Recognition.*    We recognizerevenue in accordance with the provisions of the Securities and ExchangeCommission (SEC) Staff Accounting Board (SAB) No. 104, “*Revenue Recognition”*, which states thatrevenue is realized and earned when all of the following criteria are met: (a) persuasiveevidence of the arrangement exists, (b) delivery has occurred or serviceshave been rendered, (c) the seller’s price to the buyer is fixed anddeterminable and (d) collectability is reasonably assured. Under thisprovision, revenue is recognized upon delivery and acceptance of the order.

 

We recognize revenue and report profits from purchases orders filledunder master contracts under the completed contract method. Purchase ordersreceived under master contracts may extend for periods in excess of one year.Contract costs are accumulated as deferred assets and billings and/or cashreceived are charged to a deferred revenue account during the periods ofconstruction. However, no revenues, costs or profits are recognized inoperations until the period upon completion of the order. An order isconsidered complete when all costs, except insignificant items, have beenincurred and, the installation or product is operating according tospecification or the shipment has been accepted by the customer. Provisions forestimated contract losses are made in the period that such losses aredetermined. As of June 30, 2009, there were no such provisions made.

 

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

 

All billings associated with uncompleted purchase orders under contractare recorded on the balance sheet as a deferred liability called “Billings inExcess of Costs on Uncompleted Contracts”. Upon completion of a purchase

 

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order, all suchassociated billings would be reclassified from the balance sheet to thestatement of operations as revenues. Due to the structure of our contracts,billing is not done until the purchase order is complete, therefore there areno amounts recorded as deferred liabilities as of June 30, 2009.

 

*Stock-Based Compensation.*    Stock basedcompensation consists of stock or options issued to employees, directors andcontractors for services rendered. We accounted for the stock issued using theestimated current market price per share at the date of issuance. Such cost wasrecorded as compensation in our statement of operations at the date ofissuance.

 

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

 

We have adopted the provisions of Statement of Financial AccountingStandard No. 123(R), *Share-BasedPayment* (SFAS No. 123R). In accordance with SFAS No. 123R,we will use the Black-Scholes option pricing model to measure the fair value ofour option awards granted after June 15, 2005. The Black-Scholes modelrequires the input of highly subjective assumptions including volatility,expected term, risk-free interest rate and dividend yield. In 2005, the SECissued Staff Accounting Bulletin (SAB) No. 107 (SAB No. 107) whichprovides supplemental implementation guidance for SFAS No. 123R.

 

Because we have only recently become a public entity, we will have alimited trading history.  The expectedterm of an award is based on the “simplified” method allowed by SAB No. 107,whereby the expected term is equal to the midpoint between the vesting date andthe end of the contractual term of the award. The risk-free interest rate willbe based on the rate on U.S. Treasury zero coupon issues with maturitiesconsistent with the estimated expected term of the awards. We have not paid anddo not anticipate paying a dividend on our common stock in the foreseeablefuture and accordingly, use an expected dividend yield of zero. Changes inthese assumptions can affect the estimated fair value of options granted and therelated compensation expense which may significantly impact our results ofoperations in future periods.

 

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

 

We recognized $211,692and $54,297 in stock compensation expense for the six months ended June 30,2009 and 2008, respectively.

 

*Fair Value Measurements*

 

We have adopted the provisions of Statement of Financial AccountingStandard No. 157,*Fair Value Measurements* (SFAS No. 157).  SFAS No. 157 defines fair value, establishes aframework for measuring fair value in accordance with generally acceptedaccounting principles and expands disclosures about fair value investments.SFAS No. 157 was effective for financial assets and liabilities on January 1,2008. The statement deferred the implementation of the provisions of SFAS No. 157relating to certain non-financial assets and liabilities until January 1,2009.

 

Fair value, as defined in SFAS 157, is the pricethat would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date. Thefair value of an asset should reflect its highest and best use by marketparticipants, whether using an in-use or an in-exchange valuation premise. Thefair 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 intothree categories: the market approach; the income approach; and the costapproach. The selection and application of one or more of the techniques requiressignificant judgment and are primarily dependent upon the characteristics ofthe asset or liability, the principal (or most advantageous) market in whichparticipants would transact for the asset or liability and the quality andavailability of inputs. Inputs

 

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to valuation techniques are classified as either observable orunobservable within the following hierarchy:

 

·                  Level 1 Inputs:  These inputs come fromquoted prices (unadjusted) in active markets for identical assets orliabilities.

 

·                  Level 2 Inputs:  These inputs are other thanquoted prices that are observable, for an asset or liability. This includes:quoted prices for similar assets or liabilities in active markets; quotedprices for identical or similar assets or liabilities in markets that are notactive; inputs other than quoted prices that are observable for the asset orliability; and inputs that are derived principally from or corroborated byobservable market data by correlation or other means.

 

·                  Level 3 Inputs:  These are unobservableinputs for the asset or liability which require the company’s ownassumptions.

 

**Series AConvertible Preferred Stock, Investor Warrants and Placement Agent Warrants**

 

The Series A Convertible Preferred Stock (or Series A Preferred)is redeemable with $7,500,000 due on December 31, 2009 and $7,500,00 due onDecember 31, 2010 and convertible into shares of common stock at $2.00 subjectto adjustment should we issue future common stock at a lesser price. As aresult, we have elected to record the hybrid instrument, preferred stock andconversion option together, at fair value in accordance with SFAS 133.Subsequent reporting period changes in fair value are to be reported in thestatement of operations.

 

The proceeds from the issuance of the Series A Preferred andaccompanying common stock warrants, net of direct costs including the fairvalue of warrants issued to placement agent in connection with the transaction,must be allocated to the instruments based upon relative fair value uponissuance and must be measured initially at fair value. Therefore, after theinitial recording of the Series A Preferred based upon net proceeds received,the carrying value of the Series A Preferred was adjusted to the fair value atthe date of issuance, with the difference recorded as a loss. On March 7, 2008, the date ofinitial issuance, we recorded a derivative liability of $9,832,497. On April 4,2008, the date of the second issuance, we recorded a derivative liability of$3,626,977.  These liabilities were subsequently adjusted to fair value asof June 30, 2009, which resulted in a net loss of $972,961. As of June 30,2009, the Series A Preferred liability was $12,223,642.

 

*Investor Warrants.*    The warrantsissued with the Series A Preferred (or Investor Warrants) meet thecriteria under SFAS 133 “Accounting for Derivative Instruments and HedgingActivities”. Under SFAS 133, the warrants are recorded at fair value uponthe date of issuance, with changes in the value fair value recognized as a gainor loss as they occur. On March 7, 2008, the date of initial issuance, werecorded a derivative liability of $1,142,503. On April 4, 2008, the dateof the second issuance, we recorded a derivative liability of $398,023. As of December 31, 2008, the Investor Warrant liability was$115,275.   The Investor Warrantsmet the criteria under EITF 01-6 “The Meaning of Indexed to a Company’sOwn Stock”, which provides guidance as to whether a contract is indexed to acompany’s own stock. However, since the warrants do not meet the criteria forreporting as an equity instruments under EITF 00-19 “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock”, the fair value of the Investor Warrants is included as anoncurrent liability as of December 31, 2008.

 

On May 22, 2009 we entered into a Settlement Agreement,Waiver and Amendment with the Series A Holders (or Settlement Agreement)pursuant to which, among other things, the Warrants were amended to reduce theexercise price thereof from $2.40 per share to $0.01 per share.  The warrants were exercised in full during May andJune, 2009 and the Investor Warrant liability was accordingly reclassified to AdditionalPaid in Capital.

 

For additional information, see “Liquidity and Capital Resources - Series AConvertible Preferred Stock” below.

 

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*Placement Agent Warrants.*    The warrantsissued to the Placement Agent with respect to the sale of the Series APreferred and Investor Warrants (or Placement Agent Warrants) were accountedfor as a transaction cost associated with the issuance of the Series APreferred. The Placement Agent Warrants are recorded at fair value at the dateof issuance. Under EITF 00-19 “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, wesatisfy the criteria for classification of the Placement Agent Warrants asequity. We have recorded the corresponding amount recorded as a DeferredFinancing Cost. Since the Series A Preferred and Investor Warrants areclassified as liabilities, the carrying value of the Placement Agent Warrantshas been recorded as an other asset and is amortized as additional financingcosts over the term of the Series A Preferred using the interest method.At the date of each issuance, we recorded $1,033,433 and $418,559 in deferredfinancing costs and amortized $297,916 as interest expense as of June 30,2009.

* *

*2005Warrants and 2006 Warrants*

 

Upon issuance, the 2005Warrants and 2006 Warrants met the requirements for equity classification setforth in EITF Issue 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in a Company’s Own Stock”, and SFAS No. 133.However, effective January 1, 2009, we were required to analyze theseinstruments in accordance with EITF 07-5. Based on our analysis, the 2005Warrants and 2006 Warrants include price protection provisions whereby theexercise price could be adjusted upon certain financing transaction at a lowerprice per share and could no longer be viewed as indexed to our common stock.As a result, the 2005 Warrants and 2006 Warrants were accounted for as“derivatives” and recorded as liabilities at fair value on January 1, 2009of $74,032. The fair value of these warrants was $97,435 as of June 30,2009 and we recorded loss of $1,722 and $68,340 on the changes in fair value inthe statement of operations for the three and six months ended June 30,2009. 

 

*DebtExtinguishment*

 

We accounted for theeffects of the May 22, 2009 Settlement Agreement (see Note 7 of theaccompanying condensed consolidated financial statements) in accordance withthe guidelines enumerated in EITF Issue No. 96-19 “ Debtor’s Accountingfor a Modification of Exchange of Debt Instruments.”  EITF 96-19provides that a substantial modification of terms in an existing debtinstrument should be accounted for like, and reported in the same manner as, anextinguishment of debt. EITF 96-19 further provides that the modification of adebt instrument by a debtor and a creditor in a non-troubled debt situation isdeemed to have been accomplished with debt instruments that are substantiallydifferent if the present value of cash flows under the terms of the new debtinstrument is at least ten percent different from the present value of theremaining cash flows under the terms of the original instrument at the date ofthe modifications.

 

We evaluated themodification of the payment terms and the related adjustment to financialinstruments to determine whether these modifications resulted in the issuanceof a substantially different instrument. We determined after giving effect tothe changes in the due dates of payments and the consideration paid to the debtholders, in the form of reduced conversion and exercise prices, we had issuedsubstantially different debt instruments, which resulted in a constructiveextinguishment of the original debt instrument. Accordingly, we recorded a losson the extinguishment of debt in the amount of $2,613,630 which represented thedifference in the carrying value of the old debt and fair value of the newdebt. The debt instrument charge is included in the accompanying statement ofoperations for the six months ended June 30, 2009.

 

***Comparison of theThree Months Ended June 30, 2009 and 2008***

 

*Revenues.*  Revenues from continuingoperations for the three months ended June 30, 2009 were approximately $14million, an increase of approximately $4.8 million, or 52%, over revenues ofapproximately $9.2 million in the comparable period in 2008.  This increase was due primarily to increasedorder fulfillment under our Marine Corps Contract No. M67854-07-D-5023during the second quarter of 2009 versus the same quarter in 2008, includingorders that had been expected in the fourth quarter of 2008 that were delayedinto the first and second quarters of 2009.  The revenue increasealso was due to additional sales generated from our physical security productbusiness for the three months ended June 30, 2009 of approximately $1.1million, an increase of approximately $655,000 or 147% over revenues ofapproximately $445,000 for the three months ended June 30, 2008.

 

On January 2, 2009, we discontinued theoperations of our Tactical Application Group, a tactical equipment supplybusiness.  Revenues from our discontinuedoperations for the three months ended June 30, 2008 was approximately$597,000.  There were no revenues generated from discontinued operationsduring the three months ended June 30, 2009.

 

*Cost of Revenues.* Cost of revenues for the threemonths ended June 30, 2009 was approximately $8.7 million, an increase ofapproximately $2.7 million, or 45%, over cost of revenue of $6.0 million in thecomparable period in 2008.  This increase was related to our increasedproduction costs under the Marine Corps sales contract mentioned above. The costs of revenue also increased due to additional costs of sales from ourphysical security product business during the quarter ended June 30, 2009.

 

Cost of revenues from discontinued operations for thethree months ended June 30, 2008 was approximately $424,000.  Therewere no costs of revenues generated from discontinued operations for the threemonths ended June 30, 2009.

 

*Gross profit margin*.   The gross profit margin forthe three months ended June 30, 2009 and June 30, 2008 wereapproximately $5.37 million and $3.21 million, respectively.  The grossprofit margin percentage was 38.2% and 34.8% for the three months ended June 30,2009 and June 30, 2008, respectively. The increase in gross profit marginpercentage from continuing operations from 2008 to 2009 resulted primarily froma reduction in overall costs incurred during the three months ended June 30,2009 that were associated with production on the Marine Corps sales contract.

 

*Sales and Marketing Expenses.*  Sales and marketing expensesfor the three months ended June 30, 2009 and June 30, 2008 wereapproximately $724,000 and $727,000, respectively, representing a decrease of $3,000,or 0.4%.  The increase was due primarily to an increase in trade showexpenses and related expenses from marketing T2, along with our current productline, for the three months ended June 30, 2009.  We did not offer theT2 during the three months ended June 30, 2008 and, therefore, incurred nomarketing expense for its promotion. There were no sales or marketing expenses for discontinued operationsduring the quarters ended June 30, 2009 and 2008.

 

*Researchand Development Expenses.*  Research and development expenses for the three monthsended June 30, 2009 and June 30, 2008 were approximately $17,000 and$204,000, respectively.  The decrease of $187,000 or 92% from 2008 to 2009was the result of additional testing and improvements of existing products and 

 

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continued work on our products in development during the three monthsended June 30, 2008.  There were noresearch and development expenses for discontinued operations.

 

*Generaland Administrative Expenses.*  General and administrative expenses fromcontinuing operations for the three months ended June 30, 2009 and June 30,2008 were approximately $2.2 million and $1.0 million, respectively.  Theincrease of approximately $1.2 million, or 120%, was primarily due to generalincreases in expenses of approximately $700,000 relating to board of directorcompensation, general and liability insurance, rent and general supplies, aswell as additional general and administrative expenses associated with thefacilities for our physical security product business of approximately$100,000. We also incurred approximately $400,000 in legal expenses associatedwith ongoing litigation.

 

General and administrative expenses associated withdiscontinued operations was approximately $60,000 for the three months ended June 30,2008.  There were no such expenses incurred during the three months ended June 30,2009.

 

*General and Administrative SalariesExpense.*  Generaland administrative salaries expense for the three months ended June 30,2009 and June 30, 2008 were approximately $1.0 million and $1.1  million, respectively.  The net decreaseof $100,000, or 9% was due in part to the decrease in salary expense at theHicksville facility.  In addition, weincurred no salary expense with regard to our discontinued operations, whichwere approximately $106,500 during the quarter ended June 30, 2008.  As of June 30, 2009, there were 39employees that were classified as general and administrative personnel, versus41 employees as of June 30, 2008.

 

*Depreciation expense.*  Depreciation expense was approximately$278,000 and $147,000 for the three months ended June 30, 2009 and June 30,2008, respectively.  The increase of $131,000, or 89%, was the result ofour higher property and equipment balance as of June 30, 2009 versus June 30,2008.  This increase was the result of additional leasehold improvementsand equipment associated with the expansion of our facility during 2008,property and equipment purchased in 2008 and 2009 for our Hicksville facilityand physical security product business, and T2 equipment.  This highercapital balance as of June 30, 2009 resulted in higher depreciationexpense.

 

*Other(income) and expense.*  As a result of our agreement to sell our Series AConvertible Preferred Stock and related warrants to purchase common stock (orinvestor warrants), we incurred gains which occurred upon the valuation of the Series AConvertible Preferred Stock.  Such valuation took into account thefeatures, rights and obligations of the Series A Convertible PreferredStock, which ultimately resulted in a lower fair value than the proceedsreceived.  Since the Series A Convertible Preferred Stock isrequired to be recorded at fair value, we recorded a gain on suchsecurities.  We experienced a gain on adjustment of fair value withrespect to our Series A Convertible Preferred Stock of $9,142 and$2,605,159 for the three months ended June 30, 2009 and 2008,respectively.

 

Prior to entering intothe May 22, 2009 Settlement Agreement, we recognized a loss on the derivativeand investor warrants of $107,022 and $26,350 for the three months ended June 30,2009 and 2008.** ** As a resultof the extinguishment of debt associated with the Settlement Agreement, werecorded a loss on extinguishment of debt, which represented the difference inthe carrying value of the old debt and the fair value of the new debt, in theamount of $2,613,630 for the three months ended June 30, 2009.  The investor warrants were exercised in fullduring the three months ended June 30, 2009.

 

In addition, we incurredinterest expense associated with the amortization of the deferred financingcosts and discount on the Series A Convertible Preferred Stock of $266,700and $249,599 for the three months ended June 30, 2009 and 2008,respectively. We also incurred $374,380 and $401,252 in interest expenserelated to the dividends paid on our Series A Convertible Preferred Stock forthe three months ended June 30, 2009 and 2008, respectively.

*** ***

***Comparison of theSix Months Ended June 30, 2009 and 2008***

 

*Revenues.*  Revenues from continuingoperations for the six months ended June 30, 2008 were approximately $23.5million, an increase of approximately $5.6 million, or 31%, over revenues ofapproximately $17.9 million in the comparable period in 2008.  This increase was due primarily to increasedorder fulfillment under our Marine Corp Contract No. M67854-07-D-5023during the six months ended June 30, 2009 versus the same period in 2008,including orders that had been expected in the fourth quarter of 2008 that weredelayed into the first and second quarters of 2009.  The revenueincrease also was due to additional sales generated from our physical securityproduct business for the six months ended June 30, 2009 of approximately$2,100,000, an increase of approximately $1,500,000 or 250% over revenues ofapproximately $600,000 for the six months ended June 30, 2008.

 

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Revenues from our discontinued operations for the sixmonths ended June 30, 2008 was approximately $775,000.  There were norevenues generated from discontinued operations during the six months ended June 30,2009.

 

*Cost of Revenues.* Cost of revenues for the six monthsended June 30, 2009 was approximately $14.1 million, an increase of approximately$2.8 million, or 25%, over cost of revenue of $11.3 million in the comparableperiod in 2008.  This increase was related to our increased productioncosts under the Marine Corps sales contract mentioned above.

 

Cost of revenues from discontinued operations for thesix months ended June 30, 2008 was approximately $600,000.  Therewere no costs of revenues generated from discontinued operations for the sixmonths ended June 30, 2009.

 

*Gross profit margin*.   The gross profit margin forthe six months ended June 30, 2009 and June 30, 2008 wereapproximately $9.4 million and $6.6 million, respectively.  The grossprofit margin percentage was 40% and 37% for the six months ended June 30,2009 and June 30, 2008, respectively. The increase in gross profit marginpercentage from continuing operations from 2008 to 2009 resulted primarily froma reduction in overall costs incurred during the six months ended June 30,2009 that were associated with production on the Marine Corps sales contract.

 

*Sales and Marketing Expenses.*  Sales and marketing expensesfor the six months ended June 30, 2009 and June 30, 2008 wereapproximately $1.46 million and $1.36 million, respectively, representing anincrease of $100,000, or 7%.  The increase was due primarily to an increasein trade show expenses and related expenses from marketing T2, along with ourcurrent product line for the six months ended June 30, 2009.  We didnot offer the T2 during the six months ended June 30, 2008 and, therefore,incurred no marketing expense for its promotion.  There were no sales or marketing expenses fordiscontinued operations.

 

*Research and Development Expenses.*  Research and developmentexpenses for the six months ended June 30, 2009 and June 30, 2008were approximately $203,000 and $369,000, respectively.  The decrease of$166,000 or 45% from 2008 to 2009 was the result of additional testing andimprovements of existing products and continued work on our products indevelopment during the six months ended June 30, 2008. There were noresearch and development expenses for discontinued operations.

 

*Generaland Administrative Expenses.*  General and administrative expenses fromcontinuing operations for the six months ended June 30, 2009 and June 30,2008 were approximately $4.3 million and $2.37 million, respectively.  Theincrease of approximately $1.93 million, or 81%, was primarily due to generalincreases in expenses of approximately $980,000 relating to professional fees,board of director compensation, general and liability insurance, rent andgeneral supplies, as well as additional general and administrative expensesassociated with the facilities for our physical security product business ofapproximately $190,000.  We also incurredapproximately $750,000 in professional fees associated with ongoing litigation.

 

General and administrative expenses associated withdiscontinued operations was approximately $200,000 for the six months ended June 30,2008.  There were no such expenses incurred during the six months ended June 30,2009.

 

*General and Administrative SalariesExpense.*  Generaland administrative salaries expense for the six months ended June 30, 2009and June 30, 2008 were approximately $2.1 million and $2.25 million,respectively.  The net decrease of $150,000, or 7% was due to the decreasein salary expense at the Hicksville facility and the reduction of salaryexpense with regard to our discontinued operations, which were approximately$195,900 during the six months ended June 30, 2008.  As of June 30,2009, there were 39 employees that were classified as general andadministrative personnel, versus 41 employees as of June 30, 2008.

 

*Depreciation expense.*  Depreciation expense wasapproximately $519,000 and $282,000 for the six months ended June 30, 2009and June 30, 2008, respectively.  The increase of $237,000, or 84%,was the result of our higher property and equipment balance as of June 30,2009 versus June 30, 2008.  This increase was the result ofadditional leasehold improvements and equipment associated with the expansionof our facility during 2008, property and equipment purchased in 2008 and 2009for our Hicksville facility and physical security product

 

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business, and T2 equipment.  This higher capital balance as of June 30,2009 resulted in higher depreciation expense.

 

*Other(income) and expense.*  As a result of our agreement to sell our Series AConvertible Preferred Stock and related warrants to purchase common stock (orinvestor warrants), we incurred gains and losses which occurred upon thevaluation of the Series A Convertible Preferred Stock.  Suchvaluation took into account the features, rights and obligations of the Series AConvertible Preferred Stock.   Since the Series A ConvertiblePreferred Stock is required to be recorded at fair value, we recorded gains orlosses on such securities.  We experienced a loss on adjustment of fairvalue with respect to our Series A Convertible Preferred Stock of $685,312and a gain on adjustment of fair value of $1,176,494 for the six months ended June 30,2009 and 2008, respectively.

 

We recognized a loss of $26,350and a gain of $1,313,843 on the derivative warrants for the six months ended June 30,2009 and 2008.** ** As a resultof the extinguishment of debt associated with the Settlement Agreement, theCompany recorded a loss on extinguishment of debt, which represented thedifference in the carrying value of the old debt and the fair value of the newdebt, in the amount of $2,613,630 for the six months ended June 30,2009.  The investor warrants wereexercised in full during the six months ended June 30, 2009.

 

In addition, we incurred interest expense associatedwith the amortization of the deferred financing costs and discount on the Series AConvertible Preferred Stock of $567,020 and $304,351 for the six months ended June 30,2009 and 2008, respectively.  We alsoincurred $749,830 and $401,252 in interest expense related to the dividends paidon our Series A Convertible Preferred Stock for the six months ended June 30,2009 and 2008.

 

**Liquidity and Capital Resources**

 

The primary sources of our liquidity during the six months ended June 30, 2009 have come fromoperations and to a lesser extent under our bank credit facility.  As of June 30,2009, our principal sources of liquidity were net accounts receivable ofapproximately $8.6 million and costs in excess of billings of approximately $8.3million and borrowings under our revolving credit facility with TD Bank ofapproximately $1.43 million.

 

As of June 30, 2008, our principal sources of liquidity were cashand cash equivalents totaling approximately $6.6 million, net accountsreceivable of approximately $5.5 million and costs in excess of billings ofapproximately $8.5 million.  The primary sources of our liquidity duringthe six months ended June 30,2008 came from operations and the proceeds from the sale of our Series AConvertible Preferred Stock.

 

***Series A Convertible PreferredStock***

 

In March and April 2008, we sold shares of our Series AConvertible Preferred Stock (which we also refer to as Series A PreferredStock) and warrants to purchase our common stock (also referred to as the InvestorWarrants).  We received aggregate grossproceeds of $15,000,000, before fees and expenses of the placement agent in thetransaction and other expenses.

 

During the first several months of 2009, we held discussions andnegotiations with the holders of our Series A Preferred Stock (or Series AHolders) to resolve our purported breach of certain financial covenants anddividend requirements relating to the Series A Preferred Stock.  In April 2009, the Series A Holderholding a majority of our Series A Preferred Stock demanded redemption ofits shares of Series A Preferred.

 

On May 22, 2009 we entered into a Settlement Agreement, Waiver andAmendment with the Series A Holders (or Settlement Agreement) pursuant towhich, among other things, (i) the Series A Holders waived any breach by us of such financial covenants or our obligation to timely pay dividends onthe Series A Preferred Stock for any period through September 30,2009, and waived any “Equity Conditions Failure” and any “Triggering Event”under the certificate of designations of the Series A Preferred Stock (orCertificate of Designations) otherwise arising from such breaches,  (ii) theInvestor Warrantswere amended to reduce their exercise price from $2.40 per share to $0.01 pershare, (iii) we issued the Series A Holders an aggregate of 2,000,000 shares of our common stock (or Dividend Shares), infull satisfaction of our obligation to pay dividends under the Certificate of Designations asof March 31, 2009, June 30, 2009 and September 30, 2009, and (iv) we agreed to redeem $7,500,000 in statedvalue of the Series A Preferred Stock by December 31, 2009.  We agreed that, if we fail to so redeem$7,500,000 in stated value of the Series A Preferred Stock by that date (aRedemption Failure), then, in lieu of any other remedies or damages availableto the Series A Holders (absent fraud), (i) the redemption pricepayable by us will increaseby an amount equal to 10% of the stated value, (ii) we will use our best efforts to obtain stockholder approval to reducethe conversion price of the Series A Preferred Stock from $2.00 to $0.50(which would increase the number of shares of common stock into which the Series APreferred Stock is convertible), and

 

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(iii) we will expand the size of our board of directors by two, will appointtwo persons designated by the Series A Holders to fill the twonewly-created vacancies, and will use our best efforts to amend our certificate of incorporation to grant the Series AHolders the right to elect two persons to serve on the board.  See “Item 1A. Risk Factors.  We have entered into a Settlement Agreement,Waiver and Amendment with holders of our Series A Convertible PreferredStock, pursuant to which, among other things, we have agreed to redeem$7,500,000 in stated value of the Series A Convertible Preferred Stock by December 31,2009, in addition to our prior obligation to redeem any such Preferred Stockoutstanding as of December 31, 2010. If we fail to redeem such Series A Convertible Preferred Stock, ourbusiness could be significantly harmed.”

 

Pursuantto the terms of the Settlement Agreement, we also entered into a Registration Rights Agreementwith the Series A Holders, in which we agreed to file with the Securities and ExchangeCommission, by June 1, 2009, a registration statement covering the resaleof the Dividend Shares, and to use our best efforts to have such registration statementdeclared effective as soon as practicable thereafter.  We further agreed with the Series AHolders to include in such registration statement the shares of common stockissued upon the exercise of the Investor Warrants in May and June 2009.  A registration statement was filed, andsubsequently declared effective on August 10, 2009.

 

Also pursuant tothe terms of the Settlement Agreement, each of our directors and executive officers entered into aLock-Up Agreement, pursuant to which each such person agreed that, for so longas any shares of Series A Preferred Stock remain outstanding, he will notsell any shares of our common stock owned by him as of May 22, 2009.

 

Also pursuant tothe terms of the Settlement Agreement, on May 22, 2009 our Chief Executive Officer, President andChairman, entered into an Irrevocable Proxy and Voting Agreement with the Series AHolders, pursuant to which he agreed, among other things, that if a RedemptionFailure occurs he will vote all shares of voting stock owned by him in favor of(i) reducing the conversion price of the Series A Preferred Stockfrom $2.00 to $0.50 and (ii) amending our certificate of incorporation to grant the Series AHolders the right to elect two persons to serve on the board of directors (collectivelyreferred to as the Company Actions).   Our CEO also appointed one of the Series A Holdersas his proxy to vote his shares of voting stock in favor of the CompanyActions, and against approval of any opposing or competing proposal, at anystockholder meeting or written consent of our stockholders at which such matters areconsidered.

 

***Bank Facility***

 

In May 2007, we entered into a loan agreementwith TD Bank (formerly known as Commerce Bank, N.A) pursuant to which we hadaccess to a revolving credit facility up to a maximum of $12.0 milliondepending upon the periodic balance of our qualified accounts receivable. As of June 30, 2009 and 2008, approximately $1.43 million and $0,respectively, was outstanding under the revolving credit facility.  As partof the same loan facility, we borrowed approximately $55,000 and $120,000 as ofJune 30, 2009 and 2008, respectively, under a term loan due July 1,2010, which was payable in equal monthly installments.  The credit facility was secured by all of ourassets, and bore interest at a variable rate equal to LIBOR plus a margin ofbetween 1.75% and 2.45%.  As of July 24,2009, we repaid in full the entire outstanding balance under the loan agreementwith TD Bank, following the events described below with the bank.

 

On April 1, 2009, we received a Notice of Default fromTD Bank resulting from the violation of certain financial covenants. Thebank stated that it was not presently taking action to enforce its rights andremedies under our existing revolving line of credit, however they were notwaiving their rights under any exiting or future defaults or events of default.The bank indicated it would continue to make advances under the credit line,but it had no obligation to do so and would refuse an advance request in itssole discretion without notice.  The bankalso demanded that we provide unaudited consolidated financial statements and acash flow forecast within 20 days after each month end.

 

On April 27, 2009, we entered into aForbearance Agreement and Amendment to Loan Agreement with TD Bank, pursuant towhich the bank agreed to forbear from exercising its default-related rights andremedies with respect to the defaults specified in the Notice of Default,including without limitation acceleration and foreclosure, and continue toprovide advances and other financial accommodations under our loan agreementwith the bank until

 

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June 15, 2009 unless such forbearance period was earlier terminated asa result of any Forbearance Default (as defined in the ForbearanceAgreement).  Notwithstanding the foregoing, the bank would have noobligation to make any advance if, after giving effect thereto, the aggregateprincipal amount of the advances plus outstanding letters of credit issued bythe bank for our account would exceed $2,000,000 prior to May 15, 2009 and$1,000,000 as of May 15, 2009 and thereafter.  Under the ForbearanceAgreement, we agreed, among other things, (i) not to make any RestrictedPayment (as defined in the Loan Agreement), other than a stock dividend payablein our common stock and approved by the bank in its sole discretion, (ii) touse our best efforts to obtain a refinancing, (iii) to provide certainmonthly financial information as set forth in the Forbearance Agreement and (iv) topay the advances, the term loan and all other obligations in full by June 15,2009.  Our failure to comply with any of the foregoing would constitute aForbearance Default under the ForbearanceAgreement, whichwould have resulted in termination of the Forbearance Agreement.

 

On May 27, 2009, we entered into anAmendment to the Forbearance Agreement with the bank pursuant to which the bankincreased the credit cap referenced above from $1,000,000 to $2,500,000.  Subsequently, on June 15, 2009, weentered into a  Second Amendment to theForbearance Agreement, pursuant to which the parties agreed to extend theForbearance Period to the earlier to occur of the termination of theForbearance Period as a result of any Forbearance Default (as defined in theForbearance Agreement) and July 15, 2009.

 

Thereafter, we requested extensions relating tothe forbearance period and the maturity date in order to allow us to completethe negotiation of an Accounts Receivable Purchase Agreement (discussedbelow).  The bank informally extendedsuch forbearance period and maturity date. On July 24, 2009, we repaid the remaining term loan balance, andrepaid and terminated the credit facility.

 

***Accounts Receivable Purchase Agreement***

 

On July 27,2009, we entered into an accounts receivable purchase agreement with RepublicCapital Access, LLC (or RCA), as of July 23, 2009.  Under thepurchase agreement, we can sell eligible accounts receivables to RCA. Eligible accounts receivable, subject to the full definition of such term inthe purchase agreement, generally are our receivables under prime governmentcontracts.

 

Under the terms ofthe purchase agreement, we may offer eligible accounts receivable to RCA and ifRCA purchases such receivables, we will receive an initial upfront paymentequal to 90% of the receivable.  Following RCA’s receipt of payment fromour customer for such receivable, they will pay to us the remaining 10% of thereceivable less its fees.  In addition to a Discount Factor fee and aninitial enrollment fee, we are required to pay RCA a program access fee equalto a stated percentage of the sold receivable, a quarterly program access feeif the average daily amount of the sold receivables is less than $2,250,000 andRCA’s initial expenses in negotiating the purchase agreement and other expensesin certain specified situations.  The purchase agreement also providesthat in the event, but only to the extent, that the conveyance of receivablesby us is characterized by a court or other governmental authority as a loanrather than a sale, we shall be deemed to have granted RCA effective as of thedate of the first purchase under the Purchase Agreement, a security interest inall of our right, title and interest in, to and under all of the receivablessold by us to RCA, whether now or hereafter owned, existing or arising. The initial term of the purchase agreement ends on December 31, 2009. We have not yet sold any receivables to RCA.

 

We believe that our current cash, cash equivalents, net accountsreceivable and costs in excess of billings together with our expected cashflows from operations and ability to sell accounts receivable will besufficient to meet our anticipated cash requirements for working capital andcapital expenditures for at least the next 12 months, subject to the mattersconcerning the Series A Preferred Stock redemptions.  We currently are seeking toobtain additional financing to fund the Series A Preferred Stockredemptions.  However, there is noassurance that we would be able to obtain such financing on commerciallyreasonable terms, or at all.  Foradditional information, please see “Liquidity and Capital Resources - Series AConvertible Preferred Stock” above.

 

*CashFlows from Operating Activities.** *Net cash used in operating activities wasapproximately $333,000for the six months ended June 30, 2009 compared to net cash usedin operating activities of approximately $4.2 million for the six months ended June 30,2008.  Net cash used in operating activities during the six months endedJune 30, 2009 consisted primarily of changes in our operating assets andliabilities of approximately $1.8 million, including changes in accountsreceivable, cost in excess of billing, prepaid expense, accounts payable andaccrued liabilities.  The changes in

 

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accounts receivable andcosts in excess of billing of $3.6 million and $1.1 million, respectively,reflects the increases in receivables from completed projects and costsincurred on projects in process as of June 30, 2009.  Our prepaidexpenses and other current assets increased approximately $577,000 due toamounts paid in advance in connection with prepayment of legal expense andinsurance.  As of June 30, 2008, we experienced a reduction inaccounts receivable of $1.2 million, due to increased collections during thesix month period.  The increase in itscosts in excess of billings of $3.5 million as of June 30, 2008, reflectsincreases in projects in process as of June 30, 2008.  Our prepaid expenses increased approximately $621,000due to amounts paid in advance in connection with our intent to enter thepublic market and obtain outside financing.  In addition, the changes inaccounts payable and accrued liabilities reflect the related increase inexpenses incurred, with no funds paid out.

 

As of June 30, 2009, we had net operating losscarryforwards of approximately $4.6 million available to reduce futuretaxable income. In the future, we may utilize our net operating losscarryforwards and would begin making cash tax payments at that time. Inaddition, the limitations on utilizing net operating loss carryforwards andother minimum taxes may also increase our overall tax obligations. We expectthat if we generate taxable income and/or we are not allowed to use netoperating loss carryforwards, our cash generated from operations will beadequate to meet our income tax obligations.

 

*NetCash Used In Investing**Activities.*  Net cash used in investing activities for the sixmonths ended June 30, 2009 and 2008 was approximately $300,000 and $4.4million, respectively.  Net cash used in investing activities for the sixmonths ended June 30, 2009 consisted of amounts paid out for the generaland computer equipment and miscellaneous leasehold improvements.  Net cash used in investing activities for thesix months ended June 30, 2008 consisted primarily of cash paid for theacquisition of equipment for the T2 facility and general shop equipment andmachinery.  During the six months ended June 30,2008, we also paid outcash associated with leasehold improvements and office equipment and furniturefor the expansion of our Hicksville corporate offices and warehouse.

 

*NetCash Provided by Financing**Activities.* Net cash provided by financing for the six months ended June 30, 2009 and2008 was approximately $607,000 and $13.7 million, respectively. Net cashprovided by financing activities during 2009 consisted of proceeds from theline of credit of approximately $1.4 million and proceeds from a short termloan payable of approximately $55,000 offset by approximately $879,000 paid fordeferred financing costs.  Net cash provided by financing activities during2008 consisted primarily of proceeds of $15 million received from the saleof the Series A Preferred Stock offset by approximately $1.4 millionpaid in deferred financing costs.  Inaddition, the Company received approximately $194,000 of proceeds from the sale of common stock and$62,000 from the term loan with TD Bank, offset by repayments of short termfinancing of approximately $12,000.

 

**Item 3.    Quantitative and Qualitative DisclosureAbout Market Risk**

 

We are a smaller reporting company as defined by Rule 12b-2 of theExchange Act and are not required to provide the information required underthis Item 3.

 

**Item 4.    Controls and Procedure**

 

**Evaluation of Disclosure Controls and Procedures**

 

An evaluation was carried outunder the supervision and with the participation of our management, includingour Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of1934, as amended (the “Exchange Act”)) as of the end of the period covered bythis report. Based on the evaluation of our disclosure controls and procedures,our Chief Executive Officer and our Chief Financial Officer determined that amaterial weakness exists with respect to our reporting of complex andnon-routine transactions.  As a result ofthis material weakness, on November 20, 2009 we determined that restatementswere required for our financial statements in our Annual Report for the yearended December 31, 2008 and our Quarterly Reports for the quarters ended March31, 2009 and June 30, 2009.  

 

To address this materialweakness, we have engaged outside experts to provide counsel and guidance inareas where we cannot economically maintain the required expertise internally(e.g., with the appropriate classifications and treatments of complex andnon-routine transactions).  

 

As a result of the materialweakness identified with respect to our reporting of complex transactions, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures were not effective to ensure that theinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act was recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms and that suchinformation required to be disclosed is accumulated and communicated tomanagement, including our Chief Executive Officer and Chief Financial Officer,to allow timely decisions regarding required disclosure.  

 

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**Changes in Internal Controls**

 

There were no changes in our internal controlsover financial reporting during the quarter ended June 30, 2009 that havematerially affected, or are reasonably likely to affect, our internal controlover financial reporting.

 

**Limitationson the Effectiveness of Controls**

 

Our management, includingour CEO and CFO, does not expect that our Disclosure Controls and internalcontrols will prevent all error and all fraud. A control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. Further, thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, with American Defense Systems have beendetected. These inherent limitations include the realities that judgments indecision-making can be faulty and that breakdowns can occur because of simpleerror or mistake. Additionally, controls can be circumvented by the individualacts of some persons, by collusion of two or more people or by managementoverride of the controls.   

 

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

 

PART II

 

**Item 1.    Legal Proceedings**

 

On July 10, 2007, we filed a lawsuit against a formersubcontractor, Southern California Gold Products d/b/a Gypsy Rack, the subcontractor’sPresident and owner, Glenn Harris, and a designer, James McAvoy in the UnitedStates District Court, Eastern District of New York. Defendants moved to changevenue to the Central District of California based upon insufficient contacts tothe State of New York and on October 12, 2007 the matter was transferredto the United States District Court for the Central District of California,Case Number 07-CV-02779. On February 21, 2008, pursuant to the court’sorder, we filed an amended complaint. The amended complaint names only SouthernCalifornia Gold Products and James McAvoy as defendants and asserts six countsas follows: misappropriation of trade secrets and confidential information;breach of contract; unfair competition; conversion; violation of the LanhamAct; and interference with prospective economic advantage. The amendedcomplaint seeks to enjoin the defendants from misappropriating, disclosing, orusing our confidential information and trade secrets, and recall and surrenderall products and trade secrets wrongfully misappropriated or converted by thedefendants. It also seeks compensatory damages in an amount to be establishedat trial together with prejudgment and post judgment interest, exemplarydamages, disgorgement, restitution with interest, attorney’s fees and the costsof suit. Defendants filed an answer to the amended complaint on April 16,2008. Shortly after the filing of the amended answer, defendants made a motionfor summary judgment on, among others, the grounds of collateral estoppel andres judicata. We filed opposition to the motion. The defendants motion and asubsequent application for an immediate interlocutory appeal were denied. Amediation settlement conference was held on October 31, 2008, which wasunsuccessful. The defendants made a second motion for summary judgment that wasdenied in May 2009. Discovery has continued and expert discovery is in theprocess of being completed. A second mediation settlement conference washeld in July 2009. As a result of that conference, the parties believethey may have reached a settlement in principle.   The partieshave requested that the Court stay discovery and the trial for a period ofsixty (60) days.  The parties have proposed to the Court that they willreport back to the Court on September 7, 2009 to inform the Court of theresults of these settlement discussions and to further discuss whether theparties and the case will proceed to trial.

 

On February 29, 2008, Roy Elfers, a formeremployee commenced an action against us for breach of contract arising from histermination of employment in the Supreme Court of the State of New York, NassauCounty. The Complaint seeks damages of approximately $87,000. We filed ananswer to the complaint and will be commencing discovery.  We believe meritorious defenses to the claimsexist and we intend to vigorously defend this action.

 

On March 4, 2008, Thomas Cusack, ourformer General Counsel, commenced an action with the United States Departmentof Labor, Occupational Safety and Health and Safety Administration, allegingretaliation in contravention of the Sarbanes-Oxley Act. Mr. Cusack seeksdamages in excess of $3,000,000. On April 2, 2008, we filed a response tothe charges. We believe the allegations to be without merit and intend to vigorouslydefend against the action. On March 7, 2008, Mr. Cusack alsocommenced a second action against us for breach of contract and related issuesarising from his termination of employment in New York State Supreme Court,Nassau County. On May 7, 2008, we served a motion to dismiss thecomplaint, and on or about September 26, 2008, the Court dismissed severalclaims (tortious interference with a contract, tortious interference witheconomic opportunity, fraudulent inducement to enter into a contract and breachof good faith and fair dealing). The remaining claims are Mr. Cusack’sbreach of contract claims and claims seeking the lifting of the transferrestrictions on his stock. On October 13, 2008, Mr. Cusack filed anamended complaint as to the remaining claims, and on November 5, 2008, wefiled an answer to the complaint and filed counterclaims against Mr. Cusackfor fraud.  The parties have commenceddocumentary discovery, and depositions are scheduled to occur in August andSeptember 2009.  We believemeritorious defenses to the claims exist and we intend to vigorously defendthis action.

 

**Item 1A.  Risk Factors**

 

Our business, industry and common stock aresubject to numerous risks and uncertainties. The discussion below sets forthall of such risks and uncertainties that are material. Any of the followingrisks, if realized, could

 

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materially and adversely affect our revenues, operating results,profitability, financial condition, prospects for future growth and overallbusiness, as well as the value of our common stock.

 

**Risks Relating to Our Company**

 

***We depend on the U.S. Government for asubstantial amount of our sales and our growth in the last few years has beenattributable in large part to U.S. wartime spending in support of troopdeployments in Iraq and Afghanistan. If such troop levels are reducedsignificantly, our business may be harmed; and if we do not continue toexperience demand for our products within the U.S. Government, our business mayfail.***

 

We serve primarily the defense market and oursales are highly concentrated within the U.S. government. Customers for ourproducts include the U.S. Department of Defense, including the U.S. MarineCorps and TACOM, and the U.S. Department of Homeland Security. Government taxrevenues and budgetary constraints, which fluctuate from time to time, canaffect budgetary allocations for these customers. Many government agencies havein the past experienced budget deficits that have led to decreased spending indefense, law enforcement and other military and security areas. Our results ofoperations may be subject to substantial period-to-period fluctuations becauseof these and other factors affecting military, law enforcement and othergovernmental spending.

 

U.S. defense spending historically has beencyclical. Defense budgets have received their strongest support when perceivedthreats to national security raise the level of concern over the country’ssafety, such as in Iraq and Afghanistan. As these threats subside, spending onthe military tends to decrease. Accordingly, while U.S. Department of Defensefunding has grown rapidly over the past few years, there is no assurance thatthis trend will continue. Rising budget deficits, the cost of the war on terrorand increasing costs for domestic programs continue to put pressure on allareas of discretionary spending, and the new administration has signaled that thispressure 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 spendingallocation could result in our government contracts being reduced, delayed orterminated. Reductions in our government contracts, unless offset by othermilitary and commercial opportunities, could adversely affect our ability tosustain and grow our future sales and earnings within the U.S. Department ofDefense.

 

***Our revenues in 2008 and the first sixmonths of 2009 have been concentrated in a small number of contracts obtainedthrough the U.S. Department of Defense and the loss of, or reduction inestimated revenue under, any of these contracts, or the inability to contractfurther with the U.S. Department of Defense could significantly reduce ourrevenues and harm our business.***

 

During 2008 and the first six months of 2009,two contracts with the U.S. Department of Defense represented approximately 75%of our revenue. While we believe we have satisfied and continue to satisfy theterms of these contracts, there can be no assurance that we will continue toreceive orders under such contracts. Our government customers generally havethe right to cancel any contract, or ongoing or planned orders under anycontract, at any time. If any of these two contracts were canceled, there aresignificant reductions in expected orders under any of the contracts, or wewere unable to contract further with the U.S. Department of Defense, ourrevenues could significantly decrease and our business could be severelyharmed.

 

***We have entered into a SettlementAgreement, Waiver and Amendment with holders of our Series A ConvertiblePreferred Stock, pursuant to which, among other things, we have agreed toredeem $7,500,000 in stated value of the Series A Convertible PreferredStock by December 31, 2009, in addition to our prior obligation to redeemany such Preferred Stock outstanding as of December 31, 2010.  If we fail to redeem such Series AConvertible Preferred Stock, our business could be significantly harmed.***

 

In connection with our application to list shares of our common stock onthe American Stock Exchange (now known as the NYSE Amex), we entered into a consentagreement with the holders of our Series A Convertible Preferred Stock(the “Series A Preferred”). We did not meet the financial performancetargets set forth in the consent agreement, which was filed as an exhibit toour Current Report on Form 8-K filed with the SEC on March 27, 2008.Our breach purportedly gave the holders of the Series A Preferred theright to require us to redeem all or a portion of their shares of such stock.We filed Current Reports on Form 8-K with the SEC on February 17, 2009and March 4, 2009 regarding the foregoing. On April 14, 2009, wereceived a notice from the holder of approximately

 

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94%of the Series A Preferred that it was exercising such redemption right.The Series A Preferred Stockholder also demanded that we pay them 12%dividends they assert accrued from January 1, 2009 to April 13, 2009,on our Series A Convertible Preferred Stock, in cash, as well as certainof their legal fees in connection with related matters. On May 22, 2009,we entered into a Settlement Agreement, Waiver and Amendment with the holdersof our Series A Preferred (the “Settlement Agreement”) pursuant to which,among other things, we have agreed to redeem $7,500,000 in stated value of Series APreferred by December 31, 2009. We filed a Current Report on Form 8-Kwith the SEC on May 26, 2009, regarding the foregoing. In addition,pursuant to the original terms of the Series A Preferred, we are requiredto redeem in full any remaining outstanding shares of Series A Preferredon December 31, 2010. We expect that, in order to satisfy these redemptionobligations, we will need to secure additional financing. If we are unable toobtain such financing or the cost of obtaining such financing were prohibitiveand, as a consequence, we are unable to redeem such shares, our business couldbe significantly harmed.  For additionalinformation, see Part I, Item 2 - Management’s Discussion and Analysis ofFinancial Condition and Results of Operations - Liquidity and Capital Resources- Series A Convertible Preferred Stock.

 

***We are required to comply with complexprocurement laws and regulations, and the cost of compliance with these lawsand regulations, and penalties and sanctions for any non-compliance couldadversely affect our business.***

 

We are required to comply with laws andregulations relating to the administration and performance of U.S. governmentcontracts, which affect how we do business with our customers and impose addedcosts on our business. Among the more significant laws and regulationsaffecting our business are the following:

 

·   The FederalAcquisition Regulations: Along with agency regulations supplemental to theFederal Acquisition Regulations, comprehensively regulate the formation,administration and performance of federal government contracts;

 

·   The Truth inNegotiations Act: Requires certification and disclosure of all cost and pricingdata in connection with contract negotiations;

 

·   The CostAccounting Standards and Cost Principles: Imposes accounting requirements thatgovern our right to reimbursement under certain cost-based federal governmentcontracts; and

 

·   Laws, regulationsand executive orders restricting the use and dissemination of informationclassified for national security purposes and the export of certain productsand technical data. We engage in international work falling under thejurisdiction of U.S. export control laws. Failure to comply with these controlregimes can lead to severe penalties, both civil and criminal, and can includedebarment from contracting with the U.S. government.

 

Our contracting agency customers periodicallyreview our performance under and compliance with the terms of our federalgovernment contracts. We also routinely perform internal reviews. As a resultof these reviews, we may learn that we are not in compliance with all of theterms of our contracts. If a government review or investigation uncoversimproper or illegal activities, we may be subject to civil or criminalpenalties or administrative sanctions, including:

 

·   Termination ofcontracts;

 

·   Forfeiture ofprofits;

 

·   Cost associatedwith triggering of price reduction clauses;

 

·   Suspension ofpayments;

 

·   Fines; and

 

·   Suspension ordebarment from doing business with federal government agencies.

 

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If we fail to comply with these laws andregulations, we may also suffer harm to our reputation, which could impair ourability to win awards of contracts in the future or receive renewals ofexisting contracts. If we are subject to civil and criminal penalties andadministrative sanctions or suffer harm to our reputation, our currentbusiness, future prospects, financial condition, or operating results could bematerially harmed. In addition, we are subject to industrial securityregulations of the U.S. Department of Defense and other federal agencies thatare designed to safeguard against unauthorized release or access to classifiedinformation by foreign nationals.

 

***Government contracts are usually awardedthrough a competitive bidding process that entails risks not present in theacquisition of commercial contracts.***

 

A significant portion of our contracts and taskorders with the U.S. government is awarded through a competitive biddingprocess. We expect that much of the business we seek in the foreseeable futurewill continue to be awarded through competitive bidding. Budgetary pressuresand changes in the procurement process have caused many government customers toincreasingly purchase goods and services through indefinite delivery/indefinitequantity, or IDIQ contracts, General Services Administration, or GSA schedulecontracts and other government-wide acquisition contracts, or GWACs. Thesecontracts, some of which are awarded to multiple contractors, have increasedcompetition and pricing pressure, requiring us to make sustained post-awardefforts to realize revenue under each such contract. Competitive bidding presentsa number of risks, including without limitation:

 

·   the need to bidon programs in advance of the completion of their design, which may result inunforeseen technological difficulties and cost overruns;

 

·   the substantialcost and managerial time and effort that we may spend to prepare bids andproposals for contracts that may not be awarded to us;

 

·   the need toestimate accurately the resources and cost structure that will be required toservice any contract we award; and

 

·   the expense anddelay that may arise if our or our partners’ competitors protest or challengecontract awards made to us or our partners pursuant to competitive bidding, andthe risk that any such protest or challenge could result in the resubmission ofbids on modified specifications, or in the termination, reduction or modificationof the awarded contract.

 

If we are unable to consistently win newcontract awards over any extended period, our business and prospects will beadversely affected, and that could cause our actual results to be adverselyaffected. In addition, upon the expiration of a contract, if the customerrequires further services of the type provided by the contract, there isfrequently a competitive rebidding process. There can be no assurance that wewill win any particular bid, or that we will be able to replace business lostupon expiration or completion of a contract, and the termination or non-renewalof any of our significant contracts would cause our actual results to beadversely affected.

 

***The U.S. government may reform itsprocurement or other practices in a manner adverse to us.***

 

Because we derive a significant portion of ourrevenues from contracts with the U.S. government or its agencies, we believethat the success and development of our business will depend on our continuedsuccessful participation in federal contracting programs. The currentadministration has signed a Memorandum for the Heads of Executive Departmentsand Agencies on Government Contracting, which orders significant changes togovernment contracting, including the review of existing federal contracts toeliminate waste and the issuance of government-wide guidance to implementreforms aimed at cutting wasteful spending and fraud. The federal procurementreform called for in the Memorandum requires the heads of several federal agenciesto develop and issue guidance on review of existing government contracts andauthorizes that any contracts identified as wasteful or otherwise inefficientbe modified or cancelled. If any of our contracts were to be modified orcancelled, our actual results could be adversely affected and we can give noassurance that we would be able to procure new U.S. Government contracts tooffset the revenues lost as a result of any modification or cancellation of ourcontracts. In addition, there may be substantial costs or management timerequired to respond to government review of any of our current contracts, whichcould delay or otherwise adversely affect our ability to compete for or performcontracts.

 

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Further, if the ordered reform of the U.S. Government’s procurementpractices involves the adoption of new cost-accounting standards or therequirement that competitors submit bids or perform work through teamingarrangements, that could be costly to satisfy or could impair our ability toobtain new contracts. The reform may also involve the adoption of newcontracting methods to GSA or other government-wide contracts, or new standardsfor contract awards intended to achieve certain socio-economic or other policyobjectives, such as establishing new set-aside programs for small orminority-owned businesses. In addition, the U.S. government may facerestrictions from other new legislation or regulations, as well as pressurefrom government employees and their unions, on the nature and amount ofservices the U.S. government may obtain from private contractors. These changescould impair our ability to obtain new contracts. Any new contracting methodscould be costly or administratively difficult for us to implement and, as aresult, could harm our operating results.

 

***Our contracts with the U.S. governmentand its agencies are subject to audits and cost adjustments.***

 

U.S. government agencies, including the DefenseContract Audit Agency, or the DCAA, routinely audit and investigate governmentcontracts and government contractors’ incurred costs, administrative processesand systems. Certain of these agencies, including the DCAA, review ourperformance on contracts, pricing practices, cost structure and compliance withapplicable laws, regulations and standards. They also review the adequacy ofour internal control systems and policies, including our purchase, property,estimation, compensation and management information systems. Any costs found tobe improperly allocated to a specific contract will not be reimbursed, and anysuch costs already reimbursed must be refunded. Moreover, if any of theadministrative processes and systems are found not to comply with requirements,we may be subjected to increased government scrutiny and approval that coulddelay or otherwise adversely affect our ability to compete for or performcontracts. Therefore, an unfavorable outcome of an audit by the DCAA or anothergovernment agency could cause actual results to be adversely affected anddiffer materially from those anticipated. If a government investigationuncovers improper or illegal activities, we may be subject to civil andcriminal penalties and administrative sanctions, including termination ofcontracts, forfeitures of profits, suspension of payments, fines and suspensionor debarment from doing business with the U.S. government. In addition, wecould suffer serious reputational harm if allegations of impropriety were madeagainst us. Each of these events could cause our actual results to be adverselyaffected.

 

***A portion of our business depends uponobtaining and maintaining required security clearances, and our failure to doso could result in termination of certain of our contracts or cause us to beunable to bid or re-bid on certain contracts.***

 

Obtaining and maintaining personal securityclearances (or PCLs) for employees involves a lengthy process, and it can bedifficult to identify, recruit and retain employees who already hold securityclearances. If our employees are unable to obtain or retain securityclearances, or if such employees who hold security clearances terminate theiremployment with us, the customer whose work requires cleared employees couldterminate the contract or decide not to exercise available options, or to notrenew it. To the extent we are not able to engage employees with the requiredsecurity clearances for a particular contract, we may not be able to bid on or winnew contracts, or effectively re-bid on expiring contracts, which couldadversely affect our business.

 

A facility security clearance (or FCL) is anadministrative determination by the Defense Security Service (DSS), a U.S.Department of Defense component, that a particular contractor facility has therequisite level of security, procedures, and safeguards to handle classifiedinformation requirements for access to classified information. Our ability toobtain and maintain facility security clearances has a direct impact on ourability to compete for and perform U.S. government contracts, the performanceof which requires access to classified information. Our abilityto so obtain or maintain any facility security clearance level could resultin 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 ofrevenues reflected in our backlog, which could harm our operations andsignificantly reduce our future revenues.***

 

There can be no assurances that our backlogestimates will result in actual revenues in any particular fiscal periodbecause our customers may modify or terminate projects and contracts and maydecide not to exercise contract options. We define backlog as the futurerevenue we expect to receive from our contracts. We include

 

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potential orders expected to be awarded under IDIQ contracts. Our revenueestimates for a particular contract are based, to a large extent, on the amountof revenue we have recently recognized on that contract, our experience inutilizing capacity on similar types of contracts, and our professionaljudgment. Our revenue estimate for a contract included in backlog can be lowerthan the revenue that would result from our customers utilizing all remainingcontract capacity. Our backlog includes estimates of revenues the receipt ofwhich require future government appropriation, option exercise by our clientsand/or is subject to contract modification or termination. At June 30,2009, our backlog was approximately $48 million, of which $28 millionis estimated to be realized in 2009. These estimates are based on ourexperience under such contracts and similar contracts, and we believe suchestimates to be reasonable. However, we believe that the receipt of revenuesreflected in our backlog estimate for the following twelve months willgenerally be more certain than our backlog estimate for periods thereafter. Ifwe do not realize a substantial amount of our backlog, our operations could beharmed and our future revenues could be significantly reduced.

 

***U.S. government contracts often containprovisions that are typically not found in commercial contracts and that areunfavorable to us, which could adversely affect our business.***

 

U.S. government contracts contain provisionsand are subject to laws and regulations that give the U.S. government rightsand remedies not typically found in commercial contracts, including withoutlimitation, allowing the U.S. government to:

 

·   terminateexisting contracts for convenience, as well as for default;

 

·   establishlimitations on future services that can be offered to prospective customersbased on conflict of interest regulations;

 

·   reduce or modifycontracts or subcontracts;

 

·   cancel multi-yearcontracts and related orders if funds for contract performance for anysubsequent year become unavailable;

 

·   decline toexercise an option to renew a multi-year contract;

 

·   claimintellectual property rights in products provided by us; and

 

·   suspend or bar usfrom doing business with the federal government or with a governmental agency.

 

***The ownership, control or influence ofour company by foreigners could result in the termination, non-renewal or ourinability to obtain certain U.S. government contracts, which would reduce ourrevenues and harm our business.***

 

We are subject to industrial securityregulations of the U.S. Department of Defense and other federal agencies thatare designed to safeguard against unauthorized access by foreigners and othersto classified and other sensitive information. If we were to come under foreignownership, 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 andsubcontracts. Any such actions would reduce our revenues and harm our business.

 

***We depend on our suppliers and three, inparticular, currently provide us with approximately 55% to 65% of our supplyneeds. If we can not obtain certain components for our products or we lost ourkey supplier, we might have to develop alternative designs that could increaseour costs or delay our operations.***

 

We depend upon a number of suppliers forcomponents of our products. Of these suppliers, Action Group suppliesapproximately 35% and Standard Bent Glass and Red Dot each supplies between 10%and 15% of our overall supply needs. Moreover, Action Group supplies all of oursteel pieces and hardware, Standard Bent Glass supplies all of our glassrequirements and Red Dot supplies all of our vehicle air conditioning andheating equipment

 

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for our CPKs.  There is an inherentrisk that certain components of our products will be unavailable for promptdelivery or, in some cases, discontinued. We have only limited control over anythird-party manufacturer as to quality controls, timeliness of production,deliveries and various other factors. Should the availability of certaincomponents be compromised through the loss of, or impairment of therelationship with, any of our three key suppliers or otherwise, it could forceus to develop alternative designs using other components, which could add tothe cost of goods sold and compromise delivery commitments. If we are unable toobtain components in a timelymanner, at anacceptable cost, or at all, we may need to select new suppliers, redesign orreconstruct processes we use to build our transparent and opaque armoredproducts. We may not be able to manufacture one or more of our products for aperiod of time, which could materially adversely affect our business, resultsfrom operations and financial condition.

 

***If we fail to keep pace with theever-changing market of security-related defense products, our revenues andfinancial condition will be negatively affected.***

 

The security-related defense product market israpidly changing, with evolving industry standards. Our future success willdepend in part upon our ability to introduce new products, designs,technologies and features to meet changing customer requirements and emergingindustry standards; however, there can be no assurance that we willsuccessfully introduce new products or features to our existing products ordevelop new products that will achieve market acceptance. Any delay or failureof these products to achieve market acceptance would adversely affect ourbusiness. In addition, there can be no assurance that products or technologiesdeveloped by others will not render our products or technologiesnon-competitive or obsolete. Should we fail to keep pace with the ever-changingnature of the security-related defense product market, our revenues andfinancial condition will be negatively affected.

 

We believe that, in order to remain competitivein the future, we will need to continue to invest significant financialresources to develop new and adapt or modify our existing offerings andtechnologies, including through internal research and development, acquisitionsand joint ventures or other teaming arrangements. These expenditures coulddivert our attention and resources from other projects, and we cannot be surethat these expenditures will ultimately lead to the timely development of newofferings and technologies. Due to the design complexity of our products, wemay in the future experience delays in completing the development andintroduction of new products. Any delays could result in increased costs ofdevelopment or deflect resources from other projects. In addition, there can beno assurance that the market for our offerings will develop or continue toexpand as we currently anticipate. The failure of our technology to gain marketacceptance could significantly reduce our revenues and harm our business.Furthermore, we cannot be sure that our competitors will not develop competingtechnologies which gain market acceptance in advance of our products.

 

***We may be subject to personal liabilityclaims for our products and if our insurance is not sufficient to cover suchclaims, our expenses may increase substantially.***

 

Our products are used in applications where thefailure to use our products properly or their malfunction could result inbodily injury or death. We may be subject to personal liability claims and ourinsurance may not be adequate to cover such claims. As a result, a significantlawsuit could adversely affect our business. We may be exposed to liability forpersonal injury or property damage claims relating to the use of the products.Any future claim against us for personal injury or property damage couldmaterially adversely affect the business, financial condition, and results ofoperations and result in negative publicity. We currently maintain insurancefor this type of liability as well as seek SAFETY Act certification for ourproducts where we deem appropriate. However, even if we do purchase insurance,we may experience legal claims outside of our insurance coverage, or in excessof our insurance coverage, or that insurance will not cover. Even if we are notfound liable, the costs of defending a lawsuit can be high.

 

***We are subject to substantialcompetition and we must continue research and development to remaincompetitive.***

 

We are subject to significant competition thatcould harm our ability to win business and increase the price pressure on ourproducts. We face strong competition from a wide variety of firms, includinglarge, multinational, defense and aerospace firms. Most of our competitors haveconsiderably greater financial, marketing and technological resources than wedo, which may make it difficult to win new contracts and we may not be able to

 

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compete successfully. Certain competitors operate larger facilities andhave longer operating histories and presence in key markets, greater namerecognition, larger customer bases and significantly greater financial, salesand marketing, manufacturing, distribution, technical and other resources. As aresult, these competitors may be able to adapt more quickly to new or emergingtechnologies and changes in customer requirements. They may also be ableto devote greater resources to the promotion and sale of their products.Moreover, we may not have sufficient resources to undertake the continuingresearch and development necessary to remain competitive.

 

***We must comply with environmentalregulations or we may have to pay expensive penalties or clean up costs.***

 

We are subject to federal, state, local andforeign 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 orwastes to manufacture our products. We must comply with certain requirementsfor the use, management, handling, and disposal of these materials. If we arefound responsible for any hazardous contamination, we may have to pay expensivefines or penalties or perform costly clean-up. Even if we are charged, andlater found not responsible, for such contamination or clean up, the cost ofdefending the charges could be high. Authorities may also force us to suspendproduction, alter our manufacturing processes, or stop operations if we do notcomply with these laws and regulations.

 

***We may not be able to adequatelysafeguard our intellectual property rights and trade secrets from unauthorizeduse, and we may become subject to claims that we infringe on others’intellectual property rights.***

 

We rely on a combination of patents, tradesecrets, trademarks, and other intellectual property laws, nondisclosureagreements and other protective measures to preserve our proprietary rights toour products and production processes. We currently have a number of U.S.pending patent applications.

 

These measures afford only limited protectionand may not preclude competitors from developing products or processes similaror superior to ours. Moreover, the laws of certain foreign countries do notprotect intellectual property rights to the same extent as the laws of theUnited States.

 

Although we implement protective measures andintend to defend our proprietary rights, these efforts may not be successful.From time to time, we may litigate within the United States or abroad toenforce our licensed patents, to protect our trade secrets and know-how or todetermine the enforceability, scope and validity of our proprietary rights andthe proprietary rights of others. Enforcing or defending our proprietary rightscould be expensive, require management’s attention and might not bring ustimely or effective relief.

 

Furthermore, third parties may assert that ourproducts or processes infringe their patent rights. Our patents, if granted,may be challenged, invalidated or circumvented. Although there are no pendingor threatened intellectual property lawsuits against us, we may face litigationor infringement claims in the future. Infringement claims could result insubstantial costs and diversion of our resources even if we ultimately prevail.A third party claiming infringement may also obtain an injunction or otherequitable relief, which could effectively block the distribution or sale ofallegedly infringing products. Although we may seek licenses from third partiescovering intellectual property that we are allegedly infringing, we may not beable to obtain any such licenses on acceptable terms, if at all.

 

***We depend on management and other keypersonnel and we may not be able to execute our business plan without theirservices.***

 

Our success and our business strategy depend inlarge part on our ability to attract and retain key management and operatingpersonnel. Such individuals are in high demand and are often subject tocompeting employment offers. We depend to a large extent on the abilities andcontinued participation of our executive officers and other key employees. Wepresently maintain “key man” insurance on Anthony Piscitelli, our President andChief Executive Officer. We believe that, as our activities increase and changein character, additional experienced personnel will be required to implementour business plan. Competition for such personnel is intense and we may not beable to hire them when required, or have the ability to attract and retainthem.

 

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***We depend on the use of our operatingfacilities, which currently are nearing capacity. To the extent our growthstrategy is successful, our operations could require additional space by theend of 2009 which, if not obtained on a cost-effective basis, could adverselyaffect our results of operations and financial conditions.***

 

Our success depends on the use of currentoperating facilities. However, the use of our facilities is quickly becomingmaximized. To the extent our growth strategy is successful, we may require theacquisition or lease of additional property by the end of 2009 in order toeffectively increase operating capabilities. Obtaining additional space mayresult in the investment of substantial time and capital and may not provecost-effective, which could harm our results of operations and financialcondition.

 

***We may partner with foreign entities,and domestic entities with foreign contacts, which may affect our businessplans.***

 

We recognize that there may be opportunitiesfor increased product sales in both the domestic and global defense markets. Wehave recently initiated plans to strategically team with foreign entities aswell as domestic entities with foreign business contacts in order to bettercompete for both domestic and foreign military contracts. In order to implementthese plans, we may incur substantial costs which may include additionalresearch and development, prototyping, hiring personnel with specializedskills, implementing and maintaining technology control plans, technical dataexport licenses, production, product integration, marketing, warehousing,finance charges, licensing, tariffs, transportation and other costs. In theevent that working with foreign entities and/or domestic entities with foreignbusiness contacts proves to be unsuccessful, this may ineffectively use ourresources which may affect our profitability and the costs associated with suchwork may preclude us from pursuing alternative opportunities.

 

If international sales grow, we may be exposedto certain unique and potentially greater risks than are presented in ourdomestic business. International business is sensitive to changes in the in thebudgets and priorities of international customers, which may be driven bypotentially volatile worldwide economic conditions, regional and local economicand political factors, as well as U.S. foreign policy. International sales willalso expose us to local government laws, regulations and procurement regimeswhich may differ from U.S. Government regulation, including import-exportcontrol, exchange control, investment and repatriation of earnings, as well asto varying currency and other economic risks. International contracts may alsorequire the use of foreign representatives and consultants or may require us tocommit to financial support obligations, known as offsets, and provide forpenalties if we fail to meet such requirements. As a result of these and otherfactors, we could experience award and funding delays on international projectsor could incur losses on such projects, which could negatively impact ourresults of operations and financial condition.

 

***We are presently classified as a smallbusiness and the loss of our small business status may adversely affect ourability to compete for government contracts.***

 

We are presently classified as a small businessas determined by the Small Business Administration based upon the NorthAmerican Industry Classification Systems (NAICS) industry and product specificcodes which are regulated in the United States by the Small BusinessAdministration. While we do not presently derive a substantial portion of ourbusiness from contracts which are set-aside for small businesses, we are ableto bid on small business set-aside contracts as well as contracts which areopen to non-small business entities. It is also possible that we may becomemore reliant upon small business set-aside contracts. Our continuing growth maycause us to lose our designation as a small business, and additionally, as theNAICS codes are periodically revised, it is possible that we may lose ourstatus as a small business and may sustain an adverse impact on our currentcompetitive advantage. The loss of small business status could adversely impactour ability to compete for government contracts, maintain eligibility forspecial small business programs and limit our ability to partner with otherbusiness entities which are seeking to team with small business entities thatmay be required under a specific contract.

 

***We intend to pursue international salesopportunities which may require export licenses and controls.***

 

In order to pursue international salesopportunities, we have initiated a program to obtain product classifications,commodity jurisdictions, licenses, technology control plans, technical dataexport licenses and export related programs. Due to our diverse products, it ispossible that some products may be subject to classification

 

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under the United States State Department International Traffic in ArmsRegulations (ITAR). In the event that a product is classified as anITAR-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 ofrequired licenses and/or the delay in obtaining such licenses may have asignificant adverse impact on our ability to sell products internationally.Alternatively, our products may be subject to classification under the UnitedStates Commerce Department’s Export Administration Regulations (EAR). We alsoanticipate that we may be required to comply with international regulations,tariffs and controls and we intend to work closely with experienced freightforwarders and advisors. We anticipate that an internal compliance program forinternational sales will require the commitment of significant resources andcapital.

 

***We have made, and expect to continue tomake, strategic acquisitions and investments, and these activities involverisks and uncertainties.***

 

In pursuing our business strategies, wecontinually review, evaluate and consider potential investments andacquisitions. In evaluating such transactions, we are required to makedifficult judgments regarding the value of business opportunities, technologiesand other assets, and the risks and cost of potential liabilities. Furthermore,acquisitions and investments involve certain other risks and uncertainties,including the difficulty in integrating newly-acquired businesses, thechallenges in achieving strategic objectives and other benefits expected fromacquisitions or investments, the diversion of our attention and resources fromour operations and other initiatives, the potential impairment of acquiredassets and the potential loss of key employees of the acquired businesses.

 

***The outcome of litigation in which wehave been named as a defendant is unpredictable and an adverse decision in anysuch matter could have a material adverse effect on our financial position orresults of operations.***

 

We are defendants in a number of litigationmatters. These matters may divert financial and management resources that wouldotherwise be used to benefit our operations. Although we believe that we havemeritorious defenses to the claims made in the litigation matters to which wehave been named a party and intend to contest each lawsuit vigorously, noassurances can be given that the results of these matters will be favorable tous. An adverse resolution or outcome of any of these lawsuits, claims, demandsor investigations could have a negative impact on our financial condition,results of operations and liquidity.

 

***Unanticipated changes in our taxprovisions or exposure to additional income tax liabilities could affect ourprofitability.***

 

We are subject to income taxes in the UnitedStates. In the ordinary course of our business, there are many transactions andcalculations where the ultimate tax determination is uncertain. Furthermore,changes in domestic or foreign income tax laws and regulations, or theirinterpretation, could result in higher or lower income tax rates assessed orchanges in the taxability of certain sales or the deductibility of certainexpenses, thereby affecting our income tax expense and profitability. Althoughwe believe our tax estimates are reasonable, the final determination of taxaudits could be materially different from our historical income tax provisionsand accruals. Additionally, changes in the geographic mix of our sales couldalso impact our tax liabilities and affect our income tax expense andprofitability.

 

**Risks Relating to Our Common Stock**

 

***If we fail to maintain an effectivesystem of internal controls over financial reporting, we may not be able toreport accurately our financial results. This could have a material adverseeffect on our share price.***

 

Effective internal controls are necessary forus to provide accurate financial reports. We are beginning to evaluate how todocument and test our internal control procedures to satisfy the requirementsof Section 404 of the Sarbanes Oxley Act of 2002 and the related rules of theSEC, which require, among other things, our management to assess annually theeffectiveness of our internal control over financial reporting and ourindependent registered public accounting firm to issue a report on thatassessment. During the course of this documentation and testing, we mayidentify significant deficiencies or material weaknesses that we may be unableto remediate before the deadline for those reports.

 

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There can be no assurance that we will maintainadequate controls over our financial processes and reporting in the future orthat those controls will be adequate in all cases to uncover inaccurate ormisleading financial information that could be reported by members ofmanagement. If our controls failed to identify any misreporting of financialinformation or our management or independent registered public accounting firmwere to conclude in their reports that our internal control over financial reportingwas not effective, investors could lose confidence in our reported financialinformation and the trading price of our shares could drop significantly. Inaddition, we could be subject to sanctions or investigations by the stockexchange upon which our common stock may be listed, the SEC or other regulatoryauthorities, which would require additional financial and management resources.

 

***Volatility of our stock price couldadversely affect stockholders.***

 

The market price of our common stock could fluctuatesignificantly 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 ouroperating results;

 

·   ouroperating results failing to meet the expectation of securities analysts orinvestors in a particular period;

 

·   changes in financial estimates andrecommendations by securities analysts concerning our company or the defenseindustry in general;

 

·   operating and stock price performance of othercompanies that investors deem comparable to us;

 

·   newsreports relating to trends in our markets;

 

·   changes in laws and regulations affecting ourbusiness;

 

·   material announcements by us or ourcompetitors;

 

·   salesof substantial amounts of common stock by our directors, executive officers orsignificant stockholders or the perception that such sales could occur; and

 

·   general economic and political conditions suchas recessions and acts of war or terrorism.

 

Fluctuations in the price of our common stockcould contribute to the loss of all or part of an investor’s investment in ourcompany.

 

***We currently do not intend to paydividends on our common stock and consequently your only opportunity to achievea 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 theforeseeable future. Any payment of cash dividends will depend upon ourfinancial condition, capital requirements, earnings and other factors deemedrelevant by our board of directors. Agreements governing future indebtedness will likely containrestrictions on our ability to pay cash dividends. Consequently, your onlyopportunity to achieve a return on your investment in the common stock of ourcompany will be if the market price of our common stock appreciates and yousell your common stock at a profit.

 

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***Provisions in our certificate ofincorporation and bylaws or Delaware law might discourage, delay or prevent achange 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 incorporationand bylaws contain provisions that could depress the trading price of ourcommon stock by acting to discourage, delay or prevent a change in control ofour company or changes in our management that the stockholders of our companymay deem advantageous. These provisions:

 

·   establish a classified board of directors sothat not all members of our board of directors are elected at one time;

 

·   provide that directors may be removed only “forcause” and only with the approval of 66 2/3 percent of ourstockholders;

 

·   provide that only our board of directors canfill vacancies on the board of directors;

 

·   require super-majority voting to amend ourbylaws 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 numberof outstanding shares and to discourage a takeover attempt;

 

·   limitthe ability of our stockholders to call special meetings of stockholders;

 

·   prohibit stockholder action by writtenconsent, which requires all stockholder actions to be taken at a meeting of ourstockholders;

 

·   provide that the board of directors isexpressly authorized to adopt, amend, or repeal our bylaws, subject to therights of our stockholders to do the same by super-majority vote ofstockholders; and

 

·   establish advance notice requirements fornominations for election to our board of directors or for proposing mattersthat can be acted upon by stockholders at stockholder meetings.

 

In addition, Section 203 of the DelawareGeneral Corporation Law may discourage, delay or prevent a change in control ofour company.

 

These and other provisions contained in ouramended and restated certificate of incorporation and bylaws could delay ordiscourage transactions involving an actual or potential change in control ofus or our management, including transactions in which our stockholders mightotherwise receive a premium for their shares over then current prices, and maylimit the ability of stockholders to remove our current management or approvetransactions that our stockholders may deem to be in their best interests and,therefore, could adversely affect the price of our common stock.

 

***Future Sales, or the availability for sale, of our common stock maycause our stock price to decline.***

 

We have registered shares of our common stockthat are subject to outstanding stock options, or reserved for issuance underour stock option plan, which shares can generally be freely sold in the publicmarket upon issuance.  Pursuant to asettlement with the holders of our Series A Convertible Preferred Stock in May 2009,we have also registered the resale of up to 5,695,505 shares of our commonstock held by such preferred stockholders. Sales, or the availability for sale, of substantial amounts of ourcommon stock in the public market could adversely affect the market price ofour common stock and could materially impair our future ability to raisecapital through offerings of our common stock.

 

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**Item 2.           Unregistered Sales of EquitySecurities and Use of Proceeds**

 

None.

 

**Item 3.           DefaultsUpon Senior Securities**

 

None.

 

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

 

Our Annual Meeting of Stockholders was held on May 15,2009.  We solicited proxies for themeeting pursuant to Regulation 14 under the Exchange Act; there was nosolicitation in opposition to management’s nominees as listed in the proxystatements and all such nominees were elected. The continuing directors whoseterms expire in 2010 are Gary Sidorsky, Richard P. Torykian and Victor F.Trizzino. The continuing directors whose terms expire in 2011 are Anthony J.Piscitelli, Fergal Foley and Stephen R. Seiter. At the meeting, the matterslisted below were submitted to a vote of our stockholders.

 

*Proposal One:*The election of three directors to serveuntil the 2012 Annual Meeting of Stockholders. The vote with respect to eachnominee was as follows:

 

(1) 30,228,701 votes were cast for the election ofAlfred M. Gary as a director, and 7,836,597 votes were withheld; and

 

(2) 30,215,301 votes were cast for the election ofChristopher D. Brady as a director, and 7,849,997 votes were withheld.

 

(3) 30,191,087 votes were cast for the election ofPasquale J. D’Amuro as a director, and 7,874,211 votes were withheld.

 

*Proposal Two:*Ratification of independent registeredpublic accounting firm for 2009. The vote with respect to Jewett, Schwartz,Wolfe & Associates was as follows:

 

37,086,568 votes were cast for the ratification of toJewett, Schwartz, Wolfe & Associates as our independent registeredaccounting firm, 903,500 against, and 75,230 abstentions.

 

**Item 5.           Other Information**

 

None.

 

**Item 6.           Exhibits**

 
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                 |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|
| 3.1 (1)            |       | Third Amended and Restated Certificate of Incorporation                                                                     |
| 3.2 (2)            |       | Amended and Restated Bylaws                                                                                                 |
| 10.1 (3)           |       | Contract No. M67854-D-5069 between the Company and the U.S. Marine Corps  Systems Command, effective as of March 27, 2009   |
| 10.2 (4)           |       | Settlement  Agreement, Agreement and Waiver by and among the Company and the Series A  Holders, dated May 22, 2009          |
| 10.3 (4)           |       | Registration Rights  Agreement by and among the Company and the Series A Holders, dated May 22,  2009                       |
| 10.4 (4)           |       | Form of Lock-Up  Agreement executed by each of the directors and executive officers of the  Company                         |
| 10.5 (4)           |       | Irrevocable  Proxy and Voting Agreement by and among Anthony Piscitelli and the Series A  Holders, dated May 22, 2009       |
| 10.6 (4)           |       | Contract No. M67854-09-D-5038  between the Company and the U.S. Marine Corps Systems Command, effective as  of May 20, 2009 |
| 10.7 (5)           |       | Waiver Agreement  by and among American Defense Systems, Inc. and the stockholders parties                                  |

 

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|      |   | thereto, dated  June 8, 2009.                                                                                                                                                                  |
|-----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8 (5)  |   | Amendment to  Forbearance Agreement by and among the Company, A. J. Piscitelli &  Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A.,  dated May 27, 2009.          |
| 10.9 (5)  |   | Second Amendment  to Forbearance Agreement by and among the Company, A. J. Piscitelli &  Associates, Inc., American Physical Security Group, LLC and TD Bank, N.A.,  dated June 15, 2009.  |
| 10.10 (6) |   | Accounts  Receivable Purchase Agreement, dated July 23, 2009, between American Defense  Systems, Inc. and Republic Capital Access, LLC                                                         |
| 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.* |

 

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*      Filed herewith.

 

(1)  Previously filed as an Exhibit toAmendment No. 3 to the Form 10, filed on April 22, 2008.

 

(2)  Previously filed as an Exhibit toAmendment No.1 to the Form 10, filed on March 21, 2008.

 

(3)  Previously filed as an Exhibit tothe Form 8-K, filed on May 20, 2009.

 

(4)  Previously filed as an Exhibit tothe Form 8-K, filed on May 26, 2009.

 

(5)  Previously filed as an Exhibit tothe Form 8-K, filed on June 17, 2009.

 

(6)  Previously filed as an Exhibit tothe Form 8-K, filed on July 28, 2009.

 

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** **

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                 | AMERICAN DEFENSE SYSTEMS,  INC. |
|----------------------|---------------------------------|
|                 |                            |   |
|                 |                            |   |
| Date: April 15, 2010 | By:                             | /s/ Gary Sidorsky |
|                 |                            | Chief Financial Officer |

 

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**Index to Exhibits**

 
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                                                                                   |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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. |

 

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