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 September 30, 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
November 12, 2010, 60,795,538 shares of common stock, par value $0.0001 per
share, of the registrant were outstanding.









TABLE
OF CONTENTS





PagePART
      I — FINANCIAL INFORMATIONItem
      1.
                                        Financial
      StatementsCondensed
      Consolidated Financial Statements (unaudited)
                                        
                                        3Condensed
      Consolidated Balance Sheets as of September 30, 2010 and June 30, 2010
      (unaudited)
                                        
                                        3Condensed
      Consolidated Statements of Operations for the three months ended September
      30, 2010 and 2009 (unaudited)
                                        
                                        4Condensed
      Consolidated Statements of Cash Flows for the three months ended September
      30, 2010 and 2009 (unaudited)
                                        
                                        5Notes
      to Condensed Consolidated Financial Statements
                                        
                                        6Item
      2.
                                        Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                        
                                        25Item
      3.
                                        Quantitative
      and Qualitative Disclosures about Market Risk
                                        
                                        35Item
      4T.
                                        Controls
      and Procedures
                                        
                                        35PART
      II — OTHER INFORMATIONItem
      1.
                                        Legal
      Proceedings
                                        
                                        36Item
      1A.
                                        Risk
      Factors
                                        
                                        37Item
      5.
                                        Other
      Information
                                        
                                        37Item
      6.
                                        Exhibits
                                        
                                        37SIGNATURES
                                        
                                        39




2





PART
I





Item
1. Condensed Consolidated
Financial Statements





SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


CONDENSED
CONSOLIDATED BALANCE SHEETS





September 30, 2010
                  
                  
                  June 30, 2010(Unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
                  
                  $
                  449,926
                  
                  
                  $
                  92,893Accounts
      receivable, net of allowances of $885,516 and $5,700,931 and at September
      30, 2010 and June 30, 2010, respectively
                  
                  
                  759,693
                  
                  
                  
                  3,703,825Inventories
                  
                  
                  1,451,590
                  
                  
                  
                  1,211,301Current
      portion of advances on royalties
                  
                  
                  12,891,370
                  
                  
                  
                  12,322,926Current
      portion of intellectual property licenses
                  
                  
                  383,571
                  
                  
                  
                  383,571Related
      party receivables
                  
                  
                  61,509
                  
                  
                  
                  34,509Prepaid
      expenses and other current assets
                  
                  
                  693,210
                  
                  
                  
                  695,955Total
      current assets
                  
                  
                  16,690,869
                  
                  
                  
                  18,444,980Property
      and equipment, net
                  
                  
                  2,623,114
                  
                  
                  
                  2,667,992Advances
      on royalties, net of current portion
                  
                  
                  1,538,144
                  
                  
                  
                  1,511,419Intellectual
      property licenses, net of current portion
                  
                  
                  1,438,393
                  
                  
                  
                  1,534,286Goodwill
                  
                  
                  7,911,800
                  
                  
                  
                  7,911,800Deferred
      debt issuance costs, net
                  
                  
                  667,867
                  
                  
                  
                  -Intangible
      assets, net
                  
                  
                  13,692
                  
                  
                  
                  17,025Other
      assets
                  
                  
                  11,117
                  
                  
                  
                  11,280Total
      assets
                  
                  $
                  30,894,996
                  
                  
                  $
                  32,098,782Liabilities
      and Shareholders’ EquityCurrent
      liabilities:Line
      of credit
                  
                  $
                  -
                  
                  
                  $
                  3,830,055Due
      to factor
                  
                  
                  1,940,268
                  
                  
                  
                  -Current
      portion of secured convertible debt
                  
                  
                  2,000,000
                  
                  
                  
                  950,000Current
      portion of long-term debt
                  
                  
                  66,385
                  
                  
                  
                  65,450Production
      advance payable in default
                  
                  
                  3,755,104
                  
                  
                  
                  3,755,104Accounts
      payable
                  
                  
                  10,585,161
                  
                  
                  
                  12,663,788Accrued
      royalties
                  
                  
                  1,786,608
                  
                  
                  
                  2,530,253Accrued
      expenses and other current liabilities
                  
                  
                  4,258,571
                  
                  
                  
                  3,781,711Deferred
      revenues
                  
                  
                  30,000
                  
                  
                  
                  325,301Due
      to related parties
                  
                  
                  25
                  
                  
                  
                  2,200Accrued
      expenses - related parties
                  
                  
                  113,249
                  
                  
                  
                  322,281Total
      current liabilities
                  
                  
                  24,535,371
                  
                  
                  
                  28,226,143Secured
      convertible debt, net of discount
                  
                  
                  1,522,815
                  
                  
                  
                  -Long-term
      debt, net of current portion
                  
                  
                  1,524,354
                  
                  
                  
                  1,541,081Warrant
      liability
                  
                  
                  2,807,425
                  
                  
                  
                  -Total
      liabilities
                  
                  $
                  30,389,965
                  
                  
                  $
                  29,767,224Commitments
      and contingencies
                  
                  
                  -
                  
                  
                  
                  -Shareholders’
      equity:Preferred
      stock, $0.0001 par value; 5,000,000 shares authorized; no shares issued
      and outstanding at September 30, 2010 and June 30, 2010
                  
                  
                  -
                  
                  
                  
                  -Series
      A convertible preferred stock, $0.0001 par value; 15,000,000 shares
      authorized; 5,503,833 and 5,503,833 shares issued and outstanding at
      September 30, 2010 and June 30, 2010, respectively; aggregate liquidation
      preference of $5,503,833 at September 30, 2010
                  
                  
                  550
                  
                  
                  
                  550Common
      stock, $0.0001 par value; 90,000,000 shares authorized; 59,846,537 and
      59,774,370 shares issued and outstanding at September 30, 2010 and June
      30, 2010, respectively
                  
                  
                  5,984
                  
                  
                  
                  5,976Additional
      paid-in capital
                  
                  
                  30,804,612
                  
                  
                  
                  31,154,835Accumulated
      deficit
                  
                  
                  (30,174,259
                  )
                  
                  
                  (28,973,325
                  )Accumulated
      other comprehensive (loss) income
                  
                  
                  (131,856
                  )
                  
                  
                  143,522Total
      shareholders’ equity
                  
                  
                  505,031
                  
                  
                  
                  2,331,558Total
      liabilities and shareholders’ equity
                  
                  $
                  30,894,996
                  
                  
                  $
                  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 endedSeptember 30,2010
                
                
                2009Net
      revenues
                
                $
                1,431,859
                
                
                $
                16,709,649Cost
      of goods sold:Product
      costs
                
                
                761,282
                
                
                
                3,546,686Royalties,
      net
                
                
                (67,108
                )
                
                
                5,000,671Intellectual
      property licenses
                
                
                95,893
                
                
                
                119,660Total
      cost of goods sold
                
                
                790,067
                
                
                
                8,667,017Gross
      profit
                
                
                641,792
                
                
                
                8,042,632Operating
      expenses (income):Warehousing
      and distribution
                
                
                66,089
                
                
                
                286,511Sales
      and marketing
                
                
                896,671
                
                
                
                3,655,056General
      and administrative
                
                
                1,932,315
                
                
                
                3,114,768Gain
      on settlement of trade payables
                
                
                (585,122
                )
                
                
                -Total
      operating expenses
                
                
                2,309,953
                
                
                
                7,056,335(Loss)
      income from operations
                
                
                (1,668,161
                )
                
                
                986,297Other
      expenses (income):Change
      in fair value of warrant liability
                
                
                (1,531,323
                )
                
                
                -Interest
      and financing costs, net
                
                
                1,064,096
                
                
                
                299,316Net
      (loss) income
                
                $
                (1,200,934
                )
                
                $
                686,981Basic
      (loss) income per share:
                
                $
                (0.02
                )
                
                $
                0.02Diluted
      (loss) income per share:
                
                $
                (0.02
                )
                
                $
                0.01Weighted
      average number of common shares outstanding - Basic
                
                
                57,032,339
                
                
                
                44,821,051Weighted
      average number of common shares outstanding - Diluted
                
                
                57,032,339
                
                
                
                50,649,103





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 three months ended
                  September 30,2010
                
                
                2009Cash
      flows from operating activities:Net
      (loss) income
                
                $
                (1,200,934
                )
                
                $
                686,981Adjustments
      to reconcile net (loss) income to net cash used in operating
      activities:Depreciation
      and amortization
                
                
                65,111
                
                
                
                64,877Loss
      on disposal of fixed assets
                
                
                -
                
                
                
                4,839Allowances
      for price protection, returns, and defective merchandise
                
                
                (2,257,431
                )
                
                
                958,427Bad
      debt expense, net of recoveries
                
                
                22,190
                
                
                
                (37,531
                )Stock-based
      compensation expense
                
                
                153,602
                
                
                
                156,196Amortization
      of royalties and intellectual property licenses
                
                
                183,416
                
                
                
                4,215,050Amortization
      of debt discount and issuance costs
                
                
                427,655
                
                
                
                -Change
      in fair value of warrant liability
                
                
                (1,531,323
                )
                
                
                -Fair
      market value adjustment to common stock issued for advances on
      royalties
                
                
                (1,801
                )
                
                
                -Gain
      on settlement of trade payables
                
                
                (585,122
                )
                
                
                -Changes
      in operating assets and liabilities:Due
      to/from factor
                
                
                (639,906
                )
                
                
                -Accounts
      receivable
                
                
                7,759,547
                
                
                
                (8,530,233
                )Inventories
                
                
                (240,289
                )
                
                
                (3,536,814
                )Advances
      on royalties
                
                
                (1,185,783
                )
                
                
                (1,449,716
                )Related
      party receivables
                
                
                (27,000
                )
                
                
                (38,825
                )Prepaid
      expenses and other current assets
                
                
                2,745
                
                
                
                136,031Production
      advance payable
                
                
                -
                
                
                
                3,755,104Accounts
      payable
                
                
                (1,493,505
                )
                
                
                (688,416
                )Accrued
      royalties
                
                
                (743.645
                )
                
                
                906,432Accrued
      expenses and other current liabilities
                
                
                476,860
                
                
                
                1,281,329Deferred
      revenues
                
                
                (295,301
                )
                
                
                -Accrued
      expenses - related parties
                
                
                (209,032
                )
                
                
                (105,275
                )Total
      adjustments
                
                
                (119,012
                )
                
                
                (2,908,525
                )Net
      cash used in operating activities
                
                
                (1,319,946
                )
                
                
                (2,221,544
                )Cash
      flows from investing activities:Purchases
      of property and equipment
                
                
                (16,737
                )
                
                
                (26,734
                )Change
      in restricted cash
                
                
                -
                
                
                
                417,917Net
      cash (used in) provided by investing activities
                
                
                (16,737
                )
                
                
                391,183Cash
      flows from financing activities:Proceeds
      from line of credit
                
                
                -
                
                
                
                8,117,146Repayments
      of line of credit
                
                
                (3,830,055
                )
                
                
                (6,343,234
                )Repayments
      of long-term debt
                
                
                (15,792
                )
                
                
                (11,853
                )Net
      repayments of amounts due to shareholders
                
                
                -
                
                
                
                (232,440
                )Net
      repayments of amounts due to related parties
                
                
                (2,175
                )
                
                
                (122,845
                )Proceeds
      from the issuance of senior secured convertible notes
                
                
                7,000,000
                
                
                
                -Payment
      of debt issuance costs
                
                
                (733,959
                )
                
                
                -Repayment
      of junior secured subordinated convertible promissory note
                
                
                (450,000
                )
                
                
                -Proceeds
      from the exercise of common stock warrants
                
                
                1,075
                
                
                
                -Net
      cash provided by financing activities
                
                
                1,969,094
                
                
                
                1,406,774Effect
      of exchange rate changes on cash and cash equivalents
                
                
                (275,378
                )
                
                
                48,757Net
      increase (decrease) in cash and cash equivalents
                
                
                357,033
                
                
                
                (374,830
                )Cash
      and cash equivalents at beginning of period
                
                
                92,893
                
                
                
                648,311Cash
      and cash equivalents at end of period
                
                $
                449,926
                
                
                $
                273,481Supplemental
      cash flow information:Cash
      paid during the period for interest
                
                $
                178,348
                
                
                $
                99,261Supplemental
      disclosure of non-cash activities:Fair
      value of common stock warrant liability
                
                $
                4,338,748
                
                
                $
                -Fair
      market value adjustment to common stock issued for advances on
      royalties
                
                $
                504,892
                
                
                $
                -Conversion
      of junior secured subordinated convertible promissory note to senior
      secured convertible note
                
                $
                500,000
                
                
                $Issuance
      of vested restricted stock
                
                $
                7
                
                
                $
                -Contingent
      purchase price payment obligation related to acquisition
                
                $
                -
                
                
                $
                596,634





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.
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; 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.





The
Company has one operating segment, a publisher and distributor of interactive
entertainment software for home video consoles, handheld platforms and personal
computers. To date, management has not considered discrete geographical or other
information to be relevant for purposes of making decisions about allocations of
resources.





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, and the resolution of various contingencies. 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 September 30, 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 $1,004,000
through September 30, 2010). 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 on 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 increase the amount of its factoring facility;
  and




•
            seeking
      to raise additional capital.





The
Company has also invested in key new titles from which the anticipated profits
should help improve its financial prospects. 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. The
Company’s condensed consolidated financial statements do not include any
adjustments that might result from the resolution of this
uncertainty.





On July
12, 2010, the Company repaid in full the entire outstanding balance under the
credit agreement with SunTrust Banks, Inc. (“SunTrust”) as a result of entering
into a factoring agreement with Rosenthal & Rosenthal, Inc. (see Note
4).





6





1.
Summary of Significant
Accounting Policies, Cont.







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 “Notes”) and
warrants. Mr. Phillips’ Note was issued in exchange for a junior secured
subordinated promissory note originally issued to him on April 30, 2010 (see
Note 6). The Company received $5,000,000 in cash for $5,000,000 of the Notes and
exchanged a $500,000 prior junior secured subordinated promissory note for
$500,000 of the Notes (see Note 6).





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 (see Note 6).





On
September 20, 2010, the Company entered into a purchase order financing
arrangement with Wells Fargo Bank, National Association (“Wells Fargo”), for up
to a maximum of $2,000,000, to provide funding for the development and
production of games (see Note 7).





Basis
of Presentation





The
accompanying unaudited condensed consolidated financial statements as of
September 30, 2010 and for the three month periods ended September 30, 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 months ended
September 30, 2010 are not necessarily indicative of the results that may be
expected for the 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
SouthPeak Interactive, L.L.C., SouthPeak Interactive, Ltd., Vid Sub, LLC, Gone
Off Deep, LLC, Gamecock Media Europe Ltd., and IRP GmbH. 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.





7


1. Summary of Significant
Accounting Policies, Cont.




Subsequent
events have been evaluated through the filing date of these unaudited condensed
consolidated financial statements.





Concentrations
of Credit Risk, Major Customers and Major Vendors





The
financial instruments which potentially subject the Company to concentrations of
credit risk consist primarily of cash balances with financial institutions and
accounts receivable. The Company maintains cash in bank accounts that, at times,
may exceed federally insured limits. The Company has not experienced any losses
in such accounts and believes it is not exposed to any significant risks on its
cash in bank accounts.





The
Company does not generally require collateral or other security to support
accounts receivable. Management must make estimates of the uncollectibility of
the accounts receivable. The Company considers accounts receivable past due
based on how recently payments have been received. The Company has established
an allowance for doubtful accounts based upon the facts surrounding the credit
risk of specific customers, past collections history and other
factors.





The
Company has four customers, GameStop, Target, 1C Company, and Wal-Mart, which
accounted for 27%, 15%, 14%, and 10%, respectively, of consolidated gross
revenues for the three months ended September 30, 2010. PDQ Distribution
accounted for 21% of consolidated gross accounts receivable at September 30,
2010. For the three months ended September 30, 2009, Wal-Mart, GameStop and
Topware Entertainment accounted for 20%, 15% 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 September 30, 2010 and 2009 and
for the three-month periods ended September 30, 2010 and 2009 are as
follows:




Cost of Goods Sold —
                        ProductsFor the
                        three
                        months
                      
                      
                      For the
                        three
                        months
                      
                      
                      Accounts Payableended
                        September
                        30, 2010
                      
                      
                      ended
                        September
                        30, 2009
                      
                      
                      As of
                        September30, 2010
                      
                      
                      As of
                        June 30,
                        2010Microsoft
                      
                      $
                      199,336
                      
                      
                      $
                      2,737,842
                      
                      
                      $
                      -
                      
                      
                      $
                      158,592Nintendo
                      
                      $
                      166,684
                      
                      
                      $
                      831,796
                      
                      
                      $
                      -
                      
                      
                      $
                      -Sony
                      
                      $
                      589,862
                      
                      
                      $
                      27,522
                      
                      
                      $
                      577,815
                      
                      
                      $
                      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. In
making the decision to grant price protection to customers, the Company also
considers other factors, including the facilitation of slow-moving inventory and
other market factors.





8





1. Summary of Significant
Accounting Policies, Cont.




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 following factors are
used to estimate the amount of future returns and price protection for a
particular game: historical performance of games in similar genres; historical
performance of the hardware platform; sales force and retail customer feedback;
industry pricing; weeks of on-hand retail channel inventory; absolute quantity
of on-hand retail channel inventory; the game’s recent sell-through history (if
available); marketing trade programs; and competing games. Significant
management judgments and estimates must be made and used in connection with
establishing the allowance for returns and price protection in any accounting
period. Based upon historical experience, management believes the estimates are
reasonable. However, actual returns and price protection could vary materially
from management’s allowance estimates due to a number of unpredictable reasons
including, among others, a lack of consumer acceptance of a game, the release in
the same period of a similarly themed game by a competitor, or technological
obsolescence due to the emergence of new hardware platforms. Material
differences may result in the amount and timing of the Company’s revenues for
any period if factors or market conditions change or if management makes
different judgments or utilizes different estimates in determining the
allowances for returns and price protection.





Similarly,
management must make estimates of the uncollectibility of the Company’s accounts
receivable. In estimating the allowance for doubtful accounts, the Company
analyzes the age of current outstanding account balances, historical bad debts,
customer concentrations, customer creditworthiness, current economic trends, and
changes in the Company’s customers’ payment terms and their economic condition.
Any significant changes in any of these criteria would affect management’s
estimates in establishing the allowance for doubtful accounts.





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





September
      30,
                            2010
                          
                          June 30,
                            2010Sales
      returns
                          
                          $
                          104,
      863
                          
                          $
                          2,634,097Price
      protection
                          
                          
                          182,
      224
                          
                          
                          2,257,171Doubtful
      accounts
                          
                          
                          597,006
                          
                          
                          771,442Defective
      items
                          
                          
                          1,423
                          
                          
                          38,221Total
      allowances
                          
                          $
                          885,516
                          
                          $
                          5,700,931





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 the
Company’s games. Significant changes in demand for the Company’s games would
impact management’s estimates in establishing the inventory provision. Inventory
costs include licensing fees paid to platform proprietors. These licensing fees
include the cost to manufacture the game cartridges. These licensing fees
included in “cost of goods sold - product costs” amounted to $955,882 and
$3,597,160 for the three months ended September 30, 2010 and 2009, respectively.
Licensing fees included in inventory at September 30, 2010 and June 30, 2010
totaled $152,623 and $273,166, respectively.





Advances on
Royalties





The
Company utilizes independent software developers to develop its games in
exchange for payments to the developers based upon certain contract milestones.
The Company enters into contracts with the developers once the game design has
been approved by the platform proprietors and is technologically feasible.
Accordingly, the Company capitalizes such payments to the developers during
development of the games. These payments are considered non-refundable royalty
advances and are applied against the royalty obligations owed to the developer
from future sales of the game. 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 games that are cancelled or abandoned are charged to “cost of goods
sold - royalties” in the period of cancellation. Capitalized costs for games
that are cancelled or abandoned prior to product release are charged to “cost of
goods sold - royalties” in the period of cancellation. There were no costs for
games cancelled or abandoned during the three months ended September 30, 2010
and 2009, respectively.





9





1. Summary of Significant
Accounting Policies, Cont.




Beginning
upon the related game’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 game, generally resulting in an amortization
period of twelve months or less.





The
Company evaluates the future recoverability of capitalized royalty costs on a
quarterly basis. For games that have been released in prior periods, the primary
evaluation criterion is actual title performance. For games that are scheduled
to be released in future periods, recoverability is evaluated based on the
expected performance of the specific game to which the royalties relate.
Criteria used to evaluate expected game performance include: historical
performance of comparable games developed with comparable technology; orders for
the game prior to its release; and, for any game sequel, estimated performance
based on the performance of the game 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 game performance utilizes
forecasted sales amounts and estimates of additional costs to be incurred. If
revised forecasted or actual game 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 the Company to license the use of
trademarks, copyrights, and software used in the development of games. Depending
on the agreement, the Company may use acquired intellectual property in multiple
games over multiple years or for a single game. When no significant performance
remains with the licensor upon execution of the license agreement, the Company
records an asset and a liability at the contractual amount. The Company believes
that the contractual amount represents the fair value of the liability. When
significant performance remains with the licensor, the Company records the
payments as an asset when paid and as a liability when incurred, rather than
upon execution of the agreement. The Company classifies these obligations as
current liabilities to the extent they are contractually due within the next
twelve months. Capitalized intellectual property license costs for those games
that are cancelled or abandoned are charged to “cost of goods sold -
intellectual property licenses” in the period of cancellation. There were no
costs for games cancelled or abandoned during the three months ended September
30, 2010 and 2009, respectively.





Beginning
upon the related game’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 game to total
projected revenues for all games in which the licensed property will be utilized
or (2) the straight-line amortization method over the estimated useful lives of
the licenses. 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.





The
Company evaluates the future recoverability of capitalized intellectual property
license costs on a quarterly basis. For games that have been released in prior
periods, the primary evaluation criterion is actual title performance. For games
that are scheduled to be released in future periods, recoverability is evaluated
based on the expected performance of the specific games 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 games developed with comparable technology; orders for the game prior
to its release; and, for any game sequel, estimated performance based on the
performance of the game on which the sequel is based. Further, as intellectual
property licenses may extend for multiple games over multiple years, the Company
also assesses 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 continued promotion and exploitation of the intellectual
property.





Significant
management judgments and estimates are utilized in the assessment of the
recoverability of capitalized intellectual property license costs. In evaluating
the recoverability of capitalized intellectual property license costs, the
assessment of expected game performance utilizes forecasted sales amounts and
estimates of additional costs to be incurred. If revised forecasted or actual
game 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.





10





1.
Summary
of Significant Accounting Policies, Cont.




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 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.





The
Company accounts for goodwill using the provisions within ASC Topic 350. Under
ASC Topic 350, 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 September 30, 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 September 30, 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.





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
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.





11





1. Summary of Significant
Accounting Policies, Cont.




Some of
the Company’s video games provide limited online features at no additional cost
to the consumer. Generally, the Company considers such features to be incidental
to the overall product offering and an inconsequential deliverable. Accordingly,
the Company recognizes revenue related to video games containing these limited
online features upon the transfer of title and risk of loss to the customer. In
instances where online features or additional functionality are considered a
substantive deliverable in addition to the video game, the Company takes this
into account when applying its revenue recognition policy. This evaluation is
performed for each video game together with any online transactions, such as
electronic downloads or video game add-ons when it is released. When the Company
determines that a video game contains online functionality that constitutes a
more-than-inconsequential separate service deliverable in addition to the video
game, principally because of its importance to game play, the Company considers
that its performance obligations for this game extend beyond the delivery of the
game. Fair value does not exist for the online functionality, as the Company
does not separately charge for this component of the video game. As a result,
the Company recognizes all of the revenue from the sale of the game upon the
delivery of the remaining online functionality. In addition, the Company defers
the costs of sales for this game and recognizes the costs upon delivery of the
remaining online functionality.





With
respect to online transactions, such as electronic downloads of games or add-ons
that do not include a more-than-inconsequential separate service deliverable,
revenue is recognized when the fee is paid by the online customer to purchase
online content and the Company is notified by the online retailer that the
product has been downloaded. In addition, persuasive evidence of an arrangement
must exist, collection of the related receivable must be probable and the fee
must be fixed and determinable.





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, prices and 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 as defined by ASC Topic
605.





Third-party
licensees in Europe distribute certain video games under license agreements with
the Company. The licensees paid certain minimum, non-refundable, guaranteed
royalties when entering into the licensing agreements. Upon receipt of the
advances, the Company defers their recognition and recognizes the revenues in
subsequent periods as these advances are earned by the Company. As the licensees
pay additional royalties above and beyond those initially advanced, the Company
recognizes these additional royalties as revenues when earned.





With
respect to license agreements that provide customers the right to make multiple
copies in exchange for guaranteed amounts, revenue is recognized upon delivery
of a master copy. Per copy royalties on sales that exceed the guarantee are
recognized as earned. In addition, persuasive evidence of an arrangement must
exist, collection of the related receivable must be probable, and the fee must
be fixed and determinable.





Stock-Based
Compensation





The
Company estimates the fair value of share-based payment awards on the
measurement date using the Black-Scholes 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 condensed consolidated
statements of operations.





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





12




1. Summary of Significant
Accounting Policies, Cont.




The
Company estimates the value of employee stock options on the date of grant using
the Black-Scholes option pricing model. The Company’s determination of fair
value of share-based payment awards on the date of grant using an option-pricing
model is affected by the Company’s 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.





The
Company accounts for equity instruments issued to non-employees based on the
estimated fair value of the equity instrument that is recorded on the earlier of
the performance commitment date or the date the services required are completed.
Until shares under the award are fully vested, the Company marks-to-market the
fair value of the options at the end of each accounting period.





Foreign
Currency Translation





The
functional currency for the Company’s foreign operations is the applicable local
currency. Accounts of foreign operations are translated into U.S. dollars using
exchange rates for assets and liabilities at the balance sheet date and average
prevailing exchange rates for the period for revenue and expense accounts.
Adjustments resulting from translation are included in other accumulated
comprehensive income (loss). Realized transaction gains and losses are included
in income in the period in which they occur, except on intercompany balances
considered to be long-term. Transaction gains and losses on intercompany
balances considered to be long-term are recorded in other accumulated
comprehensive income (loss). Foreign exchange transaction gains (losses)
included in general and administrative expenses in the accompanying condensed
consolidated statements of operations for the three months ended September 30,
2010 and 2009 amounted to $(49,786) and $(18,032), respectively.





Comprehensive
(Loss) Income





For the
three months ended September 30, 2010 and 2009, the Company’s comprehensive
(loss) income was as follows:





For the threemonths ended September 30,2010
                    
                    2009Net
      (loss) income
                    $
                    (1,200,934
                    )
                    $
                    686,981Change
      in foreign currency translation adjustment
                    
                    (275,378
                    )
                    
                    82,500Comprehensive
      (loss) income
                    $
                    (1,476,312
                    )
                    $
                    769,481





Fair
Value Measurements





Effective
July 1, 2009, the Company adopted the provisions of the fair value measurement
accounting and disclosure guidance which establishes a three-level hierarchy
that prioritizes the inputs used to measure fair value. The hierarchy requires
entities to maximize the use of “observable inputs” and minimize the use of
“unobservable inputs.” The three levels of inputs used to measure fair value are
as follows:




•
            Level
      1: Quoted market prices in active markets for identical assets or
      liabilities.


•
            Level
      2: Quoted prices in active markets for similar assets and liabilities,
      quoted prices for identically similar assets or liabilities in markets
      that are not active and models for which all significant inputs are
      observable either directly or
indirectly.


•
            Level
      3: Unobservable inputs reflecting the reporting entity's own assumptions
      or external inputs for inactive
markets.





13





1. Summary of Significant
Accounting Policies, Cont.
  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
                      
                      
                      UnobservableSeptember
                      
                      
                      Instruments
                      
                      
                      Inputs
                      
                      
                      Inputs30, 2010
                      
                      
                      (Level 1)
                      
                      
                      (Level 2)
                      
                      
                      (Level 3)Assets:Advances
      on royalties
                      
                      $
                      696,762
                      
                      
                      $
                      696,762
                      
                      
                      $
                      -
                      
                      
                      $
                      -Total
      assets at fair value
                      
                      $
                      696,762
                      
                      
                      $
                      696,762
                      
                      
                      $
                      -
                      
                      
                      $
                      -Liabilities:Warrant
      liability
                      
                      $
                      2,807,425
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      2,807,425Total
      liabilities at fair value
                      
                      $
                      2,807,425
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      2,807,425





On
February 23, 2010, the Company issued to the videogame publisher 3,000,000
shares of common stock, valued at $1,020,000 based on the fair market value of
the Company’s common stock on the date the agreement was executed by the
parties. The Company has capitalized such payment to the videogame publisher and
the amount is marked-to-market on a quarterly basis. The fair value of the
advances on royalties is based entirely upon quoted market prices, which is a
level 1 input. The Company recorded a $504,892 decrease to the carrying amount
of asset related to the periodic fair value remeasurement at September 30, 2010.
During the three months ended September 30, 2010, 16,158 shares were earned and
$5,773 was expensed to “cost of goods sold – royalties”, and ($1,801) was
expensed to “general and administrative” relating to the periodic fair value
remeasurement. As of September 30, 2010, 2,787,048 shares of common stock,
valued at $696,762, based on the fair market value of the Company’s common stock
were included 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 $2,807,425 at September 30, 2010. The
Company recorded a non-cash gain of $1,531,323 due to the change in fair value
of warrants during the three months ended September 30, 2010. The fair value of
the warrants was computed using the Black-Sholes option pricing model. The
Company assumed a risk-free interest rate of 1.27%, no dividends, expected
volatility of 146.18% and the remaining contractual life of the warrants of 4.8
years.





14





1. Summary of Significant
Accounting Policies, Cont.




The
following table is a rollforward of the fair value of the warrants, as to which
fair value is determined by Level 3 inputs:





Three MonthsEndedSeptember 30,Description
                      
                      2010Beginning
      balance
                      
                      $
                      -Purchases,
      issuances, and settlements
                      
                      
                      4,338,748Total
      (gain) loss included in net loss
                      
                      
                      (1,531,323
                      )Ending
      balance
                      
                      $
                      2,807,425





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 11,060,106 for the three months ended September 30,
2010.





Recent
Accounting Pronouncements





In
October 2009, the Financial Accounting Standards Board (the “FASB”) issued
Accounting Standards Update (“ASU”) No. 2009-14, “Software (Topic 985): Certain
Revenue Arrangements That Include Software Elements - a consensus of the FASB
Emerging Issues Task Force (“EITF”)” (formerly EITF 09-3). ASU 2009-14 revises
FASB ASC 985-605 to drop from its scope all tangible products containing both
software and non-software components that operate together to deliver the
products’ functions. It also amends the determination of how arrangement
consideration should be allocated to deliverables in a multi-deliverable revenue
arrangement. ASU 2009-14 is effective for fiscal years beginning after June 15,
2010. The adoption of ASU 2009-14 did not have a material impact on the
Company’s
condensed consolidated results of operations and financial
condition.





In
October 2009, the FASB issued ASU No. 2009-13, “Revenue Recognition (Topic 605):
Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging
Issues Task Force” (formerly EITF 08-1), which amends the revenue recognition
guidance for arrangements with multiple deliverables. ASU 2009-13 addresses how
to determine whether an arrangement involving multiple deliverables contains
more than one unit of accounting and how to allocate consideration to each unit
of accounting in the arrangement. This ASU replaces all references to fair value
as the measurement criteria with the term selling price and establishes a
hierarchy for determining the selling price of a deliverable. It also eliminated
the use of the residual value method for determining the allocation of
arrangement consideration. ASU 2009-13 is effective for fiscal years beginning
after June 15, 2010. The adoption of ASU 2009-13 did not have a material impact
on the Company’s condensed consolidated results of operations and financial
condition as the majority of its revenues are driven from single element
deliverables.





15





2.
Inventories





Inventories
consist of the following:





September
                  30, 2010
                
                
                June 30,
                  2010Finished
      goods
                
                $
                714,144
                
                
                $
                1,085,433Purchased
      parts and components
                
                
                737,446
                
                
                
                125,868Total
                
                $
                1,451,590
                
                
                $
                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. As
of June 30, 2010, the Company’s borrowing base could not exceed 55% of eligible
accounts receivable plus $500,000. The line of credit bore interest at prime
plus 11⁄2%, which was 4.75% at June 30, 2010. SunTrust processed payments received
on such accounts receivable as payments on the revolving line of credit. The
line was collateralized by gross accounts receivable of approximately $1,861,000
at June 30, 2010. The line of credit was further collateralized by personal
guarantees, and pledge of personal securities and assets by two Company
shareholders, one of whom is the Company’s chairman, and certain other
affiliates. The agreement contained certain financial and non-financial
covenants. At June 30, 2010, the Company was not in compliance with these
covenants.





At June
30, 2010, the outstanding line of credit balance was $3,830,055. At June 30,
2010, the Company had $-0- available under the credit facility. For the three
months ended September 30, 2010 and 2009, interest expense relating to the line
of credit was $2,021 and $51,759, 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, Inc. 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, each
of the Company, its subsidiaries, Gone Off Deep LLC, SouthPeak Interactive Ltd,
and Vid Sub, LLC, and the chairman, Terry Phillips, have executed guarantees in
favor of Rosenthal & Rosenthal. In addition, the Company, Gone Off Deep and
Vid Sub 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 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 the Company’s borrowings, which is
subject to an increase of up to $3,000,000 if shareholders’ equity increases.
The initial term of the Factoring Agreement ends on February 28,
2012.





Due (to)
from factor consists of the following:





September
                    30, 2010Outstanding
      accounts receivable sold to factor
                  
                  $
                  3,589,369Cash
      collateral
                  
                  
                  53,354Less:
      allowances
                  
                  
                  (2,580,174
                  )Less:
      advances from factor
                  
                  
                  (3,002,817
                  )$
                  (1,940,268
                  )




16


4.
Due to Factor,
Cont.




Accounts
receivable totaling $3,589,369 were sold to the factor at September 30, 2010, of
which the Company assumed credit risk of $1,828,153. The following table sets
forth adjustments to the price protection and other customer allowances included
as a reduction of amounts due (to) from factor:





Three
                    months
                    ended
                    September
                    30, 2010Beginning
      balance
                  
                  $
                  -Add:
      provision
                  
                  
                  (4,544,537
                  )Less:
      amounts charged against allowance
                  
                  
                  1,964,363Ending
      balance
                  
                  $
                  (2,580,174
                  )





For the
three months ended September 30, 2010, interest and financing costs relating to
the factoring agreement were $155,458.





5.
Production Advance
Payable





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 September 30, 2010 and June
30, 2010, respectively. Production fees relating to this production advance for
the three months ended September 30, 2010 and 2009 totaled $278,860 and
$199,946, respectively. The production fees for the three months ending
September 30, 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 September 30, 2010 and June 30, 2010, accrued and unpaid
production fees totaled $1,409,647 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 $1,004,000 through September 30,
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.





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, Inc., 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.





17





6.
Secured Convertible
Debt, Cont.




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 months ended September 30, 2010 related to the
Junior Notes was $5,411. There was $-0- and $15,548 of accrued interest
outstanding at September 30, 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 “Notes”) and
warrants. Mr. Phillips’ 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 senior secured convertible notes and exchanged a $500,000
prior Junior Note for $500,000 of the senior secured convertible notes. The
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 Notes are senior to all obligations of the Company with the exception
of the indebtedness under the Company’s Factoring Agreement with Rosenthal &
Rosenthal, Inc. (see Note 4). Interest expense for the three months ended
September 30, 2010 was $111,528 and there was $111,528 of accrued interest
outstanding at September 30, 2010.





The
principal and interest due under the Notes are convertible at a price of $0.431
per share. 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 Additional Notes are subject to the Pledge and Security
Agreement and the Guaranty made by the Company’s subsidiaries. Interest expense
for the three months ended September 30, 2010 was $38,666 and there was $38,666
of accrued interest outstanding at September 30, 2010.





The
principal and interest due under the Additional Notes are convertible at a price
of $20.00 per share. 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 July19, 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 tied 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 as are the Series A
warrants.





The
Company’s 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 statement 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.





18





6.
Secured Convertible
Debt, Cont.




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, as defined under the Notes,
will not be achieved. Because the probability at inception that the EBITDA Test
will not be achieved is considered to be de minimis (less than 5%), the fair
value of the derivative instrument is not considered to be material and no value
has been assigned to it.





As of
September 30, 2010, the unamortized debt discount amounted to $3,977,185. Total
amortization of the debt discount recorded as interest expense was $361,563 for
the three months ended September 30, 2010.





In
connection with the sale of the senior secured convertible notes and warrants,
the Company executed a Registration Rights Agreement under which it agreed to
register the shares of common stock underlying the senior secured convertible
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 Notes.





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 months ended September 30, 2010 totaled
$66,092.





7.
Purchase Order
Financing





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. No amounts were outstanding as of September 30,
2010.





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.





19





7.
Purchase Order
Financing, 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.





Included
in related party receivables at September 30, 2010 is a $35,000 receivable
resulting from a loan made to a company partially owned by the Company’s
chairman and chief executive officer. Interest on the loan is 8.0% and the
entire outstanding amount became payable upon demand on September 1,
2010.





Also
included in related party receivables at September 30 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 September 30, 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





During
the three months ended September 30, 2010 and 2009, the Company expensed $6,600
related to broadband usage from an internet service provider partially owned by
two shareholders of the Company, one of whom is the Company's chairman, of which
$25 and $2,200 remained as a payable to the affiliate and is included in due to
related parties in the accompanying condensed consolidated balance sheets at
September 30, 2010 and June 30, 2010, respectively. These amounts are included
in general and administrative expenses in the accompanying condensed
consolidated statements of operations.





Accrued
Expenses - Related Parties





Accrued
expenses - related parties as of and for the three months ended September 30,
2010 and the year ended June 30, 2009 are as follows:





Three
                  months ended
                  September30, 2010
                
                
                Year ended
                  June 30,
                  2009Balance
      at beginning of period
                
                $
                322,281
                
                
                $
                221,493Expenses
      incurred:Rent
                
                
                27,500
                
                
                
                110,000Commissions
                
                
                40,371
                
                
                
                551,932Less:
      amounts paid
                
                
                (276,903
                )
                
                
                (561,144
                )Balance
      at end of period
                
                $
                113,249
                
                
                $
                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
months ended September 30, 2010 and 2009 were $40,371 and $108,046,
respectively. These amounts are included in sales and marketing in the
accompanying condensed consolidated statements of operations.





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 for the three months ended September 30, 2010
and 2009. These amounts are included in the general and administrative expense
in the accompanying condensed consolidated statements of operations. The lease
expires on December 31, 2010.





20





8.
Related Party
Transactions, Cont.




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 $3,908 for the three months ended September 30, 2010 and 2009.
These amounts are included in general and administrative expense in the
accompanying condensed consolidated statements of operations. The lease expires
on December 31, 2010.





9.
Commitments





Total
future minimum commitments are as follows:





Software
                  
                  
                  OfficeDevelopers
                  
                  
                  Lease
                  
                  
                  TotalFor
      the year ending June 30,2011
      (nine months ended June 30, 2011)
                  
                  $
                  5,722,739
                  
                  
                  $
                  49,272
                  
                  
                  $
                  5,772,0112012
                  
                  
                  -
                  
                  
                  
                  29,029
                  
                  
                  
                  29,0292013
                  
                  
                  -
                  
                  
                  
                  33,867
                  
                  
                  
                  33,8672014
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -2015
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Total
                  
                  $
                  5,722,739
                  
                  
                  $
                  112,168
                  
                  
                  $
                  5,834,907





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 September 30, 2010 and June 30, 2010 were 85,888 and
919,372, respectively, under the 2008 Plan.





Stock
awards and shares are generally granted at prices which the Company’s board of
directors believes approximate the fair market value of the awards or shares at
the date of grant. Individual grants generally become exercisable ratably over a
period of three years from the date of grant. The contractual terms of the
options range from three to ten years from the date of grant.





The
Company uses the Black-Scholes option pricing model to determine the fair value
of stock-based compensation to employees and non-employees. The determination of
fair value is affected by the Company’s stock price and volatility, employee
exercise behavior, and the time for the shares to vest.





The
assumptions used in the Black-Scholes option pricing model to value the
Company’s option grants to employees and non-employees were as
follow:





For the three
                              months ended
                              September 30, 2010
                            
                            For the three
                              months ended
                              September30, 2009Risk-free
      interest rate
                            
                            1.6
      – 2.5%
                            
                            2.5
      - 3.5%Weighted-average
      volatility
                            
                            155
      - 157%
                            
                            161
      – 165%Expected
      term
                            
                            5.5
      – 8.7 years
                            
                            5.5
      - 9.7 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
                        September 30,2010
                      
                      
                      For the three
                        months ended
                        September 30,2009Sales
      and marketing
                      
                      $
                      10,705
                      
                      
                      $
                      27,622General
      and administrative
                      
                      
                      142,897
                      
                      
                      
                      128,574Total
      stock-based compensation expense
                      
                      $
                      153,602
                      
                      
                      $
                      156,196




21





10.
Stock-based
Compensation, Cont.




As of
September 30, 2010, the Company’s unrecognized stock-based compensation for
stock options issued to employees and non-employee directors was approximately
$623,390 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 three months ended September
30, 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 nine months ended September 30, 2010Granted
                
                
                696,500
                
                
                
                0.30
                
                
                
                9.88
                
                
                
                9,000Exercised
                
                
                -
                
                
                
                
                
                
                
                -
                
                
                
                -Forfeited,
      cancelled or expired
                
                
                58,667
                
                
                
                0.67
                
                
                
                8.81
                
                
                
                -Outstanding
      as of September 30, 2010
                
                
                3,519,961
                
                
                $
                0.90
                
                
                
                8.81
                
                
                $
                9,000Exercisable
      as of September 30, 2010
                
                
                1,226,212
                
                
                $
                1.38
                
                
                
                8.19
                
                
                $
                -Exercisable
      and expected to be exercisable
                
                
                2,293,749
                
                
                $
                0.93
                
                
                
                8.77
                
                
                $
                7,715





The
aggregate intrinsic value represents the total pre-tax intrinsic value based on
the Company’s closing stock price ($0.25 per share) as of September 30, 2010,
which would have been received by the option holders had all option holders
exercised their options as of that date.





The
weighted average fair value of stock options granted to employees and
non-employee directors during the three months ended September 30, 2010 was
$0.30 per share.





The
following table summarizes the Company’s restricted stock activity for the nine
months ended March 31, 2010:





Shares
                
                
                Weighted-
                  Average
                  Grant Date
                  Fair ValueOutstanding
      as of June 30, 2010
                
                
                1,085,000
                
                
                $
                0.37Activity
      for the nine months ended September 30, 2010Granted
                
                
                195,651
                
                
                
                0.23Vested
                
                
                65,000
                
                
                
                0.75Forfeited,
      cancelled or expired
                
                
                -
                
                
                
                -Outstanding
      as of September 30, 2010
                
                
                1,215,651
                
                
                $
                0.33Vested
      as of September 30, 2010
                
                
                178,500
                
                
                $
                1.64




22





10.
Stock-based
Compensation, Cont.




As of
September 30, 2010, the Company’s unrecognized stock-based compensation for
restricted stock issued to employees and non-employee directors was
approximately $293,211 and will be recognized over a weighted average of 1.94
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 September 30, 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 has no
estimate at this time of its potential exposure and cannot, at this time,
predict the outcome of this matter. The Company and its subsidiaries intend to
vigorously defend all claims.





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. In addition, the Company has claimed that the grant of the rights to
My Baby 3 to Majesco were unlawful. 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. A
further hearing was held on November 9,2010,
in which the Company sought to affirm the court’s prior judgment reinstating the
My Baby First Steps contract as well as to reinstate the My Baby 1 contract. The
court has not yet rendered any decision regarding these matters. The parties are
in settlement negotiations.





Other
than 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 resolution of these matters should
not have a material effect on the consolidated financial position or results of
operations of the Company. As of September 30, 2010, the Company has accrued an
aggregate amount of $839,903 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.





23





11.
Contingencies,
Cont.




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.





Legal
proceedings have been threatened by the Company’s former CFO against the Company
in connection with allegations of discrimination and retaliation against a
whistle blower and wrongful termination. The claim seeks an undisclosed amount
in lost wages in addition to certain employee benefits and punitive damages. The
Company believes this claim is without merit and intends to defend this action
vigorously.





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
three months ended September 30, 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





13. Additional
Financial Statement Information





Accrued
expenses and other current liabilities consist of the following:





September 30,
                      
                      
                      June 30,2010
                      
                      
                      2010Accrued
      expenses
                      
                      $
                      1,693,186
                      
                      
                      $
                      1,700,208Reserve
      for marketing development funds (MDF)
                      
                      
                      388,433
                      
                      
                      
                      344,210Commissions
                      
                      
                      100,344
                      
                      
                      
                      161,678Guaranteed
      royalty payments
                      
                      
                      135,000
                      
                      
                      
                      135,000Accrued
      payroll and payroll taxes
                      
                      
                      193,304
                      
                      
                      
                      266,740Customer
      cash in advance deposits
                      
                      
                      50,920
                      
                      
                      
                      31,793Accrued
      interest
                      
                      
                      1,586,386
                      
                      
                      
                      1,062,200Other
                      
                      
                      110,998
                      
                      
                      
                      79,882$
                      4,258,571
                      
                      
                      $
                      3,781,711





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




14.  Subsequent Event
 
 Effective
November 1, 2010, the number of authorized shares of common stock of the Company
was increased from 90,000,000 to 190,000,000.  The increase was
effective upon the filing of an amendment to the Company's certificate of
incorporation with the State of Delaware.  The Company's Board of
Directors and stockholders approved the amendment in July 2010, and the
amendment was filed following the delivery of an Information Statement to the
Company's stockholders on October 8, 2010.


24


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, Part I, of our annual report on Form 10-K for the
year ended June 30, 2010.
  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. 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; 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 videogames.


25





Sources
of Revenue





Revenue
is primarily derived from the sale of videogame titles 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.





Cost of Goods Sold and Operating
Expenses





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





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





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





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





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





26





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.The Company’s 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 statement of
operations.





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





Critical
Accounting Policies and Estimates





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





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





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





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





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





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





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





27





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





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





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





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





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





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





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





28





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.





Some of
our videogames provide limited online features at no additional cost to the
consumer. Generally, we consider such features to be incidental to the overall
product offering and an inconsequential deliverable. Accordingly, we recognize
revenue related to videogames containing these limited online features upon the
transfer of title and risk of loss to our customer. In instances where online
features or additional functionality are considered a substantive deliverable in
addition to the videogame, we take this into account when applying our revenue
recognition policy. This evaluation is performed for each videogame together
with any online transactions, such as electronic downloads or videogame add-ons
when it is released. When we determine that a videogame contains online
functionality that constitutes a more-than-inconsequential separate service
deliverable in addition to the videogame, principally because of its importance
to game play, we consider that our performance obligations for this game extend
beyond the delivery of the game. Fair value does not exist for the online
functionality, as we do not separately charge for this component of the
videogame. As a result, we recognize all of the revenue from the sale of the
game upon the delivery of the remaining online functionality. In addition, we
defer the costs of sales for this game and recognize the costs upon delivery of
the remaining online functionality.





With
respect to online transactions, such as electronic downloads of games or add-ons
that do not include a more-than-inconsequential separate service deliverable,
revenue is recognized when the fee is paid by the online customer to purchase
online content and we are notified by the online retailer that the product has
been downloaded. In addition, persuasive evidence of an arrangement must exist,
collection of the related receivable must be probable and the fee must be fixed
and determinable.





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, warehouses the inventory in advance of orders, prices and ships 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 as defined by
Accounting Standard Codification (“ASC”) Topic 605.





Third-party
licensees in Europe distribute videogames under license agreements with us. The
licensees pay certain minimum, non-refundable, guaranteed royalties when
entering into the licensing agreements. Upon receipt of the advances, we defer
their recognition and recognize the revenues in subsequent periods as these
advances are earned by us. As the licensees pay additional royalties above and
beyond those initially advanced, we recognize these additional royalties as
revenues when earned.





With
respect to license agreements that provide customers the right to make multiple
copies in exchange for guaranteed amounts, revenue is recognized upon delivery
of a master copy. Per copy royalties on sales that exceed the guarantee are
recognized as earned. In addition, persuasive evidence of an arrangement must
exist, collection of the related receivable must be probable, and the fee must
be fixed and determinable.





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.





29





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





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





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





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





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





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





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, expire or
are amended in a way that would no longer require these warrants to be
classified as a liability.





30





Consolidated
Results of Operations





The
following table sets forth our results of operations expressed as a percentage
of net revenues for the three months ended September 30, 2010 and
2009:





For the
                    three months ended
                    September 30,2010
                  
                  
                  2009Net
      revenues
                  
                  
                  100.0
                  %
                  
                  
                  100.0
                  %Cost
      of goods sold:Product
      costs
                  
                  
                  53.2
                  %
                  
                  
                  21.3
                  %Royalties,
      net
                  
                  
                  (4.7)
                  %
                  
                  
                  29.9
                  %Intellectual
      property licenses
                  
                  
                  6.7
                  %
                  
                  
                  0.7
                  %Total
      cost of goods sold
                  
                  
                  55.2
                  %
                  
                  
                  51.9
                  %Gross
      profit
                  
                  
                  44.8
                  %
                  
                  
                  48.1
                  %Operating
      expenses:Warehousing
      and distribution
                  
                  
                  4.6
                  %
                  
                  
                  1.7
                  %Sales
      and marketing
                  
                  
                  62.6
                  %
                  
                  
                  21.9
                  %General
      and administrative
                  
                  
                  135.0
                  %
                  
                  
                  18.6
                  %Gain
      on settlement of trade payables
                  
                  
                  (40.9)
                  %
                  
                  
                  -
                  %Total
      operating expenses
                  
                  
                  161.3
                  %
                  
                  
                  42.2
                  %(Loss)
      income from operations
                  
                  
                  (116.5)
                  %
                  
                  
                  5.9
                  %Other
      expenses (income):Change
      in fair value of warrant liability
                  
                  
                  (106.9)
                  %
                  
                  
                  -
                  %Interest
      and financing costs, net
                  
                  
                  74.3
                  %
                  
                  
                  1.8
                  %Net
      (loss) income
                  
                  
                  (83.9)
                  %
                  
                  
                  4.1
                  %





Comparison
of the Three Months Ended September 30, 2010 and 2009





Net Revenues. Net revenues
for the three months ended September 30, 2010 were $1,431,859, a decrease of
$15,277,790, or 91%, from net revenues of $16,709,649 for the three months ended
September 30, 2009. The decrease in net revenues was primarily driven by
releasing a decreased number of titles. For the three months ended September 30,
2010, the number of videogame units sold decreased to approximately 135,000, a
decrease of 602,000 units from the units sold in the comparable period in 2009.
During the three months ended September 30, 2009, we released ten new titles
versus no new titles during the current period due to the delay of certain
launch dates of upcoming releases. Additionally, due to the litigation with
Nobilis, we were unable to manufacture or ship any of the My Baby brand products
during the three months ended September 30, 2010. This decrease in new titles in
addition to being unable to ship My Baby brand products directly impacted the
amount of units shipped. Average net revenue per videogame unit sold decreased
53%, from $22.67 to $10.61 for the three months ended September 30, 2009 and
2010, respectively. This average decrease in price is mainly due to selling
older units during the three months ended September 30, 2010, which are
discounted and have a lower price point, versus the sales of new release titles
in the comparable period in 2009.





31





Cost of Goods Sold. Cost of
goods sold for the three months ended September 30, 2010 decreased to $790,067,
down $7,876,950, or 91%, from $8,667,017 for the comparable period in 2009.
Product costs for the three months ended September 30, 2010 decreased
$2,785,404, or 79%, from the comparable period in 2009. This decrease was
primarily driven by the decrease in units shipped from the prior period. For the
three months ended September 30, 2010, the number of videogame units sold
decreased to approximately 135,000, a decrease of approximately 602,000 units
from the units sold in the prior period. For the three months ended September
30, 2010, we incurred negative royalty expense of $67,108 compared to royalty
expense of $5,000,671 for the three months ended September 30, 2009. This
$5,067,779, or 101%, decrease from the comparable period in 2009 was primarily
attributed to sales discounts passed on to a distribution partner that reduced
our accrued royalty liability. Due to the significant decrease in new titles
released and net revenues, there was not enough royalty expense to offset the
reduction in liability.





Gross Profit. For the three
months ended September 30, 2010 and 2009, gross profit decreased by $7,400,840,
or 92%, to $641,792 from $8,042,632. Gross profit margin decreased to
approximately 45% for the three months ended September 30, 2010 from 48% in the
same period in 2009. The decrease in gross profit is attributable to the lack of
new release titles, which sell at a higher price point, in the three months
ended September 30, 2010, as compared to the comparable period in
2009.





Warehousing and Distribution
Expenses. For the three months ended September 30, 2010 and 2009,
warehousing and distribution expenses were $66,089 and $286,511, respectively,
resulting in a decrease of 77%. This decrease is due primarily to a decrease in
units shipped and units currently being held at our third party warehouse when
compared to the same period in 2009.





Sales and Marketing Expenses.
For the three months ended September 30, 2010, sales and marketing expenses
decreased 75% to $896,671 from $3,655,056 for the three months ended September
30, 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 three months
ended September 30, 2010 versus the comparable prior year 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
three months ended September 30, 2010 and 2009 is a non-cash charge of $10,705
and $27,622, respectively, for stock options granted to vendors and other
non-employees.





General and Administrative Expenses.For the three months ended September 30, 2010, general and administrative
expenses decreased $1,182,453 to $1,932,315 from $3,114,768 for the comparable
prior year period. Wages included in general and administrative expenses
decreased from $962,547 for the three months ended September 30, 2009 to
$716,569 for the three months ended September 30, 2010, a decrease of 26%.
Professional fees decreased 88% from $1,277,847 for the three months ended
September 30, 2009 to $153,055 for the three months ended September 30, 2010, as
a result of legal and accounting fees related to litigation in the comparable
period in 2009. Travel and entertainment expenses were $53,323 for the three
months ended September 30, 2009, as compared to $101,077 for the three months
ended September 30, 2010. General and administrative expenses as a percentage of
net revenues increased, to approximately 135% for the three months ended
September 30, 2010 from 19% for the same period in 2009. In addition, for the
three months ended September 30, 2010, general and administrative expenses
includes $142,897 for noncash compensation related to employee stock options and
restricted stock granted, an increase of $14,323, or 11%, from the comparable
period in 2009.





Gain on Settlement of Trade
Payables. For the three months ended September 31, 2010, the gain on
settlement of trade payables was $585,122, 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.





Operating (Loss) Income. For
the three months ended September 30, 2010, our operating loss was $1,668,161, an
increase of $2,654,458, or 269%, over operating income of $986,297 for the same
period in 2009.





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 the Company recorded to
operations during the three months ended September 30, 2010.





Interest and Financing Costs,
Net. For the three months ended September 30, 2010, interest and
financing costs increased to $1,064,096 from $299,316 for the comparable prior
year period due to an increase in average borrowings levels, amortization of
debt issuance costs, and as a result of expense related to the production
advance payable. Amortization of debt issuance costs related to the senior
secured convertible notes for the three months ended September 30, 2010 totaled
$66,092. 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 14, 2009, which amounted to approximately $279,000 for the three months
ending September 30, 2010. The increase in interest and financing costs is also
attributed to amortization of the debt discount associated with the Series A
warrants that were issued with the senior secured convertible notes.
Amortization of the debt discount totaled $361,562 for the three months ended
September 30, 2010.





32





Net (Loss) Income. For the
three months ended September 30, 2010, our net loss was $1,200,934 over net
income of $686,981 for the same period in 2009.





Quarterly
Operating Results Not Meaningful





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





Liquidity
and Capital Resources





Our
primary cash requirements have been to fund (i) the development, manufacturing
and marketing of our videogames, (ii) working capital, and (iii) capital
expenditures. Historically, we have met our capital needs, including working
capital, capital expenditures and commitments, through our operating activities,
our line of credit, 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 $449,926 at September 30, 2010 and $92,893 at June 30,
2010.





Line of Credit. During fiscal
year 2010, we maintained a line of credit with SunTrust that was scheduled to
mature on November 30, 2010. At June 30, 2010, the outstanding line of credit
balance was $3,830,055 and the remaining available under the line of credit
amounted to $-0-. As of July 12, 2010, we repaid in full the entire outstanding
balance owed to SunTrust through a new factoring line of credit.





Factoring Agreement.On July 12, 2010, we
entered into a factoring agreement with Rosenthal & Rosenthal, Inc. (the
“Factoring Agreement”). 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 September 30, 2010, $1,940,268 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
September 30, 2010 and June 30, 2010, amounts due from our three largest
customers comprised approximately 30% 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.





33





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.





Purchase Order Assignment
Agreement. On September 20, 2010, we entered into a master purchase order
assignment agreement (the “Purchase Order Assignment Agreement”) with Wells
Fargo Bank, National Association (“Wells Fargo”). Under the terms of the
Purchase Order Assignment 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 the Purchase Order
Assignment 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. 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, particularly in light of the
general economic downturn. 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.





During
the three months ended September 30, 2010, we had net cash used in operating
activities of $1,319,946, and during the three months ended September 30, 2009,
we had net cash used in operating activities $2,221,544.





During
the three months ended September 30, 2010, investing activities resulted in net
cash used of $16,737 and during the three months ended September 30, 2009,
investing activities resulted in net cash provided of $391,183. The cash
provided was a result of the release of restricted cash during the three months
ended September 30, 2010.





During
the three months ended September 30, 2010, financing activities resulted in net
cash provided of $1,969,094 and during the three months ended September 30,
2009, financing activities resulted in net cash provided of
$1,406,774.





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 September
30, 2010 and 2009, approximately 12% and 28%, 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.





34





Item
3. Quantitative and
Qualitative Disclosures about Market Risk





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





Item
4. Controls and
Procedures





Restatement
of Previously Issued Financial Statements





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





·
            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 September 30, 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 September 30, 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:





35





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





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





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





·
            we
      have appointed a chief financial officer with the requisite experience in
      internal accounting in the videogame industry and made other related
      personnel changes;





·
            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 September 30, 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 Financial
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. In addition,
we have claimed that the grant of the rights to My Baby 3 to Majesco were
unlawful. 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 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. A further hearing was
held on November 9,2010,
in which we sought to affirm the court’s prior judgment reinstating the My Baby
First Steps contract as well as to reinstate the My Baby 1 contract. The court
has not yet rendered any decision regarding these matters. The parties are in
settlement negotiations.





On
September 3, 2010, we, Mr. Phillips, our chairman, and Melanie J. Mroz, our CEO,
have 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





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. 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.





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





None.





Item
3.                 Defaults Upon
Senior Securities





None.





Item
4.                 (Removed and
Reserved)





Item
5.                 Other
Information





None.





Item
6. Exhibits





ExhibitNumber
            
            Exhibit3.1(1)
            
            Amended
      and Restated Certificate of Incorporation.3.2*
            
            First
      Certificate of Amendment of Amended and Restated Certificate of
      Incorporation.3.3(1)
            
            Amended
      and Restated Bylaws.4.1(2)
            
            Form
      of senior secured convertible note.4.2(2)
            
            Form
      of Series A Warrant issued to senior secured convertible note
      holders.4.3(2)
            
            Form
      of Series B Warrant issued to senior secured convertible note
      holders.4.4(3)
            
            Form
      of Additional Notes.10.1(4)
            
            Factoring
      Agreement, dated as of July 7, 2010, between SouthPeak Interactive, L.L.C.
      and Rosenthal & Rosenthal.10.2(2)
            
            Securities
      Purchase Agreement, dated July 16, 2010, among the Company and the
      purchasers named therein.10.3(2)
            
            Pledge
      and Security Agreement dated July 16, 2010 securing senior secured
      convertible notes.10.4(2)
            
            Registration
      Rights Agreement, dated July 19, 2010, executed in conjunction with
      issuance of senior secured convertible notes.10.5(5)
            
            First
      Amendment to May 12, 2008 Registration Rights Agreement dated August 17,
      2010.10.6(3)
            
            Amended
      and Restated Securities Purchase Agreement, dated August 31, 2010, among
      the Company and the purchasers named therein.10.7(6)
            
            Master
      Purchase Order Assignment Agreement, dated September 21, 2010, with Wells
      Fargo Bank, N.A.10.8(6)
            
            Security
      Agreement, dated September 21, 2010, for the benefit of Wells Fargo Bank,
      N.A.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.




37




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 Current Report on Form 8-K of the Registrant filed with the
      Commission on July 22, 2010.


(3)
            Incorporated
      by reference to an exhibit to the Current Report on Form 8-K of the
      Registrant filed with the Commission on September 3,
  2010.


(4)
            Incorporated
      by reference to an exhibit to the Current Report on Form 8-K of the
      Registrant filed with the Commission on July 14,
  2010.


(5)
            Incorporated
      by reference to an exhibit to the Current Report on Form 8-K of the
      Registrant filed with the Commission on August 20,
  2010.


(6)
            Incorporated
      by reference to an exhibit to the Current Report on Form 8-K of the
      Registrant filed with the Commission on September 27,
  2010.




38





SIGNATURES





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





SOUTHPEAK
      INTERACTIVE CORPORATIONBy:
                /s/
      Melanie MrozMelanie
      MrozPresident
      and Chief Executive Officer/s/
      Reba McDermottReba
      McDermottChief
      Financial Officer(Principal
      Accounting Officer)Date:
      November 15, 2010




39





INDEX
TO EXHIBITS





ExhibitNumber
                
                Exhibit3.2
                
                First
      Certificate of Amendment of Amended and Restated Certificate of
      Incorporation.31.1
                
                Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a),
      promulgated under the Securities Exchange Act of 1934, as
      amended.31.2
                
                Certification
      of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a),
      promulgated under the Securities Act of 1934, as
  amended.32.1
                
                Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of
2002.





40