UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2010



ORo
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACTFor the transition period from _________________ to _________________






coates logo

Commission file number 000-33155





COATES INTERNATIONAL, LTD.

(Exact Name of Registrant as Specified in its Charter)







Delaware

22-2925432(State or other Jurisdiction of

(I.R.S. EmployerIncorporation or Organization)

Identification No.)





Highway 34 & Ridgewood Road, Wall Township, New Jersey 07719


(Address of Principal Executive Office) (Zip Code)





(732) 449-7717


(Registrant's telephone number including area code)





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





Yes x No o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every


Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Yes o No o





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)





Yes o No x





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




Large accelerated filer ‚o





Accelerated filer Non-accelerated filer ‚oNon-accelerated filer ‚o





Smaller reporting company x(Do not check if a smaller reporting company)


As of November 16, 2010, 275,506,253 shares of the Registrant’s common stock were issued and outstanding.























COATES INTERNATIONAL, LTD.


QUARTERLY REPORT ON FORM 10-Q





CONTENTS





SEPTEMBER 30, 2010

















PagePART 1 – FINANCIAL INFORMATIONItem 1.
Financial Statements:Balance Sheets
3Statements of Operations
4Condensed Statements of Cash Flows
5Notes to Financial Statements
6-21Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
22-30Item 3.
Quantitative and Qualitative Disclosures About Market Risk
30Item 4T.
Controls and Procedures
30PART II  -  OTHER INFORMATIONItem 1.
Legal Proceedings
31Item 1A.
Risk Factors
32Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
32Item 3.
Defaults Upon Senior Securities
32Item 4.
(Removed and Reserved)
32Item 5.
Other Information
32Item 6.
Exhibits
32SIGNATURES
33














2




Coates International, Ltd.


Balance Sheets





September 30, 2010


December 31, 2009(Unaudited)AssetsCurrent AssetsCash

$
77,872


$
252,902Restricted cash


91,507



100,813Inventory, net


449,595



511,189Deferred financing costs and other assets


3,150



16,042Total Current Assets


622,124



880,946Property, plant and equipment, net


2,490,890



2,282,105Deferred licensing costs, net


64,937



68,149Total Assets

$
3,177,951


$
3,231,200Liabilities and Stockholders' DeficiencyCurrent LiabilitiesAccounts payable and accrued liabilities

$
1,180,362


$
1,169,518Due to related party


-



12,500Unearned revenue


303,124



-Promissory notes to related parties


308,000



300,000Mortgage loan payable


1,740,000



1,750,000Convertible promissory notes


20,100



-Derivative liability related to convertible promissory notes


26,100



-10% Convertible note


10,000



20,000Total Current Liabilities


3,587,686



3,252,018License deposits


375,000



375,000Total Liabilities


3,962,686



3,627,018Commitments and ContingenciesStockholders' DeficiencyPreferred Stock, $0.001 par value, 100,000,000 shares authorized, 14,001  and 10,000 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively


14



10Common Stock, $0.0001 par value, 1,000,000,000 shares authorized, 275,506,253  and 275,496,253 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively


27,551



27,550Additional paid-in capital


22,389,593



22,231,753Accumulated deficit


(23,201,893
)


(22,655,131
)Total Stockholders' Deficiency


(784,735
)


(395,818
)Total Liabilities and Stockholders' Deficiency

$
3,177,951


$
3,231,200






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








3




Coates International, Ltd.


Statements of Operations
 (Unaudited)


Three Months Ended September 30,


Nine Months Ended September 30,2010


2009


2010


2009(Restated)Revenue from research and development

$
-


$
-


$
850,000


$
690,000Expenses:Research and development costs


148,191



-



315,254



254,926General and administrative expenses


272,759



626,835



842,026



1,753,103Depreciation and amortization


23,730



11,118



61,618



20,820444,680



637,953



1,218,898



2,028,849Other Operating Income:Gain on sale of land and building


-



-



-



978,479Loss from Operations


(444,680
)


(637,953
)


(368,898
)


(360,370
)Interest  expense, net


57,414



50,878



177,864



58,968Loss Before Income Taxes


(502,094
)


(688,831
)


(546,762
)


(419,338
)Provision for income taxes


-



-



-



-Net Loss

$
(502,094
)

$
(688,831
)

$
(546,762
)

$
(419,338
)Basic net loss income per share

$
-


$
-


$
-


$
-Basic weighted average shares outstanding


275,506,253



274,530,511



275,506,070



274,076,137Diluted net loss per share

$
-


$
-


$
-


$
-Diluted weighted average shares outstanding


275,506,253



274,530,511



275,506,070



274,076,137








The accompanying notes are an integral part of these financial statements.
  4






Coates International Ltd. Condensed Statements of Cash Flows
 (Unaudited)


For the Nine Months Ended September 30,2010


2009Cash Flows from Operating Activities

$
(299,325
)

$
(1,045,502
)Cash Flows Used in Investing Activities:Acquisition of property, plant and equipment


(14,350
)


(2,075,346
)Net Cash Used in Investing Activities


(14,350
)


(2,075,346
)Cash Flows Used in Financing Activities:Issuance of convertible promissory notes


146,000



-Issuance of promissory notes to related parties


108,000



200,000Repayment of promissory note to related party


(100,000
)


-Repayment of 10% convertible note


(10,000
)


-Issuance of common stock and warrants


3,645



676,342(Repayment of) Proceeds from mortgage loan


(10,000
)


1,750,000Establishment of Interest reserve


-



(100,000
)Deferred financing costs


1,000



(25,000
)Net Cash Used in Financing Activities


138,645



2,501,342Net Decrease in Cash


(175,030
)


(619,506
)Cash, beginning of year


252,902



721,952Cash, end of year

$
77,872


$
102,446Supplemental Disclosure of Cash Flow Information:Cash paid during the year for interest

$
101,857


$
28,438Cash security deposit applied towards purchaseof reacquired land and building

$
-


$
195,000
  The accompanying notes are an integral part of these financial statements.





5


Coates International, Ltd.


Notes to Financial Statements


(All amounts rounded to thousands of dollars)


(Unaudited)





1.
BASIS OF PRESENTATION





The accompanying unaudited financial statements of Coates International, Ltd. (the “Company”) have been prepared in accordance with accounting principles generally accepted for interim financial information and rules and regulation of the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three and nine month periods ended September 30, 2010 and 2009 are not necessarily indicative of the results that may be expected for any other interim period or for the full year.  The unaudited financial statements should be read in conjunction with the financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2009 and the quarterly reports on Form 10-Q for the quarters ended June 30 and March 31, 2010.





The Company incurred a net loss for the nine months ended September 30, 2010 of ($547,000), and has incurred substantial net losses since inception while engaging primarily in research and development. As of September 30, 2010, the Company had accumulated losses of ($23,202,000) and had negative working capital of ($2,966,000). In addition, the current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in the Company’s challenge to secure needed additional working capital. These factors raise substantial doubt about the Company’s ability to continue as a going concern.





The doubt about the Company’s ability to continue to operate as a going concern has existed for a number of years. Management has been successful in raising sufficient new working capital throughout that time to enable the Company to continue as a going concern and, although management cannot provide assurances that it can be successful, management believes that it can continue to do so in the future. Management has instituted a cost control program intended to cut variable costs to only those expenses that are necessary to complete its activities related to research and development and manufacturing an initial shipment of natural gas fueled industrial electric power Coates Spherical Rotary Valve (“CSRV”) engine generators, enter the production phase of operations, develop additional commercially feasible applications of the CSRV system technology, seek additional sources of working capital and cover the general and administrative expenses in support of such activities. The Company has been actively undertaking efforts to secure new sources of working capital.  During the nine months ended September 30, 2010, the Company received $850,000 from research and development fees, $146,000 from the issuance of convertible promissory notes and a $303,000 initial deposit toward the first shipment of natural gas fueled industrial electric power CSRV engine generators. In October 2010, the Company issued a promissory note and received proceeds of $80,000 from the Coates Family Trust. In November 2010, the Company issued promissory notes and received proceeds of $22,000 and $50,000 from George J. Coates and one of our directors, respectively. The Company continues to actively seek out new sources of working capital; however, there can be no assurance that it will be successful in these efforts. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.





2.
ACCOUNTING POLICIES





Basis of Presentation





Certain amounts included in the accompanying financial statements for the nine months ended September 30, 2009 have been reclassified in order to make them comparable to the amounts presented for the nine month period ended September 30, 2010.









6






The gain on sale of land and building, which is more fully discussed in Note 11, amounting to $978,000 for the nine month period ended September 30, 2009, was improperly presented along with revenue from research and development in the Company’s quarterly report on Form 10-Q for the quarterly period ended September 30, 2009. This has been corrected in the accompanying financial statements to present the gain on sale of land and building in other operating income. This correction resulted in a decrease in revenues of $978,000 and a corresponding increase in other operating income for the nine month period ended September 30, 2009. There was no effect of this correction on net income or any other financial statement line items or on either basic or fully diluted loss per share for the nine month period ended September 30, 2009.





Net Loss per Share





Basic net income (loss) per share is based on the weighted average number of common shares outstanding without consideration of potentially dilutive shares of common stock. Diluted net income (loss) per share is based on the weighted average number of common and potentially dilutive common shares outstanding, when applicable.





Use of Estimates





The preparation of the Company’s financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These significant estimates include determining a value for Series A Preferred Stock issued and certain limited anti-dilution rights granted to George J. Coates as more fully described in Note 17, determining the amount of discount on convertible promissory notes, assigning useful lives to the Company’s property, plant and equipment, determining an appropriate amount to reserve for obsolete and slow moving inventory, a valuation allowance for deferred tax assets, assigning expected lives to and estimating the rate of forfeitures of stock options granted and selecting a volatility factor for the Company’s stock options in order to estimate the fair value of the Company’s stock options on the date of grant or other appropriate measurement date. Actual results could differ from those estimates.





3.                   CONCENTRATIONS OF CREDIT AND BUSINESS RISK





At September 30, 2010, the Company maintained cash balances with two financial institutions. Accounts at these institutions are currently fully insured by the Federal Deposit Insurance Corporation.





The Company’s operations are devoted to the development, application and marketing of the CSRV system technology which was invented by George J. Coates, the Company’s founder, Chairman, Chief Executive Officer, President and controlling stockholder. From July 1982 through May 1993, seven U.S. patents as well as a number of foreign patents were issued with respect to the CSRV system technology.  Since the inception of the Company in 1988, all aspects of the business have been completely dependent upon the activities of George J. Coates.  The loss of George J. Coates’ availability or service due to death, incapacity or otherwise would have a material adverse effect on the Company's business and operations. The Company does not presently have any key-man life insurance in force for Mr. Coates.





The Company is highly dependent on Almont Energy, Inc. (“Almont”) for cash flows, revenues and profits from a research and development agreement and exclusive sub-licensing agreements covering sale and distribution of natural gas fueled, industrial electric power CSRV engine generators within the territories of Canada and the United States. As discussed in more detail in Note 4, at the September 30, 2010, Almont owed the Company approximately $6 million dollars due under the research and development, sublicensing and escrow agreements.  Payment of this balance is dependent on Almont’s continuing effort to raise new equity capital. Almont has advised us that they believe the success of its efforts to raise new equity capital will be enhanced upon shipment of the first order of the natural gas fueled CSRV industrial electric power engine generators.








7





4.                  AGREEMENTS ASSIGNED TO ALMONT ENERGY INC.





In 1999, the Company granted a sublicense to Well to Wire Energy, Inc. ("WWE"), an oil and gas company in Canada.  This sublicense provided for a $5,000,000 license fee to be paid to the Company and covers the use of the CSRV system technology in the territory of Canada (the “Canadian License”). A separate research and development agreement (“R&D Agreement”) provided for WWE to pay an additional $5,000,000 fee to the Company in consideration for the development and delivery of certain prototype engines. The Company completed development of the prototypes in accordance with this agreement at the end of 2007. The research and development agreement has not been reduced to the form of a signed, written agreement.





In 2008, the Company also entered into an escrow agreement with WWE that provided conditional rights to a second sublicense agreement between the Company and WWE for the territory of the United States (the “US License”). The US license has been deposited into an escrow account and the grant of the license will not become effective until the conditions for release from escrow are satisfied. The US License provides for a license fee of $50 million.





The escrow agreement required that WWE make payment (the “Release Payment”) to the Company equal to the remaining unpaid balance of licensing fee for by the Canadian License, the R&D Agreement fee and the down payment of $1,000,000 required under the US License. WWE had been making periodic nonrefundable payments to the Company to pay down the Release Payment.





During the first quarter of 2010, with the prior consent of the Company, WWE assigned the Canadian License and the rights to the US License, subject to the terms and conditions of the escrow agreement, to Almont Energy, Inc. (“Almont”), a privately held, newly formed independent third party entity based in Alberta, Canada. In connection with the assignment, the Company waived all events of default by WWE under the escrow agreement. The Company also waived the provisions of the escrow agreement requiring the payment of interest on the unpaid balance of the Release Payment. Almont made two payments to the Company in February 2010 totaling $700,000 as a prerequisite condition to our consent to the assignment.





In connection with the assignment of the Canadian License and the rights to the US License, Almont has also assumed all of the obligations set forth in the escrow agreement between the Company and WWE, with the following modifications:





●
The Release Payment Date as defined in the escrow agreement has been extended to March 19, 2012. At the time of the assignment, the remaining unpaid balance of the Release Payment was $5,997,000. Provided that Almont remits this entire unpaid balance to the Company on or before the Release Payment Date, the US License will be released from escrow and granted to Almont. Almont is required to remit to the Company 60% of all monies it raises from future equity or debt transactions, exclusive of proceeds from equipment purchase financing transactions, until the Release Payment is paid in full.





●
Almont has also become obligated to pay the $49 million balance of the US License Fee to the Company. Payment shall be made quarterly in an amount equal to 5% of Almont’s quarterly net profits. In addition, Almont is required to remit a portion of the proceeds it receives from equity or debt transactions, exclusive of equipment financing transactions to the Company until the entire balance of the US License fee is paid in full. However, the entire $49 million licensing fee is required to be paid on or before February 19, 2015.





To the extent that Almont is not successful or experiences delays in remitting the balance of the Release Payment, the Company’s cash flow, results of operations and financial condition could be adversely affected.








8





The Canadian License





The Canadian License exclusively licenses within Canada the use of the CSRV system technology for industrial engines fueled by natural gas to generate electrical power. Additional provisions of the Canadian License agreement are as follows:





●
Licensee shall have the exclusive right to use, lease and sell electric power generators designed with the CSRV system technology within Canada.●
Licensee will have a specified right of first refusal to market the electric power generators worldwide.


●
Upon commencement of the production and distribution of the electric power generators, the minimum annual number of generators to be purchased by Licensee in order to maintain exclusivity is 120.  Until otherwise agreed between the parties, the price per generator shall be $159,000.  In the event Licensee fails to purchase the minimum 120 Coates generator engines during any year, Licensee will automatically lose its exclusivity. In such a case, Licensee would retain non-exclusive rights to continue to use and sell the CSRV generator engine in the territory of Canada.●
Licensee is required to pay a royalty to the Company equal to 5% of its gross profits plus $400,000.


●
All licensed rights under this license agreement related to the CSRV system technology will remain with the Company.





The US License





The US License will, upon Almont satisfying the Release Payment, grant to Almont the right to use, sell and lease Licensed Products manufactured by the Company, as the power source for the generation of electrical energy.  Licensed Products consist of CSRV Engines, CSRV Valve Systems, CSRV Valve Seals, CSRV Rotary Valve Spheres and CSRV Valve Components for use in electric power generation applications.





The manufacture of any Licensed Products by Licensee is prohibited.  Licensee is required to procure all internal combustion engines incorporating the CSRV system technology from the Company or its designee. The license granted to Licensee is exclusive within the Territory, provided that Licensee satisfies the minimum annual purchase commitment of 120 internal combustion engines incorporating the CSRV system technology, the Coates Engines and all component parts. The agreement also grants Licensee a right of first refusal in the event that the Company negotiates an offer with another third party for a worldwide license to use the Licensed Product.





The business plan of Almont assumes the purchase of a substantial number of CSRV units over the 5-year period commencing upon the first shipment of generator systems to Almont. Almont’s purchase of CSRV units from the Company will be made by way of standard purchase orders, issued based on market and customer demand. Over the 5-year period, Almont anticipates that the volume of total purchases from the Company will be similar to, or potentially exceed the 7,400 CSRV units contemplated in our previous arrangement with WWE. Almont plans to finance its purchases from cash flow and by way of project and/or equipment financing, proceeds from issuance of equity or corporate debt instruments and conventional bank financing.





5.                  COOPERATION AGREEMENT WITH TONGJI UNIVERSITY OF CHINA





In June 2010, the Company and the Coates Family Trust (collectively “Coates”) entered into a Cooperation Agreement with Tongji University of China (the “University”) for the purpose of enabling the University to undertake an evaluation and testing of the CSRV engine technology. The results of the evaluation and testing will be used to determine if, and to what extent, the engine technology could be applied in the manufacture and distribution of products in China. Coates is required to deliver to the University a 1600cc, 4-cylinder CSRV engine and a 1600cc, 4-cylinder poppet valve engine to facilitate comparison. The University is responsible for obtaining any required regulatory approvals in connection with the evaluation and testing activities. The costs and expenses of testing and evaluation of the engine shall be the responsibility of the University. Coates is required to provide technical assistance, as needed, to optimize the success of the evaluation and testing.






9







The University will promptly furnish Coates with a copy of its findings. Provided the results of the evaluation and testing of the CSRV engines are deemed satisfactory, Coates has agreed that it will sub-license the CSRV technology to Chinese engine manufacturers. The parties also entered into a Confidentiality and Non-Disclosure Agreement which provides for protection of the CSRV technical information and patents. The Coates Family Trust has expressed its intention to license the CSRV system technology rights to the Company for the territory to be defined in connection with any such licenses granted to Chinese manufacturers. Discussions on the timing of the next steps under this agreement are scheduled to take place during a visit by a delegation from China to the Company’s headquarters towards the latter part of November 2010.





6.                   INVESTMENT IN COATES FINANCE MANAGEMENT, LTD.





In October 2009, the Company entered into a joint venture (“JV”) arrangement with an independent third party for the purpose of undertaking a private offering of collateralized zero coupon bonds to institutional investors. A new entity, Coates Finance Management, LLC (“CFM”) was formed to carry out the objectives of the joint venture. The Company owned 90% of CFM; however, 100% of the JV entity’s profits and losses were to be allocated to the Company. This entity was being accounted for as a consolidated subsidiary.





In March 2010, after careful consideration of this proposed undertaking, the Company’s board of directors (the “Board”) concluded that the bond offering should not be further pursued and the Company terminated the joint venture arrangement. The Company was not obligated to incur any additional costs, and there are no provisions for any penalties in connection with termination of the JV Agreement. As of the effectiveness of the termination of this Joint Venture, the accounting for CFM as a consolidated subsidiary ceased.





7.                  INVENTORY





Inventory was comprised of the following:





September 30, 2010


December 31, 2009Raw materials

$
481,000


$
390,000Work-in-process


120,000



32,000Finished goods


-



240,000Reserve for obsolescence


(151,000
)


(151,000
) )Total

$
450,000


$
511,000





In March 2010, the Company decided to utilize two natural gas industrial electric power CSRV engine generators, previously included in finished goods inventory at a carrying value of $240,000, as demonstration units rather than continue to hold these units for sale. The two units are included in property, plant and equipment in the accompanying balance sheet at September 30, 2010 and are being depreciated over an estimated useful life of five years.











10











8.                   REPURCHASE OF LAND AND BUILDING





In June 2009, the Company reacquired the property which houses its headquarters, warehouse and research and development facility by submitting a winning bid at an auction of the property. The total acquisition cost, which amounted to $2,199,000, was paid from the proceeds of a mortgage loan in the amount of $1,750,000 as more fully discussed in Note 10, application of a security deposit held by the seller of $195,000 and a cash payment of $254,000. The total purchase price was allocated $1,235,000 to the land and $964,000 to the building, based on the relative estimated fair values at the date of acquisition. The building is being depreciated on the straight-line basis over a period of 40 years.





The mortgage loan bears interest at 7.5% per annum. Prior thereto, the Company was obligated under a sale/leaseback agreement which provided for monthly payments $32,500. This agreement was effectively terminated upon the closing of the reacquisition of the property. For the nine month periods ended September 30, 2010 and 2009, rent expense under the sale/leaseback agreement amounted to $-0- and $179,000, respectively.





9.                   PROPERTY, PLANT AND EQUIPMENT





Property, plant and equipment was comprised of the following:





September 30, 2010


December 31, 2009Land

$
1,235,000


$
1,235,000Building


964,000



964,000Building improvements


83,000



71,000Machinery and equipment


777,000



522,000Furniture and fixtures


39,000



39,000Less: Accumulated depreciation


(607,000
)


(549,000
)Total

$
2,491,000


$
2,282,000





10.                 MORTGAGE LOAN PAYABLE





The Company has a $1,740,000 mortgage loan on the land and building that serves as its headquarters, warehouse and research and development facility which bears interest at the rate of 7.5% per annum. The mortgage loan matures June 2011. Commencing September 2010, the Company became obligated to make principal payments of $10,000 per month which are being automatically deducted from monies in an interest-bearing restricted cash account on deposit with the lender. The Company is also required to make monthly interest-only payments. The Company incurred $35,000 of expenses in connection with initially securing this mortgage loan, which was amortized to interest expense over the initial one year term of the loan. The loan is collateralized by a security interest in all of the Company’s assets, the pledge of 5 million shares of common stock of the Company owned by George J. Coates, which were deposited into escrow for the benefit of the lender and the personal guarantee of George J. Coates. The Company is not permitted to create or permit any secondary mortgage or similar liens on the property or improvements thereon without prior consent of the lender. Up to $500,000 of the principal balance of the mortgage loan may be prepaid each year without penalty. A prepayment penalty of 2% of the outstanding loan amount would be imposed if the loan is repaid in full at or before maturity unless such prepayment funds are obtained from a permanent mortgage loan obtained from the lender.





11.                GAIN ON SALE OF LAND AND BUILDING





In 2005, the Company entered into a sale/leaseback agreement for the land and building that serves as its headquarters, warehouse and research and development facility. The sale of the property and resulting gain from this transaction was required to be deferred for accounting purposes because the sale/leaseback agreement contained an option to buy back the property.  This option lapsed unexercised in November 2008 which then triggered the recognition of the sale of the property and recognition of the gain on this sale of $2,474,000, of which $1,467,000 was recognized in 2008. The remaining portion of the gain was being recognized over the remaining life of the lease agreement. Upon reacquisition of the property in June 2009, the lease agreement effectively terminated, resulting in immediate recognition of the entire remaining balance of the deferred gain. For the nine months ended September 30, 2010 and 2009, $-0- and $978,000, respectively of this deferred gain was recognized and is included in gain on sale of land and building in the accompanying statement of operations for the nine months ended September 30, 2009.






11









12.                CONVERTIBLE PROMISSORY NOTES





In August 2010 and September 2010, the Company entered into securities purchase agreements (the “Purchase Agreements”) with an investor and issued two 8% convertible promissory notes with face amounts of $78,500 and  $67,500 (the “Convertible Notes”) and received cash proceeds of $146,000.





The Notes mature in May and June, 2011, respectively, and provide for nominal interest at the rate of eight (8%) percent per annum. The Notes may be converted into unregistered shares of the Company’s common stock, par value $0.0001 per share (the “Common Stock”), at the Conversion Price, as defined below, in whole, or in part, at any time beginning 180 days after the date of the Notes, at the option of the holder. The Conversion Price shall be equal to 61% multiplied by the Variable Conversion Rate which is equal to the average of the three (3) lowest closing bid prices of the Common Stock during the ten (10) trading day period prior to the date of conversion. The Notes also contains a prepayment option whereby the Company may make a payment to the holder equal to 150% of the then outstanding unpaid principal, interest and any other amounts that might be due for penalties or any event of a default under the Notes during the 179-day period following the date of issuance of the Notes, upon three (3) trading days’ prior written notice to the holder.





The 61% discounted Conversion Price establishes an embedded beneficial conversion feature (“EBCF”) which is required to be valued and accreted to interest expense over the six month minimum conversion period of the Convertible Notes. Accordingly, the Company recorded unamortized discount on the Convertible Notes of $112,000. The Company also recognized additional unamortized discount to recognize the estimated value of a derivative liability amounting to $26,000 arising from the convertible promissory notes. For the three and nine month periods ended September 30, 2010, the amount of interest expense resulting from accretion of the unamortized discount on the convertible promissory notes amounted to $11,000.





The derivative obligation arises because, based on historical trading patterns of the Company’s stock, the formula for determining the Conversion Rate is expected to result in a lower Conversion Rate than the closing price of the stock on the actual date of conversion (hereinafter referred to as the “Variable Conversion Rate Differential”. The Company selected the historical simulation approach to value this derivative liability believing that this method results in a valuation that most closely relates to the economic reality of these transactions. Under this approach, the Company computed the Variable Conversion Rate Differential for each trading day during the twelve month period prior to the date of issuance of each convertible promissory note and then computed the average of these daily Variable Conversion Rate Differentials over the twelve month period. In accordance with GAAP, the derivative liability is required to be re-evaluated at each balance sheet date.





The total unamortized discount represented by the value of the EBCF and the derivative liability is being accreted over the six month period until the conversion of the convertible promissory notes into common stock is permitted. This results in an overall effective interest rate of 155% and 82% on the $78,500 convertible note and the $67,500 convertible note, respectively. The remaining unamortized balance of this discount, which amounted to $126,000, has been netted against the face amount of the convertible promissory notes resulting in a net carrying amount of $20,000 which is included in the accompanying balance sheet at September 30, 2010.









12




The Company made the private placement of these securities in reliance upon Section 4(2) of the Securities Act of 1933, as amended (the “Act”), Rule 506 of Regulation D, and the rules and regulations promulgated thereunder, and/or upon any other exemption from the registration requirements of the Act, as applicable.





13.                10% CONVERTIBLE NOTE TO RELATED PARTY





The 10% Convertible Note, which is held by one of our directors, is convertible at the option of the holder into shares of the Company’s common stock at an initial conversion rate that is determined by dividing the principal amount of the note being converted by $0.45. This convertible note is payable on demand. Interest shall accrue at the rate of 10% per annum and shall be payable at the time of repayment of principal. All interest shall be forfeited upon conversion, in which case the holder would be entitled to dividends declared, if any, on the Company’s common stock during the time the convertible note was outstanding. In March 2010, $10,000 principal amount of this convertible note was repaid along with accrued interest thereon of $3,000. The Company has reserved 22,222 shares of its common stock for conversion of the remaining $10,000 balance of this note.





14.                PROMISSORY NOTES TO RELATED PARTIES





In October 2009, the Company received $100,000 from The Coates Family Trust, a trust owned and controlled by George J. Coates and $100,000 from one of its directors and issued promissory notes with maturity dates in July 2010. In December 2009, the Company received $100,000 from another one of its directors and issued a promissory note which matured in September 2010. All three promissory notes provide for interest at the rate of 17% per annum, compounded monthly and charge a transaction fee of $7,500. For accounting purposes, the transaction fees were amortized to interest expense over the initial term of the promissory notes. In March 2010, the promissory note to the Coates Family Trust was prepaid in full, including accrued interest and the transaction fee totaling $10,000. The maturity date of the promissory note with an original maturity date in July 2010 was modified and this note is now due on demand by the holder. The maturity date of the promissory note with an original maturity date in September 2010 has passed and the holder of the note, without waiving any of his rights under the note, has not made any attempts to collect the principal and interest. Accordingly, this promissory note is being treated as due on demand. For the three and nine month periods ended September 30, 2010, interest expense on these promissory notes amounted to $16,000 and $49,000, respectively. At September 30, 2010, unpaid accrued interest on these promissory notes amounting to $44,000 is included in accounts payable and accrued liabilities in the accompanying balance sheet. In July 2010, the Company received $100,000 from The Coates Family Trust and issued a promissory note that is due upon demand. In October 2010, the Company received an additional $80,000 from the Coates Family Trust and issued a promissory note that is due upon demand. In November 2010, the Company received proceeds of $22,000 and $50,000 from George J. Coates and one of our directors, respectively and issued promissory notes that are due on demand. These notes bears interest at the rate of 17% per annum, compounded monthly.





15.                CONTRACTUAL OBLIGATIONS





The following table summarizes the Company’s contractual obligations at September 30, 2010:





Amount Due WithinTotal


2010


2011Mortgage Loan Payable

$
1,740,000


$
-


$
1,740,000Employment Agreements(1)


433,000



100,000



333,000Promissory Notes to Related Parties


308,000



308,000



-Convertible Promissory Notes


146,000



-



146,00010% Convertible Note


10,000



10,000



-Total

$
2,637,000


$
418,000


$
2,219,000





(1)
The Company’s obligation under employment agreements would increase to $550,000 per year through October 23, 2011, upon the Company’s achievement of an adequate level of working capital, as defined.






13







16.                COMMON STOCK





In January 2010, the Company sold 10,000 registered shares of its common stock under the equity line of credit with Dutchess Private Equities Fund, Ltd. and received proceeds of $4,000 which were used for working capital purposes (See Note 18.)





In April 2009, the Company sold 428,571 shares of common stock and warrants to purchase 428,571 shares of its common stock at an exercise price of $0.35 per share in private sales of restricted securities to the son of a director pursuant to stock purchase agreements and received net proceeds of $150,000.





In March 2009, the Company sold 838,096 shares of its common stock, warrants to purchase 333,333 shares of its common stock at an exercise price of $0.30 per share and warrants to purchase 85,714 shares of its common stock at an exercise price of $0.35 per share in private sales of restricted securities to the son of a director pursuant to stock purchase agreements and received net proceeds of $260,000 which were used for working capital purposes.





In connection with the settlement of litigation in March 2009, a certificate representing the ownership of 25,000 shares of common stock was surrendered by one of the parties. These shares were retired and returned to authorized, unissued status.





17.                PREFERRED STOCK AND ANTI-DILUTION RIGHTS





In June 2009, the Board designated 25,000 shares of the total 100,000,000 shares of authorized shares of preferred stock as Series A Preferred Stock, $0.001 par value per share. Each share of Series A Preferred Stock entitles the holder of record the right to vote 10,000 shares of common stock with respect to all matters that are submitted to a vote of shareholders. The Series A Preferred Stock does not provide the holder any rights to share in dividends or any distribution of assets to any other shareholders of any other class of the Company’s securities in a liquidation or for any other purpose.





In February 2010, the Board agreed to the issuance of 4,001 shares of Series A Preferred Stock of the Company (representing 40,010,000 voting shares) to George J. Coates in order to restore the original percentage of all votes originally held by the Coates Family at January 1, 2005. The Coates Family shareholdings had been diluted as a result of various issuances of new shares of stock in connection with raises of new equity capital during the period from January 1, 2009 to February 12, 2010. As a result, they have requested that as a prerequisite condition to issuing any further shares to new investors and/or lenders, that George J. Coates be awarded shares of the super-majority voting shares of the Company’s Series A Preferred Stock, $0.001 par value per share in order to restore its original percentage of all votes that it held at January 1, 2005.





In order to enable the Company to raise needed working capital, the Board deemed it advisable and consented to authorize the issuance of additional shares of Series A Preferred Stock to George J. Coates to restore the Coates Family’s voting percentage upon any future issuance of new shares of the Company’s common stock as a result of a sale or conversion of securities into common stock (except that no Series A Preferred Stock shall be issued to George J. Coates to restore the Coates Family voting percentage in connection with any new shares of common stock issued upon sale or conversion of the Company’s securities issued pursuant to public offerings by the Company).





The issuance of shares of Series A Preferred Stock to George J. Coates does not have any effect on the share of dividends or liquidation value of the holders of the Company’s common stock. However, based on 275,506,253 shares of common stock outstanding on the date of issuance, the voting rights of the holders of the Company’s common stock were affected as follows:







14






Percentage of voting rights held:

George J. Coates


All other shareholdersAs of February 12, 2010


85. 73%



14.23%Immediately after issuance of the Series A Preferred Stock


87.11%



12.89%





The Company arranged for an independent professional services firm to determine the estimated fair value of the shares of Series A Preferred Stock provided to Mr. Coates. The aggregate value of the Series A Preferred Stock provided to Mr. Coates in 2010 amounted to $10,000. This amount, which was recorded as compensation expense, is included in general and administrative expenses in the accompanying statement of operations for the nine months ended September 30, 2010. The aggregate value of the Series A Preferred Stock and the limited anti-dilution protection provided to Mr. Coates in 2009 amounted to $10,000. This amount was included in deferred financing costs and was amortized to expense over the initial term of the mortgage loan discussed in Note 10.





18.                INVESTMENT AGREEMENTS WITH DUTCHESS FUNDS





In 2007, the Company entered into an Investment Agreement with Dutchess Private Equities Fund, Ltd. which expired in June 2010. Pursuant to this Agreement, the Investor committed to purchase up to $10,000,000 of the Company’s common stock.





During the nine months ended September 30, 2010, the Company sold 10,000 shares of its common stock under this equity line of credit and received proceeds of $4,000. During the nine months ended September 30, 2009, the Company sold 398,500 shares of its common stock under the equity line of credit with Dutchess Private Equities Fund, Ltd. and received proceeds of $266,000.





In August 2010, the Company entered into an investment agreement (the “Investment Agreement”) with Dutchess Opportunity Fund, II, LP, a Delaware limited partnership (“Dutchess”). Pursuant to the terms of the Investment Agreement, Dutchess shall commit to purchase up to Ten Million ($10,000,000) Dollars of our Common Stock over the course of thirty-six (36) months.





The Company also entered into a registration rights agreement (the “Registration Rights Agreement”) with Dutchess. Pursuant to the terms of the Registration Rights Agreement, the Company was obligated to file a registration statement with the Securities and Exchange Commission (“SEC”) covering 17,000,000 shares of the Common Stock underlying the Investment Agreement. By mutual agreement activities on this financing opportunity have been temporarily suspended to enable the Company to focus on commencing production and raising working capital to cover the costs of the registration of the securities.





19.                UNEARNED REVENUE





The Company received deposits aggregating $303,000 from Almont in connection with its order for the first shipment of natural gas fueled electric power CSRV engine generators. This amount, which will be recognized as revenue upon shipment of the generators, is included in unearned revenue in the accompanying balance sheet at September 30, 2010.





20.                LOSS PER SHARE





At September 30, 2010, the Company had 4,382,732 shares of common stock potentially issuable upon assumed conversion of (i) $147,000 principal amount of convertible notes, including accrued, but unpaid interest into 1,031,464 shares of common stock, (ii) $10,000 principal amount of a 10% convertible note into 22,222 shares of common stock, (iii) 42 outstanding warrants to purchase 210,000 shares of common stock at a price per share of $1.10, (iv) warrants to purchase 333,333 shares of common stock at a price per share of $0.30, (v) warrants to purchase 885,713 shares of common stock at a price per share of $0.35 and (vi) 1,725,000 vested stock options to purchase shares of common stock at a price per share of $0.44, 25,000 non-vested stock options to purchase shares of common stock at a price per share of $0.44, 100,000 non-vested stock options to purchase shares of common stock at a price per share of $0.43 and 50,000 non-vested stock options  to purchase shares of common stock at a price per share of $0.39.






15







For the three and nine month periods ended September 30, 2010 and 2009, none of the potentially issuable shares of common stock were assumed to be converted because the Company incurred a net loss in those periods and the effect of including them in the calculation would have been anti-dilutive.





21.                STOCK OPTIONS




The Company’s 2006 Stock Option and Incentive Plan (the “Stock Plan”) was adopted by the Board in October 2006. In September 2007, the Stock Plan, by consent of George J. Coates, majority shareholder, was adopted by our shareholders. The Stock Plan provides for the grant of stock-based awards to employees, officers and directors of, and consultants or advisors to, the Company and its subsidiaries, if any.  Under the Stock Plan, the Company may grant options that are intended to qualify as incentive stock options (“incentive stock options”) within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the “Code”), options not intended to qualify as incentive stock options (“non-statutory options”), restricted stock and other stock-based awards. Incentive stock options may be granted only to employees of the Company.  A total of 12,500,000 shares of common stock may be issued upon the exercise of options or other awards granted under the Stock Plan.  The maximum number of shares with respect to which awards may be granted to any employee under the Stock Plan shall not exceed 25% of the 12,500,000 total number of shares of common stock permitted to be granted under the Stock Plan.





The Stock Plan is administered by the Board and the Compensation Committee.  Subject to the provisions of the Stock Plan, the Board and the Compensation Committee each has the authority to select the persons to whom awards are granted and determine the terms of each award, including the number of shares of common stock subject to the award. Payment of the exercise price of an award may be made in cash, in a “cashless exercise” through a broker, or if the applicable stock option agreement permits, shares of common stock or by any other method approved by the Board or Compensation Committee.  Unless otherwise permitted by the Company, awards are not assignable or transferable except by will or the laws of descent and distribution.





Upon the consummation of an acquisition of the business of the Company, by merger or otherwise, the Board shall, as to outstanding awards (on the same basis or on different bases as the Board shall specify), make appropriate provision for the continuation of such awards by the Company or the assumption of such awards by the surviving or acquiring entity and by substituting on an equitable basis for the shares then subject to such awards either (a) the consideration payable with respect to the outstanding shares of common stock in connection with the acquisition, (b) shares of stock of the surviving or acquiring corporation or (c) such other securities or other consideration as the Board deems appropriate, the fair market value of which (as determined by the Board in its sole discretion) shall not materially differ from the fair market value of the shares of common stock subject to such awards immediately preceding the acquisition. In addition to or in lieu of the foregoing, with respect to outstanding stock options, the Board may, on the same basis or on different bases as the Board shall specify, upon written notice to the affected optionees, provide that one or more options then outstanding must be exercised, in whole or in part, within a specified number of days of the date of such notice, at the end of which period such options shall terminate, or provide that one or more options then outstanding, in whole or in part, shall be terminated in exchange for a cash payment equal to the excess of the fair market value (as determined by the Board in its sole discretion) for the shares subject to such stock options over the exercise price thereof.  Unless otherwise determined by the Board (on the same basis or on different bases as the Board shall specify), any repurchase rights or other rights of the Company that relate to a stock option or other award shall continue to apply to consideration, including cash, that has been substituted, assumed or amended for a stock option or other award pursuant to these provisions. The Company may hold in escrow all or any portion of any such consideration in order to effectuate any continuing restrictions.






16







The Board may at any time provide that any stock options shall become immediately exercisable in full or in part, that any restricted stock awards shall be free of some or all restrictions, or that any other stock-based awards may become exercisable in full or in part or free of some or all restrictions or conditions, or otherwise realizable in full or in part, as the case may be.





The Board or Compensation Committee may, in its sole discretion, amend, modify or terminate any award granted or made under the Stock Plan, so long as such amendment, modification or termination would not materially and adversely affect the participant.





No stock options were granted during the nine months ended September 30, 2010.  In January 2009, options to purchase 1,750,000 shares of the Company’s common stock at an exercise price of $0.29 per share were granted to the Company’s officers and directors. In July 2009, the board of directors cancelled all of these stock options.





The Company granted options to purchase 1,775,000 shares of common stock (1,750,000 shares to officers and directors) in 2007 at an exercise price of $0.44 per share. These stock options expire in 2021 and 2022. The options vest equitably over a 3-4 year vesting period.





The Company also granted 25,000 non-employee stock options to its corporate general counsel in 2007 at an exercise price of $0.44 per share. The fair value of these options is estimated on each balance sheet date for non-vested options and on the vesting date for vested options. These stock options vest over 4 years. In October 2010, the Company issued 30,000 stock options with an exercise price of $1.00 to a consultant for services rendered. The stock options vested upon issuance.





During each of the nine month periods ended September 30, 2010 and 2009, stock options to purchase 25,000 shares of common stock became vested. The weighted-average fair value of 175,000 nonvested stock options at September 30, 2010 was $49,000. Total compensation cost related to nonvested stock options at September 30, 2010 that had not been recognized was $7,000. This non-cash compensation expense will be recognized in the future over a remaining weighted average period of approximately four months.





For the three months ended September 30, 2010 and 2009, the Company recorded non-cash stock-based compensation expense amounting to $10,000 and $268,000, respectively, relating to stock options. For the three months ended September 30, 2010 and 2009, $1,000 and $-0-, respectively, of this amount is included in research and development expenses and $9,000 and $268,000, respectively, of this amount is included in general and administrative expenses in the accompanying statements of operations.





For the nine months ended September 30, 2010 and 2009, the Company recorded non-cash stock-based compensation expense amounting to $33,000 and $533,000, respectively, relating to stock options. For the nine months ended September 30, 2010 and 2009, $4,000 and $115,000, respectively, of this amount is included in research and development expenses and $29,000 and $418,000, respectively, of this amount is included in general and administrative expenses in the accompanying statements of operations.





A summary of the activity in the Company’s Stock Option Plan is as follows:





Stock options with an exercise price of $0.44 per share of common stock





Exercise Price Per Share


Number Outstanding


Weighted Average Remaining Contractual Life


Number Exercisable


Weighted Average Exercise Price


Weighted Average Fair Value Per Stock Option at Date of GrantBalance, 1/1/09

$
0.44



1,800,000



14



1,161,666


$
0.44


$
0.40Vested

$
0.44



-







568,334Forfeitures

$
0.44



(50,000
)






(30,000
)Balance, 12/31/09

$
0.44



1,750,000



13



1,700,000


$
0.44


$
0.40Vested






-







25,000Balance, 9/30/10

$
0.44



1,750,000



12



1,725,000


$
0.44


$
0.40






17







Stock options with an exercise price of $0.43 per share of common stock





Exercise Price Per Share


Number Outstanding


Weighted Average Remaining Contractual Life


Number Exercisable


Weighted Average Exercise Price


Weighted Average Fair Value Per Stock Option at Date of GrantBalance, 1/1/09

$
0.43



-



-



-


$
0.43Granted


0.43



100,000







-



0.43


$
0.272Balance, 12/31/09


0.43



100,000



15



-



0.43Vested






-







-Balance, 9/30/10

$




100,000



15



-


$
0.43





Stock options with an exercise price of $0.39 per share of common stock:





Exercise Price Per Share


Number Outstanding


Weighted Average Remaining Contractual Life


Number Exercisable


Weighted Average Exercise Price


Weighted Average Fair Value Per Stock Option at Date of GrantBalance, 1/1/09

$
0.39



-



-



-


$
0.39Granted


0.39



50,000







-



0.39


$
0.247Balance, 12/31/09


0.39



50,000



15



-



0.39Vested






-







-Balance, 9/30/10

$
0.39



50,000



15



-


$
0.39





No stock options were exercised, forfeited or expired during the nine months ended September 30, 2010. The weighted average fair value of the Company's stock options was estimated using the Black-Scholes option pricing model which requires highly subjective assumptions including the expected stock price volatility. These assumptions were as follows:





·
Historical stock price volatility


180%·
Risk-free interest rate


1.11-4.64%·
Expected life (in years)


4·
Dividend yield


0.00%










18







The valuation assumptions were determined as follows:





●
Historical stock price volatility: The Company obtained the volatility factor of other publicly traded engine manufacturers that were also in the research and development stage.●
Risk-free interest rate: The Company bases the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of the grant for a period that is commensurate with the assumed expected option life.●
Expected life: The expected life of the options represents the period of time options are expected to be outstanding. The Company has no historical data on which to base this estimate. Accordingly, the Company estimated the expected life based on its assumption that the executives will be subject to frequent black out periods during the time that the stock options will be exercisable and based on the Company’s expectation that it will complete its research and development phase and commence its initial production phase. The vesting period of these options was also considered in the determination of the expected life of each stock option grant.●
No expected dividends.





The same methodology and assumptions were utilized in estimating the fair value of non-employee stock options granted to the Company’s general corporate counsel, as discussed above.





22.                INCOME TAXES





Deferred income taxes are determined using the liability method for the temporary differences between the financial reporting basis and income tax basis of the Company’s assets and liabilities. Deferred income taxes are measured based on the tax rates expected to be in effect when the temporary differences are included in the Company’s tax return. Deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases.





Deferred tax assets increased by $774,000 for the three months ended September 30, 2010. Deferred tax assets increased by $254,000 for the three months ended September 30, 2009. Deferred tax assets increased by $607,000 for the nine months ended September 30, 2010. Deferred tax assets decreased by ($218,000) for the nine months ended September 30, 2009. These amounts were fully offset by a corresponding increase or decrease in the tax valuation allowance resulting in no net change in deferred tax assets, respectively during these periods.





No liability for unrecognized tax benefits was required to be reported at September 30, 2010 and 2009.  Based on the Company's evaluation, it has concluded that there are no significant uncertain tax positions requiring recognition in the Company's financial statements.  The Company's evaluation was performed for tax years ended 2005 through 2009, the only periods subject to examination.  The Company believes that its income tax positions and deductions will be sustained on audit and does not anticipate that adjustments, if any, will result in a material change to its financial position. For the nine months ended September 30, 2010 and 2009, there were no penalties or interest related to the Company’s income tax returns.





23.                RELATED PARTY TRANSACTIONS





Coates Motorcycle Company, Ltd.





The Company had an approximately 30% ownership interest in Coates Motorcycle Company, Ltd. (“Coates Motorcycle”), a company that was researching and developing a heavy cruiser motorcycle equipped with the CSRV system technology. George J. Coates, Gregory Coates and The Coates Family Trust collectively held the majority of the shares of common stock of Coates Motorcycle. In July 2009, the Company notified Coates Motorcycle that the license agreement for the sale of motorcycles in the territory of the Western Hemisphere was terminated under the provisions of the license due to its insolvency. Coates Motorcycle was dissolved in July 2009. As the Company has not been engaged in any other activities with Coates Motorcycle and its investment in Coates Motorcycle had previously been written down to $-0-, this did not have any impact on the Company’s financial position or results of operations. For the three and nine month periods ended September 30, 2009, Coates Motorcycle incurred losses of $-0- and $44,000, respectively. The losses primarily resulted from the recording of non-cash stock-based compensation expense.








19





Compensation and Benefits Paid





The approximate amount of compensation and benefits paid to George J. Coates, Gregory Coates and Bernadette Coates, exclusive of non-cash stock-based compensation for employee stock options granted to George J. Coates, Gregory Coates and Bernadette Coates is summarized as follows:





For the Three Months

Ended September 30,


For the Nine Months

Ended September 30,2010


2009


2010


2009George J. Coates

$
75,000


$
68,000


$
243,000


$
220,000Gregory Coates


42,000



39,000



131,000



133,000Bernadette Coates


18,000



18,000



56,000



58,000





Included in the above amounts is compensation paid for vacation earned but not taken during the prior calendar year. Also included in compensation paid to George J. Coates during the nine months ended September 30, 2010 is $10,000 representing the estimated fair value of 4,001 shares of Series A Preferred Stock awarded, as more fully discussed in Note 15.





Short-Term Loan from Stockholder





In late September 2010, George J. Coates, majority stockholder, made a short-term loan to the Company of $8,000. This loan was repaid in early October together with interest at an annual rate of 17%. In November 2010, Mr. Coates made additional short-terms loans totaling $22,000 to the company. These loans are due upon demand and bear interest at the rate of 17% per annum. Although he may choose to do so, Mr. Coates is under no obligation to make additional loans to the Company.





Other





Barry C. Kaye, Treasurer and Chief Financial Officer was paid compensation of $23,000 and $15,000 during the three months ended September 30, 2010 and 2009, respectively, and $71,000 and $53,000 during the nine months ended September 30, 2010 and 2009, respectively.





As discussed in Note 14, during the nine months ended September 30, 2009, the Company sold 1,266,667 shares of its common stock, 333,333 warrants to purchase one share of its common stock at an exercise price of $0.30 per share and 514,285 warrants to purchase one share of its common stock at an exercise price of $0.35 per share in private sales of unregistered, restricted securities to the son of a director pursuant to stock purchase agreements and received net proceeds of $410,000.





24.                LITIGATION AND CONTINGENCIES





Mark D. Goldsmith, a former executive of the Company, filed a lawsuit in January 2008 in which he asserts that the Company is liable to him for breach of an employment contract that never became effective. In the opinion of management, Mr. Goldsmith’s performance was unsatisfactory and, accordingly, he was offered the opportunity to resign. Further, management is of the opinion that the claim of Mr. Goldsmith is baseless because the Company had cause to terminate its relationship with Mr. Goldsmith. The Company intends to vigorously defend this lawsuit and has instituted a counterclaim against Mr. Goldsmith. The Company believes that Mr. Goldsmith misrepresented his background and capabilities in order to induce it and/or Coates Motorcycle Company, Ltd. ("CMC") to hire him. The Company is also contending that certain of Mr. Goldsmith's business decisions were made to further his self interest rather than the interests of the Company. The Company believes that Mr. Goldsmith's claims have no basis in fact and, accordingly, that the outcome of this legal action will not be material to its financial condition or results of operations. As a result of the information disclosed in the deposition of Mr. Goldsmith, the Company filed a dispositive motion for summary judgment. This motion together with a cross motion for summary judgment that was filed by Mr. Goldsmith (the “Cross Motion”) were argued with other motions on October 23, 2009. At the conclusion of these arguments, the Court entered an order denying Mr. Goldsmith’s Cross Motion and the Company’s motion for summary judgment. The Court, however, granted the motion for summary judgment of George Coates, thereby dismissing all claims against Mr. Coates.  On February 9, 2010, the Court entered another order requiring the parties to participate in mediation. A mediation session was held on April 20, 2010 and further efforts by the Court to settle this controversy were unsuccessful. Trial is currently scheduled for April 4, 2011. The Company intends to vigorously defend against Mr. Goldsmith’s claims and pursue its counterclaims.








20







The Company has without prejudice to its position, accrued compensation under his employment agreement for accounting purposes only, of $96,000 of his salary. Although the Company does not intend to make any payments to Mr. Goldsmith in connection with this employment agreement, this amount is included in accounts payable and accrued liabilities in the accompanying balance sheets.





In March 2004, the Company, certain of its officers and directors and other related and unrelated parties were named as co-defendants, along with WWE in a lawsuit brought in the Superior Court of New Jersey captioned H. Alton Neff v. George Coates, Coates International, Ltd. et al. A countersuit was also instituted by the Company and WWE. A plaintiff contended that he was the assignee of 1107 North West Central Avenue Inc. ("1107"). Preliminary agreements and an amendment thereto relating to purchase of a certain license by 1107 from the Company provided, inter alia, that a $500,000 deposit made by 1107 to the Company would convert to shares of the Company’s restricted common stock if certain conditions were not met by 1107. The Company maintained that such conditions were not met and therefore, the deposit converted into shares of the Company’s restricted common stock. The claims were settled in March 2009 through mediation. Pursuant thereto, the Company and WWE each paid $92,500 to 1107. The Company’s $92,500 portion of the settlement was charged to expense in December 2008. All parties executed mutual releases and all claims have been dismissed with prejudice. As a condition of the settlement, Mr. Sommer of 1107 endorsed to the Company a stock certificate evidencing 25,000 shares of the Company’s common stock. In March 2009, the shares of stock evidenced by that stock certificate were retired and restored to authorized, unissued common stock status. The Company was not required to return the $500,000 deposit originally made by 1107 and previously converted into shares of its common stock.





In March 2010, one of the Company’s vendors notified the Company of its contention that it is owed $160,000 for services rendered in 2007, plus accrued interest through September 30, 2010, of $110,000. The Company has paid such vendor for all services rendered and billed through the date that the vendor stopped providing services. The vendor asserts that it is entitled to compensation for the additional services that have never been provided to the Company. There is no written documentation to support the vendor’s assertion. The Company believes there is no basis in fact to support this assertion and that it is not likely that the vendor can be successful in prevailing in its position. Accordingly, no amount has been recorded for this liability and the Company does not intend to make any further payments to this vendor.





The Company is not a party to any other litigation that is material to its business.





25.                RECENTLY ISSUED ACCOUNTING STANDARD





In April 2010, the Financial Accounting Standards Board issued Accounting Standards Update No. 2010-17, “Milestone Method of Revenue Recognition, a consensus of the FASB Emerging Issues Task Force”. This standard provides guidance on defining a milestone and when it is appropriate to apply this standard in recognizing revenue from research and development transactions. In general, this standard permits recognition of revenue from research and development that is contingent upon achievement of one or more specified milestones defined in the research and development arrangements which meet specified criteria for such revenue recognition. This standard becomes effective for fiscal periods beginning after June 15, 2010 and early adoption is permitted. Management does not believe that adoption of this standard will have a material effect on the Company's financial statements.




26.     SUBSEQUENT EVENT
 
 In November 2010, the Company granted to George J. Coates and one of our directors stock options to purchase 275,000and 85,000shares of the Company's common stock, respectively, at a price per share of $0.40 under the Company's Stock Plan. The estimated fair value of these stock options at the date of grant of $75,000will be charged to expense over the one-year vesting period of these options.






21







Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS




Forward-Looking Statements




This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Federal securities laws, and is subject to the safe-harbor created by such Act and laws. Forward-looking statements may include our statements regarding our goals, beliefs, strategies, objectives, plans, including product and service developments, current dependence on our agreements with Almont Energy, Inc., future financial conditions, results or projections or current expectations. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms, or other comparable terminology. These statements are subject to known and unknown risks, uncertainties, assumptions and other factors that may cause actual results to be materially different from those contemplated by the forward-looking statements. The business and operations of Coates International, Ltd. are subject to substantial risks, which increase the uncertainty inherent in the forward-looking statements contained in this report. Except as required by law, we undertake no obligation to release publicly the result of any revision to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Further information on potential factors that could affect our business is described in our various periodic reports filed with the SEC. Readers are also urged to carefully review and consider the various disclosures we have made in this and such previously filed reports.





Background




We have completed development of the Coates spherical rotary valve (“CSRV”) system technology for use in internal combustion engines of all types. In the third quarter, as we were preparing for production of our natural gas powered CSRV engine generators, we observed the presence of green oxides of tungsten. We are replacing the tungsten-based components with ceramic-based components. Our testing of the engines using the ceramic based seals validated that this condition has been resolved. The ceramic components require longer lead times from our suppliers. In November 2010, we shipped the first industrial CSRV Natural Gas Electric Power Engine Generator to Almont. We also anticipate that additional CSRV engine generators will start shipping to Almont by the end of this year or early next year.





We believe that the CSRV system technology delivers significant competitive advantages over technology currently applied in conventional internal combustion engines, including substantial improvement in fuel efficiency, a substantial reduction in harmful emissions and longer intervals between scheduled engine maintenance. This technology has been successfully applied to natural gas fueled industrial electric power generator engines, automobile engines, a 35 KW synchronous residential generator and a high performance racing car engine.  We are developing plans for transitioning to large scale production in order to be properly positioned to take advantage of this technology as it achieves acceptance in the marketplace.  This includes searching for the optimal manufacturing facility based on location, shipping logistics and availability of a skilled labor pool suitable for large scale manufacturing of the CSRV system technology.  We continue to actively seek out new sources of working capital to fund our plans for the commencement of manufacturing activities.





We may also conduct new research and development activities in connection with applying this technology to other commercially feasible internal combustion engine applications and are planning to manufacture engines and/or license the technology to third party Original Equipment Manufacturers (“OEMs”) for multiple other applications and uses. We believe the CSRV system technology has wide applicability to products of all types powered by internal combustion engines.








22





Initially, we intend to sell the electric power engine generators to Almont Energy, Inc., (“Almont”) the successor in interest to Well to Wire Energy, Inc. (“WWE”) with respect to (i) a license agreement covering the territory of Canada; and, (ii) certain rights to a license covering the territory of the United States. Almont is a privately held, recently formed independent third party entity based in Alberta, Canada. The business plan of Almont assumes the purchase of a substantial number of CSRV units over a 5-year period commencing upon shipment of Almont’s first order. Almont’s purchase of CSRV units from us will be made by way of standard purchase orders, issued based on market and customer demand. Over the 5-year period, Almont anticipates that the volume of total purchases from us will be similar to, or potentially exceed the 7,400 CSRV unit quantity contemplated in our previous arrangement with WWE. Almont plans to finance its purchases from cash flow and by way of project and/or equipment financing, proceeds from issuance of equity or corporate debt instruments and conventional bank financing. We are working on the production of our first shipment of natural gas powered industrial electric generator sets for Almont.





Our ability to establish large scale manufacturing operations, recruit plant workers, finance initial manufacturing inventories and fund capital expenditures is highly dependent on our ability to successfully raise substantial new working capital in an amount and at a pace which matches our business plans. Sources of such new working capital include sales of our equity and/or debt securities through private placement and/or secondary public offerings, pursuing and entering into additional sublicensing agreements with OEM’s and/or distributors, additional payments from Almont towards the Escrow Agreement Release Payment and US Licensing fees and positive working capital generated from sales of our CSRV products to Almont and others. There can be no assurance that we will be successful in raising adequate new working capital or even any new working capital to carry out our business plans.  The current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty to our challenge to secure such additional working capital.





We have also entered into a Cooperation Agreement with Tongji University of China (the “University”) for the purpose of enabling the University to undertake evaluation and testing of the CSRV engine technology. The results of the evaluation and testing will be used to determine if, and to what extent, the engine technology could be applied in the manufacture of products in China. We are required to deliver to the University a CSRV 1600cc 4-cylinder engine and a 1600cc 4-cylinder poppet valve engine to facilitate comparison. We are also required to provide technical assistance, as needed, to optimize the success of the evaluation and testing. The University will promptly furnish us with a copy of its findings. Provided the results of the evaluation and testing of the CSRV engines are deemed satisfactory, we have agreed to sub-license the CSRV Technology to Chinese engine manufacturers. The parties also entered into a Confidentiality and Non-Disclosure Agreement at the same time, which provides for protection of the CSRV technical information and patents. The Coates Family Trust has expressed its intention to license the rights to the CSRV technology to the Company for the territory to be defined in connection with any such licenses granted to Chinese manufacturers.





We are actively engaged in efforts to raise working capital to fund our ongoing operations and the start up of large scale production of our products incorporating the CSRV system technology.





Significant Estimates





The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These significant estimates include determining a value for the Series A Preferred Stock issued and certain limited anti-dilution rights granted to George J. Coates, determining the amount of discount on convertible promissory notes,  assigning useful lives to our property, plant and equipment, determining an appropriate amount to reserve for obsolete and slow moving inventory, a valuation allowance for deferred tax assets, assigning expected lives to and estimating the rate of forfeitures of stock options granted and selecting a volatility factor for our stock options in order to estimate the fair value of our stock options on the date of grant.








23





Agreements with Well to Wire Energy, Inc. Assigned to Almont Energy, Inc.





In 1999, we granted a sublicense to Well to Wire Energy, Inc. ("WWE"), an oil and gas company in Canada.  This sublicense provides for a $5,000,000 license fee to be paid to us and covers the use of the CSRV system technology in the territory of Canada (the “Canadian License”). A separate research and development agreement (“R&D Agreement”) provided for WWE to pay us an additional $5,000,000 fee in consideration for the development and delivery of certain prototype engines. We completed development of the prototypes in accordance with this agreement at the end of 2007. The research and development agreement has not been reduced to the form of a signed, written agreement.





In 2008, we also entered into an escrow agreement with WWE that provides conditional rights to a second sublicense agreement to WWE for the territory of the United States (the “US License”). The US license has been deposited into an escrow account and the grant of the license will not become effective until the conditions for release from escrow are satisfied. The US License provides for a license fee of $50 million.





The escrow agreement requires that WWE make a payment (“Release Payment”) to us equal to the remaining unpaid balance of the licensing fee for the Canadian License, the R&D Agreement fee and the down payment of $1,000,000 required under the US License. During the nine months ending September 30, 2010 and 2009, WWE made Release Payments to us totaling $850,000 and $690,000, respectively.





During the first quarter of 2010, with our prior consent, WWE assigned the Canadian License and the rights to the US License, subject to the terms and conditions of the escrow agreement, to Almont Energy Inc. (“Almont”), a privately held, newly formed independent third party entity based in Alberta, Canada. In connection with the assignment, we waived all events of default by WWE under the escrow agreement. We also waived the provisions of the escrow agreement requiring the payment of interest on the unpaid balance of the Release Payment. Almont made two payments to us in February 2010 totaling $700,000 as a prerequisite condition to our consent to the assignment.





In connection with the assignment of the Canadian License and the rights to the US License, Almont has also assumed all of the obligations set forth in the escrow agreement with the following modifications:





●
The Release Payment Date as defined in the escrow agreement has been extended to March 19, 2012. At the time of the assignment, the remaining unpaid balance of the Release Payment was approximately $5,997,000. Provided that Almont remits this entire unpaid balance to us on or before the Release Payment Date, the US License will be released from escrow and granted to Almont. Almont is required to remit to us 60% of all monies it raises from future equity or debt transactions, exclusive of proceeds from equipment purchase financing transactions, until the Release Payment is paid in full.





●
Almont has also become obligated to pay the $49 million balance of the US License Fee to us. Payment shall be made quarterly in an amount equal to 5% of Almont’s quarterly net profits. In addition, Almont is required to remit to us a portion of the proceeds it receives from equity or debt transactions, exclusive of equipment financing transactions until the entire balance of the US License fee is paid in full. However, the entire $49 million licensing fee is required to be paid on or before February 19, 2015.





To the extent that Almont is not successful or experiences delays in remitting the balance of the Release Payment, our cash flow, results of operations and financial condition could be adversely affected.








24





The Canadian License





The Canadian License exclusively licenses within Canada the use of the CSRV system technology for industrial engine generators to be fueled by natural gas to generate electrical power. Additional provisions of the Canadian License agreement are as follows:





●
Licensee shall have the exclusive right to use, lease and sell electric power generators that are based on the CSRV system technology within Canada.●
Licensee will have a specified right of first refusal to market the electric power generators worldwide.


●
Upon commencement of the production and distribution of the electric power generators, the minimum annual number of generators to be purchased by Licensee in order to maintain exclusivity is 120.  Until otherwise agreed between the parties, the price per generator shall be $159,000.  In the event Licensee fails to purchase the minimum 120 CSRV engines during any year, Licensee will automatically lose its exclusivity. In such a case, Licensee would retain non-exclusive rights to continue to use and sell the CSRV engines in the territory of Canada.●
Licensee is required to pay a royalty to us equal to 5% of its gross profits plus $400,000.


●
All licensed rights under this license agreement related to the CSRV system technology will remain with us.





The US License





The US License will, upon Almont satisfying the Release Payment, grant to WWE the right to use, sell and lease Licensed Products manufactured by us, as the power source for the generation of electrical energy.  Licensed Products consist of CSRV Engines, CSRV Valve Systems, CSRV Valve Seals, CSRV Rotary Valve Spheres and CSRV Valve Components for use in electric power generation applications.





The manufacture of any Licensed Products by Licensee is prohibited.  Licensee is required to procure all internal combustion engines incorporating the CSRV Valve System from us or our designee. The license granted to Licensee is exclusive within the Territory, provided that Licensee satisfies the minimum annual purchase commitment of 120 internal combustion engines incorporating the CSRV system technology, the Coates engines and all component parts. The agreement also grants Licensee a right of first refusal in the event that we negotiate an offer with another third party for a worldwide license to use the Licensed Product.





The business plan of Almont assumes the purchase of a substantial number of CSRV units over a 5-year period commencing upon the shipment of Almont’s first order from us. Almont’s purchase of CSRV units from us will be made by way of standard purchase orders, issued based on market and customer demand. Over the 5-year period commencing upon the first shipment of CSRV production engines, Almont anticipates that the volume of total purchases from us will be similar to, or potentially exceed the 7,400 CSRV units contemplated in our previous arrangement with WWE. Almont plans to finance its purchases from cash flow and by way of project and/or equipment financing, proceeds from issuance of equity or corporate debt instruments and conventional bank financing.





We do not currently have the production capacity to fulfill orders for this number of engine generators over the next five years.  Management believes that we could be successful in entering into a procurement contract with one or more major engine suppliers in the United States to deliver engine blocks incorporating our proprietary pistons and heads.  Under this approach, we would complete the production of the engines by incorporating the CSRV system technology into these engine blocks.








25




There are a number of inherent risks associated with achieving this level of revenues over the next five years, including:




●
Although we intend to pursue numerous other opportunities to generate revenues from production of internal combustion engines incorporating the CSRV system technology and/or licensing of this technology to original equipment manufacturers, until we are able to enter into definitive agreements with new customers, our revenues will be concentrated with a single customer, Almont.  Almont will be required to remit periodic installments of the Release Payment due us under the escrow agreement and make timely payments for its purchases of CSRV system technology-based products from us.




●
There can be no assurances that we will have adequate capital resources to acquire an appropriate manufacturing plant and procure a sufficient number of engine blocks, inventory and parts on a timely basis, as well as cover the payroll costs for an increased labor force and overhead that would be required in order to fulfill orders for this volume of engine generators over the next five years. In the event that we are unable to fulfill this volume of orders, our revenues and profitability would be negatively impacted to the extent of any such shortfall.




Results of Operations – Three Months Ended September 30, 2010 Compared to Three Months Ended September 30, 2009 (All amounts rounded to thousands of dollars)





In the third quarter of 2010, we primarily focused on research and development aimed at improving the CSRV assembly, raising new working capital and new product development. As a result, labor and materials costs were allocated to both general and administrative costs and research and development expenses during this quarter.




No revenues from research and development were generated during the three month periods ended September 30, 2010 and 2009.




Research and development expenses were $148,000 and $-0- for the three months ended September 30, 2010 and 2009, respectively. Included in research and development expenses for the three months ended September 30, 2010 and 2009 were $109,000 and $-0-, respectively, of allocated compensation and benefits, $1,000 and $-0-, respectively, of allocated stock-based compensation expense and $38,000 and $-0-, respectively, of materials used in research and development.




General and administrative expenses decreased to $273,000 for the three months ended September 30, 2010 from $627,000 in the corresponding period in 2009. This net decrease of $354,000 primarily resulted from the following: A reduction of $259,000 in stock-based compensation expense primarily resulting from recording of stock-based compensation expense for early termination of stock options in the third quarter of 2009, a $102,000 reduction in compensation and benefits primarily due a $109,000 increase in the amount of compensation and benefits allocated to research and development expenses, a $33,000 reduction of shop supplies, a $14,000 reduction of office expenses, a $4,000 reduction in building expenses, a $4,000  reduction in marketing expenses and a $3,000 decrease in travel. These expense reductions were offset by an increase of $25,000 in legal and professional fees, an increase in miscellaneous expenses of $17,000, an increase in repairs and maintenance expenses of $7,000, an increase in franchise and other taxes of $6,000, a reduction in parts expense of $5,000 and a reduction of investor relations expense of $5,000.




Depreciation and amortization increased by $13,000 to $24,000 for the three months ended September 30, 2010 from $11,000 for the three months ended September 30, 2009. The increase primarily resulted from the depreciation of demonstrator CSRV engines transferred to machinery and equipment in 2010 and acquisition of other machinery equipment.




Interest expense, net, amounted to $58,000 for the three months ended September 30, 2010, an increase of $7,000 from interest expense, net incurred in the comparable 2009 period. This increase was primarily related to interest expense on convertible notes issued in the 3rd quarter of 2010, offset by the discontinuance in 2010 of the amortization of deferred financing costs.




The change in deferred tax assets for the three months ended September 30, 2010 and 2009 was fully offset by a valuation allowance, resulting in a $-0- net income tax provision.




We incurred a net losses of ($502,000) and ($689,000) for the three months ended September 30, 2010 and 2009, respectively.








26




Results of Operations – Nine Months Ended September 30, 2010 Compared to Nine Months Ended September  30, 2009 (All amounts rounded to thousands of dollars)





Revenue from research and development was $850,000 and $690,000 for the nine months ended September 30, 2010 and 2009, respectively. The revenue from research and development was comprised of non-refundable partial payments of the Release Payment provided for by our Escrow Agreement with Almont and prior thereto, with WWE, established in connection with our licensing and research and development agreements.




Research and development expenses were $315,000 and $255,000 for the nine months ended September 30, 2010 and 2009, respectively. Included in research and development costs for the nine months ended September 30, 2010 and 2009 were $220,000 and $138,000, respectively, of allocated compensation and benefits, $4,000 and $115,000, respectively, of stock-based compensation expense and $91,000 and $2,000, respectively, of components and materials used in research and development.




General and administrative expenses decreased to $842,000 for the nine months ended September 30, 2010 from approximately $1,753,000 in the corresponding period in 2009. This net decrease of approximately $911,000 primarily resulted from the following: A decrease in stock-based compensation expense of $389,000 due to a one-time charge in 2009 for early termination of stock options and the final vesting of a substantial portion of the outstanding stock options in 2009, a reduction in legal and professional fees of $258,000, a reduction of rent expense to $-0- from $179,000 due to the effective termination of our lease agreement in June 2009 upon the reacquisition of the property that serves as our headquarters, warehouse and research and development facility, a reduction in compensation and benefits of $58,000 due to a larger portion of compensation and benefits being allocated to research and development and production activities in 2010, a $56,000 reduction in marketing expenses, a $20,000 decrease in office expenses, a $16,000 reduction in printing costs, a $14,000 reduction in travel and entertainment expenses, and a net decrease of $2,000 in other general and administrative expenses. Theses decreases in general and administrative expenses were partially offset by an increase in shop supplies and parts of $23,000, an increase in investor relations expenses of $21,000, a $12,000 increase in real estate and other taxes, an increase in repairs and maintenance of $8,000, a $6,000 increase in tools expense, a $6,000 increase in patent maintenance costs and an increase in building expenses and utilities of $5,000.




Depreciation and amortization expense increased to approximately $62,000 in the nine months ended September 30, 2010 from approximately $21,000 in the comparable period in 2009.  The increase primarily resulted from the reacquisition and commencement of depreciation of the property that serves as our headquarters, warehouse and research and development facility, the depreciation of demonstrator CSRV engines transferred to machinery and equipment in 2010 and acquisition of other machinery equipment.




Other operating income for the nine months ended September 30, 2009 included the recognition of $978,000 of the gain on sale of the land and building which serves as our headquarters, warehouse and research and development facility. This gain resulted from a sale/leaseback transaction we entered into in 2005. The conditions for recognizing this gain were first satisfied in November 2008, upon which the deferred gain began to be recognized over the remaining life of the sale/leaseback agreement. This agreement was effectively terminated in June 2009 upon reacquisition of this property resulting in recognition of the remaining balance of the deferred gain on sale at that time.




Interest expense, net, amounted to approximately $178,000 for the nine months ended September 30, 2010 primarily related to interest expense on the convertible notes issued in the third quarter of 2010, a mortgage loan and promissory notes due to related parties. For the nine months ended September 30, 2009 interest expense, net amounted to $59,000 primarily related to a mortgage loan on the land and building and promissory notes issued to related parties in the third quarter of 2009.




The change in deferred tax assets for the nine months ended September 30, 2010 and 2009 was fully offset by a valuation allowance, resulting in a $-0- net income tax provision.




We incurred net losses for the nine months ended September 30, 2010 and 2009 of ($547,000) and ($419,000), respectively.








27




Liquidity and Capital Resources (All amounts rounded to thousands of dollars)





Our cash position at September 30, 2010 was $78,000, a decrease of $175,000 from the cash position of $253,000 at December 31, 2009. We had negative working capital of ($2,966,000) at September 30, 2010 which represents a $595,000 decrease from the ($2,371,000) of negative working capital at December 31, 2009. Our current liabilities of $3,587,000 at September 30, 2010 decreased from the $3,252,000 balance at December 31, 2009.  Current liabilities are primarily comprised of unearned revenue of $303,000, a mortgage loan in the amount of $1,740,000 which matures in July 2011, accounts payable and accrued liabilities of $1,180,000, promissory notes to related parties totaling $308,000, a derivative liability related to convertible notes of $26,000 and unamortized carrying value of convertible promissory notes of $20,000.





Operating activities utilized cash of ($299,000) during the nine months ended September 30, 2010 which primarily consisted of a net loss for the period of ($547,000), increased by non-cash interest expense of $77,000, non-cash stock-based compensation expense of $43,000 and depreciation and amortization of $62,000, offset by non-cash income from termination of a joint venture amounting to ($62,000). In addition, we realized additional operating cash of 303,000 from unearned revenue and an increase in accounts payable and accrued liabilities of $5,000. Operating cash was utilized for inventory purchases of ($176,000), repayment of an amount due to related party of ($13,000) and a ($9,000) reduction of a restricted interest reserve account.





Investing activities utilized cash of ($14,000) for the acquisition of property, plant and equipment during the nine months ended September 30, 2010.





Financing activities generated cash of approximately $139,000 for the nine months ended September 30, 2010 resulting from issuance of convertible notes amounting to $146,000, issuance of promissory notes to related parties of $108,000, proceeds from issuance of stock and warrants of $4,000 and a $1,000 expenditure for deferred financing costs, offset by repayment of a promissory note due to a related party amounting to $100,000, repayment of a portion of the 10% convertible note due to a related party amounting to $10,000 and repayment of mortgage loan principal amounting to $10,000.





During the nine months ended September 30, 2010, we received $850,000 from research and development fees, a $303,000 initial deposit toward the first shipment of natural gas industrial electric power generators and $146,000 from the issuance of convertible notes. In October 2010, we issued a promissory note to the Coates Family Trust and received proceeds of $80,000. In November 2010, we issued promissory notes and received proceeds of $22,000 and $50,000 from George J. Coates and one of our directors, respectively. We continue to actively seek out new sources of working capital; however, there can be no assurance that we will be successful in these efforts. The accompanying financial statements included in this quarterly report do not include any adjustments that might result from the outcome of this uncertainty.





In the opinion of management, we will be required to continue to raise additional working capital to fully achieve our objectives as we are entering the production phase of our operations and continue research and development activities in connection with developing other commercially viable applications of our CSRV system technology to internal combustion engines. The source of such additional working capital is anticipated to come from sales and shipments of natural gas fueled industrial electric power CSRV engine generators to Almont, cash flows under the escrow agreement with Almont, additional issuances of convertible notes and the offering of our equity securities to prospective institutional investors. In addition, the current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in our challenge to secure needed additional working capital. There can be no assurance that we will be able to obtain the necessary working capital for our production phase on a time frame that will enable us to optimize our production capacity.








28





Contractual Obligations and Commitments





The following table summarizes our contractual obligations and commitments at September 30, 2010 (rounded to thousands of dollars):





Amount Due WithinTotal


2010


2011Mortgage Loan Payable

$
1,740,000


$
-


$
1,740,000Employment Agreements(1)


433,000



100,000



333,000Promissory Notes to Related Parties


308,000



308,000



-Convertible Promissory Notes


146,000



-



146,00010% Convertible Note


10,000



10,000



-Total

$
2,637,000


$
418,000


$
2,219,000





(1)
Our obligation under employment agreements would increase to $550,000 per year through October 23, 2011, upon the achievement of an adequate level of working capital, as defined.





Plan of Operation





We have completed development of the natural gas fueled industrial electric power CSRV engine generator and are preparing to commence the production phase of our operations provided we can successfully raise sufficient new working capital for this purpose. Initially, we intend to sell the engine generators to Almont. In the third quarter of 2010 we observed the presence of green oxides of tungsten in the CSRV engine generator units. We are replacing the tungsten-based components with ceramic-based components. Our testing of the engines using the ceramic based seals validated that this condition has been resolved. The ceramic components require longer lead times from our suppliers. In November 2010, we shipped the first industrial CSRV Natural Gas Electric Power Engine Generator to Almont. We also anticipate that additional CSRV engine generators will start shipping to Almont by the end of this year or early next year.





Through September 30, 2010, Almont has remitted $303,000 towards the payment of its order for the first shipment of natural gas fueled industrial electric power CSRV engine generators. Almont has advised us that it intends to place additional orders for these engine generators promptly after the balance of the first order is shipped and installed. We intend to begin to transition to large scale manufacturing at that point to be able to fulfill orders based on Almont’s five-year business plan, which anticipates that it will require a volume of generators similar to or greater than the 7,400 units previously planned by WWE. Fulfillment is expected to occur over a five-year period. We intend to take advantage of the fact that essentially all the components of the engine generators may be sourced and acquired from subcontractors and, accordingly, expect to manufacture the engine generators in the two following ways:





●
Assembly – to develop assembly lines at a new manufacturing facility to be acquired in the future in order to increase our manufacturing capacity. When the demand for our products justifies it, we will take the required steps in order to increase our work force.  We anticipate that we will recruit a significant number of new employees and make substantial capital expenditures in connection with establishing such large scale operations.●
Licensing our CSRV system technology to Original Equipment Manufacturers (“OEM's”) – to take advantage of third party manufacturers’ production capacity by signing OEM agreements.









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Our ability to establish such manufacturing operations, recruit plant workers, finance initial manufacturing inventories and fund capital expenditures is highly dependent on our ability to successfully raise substantial new working capital in an amount and at a pace which matches our business plans. Anticipated sources of such new working capital include positive working capital generated from sales of our CSRV products to Almont and others, additional payments from Almont for the Release Payment, additional issuances of convertible notes, sales of our equity and/or debt securities through private placements and/or secondary public offerings and pursuing and entering into additional sublicensing agreements with OEM's and/or distributors. There can be no assurance that we will be successful in raising adequate new working capital or even any new working capital to carry out our business plans.  The current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in our challenge to secure such additional working capital.





Once we transition to production and delivery of our products, we intend to increase our expenditures for marketing and branding activities with the objective of increasing market awareness and acceptance of the CSRV system technology.





The extent to which we can carry out this plan of operation will be highly dependent on our success in raising new sources of capital and generating cash flows from operations in the production phase.





Going Concern (All amounts rounded to thousands of dollars)





As shown in the accompanying financial statements, we incurred a net loss for the nine month period ended September 30, 2010 of ($547,000), and have incurred substantial net losses since inception while engaging primarily in research and development. As of September 30, 2010, we had accumulated losses of ($23,202,000) and had negative working capital of ($2,966,000). In addition, the current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in our challenge to secure needed additional working capital. These factors raise substantial doubt about our ability to continue as a going concern. Our Independent Registered Public Accounting Firm has stated in its independent auditors’ report on our financial statements as of December 31, 2009 and for the year then ended that these factors raise substantial doubt about our ability to continue as a going concern.





The doubt about our ability to continue to operate as a going concern has existed for a number of years. We have been successful in raising sufficient new working capital throughout that time to enable us to continue as a going concern and, although we can not provide assurances that we can be successful, we believe that we can continue to do so in the future. Management is continuing to carefully monitor its costs and is restricting variable costs to only those expenses that are necessary to carry out our business plans. We continue to actively seek out new sources of working capital; however, there can be no assurance that we will be successful in these efforts.





The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.





Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Not applicable.





Item 4T. CONTROLS AND PROCEDURES





a) Evaluation of Disclosure Controls. Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (“Exchange Act”), we carried out an evaluation, with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) (our principal financial and accounting officers), of the effectiveness of our disclosure controls and procedures (as defined under Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.





(b)   Changes in internal control over financial reporting. There have been no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.








30








PART II - OTHER INFORMATION





Item 1. LEGAL PROCEEDINGS





Mark D. Goldsmith, a former executive of the Company, filed a lawsuit in January 2008 in which he asserts that the Company is liable to him for breach of an employment contract that never became effective. In the opinion of management, Mr. Goldsmith’s performance was unsatisfactory and, accordingly, he was offered the opportunity to resign. Further, management is of the opinion that the claim of Mr. Goldsmith is baseless because the Company had cause to terminate its relationship with Mr. Goldsmith. The Company intends to vigorously defend this lawsuit and has instituted a counterclaim against Mr. Goldsmith. The Company believes that Mr. Goldsmith misrepresented his background and capabilities in order to induce it and/or Coates Motorcycle Company, Ltd. ("CMC") to hire him. The Company is also contending that certain of Mr. Goldsmith's business decisions were made to further his self interest rather than the interests of the Company. The Company believes that Mr. Goldsmith's claims have no basis in fact and, accordingly, that the outcome of this legal action will not be material to its financial condition or results of operations. As a result of the information disclosed in the deposition of Mr. Goldsmith, the Company filed a dispositive motion for summary judgment. This motion together with a cross motion for summary judgment that was filed by Mr. Goldsmith (the “Cross Motion”) were argued with other motions on October 23, 2009. At the conclusion of these arguments, the Court entered an order denying Mr. Goldsmith’s Cross Motion and the Company’s motion for summary judgment. The Court, however, granted the motion for summary judgment of George Coates, thereby dismissing all claims against Mr. Coates. On February 9, 2010, the Court entered another order requiring the parties to participate in mediation. A mediation session, which was held on April 20, 2010 and further efforts by the Court to settle this controversy were unsuccessful. Trial is currently scheduled for April 4, 2011. The Company intends to vigorously defend against Mr. Goldsmith’s claims and pursue its counterclaims. We intend to vigorously defend against Mr. Goldsmith’s claims and pursue its counterclaims.





In March 2004, the Company, certain of its officers and directors and other related and unrelated parties were named as co-defendants, along with WWE in a lawsuit brought in the Superior Court of New Jersey captioned H. Alton Neff v. George Coates, Coates International, Ltd. et al. A countersuit was also instituted by the Company and WWE. A plaintiff contended that he was the assignee of 1107 North West Central Avenue Inc. ("1107"). Preliminary agreements and an amendment thereto relating to purchase of a certain license by 1107 from the Company provided, inter alia, that a $500,000 deposit made by 1107 to the Company would convert to shares of the Company’s restricted common stock if certain conditions were not met by 1107. The Company maintained that such conditions were not met and therefore, the deposit converted into shares of the Company’s restricted common stock. The claims were settled in March 2009 through mediation. Pursuant thereto, the Company and WWE each paid $92,500 to 1107. The Company’s $92,500 portion of the settlement was charged to expense in December 2008. All parties executed mutual releases and all claims have been dismissed with prejudice. As a condition of the settlement, Mr. Sommer of 1107 endorsed to the Company a stock certificate evidencing 25,000 shares of the Company’s common stock. In March 2009, the shares of stock evidenced by that stock certificate were retired and restored to authorized, unissued common stock status. The Company was not required to return the $500,000 deposit originally made by 1107 and previously converted into shares of its common stock.





We are not a party to any other litigation that is material to our business.








31







Item 1A. RISK FACTORS





Not applicable.





Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS





In August and September 2010, the Company issued $146,000 of convertible notes. The notes are convertible into shares of unregistered common stock at any time beginning six months after issuance. The conversion rate is equal to 61% of the average of the three lowest closing bid prices of the stock during the ten trading days prior to the date of conversion.





Item 3. DEFAULTS UPON SENIOR SECURITIES





None.





Item 4. (REMOVED AND RESERVED)





Item 5. OTHER INFORMATION





None.





Item 6. EXHIBITS.








Exhibit

Number

Description31.1 *

Section 302 Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2 *

Section 302 Certification of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1 *

Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2 *

Certification of Principal Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





* Filed herewith.










32




SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.








COATES INTERNATIONAL, LTD.Date: November 19, 2010
By:
/s/ George J. CoatesGeorge J. CoatesPresident, Chief Executive Officer

and Principal Executive Officer





Date: November 19, 2010
By:
/s/ Barry C. KayeBarry C. KayeTreasurer, Chief Financial Officer

and Principal Financial Officer