UNITED
STATES SECURITIES AND EXCHANGE COMMISSION




Washington,
DC 20549






FORM
10-K




(Mark
One)




R
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For
the fiscal year ended December 31, 2008


or


£
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For
the transition period from
to





Commission File No.:000-33155


COATES
      INTERNATIONAL, LTD.


(Name of
small business issuer in its charter)





Delaware
              (State
      or other jurisdiction of incorporation or organization)
            
            22-2925432
              (I.R.S.
      Employer Identification No.)Highway
      34 & Ridgewood Road
              Wall
      Township, New Jersey  07719
              (Address
      of principal executive offices)





Issuer’s
telephone number, including area code:(732) 449-7717




Securities
registered pursuant to Section 12(b) of the Exchange Act: None




Securities
registered pursuant to Section 12(g) of the Exchange Act: common stock, $.0001 par
value




_______________





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.


Yes £  No
R


Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.


Yes £  No
R




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 R  No £





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not
be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K.


R




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. (Check one):









Large
accelerated filer £                                                                                                 Accelerated
filer £





Non-accelerated
filer (Do not check if a smaller reporting company)   £                Smaller
reporting company R




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




State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant’s most recently completed second fiscal
quarter. $19,713,360.





Indicate
the number of shares outstanding of each of the registrant’s classes of common
stock, as of the latest practicable


date.





As of
March 26, 2009, the number of outstanding shares of the registrant’s common
stock, par value $0.0001 per share was 273,939,732.











COATES
INTERNATIONAL, LTD.





CONTENTS








PagePART IItem
      1.
                                                                                                                                                  Business
                                                                                                                                                  3Item
      1A.
                                                                                                                                                  Risk
      Factors
                                                                                                                                                  10Item
      1B.
                                                                                                                                                  Unresolved
      Staff Comments
                                                                                                                                                  14Item
      2.
                                                                                                                                                  Properties
                                                                                                                                                  15Item
      3.
                                                                                                                                                  Legal
      Proceedings
                                                                                                                                                  15Item
      4.
                                                                                                                                                  Submission
      of Matters to a Vote of Security Holders
                                                                                                                                                  15PART
      IIItem
      5.
                                                                                                                                                  Market
      for Registrant's Common Equity, Related Shareholder Matters and Issuer
      Purchases of Equity Securities
                                                                                                                                                  16Item
      6.
                                                                                                                                                  Selected
      Financial Data
                                                                                                                                                  17Item
      7.
                                                                                                                                                  Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                                                                                                                                  18Item
      7A.
                                                                                                                                                  Quantitative
      and Qualitative Disclosures About Market Risk
                                                                                                                                                  23Item
      8.
                                                                                                                                                  Financial
      Statements and Supplementary Data
                                                                                                                                                  23Item
      9.
                                                                                                                                                  Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                                                                                                                                                  23Item
      9A(T).
                                                                                                                                                  Controls
      and Procedures
                                                                                                                                                  23Item
      9B.
                                                                                                                                                  Other
      Information
                                                                                                                                                  23PART
      IIIItem  10.
                                                                                                                                                  Directors,
      Executive Officers and Corporate Governance
                                                                                                                                                  24Item  11.
                                                                                                                                                  Executive
      Compensation
                                                                                                                                                  28Item  12.
                                                                                                                                                  Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                                                                                                                                                  31Item  13.
                                                                                                                                                  Certain
      Relationships and Related Transactions, and Director
Independence
                                                                                                                                                  33Item  14.
                                                                                                                                                  Principal
      Accounting Fees and Services
                                                                                                                                                  34PART
      IVItem  15.
                                                                                                                                                  Exhibits
                                                                                                                                                  35Signatures
                                                                                                                                                  
                                                                                                                                                  37Financial
      Statements
                                                                                                                                                  F-1
      to
F-26




2




PART
I








Item
1.  Business





General





Coates
International, Ltd. ("we", “CIL” or the "Company") has been developing over a
period of more than 15 years a patented Coates spherical rotary valve system
(“CSRV”) technology which is adaptable for use in piston-driven internal
combustion engines of many types.   Independent testing of
various engines in which we incorporated our CSRV technology (“CSRV Engines”)
confirmed meaningful fuel savings when compared with internal combustion engines
based on the conventional “poppet valve” assembly prevalent in most internal
combustion engines throughout the world. In addition, our CSRV system technology
engines produced only ultra low levels of harmful emissions while in operation.
Engines operating on the Coates CSRV system technology can be powered by a wide
selection of fuels. We believe that these three major advantages of the CSRV
system technology constitute the first revolutionary technological advancement
of the internal combustion engine suitable for large scale production, since its
introduction more than one hundred years ago.





The
Coates CSRV system is designed to replace the intake and exhaust conventional
“poppet valves” currently used in almost all piston-driven stationary,
automotive, motorcycle and marine engines. Unlike conventional valves which
protrude into the engine cylinder, the CSRV System utilizes spherical valves
that rotate in a cavity formed between a two-piece cylinder head. The CSRV
system utilizes only a small fraction of the moving parts in a conventional
poppet valve assembly. As a result of the design improvements, management
believes that CSRV Engines will last significantly longer and will require less
lubrication over the life of the engine, as compared to conventional engines. In
addition, CSRV engines can be designed with larger openings into the engine
cylinder than conventional valves so that more fuel and air can be inducted into
and expelled from the cylinder in a shorter period of time.  Larger
valve openings permit higher revolutions-per-minute (“RPM’s”) and permit higher
compression ratios with lower combustion chamber temperatures, enabling the CSRV
Engine to produce more power than equivalent, conventional engines. The
extent to which higher RPM range, greater volumetric efficiency and thermal
efficiency are achieved is  a function of the engine design and
application.





We have
been granted an exclusive license to this technology from our founder, George J.
Coates and his son, Gregory Coates (the “Coates License Agreement”), in the
Territory defined to include North America, Central America and South America
(the “Americas”).





Since our
inception, the bulk of our development costs and related operational costs have
been funded primarily through cash generated from the sale of stock, through
capital contributions, loans made by the Coates Trust, through a
sale-and-leaseback transaction related to our principal facility, and from the
performance of contractual research and development activities involving the
Coates CSRV system technology. During 2008, we reported revenues from such
research and development of approximately $1,813,000 and recognized a portion of
a gain on sale of land and building of approximately $1,495,000. These two
sources of income enabled us to report the first full year net income in our
history of approximately $874,000. Prior to 2008, we had only received a minimal
amount of revenues, a number of years ago, from a small number of sales of CSRV
Engines, and from research and development activities. Prior to 2008, we
had not been profitable and had incurred substantial net losses since our
inception, including a net loss for the year ended December 31, 2007 of
approximately $2,539,000. The accumulated losses at December 31, 2008 amounted
to approximately $21,848,000. We may become unprofitable again and continue to
be unprofitable until the CSRV Engine is successfully introduced into the
marketplace, or we receive substantial licensing revenues and revenues from
research and development activities. These accumulated losses were substantially
related to research and development of our intellectual property, patent filing
and maintenance costs, write-off of certain offering costs and general and
administrative expenses in connection with our operations.





Coates
International, Ltd. is a Delaware corporation organized in October 1991 as
successor-in-interest to a Delaware corporation of the same name incorporated in
August 1988.  Our operations are located in Wall Township, New Jersey
(outside of New York City). We maintain websites at the following addresses: www.coatesengine.com and www.mostadvancedengine.com. Through a
link on our website to the SEC website, www.sec.gov,
we provide free access to our annual reports on Form 10-K, quarterly
reports on Form 10-Q, currentreports on
Form 8-K and amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as
reasonably practicable after electronic filing with the SEC. Our Code of
Business Conduct and Ethics for our directors, officers and employees can be
viewed on our website at www.coatesengine.com.  We
will post on our website any waivers of, or amendments to, such code of ethics.
Our website and the information contained therein or linked thereto are not
incorporated by reference into this report.




3




Background





The
internal combustion engine has been in use for more than 100 years and is the
most widely used engine in the world. Industry sources indicate that there are
more than 120 million new internal combustion engines built in the world every
year and that 40 million engines are rebuilt annually. In the late 1960's and
1970's, most internal combustion vehicle engines in the United States were
running at a compression ratio of 12 to 1 which resulted in an engine efficiency
of approximately 35 percent. The rest of the engine's power is lost in friction,
pumping and heat loss. When it was determined that lead additives in fuel had an
adverse effect on the environment, the use of unleaded gasoline became federally
mandated.  Unleaded gasoline is less desirable fuel than leaded
gasoline when considering fuel density and efficiency. The early use of unleaded
gasoline created a number of design problems, principally related to overheating
of the engine combustion chamber, pre-ignition and resultant
damage.  That problem was largely addressed by lowering engine
compression ratios, but at a cost of reduced efficiency from approximately 35%
to approximately 22%. This loss of efficiency reduces gas mileage and engine
performance. Efficiency can be increased by increasing “volumetric efficiency”
at maximum RPM’s, but conventional valves tend to “float” or bounce at higher
RPM’s and are consequently unable to deliver adequate air and fuel to the
cylinder. In an attempt to solve this problem, engine manufacturers increased
the number of valves per cylinder, but this approach created other problems that
cause unburned fuel to escape through the exhaust valves leading to a loss of
power, lower gas mileage and increased pollutants. In addition, variable valve
timing partially solved some of these additional problems, but that solution
involves additional moving parts that eventually degrade and wear out. Also,
variable valve timing on quick deceleration can cause piston and valve contact
with resultant serious damage. Furthermore, conventional valves with solid
“valve lifters” as opposed to hydraulic valve lifters must have clearances
readjusted periodically. In sum, conventional “poppet” valves have been the most
troublesome part of the internal combustion engine. The basic inefficiencies of
the conventional poppet valve design result in engine inefficiency and decreases
in engine life.





Conventional
poppet valves also have significant environmental deficiencies. Conventional
exhaust valves are lubricated with engine oil which burns in combustion and is
expelled directly into the atmosphere. Intake valves are also lubricated with
engine oil, which is washed off and forced into the combustion chamber with the
air and fuel mixture. This slows down the combustion process and produces
further emissions and eventually clogs the catalytic converter.Poppet valve engines
cannot use high compression ratios because they will become red hot and
pre-ignition will be experienced.





Management
believes that the patented CSRV system technology solves or significantly
mitigates these problems. Coates spherical rotary valves are vented and charged
on the opposite side of each valve sphere and rotate away from the combustion
chamber reducing engine combustion chamber heat and allowing higher compression
ratios that make the engine significantly more efficient and
powerful.





We have
adapted our patented technology to natural gas fueled industrial electric power
engine generators and intend to commence production upon securing sufficient new
sources of working capital for this purpose.





Markets





The
design of the Coates CSRV system technology provides us with the flexibility to
retrofit our existing internal combustion engines of all sizes and applications
to appeal to a number of different geographic and product markets. In addition,
the CSRV system technology has been designed to operate effectively on a wide
range of alternative fuels. Accordingly, there are no technical barriers that
need to be overcome in order to strategically target economically feasible
markets for products powered by internal combustion engines including, but not
limited to the following: engines for electric generators for various
applications ranging from home use to the largest industrial complexes to
augmented “grid” installations; engines to power motorcycles, automobiles, light
trucks, heavy trucks, machinery, railroads, marine engines, military equipment,
light aircraft, helicopters, lawn mowers, snowmobiles and jet skis,
etc.





According
to data in a table published by the Federal Highway Administration of the U.S.
Department of Transportation titled “Highway Statistics 2007” there were total
U.S. vehicle registrations for the fifty states as follows:





Automobiles
                                    
                                    
                                    Buses
                                    
                                    
                                    Trucks
                                    
                                    
                                    Total135,932,930
                                    
                                    
                                    834,436
                                    
                                    
                                    110,497,239
                                    
                                    
                                    247,264,605




4


Strategy





Our
long-term objective is to become a leader throughout the Americas in the design,
manufacture, licensing to third party manufacturers and sales and
distribution of internal combustion engines for a wide variety of uses. Our
primary targeted market is
the industrial electric power generator market. We have adapted
the CSRV System to manufacture our 14.0
liter inline, 6-cylinder, 855 cubic inch engine generator fueled by natural gas.
We have been
informed by Compliance and Research Services, Inc. of Plainfield New Jersey, a
federal Environmental Protection Agency-recognized, independent testing
facility, that our product as described above complies with the governmental
standards as set forth in Title 40 of the Code of Federal Regulations Part 1048,
that regulates environmental standards for natural gas powered industrial
engines. In parallel to penetrating the commercial/industrial generators market,
we intend  to adapt the CSRV System to be used in other markets in which
internal combustion engines are used, such as motor vehicles, motorcycles,
trucks, ships, trains, military equipment, light aircraft, helicopters and
others.




Operational
Plan





We have
recently completed development of the CSRV System-based generator engine and are
preparing to commence the production phase of our operations. Initially, we
intend to sell the engine/generators to Well to Wire Energy, Inc. ("WWE"). WWE has
delivered a firm purchase order for over 7,400 CSRV system technology Industrial
Electric Power Generators intended to be installed in oil fields throughout
Canada. Fulfillment of these orders is expected to occur over a five year
period. We intend to take advantage of the fact that essentially all the
components of the CSRV generator engine may be readily sourced and acquired from
subcontractors, and, accordingly, expect to manufacture the generator engine in
the two following ways:




●
            Assembly
      – to develop assembly lines within our premises.  We have
      been evaluating proposals from certain state officials interested in
      securing our commitment to establish large scale manufacturing operations
      within their state and expect to make a final decision in this regard
      during 2009.In
      March 2009, a formal committment from the State of Oklahoma outlining a
      package of various business and tax incentives that we would be eligible
      for if we agreed to set up large scale manufacturing operations in the
      city of Miami, Oklahoma. The package of business and tax incentives can be
      earned based on the extent to which we create qualified new jobs and make
      qualified capital expenditures. The maximum amount of business and tax
      incentives that we could earn under this commitment is approximately
      $788,000,000.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
      the technology to Original Equipment Manufacturers (“OEM'S”) – to take
      advantage of third party manufacturers’ production capacity by signing OEM
      agreements.




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.
 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 original
equipment manufacturers and/or distributors, additional payments from WWE for
the Escrow Release Payment and US Licensing fees, positive working capital
generated from sales of our CSRV products to WWE 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 their funds and low investor
confidence, has introduced additional risk and difficulty to our challenge to
secure such additional working capital.




5




Material
Agreements




License
Agreement – George J. Coates and Gregory Coates




On
October 23, 2006, we signed a license agreement with George J. Coates and
Gregory Coates (the “New Coates License Agreement”), that replaces license
agreements signed on December 22, 1997 and November 10, 2005. On April 6, 2007,
the New Coates License Agreement was amended and restated (the “Amended Coates
License Agreement”). The Amended Coates License Agreement became effective upon
execution. Under the Amended Coates License Agreement, George J. Coates and
Gregory Coates granted us an exclusive, perpetual, royalty-free, fully paid-up
license to the intellectual property that specifically relates to an internal
combustion engine that incorporates the CSRV System technology (the “CSRV
Engine”) and that is currently owned or controlled by them (the “CSRV
Intellectual Property”), plus any CSRV Intellectual Property that is developed
by them during their employment with us. The employment agreements with George
J. Coates and Gregory Coates contain two-year non-compete provisions relating to
the CSRV Intellectual Property in the event either of them is terminated for
cause, as defined, or if either of them terminates their employment without good
reason, as defined.




Under the
Amended Coates License Agreement, George J. Coates and Gregory Coates agreed
that they will not grant any licenses to any other party with respect to the
CSRV Intellectual Property in the licensed territory.




License
Agreement – Coates Trust




We did
not satisfy the working capital funding requirements of our license agreement
with the Coates Trust, dated October 23, 2006, covering the licensing of
intellectual property rights for the territory outside of the Western
Hemisphere.  On April 6, 2007, this agreement was formally
terminated.




Agreements
with Well to Wire Energy, Inc.





On
September 29, 1999, we signed a sublicense agreement with WWE, an oil and gas
company in Canada. This agreement exclusively licenses within Canada the use of
the Coates technology for industrial engines to be fueled by natural gas to
generate electrical power for the oil and gas industry (the “Canadian License”).
The agreement provided for a license fee of $5,000,000, of which a deposit
payment in the amount of $300,000 was made at that time. A separate research and
development agreement provided for WWE to pay us a $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. As of March 26, 2009, we have been paid a
total of approximately $3,528,000 by WWE under these agreements.





Additional
provisions of the Canadian License agreement are as follows:





●
            WWE
      shall have the exclusive right to use, lease and sell electric power
      generators that are based on the CSRV System technology within Canada for
      use in the oil and gas industry.


●
            WWE
      will have a specified right of first refusal to market the electric power
      generators worldwide in the oil and gas industry and landfill
      operations.


●
            Upon
      commencement of the production and distribution of the electric power
      generators, the minimum annual number of generators to be purchased by WWE
      in order to maintain exclusivity is 120. Until otherwise agreed between
      the parties, the price per generator shall be $150,000. In the event WWE
      fails to purchase the minimum 120 Coates generator engines during any
      year, WWE will automatically lose its exclusivity. In such a case, WWE
      would retain non-exclusive rights to continue to use the Coates generator
      engine in the territory of Canada.


●
            WWE
      shall not be required to pay us any royalties as part of the agreements
      between the parties.


●
            All
      licensed rights under the Coates License Agreement related to the CSRV
      System technology will remain with
Coates.





In April
2008, we entered into a conditional second sublicense agreement with
WWE for the territory of the United States (the “US License”). The US
License provides for a license fee of $50 million and annual minimum purchases
of Coates CSRV Systems as a condition of exclusivity.  The US license
has been deposited into an escrow account and the grant under the license is not
effective until the conditions for release from escrow are
satisfied.





The
escrow agreement was established to provide a more secure mechanism for us to
collect payments due under both the prior Canadian licensing and research and
development agreements and the new $50 million US License (the “Escrow
Agreement”). The Escrow Agreement provides that the US License shall be
held until WWE remits a release payment (the “Release Payment”). The
Release Payment consists of (i) an initial down payment required under the US
License of $1 million and (ii) $8.5 million in payment of the balance of the
monies due, at the date of the Escrow Agreement, to us in connection
with the license for the territory of Canada, including the Canadian License
agreement and the research and development agreement (the “Canadian
Agreements”). While the US License is held in escrow, there shall not be any
grant of license to WWE. WWE is expected to make non-refundable periodic
payments to us in unspecified amounts as partial payments of the Release Payment
until the Release Payment has been paid in full. The first $3.8 million of the
Release Payment, which has been designated as payment of the fees due under the
research and development Agreement, is being recognized as revenue at the time
the cash payments are received. WWE has made nonrefundable payments to us
totaling $1.5 million in prior years. For the year ended December 31, 2008, we
received approximately $1,813,000 of non-refundable payments from WWE which have
been recognized as research and development revenue. Upon full satisfaction
of the Release Payment, WWE would be granted a license for the territory of the
United States under the US License agreement.




6




WWE is a
privately held company and its ability to make the license payments due to us
and to honor the minimum purchase requirements under the licenses is dependent
on the success of its continued efforts to raise new equity capital. At
March 26, 2009, the remaining balance of the Release Payment was approximately
$7,472,000. Interest on the unpaid balance at 5% per annum of approximately
$298,000 is also due. To the extent that WWE is not successful or experiences
delays in raising such additional new equity capital, our cash flow, results of
operations and financial condition could be adversely affected.





WWE was
unable to remit the full amount of the Release Payment required under the Escrow
Agreement to be made by September 30, 2008 (the “Extended Payment Period”). In
recognition of WWE’s good faith effort to pay the Release Payment as evidenced
by the aggregate non-refundable payments already made under the Escrow
Agreement, in October 2008, we agreed to accommodate WWE’s request for an
additional extension of time to pay the full amount of the Release Payment under
the Escrow Agreement.





The
Extension Agreement provides that WWE shall have until April 30, 2009 to pay the
full balance of the Release Payment (the “Payment Extension Date”). Interest
shall be payable at the compounded rate of 5% per annum on the unpaid balance of
the Release Payment.  Such interest shall be recognized as income upon
receipt from WWE. The Extension Agreement also provides that the 75% of the net
proceeds from any offer of securities by WWE shall be applied towards the
Release Payment until the balance is paid in full. Should WWE fail to pay the
entire balance of the Release Payment by the Payment Extension Date, we would be
entitled to retain all monies paid and the research and development agreement,
License Agreements and Escrow Agreement would become automatically canceled
without WWE having any rights of redemption or
reinstatement.





The US
License would, if WWE is able to satisfy the Escrow Agreement release
provisions, 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 for the oil and gas industry and landfills.  Licensed Products
consist of CSRV Valve Systems, CSRV Valve Seals, CSRV Rotary Valve Spheres,
CSRV Valve Components, CSRV Engines for the Oil and Gas Industry and
Landfills.





The
manufacture of any Licensed Products by WWE is prohibited.  WWE is
required to procure all internal combustion engines incorporating the CSRV Valve
System from us or our designee. The license granted to WWE is exclusive within
the Territory, provided that WWE satisfies the minimum annual purchase
commitment of 120 internal combustion engines incorporating the CSRV System, the
Coates Engines and all component parts. The agreement also grants WWE 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 in the oil and gas industry
and landfill operations.





After
payment of the Release Payment required under the Escrow Agreement, the
remaining unpaid balance of the US License fee of $49 million is payable in
quarterly installments commencing October 27, 2008 in an amount equal to
WWE’s prior quarter net profits. As WWE has not generated a net profit to date,
no quarterly installment payments have been required. In any event, the entire
balance of the licensing fee must be paid in full on or before February 12,
2012.





Acceleration
of the balance of the licensing fee payments shall be required in the event that
WWE completes a stock offering or private placement offering.  The
entire unpaid balance of the licensing fee shall become due and payable if WWE
raises $100 million or more from such offering.




7




In May
2008, WWE secured an equipment lease finance commitment from Canada West
Corporate Finance, Inc. (“Canada West”), which is to be utilized for its
Coates CSRV engine generator purchases over the next five years pursuant to its
licensing agreement with us. The five-year WWE business plan on which this
agreement was based provides for the purchase of approximately 7,400 Engine
Generators.  On October 1, 2008, this financing agreement was
reconfirmed, expanded in scope and increased in amount.  WWE can now
depend on this agreement to finance any of its purchases of equipment from us.
In addition, the price per unit that may be paid to us by WWE under this
facility was increased to $222,000. Accordingly, should WWE fulfill its five
year business plan, this agreement could exceed an aggregate amount of $1.6
Billion. The current economic environment, which is characterized by tight
credit markets, investor uncertainty about how to safely invest their funds and
low investor confidence, has introduced additional risk and difficulty for
borrowers. Accordingly, there can be no assurance that tight credit markets will
not affect the availability of funds under the financing commitment obtained
from Canada West by WWE.





License
Agreement with Coates Motorcycle Company, Ltd.





On April
30, 2003, we amended our license agreement with Coates Motorcycle (the “Amended
Motorcycle License Agreement”).  Pursuant to a prior license
agreement, we granted certain exclusive licenses in exchange for approximately
51% of the common shares of Coates Motorcycle.  In addition, we had an
anti-dilution right. The Amended Motorcycle License Agreement expanded the
license rights granted and removed the anti-dilution provision in exchange for
1,000,000 common shares of Coates Motorcycle. As a result of these transactions,
we own 3,558,000 shares of Coates Motorcycle, representing a 30% ownership
interest.  We are under no obligation to provide any funding or
support to Coates Motorcycle under any circumstances. Under the Amended
Motorcycle License Agreement, we were granted an exclusive sublicense for North
America, South America and Central America and their territories (collectively,
the "Western Hemisphere") to make, use and sell motorcycles utilizing the CSRV
Technology. At this time, Coates Motorcycle has expended all of its cash and has
curtailed its operations.





Transaction
with Dutchess Private Equities Fund, Ltd.




On April
26, 2007, we entered into an Investment Agreement (the “Agreement”) with
Dutchess Private Equities Fund, Ltd. (“Dutchess”) to provide us with an equity
line of credit. Pursuant to this Agreement, Dutchess is contractually
obligated to purchase up to $10,000,000 of our Stock over the course
of up to 36 months. The amount that we shall be entitled to request from
each of the purchase “Puts”, shall be equal to either 1) $500,000 or 2) 200% of
the average daily volume (U.S. market only) (“ADV”), multiplied by the average
of the three (3) daily closing bid prices immediately preceding the Put Date.
 The ADV shall be computed using the ten (10) trading days prior to the Put
Date. The Purchase Price for the common stock identified in the Put Notice shall
be set at ninety-three percent (93%) of the lowest closing bid price of the
common stock during the Pricing Period. The pricing period shall be the five (5)
consecutive trading days immediately after the Put Notice Date. There are Put
restrictions applied on days between the Put Date and the Closing Date with
respect to that Put.  During this interim period we shall not be entitled
to deliver another Put Notice.




We shall
automatically withdraw that portion of the Put Notice amount, if the Market
Price with respect to that Put does not meet the Minimum Acceptable Price.
 The Minimum Acceptable Price is defined as seventy-five (75%) of the
closing bid price of the common stock for the three (3) trading days prior to
the Put Date.





In
connection with the Agreement, we entered into a Registration Rights Agreement
with Dutchess (“Registration Agreement”). Pursuant to the Registration
Agreement, we filed a registration statement with the Securities and Exchange
Commission covering the shares of common stock underlying the Investment
Agreement. This registration statement was declared effective by the SEC on June
22, 2007. During the years ended December 31, 2008 and 2007, we sold 15,000 and
2,341,803 shares of our common stock, respectively, under this equity line of
credit and received proceeds of approximately $8,000 and $1,216,000,
respectively.





Placement
Agency Agreement with Stonegate Securities, Inc.





On
December 21, 2007, we entered into a placement agent agreement with Stonegate
Securities, Inc. (“Stonegate”) to act as our placement
agent.   Stonegate has the right during the Contract Period to
identify for us prospective Purchasers in one or more Placements of Securities,
the type and dollar amount being as mutually agreed to by the Parties. The
agreement may be cancelled by either party upon ten (10) days written
notice.




8




As
compensation for services rendered by Stonegate in connection with the
Placements, we have agreed to pay Stonegate a fee of eight percent (8%) of the
gross proceeds from the sale of Securities in the Placements.  No fees
shall be due and payable in connection with sales of Securities in the Placement
to investors not introduced to us by Stonegate or by a direct or indirect party
previously introduced to us as a result of the efforts of Stonegate. As
compensation for its initial due diligence efforts, in 2007, we delivered to
Stonegate’s designee 200,000 fully paid non-assessable restricted shares of our
common stock.  The value of these shares on the date of issuance was
approximately $85,000 and was included in general and administrative costs for
the year ended December 31, 2007.




Upon
closing of a Placement, we agreed to issue to Stonegate restricted shares of our
common stock in an amount that is equal to two percent (2%) of the total number
of shares of common stock sold, and/or in the event of a sale of convertible
securities, the number of shares of common stock that would be potentially
received upon a conversion of any convertible securities sold in the
Placement.  Such number of shares to be issued to Stonegate shall be
reduced by the 200,000 shares set forth above.




We shall
also reimburse Stonegate for reasonable, actual out-of-pocket expenses incurred
by Stonegate, provided, however, that such amount in total shall not exceed one
percent (1%) of the gross proceeds of securities placed pursuant to this
Placement Agreement.





Competition





Management
believes that the Coates generator engine prototypes which are based on the CSRV
System will provide substantially enhanced efficiencies in power generation and
longevity.  We believe that the Coates generator engine will
outperform other comparable natural gas-fueled electric generator engines
currently utilized in the energy conversion market.





Notwithstanding
our perceived competitive advantages, the power generation market is a highly
competitive industry currently occupied by extremely large companies such as
Caterpillar, Inc., which owns MAK, Perkins and FG Wilson, Detroit Diesel
Corporation, AB Volvo, Cummins and Marathon, among others. These companies have
far greater financial and other resources than we do and already
occupy segments of the power generation market. In order to successfully
penetrate this industry, the Coates generator engine will have to produce the
performance and durability results anticipated by management and sell at a price
or prices that will enable it to effectively compete and gain entrance into this
market.





Parts
and Supplies





To date,
management has utilized the services of various vendors and manufacturers
available throughout the United States to provide all of the parts necessary to
assemble the Coates generator engine. We expect to continue to purchase all of
our raw materials and parts, manufactured to our specifications, from a wide
assortment of suppliers. We have signed a letter of intent with Marathon
Electric Manufacturing Corp. for the supply of generators and components. We
also entered into an agreement with Cummins Power Systems (part of Cummins
Inc.) to supply industrial engine blocks and components to us for our
manufacturing activities. We intend to commence the assembly of the Coates
generator engines at our New Jersey facility and to acquire additional
facilities to increase our manufacturing capacity, as needed.





Licenses
and Patents





The
Amended Coates License Agreement grants us an exclusive, perpetual,
royalty-free, fully paid-up license to use in North, Central and South America,
all intellectual property rights that are currently owned or controlled by the
licensors that directly relate to an internal combustion engine that includes
the CSRV Engine. The license also covers any new or improved technology and
related intellectual property rights that are directly related to the CSRV
Engine developed by the licensors during their employment with us.




Included
in the licensed intellectual property rights are 17 patents registered in the
United States; certain patents registered in Canada, Mexico and in countries in
Central and South America relating to the CSRV System; and one U.S. patent
application filed by Mr. George Coates. These patents are owned by George J.
Coates and Gregory Coates.  Under our license agreement, we are
responsible for all costs incurred relating to the ongoing maintenance of the
patents. For a description of our sublicense agreement with Coates Motorcycle
Company, see Item 12, “Certain Relationships and Related
Transactions”.




9




We rely
upon patents, trade secrets, know-how and continuing technological innovation to
develop and maintain our competitive position. We cannot assure you that we can
limit unauthorized or wrongful disclosures of trade secrets or otherwise
confidential information. In addition, to the extent we rely on trade secrets
and know-how to maintain our competitive technological position, we cannot
assure you that others may not independently develop the same, similar or
superior techniques.





Environmental
Regulatory Compliance





All of
our new engines, including the Coates generator engine, will be subject to
extensive environmental laws, rules and regulations that impose standards for
emissions and noise. Initially, compliance with the emissions standards
promulgated by the U.S. Environmental Protection Agency ("EPA"), as well as
those imposed by the State of New Jersey and other jurisdictions where we expect
our engines will be used, will have to be achieved in order to successfully
market the Coates generator engine. When selling individual engines, we are not
subject to the governmental standards as set forth in 40CFR (Code of Federal
Regulations) 1048, which regulates environmental standards for natural
gas-powered industrial engines. In this case, the purchaser or Licensee becomes
responsible for complying with applicable governmental standards in their
territory.  Our natural gas powered engine/generators comply with
governmental standards as set forth in 40CFR (Code of Federal Regulations) 1048,
that regulates environmental standards for natural gas-powered industrial
engines. Our ability to comply with applicable and future emissions standards is
necessary for us to enter the power generation and other markets. Failure to
comply with these standards could result in material adverse effect on our
business and financial condition.





Employees





At
December 31, 2008, we had 8 employees, including George J. Coates and his son
Gregory Coates, who perform management, assembly and research and development
functions. Bernadette Coates, the spouse of George J. Coates, is employed as
administrative manager for the Company. We subcontract for certain labor
services, parts and materials from Coates Precision Engineering, Inc., a
corporation owned by George J. Coates, to which, during the years ended December
31, 2008 and 2007, we paid approximately $500 and $5,000,
respectively.





Item 1A. Risk
Factors





The
following risk factors should be considered carefully in addition to the other
information contained in this report. This report contains forward-looking
statements. Forward-looking statements relate to future events or our future
financial performance. We generally identify forward-looking statements by
terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,”
“could,” “intends,” “target,” “projects,” “contemplates,” “believes,”
“estimates,” “predicts,” “potential” or “continue” or the negative of these
terms or other similar words. These statements are only predictions. The outcome
of the events described in these forward-looking statements is subject to known
and unknown risks, uncertainties and other factors that may cause our customers’
or our industry’s actual results, levels of activity, performance or
achievements expressed or implied by these forward-looking statements, to
differ. “Risk Factors,” “Management’s Discussion and Analysis of Financial
Condition and Results of Operations” and “Business,” as well as other sections
in this report, discuss some of the factors that could contribute to these
differences.





The
forward-looking statements made in this report relate only to events as of the
date on which the statements are made. We undertake no obligation to update any
forward-looking statement to reflect events or circumstances after the date on
which the statement is made or to reflect the occurrence of unanticipated
events.





This
report also contains market data related to our business and industry. These
market data include projections that are based on a number of assumptions. If
these assumptions turn out to be incorrect, actual results may differ from the
projections based on these assumptions. As a result, our markets may not grow at
the rates projected by these data, or at all. The failure of these markets to
grow at these projected rates may have a material adverse effect on our
business, results of operations, financial condition and the market price of our
common stock.




10




The
following risk factors relate to our financial condition:





Going
Concern





As shown
in our financial statements beginning on Page F-1, we have incurred
recurring losses from operations through 2007, and as of December 31, 2008, had
a Stockholders’ Deficiency of approximately $1,098,000. These factors raise
substantial doubt about our ability to continue as a going concern. In addition,
the current economic environment, which is characterized by tight credit
markets, investor uncertainty about how to safely invest their funds and low
investor confidence, has introduced additional risk and difficulty to our
challenge to secure needed additional working capital. Our Independent
Registered Public Accountants have stated in their Auditor’s Report dated March
30, 2009 with respect to our financial statements as of and for the year ended
December 31, 2008 that these circumstances raise substantial doubt about our
ability to continue as a going concern.





Management
has been closely monitoring variable costs and intends to restrict such variable
costs to those expenses that are necessary to complete activities related to
preparing for commencement of the production phase of operations, identifying
additional sources of working capital and general administrative costs in
support of such activities. We continue to actively seek new sources of working
capital. Our financial statements do not include any adjustments that might be
necessary if we are unable to continue as a going concern.





We
have significant immediate capital needs, and our ability to raise funds is
highly uncertain.




We will
need additional financing in the near future for a number of uses,
including:





●
            Purchasing
      raw material inventory and hiring plant workers to commence our production
      phase●
            Expanding
      manufacturing capacity●
            Developing
      an expanded management team to oversee the expanded scope of our operating
      activities upon commencement of production●
            Developing
      our engineering, administrative and marketing and sales
      organizations●
            Expanding
      our research and development programs with respect to the basic CSRV
      technology and applying the CSRV technology to engines used in various
      commercially viable applications●
            Implementation
      of new systems, processes and procedures to support
  growth.





Additional
financing may not be available on terms acceptable to us or may not be available
at all.





As
      with any business, many aspects of our operations and our future outlook
      are subject to events and influences which are not within our control,
      such as the current worldwide economic crisis.  This could have
      an adverse impact on us and our results of operations. For
      example:




●
            The
      current severe limitation on the availability of credit and investor
      uncertainty could result in delays or the inability to acquire additional
      working capital needed to commence meaningful
  production.●
            WWE
      may experience additional challenges and delays in raising additional
      equity capital needed to make the remaining balance of the Release Payment
      due to us under the Escrow Agreement.●
            Demand
      for our technology and products could be significantly
      reduced.●
            Estimates
      used in the preparation of our financial statements may need to be
      revised.





The
following risk factors relate to our Product Development:





To date,
we have only received a portion of the revenues from our research and
development agreement with WWE and a number of years ago, from a small number of
sales of engines, which incorporated the CSRV technology and from research and
development activities in connection with a terminated license agreement. Until
2008, we have never been profitable for a full fiscal year. Our net income in
2008 of approximately $874,000 included a portion of the gain on sale of
property in the amount of approximately $1,495,000.




None of
the cash needed to finance our business has come from sales of engines in recent
years. We expect to continue to incur losses until we commence production and
sale of products incorporating our CSRV system technology. We may not be
profitable or operating cash flow positive in 2009 unless we receive
payments from WWE as described under “Material Agreements” above, can begin to
generate positive cash flows from sales or receive cash proceeds from
new licensing agreements for our CSRV system technology.  In addition, we
may not be profitable or operating cash flow positive for several additional
years after 2009.




11




The
Coates Engine may not have the performance characteristics and longevity that we
expect.




The
Coates Engine has been tested in a “real world” environment to a very limited
degree. Commercial use of our industrial engines may not have the performance
characteristics that we expect. Similarly, until the Coates Engine has been in
use for a substantial period of time, there is no certain way to ascertain its
expected longevity. Superior performance and longevity are essential elements of
our ability to penetrate the power generation and other markets. Our failure to
do so would have a material adverse effect on our business and, unless remedied
on a timely basis, we might  be forced to close our
operations.





The
following risk factors relate to our Business:





We
are significantly dependent on our founder, George J. Coates.




We are
significantly dependent on our founder, George J. Coates, and to a lesser extent
his son, Gregory Coates. We expect that our future market capitalization will be
highly dependent on the productivity of George Coates. If the employment of
George Coates was to cease for any reason before we have hired additional senior
management and engineering personnel, our business would be materially adversely
affected and we might have to discontinue operations. We do not maintain key
person insurance on either George J. Coates or Gregory Coates.





Our
industry is subject to intense competition, and our competitors are
well-entrenched and are among the world’s largest companies.




The power
generation market is a highly competitive industry currently occupied by
extremely large companies. These companies have far greater financial and other
resources than we do and already occupy segments of the power generation market.
In order to successfully penetrate this industry, the Coates Engine will have to
produce the performance and durability results anticipated by management and
sell at a price or prices that will enable it to effectively compete and gain
entrance into this market.





Our
short term business success is highly dependent upon our United States and
Canadian licensing and research and development agreements with
WWE.





The
initial monies due under the United States and Canadian licensing agreements and
the research and development agreement with WWE represent potential new sources
of cash due to us totaling approximately $8.0 million during 2009. In addition,
the annual minimum purchase requirements under the both the United States and
Canadian licensing agreements of 120 engine generators per year will not become
effective unless WWE pays us the remaining balance of the Release Payment on a
timely basis.  WWE is a privately held company. Its ability to make
the license payments due to us and to honor the minimum purchase requirements
under the licenses is dependent on its success in raising new equity capital. As
of March 26, 2009, WWE has made nonrefundable payments to us aggregating
approximately $3,528,000. There can be no assurance that WWE will be successful
in raising the additional equity capital required for this
purpose.  To the extent that WWE is not successful or experiences
delays in raising such new equity capital, our cash flow, results of operations
and financial condition could be adversely affected.  We are
continuing discussions with a number of other third parties for the licensing of
our technology; however, there can be no assurance that we will be able to
secure new licensing agreements.




We
have no marketing and sales experience.




We have
no marketing or sales experience. The sales process is expected to be lengthy,
in part because of skepticism about the performance of the Coates Engine. We are
evaluating alternative marketing and sales channels, distributors, sublicensees
and marketing partners. We may never successfully market and sell the Coates
Engine.




12




We have only a token number of
employees, and in order to grow our business we will need to hire significant
additional personnel.




We need
to hire, train and retain additional employees for all aspects of our business
if we are to achieve our sales goals. Our success will also depend on our
ability to attract and retain a staff of qualified managerial and engineering
personnel. Qualified individuals are in high demand and are often subject to
competing offers. We cannot be certain that we will be able to attract and
retain the qualified personnel we need for our business. If we are unable to
hire additional personnel as needed, it would have a material adverse effect on
our business and operations.  In particular, we need trained engineers
and sales personnel to educate potential customers and provide post-installation
customer support.





The
following risk factors relate to our common stock:




There is a limited public market for
our outstandingcommon
stock, and there are
restrictions on transferability.




There is
presently a limited public market for our outstanding common stock. Our common
stock is quoted on the OTC Bulletin Board. Trading in stock quoted on the OTC
Bulletin Board is often thin and characterized by wide fluctuations in trading
prices, due to many factors that may have little to do with our operations or
business prospects. Moreover, the OTC Bulletin Board is not a stock exchange,
and trading of securities on the OTC Bulletin Board is more sporadic than the
trading of securities listed on a quotation system or a stock exchange. Shares
of our common stock have not been registered and cannot be disposed of unless
the requirements of Rule 144 under the Securities Act can be
satisfied.





Trading
of our common stock is restricted by the SEC’S “penny stock” regulations which
may limit a stockholder’s ability to buy and sell our stock.




The
Securities and Exchange Commission has adopted regulations which generally
define a “penny stock” to be any equity security that has a market price less
than $5.00 per share or an exercise price of less than $5.00 per share, subject
to certain exceptions. Our securities will likely be covered by the penny stock
rules, which impose additional sales practice requirements on broker-dealers who
sell to persons other than established customers and accredited investors. The
penny stock rules require a broker-dealer, prior to a transaction in a penny
stock not otherwise exempt from the rules, to deliver a standardized risk
disclosure document in a form prepared by the Securities and Exchange Commission
that provides information about penny stocks and the nature and level of risks
in the penny stock market. The broker-dealer also must provide the customer with
current bid and other quotations for the penny stock, the compensation of the
broker-dealer and its salesperson in the transaction and monthly account
statement showing the market value of each penny stock held in the customer’s
account. The bid and offer quotations, and the broker-dealer and salesperson
compensation information, must be given to the customer orally or in writing
prior to effecting the transaction and must be given to the customer in writing
before or with the customer’s confirmation. In addition, the penny stock rules
require that prior to a transaction in a penny stock not otherwise exempt from
these rules, the broker-dealer must make a special written determination that
the penny stock is a suitable investment for the purchaser and receive the
purchaser’s written agreement to the transaction. These disclosure and
suitability requirements may have the effect of reducing the level of trading
activity in the secondary market for a stock that is subject to these penny
stock rules. Consequently, these penny stock rules may affect the ability of
broker-dealers to trade our securities. We believe that the penny stock rules
discourage investor interest in and limit the marketability of our capital
stock. Trading of our capital stock may be restricted by the SEC’s “penny stock”
regulations which may limit a stockholder’s ability to buy and sell our
stock.





George
J. Coates and his family own a majority of our common stock allowing him to
unilaterally determine the outcome of all matters submitted to our stockholders
for approval, which influence may or may not conflict with our interests and the
interests of our other stockholders.




George J.
Coates, together with members of his family and related trusts, beneficially own
more than 80% of the outstanding shares of common stock at March 26, 2009 and
will therefore be able to unilaterally determine the outcome of all matters
submitted to our stockholders for approval, including the election of our
directors and other corporate actions.




13




Because
we do not intend to pay dividends for the foreseeable future, stockholders will
benefit from an investment in our common stock only if it appreciates in
value.




We have
never declared or paid any cash dividends on our common stock. We currently
intend to retain our future earnings, if any, to finance further research and
development, commence production of the Coates Engine and general and
administrative expenses and do not expect to pay any cash dividends in the
foreseeable future. As a result, the success of an investment in our common
stock will depend upon any future appreciation in its value. There is no
guarantee that our common stock will appreciate in value or even maintain the
price at which stockholders have purchased their shares.




Trading
in our common stock may be volatile, which may result in substantial declines in
its market price.




Our
common stock is likely to experience significant volatility in response to
periodic variations in:





●
            Our
      success in commencing our production phase of
operations●
            Results
      of testing of the CSRV technology as it is designed into various
      commercially feasible applications●
            Our
      prospects for entering into new potentially profitable license agreements
      for our technology●
            Performance
      of the Coates Engine in the field●
            Improvements
      in engine technology by our competitors●
            Changes
      in general conditions in the economy or the financial
    markets





The
market has also experienced significant volatility which has affected the market
prices of securities issued by many companies; often for reasons unrelated to
their operating performance, and may adversely affect the price of our common
stock. The market for our common stock is limited. We cannot assure that an
active trading market can be maintained. In such case, our stockholders may find
it difficult to dispose of shares of our common stock and, as a result, may
suffer a loss of all or a substantial portion of their investment.





Existing
stockholders may experience significant dilution from the sale of our common
stock pursuant to the investment agreement.





The sale
of our common stock to Dutchess Private Equities Fund, Ltd. in
accordance with the Investment Agreement will have a dilutive impact on our
shareholders.  As a result, our net income per share, if any, could
decrease in future periods and the market price of our common stock could
decline. In addition, the lower our stock price is at the time we exercise our
put options, the more shares of our common stock we will have to issue to
Dutchess Private Equities Fund, Ltd. in order to drawdown on the Equity Line of
Credit. If our stock price decreases, then our existing shareholders would
experience greater dilution.





The
perceived risk of dilution may cause our stockholders to sell their shares,
which would contribute to a decline in the price of our common stock. Moreover,
the perceived risk of dilution and the resulting downward pressure on our stock
price could encourage investors to engage in short sales of our common stock. By
increasing the number of shares offered for sale, material amounts of short
selling could further contribute to progressive price declines in our common
stock.





Dutchess
Private Equities Fund, Ltd. will pay less than the then-prevailing market price
of our common stock which could cause the price of our common stock to
decline.





Our
 common  stock to be issued  under the  Investment
 Agreement  will be purchased at a seven percent (7%) discount
 to the lowest  closing  bid price  during the five trading
days immediately following our notice to Dutchess Private Equities Fund, Ltd. of
our election to exercise our “put” rights.  Each issuance of shares of our
common stock will dilute the value of each share of common stock due to the
increase in the number of outstanding shares. Dutchess Private Equities Fund,
Ltd. has a financial incentive to sell our shares immediately upon
receiving the shares to realize the profit between the
discounted price and the market price. If Dutchess Private Equities Fund,
Ltd. sells our shares, the price of our common stock may decrease.  If our
stock price decreases, Dutchess Private Equities Fund, Ltd. may have a
further incentive to sell such shares.  Accordingly, the discounted
sales price in the Investment Agreement may cause the price of our
common stock to decline.





Item
1B. Unresolved Staff Comments.





N/A




14




Item
2.  Properties.





Our
executive offices and testing facility are located in an approximately 25,000
square foot building in Wall Township, New Jersey, outside of New York
City.  We entered into a sale/leaseback arrangement covering this
property, which expires November 30, 2011.  This lease agreement with
the purchaser provides for monthly payments of $32,500 over a six year period.
Under the lease agreement, we are responsible for all real estate taxes and
operating expenses of the property, including insurance.





In our
research and development operations, we own and utilize milling machines,
lathes, grinders, hydraulic lifts and presses, tooling, dynamometers emission
testing machines and computerized drafting and printing equipment. All such
equipment is in good condition.





Item
3.  Legal Proceedings.





In March
2004, CIL, 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 CIL and WWE
against Gary Sommer, a principal of one of the plaintiffs. A plaintiff contends
that he is 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 us provided, inter alia, that a $500,000 deposit
made by 1107 to us would convert to shares of our restricted common stock if
certain conditions were not met by 1107. We maintain that 1107 did not fulfill
such conditions, and failed to make a certain payment, and therefore, the
deposit converted into shares of our restricted common stock. Mr. Neff’s claims
against CIL and George Coates had been dismissed by the trial court. That
dismissal was affirmed on appeal and the claims of two other plaintiff companies
were reinstated by the appellate court upon payment by plaintiffs of a court
imposed sanction of $7,500. An additional sanction and costs were paid to WWE.
The claims asserted by all of the parties were settled in March 2009 through
mediation. Pursuant to the terms of that settlement, CIL and WWE agreed to pay
1107 a total of $185,000. The obligation to fund the settlement was shared
equally by us and WWE. Our $92,500 portion of the settlement has been accrued
and is included in accounts payable and accrued liabilities our financial
statements as of December 31, 2008. All parties executed mutual releases
and all claims have been dismissed with prejudice, without costs to any
party. As a condition of the settlement, Mr. Sommer endorsed to CIL a stock
certificate evidencing 25,000 shares of our common stock. The shares of stock
evidenced by that stock certificate have been retired and restored to
authorized, unissued common stock status. We were not required to return
the $500,000 deposit originally made by 1107 and previously converted into
shares of our common stock.





In April
2007, we received a demand letter from a law firm requesting payment of
approximately $77,000 in connection with a promissory note issued to the law
firm as security for the payment of future services to us. We have notified the
holder of this note that we do not intend to honor the promissory note because
the law firm did not provide the services contemplated to be performed as
consideration for the promissory note. No further action to pursue collection of
this promissory note has been taken to date by the holder. At this time, it is
not possible to reasonably estimate the outcome of this matter, and,
accordingly, no amount has been accrued.





Mark D.
Goldsmith, a former executive of CIL, filed suit on January 25, 2008, in which
he asserts that we are liable to him for breach of an employment contract. 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 Goldsmith is baseless because we had cause to
terminate our relationship with Mr. Goldsmith. We intend to vigorously defend
this lawsuit and have instituted a counterclaim against Mr. Goldsmith. We
believe that Mr. Goldsmith misrepresented his background and capabilities in
order to induce us and/or Coates Motorcycle Company, Ltd. ("CMC") to hire him.
We are also contending that certain of Mr. Goldsmith's business decisions were
made to further his self interest rather than the interests of CIL. We believe
that Mr. Goldsmith's claims have no basis in fact, and, accordingly that the
outcome of this legal action will not be material to our financial condition or
results of operations. Mr. Goldsmith has been served interrogatories, provided a
notice to produce documents and give deposition. On April 8, 2008, we received
notice that the court assigned this matter to mandatory mediation. A mediation
session was held on June 23, 2008. Mediation was not successful. Mr. Goldsmith's
deposition was taken on February 10, 2009. We are evaluating whether the
information disclosed in that deposition warrants the filing of a dispositive
motion. We intend to vigorously defend against Mr. Goldsmith’s claims and pursue
our counterclaims.




We have
without prejudice to our position, accrued compensation under his employment
agreement for accounting purposes only, of approximately $96,000 of his salary
during 2007. Although we do not intend to make any payments to Mr. Goldsmith in
connection with this employment agreement, this amount has been included in
accounts payable and accrued liabilities our financial statements.





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





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




·
            No
      matters were submitted to a stockholder vote in
  2008.






15


PART
II
 
 Item
5.  Market for Registrant’s Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities.
 
 Market
  Our
common stock began trading on the Over the Counter Bulletin Board (“OTC Bulletin
Board”), ticker symbol COTE, on February 26, 2007.  The closing price
of the common stock on March 26, 2009 was $0.36 per share. The high and low bid
prices for trading of our stock for each of the quarters during 2008 and the
partial trading period in the 1st Qtr of
the 2007 and the three full quarters of 2007 are as follows:
 
 1st
      Quarter
                    2008
                  2nd
      Quarter
                    2008
                  3rd
      Quarter
                    2008
                  4th
      Quarter
                    2008High
                  $0.58
                  $0.57
                  $0.46
                  $0.45Low
                  $0.35
                  $0.28
                  $0.11
                  $0.13For
      the trading period from February 26 to March 31, 2007
                  2nd
      Quarter
                    2007
                  3rd
      Quarter
                    2007
                  4th
      Quarter
                    2007High
                  $4.00
                  $2.05
                  $0.85
                  $0.85Low
                  $0.15
                  $0.2465
                  $0.25
                  $0.25
 
 
 Holders
  At March
26, 2009 the number of holders of record of our common stock was
800.
 
 Recent
Sales of Unregistered Securities
  In March
2009, we sold 838,096 shares of our common stock, 333,333 warrants to
purchase one share of our common stock at an exercise price of $0.30 per share
and 85,714 warrants to purchase one share of our common stock at an exercise
price of $0.35 per share in a private sales of unregistered,
restricted securities to the son of a director pursuant to stock purchase
agreements and received net proceeds of $260,000.
  Dividends
  We have
never declared or paid any cash dividends on shares of our common or preferred
stock. We currently intend to retain earnings, if any, to fund the development
and growth of our business and do not anticipate paying cash dividends in the
foreseeable future. Our payment of any future dividends will be at the
discretion of our board of directors after taking into account various factors,
including our financial condition, operating results, cash needs and growth
plans.


Securities
Authorized for Issuance Under Equity Compensation Plans




The
following table sets forth information with respect to our securities authorized
for issuance as of March 26, 2009, under our 2006 Stock Option and Incentive
Plan:




Number
      of securities to be issued upon exercise of outstanding options, rights
      and warrants
                      
                      
                      Weighted
      average exercise price of outstanding options, rights and
      warrants
                      
                      
                      Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in column
      (a))(a)
                      
                      
                      (b)
                      
                      
                      (c)Equity
      Compensation plans approved by security holders
                      
                      
                      3,525,000
                      
                      
                      $
                      0.37
                      
                      
                      
                      8,975,000Equity
      Compensation plans without approval by security holders
                      
                      None
                      
                      
                      
                      N/A
                      
                      
                      
                      N/ATotal
                      
                      
                      3,525,000
                      
                      
                      $
                      0.37
                      
                      
                      
                      8,975,000





Our 2006
Stock Option and Incentive Plan (the “Stock Plan”) was adopted by our Board of
Directors 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. 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.




16




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.





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.





Issuer
Purchases of Equity Securities.








Period
                
                Total
      Number of Shares Purchased
                
                
                Average
      Price Paid per Share
                
                
                Total
      Number of Shares Purchased as Part of Publicly Announced Plans or
      Programs
                
                
                Maximum
      Number of Shares that May Yet be Purchased Under the Plans or
      ProgramsSeptember
      2008
                
                
                300,000
                
                
                $
                0.30
                
                
                
                -
                
                
                
                1,700,000Total
                
                
                300,000
                
                
                $
                0.30
                
                
                
                -
                
                
                
                1,700,000




Item
6. Selected Financial Data.





N/A




17




Item
7.  Management’s Discussion and Analysis of Financial Condition and
Results of Operation.





Background




We have
completed development of the Coates spherical rotary valve engine technology.
This technology has been successfully applied to natural gas fueled industrial
electric power generator engines, automobile engines, residential generators and
high performance racing car engines. We have also completed designing and
retrofitting the CSRV technology into a diesel engine for heavy trucks. The next
steps on this diesel truck engine include completing the mapping of the computer
circuitry for certain truck functions powered by the engine and
testing.  Limited production of CSRV electric power engine generators
to fulfill orders from WWE has been temporarily delayed in order to commit our
full attention to an important new opportunity in China and in order to secure
additional working capital for production parts. We have been 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 location,
shipping logistics, manufacturing facility and qualified labor pool for such
large scale manufacturing.  We continue to actively seek out new
sources of working capital to fund our manufacturing activities. We are also
engaged in new research and development activities in connection with applying
this technology to other commercially feasible internal combustion engine
applications and intend to manufacture engines and/or license the technology to
third party OEM's for multiple other applications and uses.





Significant
Estimates





The
preparation of our financial statements in conformity with generally accepted
accounting principles 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
reported amounts of revenues and expenses during the reporting period. These
significant estimates include assigning useful lives to our property, plant and
equipment, determining an appropriate amount to reserve for obsolete and slow
moving inventory, 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.





Results
of Operations for the Years Ended December 31, 2008 and 2007




Revenues
for the year ended December 31, 2008, which amounted to approximately
$3,308,000, consisted of revenues from research and development of approximately
$1,813,000 and recognition of a gain on sale of land and building of
approximately $1,495,000.  The revenue from research and development was
comprised of non-refundable partial payments of the Release Payment provided for
by our Escrow Agreement with WWE established in connection with our licensing
and research and development agreements. We did not have any revenues in 2007.
Our principal business activities and efforts during 2008 and 2007 were devoted
to (i) completion of the research, development, manufacturing and testing of the
prototype Coates Engines for WWE, (ii) applying our technology to engines for
products in additional economically viable  markets, (iii) developing
plans for transitioning to large scale manufacturing in the event that our
technology achieves widespread market acceptance; and, (iv) undertaking efforts
to raise additional working capital.





Research
and development expenses increased to approximately $676,000 in 2008 from
approximately $606,000 in 2007. This increase primarily resulted from an
increase in research and development labor costs to approximately $436,000 in
2008 from approximately $284,000 in 2007 and an increase in inventory
utilized in research and development activities in 2008 to
approximately $78,000 from approximately $30,000 utilized in 2007,
partially offset by a decrease in stock-based compensation expense included in
research and development expenses to approximately $162,000 in 2008 from
approximately $286,000 in 2007.





We
achieved a reduction in general and administrative expenses to approximately
$1,274,000 in 2008 from approximately $1,493,000 in 2007. This approximately
($219,000), or (14.7%) decrease primarily resulted from the elimination of
offering costs of approximately ($100,000), a reduction of stock-based
compensation expense included general and administrative expenses amounting to
approximately ($73,000), a reduction in legal and professional fees of
approximately ($42,000), a reduction in testing expenses of approximately
($31,000), a reduction of compensation and benefits included in general and
administrative expenses of approximately ($26,000), a reduction of office
expenses incurred of approximately ($12,000) and a reduction of parts expense of
approximately ($10,000),  partially offset by an increase in rent
expense upon recognition of the sale of land and building subject to the
sale/leaseback agreement of approximately $33,000, an increase in marketing and
trade show expenses of approximately $28,000 and an increase in other general
and administrative expenses.




18




Depreciation
and amortization expense decreased to approximately $36,000 in 2008 from
approximately $49,000 in 2007 primarily as a result of discontinuing
depreciation on equipment that became fully depreciated.





A loss on
settlement of litigation amounting to $92,500 for the year ended December 31,
2008 resulted from the settlement in March 2009 of litigation discussed more
fully in Item 3, Legal Proceedings. This amount has been accrued and is
reflected in accounts payable and accrued liabilities in our financial
statements. No loss on settlement of litigation was incurred in
2007.





Total
operating expenses for the years ended December 31, 2008 and 2007 were
approximately $2,079,000 and $2,148,000, respectively, representing a decrease
of approximately ($69,000), which was primarily attributable to a reduction in
general and administrative expenses and depreciation and amortization discussed
above, partially offset by the loss on settlement of litigation recorded in
2008 and higher research and development costs relating to the application of
the CSRV technology to internal combustion engines used in other commercially
viable products, compared with 2007 when the research and development was
primarily focused on refining development of the natural gas fueled electric
power engine generator. Approximately $559,000 and $404,000 for the years ended
December 31, 2008 and 2007, respectively, represented labor
charges.





Income
from operations of approximately $1,230,000 was earned in 2008 compared with an
operating loss of approximately ($2,148,000) in 2007, representing an
improvement in our operating results of approximately
$3,378,000.  This improvement was achieved through the recognition of
approximately $1,813,000 of revenues from research and development, a gain on
sale of land and building of approximately $1,495,000 and a reduction in
operating expenses of approximately $69,000.





Interest
expense decreased to approximately $361,000 in 2008 from approximately $394,000
in 2007. This decrease primarily resulted because of the recognition of the sale
of our land and building under the sale/leaseback agreement, upon the lapsing in
November 2008, of the option to repurchase the property. Up until that time,
payments under the sale/leaseback were recorded as interest expense under the
finance method of accounting. Commencing in December 2008, payments are being
recorded as rent expense in accordance with the proper accounting for an
operating lease.





In 2008
and 2007, the change in deferred taxes was fully offset by a valuation
allowance, resulting in a $-0- net income tax provision.





For the
year ended December 31, 2008 we generated net income of approximately $874,000
or $0.00 per share, as compared to a net loss of approximately ($2,539,000) or
($0.01) per share for 2007.





Liquidity
and Capital Resources




Our cash
position at December 31, 2008 was approximately $722,000, a decrease of
approximately ($237,000) from the cash position of approximately $959,000 at
December 31, 2007. We had a working capital deficit of approximately
($34,000) at December 31, 2008 which represents an approximately ($450,000)
decrease from the approximately $416,000 of positive working capital at December
31, 2007. Our current liabilities of approximately $1,248,000 at December 31,
2008 increased by approximately $300,000 from approximately $948,000 at December
31, 2007.





Operating
activities utilized cash of approximately ($156,000) for the year ended December
31, 2008, a decrease of approximately $1,963,000 from the cash utilized for
operating activities of approximately ($2,119,000) for the year ended December
31, 2007. Cash utilized by operating activities in the year ended December 31,
2008 results primarily from a cash basis net loss of approximately ($368,000)
(after deducting a non-cash gain on sale of property of approximately $1,495,000
and adding back non-cash expenses for stock-based compensation expense of
approximately $217,000 and depreciation and amortization of approximately
$36,000), an increase in inventory of approximately $85,000 and an increase in
prepaid and other assets of approximately $2,000, offset by an increase in
accounts payable and accrued liabilities of approximately $300,000.




19




No cash
was utilized for investing activities during the year ended December 31, 2008 as
compared with approximately $8,000 utilized during the year ended December 31,
2007 for the purchase of property, plant and equipment.





For the
year ended December 31, 2008, we utilized cash of approximately ($82,000) for
financing activities, which consisted of the repurchase of shares of common
stock at a cost of approximately ($90,000) offset by proceeds from the issuance
of common stock of approximately $8,000.





We have
incurred recurring losses from operations through 2007, and as of December 31,
2008, had a Stockholders’ Deficiency of approximately $1,098,000. In
addition, the current economic environment, which is characterized by tight
credit markets, investor uncertainty about how to safely invest their funds and
low investor confidence, has introduced additional risk and difficulty to 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 Accountants have stated in their Auditor’s Report
dated March 30, 2009 with respect to our financial statements as of and for the
year ended December 31, 2008 that these circumstances raise substantial doubt
about our ability to continue as a going concern.





During
2008, we restricted variable costs to only those expenses that are necessary to
perform activities related to research and development and general
administrative costs in support of such activities. During the years ended
December 31, 2008 and 2007, we raised approximately $8,000 and $3,006,000,
respectively, of new working capital from sales of our common stock and from
issuance of convertible notes.





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. Under our
definitive agreement with Dutchess Private Equities Fund, Ltd., at our option,
we can access to up to an additional $8,776,000 of funding through further sales
of our common stock.




In March
2009, we sold 838,096 shares of our common stock 333,333 warrants to
purchase one share of our common stock at an exercise prise of $0.30 per share
and 85,714 warrants to purchase one share of our common stock at an exercise
price of $0.35 per share in a privates sales of unregistered, restricted
securities to the son of a director pursuant to stock purchase agreements and
received net proceeds of $260,000.




Our
 financial statements do not include any adjustments that might be
necessary if we are unable to continue as a going concern.





Additional
Release Payments are currently due us amounting to approximately $7,472,000,
after reflecting $215,000 of payments in February 2009 under the Escrow
Agreement with WWE. This amount represents a potential new source of working
capital for us. In addition, the annual minimum purchase requirements under both
the United States and Canadian licensing agreements of 120 engine generators per
year will also become effective upon the commencement of production of the
natural gas fueled industrial electric power engine generators for WWE (“WWE
Generators”). WWE is a privately held company. Its ability to make the Release
Payments due to us and to honor the minimum purchase requirements under the
licenses is dependent on its success in raising new equity capital. Thus far,
WWE has made nonrefundable payments to us totaling $1.5 million in prior years,
approximately $1,813,000 in 2008 and another approximately $215,000 in 2009.
There can be no assurance that WWE will be successful in raising the additional
equity capital required for this purpose.  We are continuing
discussions with a number of other third parties for the licensing of our
technology; however, there can be no assurance that we will be able to secure
new licensing agreements.





On
December 21, 2007, we entered into a placement agent agreement with Stonegate
Securities, Inc. (“Stonegate”) to act as our placement
agent.   Stonegate has the right during the Contract Period to
identify for us prospective Purchasers in one or more Placements of Securities,
the type and dollar amount being as mutually agreed to by the Parties. The
agreement may be cancelled by either party upon ten (10) days written
notice.




As
compensation for services rendered by Stonegate in connection with the
Placements, we have agreed to pay Stonegate a fee of eight percent (8%) of the
gross proceeds from the sale of securities in the Placements.  No fees
shall be due and payable in connection with sales of securities in the Placement
to investors not introduced to us by Stonegate or by a direct or indirect party
previously introduced to us as a result of the efforts of Stonegate. As
compensation for its initial due diligence efforts, in 2007, we delivered to
Stonegate’s designee 200,000 fully paid non-assessable restricted shares of our
common stock.  The value of these shares on the date of issuance was
approximately $85,000, which was included in general and administrative expenses
in our financial statements for the year ended December 31, 2007.




20




Upon
closing of a Placement, we agreed to issue to Stonegate restricted shares of our
common stock in an amount that is equal to two percent (2%) of the total number
of shares of common stock sold, and/or in the event of a sale of convertible
securities, the number of shares of common stock that would be potentially
received upon a conversion of any convertible securities sold in the
Placement.  Such number of shares to be issued to Stonegate shall be
reduced by the 200,000 shares set forth above.




We shall
also reimburse Stonegate for reasonable, actual out-of-pocket expenses incurred
by Stonegate, provided, however, that such amount in total shall not exceed one
percent (1%) of the gross proceeds of securities placed pursuant to this
Placement Agreement.





We will
continue our efforts to seek new sources of additional funding for our working
capital in 2009 in order to further support our operations.  Such
sources of working capital and new funding being pursued by us include (i)
additional non-refundable payments of the Release Payment under the Escrow
Agreement with WWE, (ii) payments for WWE Generators ordered by WWE as they are
completed from the proceeds of the lease finance commitment that WWE has
obtained from Canada West Corporate Finance, Inc., (iii) direct investment
and/or finance facilities in private transactions with institutional investors,
(iv) new equity investment and/or up front licensing fees from prospective new
sublicensees, (v) proceeds of stock issued to Dutchess Private Equity Fund, Ltd.
in connection with the Equity Line of Credit facility; (vi) a private placement
of equity securities with the assistance of Stonegate and, (vii) cash down
payments from potential new customers. There can be no assurance that we will be
successful in securing any of these sources of additional funding. In this
event, we may be required to substantially or completely curtail our operations,
which could have a material adverse affect on our operations and financial
condition.





Current
liabilities are primarily comprised of approximately $708,000 of legal fees due
to a law firm for its representation of us in litigation over the past several
years, other legal and professional fees of approximately $177,000,
approximately $132,000 of accrued compensation due to a former
director/executive officer, an accrued liability for a litigation settlement of
approximately $92,000 and accrued vacation benefits.





Payments
for rent, interest, real estate taxes and insurance under our sale/leaseback
agreement amount to approximately $465,000 per year. We have employment
agreements in place that provide for minimum annual salary payments to three of
our executives aggregating $400,000. This amount would increase to approximately
$675,000 upon achieving an adequate level of working capital as defined in the
employment agreements.





Contractual
Obligations and Commitments





The
following table summarizes our contractual obligations and commitments at
December 31, 2008:





Amount
      Due WithinTotal
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2011Lease
      Obligations
                    
                    $
                    1,137,500
                    
                    
                    $
                    390,000
                    
                    
                    $
                    390,000
                    
                    
                    $
                    357,500Employment
      Agreements(1)
                    
                    
                    1,133,000
                    
                    
                    
                    400,000
                    
                    
                    
                    400,000
                    
                    
                    
                    333,000Total
                    
                    $
                    2,270,500
                    
                    
                    $
                    790,000
                    
                    
                    $
                    790,000
                    
                    
                    $
                    690,500




(1)Our
obligation under employment agreements would increase to $675,000 per annum
through October 17, 2009 and to $550,000 for the period from October 18, 2009
through October 23, 2011, upon achieving an adequate level of working
capital, as defined.





Total
non-cash compensation cost related to nonvested stock options at December 31,
2008 that has not been recognized was approximately $82,000. This compensation
expense will be recognized in the future over a remaining weighted average
period of approximately 1.4 years.




21


New
Accounting Pronouncement





In
December 2007, the SEC staff issued Staff Accounting Bulletin 110 (“SAB 110”),
“Share-Based Payment,” which amends SAB 107, “Share-Based Payment,” to permit
public companies, under certain circumstances, to use the simplified method in
SAB 107 for employee option grants after December 31, 2007. Use of the
simplified method after December 2007 is permitted only for companies whose
historical data about their employees’ exercise behavior does not provide a
reasonable basis for estimating the expected term of the options. The adoption
of this pronouncement did not have a material effect on our financial
condition, results of operations or cash flows.




Plan
of Operation





We have
recently completed development of the CSRV System-based generator engine and are
preparing to commence the production phase of our operations. Initially, we
intend to sell the engine/generators to WWE. WWE has delivered a firm purchase
order for over 7,400 CSRV system technology Industrial Electric Power Generators
intended to be installed in oil fields throughout Canada over a five year
period. Once production of these orders commences, 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 CSRV generator engine may be readily
sourced and acquired from subcontractors and, accordingly, expect to manufacture
the generator engine in the two following ways:




●
            Assembly
      – to develop assembly lines within our premises.  We have been
      evaluating proposals from certain state officials interested in securing
      our commitment to establish large scale manufacturing operations within
      their state and expect to make a final decision in this regard during
      2009.  In
      March 2009, we received a formal committment from the State of Oklahoma
      outlining a package of various business and tax incentives that we would
      be eligible for if we agreed to set up large scale manufacturing
      operations in the city of Miami, Oklahoma. The package of business and tax
      incentives can be earned based on the extent to which we create qualified
      new jobs and make qualified capital expenditures. The maximum amount of
      business and tax incentives that we could earn under this commitment is
      approximately $788,000,000. 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
      the technology to Original Equipment Manufacturers (“OEM's”) – to take
      advantage of third party manufacturers’ production capacity by signing OEM
      agreements.




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.
 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 WWE for the Escrow Release Payment and US
Licensing fees and positive working capital generated from sales of our CSRV
products to WWE 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 their funds and low investor confidence, has introduced additional risk
and difficulty to our challenge to secure such additional working
capital.




22




Item
7A. Quantitative and Qualitative Disclosures About Market Risk.




N/A




Item
8.  Financial Statements and Supplementary Data.




Reference
is made to the Index to Financial Statements on page F-1.




Item
9.  Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.




None.





Item
9A(T).  Controls and Procedures.




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 Accounting Officer
(“CAO”) (our principal financial and accounting officer), 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 CAO 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 CAO, as appropriate, to allow
timely decisions regarding required disclosure.





Management’s Report on
Internal Controls over Financial Reporting





Internal
control over financial reporting is a process to provide reasonable assurance
regarding the reliability of consolidated financial reporting and the
preparation of financial statements for external purposes in accordance with
U.S. generally accepted accounting principles.  There has been no change in
our internal control over financial reporting during the year ended
December 31, 2008 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.




Our
management, including our CEO and CAO, does not expect that our disclosure
controls and procedures or our internal controls will prevent all errors and all
fraud. A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control
system are met. Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Because of the inherent limitations in all
control systems, no evaluation of the controls can provide absolute assurance
that all control issues and instances of fraud, if any, within the Company have
been detected.





Management
conducted an evaluation of the effectiveness of our internal control over
financial reporting based on the framework in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on this evaluation, management concluded that our
internal control over financial reporting was effective as of December 31,
2008.





This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial reporting.
Management's report was not subject to attestation by our registered public
accounting firm pursuant to temporary rules of the Securities and Exchange
Commission that permit us to provide only management's report in this annual
report.





Item
9B.  Other Information.




None




23




PART
III





Item 10.  Directors,
Executive Officers and Corporate Governance.





The
following table lists the current members of our board of directors and our
executive officers as of March 26, 2009. Our directors hold office until their
successors have been duly elected and qualified. The address for our directors
is c/o Coates International, Ltd., Highway 34 & Ridgewood Road, Wall
Township, New Jersey 07719. There are no family relationships among members of
our board or our executive officers, with the exception of Gregory Coates, who
is the son of George J. Coates. The Board of Directors did not meet during the
year ended December 31, 2008.





Name
                                                        
                                                        Age
                                                        
                                                        PositionGeorge
      J. Coates
                                                        
                                                        68
                                                        
                                                        Director,
      Chairman of the Board, Chief Executive Officer and
    PresidentGregory
      Coates
                                                        
                                                        38
                                                        
                                                        Director
      and President, Technology DivisionBarry
      C. Kaye
                                                        
                                                        55
                                                        
                                                        Director,
      Treasurer and Chief Financial OfficerDr.
      Richard W. Evans
                                                        
                                                        77
                                                        
                                                        Director
      and SecretaryDr.
      Frank Adipietro
                                                        
                                                        51
                                                        
                                                        Director
      *, **Glenn
      Crocker
                                                        
                                                        60
                                                        
                                                        Director
      *, **, ***Dr.
      Michael J. Suchar
                                                        
                                                        53
                                                        
                                                        Director
      *, **Richard
      Whitworth
                                                        
                                                        60
                                                        
                                                        Director
      *, **,
***





*           Serves
as an independent director.


**         Serves
as a member of our compensation committee


***       Serves
as a member of our audit committee





George J. Coates is
our founder and served since our organization and until October 23, 2006 as a
director of our Company, Chairman of the Board of Directors, President, Chief
Executive Officer, Treasurer and Chief Financial Officer. Since October 23,
2006, he was employed by us in a non-executive position, and was considered by
us as to be a significant employee. Effective March 28, 2007, Mr. Coates assumed
the position as Chairman of our Board.  He replaced his son Gregory
Coates who will continue to serve as a Director and President, Technology
Division. Mr. Coates was appointed Chief Executive Officer and President,
replacing Mark Goldsmith in March 2007.





George J.
Coates served two apprenticeships in Europe while attending the College of
Technology in London, and as an associate member of the S.A.E. He received The
City and Guilds of London for electrical and mechanical engineering. He is a
former management director of SCR motor engineers of Europe and holds the
certificates of Ministry of Transport in the United Kingdom. He worked as an
engineer for Rolls Royce and Mercedes Benz, and holds approximately 300 patents
worldwide. He invented coolant disc brakes, a hydraulic suspension, patented the
Coates rotary valve system and patented a turbine engine. George Coates is 68
years old.





Gregory Coates became
a director of the Company on October 24, 2006, and has served as the Chairman of
our Board of Directors until March 28, 2007. On October 23, 2006, he became our
President – Technology Division. For more than fifteen years, Gregory Coates has
worked with us as a design engineer, working in the research and development,
designing and building of the CSRV System and adapting this system to various
existing applications. He created certain of our licensed inventions, and
patented certain of them. Gregory Coates is an Associate Member of the Society
of Automotive Engineers, Inc., and a Member of the American Society of
Mechanical Engineers. He graduated from the College of Technology of
Ireland.




24




Barry C. Kaye­
became a director of the Company on October 24, 2006 and has been serving as our
Treasurer and Chief Financial Officer since October 18, 2006. Mr. Kaye is a
Certified Public Accountant in both New York and New Jersey.  Mr. Kaye
is also the Vice President, Finance and Operations for Corporate Subscription
Management Services LLC, a company that provides comprehensive knowledge
resources management services to large companies and organizations. From 1999 to
2007, he was an Executive Business Consultant with BCK Business Consulting which
provided various business consulting services to the business community. From
2004 to 2005, Mr. Kaye served as Corporate Controller of Development Corporation
for Israel, a registered broker-dealer that distributes bonds of the government
of Israel.  He was the Vice President, Finance & Operations for
Alliance Corner Distributors, Inc., a company engaged in sales and distribution
of video games and other forms of digital entertainment media from 2003 to
2004.  From 1987 to 1999, he served as Group Vice President, Finance
at Sharp Electronics Corporation, a $3.5 billion company engaged in sales and
distribution of consumer electronics, office equipment products and
microelectronic components, where he was responsible for all finance and “back
office” operations. From 1976 to 1987, Mr. Kaye was a Senior Audit Manager for
Arthur Andersen & Co.  He is a member of the American Institute of
Certified Public Accountants as well as a member of the New York and New Jersey
State Societies of Certified Public Accountants.  Mr. Kaye received
his Bachelor of Science in Accounting degree, graduating with Cum Laude
distinction from Brooklyn College of the City University of New
York.





Richard W. Evans
became a director of the Company in May 1996.  Dr. Evans holds an ED.D
degree from Rutgers University, was a Supervisor of the Highland Park School in
Highland Park, New Jersey, a post held for more than the preceding five years
until his retirement in June 1996.




Michael J. Suchar
became a director of the Company in May 1996. Dr. Suchar, who holds a Doctor of
Dental Surgery degree from Temple University Dental School, has been a
practicing pediatric dentistry for more than twenty years. Mr. Suchar also has a
patented invention in the field of aviation security.





Frank J. Adipietro
became a director of the Company on October 24, 2006. Dr. Adipietro earned an
M.D. degree from Downstate Medical School, Brooklyn, New York. He has also
earned an undergraduate degree from New York University, graduating with Phi
Beta Kappa and Magna Cum Laude distinction. He has been practicing in the area
of anesthesia and interventional pain management for more than twenty
years.  He has been Vice President of the Medical Staff at Eastern
Long Island Hospital in Greenpoint, New York since 2001 and serves on numerous
hospital committees.  He was affiliated with Lenox Hill Hospital, New
York, NY for more than ten years in the field of anesthesiology.





Glenn Crocker became
a director of the Company on October 24, 2006. Mr. Crocker, who holds an MBA
degree in Engineering Design, has been working for most of the past thirty five
years as a designer and design engineer with various vehicle manufacturers
including Ford Motor Company, British Leyland, Mercedes Benz, Volvo Cars,
Saturn, GM and BMW, among others.





Richard Whitworth
became a director of the Company on October 24, 2006. Mr. Whitworth earned a
Bachelor of Science degree from the University of Florida and has completed
extensive post-graduate coursework and seminars in Law, Public Administration,
Health Policy, Finance, Criminal Justice, Social Work and
Education.  He has been serving as the president of the Whitworth
Group Inc. for the past 20 years. The Whitworth Group specializes in
governmental and public relations, organizational development and financial
services. Prior to that, he was the Director for the DWI Program Office for the
Florida Supreme Court from 1979 to 1987. From 1976 to 1978 he was the Director
of Prevention for the Florida Association Drug Abuse Treatment and Education
Centers, Inc. From 1974 to 1976 he served as Specialist, Health and Mental
Health, Aging Program Office for the Department of Health and Rehabilitation
Services. Prior to that, he was the Director of Prevention for the Drug Abuse
Program under the direction of the Department of Health and Rehabilitation
Services.





Board
Committees





Our board
of directors established an audit committee and a compensation committee in
October 2006. All of the members of each of these standing committees are
independent as defined under NASDAQ rules and, in the case of the audit
committee, the independence requirements contemplated by Rule 10A-3 under
the Securities Exchange Act. The members of our audit committee are Richard
Whitworth and Glenn Crocker.




25




Audit
Committee





The audit
committee’s responsibilities include:  appointing, approving the
compensation of, and assessing the independence of our independent
auditor;  overseeing the work of our independent auditor, including
through the receipt and consideration of reports from the independent
auditor;  reviewing and discussing with management and our independent
auditor our annual and quarterly financial statements and related
disclosures;  monitoring our internal control over financial
reporting, disclosure controls and procedures, and code of business conduct and
ethics;  discussing our risk management policies; establishing
policies regarding hiring employees from our independent auditor and procedures
for the receipt and retention of accounting related complaints and concerns;
meeting independently with our independent auditor and management; and
preparing the audit committee report required by SEC rules to be included in our
proxy statements.





All audit
services and all non-audit services, except de minimis non-audit
services, must be approved in advance by the audit committee.





Our Board
of Directors has determined that it does not have a member of its audit
committee that qualifies as an "audit committee financial expert" as defined in
Item 407(d)(5)(ii) of Regulation S-K, and is "independent" as the term is used
in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934,
as amended. We have not been able to identify a qualified audit committee
financial expert to serve in such capacity.





During
the year ended December 31, 2008, the Audit Committee held four meetings. In
connection with the audit of our financial statements as of and for the years
ended December 31, 2008 by Weiser, LLP (“Weiser”), our Independent Public
Accounting Firm, our audit committee has discussed with Weiser the matters
required to be discussed by the Statement on Auditing Standards No. 61 as
adopted by the Public Company Accounting Oversight Board in Rule
3200T.  In addition, the audit committee has received the written
disclosures and the letter from Weiser required by Independence Standards Board
Standard No. 1 as adopted by the Public Company Accounting Oversight Board
in Rule 3600T and has discussed with Weiser their independence.





The audit
committee has reviewed and discussed our audited financial statements as of and
for the years ended December 31, 2008 with management and based on this review
and discussion has recommended to the board of directors that such audited
financial statements be included in this annual report on Form 10-K for filing
with the Securities and Exchange Commission.





Compensation
Committee





The
compensation committee’s responsibilities
include:


●
            annually
      reviewing and approving corporate goals and objectives relevant to
      compensation of our chief executive
  officer;


●
            determining
      the compensation of our chief executive
      officer;


●
            reviewing
      and approving, or making recommendations to our board of directors with
      respect to, the compensation of our other executive
      officers;


●
            overseeing
      an evaluation of our senior
      executives;


●
            overseeing
      and administering our cash and equity incentive
      plans; and


●
            reviewing
      and making recommendations to our board with respect to director
      compensation.





The
Compensation Committee did not meet during the year ended December 31,
2008.





Corporate
Governance





We
believe that good corporate governance is important to ensure that, as a public
company, we will manage for the long-term benefit of our stockholders. In that
regard, we have established and adopted charters for the audit committee and
compensation committee, as well as a code of business conduct and ethics
applicable to all of our directors, officers and employees. Our code of business
conduct and ethics can be viewed on our website at www.coatesengine.com.




26




Compensation
Committee Interlocks and Insider Participation





George J.
Coates, Gregory Coates and Barry C. Kaye are executive officers and members of
our board of directors. None of our executive officers serves as a member of our
compensation committee, audit committee or other committee serving an equivalent
function. None of the current members of the compensation committee of our board
has ever been one of our employees.





Liability
Limitations and Indemnification





The
following description is intended as a summary only and is qualified in its
entirety by reference to our amended and restated charter and amended and
restated by-laws filed as exhibits to this report and to Delaware law. We refer
in this section to our amended and restated charter as our charter, and we refer
to our amended and restated by-laws as our by-laws.





Our
charter and by-laws limit the liability of directors to the maximum extent
permitted by Delaware law. Delaware law provides that directors of a corporation
will not be personally liable for monetary damages for breach of their fiduciary
duties as directors, except liability for:




●
            any
      breach of their duty of loyalty to the corporation or its
      stockholders;


●
            acts
      or omissions that are not in good faith or that involve intentional
      misconduct or a knowing violation of
law;


●
            unlawful
      payments of dividends or unlawful stock repurchases or
      redemptions; or


●
            any
      transaction from which the director derived an improper personal
      benefit.





The
limitations do not apply to liabilities arising under the federal securities
laws and do not affect the availability of equitable remedies, including
injunctive relief or rescission.





Our
charter and by-laws provide that we will indemnify our directors and officers,
and may indemnify other employees and agents, to the maximum extent permitted by
law. We believe that indemnification under our by-laws covers at least
negligence and gross negligence on the part of indemnified parties. Our by-laws
also permit us to secure insurance on behalf of any officer, director, employee
or agent for any liability arising out of actions taken in his or her capacity
as an officer, director, employee or agent, regardless of whether the by-laws
would permit indemnification.





Insofar
as indemnification for liabilities arising under the Securities Act may be
permitted to our directors, officers and controlling persons under our charter
or by-laws or the indemnification agreements we have entered into with our
directors and officers, we have been advised that in the opinion of the SEC this
indemnification is against public policy as expressed in the Securities Act and
is, therefore, unenforceable.





Section
16(a) Beneficial Ownership Reporting Compliance





We know
of no person, who, at any time during the fiscal year ended December 31, 2008 to
the date hereof, was a director, officer or beneficial owner of more than
ten percent of any class of our equity securities  (a "Reporting
Person"), that failed to file on a timely basis any reports required to be
furnished pursuant to Section 16(a). Based upon a review of Forms 3, 4 and 5
furnished to us under Rule 16(a)-3(d), we know of no Reporting Person that
failed to file the required reports within the required time
limits.




27




Item 11. Executive
Compensation.





The
following table sets forth the compensation of specified executive officers for
the years ended December 31, 2008 and 2007:





Summary
Compensation Table





Option
                  
                  
                  All
      OtherName and Principal Position
                  Year
                  
                  Salary
                  
                  
                  Awards
                  
                  
                  CompensationGeorge
      J. Coates (1)
                    Chief
      Executive Officer and President
                  2008
                  
                  $
                  242,466
                  (1)
                  
                  
                  (1
                  )
                  
                  
                  (5
                  ),
      (6)2007
                  
                  $
                  190,346
                  (1)
                  
                  
                  (1
                  )
                  
                  
                  (5
                  ),
      (6)Mark
      D. Goldsmith (2)
                    Former
      Chief Executive Officer and President
                  2008
                  
                  $
                  -
                  
                  
                  
                  
                  
                  
                  $
                  -2007
                  
                  $
                  55,342
                  (2)
                  
                  
                  
                  
                  
                  $
                  -Barry
      C. Kaye (3)
                    Chief
      Financial Officer and Treasurer
                  2008
                  
                  $
                  0
                  (3)
                  
                  
                  (3
                  )
                  
                  $
                  69,975
                  (5)2007
                  
                  $
                  0
                  (3)
                  
                  
                  (3
                  )
                  
                  $
                  80,000
                  (5)Gregory
      Coates (4)
                    President,
      Technology Division
                  2008
                  
                  $
                  135,924
                  (4)
                  
                  
                  (4
                  )
                  
                  
                  (6
                  )2007
                  
                  $
                  86,044
                  (4)
                  
                  
                  (4
                  )
                  
                  
                  (6
                  )





(1)           In April 2007,we executed an
amended and restated employment agreement with George J. Coates (the “GJC
Agreement”) that replaces an employment agreement signed in
2006.   The term of the GJC Agreement, which became effective as
of October 23, 2006, is for five years.  The GJC Agreement provides
for annual salary of $183,549, an annual performance bonus determined by
unanimous vote of the independent members of the Board of Directors, plus
vacation, sick leave and participation in health, dental and life insurance and
any other established benefit plans.  The GJC Agreement further
provides that upon achieving a sufficient level of working capital, the amount
of annual salary shall be increased to $300,000, an automobile will be provided
to Mr. Coates and he will be entitled to a severance payment equal to three
years’ annual compensation, should he terminate his employment with Good Reason,
as defined, or upon his death. He will also be provided with a $2 million
life insurance policiy and work with us in securing key-man life insurance.
In accordance with the GJC Agreement, on April 18, 2007, we granted Mr. Coates
1,000,000 stock options to purchase shares of our common stock at an exercise
price of $0.44 per share. In August 2008, the Board of Directors authorized an
increase in Mr. Coates’ annual base compensation to $250,000.





(2)  In late
March 2007, Mark D. Goldsmith stepped down from his positions as Chief Executive
Officer and President, and on April 17, 2007, we notified Mr. Goldsmith in
writing that he was being terminated as a director, officer and employee with
“Cause”, as defined in his employment agreement.





(3)           In April 2007,we executed an
amended and restated employment agreement with Mr. Kaye (the “Kaye Agreement”)
that replaces an employment agreement signed in 2006. The term of the Kaye
Agreement, which became effective as of October 18, 2006, is for three years.
The Kaye Agreement provides that upon achieving a sufficient level of working
capital, annual salary shall be established at $125,000, he would become
eligible for an annual performance bonus and he would be entitled to a severance
payment equal to one year’s annual compensation, should he be terminated by us
without Cause, as defined, or if he should terminate his employment with Good
Reason, as defined. In accordance with the Agreement, on April 18, 2007, we
granted to Mr. Kaye 125,000 options to purchase shares of our common stock at an
exercise price of $0.44 per share. We are
paying for Mr. Kaye's services as a consultant to the Company until the salary
provisions become effective.





(4)           In April 2007,we executed an
amended and restated employment agreement with Gregory Coates (the “GC
Agreement”) that replaces an employment agreement signed in 2006. The term
of the GC Agreement, which became effective as of October 23, 2006, is for five
years.  The GC Agreement provides for annual salary of $79,898, plus
vacation, sick leave and participation in health, dental and life insurance and
any other established benefit plans. The GC Agreement further provides that upon
achieving a sufficient level of working capital, the amount of annual salary
shall be increased to $250,000, he will become eligible for an annual
performance bonus, a company-provided automobile and a severance payment
equal to two years’ annual compensation, should he terminate his employment with
Good Reason, as defined. He will also be provided with a $2 million life
insurance policy and will work with us in securing key-man life insurance. In
accordance with the GC Agreement, on April 18, 2007, we granted to
Gregory Coates 500,000 options to purchase shares of our common stock at an
exercise price of $0.44 per share. In August 2008, the Board of Directors
authorized an increase in Gregory Coates’ annual base compensation to
$150,000.




28




(5)           These
amounts represent payments to Mr. Kaye for consulting services provided to us
during 2008 and 2007, respectively.





(6)           George
J. Coates and Gregory Coates were provided with health care, dental care and
life insurance benefits amounting to approximately $21,700 and $4,500,
respectively, in 2008 and amounting to approximately $8,600 and $11,800,
respectively in 2007.





Outstanding
Equity Awards at Fiscal Year End





In
connection with the employment agreements entered into with George J. Coates,
Gregory Coates and Barry C. Kaye, we became obligated to grant stock options to
these employees.  In 2007, we committed to grant the stock options
enumerated in the table below at an exercise price of $0.44 per
share.





Name
                    
                    Number
      of Securities Underlying Unexercised Options that are
      Exercisable
                    
                    
                    Number
      of Securities Underlying Unexercised Options that are
      Unexercisable
                    
                    
                    Equity
      Incentive Plan Awards: Number of Securities Underlying Unexercised
      Unearned Options
                    
                    
                    Option
      Exercise Price
                    
                    Option
      Expiration DateGeorge
      J. Coates
                    
                    
                    666,666
                    
                    
                    
                    333,334
                    (1)
                    
                    
                    -
                    
                    
                    $
                    0.44
                    
                    10/23/2021Gregory
      Coates
                    
                    
                    333,333
                    
                    
                    
                    166,667
                    (1)
                    
                    
                    -
                    
                    
                    $
                    0.44
                    
                    10/23/2021Barry
      C. Kaye
                    
                    
                    91,666
                    
                    
                    
                    33,334
                    (2)
                    
                    
                    -
                    
                    
                    $
                    0.44
                    
                    10/17/2021




(1)
One-third of these stock options vested on April 30, 2007, one-third vested on
October 23, 2008 and the balance shall vest on October 23, 2009.




(2) 25,000
of these stock options vested on April 30, 2007, 33,333 vested on October 23,
2007, 33,333 vested on October 23, 2008 and the balance shall vest on October
23, 2009. The options will immediately fully vest in the event the employee
terminates his employment for a good reason, or if we terminate employee
without cause.





Vesting
of the stock options is subject to acceleration under certain circumstances in
the event of an acquisition of the Company.





Director
Compensation





Prior to
March 28, 2007, the directors did not receive any compensation for serving on
our Board of Directors, the audit or compensation committees. A compensation
program was adopted by the Board of Directors on March 28, 2007 which provides
for compensation to our directors in the amount of $1,000 per day, plus
reasonable travel expenses. This compensation plan further provides for the
granting of stock options to our non-employee directors from time to time under
our equity incentive plan to purchase our common stock at an exercise price
equal to the closing price of our stock on the Over the Counter Bulletin Board
on the day prior to the date of grant. In March 2007, our five non-employee
directors were each granted 25,000 stock options to purchase shares of our
common stock at an exercise price of $0.44 per share. One-fourth of these stock
options will vest on each of the first four annual anniversary dates after the
date of grant.





No
compensation was earned by our Directors in 2008. The following table summarizes
the components of Director compensation for the year ended December 31,
2007:





Name of Director
                
                Fees
      Earned of Paid in
Cash
                
                
                Stock
      Options Awarded
                
                
                Total
      CompensationDr.
      Frank J. Adipietro
                
                $
                1,000
                
                
                $
                5,125
                
                
                $
                6,125Glenn
      Crocker
                
                $
                1,000
                
                
                $
                5,125
                
                
                $
                6,125Dr.
      Richard W. Evans
                
                $
                1,000
                
                
                $
                5,125
                
                
                $
                6,125Dr.
      Michael J. Suchar
                
                $
                1,000
                
                
                $
                5,125
                
                
                $
                6,125Richard
      Whitworth
                
                $
                1,000
                
                
                $
                5,125
                
                
                $
                6,125




29




Employment
contracts and termination of employment and change-in-control
arrangements





In
October 2006, we signed employment contracts with George J. Coates, Gregory
Coates and Barry C. Kaye, who are serving as our employees. These employment
agreements were amended and restated on April 6, 2007.  On October 18,
2006, we entered into an employment agreement with Mark D. Goldsmith covering
the terms and conditions of his employment as Chief Executive Officer and
President. On April 17, 2007, Mr. Goldsmith was removed from these positions and
terminated for Cause, as defined in his employment agreement.





A summary
of the compensation terms under the employment agreements appears in the table
below.





Name & position
                
                Annual
      compensation
                
                
                Number
      of
                  stock options3
                
                
                Life
      insurance
                
                Severance
      payment4
                Term
      of the AgreementGeorge
      Coates, President and Chief Executive Officer
                
                $
                250,0001
                
                
                
                1,000,000
                
                
                $
                2,000,000
                
                Three
      years salary5
                Five
      yearsGregory
      Coates, President Technology Division
                
                $
                150,0001
                
                
                
                500,000
                
                
                $
                2,000,000
                
                Two
      years salary5
                Five
      yearsBarry
      C. Kaye, Treasurer and Chief Financial Officer
                
                $
                02
                
                
                
                125,000
                
                
                None
                
                One
      year salary2
                Three
      years





1The
annual salary for George J. Coates and Gregory Coates shall be increased to
$300,000 and $250,000, respectively, at such time that the Board of
Directors determines that we have Sufficient Capital, as defined.





2Mr.
Kaye’s compensation, severance and benefits shall not commence until the Board
of Directors determines that we have Sufficient Capital, as defined. At that
time, Mr. Kaye’s salary shall be $125,000 per annum. Until Mr. Kaye’s salary
commences, we are paying him for his services as a consultant on a per diem
basis. In 2008 and 2007, Mr. Kaye received approximately $70,000 and $80,000,
respectively, in consulting fees from us.





3These
Options, which were granted on April 18, 2007, expire in October 2021 and vest
as follows:




●
            The
      options granted to George J. Coates and Gregory Coates vest as follows:
      one-third vested on April 30, 2007, one-third vested on October 23, 2008
      and the balance shall vest on October 23,
2009.





●
            The
      options granted to Mr. Kaye vest as follows: 25,000 stock options vested
      on April 30, 2007, 33,333 stock options vested on October 23, 2007, 33,333
      stock options vested on October 23, 2008 and the balance shall vest on
      October 23, 2009. The options will immediately fully vest in the event the
      employee terminates his employment for a good reason, or if we terminate
      his employment without cause.





4The
entitlement for the severance payment is subject to the employee terminating his
employment for a good reason.





5The
severance payment shall become effective in the event such termination for a
good reason occurs after the Board of Directors determines that we have
Sufficient Capital, as defined.





Under the
applicable employment agreements, these employees are eligible for an annual
performance bonus only after the Board of Directors determines that we have
Sufficient Capital, as defined.





Under
their employment agreements, George and Gregory Coates undertook to vote all
their shares of the Company to elect to our Board of Directors at least two
‘independent directors’ as defined by the rules of the SEC and NASDAQ. In
addition, our rights in intellectual property developed by George and Gregory
Coates will be as set forth in a certain amended and restated license agreement
dated April 6, 2007 and described in Item 1, under caption ‘Licenses and
Patents’. Under their employment agreements, we are not entitled to terminate
the employment of either George or Gregory Coates  unless they are
terminated for cause.




30




Item
12.  Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters.





The
following table sets forth information with respect to the beneficial ownership
of our common stock as of March 26, 2009 for:




·
            each
      of our executive officers and
      directors;


·
            all
      of our executive officers and directors as a group;
  and


·
            any
      other beneficial owner of more than 5% of our outstanding common
      stock.





Beneficial
ownership is determined in accordance with the rules of the SEC. These rules
generally attribute beneficial ownership of securities to persons who possess
sole or shared voting power or investment power with respect to those securities
and include ordinary shares issuable upon the exercise of stock options that are
immediately exercisable or exercisable within 60 days. Except as otherwise
indicated, all persons listed below have sole voting and investment power with
respect to the shares beneficially owned by them, subject to applicable
community property laws. The information is not necessarily indicative of
beneficial ownership for any other purpose.





Percentage
ownership calculations are based on 273,939,732 shares outstanding as of March
26, 2009. Addresses of named beneficial owners are care of Coates International,
Ltd., Highway 34 & Ridgewood Road, Wall Township, New Jersey
07719.





Beneficial
      OwnershipOutstanding
      Shares
                                                                                    
                                                                                    Right to Acquire Within 60 Days
                                                                                    
                                                                                    Shares
      Beneficially OwnedName
      and Address of Beneficial Owner
                                                                                    
                                                                                    Beneficially
      Owned
                                                                                    
                                                                                    After
      December 31, 2007
                                                                                    
                                                                                    Number
                                                                                    
                                                                                    PercentageGeorge
      J. Coates
                                                                                    
                                                                                    208,272,760
                                                                                    1
                                                                                    666,666
                                                                                    
                                                                                    208,939,426
                                                                                    1
                                                                                    75.95%Gregory
      Coates
                                                                                    
                                                                                    14,032,520
                                                                                    
                                                                                    333,333
                                                                                    
                                                                                    14,365,853
                                                                                    
                                                                                    5.22%Frank
      J. Adipietro
                                                                                    
                                                                                    1,203,222
                                                                                    
                                                                                    10,000
                                                                                    
                                                                                    1,213,222
                                                                                    
                                                                                    0.44%Richard
      Evans
                                                                                    
                                                                                    660,000
                                                                                    
                                                                                    10,000
                                                                                    
                                                                                    670,000
                                                                                    
                                                                                    0.24%Michael
      J. Suchar
                                                                                    
                                                                                    241,600
                                                                                    2
                                                                                    44,444
                                                                                    
                                                                                    286,044
                                                                                    2
                                                                                    0.10%Barry
      C. Kaye
                                                                                    
                                                                                    99,800
                                                                                    
                                                                                    91,666
                                                                                    
                                                                                    108,133
                                                                                    
                                                                                    0.07%Glenn
      Crocker
                                                                                    
                                                                                    -
                                                                                    
                                                                                    10,000
                                                                                    
                                                                                    10,000
                                                                                    
                                                                                    0.0%Richard
      Whitworth
                                                                                    
                                                                                    -
                                                                                    
                                                                                    10,000
                                                                                    
                                                                                    10,000
                                                                                    
                                                                                    0.0%All
      executive officers and directors as a group (6 persons)
                                                                                    
                                                                                    224,509,902
                                                                                    
                                                                                    1,176,109
                                                                                    
                                                                                    225,686,011
                                                                                    
                                                                                    82.03%




(1)
Includes 1,956,960 shares owned by Mr. Coates' spouse, beneficial ownership of
which is disclaimed by George J. Coates.





(2)
Includes 20,000 shares owned by Dr. Suchar's spouse, beneficial ownership of
which is disclaimed by Michael J. Suchar.




31




2006 Stock Option and Incentive
Plan





Our 2006
Stock Option and Incentive Plan (the “Stock Plan”) was adopted by our Board
of Directors in October 2006, subject to stockholder
approval.   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.  Under the Stock Plan, we 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
our employees.  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 that
number.





The Stock
Plan is administered by the Board of Directors and the Compensation
Committee.  Subject to the provisions of the Stock Plan, the Board of
Directors 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 us,
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 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. We may hold in escrow all or any portion of any
such consideration in order to effectuate any continuing
restrictions.





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
of Directors 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.




32




Item
13.  Certain Relationships and Related Transactions, and Director
Independence.





Certain
Relationships and Related Transactions





On April
30, 2003, we entered into a sublicense agreement with Coates Motorcycle
Company, Ltd (“Coates Motorcycle”). Pursuant to the agreement, we granted an
exclusive license to utilize the CSRV System for the manufacturing use or sale
of motorcycles and gasoline powered internal combustion engines used in
motorcycles in North America, Central America and South America. In addition, we
granted the non-exclusive license to use the CSRV Seals in the manufacture of
the CSRV Systems for incorporation into motorcycle engines in North America,
Central America and South America. In consideration, we received approximately
51% of the common shares of Coates Motorcycle. We also had an anti-dilution
right. On March 5, 2004, we amended our license agreement with Coates Motorcycle
to expand the license rights granted and to remove the anti-dilution provision
in exchange for 1,000,000 common shares of Coates Motorcycle. As a result of
these transactions, we own 3,558,000 shares of Coates Motorcycle, representing a
30% ownership interest. At this time, Coates Motorcycle has expended all of its
cash and has curtailed its operations.





During
the period through March 2007, Mark Goldsmith, former Chief Executive Officer
and President also served as the Chief Executive Officer, President and Interim
Chief Financial Officer of Coates Motorcycle pursuant to an employment
agreement.  Mr. Goldsmith received salary payments of $25,000 in 2007.
He was also provided with a leased automobile and medical and dental
benefits.





The
Coates Trust has made loans to us at various times to provide working capital.
George J. Coates, Bernadette Coates, wife of George J. Coates and Gregory Coates
are beneficiaries of the Coates Trust. In April 2007, the Coates Trust advanced
$100,000 in the form of a 6% promissory note. At the same time, the outstanding
balance of the prior loans of $92,337 was converted to and included in this
promissory note. No interest was imputed on these loans for the period prior to
the time they were converted to the 6% promissory note. In May 2007, the entire
$192,337 principal amount of the 6% promissory note was repaid, along with
accrued interest of approximately $1,500.




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 and Gregory
Coates, for the two years ended December 31, 2008, is summarized as
follows:





For
      the Years Ended December 31,2008
                
                2007George
      J. Coates (a)
                
                $
                264,000
                
                
                $
                199,000Gregory
      Coates (a)
                
                
                140,000
                
                
                
                98,000Bernadette
      Coates
                
                
                65,000
                
                
                
                51,000





(a)
            Includes
      compensation paid in 2008 for 2007 vacation earned but not
      taken.





Barry C.
Kaye, Treasurer and Chief Financial Officer was paid consulting fees of
approximately $70,000 and $80,000 in 2008 and 2007, respectively.




We
subcontract certain project expenses from Coates Precision Engineering, of which
George J. Coates is the sole shareholder. During the years ended December 31,
2008 and 2007, we paid approximately $500 and $5,000, respectively, related to
these services.





Director
Independence




The
following table sets forth the members of our Board of Directors that are
independent and certain board committee assignments:




Dr.
      Frank J. Adipietro
                                  
                                  
                                  Director
      *, **Glenn
      Crocker
                                  
                                  
                                  Director
      *, **, ***Dr.
      Michael J. Suchar
                                  
                                  
                                  Director
      *, **Richard
      Whitworth
                                  
                                  
                                  Director
      *, **,
***





*           Serves
as an independent director.


**         Serves
as a member of our compensation committee


***       Serves
as a member of our audit committee




33




Item
14.  Principal Accounting Fees and Services.





Audit
Fees:




On
February 29, 2007, we engaged Weiser LLP (“Weiser”), Certified Public
Accountants as our Independent Registered Public Accounting Firm and dismissed
Rosenberg Rich Baker Berman & Company ("Rosenberg").





In 2008,
Weiser billed us in the aggregate $121,612 for professional services rendered
for their audit of our annual financial statements for the year ended December
31, 2007 included in our Form 10-K and their reviews of the quarterly financial
statements included in our Forms 10-Q for each of the three quarters in
2008.





In 2007,
Weiser billed us in the aggregate $123,620 for professional services rendered
for their audit of our annual financial statements for the year ended December
31, 2006 included in our Form 10-KSB and their reviews of the quarterly
financial statements included in our Forms 10-QSB for each of the three quarters
in 2007.





Audit-related
Fees:




In 2007,
Weiser billed us for services in connection with our filing of a registration
statement on Form SB-2 in the amount of approximately $25,000 and in connection
with addressing and responding to a comment letter received from the Securities
and Exchange Commission in the amount of approximately $6,000.





Tax
Fees:




In 2008,
Weiser billed us $8,982 for professional services rendered for tax related
services for the taxable year ended December 31, 2007.





In 2007,
Weiser billed us approximately $5,000 for professional services rendered for tax
related services for the taxable year ended December 31, 2006.





All Other
Fees:




Weiser
did not perform nor bill us for any other services during the last two fiscal
years.









34




PART
IV





Item
15.  Exhibits.








Exhibit No.
              
              Description3.1
      @
              -
              Restated
      Certificate of Incorporation3.1(i)
      @
              -
              Certificate
      of Amendment to Certificate of Incorporation  filed with the
      Secretary of State of Delaware on May 22, 20003.1(ii)
      @
              -
              Certificate  of
      Amendment to  Certificate
      of  Incorporation  filed with the Secretary of State
      of Delaware on August 31, 20013.1(iii)
      u
              -
              Certificate  of
      Amendment to  Certificate
      of  Incorporation  filed with the Secretary of State
      of Delaware on September 12, 20073.2
      @
              -
              Bylaws10.6 +
              -
              License
      Agreement, dated September 29, 1999, with Well to Wire Energy,
      Inc.10.7 +
              -
              Amendment
      No. 1 to License Agreement with Well to Wire Energy Inc. dated April 6,
      200010.8 +
              -
              Amendment
      No. 2 to License Agreement with Well to Wire Energy Inc. dated July 21,
      200010.11
      #
              -
              Sublicense  Agreement,
      dated April 30, 2003, the Company and Coates Motorcycle Company,
      Ltd.10.12
      &
              -
              Amendment  No.
      1
      to  Sublicense  Agreement,  dated  March
      5, 2004,  between  the Company and Coates Motorcycle
      Company, Ltd.10.13
      ^
              -
              Confirmation
      Letter between the Company and Well to Wire Energy Inc. dated July 7,
      200610.14 ~
              -
              2006
      Employee Stock Option and Incentive Plan adopted on October 25,
      200610.15 R
              -
              License
      Agreement between the Company and Coates Trust dated October 23,
      200610.16 R
              -
              Amended
      and Restated Employment Agreement between the Company and George J. Coates
      dated April 6, 200710.17 R
              -
              Amended
      and Restated Employment Agreement between the Company and Gregory Coates
      dated April 6, 200710.18 R
              -
              Amended
      and Restated Employment Agreement between the Company and Barry C. Kaye
      dated April 6, 200710.19
      R
              -
              Amended
      and Restated License Agreement between the Company and George J. Coates
      and Gregory Coates dated April 6, 200710.20
      R
              -
              Termination
      of License Agreement between the Company and Coates Trust dated April 6,
      2007  35
  10.21
      †
              -
              Letter
      from Rosenberg Rich Berman Baker and Company to the Securities and
      Exchange Commission dated February 8, 2007 regarding the circumstances of
      their dismissal by the Company as its Independent Registered Public
      Accounting Firm10.22
      p
              -
              Investment
      Agreement between the Company and Dutchess Private Equities Fund, Ltd.
      dated April 26, 200710.23
      p
              -
              Registration
      Rights Agreement between the Company and Dutchess Private Equities Fund,
      Ltd. dated April 26, 200710.24
      ¢
              
              Placement
      Agency Agreement between the Company and Stonegate Securities, Inc. dated
      December 21, 200710.25Ã
              
              License
      Agreement between the Company and Well to Wire Energy, Inc. dated January
      29, 2008 and executed on April 7, 200810.26Ã
              
              Escrow
      Agreement between the Company and Well to Wire Energy, Inc. dated April
      11, 200810.27÷
              
              Letter
      from Canada West Corporate Finance, Inc. to Well to Wire Energy, Inc.
      confirming commitment to $1.1 Billion Equipment Lease
      Financing.10.28÷
              
              Letter
      from Well to Wire Energy, Inc. to the Registrant advising that it has
      obtained a $1.1 Billion Equipment Lease Financing
    Commitment.31.1Ý
              -
              Certification
      of George J. Coates pursuant to Rule 13a-14(a) of the Securities Exchange
      Act of 1934.31.2Ý
              -
              Certification
      of Barry C. Kaye pursuant to Rule 13a-14(a) under the Securities Exchange
      Act of 1934.32Ý
              -
              Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
      ofthe
      Sarbanes-Oxley Act of 2002.


_______________


@ Incorporated
      by reference from the Company’s Registration Statement filed May 31, 2007
      on Form SB-2 with the Securities and Exchange Commission, File No.
      000-33155 .


R    Incorporated
by reference from the Company’s Form 10-KSB for the year ended December 31,
2006.


+  Incorporated
      by reference from the Company's Registration Statement and amendments
      thereto filed on Form 10-SB with the Securities and Exchange
      Commission, File No. 000-33155.


#     Incorporated
by reference from the Company's Form 10-QSB for the quarter ended June 30,
2003.




&    Incorporated
by reference from the Company’s Form 10-KSB for the fiscal year ended December
31, 2004.




^     Incorporated
by reference from the Company's Form 10-QSB for the quarter ended June 30,
2006.




~     Incorporated
by reference from the Company’s Form 10-KSB/A for the fiscal year ended December
31, 2005.




†  Incorporated
      by reference from the Company’s Form 8-K filed with the Securities and
      Exchange Commission on February 12,
2007.




p
      Incorporated by reference from the Company’s Form 8-K filed with the
      Securities and Exchange Commission on May 1,
  2007.




u Incorporated by
      reference from the Company’s Schedule 14C DEF filed with the Securities
      and Exchange Commission on October 1,
2007.




¢Incorporated by reference from the Company’s Form 8-K
      filed with the Securities and Exchange Commission on January 3,
      2008.




Ã  Incorporated
      by reference from the Company’s Form 8-K filed with the Securities and
      Exchange Commission on April 11,
2008.




÷Incorporated by
      reference from the Company’s Form 8-K filed with the Securities and
      Exchange Commission on May 7, 2008.




Ý   Filed
herewith.







All
reports required to be filed on Form 8-K during the last quarter of the fiscal
year ended December 31, 2008 were timely filed with the Securities and Exchange
Commission.





36




SIGNATURES





In
accordance with Section 13 or 15(d) of the Exchange Act, the issuer has caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized, on March 30, 2009.




COATES
      INTERNATIONAL, LTD.By:
              /s/ George
      J. CoatesGeorge
      J. CoatesChairman





In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the issuer and in the capacities and on the dates
indicated.





Signature
                                                                        Title
                                                                        Date/s/ George J. Coates
                                                                        
                                                                        March
      30, 2009George
      J. Coates
                                                                        Director,
      Chairman, Chief Executive Officer and President (principal executive
      officer)/s/
      Gregory CoatesGregory
      Coates
                                                                        Director,
      President-Technology Division
                                                                        March
      30, 2009/s/
      Barry C. KayeBarry
      C. Kaye
                                                                        Director,
      Treasurer, Chief Financial Officer (principal financial and accounting
      officer)
                                                                        March
      30, 2009/s/
      Richard W. EvansRichard
      W. Evans
                                                                        Director
      and Secretary
                                                                        March
      30, 2009/s/
      Michael J. SucharMichael
      J. Suchar
                                                                        Director
                                                                        March
      30, 2009/s/
      Frank AdipietroFrank
      Adipietro
                                                                        Director
                                                                        March
      30, 2009/s/
      Glenn CrockerGlenn
      Crocker
                                                                        Director
                                                                        March
      30, 2009/s/
      Richard WhitworthRichard
      Whitworth
                                                                        Director
                                                                        March
      30, 2009





37




Coates
International, Ltd.





Index
to the Financial Statements





December
31, 2008 and 2007







PageReport
      of Weiser LLP, Independent Registered Public Accounting
    Firm
                                                                              F-1Financial
      StatementsBalance
      Sheets
                                                                              F-2Statements
      of Operations
                                                                              F-3Statements
      of Stockholders' Deficiency
                                                                              F-4Statements
      of Cash Flows
                                                                              F-5Notes
      to the Financial Statements
                                                                              F-6










REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM









To the
Board of Directors and


Stockholders
of Coates International Ltd.




We have
audited the accompanying balance sheets of Coates International Ltd. as of
December 31, 2008 and 2007, and the related statements of operations,
stockholders’ deficiency and cash flows for the years then ended. These
financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on
our audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. Our audit included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the company's internal control over financial
reporting. Accordingly, we express no such opinion.  An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.




In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Coates International Ltd. as of
December 31, 2008 and 2007 and the results of its operations and its cash flows
for the years then ended in conformity with U.S. generally accepted accounting
principles.




The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in Note 1 to the financial
statements, the Company continues to have negative cash flows from
operations, recurring losses from operations in prior years, and has a
stockholders’ deficiency. These factors raise substantial doubt about the
Company’s ability to continue as a going concern. Management’s plans in regard
to these matters are also discussed in Note 1. The financial statements do not
include any adjustments that might result from the outcome of this
uncertainty.




/s/
Weiser LLP




New York,
NY


March 30,
2009








F-1





Coates
International, Ltd.


Balance
Sheets




Assets


December 31,2008
                                    
                                    2007Current
      AssetsCash
                                    
                                    $
                                    721,952
                                    
                                    
                                    $
                                    959,181Inventory, net
                                    
                                    
                                    487,549
                                    
                                    
                                    
                                    402,191Prepaid
      and other assets
                                    
                                    
                                    4,679
                                    
                                    
                                    
                                    2,223Total Current
      Assets
                                    
                                    
                                    1,214,180
                                    
                                    
                                    
                                    1,363,595Investment
      in related party
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Property,
      plant and equipment, net
                                    
                                    
                                    39,376
                                    
                                    
                                    
                                    1,474,023Deferred
      licensing costs, net
                                    
                                    
                                    72,433
                                    
                                    
                                    
                                    76,716Security
      deposit
                                    
                                    
                                    197,500
                                    
                                    
                                    
                                    197,500Total Assets
                                    
                                    $
                                    1,523,489
                                    
                                    
                                    $
                                    3,111,834Liabilities
      and Stockholders’ DeficiencyCurrent
      LiabilitiesAccounts
      payable and accrued liabilities
                                    
                                    $
                                    1,248,173
                                    
                                    
                                    $
                                    947,901Total Current
      Liabilities
                                    
                                    
                                    1,248,173
                                    
                                    
                                    
                                    947,901License
      deposits
                                    
                                    
                                    375,000
                                    
                                    
                                    
                                    375,00010%
      Convertible Note, due January 2010
                                    
                                    
                                    20,000
                                    
                                    
                                    
                                    20,000Deferred
      gain on sale of land and building
                                    
                                    
                                    978,479
                                    
                                    
                                    
                                    -Finance
      obligation
                                    
                                    
                                    -
                                    
                                    
                                    
                                    3,876,607Total
    Liabilities
                                    
                                    
                                    2,621,652
                                    
                                    
                                    
                                    5,219,508Commitments
      and Contingencies
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Stockholders'
      DeficiencyPreferred
      stock, $0.001 par value 100,000,000 shares authorized in 2008 and 2007 and
      no shares  issued or outstanding
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Common
      stock, $0.0001 par value, 1,000,000,000 shares authorized, 273,126,636 and
      273,411,636 shares issued and outstanding in 2008 and 2007,respectively
                                    
                                    
                                    27,313
                                    
                                    
                                    
                                    27,341Additional
      paid-in capital
                                    
                                    
                                    20,722,899
                                    
                                    
                                    
                                    20,587,403Accumulated
      deficit
                                    
                                    
                                    (21,848,375
                                    )
                                    
                                    
                                    (22,722,418
                                    )Total Stockholders'
      Deficiency
                                    
                                    
                                    (1,098,163
                                    )
                                    
                                    
                                    (2,107,674
                                    )Total Liabilities and
      Stockholders' Deficiency
                                    
                                    $
                                    1,523,489
                                    
                                    
                                    $
                                    3,111,834




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




F-2




Coates
International, Ltd.


Statements
of Operations





For the Years Ended December
      31,2008
                  
                  
                  2007RevenuesRevenue
      from research and development
                  
                  $
                  1,813,183
                  
                  
                  $
                  -Gain
      on sale of land and building
                  
                  
                  1,495,224
                  
                  
                  
                  -Total Revenues
                  
                  
                  3,308,407
                  
                  
                  
                  -Operating
      expenses:Research
      and development costs
                  
                  
                  676,306
                  
                  
                  
                  606,491General
      and administrative expenses
                  
                  
                  1,273,760
                  
                  
                  
                  1,493,011Depreciation
      and amortization expense
                  
                  
                  36,027
                  
                  
                  
                  48,695Loss
      on settlement of litigation
                  
                  
                  92,500
                  
                  
                  
                  -Total Operating
      Expenses
                  
                  
                  2,078,593
                  
                  
                  
                  2,148,197Income
      (Loss) from operations
                  
                  
                  1,229,814
                  
                  
                  
                  (2,148,197
                  )Other
      income (expense):Interest income
                  
                  
                  4,812
                  
                  
                  
                  3,288Interest expense
                  
                  
                  (360,583
                  )
                  
                  
                  (393,952
                  )Other income (expense),
      net
                  
                  
                  (355,771
                  )
                  
                  
                  (390,664
                  )Income
      (loss) before income taxes
                  
                  
                  874,043
                  
                  
                  
                  (2,538,861
                  )Provision
      for income taxes
                  
                  
                  -
                  
                  
                  
                  -Net
      income (loss)
                  
                  $
                  874,043
                  
                  
                  $
                  (2,538,861
                  )Basic
      net income (loss) per share
                  
                  $
                  0.00
                  
                  
                  $
                  (0.01
                  )Basic
      weighted average number of shares
                  
                  
                  273,339,751
                  
                  
                  
                  269,618,004Diluted
      net income (loss) per share
                  
                  $
                  0.00
                  
                  
                  $
                  (0.01
                  )Diluted
      weighted average number of shares
                  
                  
                  273,384,196
                  
                  
                  
                  269,618,004






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




F-3






Coates
International, Ltd.


Statements
of Stockholders' Deficiency


For
the Years Ended December 31, 2008 and 2007




Common
      Stock
                          
                          
                          Additional$0.0001
      par value per share
                          
                          
                          Paid
      in
                          
                          
                          Accumulated
                          
                          
                          Treasury
                          
                          
                          Shareholders'Shares
                          
                          
                          Amount
                          
                          
                          Capital
                          
                          
                          Deficit
                          
                          
                          Stock
                          
                          
                          DeficiencyBalance,
      January 1, 2007
                          
                          
                          266,894,278
                          
                          
                          $
                          26,689
                          
                          
                          $
                          17,176,155
                          
                          
                          $
                          (20,183,557
                          )
                          
                          $
                          -
                          
                          
                          $
                          (2,980,713
                          )Sales
      of common stock through a private placement offering
                          
                          
                          420,000
                          
                          
                          
                          42
                          
                          
                          
                          419,958
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          420,000Sales
      of common stock to the son of a Director
                          
                          
                          3,333,333
                          
                          
                          
                          333
                          
                          
                          
                          1,249,667
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          1,250,000Issuance
      of common stock under equity line of credit with Dutchess Private Equities
      Fund, Ltd., net of offering costs
                          
                          
                          2,341,803
                          
                          
                          
                          235
                          
                          
                          
                          1,142,665
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          1,142,900Issuance
      of shares of common stock to Stonegate Securities, Inc. in connection with
      Private Placement Agreement
                          
                          
                          200,000
                          
                          
                          
                          20
                          
                          
                          
                          84,980
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          85,000Conversion
      of 10% convertible notes
                          
                          
                          222,222
                          
                          
                          
                          22
                          
                          
                          
                          99,978
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          100,000Stock-based
      compensation expense
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          414,000
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          414,000Net
      loss for the year
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (2,538,861
                          )
                          
                          
                          
                          
                          
                          
                          (2,538,861
                          )Balance,
      December 31, 2007
                          
                          
                          273,411,636
                          
                          
                          
                          27,341
                          
                          
                          
                          20,587,403
                          
                          
                          
                          (22,722,418
                          )
                          
                          
                          -
                          
                          
                          
                          (2,107,674
                          )Issuance
      of common stock under equity line of creditwith
      Dutchess Private Equities Fund, Ltd.
                          
                          
                          15,000
                          
                          
                          
                          2
                          
                          
                          
                          7,951
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          7,953Shares
      of common stock repurchased
                          
                          
                          (300,000
                          )
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (
      89,485
                          )
                          
                          
                          (89,485
                          )Retirement
      of treasury stock
                          
                          
                          
                          
                          
                          
                          (30
                          )
                          
                          
                          (89,455
                          )
                          
                          
                          
                          
                          
                          
                          89,485
                          
                          
                          
                          -Stock-based
      compensation expense
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          217,000
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          217,000Net
      income for the year
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          874,043
                          
                          
                          
                          
                          
                          
                          
                          874,043Balance,
      December 31, 2008
                          
                          
                          273,126,636
                          
                          
                          $
                          27,313
                          
                          
                          $
                          20,722,899
                          
                          
                          $
                          (21,848,375
                          )
                          
                          $
                          -
                          
                          
                          $
                          (1,098,163
                          )






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






F-4




Coates
International, Ltd.


Statements
of Cash Flows




For
      the Years Ended December 31,2008
                                                  
                                                  
                                                  2007Cash
      Flows From Operating Activities:Net
      Income (Loss)
                                                  
                                                  $
                                                  874,043
                                                  
                                                  
                                                  $
                                                  (2,538,861
                                                  )Adjustments to Reconcile Net
      Income (Loss) to Net Cash Used in Operating
      Activities -Gain
      on sale of land and building
                                                  
                                                  
                                                  (1,495,224
                                                  )
                                                  
                                                  
                                                  -Stock-based
      compensation expense
                                                  
                                                  
                                                  217,000
                                                  
                                                  
                                                  
                                                  414,000Depreciation
      and amortization
                                                  
                                                  
                                                  36,027
                                                  
                                                  
                                                  
                                                  48,695Non-cash
      offering expenses
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  85,000Write-off
      of deferred offering expenses
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  15,181Provision
      for inventory obsolescence
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  6,292Changes
      in Operating Assets and Liabilities -Inventory
                                                  
                                                  
                                                  (85,358
                                                  )
                                                  
                                                  
                                                  (57,526
                                                  )Prepaid
      expenses
                                                  
                                                  
                                                  (2,456
                                                  )
                                                  
                                                  
                                                  500Accounts
      payable and accrued liabilities
                                                  
                                                  
                                                  300,271
                                                  
                                                  
                                                  
                                                  (92,082
                                                  )Net
      Cash Used in Operating Activities
                                                  
                                                  
                                                  (155,697
                                                  )
                                                  
                                                  
                                                  (2,118,801
                                                  )Cash
      Flows From Investing Activities:Acquisition
      of property, plant and equipment
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (7,784
                                                  )Net
      Cash Used in Investing Activities
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (7,784
                                                  )Cash
      Flows From Financing Activities:Purchase
      of Treasury stock
                                                  
                                                  
                                                  (89,485
                                                  )
                                                  
                                                  
                                                  -Proceeds
      from issuance of common stock
                                                  
                                                  
                                                  7,953
                                                  
                                                  
                                                  
                                                  2,885,855Issuance
      of 10% convertible notes
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  120,000Proceeds
      of promissory note from related party
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  100,000Repayment
      of promissory note from related party
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (100,000
                                                  )Repayment
      of demand loan from related party
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (92,337
                                                  )Deferred
      offering costs paid
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (72,955
                                                  )Repayments of capital lease
      obligation
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (9,039
                                                  )Net
      Cash (Used in) Provided by Financing Activities
                                                  
                                                  
                                                  (81,532
                                                  )
                                                  
                                                  
                                                  2,831,524Net (Decrease) Increase in
      Cash
                                                  
                                                  
                                                  (237,229
                                                  )
                                                  
                                                  
                                                  704,939Cash - Beginning of
      Period
                                                  
                                                  
                                                  959,181
                                                  
                                                  
                                                  
                                                  254,242Cash - End of
    Period
                                                  
                                                  $
                                                  721,952
                                                  
                                                  
                                                  $
                                                  959,181Schedule
      of Supplemental Cash Flow Data:Cash
      paid for:Income
      Taxes
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -Interest
                                                  
                                                  $
                                                  358,599
                                                  
                                                  
                                                  $
                                                  392,472






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






F-5




Coates
International, Ltd.


Notes
to Financial Statements








1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Nature of
Organization and Basis of Presentation





Coates
International, Ltd. is a Delaware corporation organized in October 1991 as
successor-in-interest to a Delaware corporation of the same name incorporated in
August 1988.  Our operations are located in Wall Township, New
Jersey.





Coates
International, Ltd. (the "Company") has acquired the exclusive licensing rights
for the Coates spherical rotary valve system (“CSRV System”) technology in North
America, Central America and South America (the “CSRV License”). The CSRV System
technology has been developed over a period of more than 15 years by the
Company’s founder George J. Coates and his son Gregory Coates. The CSRV System
is adaptable for use in piston-driven internal combustion engines of many types
and has been patented in the United States and numerous countries throughout the
world.





The
      CSRV System is designed to replace the intake and exhaust conventional
      “poppet valves” currently used in almost all piston-driven, automotive,
      truck, motorcycle, marine and electric power generator engines, among
      others. Unlike conventional valves which protrude into the engine
      cylinder, the CSRV System utilizes spherical valves that rotate in a
      cavity formed between a two-piece cylinder head. The CSRV System
      utilizes significantly fewer moving parts than conventional poppet valve
      assemblies. As a result of these design improvements, management believes
      that engines incorporating the CSRV System (“Coates Engines”) will last
      significantly longer and will require less lubrication over the life of
      the engine, as compared to conventional engines. In addition, CSRV engines
      can be designed with larger openings into the engine cylinder than with
      conventional valves so that more fuel and air can be inducted into and
      expelled from the cylinder in a shorter period of time.  Larger
      valve openings permit higher revolutions-per-minute (RPM’s) and permit
      higher compression ratios with lower combustion chamber temperatures,
      allowing the Coates Engine to produce more power than equivalent
      conventional engines. The higher the RPM range, the greater the volumetric
      efficiency and thermal efficiency that can be
  achieved.





Since
      the Company’s inception, the Company has been responsible for the
      development costs of this technology in order to optimize the value of the
      licensing rights and has incurred related operational costs, the bulk of
      which have been funded primarily through cash generated from the sale of
      stock, through capital contributions, loans made by George Coates, through
      a sale-and-leaseback transaction related to the Company’s principal
      facility, from research and development of prototype models and licensing
      fees. The Company has never received any revenues from the sale of engines
      and has incurred substantial losses from operations prior to the year
      ended December 31, 2008. The Company expects that losses from operations
      will continue until the Coates Engines are successfully introduced into
      and accepted in the marketplace, or the Company receives substantial
      licensing revenues.  These losses from operations were
      substantially related to research and development of the Company’s
      intellectual property rights, patent filing and maintenance costs and
      general and administrative
expenses.





As shown
in the accompanying financial statements, the Company has incurred recurring
losses from operations, and as of December 31, 2008, had a Stockholders’
Deficiency of approximately $1,098,000. In addition, the current economic
environment, which is characterized by tight credit markets, investor
uncertainty about how to safely invest their funds and low investor confidence,
has introduced additional risk and difficulty to our challenge to secure needed
additional working capital. These factors raise substantial doubt about the
Company’s ability to continue as a going concern. 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 entering the production
phase of our operations, develop additional commercially feasible applications
of the CSRV technology and seek additional sources of working capital and
general administrative costs in support of such activities. The Company has been
actively undertaking efforts to secure new sources of working capital. At the
end of 2008, we had negative working capital of approximately ($34,000),
compared with working capital of approximately $416,000 at the end of
2007.  In 2008, the Company received approximately $1.8 million from
research and development fees. 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 be necessary if the Company is unable to
continue as a going concern.




F-6




Revenue
Recognition





The
Company has not generated revenue from the sales of
engines.  Licensing deposits, which are non-refundable, received from
the granting of sub-licenses, are recognized as earned, generally commencing
upon the completion of certain tests and acceptance by the
licensee.  At that time, license revenue will be recognized ratably
over the period of time that the sub-license has been granted using the
straight-line method.  Upon termination of a sub-license agreement,
non-refundable license deposits, less any costs related to the termination of
the sub-license agreement are recognized as revenue. Revenue from research and
development activities is recognized when earned and realization is reasonably
assured, provided that financial risk has been transferred from the Company to
its customer.





Research
and Development





Research
and development costs are expensed when incurred.





Advertising
Costs





Advertising
costs, which are included in general and administrative expenses, are expensed
when incurred.  Advertising expense amounted to approximately
$82,000 and $41,000 for the years ended December 31, 2008 and 2007,
respectively.





Stock-Based
Compensation





Compensation expense relating to
stock-based payments is recognized as an expense using the fair-value
measurement method. Under the fair value method, the estimated fair value of
awards to employees is charged to income on a straight-line basis over the
requisite service period, which is the earlier of the employee’s retirement
eligibility date or the vesting period of the award. No stock options were
granted for the year ended December 31, 2008. In March 2007, stock options were
granted to employees, directors and an outside consultant.  (See Note
15).




F-7




Inventory





Inventory
consists of raw materials, work-in-process and finished goods, including
overhead and is stated at the lower of cost or market determined by the
first-in, first-out method. Inventory items designated as obsolete or slow
moving are reduced to net realizable value. Market value is determined using
current replacement cost.





Property,
Plant and Equipment





Property,
plant and equipment are stated at cost.  Depreciation is computed
using the straight-line method over the estimated useful life of the assets: 40
years for building and building improvements, 3 to 7 years for machinery and
equipment and 5 to 10 years for furniture and fixtures.  Repairs and
maintenance expenditures, which do not extend the useful lives of the related
assets, are expensed as incurred.





In the
event that facts and circumstances indicate that long-lived assets may be
impaired, an evaluation of recoverability is performed. Should such evaluation
indicate that there has been an impairment of one or more long-lived assets, the
cost basis of such assets would be adjusted accordingly at that
time.





Licensing
Costs





Under the
CSRV Licensing Agreement for the CSRV technology, the Company is responsible for
all costs in connection with applying for, obtaining and maintenance of patents
to protect the CSRV System intellectual technology. Such costs are expensed as
incurred.





Income
Taxes





Deferred income tax assets and liabilities are computed for
differences between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future.
Such deferred income tax asset and liability computations are based on enacted
tax laws and rates applicable to periods in which the differences are expected
to affect taxable income. Valuation allowances are established when necessary to
reduce deferred tax assets to the amount expected to be realized and are
adjusted when conditions indicate that deferred assets will be
realized.  Income tax expense (benefit) is the tax payable or
refundable for the period plus or minus the change during the period in deferred
tax assets and liabilities. No tax benefit has been recorded related to the
Company’s equity in undistributed earnings of Coates Motorcycle Company, Ltd.
(See Note 20). The income tax benefit from sales of unutilized state tax net
operating losses to third parties is recognized in the period of
sale.





The
Company has adopted the provisions of Financial Accounting Standards Board
("FASB") Interpretation No. 48, "Accounting for Uncertainty in Income Taxes (as
amended) - an interpretation of FASB Statement No. 109" ("FIN 48"), on January
1, 2007.  FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in an enterprise's financial statements in accordance with SFAS
Statement 109, "Accounting for Income Taxes," and prescribes a recognition
threshold and measurement process for financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. FIN
48 states that a tax benefit from an uncertain tax position may be recognized
only if it is "more likely than not" that the position is sustainable, based on
its technical merits. The tax benefit of a qualifying position is the largest
amount of tax benefit that is greater than 50% likely of being realized upon
settlement with a taxing authority having full knowledge of all relevant
information. A tax benefit from an uncertain tax position was previously
recognized if it was "probable" of being sustained. Under FIN 48, the liability
for unrecognized tax benefits is classified as noncurrent unless the liability
is expected to be settled in cash within 12 months of the reporting
date.  FIN 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and
transition. The adoption of FIN 48 did not have a material impact on the
Company's consolidated financial position, results of operations or cash
flows.




F-8




The
Company did not record a cumulative effect adjustment related to the adoption of
FIN 48 at January 1, 2007 and no liability for unrecognized tax benefits was
required to be reported at December 31, 2008 and 2007.  The Company
has identified its federal tax return and state tax return in New Jersey as
"major" tax jurisdictions, as defined. Based on the Company's evaluation, it has
been 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 2004 through 2008, 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 any
adjustments that will result in a material change to its financial
position.





The
Company's policy for recording interest and penalties associated with uncertain
tax positions is to record such items as a component of income before income
taxes.  Penalties are recorded in other expense and interest paid or
received is recorded in interest expense or interest income, respectively, in
the statement of operations.  For the years ended December 31, 2008
and 2007, there were no penalties and interest related to the Company’s income
tax returns.





Earnings
(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. There were no shares of preferred stock outstanding during the years
ended December 31, 2008 and 2007. Diluted net income 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 generally
accepted accounting principles 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 reported amounts of revenues and expenses during the reporting
period. These significant estimates include assigning useful lives to the
Company’s property, plant and equipment, determining an appropriate amount to
reserve for obsolete and slow moving inventory, 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.Actual results could differ
from those estimates.




F-9


2.
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION





As
compensation for its initial due diligence efforts, in 2007, the Company has
delivered to Stonegate’s designee 200,000 fully paid non-assessable restricted
shares of common stock of the Company.  The value of these shares on
the date of issuance was approximately $85,000 and was included in general and
administrative expenses for the year ended December 31, 2007 (see Note
17).





3.
CONCENTRATIONS OF CREDIT AND BUSINESS RISK





The
Company maintains 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. Development efforts have been conducted continuously since such
time.  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.  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 Well to Wire Energy, Inc. (“WWE”) 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 for use in the oil and gas
industry within the territories of Canada and the United States. At the end of
December 31, 2008, WWE owed the Company approximately $7.9 million dollars,
including interest at 5% per annum of approximately $243,000 due under the
research and development and sublicensing agreements.  Payment of this
balance is dependent on WWE’s continuing effort to raise new equity
capital.





4.
FAIR VALUE OF FINANCIAL INSTRUMENTS





Cash,
Other Assets, Accounts Payable and Accrued Liabilities and Other
Liabilities





The
carrying amount of these items approximates their fair value because of the
short term maturity of these instruments.





Limitations





Fair
value estimates are made at a specific point in time, based on relevant market
information and information about the financial instrument. These estimates are
subjective in nature and involve uncertainties and matters of significant
judgment and therefore cannot be determined with precision. Changes in
assumptions could significantly affect the estimates.





5.
INVENTORY





Inventory
at December 31, consisted of the following:





2008
                  
                  
                  2007Raw
      materials
                  
                  $
                  366,632
                  
                  
                  $
                  278,264Work-in-process
                  
                  
                  32,099
                  
                  
                  
                  35,109Finished
      goods
                  
                  
                  240,000
                  
                  
                  
                  240,000Reserve
      for obsolescence
                  
                  
                  (151,182
                  )
                  
                  
                  (151,182
                  )Total
                  
                  $
                  487,549
                  
                  
                  $
                  402,191




F-10




6.
AGREEMENTS WITH WELL TO WIRE ENERGY, INC.





On
September 29, 1999, the Company signed a sublicense agreement with Well to Wire
Energy, Inc. ("WWE"), an oil and gas company in Canada.  This
agreement exclusively licenses within Canada the use of the Coates technology
for industrial engines to be fueled by natural gas to generate electrical power
for the oil and gas industry (the “Canadian License”). The agreement provided
for a license fee of $5,000,000, of which a deposit payment in the amount of
$300,000 was made at that time. A separate research and development agreement
provided for WWE to pay a $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. As of December 31, 2008, the Company had been paid a
total of approximately $3,313,000 by WWE under these agreements.





Additional
provisions of the Canadian License agreement are as follows:





●
            WWE
      shall have the exclusive right to use, lease and sell electric power
      generators that are based on the CSRV System technology within Canada for
      use in the oil and gas industry.


●
            WWE
      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 WWE
      in order to maintain exclusivity is 120.  Until otherwise agreed
      between the parties, the price per generator shall be
      $150,000.  In the event WWE fails to purchase the minimum 120
      Coates generator engines during any year, WWE will automatically lose its
      exclusivity. In such a case, WWE would retain non-exclusive rights to
      continue to use the Coates generator engine in the territory of
      Canada.


●
            WWE
      shall not be required to pay any royalties to the Company as part of the
      agreements between the parties.


●
            All
      licensed rights under the Coates License Agreement related to the CSRV
      System technology will remain with the
Company.








In April
2008, the Company entered into a conditional second sublicense agreement
with WWE for the territory of the United States (the “US License”).
The US License provides for a license fee of $50 million and annual minimum
purchases of Coates CSRV Systems as a condition of exclusivity.  The
US license has been deposited into an escrow account and the grant under the
license is not effective until the conditions for release from escrow are
satisfied.





The
escrow agreement was established to provide a more secure mechanism for the
Company to collect payments due under both the prior Canadian licensing and
research and development agreements and the new $50 million US License (the
“Escrow Agreement”).  The Escrow Agreement provides that the US
License shall be held until WWE remits a release payment (the “Release
Payment”). The Release Payment consists of (i) an initial down payment
required under the US License of $1 million and (ii) $8.5 million in payment of
the balance of the monies due, at the date of the Escrow Agreement, to the
Company in connection with the license for the territory of Canada,
including the Canadian License agreement and the research and development
agreement (the “Canadian Agreements”). While the US License is held in escrow
there shall not be any grant of license to WWE. WWE is expected to make
non-refundable periodic payments to the Company in unspecified amounts as
partial payments of the Release Payment until the Release Payment has been paid
in full. The first $3.8 million of the Release Payment, which has been
designated as payment of the fees due under the research and development
Agreement, is being recognized as revenue at the time the cash payments are
received. WWE has made nonrefundable payments to the Company totaling $1.5
million in prior years. For the year ended December 31, 2008, the Company
received approximately $1,813,000 of non-refundable payments from WWE which have
been recognized as research and development revenue. Upon full satisfaction
of the Release Payment, WWE would be granted a license for the territory of the
United States under the US License agreement.




F-11




WWE is a
privately held company and its ability to make the license payments due to the
Company and to honor the minimum purchase requirements under the licenses is
dependent on the success of its continued efforts to raise new equity
capital. At December 31, 2008, the remaining balance of the Release Payment
was approximately $7,687,000.  Subsequent to December 31, 2008, the
Company received additional installments toward the release payment aggregating
approximately $215,000, bringing the balance of the Release Payment down to
approximately $7,472,000, not including interest on the unpaid balance at 5% per
annum of approximately $243,000. To the extent that WWE is not successful
or experiences delays in raising such additional new equity capital, the
Company’s cash flow, results of operations and financial condition could be
adversely affected.





WWE was
unable to remit the full amount of the Release Payment required under the Escrow
Agreement to be made by September 30, 2008 (the “Extended Payment Period”). In
recognition of WWE’s good faith effort to pay the Release Payment as evidenced
by the aggregate non-refundable payments already made to the Company under the
Escrow Agreement, in October 2008, the Company agreed to accommodate WWE’s
request for an additional extension of time to pay the full amount of the
Release Payment under the Escrow Agreement.





The
Extension Agreement provides that WWE shall have until April 30, 2009 to pay the
full balance of the Release Payment (the “Payment Extension Date”). Interest
shall be payable to the Company at the compounded rate of 5% per annum on the
unpaid balance of the Release Payment.  Such interest shall be
recognized as income upon receipt from WWE. The Extension Agreement also
provides that 75% of the net proceeds from any offer of securities by WWE shall
be applied towards the Release Payment until the balance is paid in full. Should
WWE fail to pay the entire balance of the Release Payment by the Payment
Extension Date, the Company would be entitled to retain all moneys paid and the
research and development agreement, License Agreements and Escrow Agreements
would become automatically canceled without WWE having any rights of redemption
or reinstatement.





The US
License would, if WWE is able to satisfy the Escrow Agreement release
provisions, grant to WWE the right to use, sell and lease Licensed Products
manufactured by the Company, as the power source for the generation of
electrical energy for the oil and gas industry and
landfills.  Licensed Products consist of CSRV Valve Systems, CSRV
Valve Seals, CSRV Rotary Valve Spheres, CSRV Valve Components and CSRV Engines
for the Oil and Gas Industry and Landfills.




F-12




The
manufacture of any Licensed Products by WWE is prohibited.  WWE is
required to procure all internal combustion engines incorporating the CSRV Valve
System from the Company or its designee. The license granted to WWE is exclusive
within the Territory, provided that WWE satisfies the minimum annual purchase
commitment of 120 internal combustion engines incorporating the CSRV System, the
Coates Engines and all component parts. The agreement also grants WWE 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 in the oil and
gas industry or landfill operations.





After
payment of the Release Payment required under the Escrow Agreement, the
remaining unpaid balance of the US License fee of $49 million is payable in
quarterly installments commencing October 27, 2008 in an amount equal to WWE’s
prior quarter net profits. As WWE has not generated a net profit to date, no
quarterly installment payments have been required. In any event, the entire
balance of the licensing fee must be paid in full on or before February 12,
2012.





Acceleration
of the balance of the licensing fee payments shall be required in the event that
WWE completes a stock offering or private placement offering.  The
entire unpaid balance of the licensing fee shall become due and payable if WWE
raises $100 million or more from such offering.





In May
2008, the Company was advised that WWE had secured an equipment lease finance
commitment from Canada West Corporate Finance, Inc. (“Canada
West”), which is to be utilized for its Coates CSRV engine generator
purchases over the next five years pursuant to its licensing agreement with the
Company. The five-year WWE business plan on which this agreement was based
provides for the purchase of approximately 7,400 Engine
Generators.  On October 1, 2008, this financing agreement was
reconfirmed, expanded in scope and increased in amount.  WWE can now
depend on this agreement to finance any of its purchases of equipment from the
Company. In addition, the price per unit that may be paid to the Company by WWE
under this facility was increased to $222,000. Accordingly, should WWE fulfill
its five year business plan, this agreement could exceed an aggregate amount of
$1.6 Billion. The current economic environment, which is characterized by
tight credit markets, investor uncertainty about how to safely invest their
funds and low investor confidence, has introduced additional risk and difficulty
for borrowers. Accordingly, there can be no assurance that tight credit markets
will not affect the availability of funds under the financing commitment
obtained from Canada West by WWE.





7.
LICENSE DEPOSITS





License
deposits, which are non-refundable, primarily relate to the $300,000 license
deposit described above from WWE.





8.
PROPERTY, PLANT AND EQUIPMENT





Property,
plant and equipment at cost, less accumulated depreciation, consists of the
following at December 31:




2008
                          
                          
                          2007Land
                          
                          $
                          -
                          
                          
                          $
                          920,550Building
                          
                          
                          -
                          
                          
                          
                          579,450Building
      improvements
                          
                          
                          -
                          
                          
                          
                          219,371Machinery
      and equipment
                          
                          
                          521,583
                          
                          
                          
                          521,582Furniture
      and fixtures
                          
                          
                          39,295
                          
                          
                          
                          39,295560,878
                          
                          
                          
                          2,280,248Less:  Accumulated
      depreciation
                          
                          
                          (521,502
                          )
                          
                          
                          (806,225
                          )Total
                          
                          $
                          39,376
                          
                          
                          $
                          1,474,023





Depreciation
expense amounted to approximately $32,000 and $44,000 for the years ended
December 31, 2008 and 2007, respectively.




F-13




9.
SECURITY DEPOSIT





Security
deposit consists of a deposit on the Company’s principal offices, warehouse and
manufacturing facility pursuant to the sale/leaseback agreement. (See Note
10).





10.
SALE/LEASEBACK OF LAND AND BUILDING





In 2005,
the Company entered into a sale/leaseback arrangement of the property which
houses its principal offices, warehouse and manufacturing
facilities.  Pursuant to generally accepted accounting principles,
this transaction was required to be accounted for under the finance method until
November 2008, because the Company had a continuing interest in the property
represented by an option to repurchase the property at any time during the first
three years of the agreement. This option lapsed unexercised in November
2008.  The Company realized net proceeds from this transaction of
$3,876,607, which was partially used to repay the approximately $868,000
remaining balance of a mortgage loan and the balance of the proceeds was
utilized for working capital purposes.  The monthly rental payments
provided for by the lease agreement were being accounted for as interest
expense, which amounted to $357,500 and $390,000 in the accompanying statement
of operations for the years ended December 31, 2008 and 2007,
respectively.




The
lapsing of this option in November 2008 requires the recognition of the sale of
the property and the determination of the amount of the gain on the sale
transaction of approximately $2,474,000, of which approximately $1,467,000 was
recognized immediately. The amount of the gain recognized immediately was equal
to the excess of the gain over the present value of the 36 remaining lease
payments under the sale/leaseback agreement. The remaining portion of the gain
of approximately $1,007,000 has been deferred and is being amortized over the
remaining 36-month term of the sale/leaseback agreement. For the year ended
December 31, 2008, approximately $28,000 of this deferred gain was also
recognized.  The total amount of the gain recognized in 2008 is
included in gain from sale of land and building in the accompanying statement of
operations for the year ending December 31, 2008. The remaining unrecognized
balance of the deferred gain on sale of approximately $978,000 is presented as
deferred gain on sale of land and building in the accompanying balance
sheet at December 31, 2008.




As a
result of recognizing the sale of the property, the land, building, building
improvements, accumulated depreciation and finance obligation have been removed
and are no longer reflected in the accompanying balance sheet at December 31,
2008. In addition, the remaining payments due under the sale/leaseback agreement
subsequent to the recognition of the sale are being charged to rent expense in
accordance with the required accounting treatment for an operating lease. Rent
expense for the year ended December 31, 2008 amounted to $32,500. There was no
rent expense for the year ended December 31, 2007.




Minimum
payments under the sale/leaseback agreement are as follows:




Year Ending December 31,
                  
                  Amount2009
                  
                  $
                  390,0002010
                  
                  
                  390,0002011
                  
                  
                  357,500Total
                  
                  $
                  1,137,500





The
Company is responsible for all operating expenses and real estate taxes under
the sale/leaseback agreement.





11.
LICENSING AGREEMENTS AND DEFERRED LICENSING COSTS





On April
6, 2007, a prior license agreement with George J. Coates and Gregory Coates was
amended and restated (the “Amended Coates License Agreement”). Under the Amended
Coates License Agreement, George J. Coates and Gregory Coates granted to the
Company an exclusive, perpetual, royalty-free, fully paid-up license to the
intellectual property that specifically relates to an internal combustion engine
that incorporates the CSRV System technology (the “CSRV Engine”) and that is
currently owned or controlled by them (the “CSRV Intellectual Property”), plus
any CSRV Intellectual Property that is developed by them during their employment
with the Company. The employment agreements with George J. Coates and Gregory
Coates contain two-year non-compete provisions relating to the CSRV Intellectual
Property in the event either of them is terminated for cause, as defined, or if
either of them terminates their employment without good reason, as
defined.




Under the
Amended Coates License Agreement, George J. Coates and Gregory Coates agreed
that they will not grant any licenses to any other party with respect to the
CSRV Intellectual Property.




At
December 31, 2008 and 2007, deferred licensing costs, comprised of expenditures
for patent costs incurred pursuant to the CSRV licensing agreement, net of
accumulated amortization, amounted to approximately $72,000 and $77,000,
respectively.





12.
ACCOUNTS PAYABLE AND ACCRUED LIABILITIES





Accounts
payable and accrued liabilities at December 31 are approximately as
follows:





2008
                  
                  
                  2007Legal
      and professional fees
                  
                  $
                  885,000
                  
                  
                  $
                  803,000Accrued
      compensation and benefits
                  
                  
                  146,000
                  
                  
                  
                  119,000General
      and administrative expenses
                  
                  
                  115,000
                  
                  
                  
                  14,000Accrued
      liability for litigation  settlement
                  
                  
                  92,000
                  
                  
                  -Other
                  
                  
                  10,000
                  
                  
                  
                  12,000Total
                  
                  $
                  1,248,000
                  
                  
                  $
                  948,000




F-14




13.
CAPITAL STOCK





Common
Stock





On
February 26, 2007, the Company’s common stock commenced trading on the Over the
Counter Bulletin Board market system under the ticker symbol COTE.





On
September 15, 2008, the Board of Directors approved a plan to repurchase up to 2
million shares of the Company’s outstanding common stock from time-to-time until
expiration of this plan on December 31, 2009. This plan was not publicly
announced in a tender offer or other notice for the purpose of identifying
shareholders desirous of selling shares to the Company. In accordance with this
plan, the following shares were purchased on the Over the Counter Bulletin Board
through a stockbroker:


.


Period
                    
                    Total
      Number of Shares Purchased
                    
                    
                    Average
      Price Paid per Share
                    
                    
                    Total
      Number of Shares Purchased as Part of Publicly Announced Plans or
      Programs
                    
                    
                    Maximum
      Number of Shares that May Yet be Purchased Under the Plans or
      ProgramsSeptember
      2008
                    
                    
                    300,000
                    
                    
                    $
                    0.30
                    
                    
                    
                    -
                    
                    
                    
                    1,700,000Total
                    
                    
                    300,000
                    
                    
                    $
                    0.30
                    
                    
                    
                    -
                    
                    
                    
                    1,700,000





During
the years ended December 31, 2008 and 2007, the Company sold 15,000 and
2,341,803 registered shares of its common stock, respectively, under an equity
line of credit with Dutchess Private Equities Fund, Ltd. and received proceeds
of approximately $8,000 and approximately $1,216,000, respectively. (See Note
16). There were no offering costs related to the shares sold in 2008. The amount
recorded to additional paid in capital in 2007, was reduced by offering costs
approximating $73,000.





In a
connection with a placement agency agreement with Stonegate Securities, Inc.,
which is discussed in more detail in Note 17, as compensation for its initial
due diligence efforts, in 2007, the Company delivered to Stonegate’s designee
200,000 fully paid non-assessable restricted shares of common stock of the
Company.





During
2007, the Company sold in a series of three transactions, 3,333,333 shares of
its common stock to the son of a director of the Company and received aggregate
gross proceeds of $1,250,000. These transactions were private sales of
unregistered securities pursuant to stock purchase agreements. These
shares were included in a registration statement, filed with the Securities and
Exchange Commission ("SEC"), declared effective June 2007.





In March
2007, the Company issued a 10% Convertible Subordinated Note, due January 2010
(“Convertible Note”) in the principal amount of $100,000 to one of its outside
directors and received cash proceeds of $100,000. In April 2007, the Company
issued an additional 10% Convertible Note in the principal amount of $20,000 to
another outside director and received cash proceeds of $20,000. This amount is
included in non-current liabilities on the accompanying balance sheets. The
proceeds from the Convertible Notes were used for working capital purposes. The
Convertible Notes are 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 notes being converted by $0.45. As the closing
price of the Company’s common stock on the date of the transaction was $0.35 per
share, there was no beneficial conversion feature. Interest shall accrue at the
rate of 10% per annum and shall be payable in cash only at maturity. 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. On May 16, 2007, $100,000 principal
amount of these convertible notes was converted into 222,222 shares of the
Company’s common stock. The Company has reserved 44,444 shares of its common
stock for conversion of the balance of these notes. The
shares of common stock reserved for issuance upon conversion of the Convertible
Notes were included in a registration statement filed with the SEC, declared
effective June 2008.





The
Company completed a private placement offering in March 2007 (the “Offering”) of
“Units” consisting of (i) one share of the Company’s 6% Series A Convertible
Preferred Stock (the “Preferred Stock”) and (ii) a Warrant to purchase five
thousand shares of the Company’s common stock at an initial exercise price of
$1.10 per share (the “Warrants”).




F-15




The
Company received aggregate net proceeds from the Offering amounting to $420,000,
which was used for working capital purposes. There were no expenses incurred
related to the Offering. All of the investors have accepted ten shares of the
Company’s common stock in lieu of each share of Preferred Stock purchased
through the Offering. No shares of Preferred Stock were issued. In June 2007,
the Company issued in the aggregate 420,000 shares of its common stock and 42
Warrants in connection with the Units sold. The amount received for the 420,000
shares of common stock is reflected in common stock and additional paid in
capital in the accompanying balance sheets. The
shares sold and the shares reserved for issuance upon exercise of the Warrants
were included in a registration statement, filed with the SEC, declared
effective June 2007.





Convertible
Preferred Stock





In
September 2007, the Company amended its certificate of incorporation canceling
all of the 14,000,000 shares of Series A Convertible Preferred Stock, par value
$0.001 per share and authorizing 100,000,000 new shares of Preferred Stock, par
value, $0.001 per share (the “Preferred Stock”).  The Company may
issue any class of the Preferred Stock in any series. The Board of Directors
shall have authority to establish and designate series, and to fix the number of
shares included in each such series and the relative rights, preferences and
limitations as between series, provided that, if the stated dividends and
amounts payable on liquidation are not paid in full, the shares of all series of
the same class shall share ratably in the payment of dividends including
accumulations, if any, in accordance with the sums which would be payable on
such shares if all dividends were declared and paid in full, and in any
distribution of assets other than by way of dividends in accordance with the
sums which would be payable on such distribution if all sums payable were
discharged in full. Shares of each such series when issued shall be designated
to distinguish the shares of each series from shares of all other
series.





14.
INCOME (LOSS) PER SHARE





At
December 31, 2008, the Company had 2,029,444 shares of common stock potentially
issuable upon assumed conversion of (i) $20,000 principal amount of 10%
convertible notes into 44,444 shares of common stock, (ii) 42 outstanding
warrants to purchase 210,000 shares of common stock a price per share of $1.10;
and, (iii) 1,151,666 vested stock options and 623,334 non-vested stock options
to purchase shares of common stock at a price per share of
$0.44.   For the year ended December 31, 2008, fully diluted
earnings per share was determined by assuming that the 10% convertible note was
converted into 44,444 shares of common stock and that the interest on such notes
during the period of approximately $2,000 was not incurred. The potentially
issuable shares related to the warrants and stock options were not included in
fully diluted earnings per share because the effect of including them in the
calculation would have been anti-dilutive. For the year ended December 31, 2007,
none of the potentially issuable shares of common stock were assumed to be
converted because the Company incurred a net loss in that year and the effect of
including them in the calculation would have been anti-dilutive.




F-16




15.
STOCK OPTIONS





The
Company’s 2006 Stock Option and Incentive Plan (the “Stock Plan”) was adopted by
the Company’s Board of Directors 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 shares of common stock covered by the Stock Plan.





The Stock
Plan is administered by the Board of Directors and the Compensation
Committee.  Subject to the provisions of the Stock Plan, the Board of
Directors 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 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.




F-17




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
of Directors 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.





There
were no stock options outstanding at the beginning of 2007. The Company granted
options to purchase 1,775,000 shares of common stock (1,750,000 shares to
officers and directors) on April 18, 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 weighted-average fair value of stock options
granted during the year ended December 31, 2007 was approximately $705,000. The
weighted-average fair value of 563,333 and 588,333 stock options which vested
during the years ended December 31, 2008 and 2007, respectively, was
approximately $225,000 and $235,000. The weighted-average fair value of 623,334
nonvested stock options at December 31, 2008 was approximately $249,000. Total
compensation cost related to nonvested stock options at December 31, 2008 that
has not been recognized was approximately $82,000. This non-cash compensation
expense will be recognized in the future over a remaining weighted average
period of approximately 1.4 years.





The
Company also granted 25,000 four-year non-employee stock options to its
corporate general counsel on April 18, 2007 at an exercise price of $0.44 per
share, which will be accounted for in accordance with the guidance in Emerging
Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments That are
Issued to Other Than Employees for Acquiring, or in Conjunction with Selling,
Goods or Services”. In accordance therewith, the fair value of each option is
estimated on the balance sheet date for non-vested options and on the vesting
date for vested options. Upon issuance, 5,000 stock options vested and the
remaining 20,000 stock options vest in equal amounts over 4 years. The fair
value of the 10,000 stock options that vested through December 31, 2008, was
approximately $2,900. At December 31, 2008, the fair value of the 15,000
unvested stock options was $-0- because the exercise price was higher than the
closing trading price of the shares of common stock at December 31,
2008.




For the
years ended December 31, 2008 and 2007, the Company recorded non-cash
stock-based compensation expense amounting to approximately $217,000 and
$414,000, respectively, relating to stock option grants. For the years ended
December 31, 2008 and 2007, approximately $162,000 and $286,000, respectively,
of this amount is included in research and development expenses and
approximately $55,000 and $128,000, respectively, of this amount is included in
general and administrative expenses in the accompanying statements of
operations.





Asummary of the activity in
the Company’s Stock Option Plan for employees and directors is as
follows:





Exercise
      Price Per Share
                                  
                                  
                                  Number
      Outstanding
                                  
                                  
                                  Weighted
      Average Remaining Contractual Life
                                  
                                  
                                  Number
      Exercisable
                                  
                                  
                                  Weighted
      Average Exercise Price
                                  
                                  
                                  Weighted
      Average Fair Value at Date of GrantBalance,
      1/1/07
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Granted
                                  
                                  $
                                  0.44
                                  
                                  
                                  
                                  1,625,000
                                  
                                  
                                  
                                  15
                                  
                                  
                                  
                                  558,333
                                  
                                  
                                  $
                                  0.44
                                  
                                  
                                  $
                                  0.40Granted
                                  
                                  $
                                  0.44
                                  
                                  
                                  
                                  150,000
                                  
                                  
                                  
                                  15
                                  
                                  
                                  
                                  30,000
                                  
                                  
                                  $
                                  0.44
                                  
                                  
                                  $
                                  0.40Balance,
      12/31/07
                                  
                                  $
                                  0.44
                                  
                                  
                                  
                                  1,775,000
                                  
                                  
                                  
                                  15
                                  
                                  
                                  
                                  588,333
                                  
                                  
                                  $
                                  0.44Vested
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  563,333Balance,
      12/31/08
                                  
                                  $
                                  0.44
                                  
                                  
                                  
                                  1,775,000
                                  
                                  
                                  
                                  15
                                  
                                  
                                  
                                  1,151,666
                                  
                                  
                                  $
                                  0.44





No stock
options were exercised, forfeited or expired during the years ended December 31,
2008 and 2007. The weighted average fair value of the Company's stock-based
compensation expense of $0.40 per share 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
                        
                        
                        4.56%-4.64
                        %●
                        Expected
      life (in years)
                        
                        
                        4●
                        Dividend
      yield
                        
                        
                        0.00





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 expectation 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.




F-18




In
connection with the employment agreements entered into with George J. Coates,
Gregory Coates and Barry C. Kaye, the Company granted non-qualified stock
options to purchase shares of the Company’s common stock with an exercise price
of $0.44 per share to these employees. At the same time, the Company granted
25,000 stock options to purchase shares of the Company’s common stock with an
exercise price of $0.44 per share to each of its outside directors. The Company
also granted 25,000 stock options to purchase shares of the Company’s common
stock with an exercise price of $0.44 per share to its general counsel and
25,000 stock options to an employee. No other stock options have been granted by
the Company through December 31, 2008. The following table sets forth
information with respect to such stock options granted:





Name
                Title
                Number
      of Shares of Common Stock Underlying Non-vested Options
                Option
      ExpirationDateGeorge
      J. Coates
                Chairman,
      Chief  Executive Officer and President
                1,000,000(1)
                10/23/2021Gregory
      Coates
                Director
      and President, Technology Division
                500,000(1)
                10/23/2021Barry
      C. Kaye
                Director,
      Treasurer and Chief Financial Officer
                125,000(2)
                10/18/2021All
      other employees
                
                25,000(4)
                4/4/2022Dr.
      Frank J. Adipietro
                Non-employee
      Director
                25,000(3)
                3/28/2022Glenn
      Crocker
                Non-employee
      Director
                25,000(3)
                3/28/2022Dr.
      Richard W. Evans
                Non-employee
      Director
                25,000(3)
                3/28/2022Dr.
      Michael J. Suchar
                Non-employee
      Director
                25,000(3)
                3/28/2022Richard
      Whitworth
                Non-employee
      Director
                25,000(3)
                3/28/2022William
      Wolf. Esq.
                Outside
      General Counsel
                25,000(4)
                4/4/2022




(1)
One-third of these stock options vested on April 30, 2007, one-third vested on
October 23, 2008 and the balance shall vest on October 23, 2009.




(2) 25,000
of these options vested on April 30, 2007, 33,333 of these stock options vested
on October 23, 2007, 33,333 vested on October 23, 2008 and the balance shall
vest on October 23, 2009.




(3)One-fifth
of these stock options vested on March 28, 2007, one-fifth vested on March 28,
2008 and the balance shall vest in three equal amounts on each of March 28,
2009, 2010 and 2011.




(4)One-fifth
of these stock options vested on April 4, 2007, one-fifth vested on April 4,
2008 and the balance shall vest in three equal amounts on each of April 4, 2009,
2010 and 2011.




Vesting
of all stock options is subject to acceleration under certain circumstances in
the event of an acquisition of the Company.




F-19




16.
INVESTMENT AGREEMENT WITH DUTCHESS PRIVATE EQUITIES FUND, LTD. AND REGISTRATION
OF SECURITIES





On April
26, 2007, the Company entered into an Investment Agreement with Dutchess Private
Equities Fund, Ltd. (the “Investor”). Pursuant to this Agreement, the Investor
has committed to purchase up to $10,000,000 of the Company’s common stock over
the course of thirty-six (36) months. The amount that the Company shall be
entitled to request from each purchase (“Puts”) shall be equal to, at the
Company’s election, either (i) up to $500,000 or (ii) 200% of the average daily
volume (U.S. market only) of the common stock for the ten (10) trading days
prior to the applicable Put Notice Date, multiplied by the average of the three
(3) daily closing bid prices immediately preceding the Put Date. The Put Date
shall be the date that the Investor receives a Put Notice of a draw down from
the Company. The purchase price shall be set at ninety-three percent (93%) of
the lowest closing Best Bid price of the common stock during the pricing period.
The pricing period shall be the five (5) consecutive trading days immediately
after the Put Notice Date. There are Put restrictions applied on days between
the Put Date and the closing date with respect to that particular Put. During
this interim period, the Company is not entitled to deliver another Put Notice.
Further, the Company shall reserve the right to withdraw that portion of the Put
that is priced below seventy-five percent (75%) of the lowest closing bid prices
for the 10-trading day period immediately preceding each Put
Notice.




In
connection with this transaction, the Company filed a registration statement on
Form SB-2 with the Securities and Exchange Commission (“SEC”) covering
15,000,000 shares of the common stock underlying the Investment Agreement. This
registration statement was declared effective by the SEC on June 22, 2007. The
Company shall have an ongoing obligation to register additional shares of our
common stock as necessary underlying the draw downs. The Company also included
in this registration statement, the registration of approximately 4,230,000
shares of common stock representing the 266,667 shares reserved for conversion
of the 10% convertible notes (222,222 of which were converted in May 2007),
630,000 shares of common stock related to the stock and warrants issued in
connection with a completed private placement of securities and 3,333,333 shares
of common stock sold in April and May 2007.





During
the years ended December 31, 2008 and 2007, the Company sold 15,000 and
2,341,803 shares of its common stock under this equity line of credit and
received proceeds of approximately $8,000 and $1,216,000, respectively. The
amount recorded to additional paid-in capital was reduced by offering costs
approximating $73,000 in 2007. The balance of this equity line of credit
available for future drawdown, at the option of the Company, at December 31,
2008 is approximately $8,776,000.





17.
PLACEMENT AGENCY AGREEMENT WITH STONEGATE SECURITIES, INC.





In
December 2007, the Company entered into a placement agent agreement with
Stonegate Securities, Inc. (“Stonegate”) to act as its placement
agent.   Stonegate has the right during the Contract Period to
identify for the Company prospective Purchasers in one or more Placements of
Securities, the type and dollar amount being as mutually agreed to by the
parties. The agreement may be cancelled by either party upon ten (10) days
written notice.





As
compensation for services rendered by Stonegate in connection with the
Placements, the Company has agreed to pay Stonegate a fee of eight percent (8%)
of the gross proceeds from the sale of Securities in the
Placements.  No fees shall be due and payable in connection with sales
of Securities in the Placement to investors not introduced to the Company by
Stonegate or by a direct or indirect party previously introduced to the Company
as a result of the efforts of Stonegate. As compensation for its initial due
diligence efforts, in 2007, the Company delivered to Stonegate’s designee
200,000 fully paid non-assessable restricted shares of its common
stock.  The value of these shares on the date of issuance was
approximately $85,000 and was included in general and administrative costs for
the year ended December 31, 2007.




F-20




Upon
closing of a Placement, the Company agreed to issue to Stonegate restricted
shares of common stock of the Company in an amount that is equal to two percent
(2%) of the total number of shares of common stock sold, and/or in the event of
a sale of convertible securities, the number of shares of common stock that
would be potentially received upon a conversion of any convertible securities
sold in the Placement.  Such number of shares to be issued to
Stonegate shall be reduced by the 200,000 shares set forth above.





The
Company shall also reimburse Stonegate for reasonable, actual out-of-pocket
expenses incurred by Stonegate, provided, however, that such amount in total
shall not exceed one percent (1%) of the gross proceeds of securities placed
pursuant to this Placement Agreement.





18.
EMPLOYMENT AGREEMENTS





George J.
Coates





In April
2007, the Company executed an amended and restated employment agreement with
George J. Coates (the “GJC Agreement”) that replaces an employment agreement
signed in 2006.   The term of the GJC Agreement, which became
effective as of October 23, 2006, is for five years.  The GJC
Agreement provides for annual salary of $183,549, an annual performance bonus
determined by unanimous vote of the independent members of the Board of
Directors, plus vacation, sick leave and participation in health, dental and
life insurance and any other established benefit plans.  The GJC
Agreement further provides that upon the Company achieving a sufficient level of
working capital, the amount of annual salary shall be increased to $300,000, an
automobile will be provided to Mr. Coates and he will be entitled to a severance
payment equal to three years’ annual compensation, should he terminate his
employment with Good Reason, as defined, or upon his death. He will also be
provided with a $2 million life insurance policy and work with the
Company in securing key-man life insurance. In accordance with the GJC
Agreement, the Company granted Mr. Coates 1,000,000 stock options at an exercise
price of $0.44 per share. These stock options were granted with a service
inception date equal to the effective date of the GJC Agreement. The Board of
Directors authorized an increase in April 2008, of Mr. Coates’ annual base
compensation to $250,000.





Barry C.
Kaye





In April
2007, the Company executed an amended and restated employment agreement with Mr.
Kaye (the “Kaye Agreement”) that replaces an employment agreement signed in
2006.  The term of the Kaye Agreement, which became effective as of
October 18, 2006, is for three years.  The Kaye Agreement initially
provides for minimum wages and benefits.  The Kaye Agreement further
provides that upon the Company achieving a sufficient level of working capital,
the amount of annual salary shall be increased to $125,000, he will become
eligible for an annual performance bonus and he will be entitled to a severance
payment equal to one year’s annual compensation, should he be terminated by the
Company without Cause, as defined, or if he should terminate his employment with
Good Reason, as defined. In accordance with the Kaye Agreement, the Company
granted Mr. Kaye 125,000 stock options at an exercise price of $0.44 per share.
These stock options were granted with a service inception date equal to the
effective date of the Kaye Agreement. Mr. Kaye is currently being paid for his
services on a per diem basis until the salary provisions of his employment
agreement become effective.




F-21




Gregory
Coates





In April
2007, the Company executed an amended and restated employment agreement with
Gregory Coates (the “GC Agreement”) that replaces an employment agreement signed
in 2006.   The term of the GC Agreement, which became effective
as of October 23, 2006, is for five years.  The GC Agreement provides
for annual salary of $79,898, plus vacation, sick leave and participation in
health, dental and life insurance and any other established benefit plans. The
GC Agreement further provides that upon the Company achieving a sufficient level
of working capital, the amount of annual salary shall be increased to $250,000,
he will become eligible for an annual performance bonus, a
company-provided automobile and a severance payment equal to two years’
annual compensation, should he terminate his employment with Good Reason, as
defined. He will also be provided with a $2 million life insurance policy and
will work with the Company in securing key-man life insurance. In accordance
with the GC Agreement, the Company granted Gregory Coates 500,000 stock options
at an exercise price of $0.44 per share. These stock options were granted with a
service inception date equal to the effective date of the GC Agreement. The
Board of Directors authorized an increase in April 2008 of Gregory Coates’
annual base compensation to $150,000.





Mark D.
Goldsmith





In late
March 2007, Mark D. Goldsmith stepped down from his positions as Chief Executive
Officer and President, and in April 2007, Mr. Goldsmith resigned his position as
a member of the Board of Directors. The amount of compensation that could be due
Mr. Goldsmith for his employment in 2007 and 2006, has without prejudice to the
Company's position been accrued for accounting purposes only, in the amount of
approximately $96,000 through April 13, 2007, the date the Company believes that
Mr. Goldsmith was terminated with Cause. This amount has been included in
accounts payable and accrued liabilities in the accompanying balance sheets. As
discussed in more detail in Note 21, Mr. Goldsmith has asserted a claim for
breach of his employment contract and is seeking compensatory and punitive
damages in connection therewith. In the opinion of management, this complaint is
without merit and the Company intends to vigorously defend against
it.  The Company does not intend to make any payments to Mr. Goldsmith
in connection with this employment agreement.





Aggregate
minimum payments under the employment agreements for George J. Coates, Gregory
Coates and Barry C. Kaye, are approximately as follows:




Year Ending December 31,
                  
                  Amount(1)2009
                  
                  $
                  400,0002010
                  
                  
                  400,0002011
                  
                  
                  333,000Total
                  
                  $
                  1,133,000





(1)As
of December 31, 2008, the provision for the payment of salary in Mr. Kaye's
employment agreement had not become effective. Mr. Kaye is being paid
for his services as a consultant to the Company until these salary provisions
become effective. The minimum payments under these employment agreements,
including Mr. Kaye’s would increase to $675,000 per annum through October 17,
2009 and to $550,000 for the period from October 18, 2009 through October 23,
2011, upon the Company achieving an adequate level of working capital, as
defined in the employment agreements.





19.
INCOME TAXES





Total
deferred tax assets and valuation allowances are approximately as follows at
December 31:





2008
                  
                  
                  2007Current
      deferred tax asset - inventory reserve
                  
                  $
                  100,000
                  
                  
                  $
                  85,000Non-current
      Deferred Tax Assets:Net
      operating loss carryforwards
                  
                  
                  5,974,000
                  
                  
                  
                  6,271,000Deferred
      gain on sale of property
                  
                  
                  367,000
                  
                  
                  
                  980,000Accrued liabilities not
      paid
                  
                  
                  262,000
                  
                  
                  
                  -Stock-based
      compensation expense
                  
                  
                  252,000
                  
                  
                  
                  166,000Other
                  
                  
                  (5,000
                  )
                  
                  
                  (4,000
                  )Total
      long-term deferred tax assets
                  
                  
                  6,850,000
                  
                  
                  
                  7,413,000Total
      deferred tax assets
                  
                  
                  6,950,000
                  
                  
                  
                  7,498,000Less:
      valuation allowance
                  
                  
                  (6,950,000
                  )
                  
                  
                  (7,498,000
                  )Net
      deferred tax assets
                  
                  $
                  -
                  
                  
                  $
                  -





The
differences between income tax provision (benefit) in the financial statements
and the tax benefit (provision) computed at the U.S. Federal statutory rate of
34% at December 31, are as follows:





2008
                  
                  
                  2007Federal
      tax provision (benefit) at the statutory rate
                  
                  
                  34.0
                  %
                  
                  
                  (34.0
                  )%State
      income taxes, net of federal benefit
                  
                  
                  3.7
                  
                  
                  
                  -Accrued
      liabilities not paid
                  
                  
                  7.4
                  
                  
                  
                  -Stock-based
      compensation expense
                  
                  
                  8.4
                  
                  
                  
                  5.5Gain
      on sale of property
                  
                  
                  (58.1
                  )
                  
                  
                  -Inventory
      reserves
                  
                  
                  -
                  
                  
                  
                  0.1Depreciation
      deduction for financial reporting purposes
                  
                  
                  0.7
                  
                  
                  
                  0.3Other
                  
                  
                  (0.2
                  )
                  
                  
                  -Valuation
      allowance
                  
                  
                  4.1
                  
                  
                  
                  28.1Effective
      tax rate
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %





During
the year ended December 31, 2008, the Company reduced the deferred tax asset
upon the denial of the Company’s application for authority to sell its 2007
State of New Jersey net operating loss. At December 31, 2008, the Company had
available, approximately $17,061,000 of net operating loss carryforwards which
may be used to reduce future federal taxable income, expiring between December
31, 2013 and 2028.  At December 31, 2008, the Company had available
approximately $2,884,000 of net operating loss carryforwards which may be used
to reduce future state taxable income, expiring between December 31, 2026 and
2028. For the year ended December 31, 2008, the valuation allowance decreased by
approximately ($548,000) and for the year ended December 31, 2007, the valuation
allowance increased by approximately $887,000.




F-22




20.
RELATED PARTY TRANSACTIONS





On April
30, 2003, the Company amended its license agreement with Coates Motorcycle (the
“Amended Motorcycle License Agreement”). Pursuant to a prior license agreement,
the Company granted certain exclusive licenses in exchange for approximately 51%
of the common shares of Coates Motorcycle.  In addition, the Company
had an anti-dilution right. The Amended Motorcycle License Agreement expanded
the license rights granted and removed the anti-dilution provision in exchange
for 1,000,000 common shares of Coates Motorcycle. As a result of these
transactions, the Company owns 3,558,000 shares of Coates Motorcycle,
representing an approximately 30% ownership interest.  The Company is
under no obligation to provide any funding or support to Coates Motorcycle under
any circumstances. Under the Amended Motorcycle License Agreement, the Company
granted an exclusive sublicense for North America, South America and Central
America and their territories (collectively, the "Western Hemisphere") to make,
use and sell motorcycles utilizing the CSRV Technology.





The
Company’s investment in Coates Motorcycle is valued at $-0-, because that was
the cost basis of the assets and the license agreement exchanged for those
shares.  This investment in Coates Motorcycle is being accounted for
under the equity method of accounting for investments.  As such, the
investment is being carried at cost, adjusted for the Company’s proportionate
share of undistributed earnings and losses.




Emerging
Issues Task Force ("EITF") 98-13, "Accounting by an Equity Method Investor for
Investee Losses When the Investor has Loans to and Investments in Other
Securities of the Investee", requires an investor using the equity method, that
has reduced the value of the investment to $-0-, but also has loans outstanding
or other forms of equity such as preferred stock to continue to report its share
of the losses. The Company’s cumulative equity in the losses of Coates
Motorcycle since the initial acquisition of its investment in Coates Motorcycle
reduced the value of the Company’s investment to $-0-. Had the Company continued
to record its proportionate share of undistributed losses after its investment
was written down to $ -0-, it would have recorded an additional share of
undistributed losses aggregating approximately $519,000 through December 31,
2008.




The
Company computed its share of the losses in accordance with EITF 99-10
"Percentage Used to Determine the Amount of Equity Method Losses," where the
percent ownership was based on the assumed conversion of the Preferred Series A
Stock held by the Company.




In 2007,
Coates Motorcycle disbursed all of its remaining cash, curtailed all of its
operations and is currently insolvent.  At this time, Coates
Motorcycle has not developed short-term plans to address this
situation.




In April
2007, the Company acquired approximately $15,000 of equipment from Coates
Motorcycle in consideration for it assuming the remaining obligations on a
capital lease on such equipment which terminated in August 2008.




Summarized
unaudited information for Coates Motorcycle is as follows:





UnauditedDecember 31,2008
                  
                  
                  2007Current
      assets
                  
                  $
                  55
                  
                  
                  $
                  175Total
      assets
                  
                  
                  55
                  
                  
                  
                  175Current
      liabilities
                  
                  
                  (668,591
                  )
                  
                  
                  (579,020
                  )Total
      liabilities
                  
                  
                  (1,560,591
                  )
                  
                  
                  (1,470,520
                  )Stockholders’
      deficiency
                  
                  
                  1,560,536
                  
                  
                  
                  1,470,345UnauditedYears Ended December 31,2008
                  
                  
                  2007Revenue
                  
                  $
                  -
                  
                  
                  $
                  -Operating
      expenses
                  
                  
                  620
                  
                  
                  
                  410,747Net
      loss
                  
                  
                  (90,191
                  )
                  
                  
                  (554,860
                  )




F-23




During
the period through March 2007, Mark Goldsmith, former Chief Executive Officer
and President also served as the Chief Executive Officer, President and Interim
Chief Financial Officer of Coates Motorcycle pursuant to an employment
agreement.  Mr. Goldsmith received salary payments of $25,000 in 2007.
He was also provided with a leased automobile and medical and dental
benefits.





During
the year ended December 31, 2007, the Company acquired approximately $15,000 of
equipment from Coates Motorcycle Company, Ltd. in consideration for assumption
of the remaining net obligation under a capital lease of the equipment amounting
to approximately $15,000. The lease term expired during the year ended December
31, 2008.





The
Coates Trust has made loans to the Company at various times to provide working
capital. George J. Coates, Bernadette Coates, wife of George J. Coates and
Gregory Coates are beneficiaries of the Coates Trust. In April 2007, the Coates
Trust advanced $100,000 in the form of a 6% promissory note. At the same time,
the outstanding balance of the prior loans of $92,337 was converted to and
included in this promissory note. No interest was imputed on these loans for the
period prior to the time they were converted to the 6% promissory note. In May
2007, the entire $192,337 principal amount of the 6% promissory note was repaid,
along with accrued interest of approximately $1,500.




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 and Gregory
Coates, for the two years ended December 31, 2008, is summarized as
follows:





For
      the Years Ended December 31,2008
                  
                  2007George
      J. Coates (a)
                  
                  $
                  264,000
                  
                  
                  $
                  199,000Gregory
      Coates (a)(b)
                  
                  
                  140,000
                  
                  
                  
                  98,000Bernadette
      Coates
                  
                  
                  65,000
                  
                  
                  
                  51,000





(a)
            Includes
      compensation paid in 2008 for 2007 vacation earned but not
      taken.


(b)
            Does
      not include $10,000 paid in 2007 as an initial payment toward a new
      technology that provides computerized control of sequential fuel
      injection, a key component of the natural gas powered CSRV engine
      generator. This technology is in the process of being
      patented.




Barry C.
Kaye, Treasurer and Chief Financial Officer was paid consulting fees of
approximately $70,000 and $80,000 in 2008 and 2007, respectively.




The
Company subcontracts certain project expenses from Coates Precision Engineering,
of which George J. Coates is the sole shareholder.  During the years
ended December 31, 2008 and 2007, the Company paid approximately $500 and
$5,000, respectively, related to these services.




F-24




21.
LITIGATION AND CONTINGENCIES





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 against Gary Sommer, a principal of one of the defendants. 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
its restricted common stock if certain conditions were not met by 1107. The
Company maintains that 1107 did not fulfill such conditions, and failed to make
a certain payment, and therefore, the deposit converted into shares of the
Company’s restricted common stock. Mr. Neff’s claims against the Company and
George Coates had been dismissed by the trial court. That dismissal was
affirmed on appeal and the claims of two other plaintiff companies were
reinstated by the appellate court upon payment by plaintiffs of a
court imposed sanction of $7,500. An additional sanction and costs were
paid to WWE. The claims asserted by all of the parties were settled in March
2009 through mediation. Pursuant to the terms of that settlement, the
Company and WWE agreed to pay 1107 a total of $185,000. The obligation to fund
the settlement was shared equally by the Company and WWE. The Company’s $92,500
portion of the settlement has been accrued and is included in accounts payable
and accrued liabilities in the accompanying balance sheet as of December 31,
2008. All parties executed mutual releases and all claims have been
dismissed with prejudice, without costs to any party. As a condition of the
settlement, Mr. Sommer endorsed over to the Company a stock certificate
evidencing 25,000 shares of the company's common stock. The shares of stock
evidenced by that stock certificate have been 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 April
2007, the Company received a demand letter from a law firm requesting payment of
approximately $77,000 in connection with a promissory note issued to the law
firm as security for the payment of future services to the Company. The Company
had notified the holder of this note that it does not intend to honor the
promissory note because the law firm did not provide the services contemplated
to be performed as consideration for the promissory note. No further action to
pursue collection of this promissory note has been taken to date by the holder.
At this time, it is not possible to reasonably estimate the outcome of this
matter and, accordingly, no amount has been accrued.





Mark D.
Goldsmith, a former executive of the Company, filed suit on January 25, 2008, in
which he asserts that the company is liable to him for breach of an employment
contract. 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 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. Mr. Goldsmith has been served
interrogatories, provided a notice to produce documents and give deposition. On
April 8, 2008, the Company received notice that the court assigned this matter
to mandatory mediation. A mediation session was held on June 23, 2008. Mediation
was not successful. Mr. Goldsmith's deposition was taken on February 10, 2009.
The Company is evaluating whether the information disclosed in that deposition
warrants the filing of a dispositive motion. The Company intends to vigorously
defend against Mr. Goldsmith’s claims and pursue its counterclaims.




F-25




The
Company has without prejudice to its position, accrued compensation under his
employment agreement for accounting purposes only, of approximately $96,000 of
his salary during 2007. Although the Company does not intend to make any
payments to Mr. Goldsmith in connection with this employment agreement, this
amount has been included in accounts payable and accrued liabilities in the
accompanying balance sheets.





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





22.
NEW ACCOUNTING PRONOUNCEMENTS





In
December 2007, the SEC staff issued Staff Accounting Bulletin 110 (“SAB 110”),
“Share-Based Payment,” which amends SAB 107, “Share-Based Payment,” to permit
public companies, under certain circumstances, to use the simplified method in
SAB 107 for employee option grants after December 31, 2007. Use of the
simplified method after December 2007 is permitted only for companies whose
historical data about their employees’ exercise behavior does not provide a
reasonable basis for estimating the expected term of the options. The adoption
of this pronouncement did not have a material effect on the Company’s
financial condition, results of operations or cash flows.




23.
SUBSEQUENT EVENTS





Stock Option
Grant





On
January 19, 2009, in accordance with the Company’s 2006 Stock Option and
Incentive Plan, stock 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. These options become vested on January 19,
2010.





Sale of Shares of Common Stock and
Warrants





In March
2009, the Company sold 838,096 shares of its common stock, 333,333 warrants
to purchase one share of our common stock at an exercise price of $0.30 per
share and 85,714 warrants to purchase one share of our 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 $260,000.












F-26