U.S.
SECURITIES AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549




FORM
10-Q




[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT


OF
1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008




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




COMMISSION
FILE NUMBER: 000-24985









PACIFICNET
INC.


(Exact
name of registrant in its charter)





DELAWARE
            91-2118007(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification Number)23/F,
      TOWER A, TIMECOURT, NO.6 SHUGUANG XILI,
              CHAOYANG
      DISTRICT, BEIJING, CHINA 100028
            N/A(Address
      of principal executive offices)
            (Zip
      Code)





Registrant’s
telephone number, including area code:  0086-10-59225000




Indicate
by check mark whether the registrant (1) has filed all reports required 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 o NO þ






Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the
Exchange Act).






Large
Accelerated FileroAccelerated
Filer oNon-accelerated
filerþ






Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).   YES o   NO þ






As of
October 31, 2008, there were 14,123,652 shares of the issuer’s common stock, par
value $0.0001 per share, outstanding.













PACIFICNET
INC.




Form 10-Q
for the Quarterly Period Ended September 30, 2008




TABLE
OF CONTENTS







PART I.
            FINANCIAL INFORMATIONItem
      1.
            Financial
      Statements
            1Consolidated
      Balance Sheets as at September 30, 2008 (Unaudited) and as at December 31,
      2007 (Audited)
            1Consolidated
      Statements of Operations (Unaudited)
            2Consolidated
      Statements of Cash Flows (Unaudited)
            3Notes
      to Consolidated Financial Statements
            4Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            33Item
      3.
            Quantitative
      and Qualitative Disclosures about Market Risk
            44Item
      4.
            Controls
      and Procedures
            47PART II.
            OTHER INFORMATION
            48Item
      1.
            Legal
      Proceedings
            48Item
      1A.
            Risk
      Factors
            48Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            49Item
      3.
            Defaults
      upon Senior Securities
            49Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            49Item
      5.
            Other
      Information
            49Item
      6.
            Exhibits
            49Signatures
            
            50









PART
I - FINANCIAL INFORMATION




ITEM
1. FINANCIAL STATEMENTS




PACIFICNET
INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


(In
thousands of United States dollars, except par values and share
numbers)





September
      30,
            
            
            December
      31,2008
            
            
            2007ASSETS
            
            (Unaudited)Current
      Assets:Cash
      and cash equivalents
            
            $
            1,081
            
            
            $
            1,911Accounts
      receivables, net
            
            
            2,949
            
            
            
            3,990Inventories,
      net
            
            
            596
            
            
            
            451Loan
      receivable from related parties
            
            
            2,326
            
            
            
            2,273Loan
      receivable from third parties
            
            
            561
            
            
            
            815Marketable
      equity securities - available for sale
            
            
            547
            
            
            
            541Current
      assets held for disposition
            
            
            1,149
            
            
            
            4,165Receivable
      in lieu of disposed subsidiary, net
            
            
            3,294
            
            
            
            -Other
      current assets, net
            
            
            851
            
            
            
            520Total
      Current Assets
            
            
            13,354
            
            
            
            14,666Property
      and equipment, net
            
            
            4,038
            
            
            
            4,375Intangible
      assets, net
            
            
            108
            
            
            
            108Investments
      - cost basis
            
            
            294
            
            
            
            120Investment
      - equity method
            
            
            3
            
            
            
            13Goodwill
            
            
            1,079
            
            
            
            602Non-current
      assets held for disposition
            
            
            707
            
            
            
            1,678Other
      receivables
            
            
            -
            
            
            
            1,499TOTAL
      ASSETS
            
            $
            19,583
            
            
            $
            23,061LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      Liabilities:Bank
      line of Credit
            
            $
            5
            
            
            $
            100Bank
      loans-current portion
            
            
            90
            
            
            
            80Accounts
      payable
            
            
            72
            
            
            
            72Accrued
      expenses
            
            
            3,237
            
            
            
            3,402Customer
      deposits
            
            
            258
            
            
            
            514Convertible
      debenture
            
            
            5,515
            
            
            
            5,809Liquidated
      damages liability
            
            
            2,697
            
            
            
            2,697Shares
      to be issued
            
            
            -
            
            
            
            127Liabilities
      related to entity held for disposition
            
            
            3,038
            
            
            
            4,251Total
      Current Liabilities
            
            
            14,911
            
            
            
            17,051Bank
      loans - non current portion
            
            
            1,750
            
            
            
            1,743Convertible
      debenture-non current portion
            
            
            -
            
            
            
            -Total
      long-term liabilities
            
            
            1,750
            
            
            
            1,743TOTAL
      LIABILITIES
            
            
            16,661
            
            
            
            18,794Minority
      interest
            
            
            922
            
            
            
            1,474Commitments
      and contingenciesStockholders'
      Equity:Preferred
      stock, par value $0.0001, Authorized
      5,000,000   sharesIssued
      and outstanding - none
            
            
            -
            
            
            
            -Common
      stock, par value $0.0001, Authorized 125,000,000 sharesIssued
      and outstanding:September
      30, 2008: 30,605,414 shares issued, 15,953,652 outstandingDecember
      31, 2007: 16,887,041 issued, 14,314,072 outstanding
            
            
            1
            
            
            
            1Treasury
      stock, at cost(2008Q3: 14,651,762 shares; 2007: 2,572,969
      shares)
            
            
            (159
            )
            
            
            (145
            )Additional
      paid-in capital
            
            
            72,460
            
            
            
            79,125Shares
      issued as deposit
            
            
            -
            
            
            
            (10,974
            )Cumulative
      other comprehensive income (loss)
            
            
            (1,022
            )
            
            
            200Accumulated
      deficit
            
            
            (68,951
            )
            
            
            (65,070
            )Stock
      subscription receivable
            
            
            (330
            )
            
            
            (345
            )Total
      Stockholders' Equity
            
            
            1,999
            
            
            
            2,792TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
            
            $
            19,583
            
            
            $
            23,061





The accompanying notes form an integral
part of these un-audited consolidated financial statements.




1




PACIFICNET
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS (Unaudited)


(In
thousands of United States dollars, except par share and share
amounts)





Three
      Months Periods Ended
              September
      30,
            
            
            Nine
      Months Periods Ended
              September
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
      RevenuesServices
            
            $
            4,648
            
            
            $
            926
            
            
            $
            2,867
            
            
            $
            3,068Product
      sales
            
            
            1,000
            
            
            
            4,328
            
            
            
            12,200
            
            
            
            12,246Total
      Net Revenues
            
            
            5,648
            
            
            
            5,254
            
            
            
            15,067
            
            
            
            15,314Cost
      of revenuesServices
            
            
            1,062
            
            
            
            509
            
            
            
            2,206
            
            
            
            1,565Product
      sales
            
            
            3,866
            
            
            
            3,565
            
            
            
            10,302
            
            
            
            10,073Total
      Cost of Revenues
            
            
            4,928
            
            
            
            4,075
            
            
            
            12,508
            
            
            
            11,638Gross
      Profit
            
            
            720
            
            
            
            1,179
            
            
            
            2,559
            
            
            
            3,676Selling,
      general and administrative expenses
            
            
            2,336
            
            
            
            1,242
            
            
            
            5,576
            
            
            
            3,371Depreciation
      and amortization
            
            
            106
            
            
            
            120
            
            
            
            309
            
            
            
            321Total
      Operating Expenses
            
            
            2,442
            
            
            
            1,362
            
            
            
            5,884
            
            
            
            3,692Loss
      From Operations
            
            
            (1,722
            )
            
            
            (183
            )
            
            
            (3,325
            )
            
            
            (16
            )Other
      income (Expenses):Interest
      income/(Expenses), net
            
            
            (130
            )
            
            (109)
            
            
            
            (352
            )
            
            
            (313
            )Share
      of earnings from investment on equity method
            
            
            (9
            )
            
            
            (23
            )
            
            
            (101
            )
            
            
            (23
            )Other
      income, net
            
            
            47
            
            
            
            303
            
            
            
            121
            
            
            
            430Total
      Other Income (Expenses)
            
            
            (92
            )
            
            
            171
            
            
            
            (332
            )
            
            
            94Income
      (Loss) from continued operations before Income Taxes and Minority
      Interest
            
            
            (1,813
            )
            
            
            (11
            )
            
            
            (3,657
            )
            
            
            79Provision
      for income taxes
            
            
            3
            
            
            
            -
            
            
            
            3
            
            
            
            -Minority
      interests
            
            
            171
            
            
            
            3
            
            
            
            326
            
            
            
            (524
            )Loss
      from Continued Operations
            
            
            (1,639
            )
            
            
            (8
            )
            
            
            (3,328
            )
            
            
            (445
            )Gain
      (Loss) on disposal
            
            
            (25
            )
            
            
            46
            
            
            
            (83
            )
            
            
            (925
            )Income/
      (Loss) from discontinued operations
            
            
            (275
            )
            
            
            (259
            )
            
            
            (992
            )
            
            
            730Total
      income/ (Loss) from discontinued operations
            
            
            (300
            )
            
            
            (213
            )
            
            
            (1,076
            )
            
            
            (195
            )Net
      Loss
            
            
            (1,939
            )
            
            
            (220
            )
            
            
            (4,404
            )
            
            
            (639
            )Other
      comprehensive income (Loss):Foreign
      currency translation gain (loss)
            
            
            (199
            )
            
            
            (76
            )
            
            
            (365
            )
            
            
            (21
            )Unrealized
      loss on marketable securities
            
            
            (584
            )
            
            
            -
            
            
            
            (857
            )Net
      Comprehensive Income (Loss)
            
            $
            (2,722
            )
            
            $
            (144
            )
            
            $
            (5,625
            )
            
            $
            (660
            )BASIC
      EARNINGS (LOSS) PER COMMON SHARE:Loss
      per share-Continued Operations
            
            $
            (0.11
            )
            
            $
            (0.00
            )
            
            $
            (0.22
            )
            
            $
            (0.03
            )Loss
      per share-Discontinued  Operations
            
            $
            (0.02
            )
            
            $
            (0.02
            )
            
            $
            (0.07
            )
            
            $
            (0.02
            )Basic
      – Income (Loss) per share
            
            $
            (0.13
            )
            
            $
            (0.02
            )
            
            $
            (0.29
            )
            
            $
            (0.05
            )DILUTED
      EARNINGS (LOSS) PER COMMON SHARE:Loss
      per share-Continued Operations
            
            $
            (0.13
            )
            
            $
            (0.00
            )
            
            $
            (0.22
            )
            
            $
            (0.03
            )Loss
      per share-Discontinued Operations
            
            $
            (0.02
            )
            
            $
            (0.02
            )
            
            $
            (0.07
            )
            
            $
            (0.02
            )Diluted
      – Income (Loss) per share
            
            $
            (0.13
            )
            
            $
            (0.02
            )
            
            $
            (0.29
            )
            
            $
            (0.05
            )Weighted
      average number of shares-Basic
            
            
            14,763,009
            
            
            
            11,931,094
            
            
            
            15,226,975
            
            
            
            11,805,686Weighted
      average number of shares- Diluted
            
            
            14,763,009
            
            
            
            12,027,315
            
            
            
            15,226,975
            
            
            
            11,858,870





The
accompanying notes form an integral part of these un-audited consolidated
financial statements.




2




PACIFICNET
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Unaudited)


(In
thousands of United States dollars)





For
      the Nine Month Periods Ended
              September
      30,2008
            
            
            2007Cash
      Flows From Operating ActivitiesNet
      Loss
            
            $
            (4,404
            )
            
            $
            (639
            )Adjustment
      to reconcile net earnings/(loss) to net cash provided by (used in)
      operating activities:Provision
      for allowance for doubtful accounts
            
            
            456
            
            
            
            1,083Minority
      Interest
            
            
            (326
            )
            
            
            524Amortization
      of debt discount
            
            
            357
            
            
            
            -Depreciation
      and amortization
            
            
            309
            
            
            
            321Share
      of earnings from investment on equity method
            
            
            101
            
            
            
            23Loss/(gain)
      from discontinued operations
            
            
            1,075
            
            
            
            195Stock-based
      compensation
            
            
            670
            
            
            
            -Change
      in fair value of derivatives
            
            
            -
            
            
            
            (143
            )Changes
      in current assets and liabilities net of effects from purchase of
      subsidiaries:Accounts
      receivable and other current assets
            
            
            (1,716
            )
            
            
            (618
            )Inventories
            
            
            (145
            )
            
            
            (365
            )Accounts
      payable and other accrued expenses
            
            
            903
            
            
            
            964Net
      cash provided by (used in) operating activities of continued
      operations
            
            
            (2,720
            )
            
            
            1,345Net
      cash provided by operating activities of discontinued
      operations
            
            
            -
            
            
            
            2,488Net
      cash provided by (used in) operating activities
            
            
            (2,720
            )
            
            
            3,833Cash
      Flows From Investing Activities:Increase
      in purchase of marketable securities
            
            
            -
            
            
            
            (474
            )Acquisition
      of property and equipment
            
            
            8
            
            
            
            (828
            )Acquisition
      of subsidiaries and affiliated companies
            
            
            (60
            )
            
            
            -Repurchase
      of treasury shares
            
            
            (15
            )
            
            
            127Net
      cash provided by (used in) investing activities of continued
      operations
            
            
            (67
            )
            
            
            (1,175
            )Net
      cash provided by investing activities of discontinued
      operations
            
            $
            1,897
            
            
            $
            122Net
      cash provided b y( used in) investing activities
            
            $
            1,830
            
            
            $
            (1,053
            )Cash
      Flows From Financing Activities:Loans
      receivable from third parties
            
            
            109
            
            
            
            (1,361
            )Loans
      receivable from related parties
            
            
            166
            
            
            
            (521
            )Loans
      payable to related party
            
            
            -
            
            
            
            212Advances
      (repayments) under bank line of credit
            
            
            (95
            )
            
            
            20Proceeds
      from exercise of stock options and subscription
            
            
            -
            
            
            
            96Advances
      under bank loans
            
            
            17
            
            
            
            766Net
      proceeds from issuance of convertible debenture
            
            
            (150
            )
            
            
            (1,790
            )Net
      cash provided by(used in) financing activities of continued
      operations
            
            
            47
            
            
            
            (2,578
            )Net
      cash provided by(used in) financing activities of discontinued
      operations
            
            
            -
            
            
            
            -Net
      cash provided by(used in) financing activities
            
            
            47
            
            
            
            (2,578
            )Effect
      of exchange rate change on cash and cash equivalents
            
            
            13
            
            
            
            20NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
            
            $
            (830
            )
            
            $
            222CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            1,911
            
            
            
            1,778CASH
      AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            1,081
            
            
            $
            2,000SUPPLEMENTAL
      CASH FLOW INFORMATION:Interest
      paid
            
            $
            (6
            )
            
            $
            -Income
      taxes paid
            
            $
            (3
            )
            
            $
            -NON-CASH
      INVESTING AND FINANCING ACTIVITIES:Investments
      in subsidiaries and affiliate through issuance of common
    stock
            
            $
            229
            
            
            $
            -Issuance
      of common stock for payment of convertible debenture
            
            
            501
            
            
            
            -Options
      exercised for shares receivable
            
            
            -
            
            
            
            484Investment
      in marketable securities by issuing shares
            
            
            1,245
            
            
            
            -Issuance
      of shares as a part of acquisition agreement
            
            
            593
            
            
            
            -Issuance
      of shares for accrued compensation
            
            
            1,087
            
            
            
            -Redemption
      of convertible debenture
            
            $
            -
            
            
            $
            1,091








The
accompanying notes form an integral part of these un-audited consolidated
financial statements.





3




PACIFICNET
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
expressed in United States dollars unless otherwise stated)





1.
BASIS OF PRESENTATION




Description of
Operations- PacificNet Inc. (“PacificNet” or the “Company”) is a leading
provider of e-commerce, gaming and mobile game technology worldwide with a focus
on emerging markets in Asia, Latin America and Europe. PacificNet's gaming
products are localized to their specific markets creating an enhanced user
experience for players and larger profits for operators.




Consolidated
Interim Financial Statements- The consolidated financial
statements have been prepared in accordance with U.S. generally accepted
accounting principles (“GAAP”) for interim financial reporting consistent in all
material respects with those applied in the Company’s Annual Report on Form
10-K, as amended, for the year ended December 31, 2007, but do not include
all disclosures required by GAAP. You should read these interim consolidated
financial statements in conjunction with the audited financial statements,
including the notes thereto, and the other information set forth in the
Company’s Annual Report on Form 10-Kfor the year ended December 31,
2007. The unaudited consolidated financial statements include the accounts of
PacificNet Inc. and its subsidiaries and variable interest entities (“VIEs”) for
which the Company is the primary beneficiary. All significant intercompany
balances and transactions have been eliminated in consolidation. In the opinion
of management, all material adjustments considered necessary for a fair
presentation of the Company’s interim results have been reflected. PacificNet’s
2007 Annual Report on Form 10-K includes certain definitions and a summary of
significant accounting policies and should be read in conjunction with this
report. The results for interim periods are not necessarily indicative of
annual results.




Use of
Estimates - The preparation of the consolidated financial statements in
conformity with GAAP requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates, and such differences may be material
to the financial statements. Certain prior year amounts have been reclassified
to conform to the current year presentation.




Reclassification- Certain items in the accompanied consolidated financial statements have
been reclassified for comparative purposes.




Going
Concern




As shown
in the accompanying consolidated financial statements, the Company incurred
accumulated losses of $69 million and $65 million as of September 30, 2008 and
December 31, 2007, respectively. Negative cash flows used in the operations were
$2.72 million for the nine months ended September 30, 2008. These matters raise
substantial doubt about the Company’s ability to continue as a going
concern.




4




In view
of the matters described in the preceding paragraph, recoverability of a major
portion of the recorded asset amounts shown in the accompanying balance sheet is
dependent upon continued operations of the Company, which in turn is dependent
upon the Company’s ability to raise additional capital, obtain financing and to
succeed in its future operations. The financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or amounts and classification of liabilities that might be necessary
should the Company be unable to continue as a going concern.




The
Company has taken certain restructuring steps to provide the necessary capital
to continue its operations. These steps included, but not limited to: 1)
accelerate disposal and spin-off of unprofitable or unfavorable
return-on-investment operations; 2) focus on execution of the new high potential
gaming business initiatives; 3) acquisition of profitable and/or strategic
operations through issuance of equity instruments; 4) formation of strategic
relationship with key gaming operators in Asia; and 5) issuance and/or
restructure of new long-term convertible debentures.




On April
18, 2008, the Company entered into a Sale and Purchase agreement to dispose of
its equity interest in PacificNet Epro Holdings Limited for a consideration of
HK$21 million (See Note 12).




On August
18, 2008, the Company entered into a purchase agreement to acquire 19% equity
interest of a Chinese lottery company called Universal KingLott (Beijing) Tech
Co., Ltd. (See Note 14)




On
September 1, 2008, the Company entered into a purchase agreement to acquire 18%
equity interest of Guangdong Poly Blue Express Communications Co., Ltd. (See
Note 14)




On
September 4 through 23, 2008, the Company entered into various definitive
agreements to dispose and reduce its equity interests in certain money losing
non-gaming operations from 15% to 0%, namely: MOABC, Clickcom, Pacificnet
Solutions Limited (PacSo), Pacificnet Power Limited (PactPower). The company
also entered into a definitive agreement with Pacificnet Ad Limited (PacAd) to
dispose and reduce its equity interests from 19% to 0%.




On March
27, 2008, three holders of PacificNet's Convertible Subordinated Debentures
filed an involuntary petition for Chapter 11 relief in federal bankruptcy court
on Saturday, March 22, 2008 in Wilmington, Delaware. The Company retained
counsel to oppose the filing because the petition fails to meet the standard for
invoking an involuntary bankruptcy and fails to take into consideration other
agreements between the Company and the petitioning creditors. Subsequently,
PacificNet also received default notice from all but one of the debenture
holders including Iroquois Master Fund Ltd., Alpha Capital AG, Whalehaven
Capital Fund Limited, DKR Soundshore Oasis Holding Fund Ltd., Basso Fund Ltd.,
Basso Multi-Strategy Holding Fund Ltd., and Basso Private Opportunities Holding
Fund Ltd. from the same Convertible Subordinated Debentures related to the
private offering of $8,000,000 principal amount variable debentures consummated
on March 13, 2006, and due March 2009.




The
amount of the debt in question was as follows: Iroquois Master Fund Ltd. $2.5
million, Whalehaven Capital Fund Limited $958,000, Alpha Capital AG $685,000 DKR
Soundshore Oasis Holding Fund Ltd $960,000, and Basso Fund Ltd., Basso Multi-
Strategy Holding Fund Ltd., and Basso Private Opportunities Holding Fund Ltd., a
combined amount of $500,000.




5




As of
August 29, 2008, PacificNet entered into a Settlement Agreement with certain
bondholders who had filed an involuntary petition seeking Chapter 11 relief in
Delaware federal bankruptcy court. Pursuant to the terms of the Settlement
Agreement, the Company has amended and restated the terms of certain convertible
debentures in the aggregate principal amount of approximately $6.2 million (the
"Debentures").  Upon entering into the Settlement Agreement, the
Company paid $150,000 of the obligations under the Debentures in cash and issued
668,321 shares of common stock to the bondholders upon conversion of a portion
of the Debentures. The remaining outstanding Debentures in the aggregate
principal amount of approximately $5.5 million are convertible at a conversion
price of $2.00 per share, subject to the terms and conditions of the
Debentures.




The
settlement of debt hasn’t changed the amount of debt (principal and accrued
interests.) but the payment schedule. The settlement price is $0.75, no gain or
loss on settlement of Debt. For the original 8M debentures, we should
pay $5,162,415 (principal outstanding and accrued interest) as of August
29, 2008 (settlement date), we had paid $150,000 in cash and $501,000 in shares
during the third quarter, the remaining $4,511,415 should be paid in 10
installments beginning October 15, 2008. In addition we
owe   $945,000 in new debentures and $58,000 accrued interests on
the new debentures. As at September 30, 2008 we owe 5.5 million in old and new
debentures including interest.




2.
RECENT ACCOUNTING PRONOUNCEMENTS




In May of
2008, FASB issued SFASB No. 163, Accounting for Financial Guarantee Insurance
Contracts-an interpretation of FASB Statement No. 60.  The scope of
the statement is limited to financial guarantee insurance (and reinsurance)
contracts.  The pronouncement is effective for fiscal years beginning
after December 31, 2008.  The company does not believe this
pronouncement will impact its financial statements.




In May 0f
2008, FSAB issued SFASB No.162, The Hierarchy of Generally Accepted Accounting
Principles.  The pronouncement mandates the GAAP hierarchy reside in
the accounting literature as opposed to the audit literature.  This
has the practical impact of elevating FASB Statements of Financial Accounting
Concepts in the GAAP hierarchy.  This pronouncement will become
effective 60 days following SEC approval.  The company does not
believe this pronouncement will impact its financial statements.




On March
19, 2008, FASB issued SFAS No. 161, Disclosures about Derivative Instruments and
Hedging Activities. The new standard is intended to improve financial reporting
about derivative instruments and hedging activities by requiring enhanced
disclosures to enable investors to better understand their effects on an
entity's financial position, financial performance, and cash flows. It is
effective for financial statements issued for fiscal years and interim periods
beginning after November 15, 2008, with early application encouraged. Currently
the Company does not carry any derivative instruments and the adoption of this
statement may not have any effect on the financial statements.




In
December 2007, FASB issued FASB Statement No. 160, Non-controlling Interests in
Consolidated Financial Statements—an amendment of ARB No. 51. This Statement
applies to all entities that prepare consolidated financial statements, except
not-for-profit organizations, but will affect only those entities that have an
outstanding non-controlling interest in one or more subsidiaries or that
deconsolidate a subsidiary. Not-for-profit organizations should continue to
apply the guidance in Accounting Research Bulletin No. 51, Consolidated
Financial Statements, before the amendments made by this Statement, and any
other applicable standards, until the Board issues interpretative guidance. This
Statement is effective for fiscal years, and interim periods within those fiscal
years, beginning on or after December 15, 2008 (that is, January 1, 2009, for
entities with calendar year-ends). Earlier adoption is prohibited. The effective
date of this Statement is the same as that of the related Statement 141(R). This
Statement shall be applied prospectively as of the beginning of the fiscal year
in which this Statement is initially applied, except for the presentation and
disclosure requirements. The presentation and disclosure requirements shall be
applied retrospectively for all periods presented. Management is currently
evaluating the effect of this pronouncement on financial
statements.




6




In
December 2007, the FASB issued SFAS No. 141(R), "Business Combinations". This
Statement replaces SFAS No. 141, Business Combinations. This Statement retains
the fundamental requirements in Statement 141 that the acquisition method of
accounting (which Statement 141 called the purchase method) be used for all
business combinations and for an acquirer to be identified for each business
combination. This Statement also establishes principles and requirements for how
the acquirer: a) recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, and any non-controlling
interest in the acquirement; b) recognizes and measures the goodwill acquired in
the business combination or a gain from a bargain purchase and c) determines
what information to disclose to enable users of the financial statements to
evaluate the nature and financial effects of the business combination. SFAS No.
141(R) will apply prospectively to business combinations for which the
acquisition date is on or after Company's fiscal year beginning October 1, 2009.
While the Company has not yet evaluated this statement for the impact, if any,
that SFAS No. 141(R) will have on its consolidated financial statements, the
Company will be required to expense costs related to any acquisitions after
September 30, 2009.




3.
EARNINGS PER SHARE




Basic and
diluted earnings or loss per share (EPS) amounts in the financial statements are
computed in accordance with SFAS No. 128, "Earnings Par Share." Basic EPS is
based on the weighted average number of common shares outstanding. Diluted EPS
is based on the weighted average number of common shares outstanding plus
dilutive common stock equivalents. Basic EPS is computed by dividing net
income/loss available to common stockholders (numerator) by the weighted average
number of common shares outstanding (denominator) during the period Diluted EPS
is calculated by dividing net earnings by the weighted average number of common
shares outstanding and other dilutive securities. Dilutive earnings per share
for the period ended September 30, 2008 exclude the potential dilutive effect of
all the 1,007,138 warrants outstanding because their impact would be
anti-dilutive based on current market prices. 2,255,587 convertible debentures
are tested by using if-converted method. The result shows when convertible
debentures are included in the computation, diluted LOSS PER SHARE increases,
therefore excluded from calculation as the effect is anti-dilutive. According to
SFAS No.128, those convertible debentures are ignored in the computation of
diluted EPS. All per share and per share information are adjusted retroactively
to reflect stock splits and changes in par value.




7




The
reconciliation of the numerators and denominators of the basic and diluted EPS
calculations was as follows (IN THOUSANDS OF UNITED STATES DOLLARS, EXCEPT
WEIGHTED SHARES AND PER SHARE AMOUNTS):





Three
      Months Ended September 30
            
            
            Nine
      Months Ended September 302008
            
            
            2007
            
            
            2008
            
            
            2007Numerator:
      Net Earnings/ (Loss)
            
            $
            (1,939
            )
            
            $
            (220
            )
            
            $
            (4,404
            )
            
            $
            (639
            )Denominator:Weighted-average
      number of shares –Basic
            
            
            14,763,009
            
            
            
            11,931,094
            
            
            
            15,226,975
            
            
            
            11,805,686Weighted-average
      number of shares – Diluted
            
            
            14,763,009
            
            
            
            12,027,315
            
            
            
            15,226,975
            
            
            
            11,858,870Basic
      Earnings/ ( Loss) per share:
            
            $
            (0.13
            )
            
            $
            (0.02
            )
            
            $
            (0.29
            )
            
            $
            (0.05
            )Diluted
      Earnings/ ( Loss) per share:
            
            $
            (0.13
            )
            
            $
            (0.02
            )
            
            $
            (0.29
            )
            
            $
            (0.05
            )




4.
OTHER CURRENT ASSETS




Other
current assets consist of the following at September 30, 2008 (in
thousands):




(USD
      ' 000s)
            
            September
      30, 2008 (Unaudited)
            
            
            December
      31, 2007Prepayment
      to suppliers
            
            $
            377
            
            
            $
            175Deposit
            
            
            238
            
            
            
            534Loans
      to employees
            
            
            188
            
            
            
            273Prepaid
      expenses
            
            
            106
            
            
            
            122Loan
      to Golden Chapel
            
            
            517
            
            
            
            517Other
      Receivables
            
            
            916
            
            
            
            518Receivables
      WeiDa for disposal Linkhead
            
            
            44
            
            
            
            150Loan
      to Beijing Webp
            
            
            406
            
            
            
            237Loan
      to Mou Yi Liang
            
            
            244
            
            
            
            244Loan
      to Bell-Pact Shanghai JV
            
            
            -
            
            
            
            102Loan
      to Beijing UASIT
            
            
            134
            
            
            
            96Provision
      for Doubtful Account
            
            
            (2,320
            )
            
            
            (2,448
            )Total
            
            $
            850
            
            
            $
            520




8




5.
GOODWILL AND BUSINESS ACQUISITIONS




The
changes in the carrying amount of goodwill for the following reporting periods
are summarized below:




Group
      1.
            
            
            Group
      2.
            
            
            Group
      3.(US$000s)
            
            Outsourcing
              Services
            
            
            Telecom
              Value-Added
              Services
            
            
            Products
              (Telecom
      &
              Gaming)
            
            
            TotalBalance
      as of December 31, 2007
            
            $
            -
            
            
            $
            193
            
            
            $
            409
            
            
            $
            602Goodwill
      acquired during the first quarter
            
            
            -
            
            
            
            -
            
            
            
            477
            
            
            
            477Balance
      as of September 30, 2008 (Unaudited)
            
            $
            
            
            
            $
            193
            
            
            $
            986
            
            
            $
            1,079





On
January 5, 2008 the Company has a supplementary agreement with Take 1 Technology
to issue all the shares as per the conditions set forth in the S&P agreement
dated January 5, 2007. Based upon the supplementary agreement, the Company was
required to issue the shares without the conditions on January 5, 2008. As a
result, the Company issued 120,000 shares to Take 1 on January 9, 2008 valued at
$477,000. The Company also issued 29,459 shares as committed on January 5, 2007
and classified as “Shares to be issued” as at December 31, 2007. The Company
recorded 120,000 additional shares at the fair market value at the date of
issuance on January 9, 2008. This additional issuance of shares contributed to
the increase in goodwill amounting to $477,000.





6.
ACCRUED EXPENSES





Accrued
expenses comprises of the following as of September 30, 2008 and December 31,
2007.





(in
      thousands of US Dollars):
            
            September
      30, 2008 (Unaudited)
            
            
            December
      31, 2007Professional
      fee
            
            $
            621
            
            
            $
            480Director
      fee
            
            
            103
            
            
            
            111Salaries
      and benefit payable
            
            
            121
            
            
            
            1,042Marketing
      expense
            
            
            477
            
            
            
            973Income
      tax payable
            
            
            6
            
            
            
            3Others
            
            
            1,909
            
            
            
            793Total
            
            $
            3,237
            
            
            $
            3,402




9




7.
STOCKHOLDERS' EQUITY




a) COMMON
STOCK




For the
Nine months period ended September 30, 2008, the Company had the following
equity transactions:




(i)
2,036,800 restricted PacificNet shares were issued as settlement of director
fees and certain employee compensation fees and executive bonuses, such shares
were valued at $1,751,800;


(ii)
10,000 PacificNet shares were repurchased from open market at $1.48 per
share;


(iii)
149,459 PacificNet shares were issued to Take 1 from escrow as consideration of
30% of Take 1’s equity interests;


(iv)
825,000 PacificNet treasury shares were issued to Shenzhen GuHaiGuangChao’s
shareholder under a share swap agreement dated March 28, 2008. In exchange for
the issuance of the 825,000 PACT treasury shares issued to the shareholder of
GHGC, we received 16,860,000 shares of First China Financial Holdings Ltd.
(“FirstChina” formerly “IFN”, listed on the HK Stock Exchange as 8123.HK) which
was issued to PacificNet Strategic Investment Holdings Limited, a wholly owned
subsidiary of PacificNet. The Company recorded unrealized loss of $857,000 on
the marketable securities as at September 30, 2008 as stipulated per SFAS
115;


(v)
1,350,000 shares were issued to Mutual International Ltd for acquisition
purpose. As the acquisition was not materialized, these shares are now held by
PacificNet as treasury shares;


(vi) As a
result of the failure of the Octavian acquisition to be consummated and the
termination of the acquisition agreement, Octavian returned the PacificNet
shares issued to it before. These 2,330,000 shares are treated as treasury
shares;


(vii) As
a result of the settlement with certain bondholders who had filed an involuntary
petition seeking Chapter 11 relief in Delaware federal bankruptcy court earlier
this year, PacificNet issued 668,321 shares of common stock to the bondholders
upon conversion of a portion of the Debentures; besides, in connection with the
execution of the Settlement Agreement, PacificNet and the Debenture Holders
simultaneously entered into an Escrow Agreement, Pursuant to the terms of
the Conversion Shares Escrow Agreement, PacificNet delivered stock certificates
representing a total of9,363,252shares of
common stock of PacificNet to Continental Stock Transfer & Trust Company
representing the number of shares of common stock of PacificNet issuable upon
full conversion of the debentures, based upon a conversion price equal to the
Escrow Conversion Price;


(viii)
60,000 shares were issued to Gu Hao for acquisition purpose;


(ix)
240,000 shares were issued to WONG TSZ YU for acquisition purpose.




b) STOCK
OPTION PLAN




Prior to
January 1, 2006, PacificNet accounted for awards granted under stock-based
compensation plans following the recognition and measurement principles of APB
25, Accounting for Stock Issued to Employees, and related interpretations.
Accordingly, compensation expense was recognized for awards granted at an
exercise price less than fair market value of the underlying common stock on the
date of grant. Effective January 1, 2006, PacificNet adopted the fair value
recognition provisions of SFAS 123(R). See Note 2 for a description of the
Company’s adoption of SFAS 123R. The fair value of stock options is determined
using the Black-Scholes option pricing model, which is consistent with the
valuation techniques previously utilized for options in footnote disclosures
required under SFAS 123, as amended by FASB Statement No.148, “Accounting for
Stock-Based Compensation - Transition and Disclosure.” The determination of the
fair value of stock-based compensation awards on the date of grant using an
option-pricing model is affected by the Company’s stock prices as well as
assumptions regarding a number of complex and subjective variables, including
the expected volatility of the Company’s stock price over the term of the
awards, actual and projected employee stock option exercise behaviors, risk-free
interest rate and expected dividends. The valuation provisions of SFAS 123(R)
apply to new grants and unvested grants that were outstanding as of the
effective date. For the Nine months ended September 30, 2008, no new options
were granted and 1,650 options were vested, thus the option-related compensation
cost is $4,545.. PacificNet elected the modified prospective method and
therefore has not restated results for prior periods due to 123R.




10




The
status of the Stock Option Plan as of September 30, 2008, is as
follows:




OPTIONS
      OUTSTANDING
            
            
            WEIGHTED
              AVERAGE
              EXERCISE
      PRICEOUTSTANDING,
      DECEMBER 31, 2006
            
            
            370,500
            
            
            $
            2.00Granted
            
            
            806,000
            
            
            
            4.26Cancelled
            
            
            (941,500
            )
            
            
            2.00Exercised
            
            
            (202,000
            )
            
            
            2.00OUTSTANDING,
      DECEMBER 31, 2007
            
            
            33,000
            
            
            
            4.31Granted
            
            
            -
            
            
            
            -Cancelled
            
            
            -
            
            
            
            -Exercised
            
            
            -
            
            
            
            -OUTSTANDING,
      SEPTEMBER 30, 2008
            
            
            33,000
            
            
            
            4.31




Following
is a summary of the status of options outstanding at September 30,
2008:




Grant
      Date
            
            
            Total
      Options
              Outstanding
            
            
            Aggregate
              Intrinsic
      Value
            
            
            Weighted
      Average Remaining
              Life
      (Years)
            
            
            Total
      Weighted
              Average
              Exercise
      Price
            
            
            Option
              Exercisable
            
            
            Weighted
              Average
              Exercise
      Price2007-8-13
            
            
            
            33,000
            
            
            $
            0
            
            
            
            4.87
            
            
            $
            4.31
            
            
            
            -
            
            
            $
            4.31




PacificNet
previously granted 788,000 options on August 11, 2007; however, as most of the
optionees did not sign or execute the option agreements before December 31,
2007, most of the options have been forfeited except for 33,000 options. These
options vesting commenced from August 8, 2008 with a 5% per quarter vesting
schedule, and the corresponding compensation costs will be recorded within the
vesting period. The weighted-average fair value of such options was $2.75.The
assumptions used in calculating the fair value of options granted using the
Black-Scholes option-pricing model are as follows:




Risk-free
      interest rate
            4.51%Expected
      life of the options
            5.86
      yearsExpected
      volatility
            67.44%Expected
      dividend yield
            0%




No other
options were granted, exercised, cancelled for the nine months ended September
30, 2008.




1,650
options were vested during the quarter ended September 30, 2008. The option
related compensation cost is $4,545.




11




c)
WARRANTS




At
September 30, 2008, the Company had outstanding and exercisable warrants to
purchase an aggregate of 1,007,138 shares of common stock. The weighted average
remaining life is 1.59 years and the weighted average exercise price per share
is $10.61 per share.




Following
is a summary of the warrant activity:




Warrantsoutstanding
            
            
            WEIGHTED
      AVERAGEEXERCISE PRICE
            
            
            Aggregate
              Intrinsic ValueOUTSTANDING,
      DECEMBER 31, 2006
            
            
            1,007,138
            
            
            $
            10.61
            
            
            $
            -GrantedForfeitedExercisedOUTSTANDING,
      DECEMBER 31, 2007
            
            
            1,007,138
            
            
            $
            10.61
            
            
            $
            -GrantedForfeitedExercisedOUTSTANDING,
      SEPTEMBER 30 ,2008
            
            
            1,007,138
            
            
            $
            10.61
            
            
            $
            -





Following is a summary of the status of
warrants outstanding at September 30, 2008:




Grant Date
            
            
            Total
      warrants
              Outstanding
            
            
            Weighted
      Average
              Remaining
      Life (Years)
            
            
            Total
      Weighted
              Average
              Exercise
      Price
            
            
            Warrants
              Exercisable
            
            
            Weighted
              Average
              Exercise
      Price2004-1-15
            
            
            
            123,456
            
            
            
            0.29
            
            
            $
            7.15
            
            
            
            123,456
            
            
            $
            7.152004-11-15
            
            
            
            117,682
            
            
            
            1.13
            
            
            $
            3.89
            
            
            
            117,682
            
            
            $
            3.892004-12-9
            
            
            
            350,000
            
            
            
            1.19
            
            
            $
            12.21
            
            
            
            350,000
            
            
            $
            12.212006-3-13
            
            
            
            416,000
            
            
            
            2.45
            
            
            $
            12.20
            
            
            
            416,000
            
            
            $
            12.20




No
warrants were granted, cancelled and exercised during the nine months period
ended September 30, 2008.




12




d)
TREASURY STOCK




The
following is a summary of the movement of the Company's shares held as treasury
stock for the quarter ended September 30, 2008:




Number
      of shares
            
            NoteEscrow
      shares returned to treasury on
            
            
            800,000Repurchase
      in the open market
            
            
            50,888Repurchase
      of shares from Take1
            
            
            149,459Cancellation
      of former employee shares
            
            
            45,000Holdback
      shares as contingent consideration due to performance targets not yet
      met
            
            
            4,209,848
            
            (1)Incomplete
      Acquisition of ChinaGoHi (GHGC)
            
            
            825,000Cancellation
      of acquisition of Allink
            
            
            200,000Repurchase
      of shares from Yueshen
            
            
            24,200Shares
      sold to the open market
            
            
            (41,426
            )Settlement
      with GHGC & Share Exchange with FirstChina
            
            
            (825,000
            )Issuance
      149,459 shares to Take 1
            
            
            (149,459
            )Settlement
      with Convertible debentures holders
            
            
            9,363,252Balance,
      September 30, 2008
            
            
            14,651,762Shares
      outstanding at September 30, 2008
            
            
            15,953,652Shares
      issued at September 30, 2008
            
            
            30,605,414





(1)  Includes
shares related to Clickcom acquisition: 78,000 PacificNet shares; Guangzhou
Wanrong acquisition: 138,348 PacificNet shares; iMobile acquisition: 153,500
PacificNet Shares; PacificNet Games Limited (PGL): 160,000 PacificNet shares;
Octavian acquisition: 2,330,000 PacificNet shares, and G-lot acquisition:
1,350,000 PacificNet shares.





8.
CONVERTIBLE DEBENTURES




8.1
Eight Million Convertible Debentures




On March
13, 2006, we completed a private placement in which we sold $8,000,000 in
convertible debentures and issued warrants to purchase up to an aggregate of
400,000 shares of common stock. The debentures are convertible at any time into
shares of our common stock at an initial fixed conversion price of $10.00 per
share, subject to adjustments for certain dilutive events. The debentures are
due March 13, 2009. The warrants are exercisable for a period of five years at
an exercise price of $12.20 per share. At the closing of the private placement,
we prepaid the first year's interest on debentures equal to 5% of the aggregate
principal amount of debentures. We will pay interest in cash or shares, provided
that certain conditions are met, at the rate of 6% for the second year the
debentures are outstanding and then 7% for the third. Beginning January 1, 2007,
we are obligated to redeem up to $320,000 every month, plus accrued, but unpaid
interest, liquidated damages and penalties. We also have the option to prepay
the debentures at any time, provided that certain conditions have been met,
after the 12 month anniversary of the effective date of the registration
statement that has been filed with the Securities and Exchange Commission with
respect to the common stock issuable upon conversion of the debentures, some or
all of the outstanding debentures for cash in an amount equal to 120% of the
principal amount outstanding, plus accrued, but unpaid interest, liquidated
damages and penalties outstanding. At any time after the nine months anniversary
of the effective date of the registration statement, we may force the holders to
convert up to 50% of the then outstanding principal amount of the debentures,
subject to certain trading conditions being met. If any event of default occurs
under the debentures or other related documents, the holders may elect to
accelerate the payment of the outstanding principal amount of the debenture,
plus accrued, but unpaid interest, liquidated damages and penalties, which shall
become immediately due and payable.




13




Under the
terms of a registration rights agreement entered into at the time of the private
placement, the Company was obligated to file a registration statement with
respect to the shares issuable under the debenture and the warrants by April 30,
2006, and have the registration statement declared effective by the SEC no later
than June 28, 2006. Due to various factors, the Company did not file the
registration statement until May 15, 2006, and it was not declared effective
until December 8, 2006. Therefore, under the terms of the registration rights
agreement, the Company was obligated to pay liquidated damages to the investors
at the rate of 2% of the principal amount of the debenture each month beginning
on June 28, 2006 until the effectiveness of the registration statement, which
was equal to $1,120,000, in the aggregate.




In
February 2007, upon reaching an agreement on the amount and payment of accrued
liquidated damages, the Company signed a Settlement and Release Agreement with
each of the investors. Under the terms of the Settlement and Release Agreements,
the Company paid an aggregate $140,000 in cash as satisfaction in full of
liquidated damages owed to Basso Fund Ltd., Basso Multi-Strategy Holding Fund
Ltd., and Basso Private Opportunities Holding Fund Ltd. Partial liquidated
damages owed to Whalehaven Capital Fund Ltd. were paid in the amount of $35,000
in cash, with the remaining liquidated damages in the amount of $105,000 paid in
the form of a new convertible debenture due February 2009, on substantially the
same terms as the original debentures, except that interest only is paid on the
new debentures until October 2008 and beginning in November 2008 until February
2009, when the new debentures are due, the monthly redemption amount under the
new debentures shall be equal to $315,000. The remaining investors also agreed
to accept the aggregate $840,000 in liquidated damages owed to them in the form
of the new convertible debentures for the amount of their respective portion of
the liquidated damages. The Company also agreed to amend the original debentures
to shorten the term for payment of the original principal amount to a 22 month
term. As a result the monthly redemption amount for the original debenture
increased from $320,000 to $ 363,638. All other terms and conditions of the
original debenture remain in full force and effect.




C.E.
Unterberg, Towbin L.L.C. acted as placement agent and received a negotiated cash
fee in the amount of $449,500 and a warrant to purchase up to 16,000 shares at
an exercise price of $12.20 per share, which expire five years from the date of
issuance. The fair value of these warrants totaled $28,141. Such amount was
charged to other assets, net, and credited to additional paid-in capital and
will be amortized over the life of the debentures. Maxim Group also acted as
Placement Agent and received a cash fee in the amount of $50,000.




In
connection with the issuance of the debentures, the Company incurred $1,106,135
of issuance costs, which primarily consisted of investment banker fees, legal
and other professional fees. These costs have been recorded as additional
expense during year 2006.




CHANGE IN
ACCOUNTING PRINCIPLE: On January 1, 2007, the Company adopted FSP EITF 00-19-2
and reclassified warranty liability to equity thru cumulative – effect
adjustment to the opening balance of retained earnings/loss by
$213,000.




14




The FSP
states that for registration payment arrangements and financial instruments
subject to those arrangements that were entered into prior to the issuance of
the FSP and that continue to be outstanding at the beginning of the period of
adoption, transition shall be achieved by reporting a change in accounting
principle through a cumulative effect adjustment to the opening balance of
retained earnings, or other appropriate component of equity or net assets in the
statement of financial position, in the first interim period of the fiscal year
in which this FSP is initially applied. No prior period information is
retrospectively adjusted following the transition provisions of
FSP.




EVENT OF
DEFAULT




On March
16, 2007 our predecessor auditor withdrew their opinion on our previously filed
financial statements for the years ended December 31, 2005, December 31, 2004
and December 31, 2003. As a result, on March 27, 2007, we notified the holders
of the outstanding convertible debenture that we suspended use of the prospectus
contained in our Registration Statement on Form S-1 (File No. 333-134127) that
was declared effective on December 8, 2006, due to the lack of fiscal year end
2005 and 2004 audited financial statements and that they must cease selling
under the prospectus. The suspension of the use of the prospectus after April
17, 2007, triggered an event of default under the registration rights agreement
and the convertible debentures, and if any of the holders so elect, they could
accelerate and demand payment under the debentures, in accordance with the
registration rights agreement based on the following provisions.




a)           "If,
during the Effectiveness Period, either the effectiveness of the Registration
Statement lapses for any reason or the Holder shall not be permitted to resell
Registrable Securities under the Registration Statement for a period of more
than 20 consecutive Trading Days or 60 non-consecutive Trading Days during any
12 month period, the Company has to pay ‘Mandatory Default Amount’ as the sum of
(i) the greater of (A) 130% of the outstanding principal amount of this
Debenture, plus all accrued and unpaid interest hereon, or (B) the outstanding
principal amount of this Debenture, plus all accrued and unpaid interest hereon,
divided by the Conversion Price on the date the Mandatory Default Amount is
either (a) demanded (if demand or notice is required to create an Event of
Default) or otherwise due or (b) paid in full, whichever has a lower Conversion
Price, multiplied by the VWAP on the date the Mandatory Default Amount is either
(x) demanded or otherwise due or (y) paid in full, whichever has a higher VWAP,
and (ii) all other amounts, costs, expenses and liquidated damages due in
respect of this Debenture."




b)           "If
any Event of Default occurs, the outstanding principal amount of this Debenture
plus accrued but unpaid interest, liquidated damages and other amounts owing in
respect thereof through the date of acceleration, shall become, at the Holder’s
selection, immediately due and payable in cash at the Mandatory Default Amount.
Commencing 5 days after the occurrence of any Event of Default that results in
the eventual acceleration of this Debenture, the interest rate on this Debenture
shall accrue at an interest rate equal to the lesser of 18% per annum or the
maximum rate permitted under applicable law."




Due to
the provisions mentioned above and as per the terms of the Debenture, the
Company has reclassified the principal amount of the Debenture of $8,000,000
(remaining balance: $4,512,000) and the principal amount of the new Debenture of
$945,000 and the interest accrued thereon to current liabilities.




15




EVENT OF
COMPLAINT AND PETITION




On or
about October 3, 2007 Iroquois Master Fund, Ltd. filed a complaint in the
Supreme Court of the State of New York against PacificNet Inc., claiming that
the Company is in default under the Amended and Restated Convertible Debenture
due March 2009 (the Amended Debenture”) in the principal amount of $3,000,000
and the Convertible Debenture due February 2009 (the New Debenture”) in the
principal amount of $420,000.




Iroquois
Master Fund, Ltd. is seeking damages of $3,253,163.80 in the aggregate, together
with any accrued but unpaid interest through the date of
judgment.  Iroquois Master Fund, Ltd. has also demanded reimbursement
of its attorney fees and other costs and expenses incurred together with costs
and disbursements of this action.




On or
about December 5, 2007, PacificNet filed its response by denying that PacificNet
is in default and assert an agreement that would enable it to bring the interest
payments up to date by the issuance of stock in the near future.




On March
27, 2008, three holders of PacificNet's Convertible Subordinated Debentures
filed an involuntary petition for Chapter 11 relief in federal bankruptcy court
late Saturday, March 22, 2008 in Wilmington, DE. The Company has retained
counsel to oppose the filing because the petition fails to meet the standard for
invoking an involuntary bankruptcy and fails to take into consideration other
agreements between the Company and the petitioning creditors. The Company
intends to vigorously oppose the petition and move for dismissal of the filing,
and if successful will seek damages and attorney fees. Subsequently, PacificNet
also received default notice from all but one of the debenture holders including
Iroquois Master Fund Ltd., Alpha Capital AG, Whalehaven Capital Fund Limited,
DKR Soundshore Oasis Holding Fund Ltd., Basso Fund Ltd., Basso Multi-Strategy
Holding Fund Ltd., and Basso Private Opportunities Holding Fund Ltd. from the
same Convertible Subordinated Debentures related to the private offering of
$8,000,000 principal amount variable debentures consummated on March 13, 2006,
and due March 2009.




PacificNet
has retained counsel to oppose the above petition. The amount of the debt
in  question is as follows: Iroquois Master Fund Ltd. $2.5 million,
Whalehaven Capital Fund Limited $958,000, Alpha Capital AG $685,000 DKR
Soundshore Oasis Holding Fund Ltd $960,000, and Basso Fund Ltd., Basso Multi-
Strategy Holding Fund Ltd., and Basso Private Opportunities Holding Fund Ltd., a
combined amount of $500,000.




EVENT OF
SETTLEMENT




On August
29, 2008, PacificNet entered into a Settlement Agreement with certain
bondholders who had filed an involuntary petition seeking Chapter 11 relief in
Delaware federal bankruptcy court. Pursuant to the terms of the Settlement
Agreement, the Company has amended and restated the terms of certain convertible
debentures in the aggregate principal amount of approximately $6.2 million (the
"Debentures").  Upon entering into the Settlement Agreement, the
Company paid $150,000 of the obligations under the Debentures in cash and issued
668,322 shares of common stock to the bondholders upon conversion of a portion
of the Debentures. The remaining outstanding Debentures in the aggregate
principal amount of approximately $5.5 million are convertible at a conversion
price of $2.00 per share, subject to the terms and conditions of the
Debentures.




16




The
Settlement Agreement provides that the Company shall make ten (10) monthly
payments under the Debentures and also apply sums due under certain receivables
toward payment.  All obligations of the Company to the bondholders
under the Debentures are due on or before July 15,
2009.  Additionally, pursuant to the terms of the Settlement
Agreement, the bondholders have received a security interest and collateral
assignment in receivables of the Company and certain of its
subsidiaries.




Additionally,
the Company has issued to the bondholders new debentures representing additional
amounts owed to them, which will be due in the event that the Company does not
comply with the terms of the Debentures.  The parties have further
agreed that the bankruptcy action and all related pending litigation will be
dismissed without prejudice immediately.




As of
September 30, 2008, PacificNet has paid $150,000 of the obligations under the
Debentures in cash and issued 668,321 shares of common stock to the bondholders
upon conversion of a portion of the Debentures. Following is the summary of
convertible debenture as of September 30, 2008:




($,000)
            
            $8
      million convertible debenture
            
            
            $945,000
      convertible debenture
            
            
            Total
      (Unaudited)Balance
      December 31, 2007
            
            $
            4,864
            
            
            $
            945
            
            
            $
            5,809Principal
      payment:Cash
      payment
            
            
            150
            
            
            
            
            
            
            
            150Stock
      payment
            
            
            501
            
            
            
            
            
            
            
            501Accrued
      interest
            
            
            299
            
            
            
            58
            
            
            
            357Balance
      September 30, 2008
            
            $
            4,512
            
            
            $
            1,003
            
            
            $
            5,515




8.2
Repossession of PacificNet Games Limited (PGL) Due To Default Notice by Pope:
Five Million Convertible Note




On
February 7, 2007, PacificNet Games Limited (PGL) entered into a definitive $5
million convertible secured note financing agreement with Pope Asset Management,
LLC (“Pope”), an institutional investor. Proceeds of the financing are to
provide Pacificnet Games Limited with additional working capital to expand its
gaming technology operations, to make further synergistic acquisitions in China
and for general corporate purposes.




The $5
million convertible secured note issued to Pope matures on February 6, 2010.
Subject to reaching certain net income milestones during fiscal year 2007,
the note is convertible into an equity interest of PacificNet Games Limited
(PGL) ranging between 26% and 32%. The interest rate of the convertible note has
initially been set at 8%, and shall increase to 15% if the note is not converted
prior to maturity. In connection with the issuance of the note, PacificNet Games
Limited (PGL) incurred financing cost of $369,000 which primarily consisted of
investment banker fees, legal and other professional fees. These costs have been
capitalized and will be amortized over three years, the life of the
note.




17




EVENT OF
DEFAULT




Pope
Asset Management LLC ("Pope") has sent PacificNet Games Limited (PGL) a default
notice on September 17, 2008, alleging that PacificNet Games Limited (PGL)
has breached the covenants and representations and warranties of the Loan
Agreement and the Stock Pledge Agreement signed between Pacificnet Games Limited
(PGL) and Pope dated February 2007.   The Company disagrees
with Pope on the timing and the reasons of the Defalult Notice that PGL has
breached the Loan Agreement.
  Although
the Company and its Board disagrees with Pope's allegations of any such
breaches, and if necessary will defend itself against any such allegations, the
Company's Board has approved a release and transfer of the shares of PacificNet
Games Limited (PGL) owned by the Company through its wholly-owned subsidiary, to
Pope.  The
escrow agent is in possession of the escrow shares, and the Company is working
with the escrow agent to transfer the escrow shares in PGL to Pope.Such escrow shares have not been released but since such release has been
approved, the rights to the shares, including voting rights have been vested
with Pope.


9. SEGMENT
INFORMATION




SFAS No.
131 “DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION.”,
establishes standards for reporting information about operating segments and for
related disclosures about products, services and geographic areas. Operating
segments are identified as components of an enterprise about which separate
discrete financial information is available for evaluation by the chief
operating decision-maker, or decision-making group, in making decisions
regarding allocation of resources and assessing performance. PacificNet’s chief
decision-makers, as defined under SFAS 131, are the Chief Executive Officer and
Chairman. During 2008 and 2007, PacificNet had four operating
segments.




The
Company’s reportable segments are operating units, which represent the
operations of the Company’s significant business operations. Summarized
financial information concerning the Company’s reportable segments is shown in
the following table. The “Other” column includes the Company’s other
insignificant services and corporate related items, and, as it relates to
segment profit (loss), income and expense not allocated to reportable
segments.




Nine
      Month Period EndedRevenue
      from un related entities (In
      thousands of US Dollars)
            
            September
      30, 2008
            
            
            September
      30, 2007(Unaudited)
            
            
            (Unaudited)Group
      1 (Outsourcing)
            
            
            1,875
            
            
            
            1,575Group
      2 (Telecom/Value added service)
            
            
            870
            
            
            
            1,261Group
      3 (Products)
            
            
            12,200
            
            
            
            12,268Group
      4 (Other Business)
            
            
            122
            
            
            
            211Total
            
            
            15,067
            
            
            
            15,315




18




Nine
      Month Period EndedIncome
      (loss) from operations (In thousands of US Dollars)
            
            September
      30, 2008
            
            
            September
      30, 2007(Unaudited)
            
            
            (Unaudited)Group
      1 (Outsourcing)
            
            
            (372
            )
            
            
            (106
            )Group
      2 (Telecom/Value added service)
            
            
            (123
            )
            
            
            453Group
      3 (Products)
            
            
            (450
            )
            
            
            1,428Group
      4 (Other Business)
            
            
            (2,380
            )
            
            
            (1,791
            )Total
            
            
            (3,325
            )
            
            
            (16
            )




Nine
      Month Period EndedIncome tax benefit
      (expense) (In thousands of US Dollars)
            
            September
      30, 2008
            
            
            September
      30, 2007(Unaudited)
            
            
            (Unaudited)Group
      1 (Outsourcing)
            
            
            -
            
            
            
            -Group
      2 (Telecom/Value added service)
            
            
            3
            
            
            
            -Group
      3 (Products)
            
            
            -
            
            
            
            -Group
      4 (Other Business)
            
            
            -
            
            
            
            -Total
            
            
            3
            
            
            
            -




Nine
      Month Period EndedNet
      Income (Loss) (In thousands of US Dollars)
            
            September
      30, 2008
            
            
            September
      30, 2007(Unaudited)
            
            
            (Unaudited)Group
      1 (Outsourcing)
            
            
            (195
            )
            
            
            (140
            )Group
      2 (Telecom/Value added service)
            
            
            (60
            )
            
            
            673Group
      3 (Products)
            
            
            (1,491
            )
            
            
            2,545Group
      4 (Other Business)
            
            
            (2,658
            )
            
            
            (3,717
            )Total
            
            
            (4,404
            )
            
            
            (639
            )




Nine
      Month Period EndedDepreciation
      and amortization (In thousands of US Dollars)
            
            September
      30, 2008
            
            
            September
      30, 2007(Unaudited)
            
            
            (Unaudited)Group
      1 (Outsourcing)
            
            
            5
            
            
            
            4Group
      2 (Telecom/Value added service)
            
            
            170
            
            
            
            93Group
      3 (Products)
            
            
            12
            
            
            
            89Group
      4 (Other Business)
            
            
            122
            
            
            
            135Total
            
            
            309
            
            
            
            321




19




Total
      Assets(In
      thousands of US Dollars)
            
            September
      30, 2008
            
            
            December
      31, 2007(Unaudited)Group
      1 (Outsourcing)
            
            
            1,235
            
            
            
            990Group
      2 (Telecom/Value added service)
            
            
            1,957
            
            
            
            383Group
      3 (Products)
            
            
            9,731
            
            
            
            9,755Group
      4 (Other Business)
            
            
            6,660
            
            
            
            11,933Total
            
            
            19,583
            
            
            
            23,061




The
Company identifies and classifies its operating segments based on reporting
entities that exhibit similar long-term financial performance based on the
nature of the products and services with similar economic characteristics such
as margins, business practices and target market. The operating segments are
classified into four major segments which are summarized as
follows:




(1)
Outsourcing Services - involves human voice services such as Business Process
Outsourcing, CRM, call center, IT Outsourcing and software development services.
These types of services are conducted through our subsidiaries
Smartime/Soluteck.




(2)
Telecom Value-Added Services (VAS) - Our subsidiary, Guangzhou Wanrong
Information Technology Co., Ltd. ("Guangzhou Wanrong"), is one of the leading
value-added telecom service providers in China. Since its inception in 2003,
Guangzhou Wanrong has achieved strong growth in its VAS including SMS, WAP,
JAVA, MMS, IVR, multimedia entertainment download services, media interactive
products, mobile email services, life, sports, entertainment, and business
information services.




(3)
Product (Telecom & Gaming) Services Group - involves communication and
gaming products, GSM/CDMA/3G Products, Multimedia Communication Kiosks. This
Group includes the following subsidiaries: PacificNet Communications Limited
(PacCom), iMobile and Take1. Take1 Technologies (Take 1), is in the business of
designing and manufacturing electronic multimedia entertainment kiosks, coin-op
kiosks and machines, Electronic Gaming Machines (EGM), bingo and slot machines,
AWP (Amusements With Prizes) games, server-based downloadable games systems, and
Video Lottery Terminals (VLT) such as Keno and Bingo machines, including
hardware, software, and cabinets.




20




(4) Other
Business -other administrative, financial and investment services and non-core
businesses.




Product
and service revenues classified by major geographic areas are as follows (in
thousands of US Dollars):






For
      the three months ended September 30, 2008
            Hong Kong,
      Macau
            PRC
            United
      States
            TotalProduct
      revenues
            104
            4,544
            
            4,648Service
      revenues
            3
            997
            
            1,000






For
      the three months ended September 30, 2008
              Hong
      Kong, Macau
              PRC
              United
      States
              TotalProduct
      revenues
              1,776
              2,573
              (21)
              4,328Service
      revenues
              37
              889
              
              926
   For
      the three months ended September 30, 2008
              Hong
      Kong, Macau
              PRC
              United
      States
              TotalProduct
      revenues
              1,199
              11,001
              
              12,200Service
      revenues
              41
              2,826
              
              2,867
 
  For
      the three months ended September 30, 2008
              Hong
      Kong, Macau
              PRC
              United
      States
              TotalProduct
      revenues
              6,759
              5,508
              (21)
              12,246Service
      revenues
              178
              2,890
              
              3,068


10.
RELATED PARTY TRANSACTIONS




LOAN DUE TO AND FROM RELATED
PARTIES




As of
September 30, 2008, there was a total loan receivable of approximately
$2,326,000 while the loan due to related party was zero.




As at the
year ended December 31, 2007, there was a total loan receivable of approximately
$2,273,000 due from related parties while the loan due to related party was
zero.




As of
September 30, 2008 the related party loans receivable included $630,000 due from
Pacificnet Power Limited (PactPower), $771,000 due from MOABC, $594,000 due from
Linkhead, $2,000 due from Clickcom, $150,000 due from PacSo-HK, and $179,000 due
from shareholders and directors of certain of the Company’s subsidiaries in
connection with the acquisition of these subsidiaries. The loans receivable from
shareholders and directors of these subsidiaries are comprised of $115,000 due
from a shareholder of Victor Choi and $64,000 due from a director of
Soluteck.




21




As of
December 31, 2007 the related party loans receivable included $781,000 due from
Pacificnet Power Limited (PactPower), $523,000 due from MOABC, $625,000 due from
PACT Linkhead, $15,000 due form PACT AD, $150,000 due from PACT Solution, and
$179,000 due from shareholders and directors of certain of the Company’s
subsidiaries in connection with the acquisition of these subsidiaries. The loans
receivable from shareholders and directors of these subsidiaries are comprised
of $115,000 due from a shareholder of Victor Choi and $64,000 due from a
director of Soluteck.




The terms
of these related parties loan receivables and payables are summarized
below:




LOAN TO PACIFICNET POWER
LIMITED (PactPower)




A
convertible loan of $630,000 is outstanding from PactPower. The maturity date of
loan was September 9, 2007. Within ninety (90) days overdue, an additional
interest charge of 5% per annum will be levied as a penalty. The loan is
currently due on demand, non-interest bearing and unsecured.




LOAN TO
MOABC




A
convertible loan of $771,000 is outstanding from MOABC as of September 30, 2008.
The maturity date of loan is January 1, 2009.




LOAN TO
LINKHEAD




Linkhead
is an affiliated company, 15% owned by PacificNet, as of September 30, 2008. A
convertible loan of $594,000 is outstanding from Linkhead. The maturity date of
loan was January 1, 2008. The loan is currently due on demand, non-interest
bearing and unsecured.




LOAN TO
CLICKCOM




A
convertible loan of $2,000 is outstanding from Clickcom as at September 30,
2008.




LOAN TO PACIFICNET SOLUTION
LIMITED (PactSo-HK)




A
convertible loan of $150,000 is outstanding from PactSo-HK. The maturity date of
loan was January 6,2007. The loan is
currently due on demand, non-interest bearing and unsecured.




LOAN TO VICTOR CHOI
SHAREHOLDER




As of
September 30, 2008, there was a loan outstanding of $115,000 receivable from the
shareholder of Victor Choi. This loan is secured by 30,000 PacificNet shares.
The loan is currently due on demand and non-interest bearing.




22




LOAN TO SOLUTECK’S
DIRECTOR




As of
September 30, 2008, there was a loan outstanding of $64,000 receivable from a
director of Soluteck. The interest rate for the loan is 8% per annum plus 5%
penalty interest in case it has not been timely paid. The loan is collateralized
with 100,000 PacificNet’s shares owned by the borrowing director and Ms Iris Lo,
and the remaining assets of Smartime Holding Ltd. The maturity date of loan was
January 31,2007. The loan is
currently due on demand, non-interest bearing and unsecured.




11.
COMMITMENTS AND CONTINGENCIES




OPERATING
LEASES - The Company leases warehouse and office space under operating leases
with fixed monthly rentals. None of the leases included contingent rentals.
Operating lease expense charged to operations for 2008 Q3 amounted to $277,000
(2007 Q3: $120,000). Future minimum lease payments under non-cancelable
operating leases are $192,000 for the period from October 2008 to September 2009
and $85,000 for the period from October 2009 to September 2012.




BANK
LOANS-Bank loans
represent the following at September 30, 2008 (in thousands)




September 30, 2008(Unaudited)
            
            
            December
      31, 2007
              (Audited)Unsecured
            
            
            1,840
            
            
            
            1,823Less:
      current portion
            
            
            90
            
            
            
            80Non
      current portion
            
            $
            1,750
            
            
            $
            1,743





Aggregate
future maturities of borrowing for the next five years are as follows (In
thousands of US Dollars):




(US$000s)
            
            October
      2008 to September 2009
            
            
            October
      2009 to September 2010
            
            
            October
      2010 to September 2011
            
            
            October
      2011 to September 2012
            
            
            October
      2012 to September 2013
            
            
            Thereafter
            
            
            TOTALBeijing
      PACT office mortgage (1)
            
            
            63
            
            
            
            66
            
            
            
            70
            
            
            
            74
            
            
            
            78
            
            
            
            750
            
            
            
            1102Shenzhen
      PACT office mortgage (2)
            
            
            27
            
            
            
            29
            
            
            
            31
            
            
            
            32
            
            
            
            35
            
            
            
            584
            
            
            
            737TOTAL
            
            
            90
            
            
            
            95
            
            
            
            101
            
            
            
            107
            
            
            
            113
            
            
            
            1,334
            
            
            
            1,840




(1)
            Fixed
      mortgages expiring in 2012 at interest rate of 5.5% per
    annum.(2)
            Fixed
      mortgage expiring in 2012 at interest rate of 6.2% per
    annum.




23




STATUS OF ACQUISITION OF
OCTAVIAN INTERNATIONAL LIMITED ("OCTAVIAN")




On
January 22 2008, the Company announced the acquisition of Octavian International
Limited (“Octavian”), a worldwide supplier of gaming technology, solutions and
systems.   The Company had previously reported on a Form 8-K
filed with the Securities and Exchange Commission on December 13, 2007, the
execution of definitive agreements, including that certain Agreement among,
PacificNet Games International Corporation (PGIC), Octavian, Emperor Holdings
Limited, Ziria Enterprises Limited and the Company on December 7, 2007, for the
acquisition of 100% of Octavian (the “Agreement”).  PacificNet,
through its wholly-owned subsidiary, Pacificnet Games International Corporation,
signed an agreement to acquire from Ziria Enterprises Limited, a company
incorporated in Cyprus (the “Seller”), 100% of the issued and outstanding shares
(the “Shares”) of Emperor Holdings Limited, a company incorporated in Cyprus
(the “Holding Company”), which is the parent company of Octavian.




Up to
April 14, 2008, Ziria Enterprises Limited did not deliver to PacificNet the
share certificates of Emperor Holdings Limited, the legal owner of Octavian
International Limited.  As a result of Ziria’s failure to deliver the
share certificates, which was a condition to closing the acquisition of
Octavian, on May 21, 2008, the Company, Ziria, PacificNet Games International
Corporation, Octavian and Emperor Holdings Limited terminated the agreement to
acquire Octavian.  Under the acquisition agreement, if the transaction
had been consummated, PacificNet was obligated to issue, in the aggregate,
2,330,000 restricted shares of PACT representing approximately 19.5% of
PacificNet's outstanding shares and cash of up to $18,900,000, which would have
been paid upon the completion of certain net profit performance
targets.





All
parties involved have agreed not to complete the merger but will remain
distribution partners of complimentary products in each others respective
markets.





As a
result of the failure of the Octavian acquisition to be consummated and the
termination of the acquisition agreement, on May 21, 2008, Mr. Harmen
Brenninkmeijer, Chief Executive Officer of Octavian, resigned as a member of the
Board of Directors of PacificNet.  It was a condition to the closing
of the acquisition of Octavian that Mr. Brenninkmeijer was appointed to the
Board of Directors.  There was no disagreement between Mr.
Brenninkmeijer and PacificNet on any matter relating
to   PacificNet’s operations, policies or practices.




As at
December 31, 2007 the 2,330,000 shares were issued and recorded as deposit total
amounted to approx. $10,974,000. These shares were received from Octavian as at
September 30, 2008 and included under treasury stock.




12.
DISCONTINUED OPERATION /NET ASSETS HELD FOR DISPOSITION




Sale
of Interest in Guangzhou 3G Information Technology Co., Ltd. ("Guangzhou
3G")




On April
30, 2007, through our wholly-owned subsidiary, PacificNet Strategic Investment
Holdings Limited (“PSI Holdings”), we entered into a stock purchase and sale
agreement with Heyspace International Limited to sell PSI Holdings’ 51% interest
in Guangzhou 3G's parent company, Pacific 3G Information & Technology Co.
Limited. The purchase price is $6,000,000 payable in installments over a six
month period or earlier if Heyspace completes its initial public offering prior
to October 31, 2007. Heyspace paid an initial purchase price of $1,000,000 and
the remaining balance to be paid by October 2007. Due to non payment of the
remaining balance by Heyspace as per the agreement, the Company on November 25,
2007 entered into a memorandum of understanding (“MOU”) with Heyspace. Pursuant
to the MOU, we agreed with Heyspace that for a period commencing on November 25,
2007 through March 31, 2008, we are free to seek new buyers to purchase PSI
Holdings’ share ownership in Guangzhou 3G at a consideration and term which at a
minimum will not cause any disposal loss to us.




24




PacificNet
and Heyspace entered into a Supplement Agreement for 3G’s deal on 20th March,
2008. According to this supplement agreement, PacificNet will apply $500,000
received as of December 31, 2007 against the 5% ownership interest and the
remaining $500,000 will be served as a collateral along with the transfer of the
share certificates of 46% shares to PacificNet from Heyspace. If Heyspace fails
to pay the remaining USD$5,000,000 on or before 31 March, 2009, PacificNet has
right to reclaim for the unpaid 46% shares of Pacific 3G Information &
Technology Co., Limited, and demand for an annual interest rate of 12%. As at
September 30, 2008, the company has made $3.5 million provision against the
receivable from Heyspace.




Sale
of Interest in PacificNet Epro Holdings Limited ("Epro")




On April
18, 2008, PacificNet consummated the sale of the Company's subsidiary,
PacificNet Epro Holdings Limited, a company incorporated in the Hong Kong
Special Administrative Region of the PRC ("Epro"), which is primarily engaged in
the business of providing call center telecom and customer relationship
management services as well as other business outsourcing services in China.
Pursuant to the terms of the Sales and Purchase Agreement (the "Agreement")
entered into between the Company and Epro Group International Limited (the "Epro
Group International"), PacificNet sold its entire share ownership of 7,766,993
shares in Epro for HK$21 million. The Company received a payment of HK$3 million
upon execution of the Agreement and a payment of HK$4 million on September 30,
2008. PacificNet shall receive the remaining purchase price in installments over
the next twenty-four months. Pursuant to the terms of the Agreement, within
sixty days of the closing, Epro shall repay PacificNet HK$2 million for an
interest bearing loan granted from PacificNet to Epro. The loan has now been
fully repaid by Epro in 2 installments, HK$1 million was paid on May 21, 2008
and the balance of HK$1 million was paid on July 7, 2008.





Following
is the summary of net assets held for disposition as of April 11, 2008 (In
thousands of US dollars):





Assets
      :-Cash
      and cash equivalents
            
            $
            424Accounts
      receivable, net
            
            
            1,398Other
      receivable
            
            
            410Other
      current assets
            
            
            620Property,
      Plant & Equipment, net
            
            
            518Others
            
            
            131Total
      Assets
            
            
            3,501Liabilities
      :-Accounts
      payable and accrued expense
            
            
            495Others
            
            
            443Total
      Liabilities
            
            
            938





The
components of loss from operations related to the entity held for disposal for
the year ended April 11, 2008 are shown below (In thousands of US
dollars).




25




Net
      sales
            
            $
            398Operating
      expensesSelling,
      general and administrative
            
            
            284Depreciation
      and amortization
            
            
            38Total
      operating expenses
            
            
            322Loss
      from operations
            
            
            76Non-operating
      income (expenses) :-Other
      income
            
            
            (2
            )Interest
      income
            
            
            (18
            )Net
      profit before income tax
            
            
            56Provision
      for Income tax
            
            
            -Minority
      interest-PL
            
            
            2Net
      profit from entity held for disposal
            
            $
            58




Reposession
of PacificNet Games Limited (PGL) Due to Default Notice from Pope Asset
Management, LLC (Pope)




Pope
Asset Management LLC ("Pope") has sent PacificNet Games Limited (PGL) a default
notice on September 17, 2008, alleging that PacificNet Games Limited
(PGL) has breached the covenants and representations and warranties of the Loan
Agreement and the Stock Pledge Agreement signed between PacificNet Games Limited
(PGL) and Pope dated February 2007.   The Company disagrees with
Pope on the timing and the reasons of the Default Notice that PGL has breached
the Loan Agreement.
  Although
the Company and its Board disagrees with Pope's allegations of any such
breaches, and if necessary will defend itself against any such allegations, the
Company's Board has approved a release and transfer of the shares of PacificNet
Games Limited (PGL) owned by the Company through its wholly-owned subsidiary, to
Pope.  The
escrow agent is in possession of the escrow shares, and the Company is working
with the escrow agent to transfer the escrow shares in PGL to Pope.Such escrow shares have not been released but since such release has been
approved, the rights to the shares, including voting rights have been vested
with Pope.
  As of
September 30, 2008, PGL was not consolidated and reclassified as held for
disposal in the accompanying financial statements.


26




Following
is the summary of net assets held for disposition as of September 30, 2008 (In
thousands of US Dollars):





Assets
      :-Cash
      and cash equivalents
            
            $
            115Accounts
      receivable, net
            
            
            735Inventory
            
            
            125Other
      current assets
            
            
            110Other
      receivable
            
            
            64Property,
      Plant & Equipment, net
            
            
            440Intangible
      assets
            
            
            75Others
            
            
            192Total
      Assets
            
            
            1,856Liabilities
      :-Accounts
      payable and accrued expense
            
            
            149Convertible
      debenture  - non current portion
            
            
            2,737Others
            
            
            152Total
      Liabilities
            
            
            3,038





The
components of loss from operations related to the entity held for disposal for
the year ended September 30, 2008 are shown below (In thousands of US
Dollars).





Net
      sales
            
            $
            8Operating
      expensesSelling,
      general and administrative
            
            
            1,264Depreciation
      and amortization
            
            
            240Total
      operating expenses
            
            
            1,505Profit
      (Loss) from operations
            
            
            (1,497
            )Non-operating
      income (expenses) :-Other
      income
            
            
            -Interest
      income
            
            
            (563
            )Net
      profit before income tax
            
            
            (2,060
            )Provision
      for Income tax
            
            
            -Minority
      interests
            
            
            1,010Net
      profit from entity held for disposal
            
            $
            (1,050
            )




Information
relating to the operations of the subsidiaries up to the nine month periods of
September 30, 2008 is as follows (in thousands of US Dollars):




(In
      US$ thousands)
            
            
            
            
            
            
            
            
            
            
            September
      30, 2008
            
            
            December
      31, 2007Epro
            
            
            PactGames
      (BVI)
            
            
            Clickcom
            
            
            (Unaudited)
            
            
            (Audited)Income
      (loss) from discontinued operations
            
            $
            58
            
            
            
            (1,050
            )
            
            
            -
            
            
            
            992
            
            
            
            (1,141
            )Gain
      (loss) on disposal
            
            $
            (59
            )
            
            
            -
            
            
            
            (24
            )
            
            
            (83
            )
            
            
            2,181




27





Receivable
in lieu of disposed subsidiary comprised of the following:





(in
      000’ $)
            
            September
      30, 2008
            
            
            December
      31, 2007Receivable
      from Epro
            
            $
            1,794
            
            
            $
            -Receivable
      from G3G
            
            
            5,000
            
            
            
            5,000Provision
      for bad debt
            
            
            (3,500
            )
            
            
            (3,500
            )Receivable,
      net
            
            $
            3,294
            
            
            $
            1,500




13.
INVESTMENTS IN AFFILIATED COMPANIES




Investments




Investments
that are recorded at cost are evaluated for any impairment that are not
temporary in nature and adjusted for the impairment.




Investments
in affiliated companies are consisted of the following as of September 30,
2008:




Under
Cost Method:




(USD’000)
            
            September
      30, 2008 (Unaudited)
            
            
            December
      31, 2007 (Audited)
            
            DESCRIPTIONGlad
      Smart
            
            $
            -
            
            
            $
            30Linkhead
            
            
            65
            
            
            
            65
            
            15%
      ownership interestClickcom
            
            
            -
            
            
            
            25KingLott
            
            
            168
            
            
            
            -
            
            19%
      ownership interestPoly
      Blue
            
            
            61
            
            
            
            -
            
            18%
      ownership interestTotal
            
            $
            294
            
            
            $
            120




Under
Equity Method:




Investments
accounted for under the equity method are carried at cost and adjusted for the
Company’s proportionate share of undistributed earnings and losses.





(USD
      ' 000s)
            
            September
      30, 2008 (Unaudited)
            
            
            December
      31, 2007 (Audited)
            
            DESCRIPTIONBell-Pact
      Shanghai JV
            
            $
            3
            
            
            $
            13
            
            40%
      ownership interest




28




14.
ACQUISITION




(1)
ACQUISITION OF UNIVERSAL KINGLOTT (BEIJING) TECH CO., LTD.




On August
18, 2008, the Company entered into a purchase agreement to acquire 19% equity
interest of a Chinese lottery company called Universal KingLott (Beijing) Tech
Co., Ltd...We paid entirely with shares of 240,000 PacificNet Shares, valued at
$0.58 per share on Sep 16, 2008.




(2)
ACQUISITION OF GUANGDONG POLY BLUE EXPRESS COMMUNICATIONS CO., LTD




On
September 01, 2008, the Company entered into a purchase agreement to acquire 18%
equity interest of Guangdong Poly Blue Express Communications Co.,Ltd.. We paid
entirely with shares of 60,000 PacificNet Shares, valued at $0.80 per share on
Sep 4, 2008.




15.
LEGAL PROCEEDINGS




1.
Johnson Controls Hong Kong Limited (JCHKL) vs. PacificNet Power Limited
(PactPower)




On
January 19, 2007, Johnson Controls Hong Kong Limited filed a civil claim against
PacificNet Power Limited (a 15% owned subsidiary of PacificNet) in the High
Court of the Hong Kong Special Administrative Region seeking HK$4,800,000 as
payment for services rendered to replace 3 sets of rain water-cooled chillers,
together with energy saving performance (the "Chiller System"), at the Fortress
Tower in Hong Kong.




In
connection with the claim, PacificNet Power reviewed a letter from its client,
China Weal Property Management Ltd., dated January 22, 2007 stating that the
construction work by JCHKL had not been completed as of the date of the letter,
and that certain violations itemized in a letter issued by the Hong Kong
Environment Protection Department (EPD) (Noise Abatement Notice No. N806030)
addressed to JCHKL with respect to acoustic problems with JCHKL’s equipment had
not been abated.




The board
of directors of PacificNet Power Limited has reviewed the case with its client,
China Weal Property Management Ltd., and our Hong Kong legal counsel and it is
the belief of the board that the project work undertaken JCHKL is defective in
numerous aspects.  As a result, the board believes that the
construction work has not been completed by JCHKL, and therefore, JCHKL is not
entitled to payment for its services.




On
February 13, 2007, the board instructed the Hong Kong legal counsel to issue a
Defense and Counterclaim to JCHKL to counter-claim that ( i) JCHKL's
construction work has not complied with the applicable rules and regulations of
various government authorities in Hong Kong; (ii) the Chiller System provided by
JCHKL was defective and merchantable unfit and JCHKL has failed and/or refused
to rectify such defective works; and (iii) JCHKL shall return the work deposit
in the amount of HK$1,500,000 to PacificNet Power Limited and shall compensate
and keep PacificNet Power Limited indemnified against all the loss and damages
suffered as a result of any claims from the China Weal Property Management
Ltd..




29




The case
is now in the discovery stage before proceeding to the stage of fixing a date
for trial in the High Court of Hong Kong and the board intends to vigorously
defend against the allegations. We are unable to predict the outcome of these
actions, or a reasonable estimate of the range of possible loss, if
any.




2. PacificNet Power Limited
(PactPower) vs Johnson Controls Hong Kong Limited (JCHKL)




On or
about December 2005, Johnson Controls Hong Kong Limited approached PacificNet
Power Limited (a 51% owned subsidiary of PacificNet) and made a representation
that they had submitted a tender to “The Incorporated Owners of Nan Fung Centre,
Tsuen Wan (“the Employer”) for the “construction and replacement works of
existing air-cooled chiller plant by new water-cooled chiller plant for Tsuen
Wan Nan Fung Centre and energy saving performance contract” (“the Contract”).
JCHKL invited and induced PacificNet Power Limited to act as the main contractor
for the Contract and it would then act as a sub-contractor.




PacificNet
Power also expressly made known to JCHKL that the said construction and
replacement works and the guaranteed energy saving should meet all the tender
requirements if PacificNet Power accepted the invitation to act as the main
contractor for the Contract, and PacificNet Power further said that if there
should be any quality defects with the system and/ or the construction work, the
Employer and/ or their prospective tenants would claim against JCHKL and JCHKL
should compensate.




PacificNet
Power however received some correspondences and complaints from the Employer
about the poor and/ or sub-standard works done by JCHKL. PacificNet Power, after
separate investigation, discovered the poor workmanship and sub-standard works
done by JCHKL. Accordingly, the Employer and/ or their representatives have
delayed the monthly installments payment to PacificNet Power.




On April
23, 2007, PacificNet Power instructed the Hong Kong lawyers to issue a letter to
the Defendant requesting and demanding them, being the sub-contractor of the
Construction and Replacement Works Contract, to take immediate rectification
action within seven days from the date of the said letter to (i) rectify and
complete all outstanding defective works of the Construction and Replacement
Works Contract; (ii) replace the water-cooled chiller plant and/or equipments
which are not conformed with the requirements of the tender documents previously
submitted by the Defendant to the Employer; and (iii) improve the poor
performance of energy saving of the new water-cooled chiller plant.




Despite
the said letter, JCHKL had failed and/ or refused to rectify and complete all
outstanding works and/ or replace the defective system. And therefore PacificNet
Power claims against JCHKL for: (i) refund HK$6,414,300.00, being the Contract
Price paid by PacificNet Power to JCHKL; (ii) costs and expenses incurred by
PacificNet Power to rectify all defective works of the Contract; (iii) all
damage and loss suffered by PacificNet Power, and further and other
relief.




On July
25, 2007, JCHKL issued a Defense and Counterclaim to PacificNet Power to argue
that: (i) they had carried out the works according to the Contract terms; (ii)
the works had been approved by PKL Consultants Limited, the consultant
representative of the Employer; and (iii) a sum of HK$30,000 is still due and
owing by PacificNet Power to JCHKL.




30




The case
is now in the discovery stage before proceeding to the stage of fixing a date
for trial in the High Court of Hong Kong. We are unable to predict the outcome
of these actions, or a reasonable estimate of the range of possible loss, if
any.




3.
PacificNet Inc. vs. HLB Hodgson Impey Cheng (HLB or Defendant), a firm of
Chartered Accountants and Certified Public Accountants in Hong Kong




On
September 20, 2007, PacificNet Inc. filed a claim against its former auditors
HLB Hodgson Impey Cheng (HLB), a firm of Chartered Accountants and Certified
Public Accountants, in the High Court of the Hong Kong Special Administrative
Region seeking refund of the professional fees, compensation of professional
fees and expenses for Company to engage and deploy new auditors to take over the
incomplete audit works from the Defendant and returning and/or providing all
relevant accounting records, vouchers, audit program and working papers retained
by the Defendant and losses and damages incurred.




The case
is still in the pleadings stage (i.e. filing and serving of Statement of Claim,
Defense and/or Counterclaim and Reply) without any update.




4.
Iroquois Master Fund, Ltd. vs. Pacificnet Inc.




On or
about October 3, 2007 Iroquois Master Fund, Ltd. filed a complaint in the
Supreme Court of the State of New York against PacificNet Inc., (Company)
claiming that the Company is in default under the Amended and Restated
Convertible Debenture due March 2009 (the Amended Debenture”) in the principal
amount of $3,000,000 and the Convertible Debenture due February 2009 (the New
Debenture”) in the principal amount of $420,000.




As of
August 29, 2008, Company entered into a Settlement and Release Agreement (the
"Settlement Agreement") relating to all outstanding disputes and litigation with
each of the holders of its debentures, Iroquois Master Fund, Ltd., C.E.
Unterberg, Towbin Capital Partners I (n/k/a Collins Stewart), Alpha Capital AG,
Whalehaven Capital Fund Ltd., DKR Soundshore Oasis Holding Fund, Ltd., Basso
Fund Ltd., Basso Multi-Strategy Holding Fund Ltd., and Basso Private
Opportunities Holding Fund Ltd. (collectively the "Debenture
Holders").




Pursuant
to the terms of the Settlement Agreement, the Company has amended and restated
the terms of certain convertible debentures in the aggregate principal amount of
approximately $6.2 million (the ''Debentures''). Upon entering into the
Settlement Agreement, the Company paid $150,000 of the obligations under the
Debentures in cash and issued 668,322 shares of common stock to the Debenture
Holders upon conversion of a portion of the Debentures. The remaining
outstanding Debentures in the aggregate principal amount of approximately $5.5
million are convertible at a conversion price of $2.00 per share, subject to the
terms and conditions of the Debentures.




The
Settlement Agreement provides that the Company shall make ten (10) monthly
payments under the Debentures and also apply sums due under certain receivables
toward payment. All obligations of the Company to the Debentures Holders under
the Debentures are due on or before July 15, 2009. Additionally, pursuant to the
terms of the Settlement Agreement, the Debentures Holders have received a
security interest and collateral assignment in receivables of the Company and
certain of its subsidiaries.




31




Additionally,
the Company has issued to the Debentures Holders new debentures representing
additional amounts owed to them, which will be due in the event that the Company
does not comply with the terms of the Debentures. The parties have further
agreed that the bankruptcy action and all related pending litigation will be
dismissed without prejudice immediately. On December 15, 2008, provided there
are no defaults under the settlement documents, these dismissals would be with
prejudice.




16.
CURRENT VULNERABILITY DUE TO CERTAIN CONCENTRATIONS




The
Company's operations are carried out in the PRC. Accordingly, the Company's
business, financial condition and results of operations may be influenced by the
political, economic and legal environments in the PRC, by the general state of
the PRC's economy. The Company's business may be influenced by changes in
governmental policies with respect to laws and regulations, anti-inflationary
measures, currency conversion and remittance abroad, and rates and methods of
taxation, among other things.




The three
top customers contributed to sales amounting to $2,700,000, $214,000 and
$360,000, the receivable from these customers was $1,346,000, $142,000 and
$198,000 respectively as at September 30, 2008. The three top vendors
contributed to purchases amounting to $280,000, $201,000 and $185,000, the
payable to these vendors was $62,000, $56,000 and $53,000 respectively as at
September 30, 2008.




32




ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION




THE
FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE INFORMATION
CONTAINED IN THE FINANCIAL STATEMENTS OF THE COMPANY AND THE NOTES THERETO
APPEARING ELSEWHERE HEREIN AND IN CONJUNCTION WITH THE MANAGEMENT'S DISCUSSION
AND ANALYSIS SET FORTH IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR
ENDED DECEMBER 31, 2007, AS AMENDED.




PRELIMINARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS




The
statements contained in this Form 10-Q that are not purely historical are
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. These include statements about the Company's expectations, beliefs,
intentions or strategies for the future, which are indicated by words or phrases
such as "anticipate," "expect," "intend," "plan," "will," "the Company
believes," "management believes" and similar words or phrases. The
forward-looking statements are based on the Company's current expectations and
are subject to certain risks, uncertainties and assumptions, including those set
forth in the discussion under "Description of Business," including the "Risk
Factors" described in that section, and "Management's Discussion and Analysis or
Plan of Operation." The Company's actual results could differ materially from
results anticipated in these forward-looking statements. All forward-looking
statements included in this document are based on information available to the
Company on the date hereof, and the Company assumes no obligation to update any
such forward-looking statements.




FACTORS
THAT COULD AFFECT FUTURE RESULTS




Factors
that might cause actual results, performance or achievements to differ
materially from those projected or implied in such forward-looking statements
include, among other things:




●           The
impact of competitive products;


●           Changes
in laws and regulations;


●           Limitations
on future financing;


●           Increases
in the cost of borrowings and unavailability of debt or equity
capital;


●           The
inability of the Company to gain and/or hold market share;


●           Exposure
to and expense of resolving and defending litigation;


●           Consumer
acceptance of the Company's products;


●           Managing
and maintaining growth;


●           Customer
demands;


●           Market
and industry conditions;


●           The
success of product development and new product introductions into the
marketplace;


●           The
departure of key members of management; and


●           The
effect of the United States War on Terrorism, as well as other risks and
uncertainties that are described from time to time in the Company's filings with
the Securities and Exchange Commission.




CRITICAL ACCOUNTING POLICIES AND ESTIMATES




Our
discussion and analysis or plan of operations is based upon our consolidated
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these
financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities.




33




On an
on-going basis, we evaluate our estimates, including those related to accounts
receivable reserves, provisions for impairment losses of affiliated companies
and other intangible assets, income taxes and contingencies. We base our
estimates on historical experience and on various other assumptions that are
believed 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 may differ from
these estimates under different assumptions or conditions.




Management
believes the following critical accounting policies reflect our more significant
estimates and assumptions used in the preparation of our consolidated financial
statements:




Allowance
for Doubtful Accounts




We
evaluate the collect-ability of our trade receivables based on a combination of
factors. We regularly analyze our significant customer accounts, and, when we
become aware of a specific customer's inability to meet its financial
obligations to us, such as in the case of bankruptcy filings or deterioration in
the customer's operating results or financial position, we record a specific
reserve for bad debt to reduce the related receivable to the amount we
reasonably believe is collectible. We also record reserves for bad debt for all
other customers based on a variety of factors including the length of time the
receivables are past due, the financial health of the customer, macroeconomic
considerations and historical experience. If circumstances related to specific
customers change, our estimates of the recoverability of receivables could be
further adjusted. In the event that our trade receivables become uncollectible,
we would be forced to record additional adjustments to receivables to reflect
the amounts at net realizable value. The accounting effect of this entry would
be a charge to earnings, thereby reducing our net earnings. Although we consider
the likelihood of this occurrence to be remote based on past history and the
current status of our accounts, there is a possibility of this
occurrence.




In the
beginning of the third quarter of 2006, the Chinese government announced that it
would implement several new policies regarding mobile phone value-added service
providers effective from July 10, 2006. These policies include a “double
confirmation” policy and the requirement that value-added service providers
provide one-month trial subscriptions. By requiring that mobile phone customers
“double-confirm” their intention to purchase services, and by requiring free
subscriptions, these policies have negatively affected value-added service
providers.




Inventory




Our
inventory purchases and commitments are made in order to build inventory to meet
forecasted demand for our products. We perform a detailed assessment of
inventory for each period, which includes a review of, among other factors,
demand requirements, product life cycle and development plans, component cost
trends, product pricing and quality issues. Based on this analysis, we record
adjustments to inventory for excess, obsolescence or impairment, when
appropriate, to reflect inventory at net realizable value. Revisions to our
inventory adjustments may be required if actual demand, component costs or
product life cycles differ from our estimates. In the event we were unable to
sell our products, the demand for our products diminished, and/or other
competitors offered similar or better products, we would be forced to record an
adjustment to inventory for impairment or obsolescence to reflect inventory at
net realizable value. The accounting effect of this entry would be a charge to
earnings, thereby reducing our net earnings.




34




Income
Taxes




We record
a valuation allowance to reduce our deferred tax assets to the amount that is
more likely than not to be realized. We have considered future market growth,
forecasted earnings, future taxable income, and the mix of earnings in the
jurisdictions in which we operate and prudent and feasible tax planning
strategies in determining the need for a valuation allowance. We currently have
recorded a full valuation allowance against net deferred tax assets as we
currently believe it is more likely than not that the deferred tax assets will
not be realized. In the event we determine that we would not be able to realize
all or part of our net deferred tax assets in the future, an adjustment to the
deferred tax assets would be charged to earnings in the period such
determination is made. Likewise, if we later determine that it is more likely
than not that the net deferred tax assets would be realized, the previously
provided valuation allowance would be reversed




Contingencies




We may be
subject to certain asserted and unasserted claims encountered in the normal
course of business. It is our belief that the resolution of these matters will
not have a material adverse effect on our financial position or results of
operations, however, we cannot provide assurance that damages that result in a
material adverse effect on our financial position or results of operations will
not be imposed in these matters. We account for contingent liabilities when it
is probable that future expenditures will be made and such expenditures can be
reasonably estimated.




Valuation of Long-Lived Assets
Including Goodwill and Purchased Intangible Assets




We review
property, plant and equipment, goodwill and purchased intangible assets for
impairment whenever events or changes in circumstances indicate the carrying
value of an asset may not be recoverable. Our asset impairment review assesses
the fair value of the assets based on the future cash flows the assets are
expected to generate. An impairment loss is recognized when estimated
undiscounted future cash flows expected to result from the use of the asset plus
net proceeds expected from disposition of the asset (if any) are less than the
carrying value of the asset. This approach uses our estimates of future market
growth, forecasted revenue and costs, expected periods the assets will be
utilized and appropriate discount rates. Such evaluations of impairment of
long-lived assets including goodwill arising on a business combination and
purchased intangible assets are an integral part of, but not limited to, our
strategic reviews of our business and operations performed in conjunction with
restructuring actions. When impairment is identified, the carrying amount of the
asset is reduced to its estimated fair value. Deterioration of our business in a
geographic region or within a business segment in the future could also lead to
impairment adjustments as such issues is identified. The accounting effect of an
impairment loss would be a charge to earnings, thereby reducing our net
earnings.




35




Convertible
debt




In
accordance with recent FASB accounting guidance, due to certain factors,
including a liquidated damages provision in the registration rights agreement
and an indeterminate amount of shares to be issued upon conversion of the
debentures, the Company values and accounts for the embedded conversion feature
related to the Debentures, the Investors’ warrants, and the registration rights
as derivative liabilities. Accordingly, these derivative liabilities are
measured at fair value with changes in fair value reported in earnings as long
as they remain classified as liabilities. The Company reassesses the
classification at each balance sheet date. If the classification required under
EITF No. 00-19 changes as a result of events during the period, the contract
should be reclassified as of the date of the event that caused the
reclassification.




The fair
value of these derivative instruments, as determined by applying the
Black-Scholes valuation model, is adjusted quarterly. The Black-Scholes
valuation model requires the input of highly subjective assumptions, including
the expected stock price volatility. Additionally, although the Black-Scholes
model meets the requirements of SFAS 133, the fair values generated by the model
may not be indicative of the actual fair values as our derivative instruments
have characteristics significantly different from traded options. Accordingly,
the results obtained could be significantly different if other assumptions were
used. The effect of this entry would be a charge to net earnings, thereby either
increasing or reducing our net earnings based upon the assumptions used and the
results obtained.




NATURE
OF THE OPERATIONS OF THE COMPANY




NATURE
OF BUSINESS




PacificNet
Inc. (referred to herein as “PacificNet” or the “Company”) was originally
incorporated in the State of Delaware on April 8, 1987. PacificNet is a leading
provider of gaming and mobile game technology worldwide with a focus on emerging
markets in Asia. PacificNet's gaming products are localized to their specific
markets creating an enhanced user experience for players and larger profits for
operators. PacificNet's gaming clients include the leading hotels, casinos, and
gaming operators in Macau, Europe and elsewhere around the world. PacificNet
also maintains legacy subsidiaries in the call center and ecommerce business in
China. PacificNet employs about 500 staff in its various subsidiaries with
offices in the US, Hong Kong, Macau, China. Through our subsidiaries we provide
outsourcing services, value-added telecom services (VAS) and products (telecom
and gaming) services. Our business process outsourcing (BPO) services include
call centers, providing customer relationship management (CRM), and
telemarketing services, and our information technology outsourcing (ITO)
includes software programming and development. Our products (telecom and gaming)
include gaming technology and communication products distribution. The Company’s
operations are primarily targeted in Greater China and certain Asian country
markets.




36




PacificNet's
Gaming Products:




We offer
the following gaming technology products for sale:




Electronic
gaming machines (EGM). Our line of electronic gaming machines combine localized
Chinese and Asian themes and content, advanced graphics, digital sound effects
and music, and secondary bonus games.


●           Multi-player
Electronic Table Games, eTable Series of Multiplayer Gaming
Machines


●           Multi-player
Electronic Baccarat Machines


●           Multi-player
Electronic Sicbo Machines


●           Multi-player
Electronic Roulette Machines


●           Multi-player
Electronic Fish-Prawn-Crab Machines


●           Slot
Machines


●           Electronic
Bingo Machines


●           Video
Lottery Terminals (VLTs)


●           Server-Based
Gaming Machines (SBG)


●           Amusement
With Prices (AWP) Machines


●           Online
Gaming Software Development


●           Client-Server
Gaming Systems


●           CMM
Level 3 Certified Gaming Software Development Center in China


●           Cabinet
Design and Sales, Parts Sales, OEM Games. We design and sell gaming machine
cabinets, replacement parts.




PaificNet’s
Major Operating Subsidiaries




Take1
Technologies (http://www.take1technologies.com), is in the business of designing
and manufacturing electronic multimedia entertainment kiosks, coin-op kiosks and
machines, Electronic Gaming Machines (EGM), bingo and slot machines, Amusements
With Prizes(AWP) games, server-based downloadable games systems, and Video
Lottery Terminals (VLT) such as Keno and Bingo machines, including hardware,
software, client-server systems and cabinets. Take1 is a leading designer,
developer and manufacturer of multimedia entertainment and communication kiosk
products including photo and video entertainment kiosks, digital camera photo
development stations, Multimedia Messaging Services (MMS) and mobile content
download stations for mobile phones, and other coin-operated peripherals and
consumables. Take1 Technologies is based in Hong Kong and markets and
distributes its products around the world including the USA, Canada, Mexico,
Europe, China, and Southeast Asia.




* To Be
Disposed:  PacificNet Communications Limited (referred to herein as
"PacCom"), incorporated in Hong Kong, is a wholly owned subsidiary of PacificNet
that specializes in the sales and distribution of mobile communication products,
accessories, phone cards and mobile SIM cards, and telecom related services in
Hong Kong and Greater China.




PacificNet
iMobile (Beijing) Technology Co., Ltd ("iMobile") is the leading internet
e-commerce distributor of mobile products in China. It provides Internet, email,
customer service centers, pre and post-sale services, logistics and Cash On
Delivery (COD) services to mobile consumers in China. iMobile's 18900.com
e-commerce operations combine online internet services with its offline customer
services network comprised of a nationwide chain of logistics and customer
service centers covering 21 provinces and 40 major cities in China including
Beijing, Shanghai, Chongqing, Tianjin, Chengdu, Dalian, Qingdao, Guangzhou,
Shenzhen, Zhuhai, Dongguan, Hangzhou, Suzhou, Ningbo, Wenzhou, Nanjing, Wuhan,
Xian, Harbin, Qiqihaer, Hunan and Changsha. iMobile has developed into the
largest online mobile phone sales company in China and has partnered with Sina,
Netease, China.com, joyo.com, and 263.net on e-commerce cooperation. iMobile's
18900.com operation is the designated Internet distributor for Motorola, Nokia,
and NEC's mobile products in China.





37




PACT
Gaming Technology Operations




1. Participation games:Company-owned gaming machines that we lease to casino operators based
upon any of the following payment methods: (1) a percentage of the net win of
the gaming machines, (2) fixed daily fees, or (3) in the case of wide-area
progressive gaming machines, a percentage of the amount wagered or a combination
of a fixed daily fee and a percentage of the amount wagered.




2. Wide Area Game Network, Community
Gaming: Electronically linked gaming machines that are located across
multiple casinos within a gaming jurisdiction contribute to and compete for
large, system-wide progressive jackpots. They are designed to increase gaming
machine play for participating casinos by giving the players the opportunity to
win a larger jackpot than on a stand-alone gaming machine.




3. Local Area Progressive Jackpots
(LAP) participation games:Electronically linked gaming machines that are
located within a single casino to a progressive jackpot for that specific
casino.




4. Lottery Products, Video Lottery
Terminals, Mobile Lottery Terminals, Online Paperless Lottery Sales
Systems: Video gaming machines featured with localized Chinese and Asian
themes and contents, advanced graphics, digital sound effects and music and
incorporate many of the same features as our other gaming machines.




5. Server-based Gaming: A
gaming system in which game content and peripherals are configured, maintained
and refreshed over a network that links groups of gaming machines to a remote
server that also enables custom configuration by operators and central
determination of game outcomes.




Gaming
Market Overview on Macau, China




According
to Macau government statistics, casinos in Macau raked in more than US$10.3
billion (euro7.11 billion) in gaming revenue in 2007, an increase of 46 percent
over the previous year as Las Vegas operators rushed to open luxury resorts
targeting China's newly wealthy. Macau, the only place in China where casino
gambling is legal, overtook the Las Vegas Strip as the world's top gambling
center in 2006. During 2006, the 24 casinos in Macau rang up US$6.95 billion in
gaming revenue, while the Strip made US$6.69 billion, regulators in the cities
said.  Macau, a former Portuguese territory and now a special
administration region of China, added four new casinos in 2006 and is now
rivaling the entire U.S. state of Nevada in gaming revenue, according to figures
posted on the Web site of Macau's Gaming Inspection and Coordination Bureau.
Nevada reported gaming revenues of US$12.7 billion (euro8.77 billion) for the
year to Nov. 30, 2007, according to the state's Gaming Control
Board.





In 2008,
PacificNet and its gaming subsidiaries will focus on emerging gaming markets
worldwide including Asia, South America and Europe. Specific markets will
include the UK, Russia, Ukraine, Italy, Germany, Argentina, Colombia, India,
Australia, Cambodia, and most notably, Macau, China. PacificNet has chosen to
focus on emerging markets due to their projected growth and low barrier to
entry.




38




RESULTS
OF OPERATIONS




REVENUES




Revenues for the three and nine months ended
September 30, 2008 amounted to $5,648,000 and $15,067,000 respectively, a
year-over-year decline of 7% and 2% as compared to $5,254,000 and $15,314,000
for the same periods of the prior year. The year-over-year decrease in revenues
was mainly due to the disposal of major legacy CRM and call center unit.
Segmented financial information of the three business operating groups is set
out below followed by a brief discussion of each business
group.




THREE AND
NINE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 2007




Group
      1
            
            
            Group
      2.
            
            
            Group
      3
            
            
            Group
      4For
      The Three Months Ended September 30, 2008
            
            Outsourcing
      Services
            
            
            Telecom
      Value-Added Services
            
            
            Products
      (Telecom & Gaming)
            
            
            Other
      Business
            
            
            Total(In
      thousands of US Dollars)
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)Revenues
            
            
            591
            
            
            
            369
            
            
            
            4,649
            
            
            
            39
            
            
            
            5,648Earnings
      / (Loss) from Operations
            
            
            (61
            )
            
            
            (156
            )
            
            
            (105
            )
            
            
            (1,400
            )
            
            
            (1,722
            )





Group
      1
            
            
            Group
      2.
            
            
            Group
      3
            
            
            Group
      4For
      The Three Months Ended September 30, 2007
            
            Outsourcing
      Services
            
            
            Telecom
      Value-Added Services
            
            
            Products
      (Telecom & Gaming)
            
            
            Other
      Business
            
            
            Total(In
      thousands of US Dollars)
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)Revenues
            
            
            510
            
            
            
            360
            
            
            
            4,349
            
            
            
            35
            
            
            
            5,254Earnings
      / (Loss) from Operations
            
            
            (82
            )
            
            
            99
            
            
            
            125
            
            
            
            (325
            )
            
            
            (183
            )





Group
      1
            
            
            Group
      2.
            
            
            Group
      3
            
            
            Group
      4For
      The Nine Months Ended September 30, 2008
            
            Outsourcing
      Services
            
            
            Telecom
      Value-Added Services
            
            
            Products
      (Telecom & Gaming)
            
            
            Other
      Business
            
            
            Total(In
      thousands of US Dollars)
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)Revenues
            
            
            1,875
            
            
            
            870
            
            
            
            12,200
            
            
            
            122
            
            
            
            15,067Earnings
      / (Loss) from Operations
            
            
            (372
            )
            
            
            (123
            )
            
            
            (450
            )
            
            
            (2,380
            )
            
            
            (3,325
            )





39





Group
      1
            
            
            Group
      2.
            
            
            Group
      3
            
            
            Group
      4For
      The Nine Months Ended September 30, 2007
            
            Outsourcing
      Services
            
            
            Telecom
      Value-Added Services
            
            
            Products
      (Telecom & Gaming)
            
            
            Other
      Business
            
            
            Total(In
      thousands of US Dollars)
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)
            
            
            ($)Revenues
            
            
            1,575
            
            
            
            1,261
            
            
            
            12,268
            
            
            
            211
            
            
            
            15,314Earnings
      / (Loss) from Operations
            
            
            (106
            )
            
            
            453
            
            
            
            1,428
            
            
            
            (1,791
            )
            
            
            (16
            )




(1)
            Outsourcing
      Services:




Revenues
from outsourcing services for the three and nine months ended September 30, 2008
amounted to $591,000 and $1,875,000 respectively as compared to $510,000 and
$1,575,000 for the same periods of last year. Outsourcing services revenues for
the third quarter this year made up of 10 % of the Company’s total revenues and
was mainly derived from the software development, R&D, and project
management services.




(2)
            Telecom Value-added
      Services (VAS):




Revenues
for the three months and nine months ended September 30, 2008 were $369,000 and
$870,000 respectively, a year-over-year increase of 3% and (31) % as compared to
$360,000 and $1,261,000 for the same periods last year.


(3)
              Products (Telecom
      & Gaming):


Revenues
for the three and nine months ended September 30, 2008 were $4,649,000 and
$12,200,000 respectively, as compared to $4,349,000 and $12,268,000 for the same
periods of the prior year. Quarterly products revenues accounted for 82% of the
Company's total revenues for the third quarter of FY2008, and mainly derived
from mobile phone wholesaling and distribution business.




COST
OF REVENUES




Cost of
revenues for the three and nine months ended September 30, 2008 were $4,928,000
and $12,508,000 respectively, representing a year-over-year increase of 21% and
2% as compared to $4,075,000 and $11,638,000 for the same periods last
year. Cost of revenues as a percentage of the corresponding revenues was
approximately 87% and 83% for the three and nine months ended September 30, 2008
respectively as compared to 78% and 76% for the same periods of the prior
year.




40




(1) Outsourcing
services:




Cost of
revenues from outsourcing services for the three and nine months ended September
30, 2008 were $496,000 and $1,451,000 respectively, a year-over-year increase of
20% and 22% as compared to $416,000 and $1,191,000 for the same periods last
year. Increase in cost of revenues was largely due to headcount increase at
service staff level.




(2) Telecom Value-added
Services (VAS):




Cost of
revenues from VAS for the three months and nine months ended September 30, 2008
were $335,000 and $489,000 respectively, a year-over-year increase of 309 % and
40% as compared to the same periods last year.




(3) Products (Telecom &
Gaming):




Cost of
revenues derived from Products for the three and nine months ended September 30,
2008 were $4,095,000 and $10,531,000 respectively, a year-over-year decrease of
12% and 5% as compared to the same periods last year. Approximately 96% of the
cost of revenues related to Products for the third quarter of FY2008 was derived
from the sales of mobile phones, and 3% was derived from the sales of electronic
gaming machines.




GROSS
PROFIT




Gross
profit for the three and nine months ended September 30, 2008 was $720,000 and
$2,559,000, a year-over-year decrease of 39 % and 30% as compared to $1,179,000
and $3,676,000 for the same periods of the prior year. Gross margin for the
three and nine months ended September 30, 2008 was 13% and 17% respectively as
compared to 22% and 24% for the same periods last year.




SELLING,
GENERAL AND ADMINISTRATIVE EXPENSES




Selling,
general and administrative expenses (SG&A) totaled $2,336,000 and $5,576,000
for the three and nine months ended September 30, 2008 respectively, a
year-over-year increase of 88% and 65% as compared to $1,242,000 and $3,371,000
for the same periods of the prior year. SG&A as a percentage of quarterly
revenues, however, recorded a quarter-over-quarter increase from 24% to 41%.
SG&A for the nine months ended September 30, 2008 was mainly derived from
the provisions for bad debts of $1,506,000 against receivables, the stock-based
compensation cost of $670,000 and the legal or professional expenses of
$507,000. SG&A consist primarily of indirect staff salaries, office rental,
insurance, advertising expenditure and traveling cost.




Three
      months ended September 30
            
            
            PercentageSELLING,
      GENERAL AND ADMINISTRATIVE EXPENSES
            
            2008
            
            
            2007
            
            
            Change(in
      thousands, except percentages)
            
            ($)
            
            
            ($)
            
            
            (%)Remuneration
      and related expenses
            
            
            1,255
            
            
            
            660
            
            
            
            90Office
      (majority is rental and utilities)
            
            
            245
            
            
            
            171
            
            
            
            43Travel
            
            
            87
            
            
            
            111
            
            
            
            (21
            )Entertainment
            
            
            38
            
            
            
            38
            
            
            
            0Professional
      (legal and consultant)
            
            
            409
            
            
            
            115
            
            
            
            255Audit
            
            
            11
            
            
            
            577
            
            
            
            (98
            )Selling
            
            
            180
            
            
            
            102
            
            
            
            77Recovery
      of provisions for doubtful accounts from subsequent
      collections
            
            
            (134
            )
            
            
            (655
            )
            
            
            (80
            )Other
            
            
            245
            
            
            
            124
            
            
            
            98Total
            
            
            2,336
            
            
            
            1,242
            
            
            
            88




41




Nine
      months ended September 30
            
            
            PercentageSELLING,
      GENERAL AND ADMINISTRATIVE EXPENSES
            
            2008
            
            
            2007
            
            
            Change(in
      thousands, except percentages)
            
            ($)
            
            
            ($)
            
            
            (%)Remuneration
      and related expenses
            
            
            2,611
            
            
            
            2,284
            
            
            
            14Office
      (majority is rental and utilities)
            
            
            588
            
            
            
            500
            
            
            
            18Travel
            
            
            286
            
            
            
            282
            
            
            
            1Entertainment
            
            
            119
            
            
            
            92
            
            
            
            29Professional
      (legal and consultant)
            
            
            649
            
            
            
            449
            
            
            
            44Audit
            
            
            167
            
            
            
            689
            
            
            
            (76
            )Selling
            
            
            496
            
            
            
            226
            
            
            
            119Recovery
      of provisions for doubtful accounts from subsequent
      collections
            
            
            393
            
            
            
            (1,389
            )
            
            
            (128
            )Other
            
            
            266
            
            
            
            237
            
            
            
            12Total
            
            
            5,576
            
            
            
            3,371
            
            
            
            65




INCOME
(LOSS) FROM OPERATIONS




On a
year-over-year basis, Loss from operations amounted to $1,722,000 and $3,325,000
for the three and nine months ended September 30, 2008, as compared to Loss from
operations of $183,000 and $16,000 for the same periods of prior year. Operating
loss for the nine months was mainly due to the year-over-year increased SG&A
expenses amounted to $2,205,000 as the Company created approximately $1.5
million provisions for bad debts against receivables.




INCOME
TAXES




Income
tax provisions for the nine months ended September 30, 2008 was $3,000 (2007Q3:
zero). The provision of income taxes depends on the tax rate and tax exemption.
Pursuant to the PRC Income Tax Laws, the Company’s subsidiaries and VIEs are
generally subject to Enterprise Income Taxes (“EIT”) at a statutory rate of 33%,
which comprises 30% national income tax and 3% local income tax. Certain
subsidiaries and VIEs are qualified for preferred high technology or software
enterprise tax status, and they are subject to preferential tax rate of 15%
under PRC Income Tax Rules.




42




MINORITY
INTERESTS




Minority
interests for the three and nine months ended September 30, 2008 totaled
$171,000 and $326,000 respectively as compared to $3,000 and $(524,000) for the
same period of the prior year, representing minority ownership interests in
subsidiaries in the Company’s consolidated financial statement.




NET
INCOME (LOSS)




On a
year-over-year basis, Net Loss amounted to $1,939,000 and $4,404,000
respectively for the three and nine months ended September 30, 2008, as compared
to $220,000 and $639,000 for the same periods of the prior year. The
year-over-year increased Net Loss was mainly due to the disposal of assets and
the provisions for bad debts.




CASH




Net cash
and cash equivalents at September 30, 2008 were approximately $1.08 million as
compared to $1.91 million at December 31, 2007. This was primarily due to
the cash flow-out from the purchase of Intellectual Property (IP) assets and
Slot Machines., and the payment of Convertible Debenture.




CONTRACTUAL
OBLIGATIONS




CONTRACTUAL
OBLIGATIONS




Cash
resources required to satisfy short and long term Contractual obligations as of
September 30, 2008 are tabulated below:




Payments
Due by Period




Contractual
      Obligations (in thousands)
            
            Total
            
            
            Less
      than 1 year
            
            
            1-5
      years
            
            After
      5 yearsLine
      of credit
            
            $
            5
            
            
            
            5Bank
      Loans
            
            
            1,840
            
            
            
            90
            
            
            
            1,750Operating
      leases
            
            
            277
            
            
            
            192
            
            
            
            85Total
      cash contractual obligations
            
            $
            2,122
            
            
            
            287
            
            
            
            1,835




OFF-BALANCE SHEET
ARRANGEMENTS




There
were no off-balance sheet guarantees, interest rate swap transactions, foreign
currency forward contracts or long term purchase commitments outstanding as of
September 30, 2008. Further, the Company had not engaged in any non-exchange
trading activities during the third quarter of 2008.




INFLATION





Inflation
has not had a material impact on the Company's business in recent
years.




43




CURRENCY
EXCHANGE FLUCTUATIONS





All of the Company's revenues are
denominated either in U.S. dollars or Hong Kong dollars, while its expenses are
denominated primarily in Hong Kong dollars and Renminbi ("RMB"), the currency of
the People's Republic of China. The value of the RMB-to-U.S. dollar or Hong Kong
dollar-to-United States dollar and other currencies may fluctuate and is
affected by, among other things, changes in political and economic conditions.
Since 1994, the conversion of Renminbi into foreign currencies, including U.S.
dollars, has been based on rates set by the People's Bank of China, which are
set daily based on the previous day's interbank foreign exchange market rates
and current exchange rates on the world financial markets. Since 1994, the
official exchange rate generally has been stable. Recently there has been
increased political pressure on the Chinese government to decouple the RMB from
the United States dollar. Although a devaluation of the Hong Kong dollar or RMB
relative to the United States dollar would likely reduce the Company's expenses
(as expressed in United States dollars), any material increase in the value of
the Hong Kong dollar or RMB relative to the United States dollar would increase
the Company's expenses, and could have a material adverse effect on the
Company's business, financial condition and results of operations. The Company
has never engaged in currency hedging operations and has no present intention to
do so.




ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




We are
exposed to various market risks arising from adverse changes in market rates and
prices, such as foreign exchange fluctuations and interest rates, which could
impact our results of operations and financial position. We do not currently
engage in any hedging or other market risk management tools, and we do not enter
into derivatives or other financial instruments for trading or speculative
purposes.




Foreign
Currency Exchange Rate Risk




Fluctuations
in the rate of exchange between the U.S. dollar and foreign currencies,
primarily the Hong Dollar and the Chinese Renminbi, could adversely affect our
financial results. During the quarter ended September 30, 2006, approximately
all of our sales are denominated in foreign currencies. We expect that foreign
currencies will continue to represent a similarly significant percentage of our
sales in the future. Selling, marketing and administrative costs related to
these sales are largely denominated in the same respective currency, thereby
mitigating our transaction risk exposure. We therefore believe that the risk of
a significant impact on our operating income from foreign currency fluctuations
is not substantial. However, for sales not denominated in U.S. dollars, if there
is an increase in the rate at which a foreign currency is exchanged for U.S.
dollars, it will require more of the foreign currency to equal a specified
amount of U.S. dollars than before the rate increase. In such cases and if we
price our products in the foreign currency, we will receive less in U.S. dollars
than we did before the rate increase went into effect. If we price our products
in U.S. dollars and competitors price their products in local currency, an
increase in the relative strength of the U.S. dollar could result in our price
not being competitive in a market where business is transacted in the local
currency. All of our sales denominated in foreign currencies are denominated in
the Hong Dollar and the Chinese Renminbi. Our principal exchange rate risk
therefore exists between the U.S. dollar and these two currencies. Fluctuations
from the beginning to the end of any given reporting period result in the
re-measurement of our foreign currency-denominated receivables and payables,
generating currency transaction gains or losses that impact our non-operating
income/expense levels in the respective period and are reported in other
(income) expense, net in our combined consolidated financial statements. We do
not currently hedge our exposure to foreign currency exchange rate fluctuations.
We may, however, hedge such exposure to foreign currency exchange rate
fluctuations in the future.




44




All of
our sales denominated in foreign currencies are denominated in the Hong Dollar
and the Chinese Renminbi. Our principal exchange rate risk therefore exists
between the U.S. dollar and these two currencies. Fluctuations from the
beginning to the end of any given reporting period result in the re-measurement
of our foreign currency-denominated receivables and payables, generating
currency transaction gains or losses that impact our non-operating
income/expense levels in the respective period and are reported in other
(income) expense, net in our combined consolidated financial statements. We do
not currently hedge our exposure to foreign currency exchange rate fluctuations.
We may, however, hedge such exposure to foreign currency exchange rate
fluctuations in the future.




Interest
Rate Risk




Changes
in interest rates may affect the interest paid (or earned) and therefore affect
our cash flows and results of operations. We are exposed to interest rate change
risk with respect to one of our subsidiaries credit facility with a commercial
lender. However, we do not believe that this interest rate change risk is
significant.




Inflation




Inflation
has not had a material impact on the Company's business in recent
years.




Currency
Exchange Fluctuations




All of
the Company's revenues are denominated either in U.S. dollars or Hong Kong
dollars, while its expenses are denominated primarily in Hong Kong dollars and
Chinese Renminbi ("RMB"). The value of the RMB-to-U.S. dollar or Hong Kong
dollar-to-United States dollar and other currencies may fluctuate and is
affected by, among other things, changes in political and economic conditions.
Since 1994, the conversion of Renminbi into foreign currencies, including U.S.
dollars, has been based on rates set by the People's Bank of China, which are
set daily based on the previous day's inter-bank foreign exchange market rates
and current exchange rates on the world financial markets. Since 1994, the
official exchange rate for the conversion of Renminbi to U.S. dollars had
generally been stable and the Renminbi had appreciated slightly against the U.S.
dollar. However, on July 21, 2005, the Chinese government changed its policy of
pegging the value of Chinese Renminbi to the U.S. dollar. Under the new policy,
Chinese Renminbi may fluctuate within a narrow and managed band against a basket
of certain foreign currencies. Recently there has been increased political
pressure on the Chinese government to decouple the Renminbi from the United
States dollar. At the recent quarterly regular meeting of People's Bank of
China, its Currency Policy Committee affirmed the effects of the reform on
Chinese Renminbi exchange rate. Since February 2006, the new currency rate
system has been operated; the currency rate of Renminbi has become more flexible
while basically maintaining stable and the expectation for a larger appreciation
range is shrinking. Although a devaluation of the Hong Kong dollar or Renminbi
relative to the United States dollar would likely reduce the Company's expenses
(as expressed in United States dollars), any material increase in the value of
the Hong Kong dollar or Renminbi relative to the United States dollar would
increase the Company's expenses, and could have a material adverse effect on the
Company's business, financial condition and results of operations. For
fluctuations in period to period exchange rates, the translation adjustment is
required to translate from local functional currency to the USD reporting
currency (not RMB to HKD to USD). The Company has never engaged in currency
hedging operations and has no present intention to do so.




45




Concentration
of Credit Risk




Credit
risk represents the accounting loss that would be recognized at the reporting
date if counterparties failed completely to perform as contracted.
Concentrations of credit risk (whether on or off balance sheet) that arise from
financial instruments exist for groups of customers or counterparties when they
have similar economic characteristics that would cause their ability to meet
contractual obligations to be similarly affected by changes in economic or other
conditions as described below:




●
            The
      Company's business is characterized by rapid technological change, new
      product and service development, and evolving industry standards and
      regulations. Inherent in the Company's business are various risks and
      uncertainties, including the impact from the volatility of the stock
      market, limited operating history, uncertain profitability and the ability
      to raise additional capital.




●
            All
      of the Company's revenue is derived from Asia and Greater China. Changes
      in laws and regulations, or their interpretation, or the imposition of
      confiscatory taxation, restrictions on currency conversion, devaluations
      of currency or the nationalization or other expropriation of private
      enterprises could have a material adverse effect on our business, results
      of operations and financial
condition.




●
            If
      the Company is unable to derive any revenues from Greater China, it would
      have a significant, financially disruptive effect on the normal operations
      of the Company.




A
substantial portion of the operations of business operations depend on mobile
telecommunications operators (operators) in China and any loss or deterioration
of such relationship may result in severe disruptions to their business
operations and the loss of a significant portion of the Company's revenue. The
VIEs rely entirely on the networks and gateways of these operators to provide
its wireless value-added services. Specifically these operators are the only
entities in China that have platforms for wireless value-added services. The
Company's agreements with these operators are generally for a period of less
than one year and generally do not have automatic renewal provisions. If neither
of them is willing to continue to cooperate with the Company, it would severely
affect the Company's ability to conduct its existing wireless value-added
services business.


.


Seasonality
and Quarterly Fluctuations




Several
of our businesses experience fluctuations in quarterly performance.
Traditionally, the first quarter from January to March is a low season for our
call center business due to the long Lunar New Year holidays in China Revenues
and income from gaming products, call center and telecom value-added services
tend to be higher in the fourth quarter due to special holiday promotions.
Internet/Direct Commerce revenues also tend to be higher in the fourth quarter
due to increased consumer spending during that period. Revenues from the gaming
and VAS can vary from quarter to quarter due to new product launches and the
seasonality of certain product lines.




46




Sales of
our gaming machines to Macau and other Asian casinos and gaming operators are
generally strongest in Q3 and Q4 and slowest in the Chinese New Year holiday
season in Q1. In addition, quarterly revenues and net income may increase when
we receive a larger number of approvals for new games from regulators and gaming
operators than in other quarters, when a game or platform that achieves
significant player appeal is introduced or if gaming is permitted in a
significant new jurisdiction. In addition, as further technology advancements
become available for the gaming industry, replacement or conversion of gaming
machines will be impacted once any such advanced technology is approved by
regulators.




ITEM
4T. CONTROLS AND PROCEDURES




(a)
Disclosure Controls and Procedures




Pursuant
to Rule 13a-15 and 15d-15 under the Exchange Act, we carried out an evaluation
under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, of the effectiveness of
and design and operation of our disclosure controls and procedures as of
September 30, 2008. Based on that evaluation, our disclosure controls and
procedures were ineffective, as of the end of the period covered by this report,
due to the material weakness in our internal control over financial reporting
described below.




In
designing and evaluating our disclosure controls and procedures, our management
recognizes that any controls and procedures, no matter how well designed and
operated, can provide only reasonable assurance of achieving the desired control
objectives, and management necessarily is required to apply its judgment in
designing and evaluating the controls and procedures. We regularly review and
document our disclosure controls and procedures, and our internal controls over
financial reporting, and may from time to time make appropriate changes aimed at
enhancing their effectiveness and ensure that our systems evolve with our
business.




(b)
Internal Control Over Financial Reporting




Our
management is responsible for establishing and maintaining an adequate system of
internal control over financial reporting, as defined by Exchange Act Rule
13a-15(f) and 15d-15(f). Our management carried out an evaluation with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of our internal control over financial
reporting as of the end of the period covered by this report. Management used
the framework established by the Committee of Sponsoring Organizations of the
Treadway Commission in Internal Control — Integrated Framework (COSO) in
conducting its evaluation. Because of its inherent limitations, internal control
over financial reporting cannot provide absolute assurance of achieving
financial reporting objectives. Internal control over financial reporting is a
process that involves human diligence and compliance and is subject to lapses in
judgment and breakdowns resulting from human failures. Internal control over
financial reporting also can be circumvented by collusion or improper management
override. Because of such limitations, there is a risk that material
misstatements may not be prevented or detected on a timely basis by internal
control over financial reporting. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions or that the degree of compliance
with established policies or procedures may deteriorate.




47




A
material weakness is a control deficiency, or a combination of control
deficiencies, that results in a reasonable possibility that a material
misstatement of the annual or interim financial statements will not be prevented
or detected. Based on our evaluation described above, management has concluded
that our internal control over financial reporting was not effective as of
September 30, 2008. Management has determined that (i) our inadequate staffing
and supervision and (ii) the significant amount of manual intervention required
in our accounting and financial reporting process are material weaknesses in our
internal control over financial reporting.




(c)
Changes in Internal Control over Financial Reporting




There was
no change in our internal control over financial reporting that occurred during
our most recently completed fiscal quarter that materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.




Regarding
the material weakness described above, we have identified the following changes
necessary to improve our internal control over financial reporting. We have
recently signed an agreement with MetricStream to install their software
programs on our system and they will also assist us in the training of our
accounting staff and implementation of the system as well as on-going compliance
monitoring. MetricStream is a market leader in enterprise-wide governance, risk,
compliance and quality solutions for global corporations. MetricStream solutions
are used by leading corporations such as Pfizer, Covidien, NASDAQ, SanDisk, BP,
Entergy, Subway, Fairchild Semiconductor, Hitachi and TaylorMade-Adidas Golf in
diverse industries such as pharmaceuticals, medical devices, automotive, food,
high tech manufacturing, energy and financial services to manage their quality
processes, regulatory and industry-mandated compliance and corporate governance
initiatives, as well as by over a million compliance professionals worldwide via
complianceonline.com portal.




PART
II - OTHER INFORMATION




ITEM
1. LEGAL PROCEEDINGS




None




ITEM
1A. RISK FACTORS




In
addition to the other information set forth in this report, you should carefully
consider the factors discussed in “Risk Factors” in our Annual Report on Form
10-K for the year ended December 31, 2007, which could materially affect our
business, financial condition or future results. The risks described in our
Annual Report on Form 10-K are not the only risks facing us Additional
risks and uncertainties not currently known to us or that we currently deem to
be immaterial also may materially adversely affect our business, financial
condition and/or operating results.




48




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




None.




ITEM
3. DEFAULTS UPON SENIOR SECURITIES




None.




ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS




None.




ITEM
5. OTHER INFORMATION




None.




ITEM
6. EXHIBITS




The
following exhibits are filed as part of this report:




EXHIBIT
              NUMBER
            DESCRIPTION




31.1
            Rule
      13a-14(a) Certification of Chief Executive Officer (Principal Executive
      Officer)




31.2
            Rule
      13a-14(a) Certification of Chief Financial Officer (Principal Financial
      Officer)




32.1
            18
      U.S.C. Section 1350 Certifications




49




SIGNATURES




In
accordance with the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.




PACIFICNET
      INC.Date: November
      21, 2008
            By:
            /s/Victor
      TongVictor
      Tong
              Chief
      Executive Officer
              (Principal
      Executive Officer)Date:
      November 21, 2008
            By:
            /s/ Phillip WongPhillip
      Wong
              Chief
      Financial Officer
              (Principal
      Financial Officer)