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 December 31, 2010


 ̈
            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 
 ̈





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   ̈





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





Large
      accelerated filer   ̈
            Accelerated
      filer   ̈
            Non-accelerated
      filer   ̈
            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 
 ̈
     No  þ





As of
February 11, 2011, 60,799,538  shares of common stock, par value
$0.0001 per share, of the registrant were outstanding.







TABLE OF CONTENTS




PagePART I —
      FINANCIAL INFORMATIONItem
      1.
                  Financial
      Statements
                  
                  3Condensed
      Consolidated Financial Statements (unaudited)
                  
                  3Condensed
      Consolidated Balance Sheets as of December 31, 2010 (unaudited) and June
      30, 2010
                  
                  3Condensed
      Consolidated Statements of Operations for the three months and six months
      ended December 31, 2010 and 2009 (unaudited)
                  
                  4Condensed
      Consolidated Statements of Cash Flows for the six months ended December
      31, 2010 and 2009 (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
      4.
                  Controls
      and Procedures
                  
                  35PART II —
      OTHER INFORMATIONItem
      1.
                  Legal
      Proceedings
                  
                  36Item
      1A.
                  Risk
      Factors
                  
                  37Item
      2.
                  Unregistered
      Sales of Equity Securities and Use of Proceeds
                  
                  38Item
      3.
                  Defaults
      Upon Senior Securities
                  
                  38Item
      5.
                  Other
      Information
                  
                  38Item
      6.
                  Exhibits
                  
                  39SIGNATURES
                  
                  40


2




PART I





Item 1.
Condensed Consolidated
Financial Statements





SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


CONDENSED
CONSOLIDATED BALANCE SHEETS





December 31, 2010
                    
                    
                    June 30, 2010(Unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
                    
                    $
                    78,631
                    
                    
                    $
                    92,893Accounts
      receivable, net of allowances of $928,451 and $5,700,931 at December 31,
      2010 and June 30, 2010, respectively
                    
                    
                    1,150,873
                    
                    
                    
                    3,703,825Inventories
                    
                    
                    1,131,915
                    
                    
                    
                    1,211,301Current
      portion of advances on royalties
                    
                    
                    11,911,559
                    
                    
                    
                    12,322,926Current
      portion of intellectual property licenses
                    
                    
                    353,571
                    
                    
                    
                    383,571Related
      party receivables
                    
                    
                    16,260
                    
                    
                    
                    34,509Prepaid
      expenses and other current assets
                    
                    
                    457,836
                    
                    
                    
                    695,955Total
      current assets
                    
                    
                    15,100,645
                    
                    
                    
                    18,444,980Property
      and equipment, net
                    
                    
                    2,559,579
                    
                    
                    
                    2,667,992Advances
      on royalties, net of current portion
                    
                    
                    1,920,978
                    
                    
                    
                    1,511,419Intellectual
      property licenses, net of current portion
                    
                    
                    1,237,500
                    
                    
                    
                    1,534,286Goodwill
                    
                    
                    7,911,800
                    
                    
                    
                    7,911,800Deferred
      debt issuance costs, net
                    
                    
                    532,681
                    
                    
                    
                    -Intangible
      assets, net
                    
                    
                    10,358
                    
                    
                    
                    17,025Other assets
                    
                    
                    10,955
                    
                    
                    
                    11,280Total
      assets
                    
                    $
                    29,284,496
                    
                    
                    $
                    32,098,782Liabilities
      and Shareholders’ Equity (Deficit)Current
      liabilities:Line
      of credit
                    
                    $
                    -
                    
                    
                    $
                    3,830,055Due
      to factor
                    
                    
                    864,902
                    
                    
                    
                    -Secured
      convertible debt in default, net of discount
                    
                    
                    3,884,377
                    
                    
                    
                    950,000Warrant
      liability
                    
                    
                    1,276,102
                    
                    
                    
                    -Current
      portion of long-term debt
                    
                    
                    67,334
                    
                    
                    
                    65,450Production
      advance payable in default
                    
                    
                    3,755,104
                    
                    
                    
                    3,755,104Accounts
      payable
                    
                    
                    9,951,665
                    
                    
                    
                    12,663,788Accrued
      royalties
                    
                    
                    4,455,312
                    
                    
                    
                    2,530,253Accrued
      expenses and other current liabilities
                    
                    
                    4,877,623
                    
                    
                    
                    3,781,711Deferred
      revenues
                    
                    
                    77,312
                    
                    
                    
                    325,301Due
      to related parties
                    
                    
                    4,425
                    
                    
                    
                    2,200Accrued
      expenses - related parties
                    
                    
                    341,618
                    
                    
                    
                    322,281Total
      current liabilities
                    
                    
                    29,555,774
                    
                    
                    
                    28,226,143Long-term
      debt, net of current portion
                    
                    
                    1,507,310
                    
                    
                    
                    1,541,081Total
      liabilities
                    
                    $
                    31,063,084
                    
                    
                    $
                    29,767,224Commitments
      and contingencies
                    
                    
                    -
                    
                    
                    
                    -Shareholders’
      equity (deficit):Preferred
      stock, $0.0001 par value; 5,000,000 shares authorized; no shares issued
      and outstanding at December 31, 2010 and June 30, 2010
                    
                    
                    -
                    
                    
                    
                    -Series
      A convertible preferred stock, $0.0001 par value; 15,000,000 shares
      authorized; 5,503,833 shares issued and outstanding at December 31, 2010
      and June 30, 2010, respectively; aggregate liquidation preference of
      $5,503,833 at December 31, 2010
                    
                    
                    550
                    
                    
                    
                    550Common
      stock, $0.0001 par value; 190,000,000 and 90,000,000 shares authorized at
      December 31, 2010 and June 30, 2010, respectively; 60,181,870 and
      59,774,370 shares issued and outstanding at December 31, 2010 and June 30,
      2010, respectively
                    
                    
                    6,018
                    
                    
                    
                    5,976Additional
      paid-in capital
                    
                    
                    30,559,705
                    
                    
                    
                    31,154,835Accumulated
      deficit
                    
                    
                    (32,257,094
                    )
                    
                    
                    (28,973,325
                    )Accumulated
      other comprehensive income (loss)
                    
                    
                    (87,767
                    )
                    
                    
                    143,522Total
      shareholders’ equity (deficit)
                    
                    
                    (1,778,588
                    )
                    
                    
                    2,331,558Total
      liabilities and shareholders’ equity (deficit)
                    
                    $
                    29,284,496
                    
                    
                    $
                    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
                    December 31,
                  
                  
                  For the six months ended
                    December 31,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Net
      revenues
                  
                  $
                  7,470,053
                  
                  
                  $
                  10,063,952
                  
                  
                  $
                  8,901,912
                  
                  
                  $
                  26,773,601Cost
      of goods sold:Product
      costs
                  
                  
                  3,097,437
                  
                  
                  
                  5,149,597
                  
                  
                  
                  3,858,719
                  
                  
                  
                  8,696,283Royalties,
      net
                  
                  
                  3,298,538
                  
                  
                  
                  1,618,962
                  
                  
                  
                  3,231,430
                  
                  
                  
                  6,619,633Intellectual
      property licenses
                  
                  
                  95,893
                  
                  
                  
                  99,797
                  
                  
                  
                  191,786
                  
                  
                  
                  219,457Total
      cost of goods sold
                  
                  
                  6,491,868
                  
                  
                  
                  6,868,356
                  
                  
                  
                  7,281,935
                  
                  
                  
                  15,535,373Gross
      profit
                  
                  
                  978,185
                  
                  
                  
                  3,195,596
                  
                  
                  
                  1,619,977
                  
                  
                  
                  11,238,228Operating
      expenses (income):Warehousing
      and distribution
                  
                  
                  282,327
                  
                  
                  
                  320,723
                  
                  
                  
                  348,416
                  
                  
                  
                  607,234Sales
      and marketing
                  
                  
                  974,498
                  
                  
                  
                  2,215,620
                  
                  
                  
                  1,871,169
                  
                  
                  
                  5,870,676General
      and administrative
                  
                  
                  2,091,082
                  
                  
                  
                  2,973,944
                  
                  
                  
                  4,023,397
                  
                  
                  
                  6,088,712Litigation
      costs
                  
                  
                  -
                  
                  
                  
                  3,075,206
                  
                  
                  
                  -
                  
                  
                  
                  3,075,206Gain
      on settlement of trade payables
                  
                  
                  -
                  
                  
                  
                  (3,256,489
                  )
                  
                  
                  (585,122
                  )
                  
                  
                  (3,256,489
                  )Total
      operating expenses
                  
                  
                  3,347,907
                  
                  
                  
                  5,329,004
                  
                  
                  
                  5,657,860
                  
                  
                  
                  12,385,339Loss
      from operations
                  
                  
                  (2,369,722
                  )
                  
                  
                  (2,133,408
                  )
                  
                  
                  (4,037,883
                  )
                  
                  
                  (1,147,111
                  )Other
      expenses (income):Change
      in fair value of warrant liability
                  
                  
                  (1,531,323
                  )
                  
                  
                  -
                  
                  
                  
                  (3,062,646
                  )
                  
                  
                  -Interest
      and financing costs, net
                  
                  
                  1,244,436
                  
                  
                  
                  508,858
                  
                  
                  
                  2,308,532
                  
                  
                  
                  808,174Net
      loss
                  
                  $
                  (2,082,835
                  )
                  
                  $
                  (2,642,266
                  )
                  
                  $
                  (3,283,769
                  )
                  
                  $
                  (1,955,285
                  )Basic
      loss per share:
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.06
                  )
                  
                  $
                  (0.06
                  )
                  
                  $
                  (0.04
                  )Diluted
      loss per share:
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.06
                  )
                  
                  $
                  (0.06
                  )
                  
                  $
                  (0.04
                  )Weighted
      average number of common shares outstanding - Basic
                  
                  
                  57,252,122
                  
                  
                  
                  45,039,292
                  
                  
                  
                  57,140,971
                  
                  
                  
                  44,930,125Weighted
      average number of common shares outstanding - Diluted
                  
                  
                  57,252,122
                  
                  
                  
                  45,039,292
                  
                  
                  
                  57,140,971
                  
                  
                  
                  44,930,125




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 six months ended
                      December 31,2010
                    
                    
                    2009Cash flows from
      operating activities:Net
      loss
                    
                    $
                    (3,283,769
                    )
                    
                    $
                    (1,955,285
                    )Adjustments
      to reconcile net loss to net cash (used in) provided by operating
      activities:Depreciation
      and amortization
                    
                    
                    132,142
                    
                    
                    
                    129,972Allowances
      for price protection, returns, and defective merchandise
                    
                    
                    (2,463,231
                    )
                    
                    
                    (531,050
                    )Bad
      debt expense, net of recoveries
                    
                    
                    (49,161
                    )
                    
                    
                    (35,321
                    )Stock-based
      compensation expense
                    
                    
                    214,283
                    
                    
                    
                    359,920Common
      stock and warrants issued to vendor
                    
                    
                    -
                    
                    
                    
                    104,500Amortization
      of royalties and intellectual property licenses
                    
                    
                    960,543
                    
                    
                    
                    5,443,825Loss
      on disposal of fixed assets
                    
                    
                    -
                    
                    
                    
                    4,839Amortization
      of debt discount and issuance costs
                    
                    
                    924,403
                    
                    
                    
                    -Change
      in fair value of warrant liability
                    
                    
                    (3,062,646
                    )
                    
                    
                    -Fair
      market value adjustment to common stock issued for advances on
      royalties
                    
                    
                    (2,112
                    )
                    
                    
                    -Gain
      on settlement of trade payables
                    
                    
                    (585,122
                    )
                    
                    
                    (3,256,489
                    )Changes
      in operating assets and liabilities:Due
      to/from factor, net
                    
                    
                    (1,395,186
                    )
                    
                    
                    -Accounts
      receivable
                    
                    
                    7,325,432
                    
                    
                    
                    (1,788,962
                    )Inventories
                    
                    
                    79,386
                    
                    
                    
                    749,689Advances
      on royalties
                    
                    
                    (1,575,876
                    )
                    
                    
                    (3,651,309
                    )Related
      party receivables
                    
                    
                    18,249
                    
                    
                    
                    (27,635
                    )Prepaid
      expenses and other current assets
                    
                    
                    238,119
                    
                    
                    
                    42,696Production
      advance payable
                    
                    
                    -
                    
                    
                    
                    3,755,104Accounts
      payable
                    
                    
                    (2,127,001
                    )
                    
                    
                    (4,318,114
                    )Accrued
      royalties
                    
                    
                    1,925,059
                    
                    
                    
                    1,279,109Accrued
      expenses and other current liabilities
                    
                    
                    1,230,912
                    
                    
                    
                    1,988,225Accrued
      litigation costs
                    
                    
                    -
                    
                    
                    
                    4,308,035Deferred
      revenues
                    
                    
                    (247,989
                    )
                    
                    
                    (2,547,339
                    )Accrued
      expenses - related parties
                    
                    
                    19,337
                    
                    
                    
                    (47,478)Total
      adjustments
                    
                    
                    1,559,541
                    
                    
                    
                    1,962,217Net
      cash (used in) provided by operating activities
                    
                    
                    (1,724,228
                    )
                    
                    
                    6,932Cash
      flows from investing activities:Purchases
      of property and equipment
                    
                    
                    (16,737
                    )
                    
                    
                    (65,544
                    )Change
      in restricted cash
                    
                    
                    -
                    
                    
                    
                    395,982Net
      cash (used in) provided by investing activities
                    
                    
                    (16,737
                    )
                    
                    
                    330,438Cash
      flows from financing activities:Proceeds
      from line of credit
                    
                    
                    -
                    
                    
                    
                    16,557,571Repayments
      of line of credit
                    
                    
                    (3,830,055
                    )
                    
                    
                    (16,596,792
                    )Proceeds
      from inventory financing
                    
                    
                    1,710,281
                    
                    
                    
                    -Repayments
      of inventory financing
                    
                    
                    (1,710,281
                    )
                    
                    
                    -Repayments
      of long-term debt
                    
                    
                    (31,887
                    )
                    
                    
                    (25,013
                    )Net
      proceeds from (repayments of) amounts due to shareholders
                    
                    
                    -
                    
                    
                    
                    (232,440
                    )Net
      proceeds from (repayments of) amounts due to related
    parties
                    
                    
                    2,225
                    
                    
                    
                    (120,645
                    )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
                    
                    
                    
                    -Net
      cash provided by (used in) financing activities
                    
                    
                    1,957,992
                    
                    
                    
                    (417,319
                    )Effect
      of exchange rate changes on cash and cash equivalents
                    
                    
                    (231,289
                    )
                    
                    
                    90,247Net
      (decrease) increase in cash and cash equivalents
                    
                    
                    (14,262
                    )
                    
                    
                    10,298Cash
      and cash equivalents at beginning of the period
                    
                    
                    92,893
                    
                    
                    
                    648,311Cash
      and cash equivalents at end of the period
                    
                    $
                    78,631
                    
                    
                    $
                    658,609Supplemental
      cash flow information:Cash
      paid during the period for interest
                    
                    $
                    514,
      642
                    
                    
                    $
                    243,011Supplemental
      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
                    
                    $
                    811,039
                    
                    
                    $
                    -Conversion
      of junior secured subordinated convertible promissory note to senior
      secured convertible note
                    
                    $
                    500,000
                    
                    
                    $
                    -Issuance
      of vested restricted stock
                    
                    $
                    40
                    
                    
                    $
                    -Contingent
      purchase price payment obligation related to Gamecock
      acquisition
                    
                    $
                    -
                    
                    
                    $
                    597,124Decrease
      in goodwill with respect to finalizing purchase price
      allocation
                    
                    $
                    -
                    
                    
                    $
                    55,423Purchase
      of vehicle through the assumption of a note payable
                    
                    $
                    -
                    
                    
                    $
                    73,459





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
December 31, 2010 and for the three and six month periods ended December 31,
2010 and 2009 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 six
month periods ended December 31, 2010 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 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.


6




1. 
Principal Business
Activity and Summary of Significant Accounting Policies,
Cont.




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, curing the default
on the production advance payable (see Note 5), and the resolution of various
contingencies (see Note 11).





As of
December 31, 2010, 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 $3,755,104 at December 31, 2010 (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
$1,298,000 through December 31, 2010). Given the manner in which the Company was
required to enter into this agreement, the Company is contesting its liability
for this obligation.





On
December 31, 2010, the Company failed to make a timely payment of interest
required pursuant to the secured convertible notes (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 a Waiver and Forbearance Agreement (each, a “Waiver Agreement” and
collectively, the “Waiver Agreements”) with the holders of the Notes (see Note
6).  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.




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.•
                applying
      the anticipated profits from several key game releases towards payment of
      its outstanding
obligations.


7




1. 
Principal Business
Activity and Summary of Significant Accounting Policies,
Cont.
  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 four customers, Wal-Mart, GameStop, Atari, and Target, which
accounted for 19%, 17%, 14%, and 10%, respectively, of consolidated gross
revenues for the six months ended December 31, 2010.  GameStop,
Solutions2Go, and Atari accounted for 29%, 16%, and 15%, respectively, of
consolidated gross accounts receivable at December 31, 2010.  For the six
months ended December 31, 2009, Wal-Mart, GameStop, PDQ Distribution Limited and
Solutions 2 Go accounted for 20%, 15%, 11% and 10%, 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 December 31, 2010 and June 30,
2010 and for the three-month and six-month periods ended December 31, 2010 and
2009 are as follows:





Cost of Goods Sold — Products
                
                
                Accounts PayableFor the
                  three
                  months
                  ended
                  December
                  31, 2010
                
                
                For the
                  three
                  months
                  ended
                  December
                  31, 2009
                
                
                For the
                  six
                  months
                  ended
                  December
                  31, 2010
                
                
                For the six
                  months
                  ended
                  December
                  31, 2009
                
                
                As of
                  December
                  31, 2010
                
                
                As of
                  June 30,
                  2010Microsoft
                
                $
                503,087
                
                
                $
                214,598
                
                
                $
                702,423
                
                
                $
                2,952,440
                
                
                $
                424,710
                
                
                $
                158,592Nintendo
                
                $
                1,109,701
                
                
                $
                3,194,743
                
                
                $
                1,276,385
                
                
                $
                4,026,539
                
                
                $
                -
                
                
                $
                -Sony
                
                $
                300,123
                
                
                $
                81,265
                
                
                $
                889,985
                
                
                $
                108,787
                
                
                $
                18,121
                
                
                $
                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.


8


1. 
Principal Business
Activity and Summary of Significant Accounting Policies,
Cont.




At
December 31, 2010 and June 30, 2010, accounts receivable allowances consisted of
the following:




December
                  31, 2010
                
                
                June 30,
                  2010Sales
      returns
                
                $
                121,338
                
                
                $
                2,634,097Price
      protection
                
                
                297,544
                
                
                
                2,257,171Doubtful
      accounts
                
                
                505,056
                
                
                
                771,442Defective
      items
                
                
                4,513
                
                
                
                38,221Total
      allowances
                
                $
                928,451
                
                
                $
                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 December 31, 2010. 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 December 31, 2010, 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.


9




1. 
Principal Business
Activity and Summary of Significant Accounting Policies,
Cont.




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.





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 six months ended December 31, 2010 amounted to $(14,884) and
$(64,670), respectively. Foreign exchange transaction gains (losses) for the
three and six months ended December 31, 2009 amounted to $10,535 and $(7,497),
respectively.





Comprehensive
(Loss) Income





For the
three-month and six-month periods ended December 31, 2010 and 2009, the
Company’s comprehensive loss was as follows:





Three months ended
                
                
                Six months endedDecember 31,
                  2010
                
                
                December31,
                  2009
                
                
                December 31,
                  2010
                
                
                December31,
                  2009Net
      loss
                
                $
                (2,082,835
                )
                
                $
                (2,642,266
                )
                
                $
                (3,283,769
                )
                
                $
                (1,955,285
                )Other
      comprehensive income (loss)Change
      in foreign currency translation adjustment
                
                
                44,089
                
                
                
                7,747
                
                
                
                (231,289
                )
                
                
                90,247Comprehensive
      loss
                
                $
                (2,038,746
                )
                
                $
                (2,634,519
                )
                
                $
                (3,515,058
                )
                
                $
                (1,865,038
                )





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
                
                
                UnobservableDecember
                
                
                Instruments
                
                
                Inputs
                
                
                Inputs31, 2010
                
                
                (Level 1)
                
                
                (Level 2)
                
                
                (Level 3)Assets:Advances
      on royalties
                
                $
                389,667
                
                
                $
                389,667
                
                
                $
                -
                
                
                $
                -Total
      assets at fair value
                
                $
                389,667
                
                
                $
                389,667
                
                
                $
                -
                
                
                $
                -Liabilities:Warrant
      liability
                
                $
                1,276,102
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,276,102Total
      liabilities at fair value
                
                $
                1,276,102
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,276,102


10




1. 
Principal Business
Activity and Summary of Significant Accounting Policies,
Cont.




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 an $811,039 decrease to the carrying
amount of asset related to the periodic fair value remeasurement at December 31,
2010. During the six months ended December 31, 2010, 19,817 shares were earned
and $8,521 was expensed to “cost of goods sold – royalties”, and $2,112 was
expensed to “general and administrative” relating to the periodic fair value
remeasurement. As of December 31, 2010, 2,783,337 shares of common stock, valued
at $389,667, 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 $1,276,102 at December 31, 2010. The Company
recorded a non-cash gain of $3,062,646 due to the change in fair value of
warrants during the six months ended December 31, 2010. The fair value of the
warrants at December 31, 2010 was computed using the Black-Sholes option pricing
model. The Company assumed a risk-free interest rate of 2.01%, no dividends,
expected volatility of 126.64% and the remaining contractual life of the
warrants of 4.6 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:





Six MonthsEndedDecember 31,Description
                
                2010Beginning
      balance
                
                $
                -Purchases,
      issuances, and settlements
                
                
                4,338,748Total
      gain included in net loss
                
                
                (3,062,646
                )Ending
      balance
                
                $
                1,276,102





11




1. 
Principal Business
Activity and Summary of Significant Accounting Policies,
Cont.




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.  Potentially dilutive
securities including outstanding options, warrants, restricted stock, and the
conversion of preferred stock amounted to 11,168,697 and 11,109,787for
the three-month and six-month periods ended December 31, 2010,
respectively.





2. 
Inventories





Inventories
consist of the following:




December31,
                  2010
                
                
                June 30,
                  2010Finished
      goods
                
                $
                970,232
                
                
                $
                1,085,433Purchased
      parts and components
                
                
                161,683
                
                
                
                125,868Total
                
                $
                1,131,915
                
                
                $
                1,211,301




3. 
Line of
Credit





The
Company had a $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
six months ended December 31, 2010, interest expense relating to the line of
credit was $-0- and $2,021, respectively. For the three and six months ended
December 31, 2009, interest expense related to the line of credit was $65,211
and $116,970, 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.





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.


12




4. 
Due to Factor,
Cont.




Due (to)
from factor consists of the following:





December31,
                  2010Outstanding
      accounts receivable sold to factor
                
                $
                5,200,626Cash
      collateral
                
                
                109,650Less:
      allowances
                
                
                (2,260,088
                )Less:
      advances from factor
                
                
                (3,915,090
                )$
                (864,902
                )





Accounts
receivable totaling $5,200,626 were sold to the factor at December 31, 2010, of
which the Company assumed credit risk of $1,578,909. The following table sets
forth adjustments to the price protection and other customer allowances included
as a reduction of amounts due (to) from factor:





Six
                  months
                  ended
                  December 31,
                  2010Beginning
      balance
                
                $
                -Add:
      provision
                
                
                (5,441,699
                )Less:
      amounts charged against allowance
                
                
                3,181,611Ending
      balance
                
                $
                (2,260,088
                )





For the
three-month and six-month periods ended December 31, 2010, interest and
financing costs relating to the factoring agreement were $102,480 and $257,938,
respectively.


13





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 $3,755,104 at December 31,
2010.  Production fees relating to this production advance for the
three-month and six-month periods ended December 31, 2010 totaled $294,018, and
$572,878, respectively.  The production fees for the three-month and
six-month periods ended December 31, 2010 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 December 31, 2010 and
June 30, 2010, accrued and unpaid production fees totaled $1,658,914 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 $1,298,000 through December 31,
2010).  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, t




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 six-month periods ended December 31,
2010 related to the Junior Notes was $5,411 and $5,411, respectively. There was
$-0- and $15,548 of accrued interest outstanding at December 31, 2010 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 six-month
periods ended December 31, 2010 was $140,556 and $252,083, respectively, and
there was $252,083 of accrued interest outstanding at December 31,
2010.


14




6. 
Secured Convertible
Debt, Cont.




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 six-month periods ended December 31, 2010 was $122,667 and
$161,333, respectively, and there was $161,333 of accrued interest outstanding
at December 31, 2010.





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.


15




6. 
Secured Convertible
Debt, Cont.




As of
December 31, 2010, the unamortized debt discount amounted to $3,615,623. Total
amortization of the debt discount recorded as interest expense was $361,562 and
$723,125 for the three-month and six-month periods ended December 31, 2010,
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, 2011, if it is not subject to full review by the SEC, and by March
15, 2011, 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.





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 six-month periods ended December 31, 2010
totaled $135,186 and $201,278, 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 December 31, 2010, no amounts were outstanding under
the agreement. Interest expense for the three month and six month periods ended
December 31, 2010 was $42,070 and $42,070, 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




7. 
Inventory Financing
Payable, Cont.




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 December 31 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 December 31, 2010 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 six months ended December 31, 2010 were $6,625 and
$13,225, respectively.  Broadband usage fees for the three and six
months ended December 31, 2009 were $6,600 and $13,200, respectively. These
amounts are included in general and administrative expenses in the accompanying
condensed consolidated statements of operations. At December 31, 2010 and June
30, 2010, $4,425 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 six months ended December 31, 2010
and the year ended June 30, 2010 are as follows:




Six
                  months ended
                  December 31,
                  2010
                
                
                Year ended
                  June 30,
                  2010Balance
      at beginning of period
                
                $
                322,281
                
                
                $
                221,493Expenses
      incurred:Rent
                
                
                55,000
                
                
                
                110,000Commissions
                
                
                56,848
                
                
                
                551,932Cash
      in advance
                
                
                210,623
                
                
                
                -Less:
      amounts paid
                
                
                (303,134
                )
                
                
                (561,144
                )Balance
      at end of period
                
                $
                341,618
                
                
                $
                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 six months ended December 31, 2010 were $16,478 and $56,848,
respectively.  Sales commissions for the three and six months ended
December 31, 2009 were $172,231 and $265,297, respectively.  These amounts
are included in sales and marketing in the accompanying condensed consolidated
statements of operations.


17




8.  Related Party
Transactions, Cont.




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
December 31, 2010, $210,623 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.





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 $55,000 for the three months and six
months ended December 31, 2010, respectively.    Related
party lease expense was $27,500 and $55,000 for the three and six months ended
December 31, 2009, 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 $3,907 and $7,815 for the three months and six months
ended December 31, 2010, respectively.  Related lease income was
$3,907 and $7,815 for the three and six months ended December 31, 2009,
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
      (six months ended June 30, 2011)
                
                $
                2,506,000
                
                
                $
                74,122
                
                
                $
                2,580,1222012
                
                
                596,318
                
                
                
                148,244
                
                
                
                744,5622013
                
                
                -
                
                
                
                125,935
                
                
                
                125,9352014
                
                
                -
                
                
                
                55,000
                
                
                
                55,0002015
                
                
                -
                
                
                
                -
                
                
                
                -Total
                
                $
                3,102,318
                
                
                $
                403,301
                
                
                $
                3,505,619





Total
future commitments pursuant to vendor settlement agreements are as
follows:





VendorPaymentsFor
      the year ending June 30,2011
      (six months ended June 30, 2011)
                  
                  $
                  386,7382012
                  
                  
                  -2013
                  
                  
                  -2014
                  
                  
                  -2015
                  
                  
                  -Total
                  
                  $
                  386,738





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 December 31, 2010 and June 30, 2010 were
695,989 and 919,372, respectively, under the 2008 Plan.


18




10. 
Stock-based
Compensation, Cont.




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:





For the six
                  months ended
                  December 31, 2010
                
                
                For the six
                  months ended
                  December 31, 2009Risk-free
      interest rate
                
                
                1.60
      – 3.30%
                
                
                
                2.20
      – 3.85%Weighted-average
      volatility
                
                
                154
      - 157%
                
                
                
                160.78
      – 166.29%Expected
      term
                
                
                5.5
      – 8.7
                
                
                
                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
                  December 31,
                  2010
                
                
                For the three
                  months ended
                  December 31,
                  2009
                
                
                For the six
                  months ended
                  December31,
                  2010
                
                
                For the six
                  months ended
                  December31,
                  2009Sales
      and marketing
                
                $
                (1,196
                )
                
                $
                12,196
                
                
                $
                9,509
                
                
                $
                39,818General
      and administrative
                
                
                61,877
                
                
                
                191,528
                
                
                
                204,774
                
                
                
                320,102Total
      stock-based compensation expense
                
                $
                60,681
                
                
                $
                203,724
                
                
                $
                214,283
                
                
                $
                359,920





As of
December 31, 2010, the Company’s unrecognized stock-based compensation for stock
options issued to employees and non-employee directors was approximately
$388,206 and will be recognized over a weighted average of 1.8 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 six months ended December
31, 2010:





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 six months ended December 31, 2010Granted
                
                
                696,500
                
                
                
                0.30
                
                
                
                -
                
                
                
                -Exercised
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Forfeited,
      cancelled or expired
                
                
                666,768
                
                
                
                0.69
                
                
                
                -
                
                
                
                -Outstanding
      as of December 31, 2010
                
                
                2,911,860
                
                
                $
                0.93
                
                
                
                8.51
                
                
                $
                -Exercisable
      as of December 31, 2010
                
                
                1,227,013
                
                
                $
                1.40
                
                
                
                7.93
                
                
                $
                -Exercisable
      and expected to be exercisable
                
                
                2,764,994
                
                
                $
                0.96
                
                
                
                8.47
                
                
                $
                -


19




10. 
Stock-based
Compensation, Cont.




The
aggregate intrinsic value represents the total pre-tax intrinsic value based on
the Company’s closing stock price ($0.14 per share) as of December 31, 2010,
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 six
months ended December 31, 2010:





Shares
                
                
                Weighted-
                  Average
                  Grant Date
                  Fair ValueOutstanding
      as of June 30, 2010
                
                
                1,085,000
                
                
                $
                0.37Activity
      for the nine months ended December 31, 2010Granted
                
                
                195,651
                
                
                
                0.23Vested
                
                
                396,333
                
                
                
                0.41Forfeited,
      cancelled or expired
                
                
                2,000
                
                
                
                1.20Outstanding
      as of December 31, 2010
                
                
                882,318
                
                
                $
                0.32Vested
      as of December 31, 2010
                
                
                509,833
                
                
                $
                0.80





As of
December 31, 2010, the Company’s unrecognized stock-based compensation for
restricted stock issued to employees and non-employee directors was
approximately $268,545 and will be recognized over a weighted average of 1.85
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 December 31, 2010, 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. However,
legal issues are subject to inherent uncertainties and there exists the
possibility that the ultimate resolution of this matter could have a material
adverse effect on the Company’s consolidated financial position and the results
of operations in the period in which any such effect is recorded.





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. Based upon the current status of this claim, the Company is of the
opinion that it has limited or no exposure in connection with this
claim.





On May
10, 2010, SouthPeak Interactive, L.L.C. and Melanie Mroz were served with a
complaint by Spidermonk Entertainment, LLC or Spidermonk, alleging various
breach of contract and other claims related to a publishing agreement, or the
Publishing Agreement, entered into between Southpeak and Spidermonk in November
2007.  Spidermonk is seeking the unpaid milestone payments related to the
development of the game “Roogoo” videogame as well as other highly speculative
damages related to the poor sales performance of this game. The Company and its
subsidiaries intend to vigorously defend all claims.


20




11. 
Contingencies,
Cont.




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 which a sister fund, BVT Games
Fund III Dynamic GmbH & Company (“Fund III”), had financed. 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.





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, as required by law,
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. Because of this error in
translation, 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. No
answer has yet been filed. 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.




21




11. 
Contingencies,
Cont.




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. As of December
31, 2010, the Company has accrued an aggregate amount of $2,376,153 related to
such matters. The Company expenses legal costs as incurred in connection with a loss
contingency.





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 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.




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 six
months ended December 31, 2010, the Company’s gain on settlement of trade
payables was as follows:




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
                    )
                    
                    
                    -
                    
                    
                    
                    583,122$
                    1,076,848
                    
                    
                    $
                    -
                    
                    
                    $
                    (491,726
                    )
                    
                    $
                    -
                    
                    
                    $
                    585,122




For the
six months ended December 31, 2009, 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
                    )
                    
                    
                    -
                    
                    
                    
                    164,989$
                    6,900,681
                    
                    
                    $
                    (1,422,334
                    )
                    
                    $
                    (2,117,358
                    )
                    
                    $
                    (104,500
                    )
                    
                    $
                    3,256,489




22




12. 
Gain on Settlement of
Trades Payables, Cont.




(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:





December 31,
                    
                    
                    June 30,2010
                    
                    
                    2010Accrued
      expenses
                    
                    $
                    1,705,947
                    
                    
                    $
                    1,700,208Reserve
      for marketing development funds (MDF)
                    
                    
                    446,141
                    
                    
                    
                    344,210Commissions
                    
                    
                    157,461
                    
                    
                    
                    161,678Guaranteed
      royalty payments
                    
                    
                    -
                    
                    
                    
                    135,000Accrued
      payroll and payroll taxes
                    
                    
                    153,442
                    
                    
                    
                    266,740Customer
      cash in advance deposits
                    
                    
                    117,786
                    
                    
                    
                    31,793Accrued
      interest
                    
                    
                    2,132,966
                    
                    
                    
                    1,062,200Other
                    
                    
                    163,880
                    
                    
                    
                    79,882$
                    4,877,623
                    
                    
                    $
                    3,781,711





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




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.




24




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.




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.





Second
Quarter 2011 Releases




We
released the following videogames in the three months ended December 31,
2010:




Title
                    
                    Platform
                    
                    Date
      ReleasedSled
      Shred
                    
                    Wii
                    
                    10/12/10Noah’s
      Ark
                    
                    NDS
                    
                    11/2/10Nail’d
                    
                    X360,
      PS3, PC
                    
                    11/30/10SBK
      X
                    
                    X360,
      PS3, PC
                    
                    12/7/10NewU
      Yoga & Pilates Workout
                    
                    Wii
                    
                    12/7/10




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.




25




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.





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.




26




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.




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.




27




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.




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.




28




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.





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 six months ended December 31, 2010 and
2009:




For the
                                      three months ended
                                      December 31,
                                    
                                    
                                    For the
                                      six months ended
                                      December 31,2010
                                    
                                    
                                    2009
                                    
                                    
                                    2010
                                    
                                    
                                    2009Net
      revenues
                                    
                                    
                                    100.0
                                    %
                                    
                                    
                                    100.0
                                    %
                                    
                                    
                                    100.0
                                    %
                                    
                                    
                                    100.0
                                    %Cost
      of goods sold:Product
      costs
                                    
                                    
                                    41.5
                                    %
                                    
                                    
                                    51.2
                                    %
                                    
                                    
                                    43.3
                                    %
                                    
                                    
                                    32.5
                                    %Royalties
                                    
                                    
                                    44.2
                                    %
                                    
                                    
                                    16.1
                                    %
                                    
                                    
                                    36.3
                                    %
                                    
                                    
                                    24.7
                                    %Intellectual
      property licenses
                                    
                                    
                                    1.3
                                    %
                                    
                                    
                                    0.9
                                    %
                                    
                                    
                                    2.2
                                    %
                                    
                                    
                                    0.8
                                    %Total
      cost of goods sold
                                    
                                    
                                    86.9
                                    %
                                    
                                    
                                    68.2
                                    %
                                    
                                    
                                    81.8
                                    %
                                    
                                    
                                    58.0
                                    %Gross
      profit
                                    
                                    
                                    13.1
                                    %
                                    
                                    
                                    31.8
                                    %
                                    
                                    
                                    18.2
                                    %
                                    
                                    
                                    42.0
                                    %Operating
      expenses (income):Warehousing
      and distribution
                                    
                                    
                                    3.8
                                    %
                                    
                                    
                                    3.2
                                    %
                                    
                                    
                                    3.9
                                    %
                                    
                                    
                                    2.3
                                    %Sales
      and marketing
                                    
                                    
                                    13.0
                                    %
                                    
                                    
                                    22.0
                                    %
                                    
                                    
                                    21.0
                                    %
                                    
                                    
                                    21.9
                                    %General
      and administrative
                                    
                                    
                                    28.0
                                    %
                                    
                                    
                                    29.6
                                    %
                                    
                                    
                                    45.2
                                    %
                                    
                                    
                                    22.8
                                    %Litigation
      costs
                                    
                                    
                                    -
                                    %
                                    
                                    
                                    30.6
                                    %
                                    
                                    
                                    -
                                    %
                                    
                                    
                                    11.5
                                    %Gain
      on settlement of trade payables
                                    
                                    
                                    -
                                    %
                                    
                                    
                                    (32.4)
                                    %
                                    
                                    
                                    (6.6)
                                    %
                                    
                                    
                                    (12.2)
                                    %Total
      operating expenses
                                    
                                    
                                    44.8
                                    %
                                    
                                    
                                    53.0
                                    %
                                    
                                    
                                    63.6
                                    %
                                    
                                    
                                    46.3
                                    %Loss
      from operations
                                    
                                    
                                    (31.7)
                                    %
                                    
                                    
                                    (21.2)
                                    %
                                    
                                    
                                    (45.4)
                                    %
                                    
                                    
                                    (4.3)
                                    %Other
      expenses (income):Change
      in fair value of warrant liability
                                    
                                    
                                    (20.5)
                                    %
                                    
                                    
                                    -
                                    %
                                    
                                    
                                    (34.4)
                                    %
                                    
                                    
                                    -
                                    %Interest
      and financing costs, net
                                    
                                    
                                    16.7
                                    %
                                    
                                    
                                    5.1
                                    %
                                    
                                    
                                    25.9
                                    %
                                    
                                    
                                    3.0
                                    %Net
      loss
                                    
                                    
                                    (27.9)
                                    %
                                    
                                    
                                    (26.3)
                                    %
                                    
                                    
                                    (36.9)
                                    %
                                    
                                    
                                    (7.3)
                                    %




29




Three
Months Ended December 31, 2010 and 2009




Net Revenues. Net revenues
for the three months ended December 31, 2010 were $7,470,053, a decrease of
$2,593,899, or 26%, from net revenues of $10,063,952 for the three months ended
December 31, 2009. The decrease in net revenues was primarily driven by the
decrease in units shipped during the three months ended December 31, 2010 versus
the three months ended December 31, 2009.  For the three months ended
December 31, 2010, the number of videogame units sold decreased to approximately
464,000, a decrease of 181,000 units from 645,000 sold in the prior period.
Average net revenue per videogame unit sold increased 3%, from $15.60 to $16.10
for the three months ended December 31, 2009 and 2010, respectively. This
average increase in price per unit is due to selling more units for next
generation platforms (Xbox 360, PlayStation 3), which have a higher
Manufacturer’s Suggested Retail Price (“MSRP”), during the three months ended
December 31, 2010 versus the prior period.





Cost of Goods
Sold.  Cost of goods sold for the three months ended December
31, 2010 decreased to $6,491,868, down $376,488, or 5%, from $6,868,356 for the
prior period. Product costs for the three months ended December 31, 2010
decreased $2,052,160, or 40%, from the comparable period in
2009.  This decrease was primarily driven by the decrease in units
shipped.  The cost of royalty expense for the three months ended
December 31, 2010 was $3,298,538, an increase of 104%, from royalty expense of
$1,618,962 for the three months ended December 31, 2009.  This
increase is primarily attributable to expense associated with the sale of our
co-publishing games, Nail’d, SBK X, and NewU Yoga & Pilates
Workout.





Gross Profit.  For
the three months ended December 31, 2010 and 2009, gross profit decreased to
$978,185 from $3,195,596, or 69%. Gross profit margin decreased to approximately
13% for the three months ended December 31, 2010 from 32% in the same period in
2009. The decrease in gross profit is attributed to increased royalty expense
associated with the sale of co-publishing titles during the three months ended
December 31, 2010 versus the prior period.





Warehousing and Distribution
Expenses.  For the three months ended December 31, 2010 and
2009, warehousing and distribution expenses were $282,327 and $320,723,
respectively, resulting in an decrease of 12%. This decrease is primarily
attributed to the decrease in units produced and shipped.





Sales and Marketing Expenses.
For the three months ended December 31, 2010, sales and marketing expenses
decreased 56% to $974,498 from $2,215,620 for the three months ended December
31, 2009. This decrease is primarily due to our cost reduction
strategy.  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 December 31, 2010 and
2009, the gain on settlement of trade payables was $-0- and $3,256,489, which
was the result of negotiations with various unsecured creditors for the
settlement and payment of trade payables at amounts less than the recorded
liability.




30




General and Administrative
Expenses.  For the three months ended December 31, 2010,
general and administrative expenses decreased $882,862 to $2,091,082 from
$2,973,944 for the prior period. Wages included in general and administrative
expenses decreased from $1,019,144 for the three months ended December 31, 2009
to $643,880 for the three months ended December 31, 2010, a decrease of
37%.  Professional fees increased 41% from $632,714 for the three
months ended December 31, 2009 to $891,810 for the three months ended December
31, 2010, as a result of legal fees associated with the successful resolution of
the Nobilis litigation. Travel and entertainment expenses were $61,828 for the
three months ended December 31, 2009, as compared to $71,580 for the three
months ended December 31, 2010.  General and administrative expenses
as a percentage of net revenues decreased, to approximately 28% for the three
months ended December 31, 2010 from 30% for the prior period.  In
addition, for the three months ended December 31, 2010, general and
administrative expenses includes $61,877 for noncash compensation related to
employee stock options and restricted stock granted, a decrease of $129,528, or
68%, from the comparable period in 2009.





Operating Loss. For the three
months ended December 31, 2010, our operating loss was $2,369,722, an increase
of $236,314, or 11%, over operating loss of $2,133,408 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 $1,531,323, which we recorded to
operations during the three months ended December 31, 2010.





Interest and Financing
Costs.  For the three months ended December 31, 2010, interest
and financing costs increased to $1,244,436 from $508,858 for the prior period
due to due to amortization of debt issuance costs, interest attributed to the
secured convertible debt, amortization of the secured convertible debt discount,
and interest associated with the production advance payable. Amortization of
debt issuance costs amounted to $135,186 for the three months ending December
31, 2010. Interest attributed to the secured convertible debt totaled $263,223
and amortization of the secured convertible debt discount was $361,563 for the
three months ending December 31, 2010. Interest associated with the production
advance payable totaled $294,018 for the three months ending December 31,
2010.





Net Loss. For the three
months ended December 31, 2010, our net loss was $2,082,835, a decrease of
$559,431, or 21%, over net loss of $2,642,266 for the prior period.





Six
Months Ended December 31, 2010 and 2009





Net Revenues. Net revenues
for the six months ended December 31, 2010 were $8,901,912, a decrease of
$17,871,689, or 67%, from net revenues of $26,773,601 for the six months ended
December 31, 2009. The decrease in net revenues was primarily driven by a
decrease in units produced and shipped during the six months ended December 31,
2010 versus the six months ended December 31, 2009.  For the six
months ended December 31, 2010, the number of videogame units sold decreased to
approximately 599,000, a decrease of 783,000 units from 1,382,000 sold in the
prior period. Average net revenue per videogame unit sold decreased 23%, from
$19.37 to $14.86 for the six months ended December 31, 2009 and 2010,
respectively. This average decrease in price per unit is due to the sale of
predominantly older titles during the six months ended December 31, 2010, which
were marked down considerably, versus the prior period when the majority of the
sales incurred were comprised of new releases.





Cost of Goods
Sold.  Cost of goods sold for the six months ended December 31,
2010 decreased to $7,281,935, down $8,253,438, or 53%, from $15,535,373 for the
prior period. Product costs for the six months ended December 31, 2010 decreased
$4,837,564, or 56%, from the comparable period in 2009. The cost of royalty
expense for the six months ended December 31, 2010 was $3,231,430, a decrease of
51%, from royalty expense of $6,619,633 for the six months ended December 31,
2009. These decreases were primarily driven by the decrease in units produced
and sold.





Gross Profit.  For
the six months ended December 31, 2010 and 2009, gross profit decreased to
$1,619,977 from $11,238,228, or 86%. Gross profit margin decreased to
approximately 18% for the six months ended December 31, 2010 from 42% in the
same period in 2009. The decrease in gross profit is attributed to high royalty
costs attributed to the sale of co-publishing titles as well as lower selling
price due to the sale of older titles during the six months ended December 31,
2010 versus the prior period.





Warehousing and Distribution
Expenses.  For the six months ended December 31, 2010 and 2009,
warehousing and distribution expenses were $348,416 and $607,234, respectively,
resulting in a decrease of 43%. This decrease is primarily attributed to the
significant decline in units produced and shipped.




31




Sales and Marketing Expenses.
For the six months ended December 31, 2010, sales and marketing expenses
decreased 68% to $1,871,169 from $5,870,676 for the six months ended December
31, 2009. This decrease is primarily due to our cost reduction strategy as well
as the decrease in the number of new titles released during the six months ended
December 31, 2010 versus the prior period.  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. Included in sales and marketing expenses for the six months ended
December 31, 2010 and 2009 is a non-cash charge of $9,509 and $39,818,
respectively, for stock options granted to vendors and other
non-employees.





Gain on Settlement of Trade
Payables.  For the six months ended December 31, 2010 and 2009,
the gain on settlement of trade payables was $585,122 and $3,256,489, which was
the result of negotiations with various unsecured creditors for the settlement
and payment of trade payables at amounts less than the recorded
liability.





General and Administrative
Expenses.  For the six months ended December 31, 2010, general
and administrative expenses decreased $2,065,315 to $4,023,397 from $6,088,712
for the prior period. Wages included in general and administrative expenses
decreased from $1,981,694 for the six months ended December 31, 2009 to
$1,360,447 for the six months ended December 31, 2010, a decrease of
31%.  Professional fees decreased 45% from $1,910,561 for the six
months ended December 31, 2009 to $1,044,865 for the six months ended December
31, 2010, as a result of prior period litigation costs and accounting fees.
Travel and entertainment expenses were $115,151 for the six months ended
December 31, 2009, as compared to $150,144 for the six months ended December 31,
2010.  General and administrative expenses as a percentage of net
revenues increased, to approximately 45% for the six months ended December 31,
2010 from 23% for the prior period.  In addition, for the six months
ended December 31, 2010, general and administrative expenses includes $204,774
for noncash compensation related to employee stock options and restricted stock
granted, a decrease of $115,328, or 36%, from the comparable period in
2009.





Operating Loss. For the six
months ended December 31, 2010, our operating loss was $4,037,883, an increase
of $2,890,772, or 252%, over operating loss of $1,147,111 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 $3,062,646, which we recorded to
operations during the six months ended December 31, 2010.





Interest and Financing
Costs.  For the six months ended December 31, 2010, interest
and financing costs increased to $2,308,532 from $808,174 for the prior period
due to amortization of debt issuance costs, interest attributed to the secured
convertible debt, amortization of the secured convertible debt discount, and
interest associated with the production advance payable. Amortization of debt
issuance costs amounted to $201,278 for the six months ending December 31, 2010.
Interest attributed to the secured convertible debt totaled $413,416 and
amortization of the secured convertible debt discount was $723,125 for the six
months ending December 31, 2010. Interest associated with the production advance
payable totaled $572,878 for the six months ending December 31,
2010.





Net Loss. For the six months
ended December 31, 2010, our net loss was $3,283,769, an increase of $1,328,484,
or 68%, over net loss was $1,955,285 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.




32




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 $78,631 at December
31, 2010 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
December 31, 2010, $864,902 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
December 31, 2010 and June 30, 2010, amounts due from our three largest
customers comprised approximately 61% 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.





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”) 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.




33




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.





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
six months ended December 31, 2010 we had net cash used in operating activities
of $1,724,228, and in 2009 we had net cash provided by operating activities of
$6,932.





During
the six months ended December 31, 2010, investing activities resulted in net
cash used of $16,737 and during the six months ended December 31, 2009,
investing activities resulted in net cash provided of $330,438. The cash
provided was a result of the increase in restricted cash during the six months
ended December 31, 2009.





During
the six months ended December 31, 2010, financing activities resulted in net
cash provided of $1,957,992 and during the six months ended December 31, 2009,
financing activities resulted in net cash used of $417,319.





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 December
31, 2010 and 2009, approximately 4% and 27%, 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.




34




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.





·
            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 December 31, 2010 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 December 31, 2010, 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;




35




·
            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.





Remediation
Steps to Address Material Weakness





During
the quarter ended December 31, 2010, 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




In
September 2010, we instituted summary proceedings in the Lyon France Commercial
Court against Nobilis Group in which we have alleged the Licensing and
Distribution Agreements for the games we were to obtain and have obtained from
Nobilis, including the My Baby games, were wrongfully terminated. We are seeking
the reinstatement of the agreements and damages associated with the actions of
Nobilis.  Following a hearing on October 26, 2010, the court 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 court confirmed its reinstatement of the agreement and
that Nobilis’ termination of the agreement was null and
void.





On
September 3, 2010, we, Mr. Phillips, our chairman, and Melanie J. Mroz, our CEO,
received Wells Notices from the staff of the SEC (the “Staff”) advising that the
staff will recommend that the SEC institute a cease and desist proceeding
against us and Ms. Mroz with respect to our alleged violations of Sections
13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and certain rules adopted
thereunder, and bring a civil injunctive action against Mr. Phillips for abiding
and abetting the foregoing violations of our company. In addition, the Staff
intends to recommend that, in the civil action, the SEC seek a civil penalty
against Mr. Phillips. These alleged violations result from the facts underlying
then need to file an amended quarterly report on Form 10-Q for the fiscal
quarter ended March 31, 2009.




36




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,
filed suit against us in the Regional Court in Munich, Germany to recover funds
advanced to us to manufacture two titles which a sister fund, BVT Games Fund III
Dynamic GmbH & Company (“Fund III”), had financed. A distribution agreement
existed for these titles with Phillips Sales, Inc. (“Phillips Sales”) and not us
although we had guaranteed the obligations of Phillips Sales.  In this
litigation, Fund IV is seeking €3,115,341 (approximately USD $4.1 million) plus
interest. We are actively contesting this litigation and believe that we have
multiple defenses. The liability associated with the production advance is
reflected in our condensed consolidated financial statements.





In
November 2010, we first learned that III had obtained a judgment against us 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
our then chief financial officer, as required by law, what was supposed to be
the English translation of the lawsuit which Fund III had filed. Instead, Fund
III served upon us a translation of the Fund IV lawsuit that Fund IV intended to
serve on us. Because we knew of the filing of the Fund IV case before being
properly served with that case, we had already engaged German counsel to
represent our 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, we took no action since we believed this matter was already in the
hands of our attorney. The failure to respond resulted in a default judgment in
the Fund III case for which no proper translation has yet been received. Because
of this error in translation, we are seeking to have the judgment vacated and
believes we will be successful in this regard. We are of the opinion when, and
if, we are required to defend the litigation, that we have strong defenses to
assert, including that Phillips Sales is not obligated to Fund III thereby
avoiding our guaranty obligation. We cannot predict the potential
outcome.  No amounts have been recorded in our condensed consolidated
financial statements in connection with the liability underlying the
claim.





In
November 2010, in connection with the Circuit City Stores, Inc. (“Circuit City”)
bankruptcy proceedings, 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. We believe that we have
meritorious defenses to these avoidance actions, intend to vigorously defend
against them and believe that the likelihood of the avoidance actions prevailing
is remote. Accordingly, we have not accrued any loss reserve related to this
claim.





On
January 26, 2011, Codemasters Group Holdings Limited (“Codemasters”) 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 is due.  No answer has yet been
filed.  We recognize our liability to Codemasters which has been recorded
on our books but believe we are entitled to certain credits which Codemasters
has not reflected in its lawsuit. It is our intent to try to resolve this
matter with Codemasters.





Other
than the foregoing, there have been no material development in any material
legal proceedings. From time to time, however, we are named as a defendant in
legal actions arising from our normal business activities. Although we cannot
accurately predict the amount of our liability, if any, that could arise with
respect to legal actions currently pending against us, we do not expect that any
such liability will have a material adverse effect on our consolidated financial
position, operating results or cash flows. We believe that we have obtained
adequate insurance coverage, rights to indemnification, or where appropriate,
have established reserves in connection with these legal
proceedings.





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.




37




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 six months ended December 31,
2010 and for the fiscal years 2010 and 2009, our operating losses were $4,037,883,
$4,205,300 and $11,807,405, respectively, and negative cash flows from operating
activities were $1,724,228, $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.





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





On
February 16, 2011, the Company entered into a Waiver and Forbearance Agreement
(each, a “Waiver Agreement” and collectively, the “Waiver Agreements”) with the
holders of the Notes (see Note 6).  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, 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. The description of the Waiver Agreements and the terms thereof are
qualified in their entirety to the full text of the form of Waiver Agreements,
which is filed as an exhibit hereto and incorporated herein by
reference.




38




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.10.1*
                  
                  Form
      of Guarantee, dated July 7, 2010, executed by the Registrant, certain of
      its subsidiaries and its chairman.10.2*
                  
                  Form
      of General Security Agreement, dated July 12, 2010, executed by the
      Registrant and certain of its subsidiaries.10.3*
                  
                  Form
      of Waiver and Forbearance Agreement, dated February 16, 2011, between the
      Registrant and each holder of the Notes.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.




39




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
      Mroz
                  President
      and Chief Executive Officer/s/
      James HuyckJames
      Huyck
                  Senior
      Cost Accountant(Principal
      Accounting Officer)Date: February
      17, 2011




40




INDEX
TO EXHIBITS




ExhibitNumber
                  
                  Exhibit10.1*
                  
                  Form
      of Guarantee, dated July 7, 2010, executed by the Registrant, certain of
      its subsidiaries and its chairman.10.2*
                  
                  Form
      of General Security Agreement, dated July 12, 2010, executed by the
      Registrant and certain of its subsidiaries.10.3*
                  
                  Form
      of Waiver and Forbearance Agreement, dated February 16, 2011, between the
      Registrant and each holder of the Notes.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 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.





*
            Filed
      herewith




41