UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 Form 10-Q
 (Mark One)
 
 þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended March 31, 2011
 o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Transition Period from          to
  Commission File Number 000-51869
 SouthPeak Interactive Corporation
 (Exact Name of Registrant as Specified in Its Charter)
 
 Delaware

20-3290391(State or Other Jurisdiction of

(I.R.S. EmployerIncorporation or Organization)

Identification No.)
 
 2900 Polo Parkway
 Midlothian, Virginia 23113
 (804) 378-5100
 (Address including zip code, and telephone number,
 including area code, of principal executive offices)
 
 Not applicable
 (Former name, former address and former fiscal year, if changed since last report)
 
 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  þ      No  o
 
 Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 Yes  o      No  o
 
 Indicate by check mark whether the registrant is a 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  o
Accelerated filer  o
Non-accelerated filer  o
Smaller reporting company  þ
 (Do not check if a smaller reporting company)
 
 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
 Yes  o      No  þ
 
 As of May 20, 2011, 60,788,538 shares of common stock, par value $0.0001 per share, of the registrant were outstanding.
  
 
 TABLE OF CONTENTS
 
 PagePART I — FINANCIAL INFORMATION

3Item 1.
Financial Statements

3Condensed Consolidated Financial Statements (unaudited)

3Condensed Consolidated Balance Sheets as of March 31, 2011 (unaudited) and June 30, 2010

3Condensed Consolidated Statements of Operations for the three months and nine months ended March 31, 2011 and 2010 (unaudited)

4Condensed Consolidated Statements of Cash Flows for the three months and nine months ended March 31, 2011 and 2010 (unaudited)

5Notes to Condensed Consolidated Financial Statements

6Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

24Item 3.
Quantitative and Qualitative Disclosures about Market Risk

34Item 4T.
Controls and Procedures

34PART II — OTHER INFORMATION36Item 1.
Legal Proceedings

36Item 1A.
Risk Factors

36Item 5.
Other Information

37Item 6.
Exhibits

37SIGNATURES

38
  2
  PART I
 
 Item 1. Condensed Consolidated Financial Statements
  SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
 CONDENSED CONSOLIDATED BALANCE SHEETS
 
 March 31,

2011


June 30, 2010(Unaudited)AssetsCurrent assets:Cash and cash equivalents

$
529,836


$
92,893Accounts receivable, net of allowances of $1,567,911 and $5,700,931 at March 31, 2011 and June 30, 2010, respectively


2,680,675



3,703,825Due from factor


1,705,336



-Inventories


1,197,008



1,211,301Current portion of advances on royalties


9,479,698



12,322,926Current portion of intellectual property licenses


353,571



383,571Related party receivables


7,895



34,509Prepaid expenses and other current assets


622,795



695,955Total current assets


16,576,814



18,444,980Property and equipment, net


2,502,102



2,667,992Advances on royalties, net of current portion


2,099,160



1,511,419Intellectual property licenses, net of current portion


1,149,107



1,534,286Goodwill


7,911,800



7,911,800Deferred debt issuance costs, net


412,550



-Intangible assets, net


7,025



17,025Other assets


10,796



11,280Total assets

$
30,669,354


$
32,098,782Liabilities and Shareholders’ EquityCurrent liabilities:Line of credit

$
-


$
3,830,055Secured convertible debt in default, net of discount


4,245,940



950,000Warrant liability


1,914,153



-Current portion of long-term debt


67,764



65,450Production advance payable in default


3,687,177



3,755,104Accounts payable


9,933,788



12,663,788Accrued royalties


2,152,917



2,530,253Accrued expenses and other current liabilities


5,192,308



3,781,711Deferred revenues


151,152



325,301Due to related parties


-



2,200Accrued expenses - related parties


200,809



322,281Total current liabilities


27,546,008



28,226,143Long-term debt, net of current portion


1,493,096



1,541,081Total liabilities


29,039,104



29,767,224Commitments and contingencies


-



-Shareholders’ equity:Preferred stock, $0.0001 par value; 5,000,000 shares authorized; no shares issued and outstanding at March 31, 2011 and June 30, 2010


-



-Series A convertible preferred stock, $0.0001 par value; 15,000,000 shares authorized; 5,503,833 and 5,503,833 shares issued and outstanding at March 31, 2010 and June 30, 2010, respectively; aggregate liquidation preference of $5,503,833 at March 31, 2011


550



550Common stock, $0.0001 par value; 90,000,000 shares authorized; 60,188,536 and 59,774,370 shares issued and outstanding at March 31, 2011 and June 30, 2010, respectively


6,019



5,976Additional paid-in capital


30,848,266



31,154,835Accumulated deficit


(29,044,331
)


(28,973,325
)Accumulated other comprehensive income (loss)


(180,254
)


143,522Total shareholders’ equity


1,630,250



2,331,558Total liabilities and shareholders’ equity

$
30,669,354


$
32,098,782
 
 The accompanying notes are an integral part of these condensed consolidated financial statements.
  3
  SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (Unaudited)
  For the three months ended

March 31,


For the nine months ended

March 31,2011


2010


2011


2010Net revenues

$
16,118,896


$
7,538,840


$
25,020,808


$
34,312,441Cost of goods sold:Product costs


4,975,572



3,778,704



8,834,291



12,474,987Royalties


2,721,656



3,251,395



5,953,086



9,871,028Intellectual property licenses


88,393



95,893



280,179



315,350Total cost of goods sold


7,785,621



7,125,992



15,067,556



22,661,365Gross profit


8,333,275



412,848



9,953,252



11,651,076Operating expenses:Warehousing and distribution


328,669



327,286



677,085



934,520Sales and marketing


1,633,499



988,226



3,504,668



6,858,902General and administrative


1,350,875



2,665,494



5,374,272



8,754,206Litigation costs


-



-



-



3,075,206Gain on settlement of contingent purchase price obligation


-



(908,210
)


-



(908,210
)Gain on extinguishment of accrued litigation costs


-



(3,249,610
)


-



(3,249,610
)Loss (gain) on settlement of trade payables


(261,416
)


4,118



(846,538
)


(3,252,371
)Total operating (income) expenses


3,051,627



(172,696
)


8,709,487



12,212,643Income (loss) from operations


5,281,648



585,544



1,243,765



(561,567
)Other expenses (income):Change in fair value of warrant liability


638,051



-



(2,424,595
)


-Interest expense, net


1,430,834



393,404



3,739,366



1,201,578Net income (loss)

$
3,212,763


$
192,140


$
(71,006
)

$
(1,763,145
)Basic income (loss) per share:

$
0.06


$
0.004


$
(0.001
)

$
(0.04
)Diluted income (loss) per share:

$
0.05


$
0.004


$
(0.001
)

$
(0.04
)Weighted average number of common shares outstanding - Basic


57,429,675



45,356,744



57,240,695



45,069,852Weighted average number of common shares outstanding - Diluted


68,653,293



53,297,317



57,240,695



45,069,852
  The accompanying notes are an integral part of these condensed consolidated financial statements.
  4
  SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (Unaudited)
 
 For the nine months ended

March 31,2011


2010Cash flows from operating activities:Net loss

$
(71,006
)

$
(1,763,145
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization


195,430



200,191Allowances for price protection, returns, and defective merchandise


(598,135
)


(573,870
)Bad debt expense, net of recoveries


(72,557
)


(23,364
)Stock-based compensation expense


333,138



551,325Common stock issued to seller for settlement of contingent purchase price obligation


-



245,000Common stock and warrants issued to vendor


-



104,500Amortization of royalties and intellectual property licenses


3,508,174



6,235,905Loss on disposal of fixed assets


-



4,839Amortization of debt discount and issuance costs


1,406,096



-Change in fair value of warrant liability


(2,424,595
)


-Fair market value adjustment to common stock issued for advances on royalties


(2,964
)


-Gain on settlement of trade payables


(846,538
)


(3,252,371
)Gain on settlement of contingent purchase price obligation


-



(908,210)Gain on extinguishment of accrued litigation costs


-



(3,249,610)Changes in operating assets and liabilities:Due to/from factor, net


(5,167,664
)


-Accounts receivable


5,156,170



582,233Inventories


14,293



2,060,950Advances on royalties


(1,610,876
)


(5,600,173
)Related party receivables


26,614



(29,404
)Prepaid expenses and other current assets


73,160



(297,519
)Production advance payable


-



3,755,104Accounts payable


(1,883,462
)


(5,420,220
)Accrued royalties


(377,336
)


2,477,615Accrued expenses and other current liabilities


1,545,597



7,153,737Deferred revenues


(174,149
)


(2,547,339
)Accrued expenses - related parties


(121,472
)


36,163Total adjustments


(1,021,076
)


1,505,482Net cash used in operating activities


(1,092,082
)


(257,663
)Cash flows from investing activities:Purchases of property and equipment


(19,056
)


(83,225
)Change in restricted cash


-



739,799Net cash provided by (used in) investing activities


(19,056
)


656,574Cash flows from financing activities:Proceeds from line of credit


-



23,538,071Repayments of line of credit


(3,830,055
)


(24,143,833
)Proceeds from inventory financing


3,528,237



-Repayments of inventory financing


(3,528,237
)


-Repayments of long-term debt


(45,671
)


(40,943
)Net proceeds from (repayments of) amounts due to shareholders


-



(232,440
)Net proceeds from (repayments of) amounts due to related parties


(2,200
)


(111,845
)Proceeds from the issuance of subordinated convertible promissory notes


7,000,000



-Payment of debt issuance costs


(733,959
)


-Repayments of subordinated convertible promissory notes


(450,000
)


-Proceeds from the exercise of common stock warrants


1,668



-Advances from related parties


-



-Proceeds from the issuance of Series A convertible preferred stock, net of cash offering costs


-



-Net cash (used in) provided by financing activities


1,939,783



(990,990
)Effect of exchange rate changes on cash and cash equivalents


(391,702
)


267,186Net decrease in cash and cash equivalents


436,943



(324,893
)Cash and cash equivalents at beginning of the period


92,893



648,311Cash and cash equivalents at end of the period

$
529,836


$
323,418Supplemental cash flow information:Cash paid during the period for interest

$
1,224,851


$
383,105Cash paid during the period for taxes

$
-


$
-Supplemental disclosure of non-cash activities:Fair value of common stock warrant liability at issuance date

$
4,338,748


$
-Fair market value adjustment to common stock issued for advances on royalties

$
(641,332
)

$
-Conversion of junior secured subordinated convertible promissory note to senior secured convertible note

$
500,000


$
-Issuance of vested restricted stock

$
41


$
-Intellectual property licenses included in accrued expenses and other current liabilities

$
-


$
135,000Contingent purchase price payment obligation related to Gamecock acquisition

$
-


$
477,158Decrease in goodwill with respect to finalizing purchase price allocation

$
-


$
55,423Purchase of vehicle through the assumption of a note payable

$
-


$
73,459Advances on royalties paid with common stock

$
-


$
1,035,000Purchase of videogame development contract paid with common stock

$
-


$
4,000,000
 
 The accompanying notes are an integral part of these condensed consolidated financial statements.
  5
  SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
 Notes to Condensed Consolidated Financial Statements
 (Unaudited)
 
 1.  Principal Business Activity and Summary of Significant Accounting Policies
 
 Business
 
 SouthPeak Interactive Corporation (the “Company”) is an independent developer and publisher of interactive entertainment software.  The Company develops, markets and publishes videogames for all leading gaming and entertainment hardware platforms, including home videogame consoles such as Microsoft Corporation’s (“Microsoft”) Xbox 360 (“Xbox360”), Nintendo Co. Ltd.’s (“Nintendo”) Wii (“Wii”), Sony Computer Entertainment’s (“Sony”) PlayStation 3 (“PS3”) and PlayStation 2 (“PS2”); handheld platforms such as Nintendo Dual Screen (“DS”), Nintendo DSi, Sony PlayStation Portable (“PSP”), Sony PSPgo, Apple Inc. (“Apple”) iPhone; game applications for the Next Generation NVIDIA® TegraTM mobile processor used in Droid phones and tablets; and personal computers.  The Company’s titles span a wide range of categories and target a variety of consumer demographics, ranging from casual players to hardcore gaming enthusiasts.
 
 The Company maintains its operations in the United States and the United Kingdom. The Company sells its games to retailers and distributors in North America and United Kingdom, and primarily to distributors in the rest of Europe, Australia and Asia.
 
 Basis of Presentation
 
 The accompanying unaudited condensed consolidated financial statements as of March 31, 2011 and for the three and nine month periods ended March 31, 2011 and 2010 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial reporting. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, all adjustments (all of which are of a normal, recurring nature) considered for a fair presentation have been included. Operating results for the three and nine month periods ended March 31, 2011 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2011.
 
 The accounting policies followed by the Company with respect to unaudited interim financial statements are consistent with those stated in the Company’s annual report on Form 10-K. The accompanying June 30, 2010 financial statements were derived from the Company’s audited financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended June 30, 2010 filed with the Securities and Exchange Commission (the “SEC”) on October 13, 2010.
 
 The accompanying unaudited condensed consolidated financial statements include the accounts of SouthPeak Interactive Corporation, and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
 
 The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of net revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to the recoverability of advances on royalties, intellectual property licenses and intangibles, valuation of inventories, realization of deferred income taxes, the adequacy of allowances for sales returns, price protection and doubtful accounts, accrued and contingent liabilities, the valuation of stock-based transactions and assumptions used in the Company’s goodwill impairment test.  These estimates generally involve complex issues and require the Company to make judgments, involve analysis of historical and the prediction of future trends, and are subject to change from period to period. Actual amounts could differ significantly from these estimates.
 
 Subsequent events have been evaluated through the filing date of these unaudited condensed consolidated financial statements.
 
 Going Concern
 
 The accompanying condensed consolidated financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  The ability of the Company to continue as a going concern is predicated upon, among other things, generating positive cash flows from operations and the resolution of various contingencies (see Note 11).
  6
 
 As of March 31, 2011, the Company had insufficient cash resources to satisfy its liabilities, many of which are past due. Further, the Company has various unresolved contingencies that could require future cash payments in excess of available funds (see Note 11).
 
 On August 17, 2009, the Company entered into a unit production financing agreement with a producer relating to the production of certain games, of which the balance outstanding under this agreement was $4,090,612 at March 31, 2011, $403,435 of which are included in “Accrued expenses and other current liabilities” in the Company’s condensed consolidated balance sheets (see Note 5).  The Company has failed to make the required payments under this agreement.  As a result, the production advance payable is currently in default and is accruing additional production fees at $0.009 per unit (based upon 382,000 units) for each day after November 15, 2009 (approximately $1,659,000 through March 31, 2011). Given the manner in which the Company was required to enter into this agreement, the Company is contesting its liability for this obligation.
 
 On March 15, 2011, the Company failed to pay the outstanding amount of principal, interest and late charges due on the Additional Notes (as defined below), and such failure triggered a default provision under the Additional Notes following a seven day cure period (the “Maturity Payment Default”).  The Company also failed to have a registration statement (the “Initial Registration Statement”) relating to the shares of common stock underlying the Initial Notes (as defined below) and associated warrants declared effective by March 15, 2011, and such failure triggered a default provision under the Initial Notes (the “Registration Default”).  On May 23, 2011, the Company entered into a Waiver and Amendment Agreement (the “Amendment Agreement”) with the holders of the Notes (See Note 6).  Pursuant to the Amendment Agreement, the holders of the Notes have waived the Maturity Payment Default and Registration Default, as applicable, the maturity date for the Additional Notes has been extended to December 31, 2011, and the interest rate for the Additional Notes has been increased to 29%.  The Amendment Agreement provides that the initial effectiveness deadline by which the Initial Registration Statement must be declared effective by the SEC has been extended (i) to January 31, 2012, in the event that the Initial Registration Statement is not subject to a full review by the SEC, or (ii) to April 30, 2012, in the event that the Initial Registration statement is subject to a full review by the SEC.  As a material inducement for the holders of the Additional Notes to enter into the Amendment Agreement, the Company and certain of its subsidiaries have agreed to (i) instruct its online distribution partners to remit all payments arising from sales through online gaming platforms of the electronic game “Stronghold 3” (the “Game”) to the collateral agent under the relevant security documents, (ii) remit all receivable arising from sales of the Game in Europe directly to the collateral agent, and (iii) pay the collateral agent, upon its demand, 60% of any amounts in excess of $350,000 paid to the Company under the factoring agreement between the Company and Rosenthal & Rosenthal, Inc.
 
 A failure to generate additional revenues, raise additional capital or manage discretionary spending could have a material adverse effect on the Company's ability to continue as a going concern and to achieve its intended business objectives. Accordingly, there is substantial doubt about the Company’s ability to continue as a going concern. A going concern uncertainty may limit the Company’s ability to access certain types of financing, or may prevent the Company from obtaining financing on acceptable terms. If the Company is unable to obtain additional financing, it may not be able to continue as a going concern after its funds have been exhausted and the Company could be required to significantly curtail or cease operations, file for bankruptcy, or liquidate and dissolve. The accompanying condensed consolidated financial statements have been prepared on the basis of the Company continuing as a going concern. No adjustments have been made to carrying value of the assets and liabilities that might result from the outcome of this uncertainty.
 
 Management plans to maintain the Company’s viability as a going concern by:
 
 •
attempting to expeditiously resolve its contingencies for amounts significantly less than currently accrued for in order to reduce aggregate liabilities on the Company’s condensed consolidated balance sheet and negotiate payment terms manageable by the Company;
 
 •
reducing costs and expenses in order to reduce the Company’s ongoing working capital needs and monthly cash burn;
 
 •
seeking to raise additional capital; and
 
 •
applying the anticipated profits from several key game releases towards payment of its outstanding obligations.
  7
 
 While the Company is committed to pursuing these options and others to address its viability as a going concern, there can be no assurance that these plans will be successfully completed or available on acceptable terms; and therefore, there is uncertainty about the Company’s ability to realize its assets or satisfy its liabilities in the normal course of business. If the Company is unsuccessful in pursuing these plans, it may be required to defer, reduce, or eliminate certain planned expenditures.
 
 Concentrations of Major Customers and Major Vendors
 
 The Company has two customers, GameStop, and Wal-Mart, which accounted for 33%, and 18%, respectively, of consolidated gross revenues for the nine months ended March 31, 2011.  GameStop and Solutions2Go accounted for 45% and 17%, respectively, of consolidated gross accounts receivable at March 31, 2011.  For the nine months ended March 31, 2010, Wal-Mart and GameStop accounted for 21% and 20%, respectively, of consolidated gross revenues.  GameStop, Wal-Mart, and Atari accounted for 29%, 15% and 10%, respectively, of consolidated gross accounts receivable at June 30, 2010.
 
 The Company publishes videogames for the proprietary console and hand-held platforms created by Microsoft, Sony and Nintendo, pursuant to the licenses they have granted to the Company. Should the Company’s licenses with any of such three platform developers not be renewed by the developer, it would cause a disruption in the Company’s operations. The Company expects that such contracts will be renewed in the normal course of business.
 
 Amounts incurred related to these three vendors as of March 31, 2011 and June 30, 2010 and for the three-month and nine-month periods ended March 31, 2011 and 2010 are as follows:
 
 Cost of Goods Sold — Products


Accounts PayableFor the

three

months

ended

March 31, 2011


For the

three

months

ended

March 31, 2010


For the

nine

months

ended

March 31, 2011


For the nine

months

ended

March 31, 2010


As of

March 31, 2011


As of

June 30,

2010Microsoft

$
2,000,924


$
552,048


$
2,703,347


$
3,504,488


$
-


$
158,592Nintendo

$
86,396


$
1,732,535


$
1,362,781


$
5,759,074


$
1,128


$
-Sony

$
1,433,484


$
276,256


$
2,323,469


$
385,043


$
9,377


$
449,042
 
 Allowances for Returns, Price Protection, and Doubtful Accounts
 
 Management closely monitors and analyzes the historical performance of the Company’s various games, the performance of games released by other publishers, and the anticipated timing of other releases in order to assess future demands of current and upcoming games. Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets, but at the same time are controlled to prevent excess inventory in the channel.
 
 The Company may permit product returns from, or grant price protection to, its customers under certain conditions. Price protection refers to the circumstances when the Company elects to decrease the wholesale price of a product based on the number of products in the retail channel and, when granted and taken, allows customers a credit against amounts owed by such customers to the Company with respect to open and/or future invoices. The criteria the Company’s customers must meet to be granted the right to return products or price protection include, among other things, compliance with applicable payment terms, and consistent delivery to the Company of inventory and sell-through reports.
 
 Management must estimate the amount of potential future product returns and price protection related to current period revenues utilizing industry and historical Company experience, information regarding inventory levels, and the demand and acceptance of the Company’s games by end consumers. The Company regularly reviews its reserves and allowances for these items and assesses the adequacy of the amounts recorded. Similarly, management must make estimates of the uncollectibility of the Company’s accounts receivable.
 
 At March 31, 2011 and June 30, 2010, accounts receivable allowances consisted of the following:
  8
 
 March 31,

2011


June 30,

2010Sales returns

$
297,001


$
2,634,097Price protection


756,837



2,257,171Doubtful accounts


498,609



771,442Defective items


15,464



38,221Total allowances

$
1,567,911


$
5,700,931
 
 Assessment of Impairment of Assets
 
 Current accounting standards require that the Company assess the recoverability of purchased intangible assets subject to amortization and other long-lived assets whenever events or changes in circumstances indicate the remaining value of the assets recorded on its condensed consolidated balance sheets is potentially impaired. In order to determine if a potential impairment has occurred, management must make various assumptions about the estimated fair value of the asset by evaluating future business prospects and estimated cash flows. For some assets, the Company’s estimated fair value is dependent upon predicting which of its products will be successful. This success is dependent upon several factors, which are beyond the Company’s control, such as which operating platforms will be successful in the marketplace, market acceptance of the Company’s products and competing products. Also, the Company’s revenues and earnings are dependent on the Company’s ability to meet its product release schedules.
 
 Goodwill is considered to have an indefinite life, and is carried at cost. Goodwill is not amortized, but is subject to an impairment test annually and in between annual tests when events or circumstances indicate that the carrying value may not be recoverable. The Company performs its annual impairment testing at June 30.  Impairment of goodwill is tested at the reporting unit level.  The Company has one reporting unit, because none of the components of the Company constitute a business for which discrete financial information is available and for which Company management regularly reviews the results of operations.
 
 To determine the fair value of the reporting unit used in the first step, the Company uses a combination of the market approach, which utilizes comparable companies’ data and/or the income approach, or discounted cash flows. Each step requires management to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on the Company’s weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. The Company’s estimates for market growth, its market share, and costs are based on historical data, various internal estimates, and certain external sources, and are based on assumptions that are consistent with the plans and estimates the Company is using to manage the underlying business. The Company’s business consists of publishing and distribution of interactive entertainment software and content using both established and emerging intellectual properties, and its forecasts for emerging intellectual properties are based upon internal estimates and external sources rather than historical information and have an inherently higher risk of accuracy. If future forecasts are revised, they may indicate or require future impairment charges. The Company bases its fair value estimates on assumptions it believes to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.
 
 The Company determined that current business conditions, and the resulting decrease in the Company’s projected cash flows, constituted a triggering event which required the Company to perform interim impairment tests related to its long-lived assets and goodwill during the quarter ended March 31, 2011. The Company’s interim test on its long-lived assets indicated that the carrying value of its long-lived assets was recoverable and that no impairment existed as of the testing date.  As of March 31, 2011, there was no impairment to goodwill.  The Company will continue to monitor its goodwill and indefinite-lived intangible and long-lived assets for possible future impairment.
 
 Revenue Recognition
 
 The Company recognizes revenue from the sale of video games upon the transfer of title and risk of loss to the customer. Accordingly, the Company recognizes revenue for software titles when (1) there is persuasive evidence that an arrangement with the customer exists, which is generally a purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable and (4) collection of the customer receivable is deemed probable.  The Company’s payment arrangements with customers typically provide for net 30 and 60 day terms. Advances received for licensing and exclusivity arrangements are reported on the condensed consolidated balance sheets as deferred revenues until the Company meets its performance obligations, at which point the revenues are recognized. Revenue is recognized after deducting estimated reserves for returns, price protection and other allowances. In circumstances when the Company does not have a reliable basis to estimate returns and price protection or is unable to determine that collection of a receivable is probable, the Company defers the revenue until such time as it can reliably estimate any related returns and allowances and determine that collection of the receivable is probable.
  9
 
 The Company has an arrangement pursuant to which it distributes videogames co-published with another company for a fee based on the gross sales of the videogames.  Under the arrangement, the Company bears the inventory risk as the Company purchases and takes title to the inventory, warehouses the inventory in advance of orders, ships the inventory, and invoices its customers for videogame shipments.  Also under the arrangement, the Company bears the credit risk as the supplier does not guarantee returns for unsold videogames and the Company is not reimbursed by the supplier in the event of non-collection. The Company records the gross amount of revenue under the arrangement as it is not acting as an agent for the principal in the arrangement.
 
 Foreign Currency Translation
 
 Foreign exchange transaction gains (losses) included in general and administrative expenses in the accompanying condensed consolidated statements of operations for the three and nine months ended March 31, 2011 amounted to $4,326 and $68,996, respectively. Foreign exchange transaction gains (losses) for the three and nine months ended March 31, 2010 amounted to $246,892 and $254,390, respectively.
 
 Comprehensive (Loss) Income
 
 For the three-month and nine-month periods ended March 31, 2011 and 2010, the Company’s comprehensive loss was as follows:
 
 For the

For theThree months ended

Nine months endedMarch 31,

2011


March 31,

2010

March 31,

2011

March 31,

2010Net income (loss)


3,212,762


$
192,140


$
(71,006
)

$
(1,763,145
)Other comprehensive income (loss)Change in foreign currency translation adjustment


(92,486
)


176,939



(323,775
)


267,186Comprehensive income (loss)


3,120,276


$
369,079


$
(394,781
)

$
(1,495,959
)
 
 Fair Value Measurements
 
 The following table summarizes the Company’s financial assets and liabilities that are measured at fair value on a recurring basis.
 
 Fair Value Measurements at Reporting Date UsingQuoted Prices

inActive Markets


Significantfor Identical


Other


SignificantAs of


Financial


Observable


UnobservableMarch


Instruments


Inputs


Inputs31, 2011


(Level 1)


(Level 2)


(Level 3)Assets:Advances on royalties

$
551,772


$
551,772


$
-


$
-Total assets at fair value

$
551,772


$
551,772


$
-


$
-Liabilities:Warrant liability

$
1,914,153


$
-


$
-


$
1,914,153Total liabilities at fair value

$
1,914,153


$
-


$
-


$
1,914,153
  10
 
 On February 23, 2010, the Company issued to a videogame publisher 3,000,000 shares of common stock as an advance on royalties, valued at $1,020,000 based on the fair market value of the Company’s common stock on the date the agreement was executed by the parties. The Company has capitalized such payment to the videogame publisher and the amount is marked-to-market on a quarterly basis. The fair value of the advances on royalties is based entirely upon quoted market prices, which is a level 1 input. The Company recorded a $641,332 decrease to the carrying amount of asset related to the periodic fair value remeasurement at March 31, 2011. During the nine months ended March 31, 2011, 44,828 shares were earned and $15,493 was expensed to “cost of goods sold – royalties,” and ($2,964) was expensed to “general and administrative” relating to the periodic fair value remeasurement. As of March 31, 2011, 2,758,861 shares of common stock, valued at $551,772, based on the fair market value of the Company’s common stock were included in advances on royalties.
 
 On July 19, 2010, the Company issued Series A warrants in connection with the sale of $5,500,000 of senior secured convertible notes. The Series A warrants entitle the holders to purchase an aggregate of 12,761,021 shares of common stock. The Series A warrants have an exercise price of $0.375 per share and a term of five years, and became exercisable upon the issue date. The Company has accounted for the Series A warrants as a liability because the exercise price of the warrants will reset if the Company issues stock at a lower price. At inception, the fair value of the Series A warrants of $4,338,748 was separated from the debt liability and recorded as a derivative liability which resulted in a reduction of the initial notional carrying amount of the senior secured convertible notes. The fair value of the warrants was computed using the Black-Scholes option pricing model. The Company assumed a risk-free interest rate of 1.73%, no dividends, expected volatility of 148.24% and the contractual life of the warrants of 5 years.
 
 In addition, the purchasers of the senior secured convertible notes received Series B warrants which will expire, if the warrants become exercisable, on the fifth year anniversary of the date the Company announces its 2011 operating results. The number of Series B warrants each purchaser received is equal to 75% of the Series A warrants they obtained. The Series B warrants can only be exercised if the EBITDA Test under the senior secured convertible notes is not achieved or if the Company fails to announce its 2011 operating results by September 28, 2011. The obligation to deliver the Series B warrants was determined to be an embedded derivative. The Company has approached the valuation of this embedded derivative based on the probability that the EBITDA Test under the senior secured convertible notes will be achieved. Because the probability at inception that the EBITDA Test will not be achieved is considered to be de minimis (less than 5%), the fair value of the derivative instrument is not considered to be material and no value has been assigned to it.
 
 The Company measures the fair value of the warrants at each balance sheet date, and records the change in fair value as a non-cash charge or gain to earnings each period. The warrants were valued at $1,914,153 at March 31, 2011. The Company recorded a non-cash gain of $2,424,595 due to the change in fair value of warrants during the nine months ended March 31, 2011. The fair value of the warrants at March 31, 2011 was computed using the Black-Sholes option pricing model.  The Company assumed a risk-free interest rate of 2.24%, no dividends, expected volatility of 128.62% and the remaining contractual life of the warrants of 4.3 years.
 
 The following table is a rollforward of the fair value of the warrants, as to which fair value is determined by Level 3 inputs:
 
 Nine MonthsEndedMarch 31,Description

2011Beginning balance

$
-Purchases, issuances, and settlements


4,338,748Total gain included in net loss


(2,424,595
)Ending balance

$
1,914,153
 
 Earnings (Loss) Per Common Share
 
 Basic earnings (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of common shares outstanding for all periods.  Diluted earnings per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of shares outstanding, increased by common stock equivalents.  Common stock equivalents represent incremental shares issuable upon exercise of outstanding options and warrants, the conversion of preferred stock and the vesting of restricted stock. However, potential common shares are not included in the denominator of the diluted earnings (loss) per share calculation when inclusion of such shares would be anti-dilutive, such as in a period in which a net loss is recorded.
  11
 
 The following table sets forth the computation of basic and diluted earnings per share of common:
  For the three months ended

March 31,


For the nine months ended

March 31,2011


2010


2011


2010Numerator:Net income

$
3,212,763


$
192,140


$
(71,006
)

$
(1,763,145
)Denominator:Weighted-average shares outstanding


57,429,675



45,356,744



57,240,695



45,069,852Effect of dilutive securities


11,223,618



7,940,573



-



-Weighted-average shares diluted


68,653,293



53,297,317



57,240,695



45,069,852Basic earnings per common share

$
0.06


$
0.004


$
(0.001
)

$
(0.04
)Diluted earnings per common share

$
0.05


$
0.004


$
(0.001
)

$
(0.04
)
  Dilutive securities are not included in the computation of diluted earnings per share when a company is in a loss position. As such, the numerator and the denominator used in computing both basic and diluted net loss per share for the nine months ended March 31, 2011 and 2010, respectively, are the same. Diluted weighted average shares outstanding were 63,383,414 and 51,744,223 for the nine months ended March 31, 2011 and 2010, respectively.
  2.  Inventories
 
 Inventories consist of the following:
 
 March 31,

2011


June 30,

2010Finished goods

$
955,575


$
1,085,433Purchased parts and components


241,433



125,868Total

$
1,197,008


$
1,211,301
 
 3.  Line of Credit
 
 The Company had an $8.0 million revolving line of credit facility with SunTrust Banks, Inc. (“SunTrust”) that was scheduled to mature on November 30, 2010. The line of credit bore interest at prime plus 11⁄2%, which was 4.75% at June 30, 2010. At June 30, 2010, the Company was not in compliance with certain financial and non-financial covenants and $3,830,055 was outstanding. For the three and nine months ended March 31, 2011, interest expense relating to the line of credit was $-0- and $2,021, respectively. For the three and nine months ended March 31, 2010, interest expense related to the line of credit was $43,595 and $160,565, respectively. There was $33,284 of accrued interest at June 30, 2010.
 
 On July 12, 2010, the Company repaid in full the entire outstanding balance under the credit agreement as a result of entering into a factoring agreement with Rosenthal & Rosenthal, Inc. (see Note 4, Due to Factor for further discussion). As a result of such repayment, (i) the loan agreement has automatically terminated, (ii) SunTrust’s lien or security interest in the Company’s assets has been terminated, and (iii) all obligations of the Company under the loan agreement have been satisfied in full.
 
 4.  Due to Factor
 
 On July 7, 2010, the Company entered into a Factoring Agreement with Rosenthal & Rosenthal. Under the Factoring Agreement, the Company agreed to sell certain receivables to Rosenthal & Rosenthal arising from sales of inventory to customers. In connection with the execution of the Factoring Agreement, the Company, certain subsidiaries, and the chairman, Terry Phillips, have executed guarantees in favor of Rosenthal & Rosenthal. In addition, the Company and certain subsidiaries each granted to Rosenthal & Rosenthal a security interest against all their respective assets.
  12
 
 Under the terms of the Factoring Agreement, the Company is selling certain of its receivables to Rosenthal & Rosenthal. For the approved receivables, Rosenthal & Rosenthal will assume the risk of collection. The Company has agreed to pay Rosenthal & Rosenthal a commission of .60% of the amount payable under all of the Company’s invoices to most of the Company’s customers against a minimum commission of $30,000 multiplied by the number of months in a contract period, with the first period being 12 months and the second 7 months. All payments received by Rosenthal & Rosenthal are payable to the Company after amounts due to Rosenthal & Rosenthal are satisfied. Under the Factoring Agreement, the Company has the right to borrow against payments due the Company at the rate of 65% of credit approved receivables. The borrowing rate against non-credit approved receivables is subject to negotiation. The interest rate on borrowings is equal to the greater of prime plus 1.5% per annum or 6.5% per annum. A $10,000,000 loan cap applies against the Company’s borrowings, which is subject to an increase of up to $3,000,000 if shareholders’ equity increases. The initial term of the Factoring Agreement ends on February 28, 2012.
 
 Due (to) from factor consists of the following:
 
 March 31, 2011Outstanding accounts receivable sold to factor

$
10,201,416Cash collateral


560,401Less: allowances


(3,462,328
)Less: advances from factor


(5,594,154
)$
1,705,336
 
 Accounts receivable totaling $10,201,416 were sold to the factor at March 31, 2011, of which the Company assumed credit risk of $343,695. The following table sets forth adjustments to the price protection and other customer allowances included as a reduction of amounts due (to) from factor:
 
 Nine

months

ended

March 31, 2011Beginning balance

$
-Add: provision


(9,616,949
)Less: amounts charged against allowance


7,911,613Ending balance

$
(1,705,336
)
 
 For the three-month and nine-month periods ended March 31, 2011, interest and financing costs relating to the factoring agreement were $219,078 and $477,015, respectively.
 
 5.Production Advance Payable
 
 On August 17, 2009, the Company entered into a euro-denominated unit production financing agreement with a producer relating to the production of certain games, of which the balance outstanding under this agreement was $4,090,612 at March 31, 2011, $403,435 of which are included in “Accrued expenses and other current liabilities” in the Company’s condensed consolidated balance sheet.  Production fees relating to this production advance for the three-month and nine-month periods ended March 31, 2011 totaled $288,971, and $861,849, respectively.  The production fees for the three-month and nine-month periods ended March 31, 2011 related to the default status of the production advance, as described in the subsequent paragraph.  These amounts are included in interest and financing costs, net on the accompanying condensed consolidated statements of operations. As of March 31, 2011 and June 30, 2010, accrued and unpaid production fees totaled $2,062,769 and $1,000,392, respectively, and are included in accrued expenses and other current liabilities. The Company is obligated to pay approximately $99,000 of production fees for every month the full production advance is outstanding past its due date of November 15, 2009.  Pursuant to the agreement, the Company has assigned to the producer a portion of the net revenues related to the sale of certain games in Europe.
 
 The Company has failed to make the required payments under this agreement.   Accordingly, the production advance payable is currently in default and is accruing production fees at $0.009 per unit (based upon 382,000 units) for each day after November 15, 2009 (approximately $1,659,000 through March 31, 2011).  Pursuant to the terms of the production financing agreement, the producer is free to exercise any rights in connection with the security interests granted. Because of several issues surrounding the facts associated with the production advance agreement, the Company is currently contesting its obligation to repay this advance.
  13
 
 6.  Secured Convertible Debt
 
 On April 29 and 30, 2010, the Company entered into a note purchase agreement pursuant to which the Company could issue up to $5,000,000 of junior secured subordinated promissory notes (the “Junior Notes”) in one or more closings and each of the Company’s subsidiaries guaranteed the Company’s obligations under the Junior Notes. Pursuant to the note purchase agreement, the Company issued Junior Notes in the aggregate principal amount of $950,000 in private placements that closed on April 30, 2010 and May 6, 2010. Of the Junior Notes issued on April 29 and 30, 2010, the Company’s chairman, purchased $500,000.
 
 The Junior Notes were due and payable in full on December 27, 2010 and bore interest at the rate of 10% per annum. The Junior Notes were secured by all of the assets of the Company and its subsidiaries and the indebtedness under the Junior Notes and the security interest granted by the Company and its subsidiaries in the note purchase agreement were junior to the Company’s indebtedness to SunTrust Banks the Company’s senior lender, and the indebtedness held by any future senior lender of the Company or its subsidiaries. The principal and accrued interest outstanding under each Junior Note was convertible, in whole or in part, at the option of its holder into shares of the Company’s common stock at a price per share of $0.45 per share.
 
 The Company evaluated the conversion feature of the Junior Notes and determined that there was no beneficial conversion feature as the conversion price of $0.45 per share was greater than the fair value of the stock at the time of issuance.
 
 On July 16, 2010, the Company repaid the $450,000 Junior Note plus accrued interest thereon with proceeds from the senior secured convertible notes. On July 16, 2010, the Company exchanged the $500,000 Junior Note issued to the Company’s chairman for a $500,000 senior secured convertible note (see discussion below). Interest expense for the three-month and nine-month periods ended March 31, 2011 related to the Junior Notes was $5,411 and $5,411, respectively. There was $-0- and $15,548 of accrued interest outstanding at March 31, 2011 and June 30, 2010, respectively.
 
 On July 16, 2010, the Company entered into a Securities Purchase Agreement with CNH Diversified Opportunities Master Account, L.P., CNH CA Master Account, L.P., AQR Diversified Arbitrage Fund and Terry Phillips, the Company’s chairman, for the sale of $5,500,000 of senior secured convertible notes (the “Initial Notes”) and warrants. Mr. Phillips’ Initial Note was issued in exchange for a Junior Note originally issued to him on April 30, 2010. The Company received $5,000,000 in cash for $5,000,000 of the Initial Note and exchanged a $500,000 prior Junior Note for $500,000 of the Initial Note. The Initial Notes are due and payable in full on July 19, 2013 and bear interest at the rate of 10.0% per annum. Interest is payable semi-annually commencing on December 31, 2010. The Company did not make its first interest payment of $252,083 on December 31, 2010 and was in default on the Notes with respect to which default the Company entered into a Waiver Agreement with each holder of the Initial Note (see discussion regarding the waiver and forbearance agreements below). Pursuant to their respective terms, in the event of a default, the interest rate of the Initial Notes increases to 15.0% per annum until the interest is paid. Once the interest is paid, the interest rate will return to the original 10.0% per annum. The Initial Notes are senior to all obligations of the Company with the exception of the indebtedness under the Company’s Factoring Agreement with Rosenthal & Rosenthal (see Note 4). Interest expense for the three-month and nine-month periods ended March 31, 2011 was $198,611 and $450,694, respectively, and there was $147,094 of accrued interest outstanding at March 31, 2011.
 
 The principal and interest due under the Notes are convertible at a price of $0.431 per share at the option of the holders. The Company evaluated the conversion feature of the Notes and determined that there was no beneficial conversion feature as the conversion price of $0.431 per share was greater than the fair value of the stock at the time of issuance.
 
 On August 31, 2010, the Company entered into an Amended and Restated Securities Purchase Agreement (the “Amended Purchase Agreement”), pursuant to which it sold an aggregate of $2,000,000 of a new series of senior secured convertible notes (the “Additional Notes”) to AQR Opportunistic Premium Offshore Fund, L.P., Advanced Series Trust, solely on behalf of the AST Academic Strategies Asset Allocation Portfolio, and Terry Phillips, the Company’s chairman. The Company received $2,000,000 in cash for $2,000,000 of the Additional Notes, of which $200,000 was paid by Terry Phillips, the Company’s chairman. The Additional Notes are due and payable in full on March 15, 2011 and bear interest at the rate of 24.0% per annum. Interest is payable on December 31, 2010 and on March 15, 2011, the maturity date. The Company did not make its first interest payment of $161,333 on December 31, 2010 and was in default on the Additional Notes as of December 31, 2010 with respect to which default the Company entered into a waiver and forbearance agreement with each holder of the Initial Note (see discussion regarding the waiver and forbearance agreements below).  Pursuant to their respective terms, in the event of a default, the interest rate of the Additional Notes increases to 29.0% per annum until the interest is paid. Once the interest is paid, the interest rate will return to the original 24.0% per annum. The Additional Notes are subject to the Pledge and Security Agreement and the Guaranty made by the Company’s subsidiaries. Interest expense for the three-month and nine-month periods ended March 31, 2011 was $142,334 and $303,667, respectively, and there was $193,267 of accrued interest outstanding at March 31, 2011.
  14
 
 The principal and interest due under the Additional Notes are convertible at a price of $20.00 per share at the option of the holders. The Company evaluated the conversion feature of the Notes and determined that there was no beneficial conversion feature as the conversion price of $20.00 per share was greater than the fair value of the stock at the time of issuance.
 
 As a part of the issuance of the Notes, the Company issued Series A warrants to the purchasers of the Notes giving them the right to purchase up to an aggregate of 12,761,021 shares of common stock at an exercise price of $0.375 per share. The Series A warrants expire on July 19, 2015, unless sooner exercised.
 
 In addition, the purchasers of the Notes received Series B warrants which will expire, if the warrants become exercisable, on the fifth year anniversary of the date the Company announces its 2011 operating results. The number of Series B warrants each purchaser received is equal to 75% of the Series A warrants they obtained. The Series B warrants can only be exercised if the EBITDA Test, as defined under the Notes, is not achieved or if the Company fails to announce its 2011 operating results by September 28, 2011. The exercise price of the Series B warrants is equivalent to the weighted average price of the Company’s common stock for each of the 30 consecutive trading days following the earlier of the announcement of the Company’s 2011 operating results or September 28, 2011. The exercise price per share is also subject to full ratchet anti-dilution protection and limitations on exercise similar to the provisions for the Series A warrants.
 
 The Company’s Notes and certain warrants have been accounted for in accordance with applicable authoritative guidance for derivative instruments which requires identification of certain embedded features to be bifurcated from debt instruments and accounted for as derivative assets or liabilities. The derivative assets and liabilities are initially recorded at fair value and then at each reporting date, the change in fair value is recorded in the condensed consolidated statements of operations.
 
 The Company has accounted for the Series A warrants as a liability because the exercise price of the warrants will reset if the Company issues stock at a lower price. At inception, the fair value of the Series A warrants of $4,338,748 was separated from the Notes and recorded as a derivative liability which resulted in a reduction of the initial notional carrying amount of the Notes, and as unamortized discount, which is being accreted over the term of the Notes using the straight-line method. The fair value of the warrants was computed using the Black-Scholes option pricing model. The Company assumed a risk-free interest rate of 1.73%, no dividends, expected volatility of 148.24% and the contractual life of the warrants of 5 years.
 
 The obligation to deliver the Series B warrants was determined to be an embedded derivative. The Company has determined the valuation of this embedded derivative based on the probability that the EBITDA Test, as defined under the Notes, will not be achieved. Because the probability at inception that the EBITDA Test will not be achieved is considered to be de minimis (less than 5%), the fair value of the derivative instrument is not considered to be material and no value has been assigned to it.
 
 As of March 31, 2011, the unamortized debt discount amounted to $3,254,060. Total amortization of the debt discount recorded as interest expense was $361,563 and $1,084,688 for the three-month and nine-month periods ended March 31, 2011, respectively.
 
 In connection with the sale of the Initial Notes and warrants, the Company executed a Registration Rights Agreement under which it agreed to register the shares of common stock underlying the Initial Notes and warrants. The Registration Rights Agreement has been amended and currently provides that the Company file a registration statement by November 19, 2010 and to have it declared effective by January 31, 2012, if it is not subject to full review by the SEC, and by April 30, 2012, if it is subject to full review.  Failure to have the registration statement declared effective within 60 days from the prescribed effectiveness deadline constitutes a default under the Initial Notes.
 
 On December 31, 2010, the Company failed to make a timely payment of interest required under the Notes.  Such failure triggered a default provision under the Notes following a seven day cure period.  On February 16, 2011, the Company entered into Waiver Agreements with each holder of the Notes.  Pursuant to the Waiver Agreements, the holders of the Notes waived their right of redemption and remedies regarding the Company’s failure to have paid the required interest and agreed to forbear from exercising all remedies available in connection with such failure until March 15, 2011. Pursuant to the Waiver Agreement, the Company is not required to pay the required interest until March 15, 2011 and the interest rates under the Notes increase to 15% and 29%, as applicable, from December 31, 2010 to March 15, 2011.
  15
 
 On March 15, 2011, the Company failed to pay the outstanding amount of principal, interest and late charges due on the Additional Notes (as defined below), and such failure triggered a default provision under the Additional Notes following a seven day cure period (the “Maturity Payment Default”).  The Company also failed to have a registration statement (the “Initial Registration Statement”) relating to the shares of common stock underlying the Initial Notes (as defined below) and associated warrants declared effective by March 15, 2011, and such failure triggered a default provision under the Initial Notes (the “Registration Default”).  On May 23, 2011, the Company entered into a Waiver and Amendment Agreement (the “Amendment Agreement) with the holders of the Notes (See Note 6).  Pursuant to the Amendment Agreement, the holders of the Notes have waived the Maturity Payment Default and Registration Default, as applicable, the maturity date for the Additional Notes has been extended to December 31, 2011, and the interest rate for the Additional Notes has been increased to 29%.  The Amendment Agreement provides that the initial effectiveness deadline by which the Initial Registration Statement must be declared effective by the SEC has been extended (i) to January 31, 2012, in the event that the Initial Registration Statement is not subject to a full review by the SEC, or (ii) to April 30, 2012, in the event that the Initial Registration statement is subject to a full review by the SEC.  As a material inducement for the holders of the Additional Notes to enter into the Amendment Agreement, the Company and certain of its subsidiaries have agreed to (i) instruct its online distribution partners to remit all payments arising from sales through online gaming platforms of the electronic game “Stronghold 3” (the “Game”) to the collateral agent under the relevant security documents, (ii) remit all receivable arising from sales of the Game in Europe directly to the collateral agent, and (iii) pay the collateral agent, upon its demand, 60% of any amounts in excess of $350,000 paid to the Company under the factoring agreement between the Company and Rosenthal & Rosenthal, Inc.
 
 The purchasers of the senior secured convertible notes and warrants were introduced to the Company by an investment bank pursuant to an engagement letter agreement with the Company. Pursuant to the engagement letter, the investment bank received a cash fee that was approximately equal to 5.0% of the aggregate proceeds raised in the financing. The Company recorded the cash fee and other direct costs incurred for the issuance of the senior secured convertible notes in aggregate of $733,959 as deferred debt issuance costs. Debt issuance costs are amortized on the straight-line method over the terms of the senior secured convertible notes, with the amounts amortized being recognized as interest expense. Amortization of deferred debt issuance costs included in interest expense for the three-month and nine-month periods ended March 31, 2011 totaled $120,132 and $321,410, respectively.
 
 7.  Inventory Financing Payable
 
 On September 20, 2010, the Company entered into a Master Purchase Order Assignment Agreement with Wells Fargo Bank, National Association (“Wells Fargo”). In connection with the execution of this Agreement, each of the Company, its subsidiaries, Gone Off Deep, LLC and Vid Sub, LLC, and the chairman, Terry Phillips (the “Guarantors”), have executed a Guaranty in favor of, and, along with the Company, have entered into a Security Agreement and Financing Statement with, Wells Fargo.
 
 Under the terms of the agreement, the Company may request that Wells Fargo accept the assignment of customer purchase orders and request that Wells Fargo purchase the required materials to fulfill such purchase orders. If accepted, Wells Fargo, in turn, will retain the Company to manufacture, process, and ship the ordered goods. Wells Fargo’s aggregate outstanding funding under the agreement shall not exceed $2,000,000. As of March 31, 2011, no amounts were outstanding under the agreement. Interest expense for the three month and nine month periods ended March 31, 2011 was $61,285 and $103,355, respectively.
 
 Upon receipt of customer payments by Wells Fargo, the Company will be paid a fee for its services, with such fee calculated pursuant to the terms of the agreement. Also from such customer payments, Wells Fargo shall be entitled to receive the following: (1) a transaction initiation and set-up fee equal to 1.5% of the aggregate amount outstanding on all amounts (including letters of credit) advanced by Wells Fargo; (2) a daily maintenance fee equal to 0.05% of all amounts (including letters of credit) advanced by Wells Fargo which remain outstanding for more than 30 days; and (3) a product advance fee equal to (a) the prime rate plus 2%, divided by 360, multiplied by (b) (i) the aggregate amount outstanding on all amounts (including letters of credit) advanced by Wells Fargo on account of purchases of products or other advances made in connection with a customer purchase order, multiplied (ii) by the number of days from the earlier of (A) the date on which any such letter of credit or purchase order or financial accommodation is negotiated into cash, or (B) the date funds are advanced by other than issuing a letter of credit or purchase order.
 
 In addition, Wells Fargo is entitled to a commitment fee of $120,000 to be paid on the earlier of (a) September 20, 2011 or (b) the date on which the Agreement is terminated. Wells Fargo is also entitled to additional commitment fees for each renewal of the Agreement, and such fees will be paid on the earlier of (a) the first anniversary of the beginning of each renewal term or (b) the date on which the Agreement is terminated.
  16
 
 Subject to the rights of senior lenders, the Company and the Guarantors have granted security interests in their assets to Wells Fargo under the Security Agreement and Financing Statement to secure the LLC’s obligations under the Agreement and the Guarantors’ guarantees of such obligations.
 
 8.  Related Party Transactions
 
 For all periods presented, the Company had the following related party transactions.
 
 Related Party Receivables
 
 Related party receivables consist primarily of short-term advances to employees. No allowance has been provided due to the short-term nature and recoverability of such advances.
 
 Also included in related party receivables at March 31, 2011 and June 30, 2010 is a receivable attributed to lease income. The Company leases certain office space to a company whose shareholders are also shareholders of the Company, one of whom is the Company's chairman.  At March 31, 2011 and June 30, 2010, $-0- and $7,815, respectively, was owed to the Company and is included in related party receivables.
 
 Due to Related Parties
 
 The Company incurred fees for broadband usage to an entity partially owned by two shareholders of the Company, one of whom is the Company’s chairman. Broadband usage fees for the three and nine months ended March 31, 2011 were $(2,225) and $11,000, respectively.  Broadband usage fees for the three and nine months ended March 31, 2010 were $8,800 and $22,000, respectively.  These amounts are included in general and administrative expenses in the accompanying condensed consolidated statements of operations. At March 31, 2011 and June 30, 2010, $-0- and $2,200, respectively, remained as a payable to the affiliate and is included in due to related parties in the accompanying condensed consolidated balance sheets.
 
 Accrued Expenses - Related Parties
 
 Accrued expenses - related parties as of and for the nine months ended March 31, 2011 and the year ended June 30, 2010 are as follows:
 
 Nine

months ended

March 31,

2011


Year ended

June 30,

2010Balance at beginning of period

$
322,281


$
221,493Expenses incurred:Rent


82,500



110,000Commissions


88,517



551,932Cash in advance


114,260



-Less: amounts paid


(406,749
)


(561,144
)Balance at end of period

$
200,809


$
322,281
 
 The Company incurred sales commissions for the marketing and sale of videogames with four affiliates of the Company’s chairman. Sales commissions for the three and nine months ended March 31, 2011 were $31,669 and $88,517, respectively. Sales commissions for the three and nine months ended March 31, 2010 were $113,096 and $378,393, respectively. These amounts are included in sales and marketing in the accompanying condensed consolidated statements of operations.
 
 Cash in Advance - Related Party
 
 On December 30, 2010, the Company received $210,623 cash in advance for goods not yet delivered from an affiliate of the Company’s chairman.  At March 31, 2011, $114,260 was included in accrued expenses – related parties in the accompanying condensed consolidated balance sheets and will be recognized as revenue when the goods are delivered.
  17
 
 Lease - Related Parties
 
 The Company leases certain office space from a company whose shareholders are also shareholders of the Company, one of whom is the Company’s chairman.  Related party lease expense was $27,500 and $82,500 for the three months and nine months ended March 31, 2011, respectively.    Related party lease expense was $27,500 and $82,500 for the three and nine months ended March 31, 2010, respectively.   These amounts are included in the general and administrative expense in the accompanying condensed consolidated statements of operations. The lease expires on December 31, 2013.
 
 The Company leases certain office space to a company whose shareholders are also shareholders of the Company, one of whom is the Company’s chairman.  Related lease income was $3,973 and $11,788 for the three months and nine months ended March 31, 2011, respectively.  Related lease income was $3,907 and $11,722 for the three and nine months ended March 31, 2010, respectively.  These amounts are included in general and administrative expense in the accompanying condensed consolidated statements of operations.  The lease expires on January 31, 2014.
 
 9.  Commitments
 
 Total future minimum commitments are as follows:
 
 Software


OfficeDevelopers


Lease


TotalFor the year ending June 30,2011 (three months ended June 30, 2011)

$
300,000


$
36,214


$
336,2142012


1,794,410



144,857



1,939,2672013


-



124,524



124,5242014


-



55,000



55,0002015


-



-



-Total

$
2,094,410


$
360,595


$
2,455,005
 
 Total future commitments pursuant to vendor settlement agreements are as follows:
 
 VendorPaymentsFor the year ending June 30,2011 (three months ended June 30, 2011)

$
220,8342012


-2013


-2014


-2015


-Total

$
220,834
 
 10.  Stock-based Compensation
 
 In May 2008, the Company’s board of directors and its shareholders approved the 2008 Equity Incentive Compensation Plan (the “2008 Plan”) for the grant of stock awards, including restricted stock and stock options, to officers, directors, employees and consultants.  The 2008 Plan expires in May 2018. Shares available for future grant as of March 31, 2011 and June 30, 2010 were 847,324 and 919,372, respectively, under the 2008 Plan.
 
 Stock awards and shares are generally granted at prices which the Company’s board of directors believes approximate the fair market value of the awards or shares at the date of grant. Individual grants generally become exercisable ratably over a period of three years from the date of grant. The contractual terms of the options range from three to ten years from the date of grant.
 
 The Company uses the Black-Scholes option pricing model to determine the fair value of stock-based compensation to employees and non-employees. The determination of fair value is affected by the Company’s stock price and volatility, employee exercise behavior, and the time for the shares to vest.
 
 The assumptions used in the Black-Scholes option pricing model to value the Company’s option grants to employees and non-employees were as follow:
  18
 
 For the nine

months ended

March 31, 2011


For the nine

months ended

March 31, 2010Risk-free interest rate


1.60 – 3.30
%

2.20 – 3.85
%Weighted-average volatility


150.31 - 157
%

160.78 – 166.29
%Expected term

5.5 – 8.7 years


5.5 - 9.4 yearsExpected dividends


0.0
%

0.0
%
 
 The following table summarizes the stock-based compensation expense resulting from stock options and restricted stock in the Company’s consolidated statements of operations:
 
 For the three

months ended

March 31,

2011


For the three

months ended

March 31,

2010


For the nine

months ended

March 31,

2011


For the nine

months ended

March 31,

2010Sales and marketing

$
20,075


$
19,940


$
29,584


$
59,758General and administrative


98,780



171,465



303,554



491,567Total stock-based compensation expense

$
118,855


$
191,405


$
333,138


$
551,325
 
 As of March 31, 2011, the Company’s unrecognized stock-based compensation for stock options issued to employees and non-employee directors was approximately $278,250 and will be recognized over a weighted average of 2.0 years.  The Company estimated a 5.0% forfeiture rate related to the stock-based compensation expense calculated for employees and non-employee directors.
 
 The following table summarizes the Company’s stock option activity for employees, non-employee directors, and non-employees for the nine months ended March 31, 2011:
 
 Options


Weighted-

Average

Exercise

Price


Weighted-

Average

Remaining

Contractual

Term

(in years)


Aggregate

Intrinsic

ValueOutstanding as of June 30, 2010


2,882,128


$
1.16



-


$
-Activity for the nine months ended March 31, 2011Granted


776,500



0.28



9.42



4,400Exercised


-



-



-



-Forfeited, cancelled or expired


898,103



0.82



8.46



-Outstanding as of March 31, 2011


2,760,525



0.89



8.31



4,400Exercisable as of March 31, 2011


1,093,353



1.30



7.72



-Exercisable and expected to be exercisable


2,629,142



0.91



8.27



3,819
 
 The aggregate intrinsic value represents the total pre-tax intrinsic value based on the Company’s closing stock price ($0.20 per share) as of March 31, 2011, which would have been received by the option holders had all option holders exercised their options as of that date.
 
 The following table summarizes the Company’s restricted stock activity for the nine months ended March 31, 2011:
 
 Shares


Weighted-

Average

Grant Date

Fair ValueOutstanding as of June 30, 2010


1,085,000


$
0.37Activity for the nine months ended March 31, 2011Granted


195,651



0.23Vested


402,999



0.41Forfeited, cancelled or expired


2,000



1.20Outstanding as of March 31, 2011


875,652



0.32Vested as of March 31, 2011


516,499



0.79
  19
 
 As of March 31, 2011, the Company’s unrecognized stock-based compensation for restricted stock issued to employees and non-employee directors was approximately $211,535 and will be recognized over a weighted average of 1.5 years.
 
 11.  Contingencies
 
 On October 27, 2008, Gamecock was served with a demand for arbitration by a developer alleging various breaches of contract related to a publishing agreement entered into between Gamecock and the developer on December 12, 2007. The developer is seeking an award of $4,910,000, termination of the agreement, exclusive control of the subject videogame, and discretionary interest and costs. Gamecock has responded stating that the developer’s attempts to terminate the publishing agreement constitute wrongful termination of the agreement and breach of the agreement. Gamecock has also filed a counterclaim against the developer seeking the return of approximately $5.9 million in advances on royalties in the event the publishing agreement is terminated.  The developer has filed a supplemental demand for arbitration concerning royalty payments due under a separate publishing agreement and is seeking an award of $41,084.  An arbitration scheduled for January 2010 has been put on hold pending possibility of settlement.  As of March 31, 2011, the Company believes it has accrued sufficient amounts to cover potential losses related to this matter.  The Company’s management currently believes that resolution of this matter will not have a material adverse effect on the Company’s consolidated financial position or results of operations.  A settlement agreement has been executed which will result in no liability to Gamecock upon payment of $80,000 to the developer.
 
 In February 2010, the Company, SouthPeak Interactive, L.L.C., and Gamecock were served with a complaint by TimeGate Studios, Inc., or TimeGate, alleging various breach of contract and other claims related to a publishing agreement, or the Publishing Agreement, entered into between Gamecock and TimeGate in June 2007.  TimeGate is seeking the return of all past and future revenue generated from the videogame related to the Publishing Agreement, an injunction against the Company and its subsidiaries, damages to be assessed, and discretionary interest and costs. This case was referred to an arbitrator and an arbitration proceeding is now pending.  Based upon the current status of the arbitration, the Company is of the opinion that it has no exposure in connection with this claim.
 
 In September 2010, the Company instituted summary proceedings in the Lyon France Commercial Court against Nobilis Group in which the Company has alleged the Licensing and Distribution Agreements for the games the Company was to obtain and has obtained from Nobilis, including the My Baby games, were wrongfully terminated. The Company is seeking the reinstatement of the agreements and damages associated with the actions of Nobilis. Following a hearing on October 26, 2010, the court has rendered a temporary summary judgment reinstating the agreement for My Baby First Steps and ordered Nobilis to advise Nintendo to build all products pursuant to the My Baby First Steps contract, which includes the My Baby First Steps game and an additional fourteen games. On December 7, 2010, the Lyon France Commercial Court issued a judgment confirming that Nobilis's termination of the distribution agreement was null and void. The Court has ordered that Nobilis restore SouthPeak's ability to manufacture licensed games under the agreement with immediate effect.
 
 In November 2010, in connection with the Circuit City Stores, Inc. (“Circuit City”) bankruptcy proceedings, Alfred H. Siegal, Trustee of the Circuit City Liquidating Trust, filed a lawsuit against the Company in United States Bankruptcy Court in the Eastern District of Virginia for the avoidance of payments totaling $1,155,300 as allegedly preferential transfers paid to the Company during the 90 days preceding the filing of the bankruptcy petition of Circuit City on November 10, 2008. The Company believes it has meritorious defenses to these avoidance actions, intends to vigorously defend against them and believes that the likelihood of the avoidance actions prevailing is remote. Accordingly, the Company has not accrued any loss reserve related to this claim.
 
 In October 2010, BVT Games Fund IV Dynamic GmbH & Company (“Fund IV”), an investment fund based in Germany that finances the development of video games, sued the Company in the Regional Court in Munich, Germany to recover funds advanced to the Company to manufacture two titles for which a sister fund, BVT Games Fund III Dynamic GmbH & Company (“Fund III”), had financed the development through a third-party publisher. A distribution agreement existed for these titles with Phillips Sales, Inc. and not the Company although the Company had guaranteed the obligations of Phillips Sales, Inc. In this litigation, Fund IV is seeking €3,115,341 (approximately USD $4.1 million) plus interest. The Company is actively contesting this litigation and has multiple defenses. The liability associated with the production advance is reflected in the Company’s condensed consolidated financial statements.
  20




In November 2010, the Company first learned that Fund III had obtained a judgment against the Company in the Regional Court in Munich, Germany, seeking payments of approximately €2,300,000 (approximately USD $3.0 million) due under the above-referenced distribution agreement. Prior to gaining such knowledge, Fund III served upon the Company’s then chief financial officer what was supposed to be the English translation of the lawsuit which Fund III had filed. Instead, Fund III served upon the Company a translation of the Fund IV lawsuit that Fund IV intended to serve on the Company. Because the Company knew of the filing of the Fund IV case before being properly served with that case, the Company had already engaged German counsel to represent its interests in the Fund IV case. Since German counsel’s representation had been noted in the Fund IV case, counsel was awaiting notice from the court or opposing counsel that service of the Fund IV case had occurred. Therefore, when the Fund III case was served with a translation of the Fund IV case, the Company took no action since it believed this matter was already in the hands of its attorney. The failure to respond resulted in a default judgment in the Fund III case for which no proper translation has yet been received. In addition, service on the chief financial officer was also deficient as a matter of law. Because of this error in translation and improper service, the Company is seeking to have the judgment vacated and believes it will be successful in this regard. The Company is of the opinion when, and if, it is required to defend the litigation, that it has strong defenses to assert, including that Phillips Sales is not obligated to Fund III thereby avoiding the Company’s guaranty obligation. The Company cannot predict the potential outcome.  No amounts have been recorded in the Company’s condensed consolidated financial statements in connection with the liability underlying the claim.





On January 26, 2011, Codemasters Group Holdings Limited filed suit against the Company in the United States District Court for the Eastern District of Virginia, Richmond Division, seeking to enforce a Settlement Agreement under which Codemasters claims that $1,265,000 plus interest thereon is due. The suit was dismissed on April 8, 2011. The Company recognizes its liability to Codemasters which has been recorded on its condensed consolidated financial statements but believes it is entitled to certain credits which Codemasters has not reflected in its lawsuit. It is the Company's intent to try to resolve this matter with Codemasters.





In addition to the foregoing, the Company is engaged in litigation incidental to the Company’s business to which the Company is a party.  While the Company cannot predict the ultimate outcome of these various legal proceedings, it is management’s opinion that, individually, the unfavorable resolution of these matters could have a material effect on the condensed consolidated financial position or results of operations of the Company.





On August 26, 2009, the Company was notified that the SEC was conducting a non-public, fact-finding investigation regarding certain matters underlying the amendment of its Form 10-Q, and the restatement of its financial statements, for the period ended March 31, 2009, and the termination of its former chief financial officer.  The Company has provided the SEC with the documents requested and has cooperated in all respects with the SEC’s investigation.





On September 3, 2010, the Company, Terry Phillips, the Company’s chairman, and Melanie Mroz, the Company’s CEO,  received Wells Notices from the staff of the Securities and Exchange Commission advising that the staff will recommend to the Securities and Exchange Commission that cease and desist orders issue for alleged violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rules 12b-20 and 13a-13 adopted under this act.  In addition, the staff has alleged violations by Mr. Phillips and Ms. Mroz of Rule 13b-2 and Rule 13a-14 by Ms. Mroz. These alleged violations result from the facts underlying the need to file an amended Form 10Q/A for the fiscal quarter ended March 31, 2009.   On April 21, 2011, the Company and Terry Phillips settled with the SEC without admitting any wrong doing.  All violations attributable to Ms. Mroz were dismissed.  Mr. Phillips agreed to pay a $50,000 civil penalty pursuant to Section 21(d)(3) of the Exchange Act.





From time to time, the Company is subject to various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, the Company would record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary.





12.  Gain on Settlement of Trades Payables





The gain on the settlement of trade payables at less than recorded values results from negotiations with various unsecured creditors for the settlement and payment of the trade payable at amounts less than that the recorded liability. For the nine months ended March 31, 2011, the Company’s gain on settlement of trade payables was as follows:


21





Net Trade

Payables

Settled


Other Assets

Acquired/

Liabilities

Assumed


Payments

in Cash


Payments

in Equity


Forgiveness

of DebtVendor 1

$
12,000


$
-


$
(10,000
)

$
-


$
2,000Vendor 2


1,064,848



-



(481,726
)


-



583,122Vendor 3


251,979



-



(173,610
)


-



78,369Vendor 4


16,674



-



(13,000
)


-



3,674Vendor 5


61,016



-



(31,490
)


-



29,526Vendor 6


208,024



-



(150,000
)


-



58,024Vendor 7


52,735



-



(40,000
)


-



12,735Vendor 8


145,385



-



(75,000
)


-



70,385Vendor 9


10,282



-



(1,579
)


-



8,703$
1,822,943


$
-


$
(976,405
)

$
-


$
846,538





For the nine months ended March 31, 2010, the Company’s gain on settlement of trade payable was as follows:





Net Trade

Payables

Settled


Other Assets

Acquired/

Liabilities

Assumed


Payments

in Cash


Payments

in Equity


Forgiveness

of DebtVendor 1 (1)

$
6,418,334


$
(1,422,334
)

$
(2,000,000
)

$
-


$
2,996,000Vendor 2 (2)


250,000



-



(50,000
)


(104,500
)


95,500Vendor 3


232,347



-



(67,358
)


-



164,989Vendor 4


49,384



-



-



-



49,384Vendor 5


185,549



(239,051
)


-



-



(53,502
)$
7,135,614


$
(1,661,385
)

$
(2,117,358
)

$
(104,500
)

$
3,252,371





(1)
In connection with this settlement agreement, the Company received inventory valued at $135,276, assumed the vendor’s future liability for price protection, returns, and defective merchandise, for games previously sold by or held by the Company, estimated to be $306,248, and recorded an inventory write-down, for inventory currently held by the Company, in the amount of $1,251,362 as a result of a reduction to a lower of cost or market value.  The reduction in inventory is required as the Company is prohibited from any future inventory returns and is completely responsible for the final disposition of inventory.





(2)
Consists of 175,000 shares of common stock, which were valued based on the fair market value of the Company’s common stock on the settlement date and 150,000 warrants to purchase common stock, which were valued on the settlement date, at $0.30 per share using the Black-Scholes option pricing model with assumptions of 3.57 years expected term (equivalent to contractual term), volatility of 170.76%, 0% dividend yield, 2.35% risk-free interest rate, and stock price of $0.34 per share.





13.  Additional Financial Statement Information





Accrued expenses and other current liabilities consist of the following:





March 31,


June 30,2011


2010Accrued expenses

$
1,618,132


$
1,700,208Reserve for marketing development funds (MDF)


379,735



344,210Commissions


333,194



161,678Guaranteed royalty payments


-



135,000Accrued payroll and payroll taxes


80,594



266,740Customer cash in advance deposits


223,234



31,793Accrued interest


2,491,997



1,062,200Other


65,422



79,882$
5,192,308


$
3,781,711


22


No other items accounted for greater than five percent of total current liabilities as of March 31, 2011 or June 30, 2010.





14.  Subsequent Events





On April 8, 2011, Codemasters dismissed the case it had filed and accepted the Company’s defense that the court in which the case was filed did not have the authority to consider the claim over the objection of the Company.





On April 21, 2011, the Company and Terry Phillips settled with the SEC without admitting any wrong doing.  All violations attributable to Ms. Mroz were dismissed.  Mr. Phillips agreed to pay a $50,000 civil penalty pursuant to Section 21(d)(3) of the Exchange Act.





On April 22, 2011, the Company received notice from a video game publisher of its intent to terminate a co-publishing and distribution agreement that had been entered into for various video game titles.  The party subsequently entered into an agreement with another distributor for certain of the titles under contract with the Company.  As of March 31, 2011, the Company had $552,000 in advances on royalties on its balance sheet related to these yet un-released titles.  The Company strongly believes that the publisher’s attempt terminate the contract is without merit.  The Company filed a complaint against the publisher on May 13, 2011 in the Superior Court of California, San Francisco County seeking injunctive and declaratory relief.  If the Company is unsuccessful in securing its rights under the agreement, it would be required to write-off the advances, which were granted in the form of Company stock.  This would result in an adjustment to Additional Paid in Capital as the publisher would be required to return the stock granted as part of the advance.  No additional liabilities would result.






23


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





The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this report and in our annual report on Form 10-K for the year ended June 30, 2010.





This report includes forward-looking statements that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified by the use of words such as “anticipate,” “believe,” “estimate,” “may,” “intend,” “expect,” “will,” “should,” “seeks” or other similar expressions. Forward-looking statements reflect our plans, expectations and beliefs, and involve inherent risks and uncertainties, many of which are beyond our control. You should not place undue reliance on any forward-looking statement, which speaks only as of the date made. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, and in “Risk Factors” in Item 1A of Part I of our annual report on Form 10-K for the year ended June 30, 2010.





Going Concern





The accompanying condensed and consolidated financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  Our ability to continue as a going concern is predicated upon, among other things, generating positive cash flows from operations, curing the default on the production advance payable, and the resolution of various contingencies.  In their report on our audited financial statements for the year ended June 30, 2010, our independent registered public accounting firm included an explanatory paragraph regarding concerns about our ability to continue as a going concern.





Overview





We are an independent developer and publisher of interactive entertainment software. We utilize our network of independent studios and developers to create videogames for all popular videogame systems, including:





·
home videogame consoles such as Microsoft Xbox 360, Nintendo Wii, Sony PlayStation 3 and Sony PlayStation 2;





·
handheld platforms such as Nintendo DS, Nintendo DSi, Sony PSP, Sony PSPgo and Apple iPhone, game applications for the Next Generation NVIDIA® TegraTM mobile processor used in Droid phones and tablets; and





·
personal computers.





Our portfolio of games extends across a variety of consumer demographics, ranging from adults to children and hard-core game enthusiasts to casual gamers.





We are an “indie” videogame developer and publisher working with independent software developers and videogame studios to create our videogames. We have cultivated relationships globally with independent developers and studios that provide us with innovative and compelling videogame concepts.





Our strategy is to establish a portfolio of successful proprietary content for the major videogame systems, and to capitalize on the growth of the interactive entertainment market. We currently work exclusively with independent software developers and videogame studios to develop our videogames. This strategy enables us to source and create highly innovative videogames while avoiding the high fixed costs and risk of having a large internal development studio. Through outsourcing, we are also able to access videogame concepts and content from emerging studios globally, providing us with significant new product opportunities with limited initial financial outlay, compared to internally developed video games.





Sources of Revenue





Revenue is primarily derived from the sale of software video games developed on our behalf by third parties and other content partnerships. Our unique business model of sourcing and developing creative product allows us to better manage our fixed costs relative to industry peers.


24


Our operating margins are dependent in part upon our ability to continually release new products that perform according to our budgets and forecasts, and manage our product development costs. Our product development costs include license acquisition, videogame development, and third-party royalties. Agreements with third-party developers generally give us exclusive publishing and marketing rights and require us to make advance royalty payments, pay royalties based on product sales and satisfy other conditions.





Third Quarter 2011 Releases





We released the following videogames in the three months ended March 31, 2011:





Title

Platform

Date ReleasedTwo Worlds II

X360 , PS3

January 25, 2011





Cost of Goods Sold and Operating Expenses





Cost of Goods Sold. Cost of goods sold consists of royalty payments to third party developers, license fees to videogame manufacturers, intellectual property costs for items such as trademarked characters and game engines, manufacturing costs of the videogame discs, cartridges or similar media and the write-off of acquired game sequel titles. Videogame system manufacturers approve and manufacture each videogame for their videogame system. They charge their license fee for each videogame based on the expected retail sales price of the videogame. Such license fee is paid by us based on the number of videogames manufactured. Should some of the videogames ultimately not be sold, or the sales price to the retailer be reduced by us through price protection, no adjustment is made by the videogame system manufacturer in the license fee originally charged. Therefore, because of the terms of these license fees, we may have an increase in the cost of goods as a percent of net revenue should we fail to sell a number of copies of a videogame for which a license has been paid, or if the price to the retailer is reduced.





We utilize third parties to develop our videogames on a royalty payment basis. We enter into contracts with third party developers once the videogame design has been approved by the videogame system manufacturer and is technologically feasible. Specifically, payments to third party developers are made when certain contract milestones are reached, and these payments are capitalized. These payments are considered non-refundable royalty advances and are applied against the royalty obligations owing to the third party developer from the sales of the videogame. To the extent these prepaid royalties are sales performance related, the royalties are expensed against projected sales revenue at the time a videogame is released and charged to costs of goods sold. Any pre-release milestone payments that are not prepayments against future royalties are expensed when a videogame is released and then charged to costs of goods sold. Capitalized costs for videogames that are cancelled or abandoned prior to product release are charged to “cost of goods sold - royalties” in the period of cancellation.





Warehousing and Distribution Expenses. Our warehousing and distribution expenses primarily consist of costs associated with warehousing, order fulfillment, and shipping. Because we use third-party warehousing and order fulfillment companies in the United States and in Europe, the expansion of our product offerings and escalating sales will increase our expenditures for warehousing and distribution in proportion to our increased sales.





Sales and Marketing Expenses. Sales and marketing expenses consist of advertising, marketing and promotion expenses, and commissions to external sales representatives. As the number of newly published videogames increases, advertising, marketing and promotion expenses are expected to rise accordingly. We recognize advertising, marketing and promotion expenses as incurred, except for production costs associated with media advertising, which are deferred and charged to expense when the related ad is run for the first time. We also engage in cooperative marketing with some of our retail channel partners. We accrue marketing and sales incentive costs when revenue is recognized and such amounts are included in sales and marketing expense when an identifiable benefit to us can be reasonably estimated; otherwise, the incentives are recognized as a reduction to net revenues. Such marketing is offered to our retail channel partners based on a single sales transaction, as a credit on their accounts receivable balance, and would include items such as contributing to newspaper circular ads and in store banners and displays.





General and Administrative Expenses. General and administrative expenses primarily represent personnel-related costs, including corporate executive and support staff, general office expenses, consulting and professional fees, and various other expenses. Personnel-related costs represent the largest component of general and administrative expenses. We expect that our personnel costs will increase as the business continues to grow.


25


Gain on Settlement of Trade Payables. Gain on settlement of trade payables is the result of negotiations with various unsecured creditors for the settlement and payment of trade payables at amounts less than the recorded liability.





Change in Fair Value of Warrant Liability.  Our senior secured convertible notes and certain warrants have been accounted for in accordance with applicable authoritative guidance for derivative instruments which requires identification of certain embedded features to be bifurcated from debt instruments and accounted for as derivative assets or liabilities. The derivative assets and liabilities are initially recorded at fair value and then at each reporting date, the change in fair value is recorded in the condensed consolidated statements of operations.





Interest and Financing Costs. Interest and financing costs are attributable to our financing arrangements that are used to fund development of videogames with third parties, which often takes 12-24 months. Additionally, such costs are used to finance the accounts receivables prior to payment by customers.





Critical Accounting Policies and Estimates





Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Estimates were based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from these estimates under different assumptions or conditions.





Our significant accounting policies are described in Note 1 to the accompanying condensed consolidated financial statements and in our annual report on Form 10-K for the year ended June 30, 2010. The following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.





Allowances for Returns, Price Protection and Other Allowances.  We accept returns from, and grant price concessions to, our customers under certain conditions. Following reductions in the price of our videogames, we grant price concessions to permit customers to take credits against amounts they owe us with respect to videogames unsold by them. Our customers must satisfy certain conditions to entitle them to return videogames or receive price concessions, including compliance with applicable payment terms and confirmation of field inventory levels and sell-through rates.





We make estimates of future videogame returns and price concessions related to current period revenue. We estimate the amount of future returns and price concessions for published titles based upon, among other factors, historical experience and performance of the titles in similar genres, historical performance of the videogame system, customer inventory levels, analysis of sell-through rates, sales force and retail customer feedback, industry pricing, market conditions and changes in demand and acceptance of our videogame by consumers.





Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price concessions in any accounting period. We believe we can make reliable estimates of returns and price concessions. However, actual results may differ from initial estimates as a result of changes in circumstances, market conditions and assumptions. Adjustments to estimates are recorded in the period in which they become known.





Inventories. Inventories are stated at the lower of average cost or market. Management regularly reviews inventory quantities on hand and in the retail channel and records a provision for excess or obsolete inventory based on the future expected demand for our games. Significant changes in demand for our games would impact management’s estimates in establishing the inventory provision.





Advances on Royalties. We utilize independent software developers to develop our videogames and make payments to the developers based upon certain contract milestones. We enter into contracts with the developers once the videogame design has been approved by the videogame system manufacturers and is technologically feasible. Accordingly, we capitalize such payments to the developers during development of the videogames. These payments are considered non-refundable royalty advances and are applied against the royalty obligations owed to the developer from future sales of the videogame. Any pre-release milestone payments that are not prepayments against future royalties are expensed to “cost of goods sold - royalties” in the period when the game is released. Capitalized royalty costs for those videogames that are cancelled or abandoned are charged to “cost of goods sold - royalties” in the period of cancellation.


26


Beginning upon the related videogame’s release, capitalized royalty costs are amortized to “cost of goods sold – royalties,” based on the ratio of current revenues to total projected revenues for the specific videogame, generally resulting in an amortization period of twelve months or less.





We evaluate the future recoverability of capitalized royalty costs on a quarterly basis. For videogames that have been released in prior periods, the primary evaluation criterion is actual title performance. For videogames that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific videogame to which the royalties relate. Criteria used to evaluate expected game performance include: historical performance of comparable videogames developed with comparable technology; orders for the videogame prior to its release; and, for any videogame sequel, estimated performance based on the performance of the videogame on which the sequel is based.





Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized royalty costs. In evaluating the recoverability of capitalized royalty costs, the assessment of expected videogame performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual videogame sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.





Intellectual Property Licenses. Intellectual property license costs consist of fees paid by us to license the use of trademarks, copyrights, and software used in the development of videogames. Depending on the agreement, we may use acquired intellectual property in multiple videogames over multiple years or for a single videogame. When no significant performance remains with the licensor upon execution of the license agreement, we record an asset and a liability at the contractual amount. We believe that the contractual amount represents the fair value of the liability. When significant performance remains with the licensor, we record the payments as an asset when paid to the licensee and as a liability upon achievement of certain contractual milestones rather than upon execution of the agreement. We classify these obligations as current liabilities to the extent they are contractually due within the next 12 months. Capitalized intellectual property license costs for those videogames that are cancelled or abandoned are charged to “cost of goods sold - intellectual property licenses” in the period of cancellation.





Beginning upon the related videogame’s release, capitalized intellectual property license costs are amortized to “cost of sales - intellectual property licenses” based on the greater of: (1) the ratio of current revenues for the specific videogame to total projected revenues for all videogames in which the licensed property will be utilized or (2) the straight-line amortization based on the useful lives of the asset. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.





We evaluate the future recoverability of capitalized intellectual property license costs on a quarterly basis. For videogames that have been released in prior periods, the primary evaluation criterion is actual title performance. For videogames that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific videogames to which the costs relate or in which the licensed trademark or copyright is to be used. Criteria used to evaluate expected game performance include: historical performance of comparable videogames developed with comparable technology; orders for the game prior to its release; and, for any videogame sequel, estimated performance based on the performance of the videogame on which the sequel is based. Further, as intellectual property licenses may extend for multiple videogames over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property and the holder’s right to continued promotion and exploitation of the intellectual property.





Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized intellectual property license costs. In evaluating the recoverability of capitalized intellectual property license costs, the assessment of expected game performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual videogame sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.


27


Revenue Recognition. We recognize revenues from the sale of our videogames upon the transfer of title and risk of loss to the customer.   We recognize revenues for software titles when (1) there is persuasive evidence that an arrangement with the customer exists, which is generally a purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable, and (4) collection of the customer receivable is deemed probable. Our payment arrangements with customers typically provide for net 30 and 60 day terms. Advances received for licensing and exclusivity arrangements are reported on the consolidated balance sheets as deferred revenues until we meet our performance obligations, at which point the revenues are recognized. Revenue is recognized after deducting estimated reserves for returns, price protection and other allowances. In circumstances when we do not have a reliable basis to estimate returns and price protection or we are unable to determine that collection of a receivable is probable, we defer the revenue until such time as we can reliably estimate any related returns and allowances and determine that collection of the receivable is probable.





We have an arrangement pursuant to which we distribute videogames co-published with another company for a fee based on the gross sales of the videogames.  Under the arrangement, we bear the inventory risk as we purchase and take title to the inventory, warehouse the inventory in advance of orders, ship the inventory and invoices its customers for videogame shipments.  Also under the arrangement, we bear the credit risk as the supplier does not guarantee returns for unsold videogames and we are not reimbursed by the supplier in the event of non-collection. We record the gross amount of revenue under the arrangement as we are not acting as an agent for the principal in the arrangement.





Stock-Based Compensation. We account for stock-based compensation in accordance with ASC Topic 718, Compensation – Stock Compensation. ASC 718 requires companies to estimate the fair value of share-based payment awards on the measurement date using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations.





Stock-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.





We account for equity instruments issued to non-employees in accordance with ASC Topic 505, Equity, Subtopic 50, Equity-Based Payments to Non-Employees.





We estimate the value of employee, non-employee director and non-employee stock options on the date of grant using the Black-Scholes option pricing model. Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.





Amortizable Intangible Assets. Intangible assets subject to amortization are carried at cost less accumulated amortization. Amortizable intangible assets consist of game sequels, non-compete agreements and distribution agreements. Intangible assets subject to amortization are amortized over the estimated useful life in proportion to the pattern in which the economic benefits are consumed, which for some intangibles assets are approximated by using the straight-line method. Long-lived assets including amortizable intangible assets are reviewed for impairment in accordance with ASC Topic 360, Property, Plant, and Equipment, whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of any impairment loss for long-lived assets and amortizable intangible assets is based on the amount by which the carrying value exceeds the fair value of the asset.





Assessment of Impairment of Goodwill. ASC Topic 350, Intangibles – Goodwill and Other, Subtopic 20, Goodwill, (“ASC 350-20”) requires a two-step approach to testing goodwill for impairment. ASC 350-20 requires that the impairment test be performed at least annually by applying a fair-value-based test. The first step measures for impairment by applying fair-value-based tests. The second step (if necessary) measures the amount of impairment by applying fair-value-based tests to the individual assets and liabilities.





To determine the fair values of the reporting units used in the first step, we use a combination of the market approach, which utilizes comparable companies’ data and/or the income approach, or discounted cash flows. Each step requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on our weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. Our estimates for market growth, our market share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. Our business consists of publishing and distributing interactive entertainment software and content using both established and emerging intellectual properties and our forecasts for emerging intellectual properties are based upon internal estimates and external sources rather than historical information and have an inherently higher risk of accuracy. If future forecasts are revised, they may indicate or require future impairment charges. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.


28


Change in Fair Value of Warrant Liability. We are required to classify the fair value of certain warrants issued as a liability, with subsequent changes in fair value to be recorded as income (loss) on change in fair value of warrant liability. The fair value of the warrants is determined using the Black-Scholes option pricing model and is affected by changes in inputs to that model including our stock price, expected stock price volatility, the contractual term, and the risk-free interest rate. Our estimate of the expected volatility is based on historical volatility. The expected term of the warrants is based on the time to expiration of the warrants from the date of measurement. Risk-free interest rates are derived from the yield on U.S. Treasury debt securities. We will continue to classify the fair value of the warrants as a liability until the warrants are exercised, expired or are amended in a way that would no longer require these warrants to be classified as a liability.





Consolidated Results of Operations





The following table sets forth our results of operations expressed as a percentage of net revenues for the three months and nine months ended March 31, 2011 and 2010:





For the

three months ended

March 31,


For the

nine months ended

March 31,2011


2010


2011


2010Net revenues


100.0
%


100.0
%


100.0
%


100.0
%Cost of goods sold:Product costs


30.9
%


50.1
%


35.3
%


36.4
%Royalties


16.9
%


43.1
%


23.8
%


28.8
%Intellectual property licenses


0.5
%


1.3
%


1.1
%


0.8
%Total cost of goods sold


48.3
%


94.5
%


60.2
%


66.0
%Gross profit


51.7
%


5.5
%


39.8
%


34.0
%Operating expenses:Warehousing and distribution


2.0
%


4.3
%


2.7
%


2.7
%Sales and marketing


10.1
%


13.1
%


14.0
%


20.0
%General and administrative


8.4
%


35.4
%


21.5
%


25.5
%Restructuring costs


-
%


-
%


-
%


-
%Transaction costs


-
%


-
%


-
%


-
%Litigation costs


-
%


-
%


-
%


9.0
%Gain on settlement of contingent purchase price obligation


-
%


(12.0
)%


-
%


(2.6
)%Gain on extinguishment of accrued litigation costs


-
%


(43.1
)%


-
%


(9.5
)%Gain on settlement of trade payables


(1.6
)%


-
%


(3.4
)%


(9.5
)%Total operating (income) expenses


18.9
%


(2.3
)%


34.8
%


35.6
%Income (loss) from operations


32.8
%


7.8
%


5.0
%


(1.6
)%Other expenses (income):Change in fair value of warrant liability


4.0
%


-
%


(9.7
)%


-
%Interest expense, net


8.9
%


5.3
%


14.9
%


3.5
%Net income (loss)


19.9
%


2.5
%


(0.2
)%


(5.1
)%


29


Three Months Ended March 31, 2011 and 2010





Net Revenues. Net revenues for the three months ended March 31, 2011 were $16,118,896, an increase of $8,580,056, or 113.8%, from net revenues of $7,538,840 for the three months ended March 31, 2010. The increase in net revenues was primarily driven by the release of Two Worlds II, which totaled over $16,800,000 in gross revenues during the three months ended March 31, 2011 versus the three months ended March 31, 2010.  For the three months ended March 31, 2011, the number of videogame units sold increased to approximately 547,000, an increase of 12,000 units from 535,000 sold in the prior period. Average net revenue per videogame unit sold increased 109.1%, from $14.09 to $29.47 for the three months ended March 31, 2010 and 2011, respectively. This average increase in price per unit is due to sales of Two Worlds II which has a wholesale price averaged over $46.00 per unit during the three months ended March 31, 2011 versus the prior period.





Cost of Goods Sold.  Cost of goods sold for the three months ended March 31, 2011 increased to $7,785,621, up $659,629, or 9.3%, from $7,125,992 for the prior period. Product costs for the three months ended March 31, 2011 increased $1,196,868, or 31.7%, from the comparable period in 2010.  This increase was primarily driven by an increase in sales of platform titles on the X360 and PS3 as opposed to sales of PC and NDS games in the prior period.  The cost of royalty expense for the three months ended March 31, 2011 was $2,721,656, a decrease of 16.3%, from royalty expense of $3,251,395 for the three months ended March 31, 2010.  This decrease is primarily attributable to distribution deals in 2010 which required a higher royalty expense per unit compared to 2011.





Gross Profit.  For the three months ended March 31, 2011 and 2010, gross profit increased to $8,333,275 from $412,848, or 1,918.5%. Gross profit margin increased to approximately 51.7% for the three months ended March 31, 2011 from 5.5% in the same period in 2010. The increase in gross profit is attributed to the successful release of Two Worlds II during the three months ended March 31, 2011 versus the prior period.





Warehousing and Distribution Expenses.  For the three months ended March 31, 2011 and 2010, warehousing and distribution expenses were $328,669 and $327,286, respectively, resulting in an increase of 0.4%. This increase is primarily attributed to slightly more units being shipped in 2011.





Sales and Marketing Expenses. For the three months ended March 31, 2011, sales and marketing expenses increased 65.3% to $1,633,499 from $988,226 for the three months ended March 31, 2010. This increase is primarily due to the marketing expenses on Two Worlds II.  Sales and marketing costs vary on a videogame by videogame basis depending on market conditions and consumer demand, and do not necessarily increase or decrease proportionate to sales volumes.





Gain on Settlement of Trade Payables.  For the three months ended March 31, 2011 and 2010, the gain on settlement of trade payables was $261,416 and $4,118, which was the result of negotiating a final payment with our third party warehouse in the quarter.





General and Administrative Expenses.  For the three months ended March 31, 2011, general and administrative expenses decreased $1,314,619 to $1,350,875 from $2,665,494 for the prior period. Wages included in general and administrative expenses decreased from $935,018 for the three months ended March 31, 2010 to $552,855 for the three months ended March 31, 2011, a decrease of 40.9%.  Professional fees decreased 67.3% from $551,807 for the three months ended March 31, 2010 to $180,463 for the three months ended March 31, 2011, as a result of a decrease in legal fees for the quarter. Travel and entertainment expenses were $88,501 for the three months ended March 31, 2010, as compared to $50,103 for the three months ended March 31, 2011.  General and administrative expenses as a percentage of net revenues decreased, to approximately 8.1% for the three months ended March 31, 2011 from 35.4% for the prior period.  In addition, for the three months ended March 31, 2011, general and administrative expenses includes $98,780 for noncash compensation related to employee stock options and restricted stock granted, a decrease of $72,685, or 42.4%, from the comparable period in 2010.





Operating Income (Loss). For the three months ended March 31, 2011, our operating income was $5,281,648, an increase of $4,696,104, or 802.0%, over operating income of $585,544 for the prior period.





Change in Fair Value of Warrant Liability. We are required to classify the fair value of certain warrants issued as a liability, with subsequent changes in fair value to be recorded as income (loss) on change in fair value of warrant liability. The fair value of the warrants is determined using the Black-Scholes option pricing model and is affected by changes in inputs to that model including our stock price, expected stock price volatility, the contractual term, and the risk-free interest rate. This revaluation resulted in a loss of $638,051, which we recorded to operations during the three months ended March 31, 2011.





Interest and Financing Costs.  For the three months ended March 31, 2011, interest and financing costs increased to $1,430,834 from $393,404 for the prior period due to additional interest due related to our factoring and inventory financing agreement. Amortization of debt issuance costs amounted to $120,131 for the three months ending March 31, 2011. Interest attributed to the secured convertible debt totaled $335,533 and amortization of the secured convertible debt discount was $361,562 for the three months ending March 31, 2011. Interest associated with the production advance payable totaled $288,971 for the three months ending March 31, 2011.


30


Net Income (Loss). For the three months ended March 31, 2011, our net income was $3,212,763, an increase of $3,020,623, or 1,572.1%, over net income of $192,140 for the prior period.





Nine Months Ended March 31, 2011 and 2010





Net Revenues. Net revenues for the nine months ended March 31, 2011 were $25,020,808, a decrease of $9,291,633, or 27.1%, from net revenues of $34,312,441 for the nine months ended March 31, 2010. The decrease in net revenues was primarily driven by an overall $17,700,000 decrease in gross revenue due to the decrease in the number of videogame units sold in the first and second fiscal quarters of this year during the nine months ended March 31, 2011 versus the nine months ended March 31, 2010.  For the nine months ended March 31, 2011, the number of videogame units sold decreased to approximately 1,146,000, a decrease of 771,000 units from 1,917,000 sold in the prior period. Average net revenue per videogame unit sold increased 22.0%, from $17.90 to $21.83 for the nine months ended March 31, 2010 and 2011, respectively. This average increase in price per unit is due to sales of Two Worlds II which had a 49.99 wholesale price during the nine months ended March 31, 2011 versus the prior period.





Cost of Goods Sold.  Cost of goods sold for the nine months ended March 31, 2011 decreased to $15,067,556, down $7,593,809, or 33.5%, from $22,661,365 for the prior period. Product costs for the nine months ended March 31, 2011 decreased $3,640,696, or 29.2%, from the comparable period in 2010.  This decrease was primarily driven by a decrease in the number of units sold from 2011 to 2010.  The cost of royalty expense for the nine months ended March 31, 2011 was $5,953,086, a decrease of 39.7%, from royalty expense of $9,871,028 for the nine months ended March 31, 2010. This decrease is primarily attributable to distribution deals in 2010 which required a higher royalty expense per unit compared to 2011.





Gross Profit.  For the nine months ended March 31, 2011 and 2010, gross profit decreased to $9,953,252 from $11,651,076, or 14.6%. Gross profit margin increased to approximately 39.8% for the nine months ended March 31, 2011 from 34.0% in the same period in 2010. The increase in gross profit margin is attributed to the release of Two Worlds II which has a higher profit margin than the other titles released in 2010 during the nine months ended March 31, 2011 versus the prior period.





Warehousing and Distribution Expenses.  For the nine months ended March 31, 2011 and 2010, warehousing and distribution expenses were $677,085 and $934,520, respectively, resulting in a decrease of 27.5%. This decrease is primarily attributed to the decrease in the number of units shipped in 2011.





Sales and Marketing Expenses. For the nine months ended March 31, 2011, sales and marketing expenses decreased 48.9% to $3,504,668 from $6,858,902 for the nine months ended March 31, 2010. This decrease is primarily due to higher marketing budgets for Section 8 and My Baby First Steps released in fiscal year 2010.  Sales and marketing costs vary on a videogame by videogame basis depending on market conditions and consumer demand, and do not necessarily increase or decrease proportionate to sales volumes.





Gain on Settlement of Trade Payables.  For the nine months ended March 31, 2011 and 2010, the gain on settlement of trade payables was $846,538 and $3,252,371.





General and Administrative Expenses.  For the nine months ended March 31, 2011, general and administrative expenses decreased $3,379,934 to $5,374,272 from $8,754,206 for the prior period. Wages included in general and administrative expenses decreased from $2,916,712 for the nine months ended March 31, 2010 to $1,913,304 for the nine months ended March 31, 2011, a decrease of 34.4%.  Professional fees decreased 50.2% from $2,462,368 for the nine months ended March 31, 2010 to $1,225,328 for the nine months ended March 31, 2011, as a result of fewer legal fees incurred during the nine months ended March 31, 2011. Travel and entertainment expenses were $203,653 for the nine months ended March 31, 2010, as compared to $200,247 for the nine months ended March 31, 2011.  General and administrative expenses as a percentage of net revenues decreased, to approximately 20.9% for the nine months ended March 31, 2011 from 25.5% for the prior period.  In addition, for the nine months ended March 31, 2011, general and administrative expenses includes $303,554 for noncash compensation related to employee stock options and restricted stock granted, a decrease of $188,013, or 38.2%, from the comparable period in 2010.


31


Operating Income (Loss). For the nine months ended March 31, 2011, our operating income was $1,243,765, an increase of $1,805,332, over operating loss of $561,567 for the prior period.





Change in Fair Value of Warrant Liability. We are required to classify the fair value of certain warrants issued as a liability, with subsequent changes in fair value to be recorded as income (loss) on change in fair value of warrant liability. The fair value of the warrants is determined using the Black-Scholes option pricing model and is affected by changes in inputs to that model including our stock price, expected stock price volatility, the contractual term, and the risk-free interest rate. This revaluation resulted in a gain of $2,424,595, which we recorded to operations during the nine months ended March 31, 2011.





Interest and Financing Costs.  For the nine months ended March 31, 2011, interest and financing costs increased to $3,739,366 from $1,201,578 for the prior period due to a new factoring agreement and inventory financing agreement. Amortization of debt issuance costs amounted to $321,409 for the nine months ending March 31, 2011. Interest attributed to the secured convertible debt totaled $754,361 and amortization of the secured convertible debt discount was $1,084,687 for the nine months ending March 31, 2011. Interest associated with the production advance payable totaled $861,849 for the nine months ending March 31, 2011.





Net Income (Loss). For the nine months ended March 31, 2011, our net loss was $76,001, an increase of $1,692,139, over net loss of $1,763,145 for the prior period.





Quarterly Operating Results Not Meaningful





Our quarterly net revenues and operating results have varied widely in the past and can be expected to vary in the future due to numerous factors, several of which are not under our control. These factors include the timing of our release of new titles, the popularity of both new titles and titles released in prior periods, changes in the mix of titles with varying gross margins, the timing of customer orders, and fluctuations in consumer demand for gaming platforms. Accordingly, our management believes that quarter-to-quarter comparisons of our operating results are not meaningful.





Liquidity and Capital Resources





Our primary cash requirements have been to fund (i) the development, manufacturing and marketing of our videogames, (ii) working capital, and (iii) capital expenditures. Historically, we have met our capital needs, including working capital, capital expenditures and commitments, through our operating activities, our credit arrangements, through the sale of our equity securities, and, prior to the reverse acquisition, loans from related parties and our shareholders.  Our cash and cash equivalents were $529,836 at March 31, 2011 and $92,893 at June 30, 2010.





Factoring Agreement. On July 12, 2010, we entered into a factoring agreement (the “Factoring Agreement”) with Rosenthal & Rosenthal, Inc. (“Rosenthal  & Rosenthal”).  Under the Factoring Agreement, we agreed to sell receivables arising from sales of inventory to Rosenthal & Rosenthal.  Under the terms of the Factoring Agreement, we are selling all of our receivables to Rosenthal & Rosenthal.  For the approved receivables, Rosenthal & Rosenthal will assume the risk of collection. We have agreed to pay Rosenthal & Rosenthal a commission of .60% of the amount payable under all of our invoices to most of our customers against a minimum commission of $30,000 multiplied by the number of months in a contract period, with the first period being 12 months and the second 7 months.  All payments received by Rosenthal & Rosenthal are payable to us after amounts due to Rosenthal & Rosenthal are satisfied.  Under the Factoring Agreement, we have the right to borrow against payments due us at the rate of 65% of credit approved receivables.  The borrowing rate against non-credit approved receivables is subject to negotiation. The interest rate on borrowings is equal to the greater of prime plus 1.5% per annum or 6.5% per annum.  A $10,000,000 loan cap applies against our borrowings, which is subject to an increase of up to $3,000,000 if shareholders’ equity increases.  The initial term of the Factoring Agreement ends on February 28, 2012.  At March 31, 2011, $5,594,000 was due to Rosenthal & Rosenthal under the Factoring Agreement.





Accounts Receivable. Generally, we have been able to collect our accounts receivable in the ordinary course of business. We do not hold any collateral to secure payment from customers. We are subject to credit risks, particularly if any of our accounts receivable represent a limited number of customers. If we are unable to collect our accounts receivable as they become due, it could adversely affect our liquidity and working capital position.





At March 31, 2011 and June 30, 2010, amounts due from our three largest customers comprised approximately 64% and 54% of our gross accounts receivable balance, respectively. We believe that the receivable balances from these largest customers do not represent a significant credit risk based on past collection experience, although we actively monitor each customer’s credit worthiness and economic conditions that may impact our customers’ business and access to capital. We continue to monitor the lagging economy, the global contraction of credit markets and other factors as they relate to our customers in order to manage the risk of uncollectible accounts receivable.


32


Senior Secured Convertible Notes. On July 16, 2010, we entered into a Securities Purchase Agreement with CNH Diversified Opportunities Master Account, L.P., CNH CA Master Account, L.P., AQR Diversified Arbitrage Fund and Terry Phillips, our chairman, for the sale of $5,500,000 of senior secured convertible notes (the “Initial Notes”) and related warrants.  Mr. Phillips’ Initial Note was issued in exchange for a junior secured convertible note originally issued to him on April 30, 2010.  We received $5,000,000 in cash for $5,000,000 of the senior secured convertible notes and exchanged a $500,000 prior junior secured convertible note for $500,000 of the senior secured convertible notes.





On August 31, 2010, we entered into an Amended and Restated Securities Purchase Agreement, pursuant to which we sold an aggregate of $2,000,000 of a new series of senior secured convertible promissory notes (the “Additional Notes” and together with the Initial Notes, the “Notes”) to AQR Opportunistic Premium Offshore Fund, L.P., Advanced Series Trust, solely on behalf of the AST Academic Strategies Asset Allocation Portfolio, and Terry Phillips, our chairman.  We received $2,000,000 in cash for $2,000,000 of the Additional Notes, of which $200,000 was paid by Mr. Phillips.





On December 31, 2010, we failed to make a timely payment of interest required under its secured convertible notes (the “Notes”).  Such failure triggered a default provision under the Notes following a seven day cure period.  On February 16, 2011, we entered into a Waiver and Forbearance Agreement (each, a “Waiver Agreement” and collectively, the “Waiver Agreement”) with the holders of the Notes.  Pursuant to the Waiver Agreements, the holders of the Notes waived their rights of redemption and remedies regarding our failure to have paid the required interest and agreed to forbear from exercising all remedies available in connection with such failure until March 15, 2011. Pursuant to the Waiver Agreement, we are not required to pay the required interest until March 15, 2011 and the interest rates under the Notes increase to 15% and 29%, as applicable, from December 31, 2010 to March 15, 2011.





On March 15, 2011, we failed to pay the outstanding amount of principal, interest and late charges due on the Additional Notes (as defined below), and such failure triggered a default provision under the Additional Notes following a seven day cure period (the “Maturity Payment Default”).  We also failed to have a registration statement (the “Initial Registration Statement”) relating to the shares of common stock underlying the Initial Notes (as defined below) and associated warrants declared effective by March 15, 2011, and such failure triggered a default provision under the Initial Notes (the “Registration Default”).  On May 23, 2011, we entered into a Waiver and Amendment Agreement (the “Amendment Agreement) with the holders of the Notes (See Note 6).  Pursuant to the Amendment Agreement, the holders of the Notes have waived the Maturity Payment Default and Registration Default, as applicable, the maturity date for the Additional Notes has been extended to December 31, 2011, and the interest rate for the Additional Notes has been increased to 29%.  The Amendment Agreement provides that the initial effectiveness deadline by which the Initial Registration Statement must be declared effective by the SEC has been extended (i) to January 31, 2012, in the event that the Initial Registration Statement is not subject to a full review by the SEC, or (ii) to April 30, 2012, in the event that the Initial Registration statement is subject to a full review by the SEC.  As a material inducement for the holders of the Additional Notes to enter into the Amendment Agreement, the Company and certain of its subsidiaries have agreed to (i) instruct its online distribution partners to remit all payments arising from sales through online gaming platforms of the electronic game “Stronghold 3” (the “Game”) to the collateral agent under the relevant security documents, (ii) remit all receivable arising from sales of the Game in Europe directly to the collateral agent, and (iii) pay the collateral agent, upon its demand, 60% of any amounts in excess of $350,000 paid to us under the factoring agreement between us and Rosenthal & Rosenthal, Inc.





Purchase Order Assignment Agreement.  On September 20, 2010, we entered into a master purchase order assignment agreement with Wells Fargo Bank, National Association. Under the terms of the agreement, we may request that Wells Fargo accept the assignment of customer purchase orders and request that Wells Fargo purchase the required materials to fulfill such purchase orders.  If accepted, Wells Fargo, in turn, will retain us to manufacture, process, and ship the ordered goods. Wells Fargo’s aggregate outstanding funding under the agreement shall not exceed $2,000,000. Upon receipt of customer payments by Wells Fargo, we will be paid a fee for its services, with such fee calculated pursuant to the terms of the agreement. Also from such customer payments, Wells Fargo shall be entitled to receive the following: (1) a transaction initiation and set-up fee equal to 1.5% of the aggregate amount outstanding on all amounts (including letters of credit) advanced by Wells Fargo; (2) a daily maintenance fee equal to 0.05% of all amounts (including letters of credit) advanced by Wells Fargo which remain outstanding for more than 30 days; and (3) a product advance fee equal to (a) the prime rate plus 2%, divided by 360, multiplied by (b) (i) the aggregate amount outstanding on all amounts (including letters of credit) advanced by Wells Fargo on account of purchases of products or other advances made in connection with a customer purchase order, multiplied (ii) by the number of days from the earlier of (A) the date on which any such letter of credit or purchase order or financial accommodation is negotiated into cash, or (B) the date funds are advanced by other than issuing a letter of credit or purchase order. A security agreement secures the advances made to us under this agreement.


33


Although there can be no assurance, we believe our current cash and cash equivalents and projected cash flow from operations, along with availability under our factoring line and Wells Fargo agreement, will provide us with sufficient liquidity to satisfy our cash requirements for working capital, capital expenditures and commitments through at least the next 12 months. Our belief is based upon the revenues we anticipate generating from two video games, many of our creditors are providing us with concessions on payment terms and we have, but for one litigation claim, limited exposure within the next 12 months, for the litigation in which we are involved. In addition, if we were unable to fully fund our cash requirements through current cash and cash equivalents and projected cash flow from operations, we would need to obtain additional financing through a combination of equity and debt financings. If any such activities become necessary, there can be no assurance that we would be successful in obtaining additional financing. In their report on our audited financial statements for the year ended June 30, 2010, our independent registered public accounting firm included an explanatory paragraph regarding concerns about our ability to continue as a going concern. See "Note 1. Summary of Significant Accounting Policies- Going Concern" to our condensed consolidated financial statements included elsewhere in this report for additional information.





Cash Flows. We expect that we will make expenditures relating to advances on royalties to third-party developers to which we have made commitments to fund. Cash flows from operations are affected by our ability to release successful titles. Though many of these titles have substantial royalty advances and marketing expenditures, once a title recovers these costs, incremental net revenues typically will directly and positively impact cash flows. However, if sales projections or the release schedule dates do not meet our forecast, this could have a negative impact on our cash flows.





For the nine months ended March 31, 2011 we had net cash used in operating activities of $1,092,082, and in 2010 we had net cash used in operating activities of $257,663.





During the nine months ended March 31, 2011, investing activities resulted in net cash used of $19,056 and during the nine months ended March 31, 2010, investing activities resulted in net cash provided of $656,574.





During the nine months ended March 31, 2011, financing activities resulted in net cash provided of $1,939,783 and during the nine months ended March 31, 2010, financing activities resulted in net cash used of $990,990.





International Operations. Net revenue earned outside of North America is principally generated by our operations in Europe, Australia and Asia. For the three months ended March 31, 2011 and 2010, approximately -0-% and -0-%, respectively, of our net revenue was earned outside of the U.S. We are subject to risks inherent in foreign trade, including increased credit risks, tariffs and duties, fluctuations in foreign currency exchange rates, shipping delays and international political, regulatory and economic developments, all of which can have a significant impact on our operating results.





Item 3. Quantitative and Qualitative Disclosures about Market Risk





For quantitative and qualitative disclosures about market risk, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our annual report on Form 10-K for the year ended June 30, 2010. Our exposures to market risk have not changed materially since June 30, 2010.





Item 4.  Controls and Procedures





Restatement of Previously Issued Financial Statements





On September 11, 2009, we filed an amendment to our quarterly report on Form 10-Q for the quarter ended March 31, 2009 with the Securities Exchange Commission (the “SEC”) to restate our previously issued financial statements included in the report. In connection with that filing, during the first fiscal quarter of 2010, management reevaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)). Based on that reevaluation, our chief executive officer, who was then also serving as our interim chief financial officer, and in consultation with our chairman, concluded that our disclosure controls and procedures were not effective as of March 31, 2009 as a result of a number of material weakness in our internal control over financial reporting, all of which, other than as set forth in the following paragraph, were remediated during the fiscal year ended June 30, 2010 and disclosed in our Form 10-K for such period.


34


·
There were material operational deficiencies related to the preparation and review of financial information during our quarter end closing process. These items resulted in more than a remote likelihood that a material misstatement or lack of disclosure within our interim financial statements would not be prevented or detected. Our senior financial management lacked the necessary experience and we did not maintain a sufficient number of qualified personnel to support our financial reporting and close process. This reduced the likelihood that such individuals could detect a material adjustment to our books and records or anticipate, identify, and resolve accounting issues in the normal course of performing their assigned functions. This material weakness resulted in adjustments to inventories, accounts payable, accrued royalties, accrued expenses and other current liabilities, due to shareholders, additional paid-in capital, product costs, royalties, sales and marketing and general and administrative expenses in our condensed consolidated financial statements for the three and nine month periods ended March 31, 2009.





Evaluation of Disclosure Controls and Procedures





An evaluation was carried out under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, and in consultation with our chairman, of the effectiveness of the design and operation of our disclosure controls and procedures, to ensure that the information required to be disclosed by us in this quarterly report was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and Form 10-Q and that such information required to be disclosed was accumulated and communicated to management, including our chief executive officer and our chief financial officer, to allow timely decisions regarding required disclosure. Based upon this reevaluation, our chief executive officer and our chief financial officer, concluded that our disclosure controls and procedures were not effective as of March 31, 2011 as a result of the material weakness in our internal control over financial reporting identified in the paragraph above.





Changes in Internal Control over Financial Reporting





As discussed above, as of March 31, 2011, we had a material weakness in our internal control over financial reporting.





In addition to the remediation measures described below under the heading “Remediation Steps to Address Material Weakness,” we have made the following changes to address the previously reported material weaknesses in internal control over financial reporting and disclosure controls and procedures:





·
we implemented a closing calendar and consolidation process that includes accrual based financial statements being reviewed by qualified personnel in a timely manner;





·
we review consolidating financial statements with senior management and the audit committee of the board of directors;





·
we complete disclosure checklists for both GAAP and SEC required disclosures to ensure disclosures are complete;





·
we did appoint a chief financial officer with the requisite experience in internal accounting in the videogame industry and made other related personnel changes to improve our internal controls;





·
we engaged external consultants to backfill duties and controls performed by the chief financial officer upon her exit from our company;





·
we have enhanced our computer software and internal procedures related to information technology in order to migrate from spreadsheet applications into automated functions within the accounting system;





·
we have implemented access controls into our financial accounting software;





·
we have made staff changes so that the accounting persons responsible for the preparation of external reporting, including public filings, are qualified accountants who stay abreast of new requirements through subscriptions and training. New pronouncements are summarized and reported to accounting staff, management and the audit committee as appropriate; and





·
we continue to communicate and enforce all policies and procedures relating to purchasing for our company.





In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law.  This legislation includes an exemption for companies with less than $75 million in market capitalization (non-accelerated filers) to Section 404(b) of the Sarbanes-Oxley Act of 2002, which requires an external auditor’s report on the effectiveness of a registrant’s internal control over financial reporting.  The SEC has not published a final rule on this new law.  We are in the process of determining the effects, if any, of this new law.


35


Remediation Steps to Address Material Weakness





During the quarter ended March 31, 2011, we continued to remediate the remaining material weakness in our internal controls over financial reporting by putting in effect further additional controls to restrict access to our automated accounting system and restricting access to our automated accounting system to only those employees under the direct supervision of our Chief Executive Officer.





Management anticipates that the actions described above and the resulting improvements in controls will strengthen its internal control over financial reporting relating to the preparation of the condensed consolidated financial statements. As we improve our internal control over financial reporting and implement remediation measures, we may supplement or modify the remediation measures described above. Management is committed to implementing effective control policies and procedures and will continually update our Audit Committee as to the progress and status of our remediation efforts to ensure that they are adequately implemented.





PART II





Item 1.Legal Proceedings





As previously reported in our Form 10-Q for the period ended December 31, 2010, on September 3, 2010, we, Terry Phillips, our chairman, and Melanie Mroz, our CEO,  received Wells Notices from the staff of the SEC advising that the staff will recommend to the SEC that cease and desist orders issue for alleged violations. On April 21, 2011, Mr. Phillips and we reached a settlement with the SEC without admitting any wrong doing.  All violations alleged to Ms. Mroz were dropped.  Mr. Phillips agreed to pay a $50,000 civil penalty pursuant to Section 21(d)(3) of the Exchange Act.




Reference is made to our Form 10-Q for the period ended December 31, 2010 for litigation filed in Germany against us, by BVT Games Fund III Dynamic GmbH & Company (“Fund III”) and BVT Games Fund IV Dynamic GmbH & Company (“Fund IV”), investment funds based in Germany that finances the development of video games.  The Fund IV litigation remains dormant as the court considers the merits of our defenses to overturn the default judgment entered in favor of Fund III.





Reference is made to our Form 10-Q for the period ended December 31, 2010 in which we reported a preference claim asserted against us by the Trustee of the Circuit City Liquidating Trust filed a lawsuit against us in United States Bankruptcy Court in the Eastern District of Virginia for the avoidance of payments totaling $1,155,300 as allegedly preferential transfers paid to us during the 90 days preceding the filing of the bankruptcy petition of Circuit City on November 10, 2008. No material events have occurred in this matter.





On January 26, 2011, Codemasters Group Holdings Limited filed suit against us in the United States District Court for the Eastern District of Virginia, Richmond Division, seeking to enforce a Settlement Agreement under which Codemasters claims that $1,265,000 plus interest thereon is due. The suit was dismissed on April 8, 2011, and remains subject to being refiled in England.  Amounts have been accrued for the liability to Codemasters. The actual amount of the liability remains in dispute.





Item 1A. Risk Factors





“Item 1A. Risk Factors” of our annual report on Form 10-K for the year ended June 30, 2010 includes a discussion of our risk factors.  Except as presented below, there have been no material changes to risk factors as previously disclosed in our annual report on Form 10-K filed with the Securities and Exchange Commission on October 13, 2010.





We have a history of operating losses and negative cash flows from operating activities and we anticipate such losses and negative cash flows in future reporting periods.  Unless we are able to generate operating profits and positive cash flows from operating activities, we may not be able to continue operations in the manner we have in the past, or at all.





For the nine months ended March 31, 2011, 2010, and 2009, our operating losses were $76,001, $4,205,300 and $11,807,405, respectively, and negative cash flows from operating activities were $1,092,082, $961,475 and $3,251,878.  We expect operating losses and negative cash flows from operating activities to continue in future reporting periods and to possibly increase from current levels if we increase expenditures for sales and marketing, license fees and general business enhancement to support efforts to grow our business.  Increase in on-going operating expenses would require us to generate significant revenues to achieve profitability.  Consequently, we cannot predict when we would achieve profitability.  Even if we do achieve profitability, we may not sustain or increase profitability on a quarterly or annual basis in the future.  If we are unable to achieve or sustain profitability in the future, we may be unable to continue our operations in the manner we have in the past, or all.


36


We are exposed to legal proceedings and contingent liabilities that could result in material liabilities that we have not reserved against and the incurrence of which could adversely affect our results of operations or significantly harm our business.





We are a party to various legal proceedings described in Part II, Item 1. Legal Proceedings and are subject to certain important contingent liabilities described more fully under the caption “Contingencies” in the notes to our condensed consolidated financial statements included in this report. If one or more of these legal proceedings or contingent liabilities, or others that may later arise, were to be resolved in a manner adverse to us, we could suffer losses that are material to our business, results of operations and financial condition. We have established reserves for these contingent liabilities, and certain of these contingent liabilities, if resolved at levels exceeding the reserved amounts, could have a material adverse effect on our business, results of operations and financial condition in addition to the effect of any potential monetary judgment or sanction against us.  Furthermore, any legal proceedings, regardless of the outcome, could result in substantial costs and diversion of resources that could have a material adverse effect on our business, results of operations, and financial condition.





Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds





None.





Item 3.  Defaults Upon Senior Securities





None.





Item 4.  (Removed and Reserved)





Item 5.  Other Information





None.





Item 6. Exhibits





ExhibitNumber

Exhibit3.1(1)

Amended and Restated Certificate of Incorporation.3.2(1)

Amended and Restated Bylaws.3.2(2)

First Certificate of Amendment of Amended and Restated Certificate of Incorporation.31.1*

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

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

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





*
Filed herewith


(1)
Incorporated by reference to an exhibit to the Current Report on Form 8-K of the Registrant filed with the Securities and Exchange Commission on May 15, 2008.


(2)
Incorporated by reference to an exhibit to the Quarterly Report on Form 10-Q of the Registrant filed with the Securities and Exchange Commission on November 15, 2010.


37


SIGNATURES





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





SOUTHPEAK INTERACTIVE CORPORATIONBy:
/s/ Melanie MrozMelanie MrozPresident and Chief Executive Officer/s/ James HuyckJames HuyckSenior Cost Accountant(Principal Accounting Officer)Date: May 23, 2011


38


INDEX TO EXHIBITS





ExhibitNumber

Exhibit31.1

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

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

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


39