**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

| **x**                                                                                                                                                                                                                                                                                                                                                   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934**                |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **For  the quarterly period ended September 30, 2005**                                                                                                                                                                                                                                                                                             |
| **o**                                                                                                                                                                                                                                                                                                                                                   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
| **For  the transition period from                             to                           ** |

 

**Commissionfile number 000-29335**

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**WITNESS SYSTEMS, INC.**

(Exact Name of Registrantas Specified in its Charter)

| **Delaware**                                                     | ** ** | **23-2518693**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization) |       | (I.R.S. Employer  Identification No.) |
| **300 Colonial Center Parkway  Roswell, Georgia**                | ** ** | **30076**                             |
| (Address of  Principal Executive Offices)                        |       | (Zip Code)                            |

 

**Registrant’s telephone number,including area code**770-754-1900

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes  x   No  o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes  x   No  o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes  o   No  x

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

| Class                                   | ** ** | **Outstanding at October 28, 2005** |
|-----------------------------------------|------------|------------------------------------------|
| Common Stock, par  value $.01 per share |       | 27,786,990                               |

 

 

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**WITNESS SYSTEMS, INC.FORM 10-QINDEX**
| PART I.  | FINANCIAL  INFORMATION                                                                                                 | 3  |
|---------------|------------------------------------------------------------------------------------------------------------------------|----|
| Item 1.       | Financial  Statements:                                                                                                 | 3  |
|          | Condensed  Consolidated Balance Sheets at September 30, 2005 and December 31,  2004                          | 3  |
|          | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2005 and 2004 | 4  |
|          | Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2005 and 2004           | 5  |
|          | Notes to  the Condensed Consolidated Financial Statements                                                              | 6  |
| Item 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            | 16 |
| Item 3.       | Quantitative  and Qualitative Disclosures About Market Risk                                                            | 39 |
| Item 4.       | Controls  and Procedures                                                                                               | 39 |
| PART II. | OTHER  INFORMATION                                                                                                     | 40 |
| Item 1.       | Legal Proceedings                                                                                                      | 40 |
| Item 6.       | Exhibits                                                                                                               | 41 |
| SIGNATURES    | 42                                                                                                                     |

 

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**PART 1: FINANCIAL INFORMATION**

**Item 1.   FinancialStatements**

**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATEDBALANCE SHEETS(In thousands, except share data)(unaudited)**

| ** **                                                                                                                                                                                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                                                            | ** ** |                   | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current assets:                                                                                                                                                                                       |       |                   |       | ** **            |       |   |   | ** ** |   |
| Cash and cash equivalents                                                                                                                                                                             |       |                   | $          | 33,090                | ** ** |   |   | $ | 42,641 | ** ** |   |
| Investments                                                                                                                                                                                           |       |                   | 1,493      | ** **            |       |   | 33,842 | ** ** |   |
| Accounts receivable, net of allowance of $3,903 at  September 30, 2005 and $3,250 at December 31, 2004                                                                                      |       |                   | 37,502     | ** **            |       |   | 25,681 | ** ** |   |
| Prepaid and other current assets                                                                                                                                                                      |       |                   | 6,519      | ** **            |       |   | 4,497 | ** ** |   |
| Total current assets                                                                                                                                                                                  |       |                   | 78,604     | ** **            |       |   | 106,661 | ** ** |   |
| Intangible  assets, net                                                                                                                                                                               |       |                   | 39,711     | ** **            |       |   | 10,802 | ** ** |   |
| Goodwill                                                                                                                                                                                              |       |                   | 37,635     | ** **            |       |   | — | ** ** |   |
| Property and  equipment, net                                                                                                                                                                          |       |                   | 7,656      | ** **            |       |   | 6,197 | ** ** |   |
| Other assets                                                                                                                                                                                          |       |                   | 879        | ** **            |       |   | 839 | ** ** |   |
|                                                                                                                                                                                                  |       |                   | $          | 164,485               | ** ** |   |   | $ | 124,499 | ** ** |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                   |       | ** **            |       |   |   | ** ** |   |
| Current  liabilities:                                                                                                                                                                                 |       |                   |       | ** **            |       |   |   | ** ** |   |
| Accounts payable                                                                                                                                                                                      |       |                   | $          | 4,381                 | ** ** |   |   | $ | 4,454 | ** ** |   |
| Accrued expenses                                                                                                                                                                                      |       |                   | 18,275     | ** **            |       |   | 16,308 | ** ** |   |
| Deferred revenue                                                                                                                                                                                      |       |                   | 26,229     | ** **            |       |   | 25,406 | ** ** |   |
| Total current liabilities                                                                                                                                                                             |       |                   | 48,885     | ** **            |       |   | 46,168 | ** ** |   |
| Other long-term  liabilities                                                                                                                                                                          |       |                   | 3,338      | ** **            |       |   | 3,703 | ** ** |   |
| Deferred income  tax liabilities                                                                                                                                                                      |       |                   | 942        | ** **            |       |   | 254 | ** ** |   |
| Total liabilities                                                                                                                                                                                     |       |                   | 53,165     | ** **            |       |   | 50,125 | ** ** |   |
| Commitments and  contingencies:                                                                                                                                                                       |       |                   |       | ** **            |       |   |   | ** ** |   |
| Stockholders’ equity:                                                                                                                                                                            |       |                   |       | ** **            |       |   |   | ** ** |   |
| Preferred stock, $.01 par value; 10,000,000 shares  authorized; (50,000 shares of which have been designated as Series A  Junior Participating Preferred Stock), no shares issued or outstanding |       |                   | —     | ** **            |       |   | — | ** ** |   |
| Common stock, $.01 par value; 50,000,000 shares  authorized; 27,770,979 and 24,476,289 shares issued and outstanding at  September 30, 2005 and December 31, 2004, respectively             |       |                   | 278        | ** **            |       |   | 245 | ** ** |   |
| Additional paid-in capital                                                                                                                                                                            |       |                   | 154,303    | ** **            |       |   | 108,247 | ** ** |   |
| Accumulated deficit                                                                                                                                                                                   |       |                   | (47,214    | )                     |       |   | (39,060 | ) |   |
| Accumulated other comprehensive income                                                                                                                                                                |       |                   | 3,953      | ** **            |       |   | 4,942 | ** ** |   |
| Total stockholders’ equity                                                                                                                                                                       |       |                   | 111,320    | ** **            |       |   | 74,374 | ** ** |   |
|                                                                                                                                                                                                  |       |                   | $          | 164,485               | ** ** |   |   | $ | 124,499 | ** ** |   |

 

See accompanying notes to condensed consolidated financial statements.

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS(In thousands, except per share data)(unaudited)**

| ** **                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                         |       | $                                                    | 18,306     |                                                | $          | 13,925 |   | $ | 53,592 |   | $ | 41,965 |   |
| Services                                        |       | 28,843                                               |       | 21,332                                              |       | 80,887 |   | 60,662 |   |
| Total revenue                                   |       | 47,149                                               |       | 35,257                                              |       | 134,479 |   | 102,627 |   |
| Cost of revenue:                                |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                         |       | 4,543                                                |       | 2,737                                               |       | 13,803 |   | 10,361 |   |
| Services                                        |       | 10,801                                               |       | 8,036                                               |       | 31,110 |   | 24,335 |   |
| Total cost of revenue                           |       | 15,344                                               |       | 10,773                                              |       | 44,913 |   | 34,696 |   |
| Gross profit                                    |       | 31,805                                               |       | 24,484                                              |       | 89,566 |   | 67,931 |   |
| Operating expenses:                             |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative             |       | 21,601                                               |       | 16,422                                              |       | 63,019 |   | 47,663 |   |
| Research and development                        |       | 6,938                                                |       | 5,470                                               |       | 20,025 |   | 15,308 |   |
| Merger-related and integration costs            |       | 1,059                                                |       | 152                                                 |       | 3,643 |   | 675 |   |
| Acquired in-process research and development    |       | —                                               |       | —                                              |       | 9,000 |   | — |   |
| Operating income (loss)                         |       | 2,207                                                |       | 2,440                                               |       | (6,123 | ) | 4,285 |   |
| Interest and  other income, net                 |       | 245                                                  |       | 435                                                 |       | 439 |   | 743 |   |
| Income (loss) before provision for income taxes |       | 2,452                                                |       | 2,875                                               |       | (5,682 | ) | 5,028 |   |
| Provision for  income taxes                     |       | 1,822                                                |       | (68                                                 | )          | 2,472 |   | 101 |   |
| Net income (loss)                               |       | $                                                    | 630        |                                                | 2,943      |   | $ | (8,154 | ) | $ | 4,927 |   |
| Net income (loss)  per share:                   |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                           |       | $                                                    | 0.02       |                                                | $          | 0.12 |   | $ | (0.30 | ) | $ | 0.21 |   |
| Diluted                                         |       | $                                                    | 0.02       |                                                | $          | 0.11 |   | $ | (0.30 | ) | $ | 0.19 |   |
| Weighted-average common  shares outstanding:    |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                           |       | 27,475                                               |       | 23,631                                              |       | 26,938 |   | 23,035 |   |
| Diluted                                         |       | 30,097                                               |       | 26,202                                              |       | 26,938 |   | 25,745 |   |

 

See accompanying notes to condensed consolidated financial statements.

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS(In thousands)(unaudited)**

| ** **                                                                                | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| Cash flows from  operating activities:                                                    | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net (loss) income                                                                         |       | $                                                   | (8,154     | ) | $ | 4,927 |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities: |       |                                                |       |   |   |
| Acquired in-process research and development                                              |       | 9,000                                               |       | — |   |
| Amortization of intangible assets                                                         |       | 11,220                                              |       | 5,028 |   |
| Depreciation and amortization of property and  equipment                                  |       | 3,238                                               |       | 2,398 |   |
| Provision for accounts receivable                                                         |       | 2,546                                               |       | 516 |   |
| Deferred income taxes                                                                     |       | 1,736                                               |       | (86 | ) |
| Other non-cash items, net                                                                 |       | 312                                                 |       | 413 |   |
| Changes in  operating assets and liabilities:                                             |       |                                                |       |   |   |
| Accounts receivable                                                                       |       | (10,890                                             | )          | 3,763 |   |
| Prepaid and other assets                                                                  |       | (1,194                                              | )          | (285 | ) |
| Accounts payable and accrued expenses                                                     |       | (1,370                                              | )          | (3,972 | ) |
| Deferred revenue                                                                          |       | (1,579                                              | )          | 3,214 |   |
| Accrued restructuring and integration costs                                               |       | (4,131                                              | )          | (3,587 | ) |
| Net cash provided by operating activities                                                 |       | 734                                                 |       | 12,329 |   |
| Cash flows from  investing activities:                                                    |       |                                                |       |   |   |
| Capital expenditures                                                                      |       | (3,976                                              | )          | (2,185 | ) |
| Purchases of investments                                                                  |       | —                                              |       | (33,904 | ) |
| Proceeds from maturities of investments                                                   |       | —                                              |       | 3,000 |   |
| Proceeds from sales of investments                                                        |       | 32,562                                              |       | 18,268 |   |
| Acquisition of Blue Pumpkin Software, Inc., net  of cash acquired of $3,728          |       | (41,637                                             | )          | — |   |
| Acquisition of Optimis Group Ltd., net of cash  acquired of $1,287                        |       | (4,374                                              | )          | — |   |
| Net cash used in investing activities                                                     |       | (17,425                                             | )          | (14,821 | ) |
| Cash flows from  financing activities:                                                    |       |                                                |       |   |   |
| Proceeds from exercise of stock options and employee  stock purchase plan                 |       | 8,495                                               |       | 11,389 |   |
| Other                                                                                     |       | (151                                                | )          | — |   |
| Net cash provided by financing activities                                                 |       | 8,344                                               |       | 11,389 |   |
| Effect of exchange rate changes on cash                                                   |       | (1,204                                              | )          | 1,003 |   |
| Net (decrease) increase in cash and cash equivalents                                      |       | (9,551                                              | )          | 9,900 |   |
| Cash and cash  equivalents at beginning of period                                         |       | 42,641                                              |       | 21,517 |   |
| Cash and cash  equivalents at end of period                                               |       | $                                                   | 33,090     |   | $ | 31,417 |   |
| Supplemental cash flow  information:                                                      |       |                                                |       |   |   |
| Cash paid for interest                                                                    |       | $                                                   | 14         |   | $ | — |   |
| Cash paid for  income taxes                                                               |       | $                                                   | 428        |   | $ | 203 |   |

 

See accompanying notes to condensed consolidated financial statements.

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**WITNESS SYSTEMS, INC. ANDSUBSIDIARIESNOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTSSeptember 30, 2005(unaudited)**

**1.**   Basis ofPresentation

***Business—***Witness Systems, Inc. (“Witness”) is apublicly traded company that provides the contact center market acomplete workforce optimization software and services solution that enablesglobal enterprises to capture customer intelligence and improve workforceperformance. Witness software iscomprised of quality monitoring, compliance, high-volume and IPTelephony recording solutions, as well as workforce management, actionablelearning and performance management applications. These solutions play astrategic role in the customer interaction centers of Global 2000 and small-and medium-sized businesses (“SMBs”) as well as back office environments,and throughout the extended enterprise, including branch offices. The solutionsenable organizations to optimize their people, processes and technologythroughout the enterprise. Customers benefit from an integrated businessconsulting, implementation and training methodology that supports a rapiddeployment, enabling them to drive revenue, reduce operational costs, andachieve greater customer retention and loyalty. Our solutions frameworksupports local and enterprise traditional time division multiplexing (“TDM”)switch environments and Internet Protocol (“IP”) Telephony environments andleverages standard operating systems and hardware platforms.

Our solution set is designed to enhance the quality ofcustomer interactions across multiple communications media, including thetelephone, e-mail and the Internet, and is used primarily in the organization’scontact center(s). Our enterprise collaboration architecture allows contactcenter management to share information gathered in the contact center withother departments that service the customer, as well as throughout theorganization. The result is a proactive management tool for optimizing theircustomer relationship management (“CRM”), improving communication amongdepartments, and fine-tuning workflow, processes and quality of service fromwithin the contact center and throughout the enterprise. As a result, webelieve our customers are able to generate additional revenue opportunities,improve profitability, enhance customer retention, reduce employee turnover andimprove their overall customer service and intelligence. Using an integratedbusiness consulting, installation and training methodology, we provide servicesto support an effective and rapid deployment of our software that enablesorganizations to maximize their return on an investment on our products andservices. Our software is designed to integrate with a variety of third-partysoftware applications, such as CRM and enterprise resource planningapplications, and with existing telephony and computer network hardware andsoftware. Many of our customers are companies with an international presenceand one or more contact centers that handle voice and data customerinteractions for outbound sales and marketing operations, inboundservice/support lines, or both.

We are headquartered in Roswell,Georgia with other offices in the United States, Australia, Brazil, Canada,China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africaand the United Kingdom. We were originally incorporated in 1988 in Georgia andwere reincorporated in Delaware in 1997.

***Principles of Consolidationand Reclassifications—***The unaudited interim condensed consolidated financial statements includethe financial statements of Witness Systems, Inc. and its wholly-ownedsubsidiaries. All significant intercompany balances and transactions have beeneliminated in consolidation. Certain prior year amounts have been reclassifiedto conform to the current year presentation. In particular, prior periodinformation related to auction rate securities in the statement of cash flowswas 

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reclassified,which impacted cash flows from investing activities by $(4.2) million for thenine month period ended September 30, 2004. There was no impact on netincome or cash flow from operations as a result of the reclassification.

The financial statements hereinhave been prepared in accordance with the requirements of Form 10-Qand, therefore, do not include all information and footnotes required bygenerally accepted accounting principles in the United States of America. However,in the opinion of management, all adjustments necessary for a fair presentationof the results of operations for the relevant periods have been made. Resultsfor the interim periods are not necessarily indicative of the results to beexpected for the year. These financial statements should be read in conjunctionwith the summary of significant accounting policies and the notes to theconsolidated financial statements included in our Annual Report on Form 10-Kfor the year ended December 31, 2004, filed with the U.S. Securities andExchange Commission.

***Use of Estimates—***Thepreparation of these financial statements requires us to make certain estimatesand judgments that affect our reported assets, liabilities, revenue andexpenses, and our related disclosure of contingent assets and liabilities. Webase our estimates on historical experience and on various assumptions that webelieve to be reasonable under the circumstances. Actual results may differfrom these estimates.

**2.**   Revenue Recognition and Deferred Revenue

We recognize revenue inaccordance with the American Institute of Certified Public Accountants’Statement of Position (“SOP”) 97-2, *Software RevenueRecognition*, and SOP 98-9, *Modification of*SOP 97-2, *Software RevenueRecognition, With Respect to Certain Transactions*. Revenue isprimarily derived from licensing software and providing related servicesincluding maintenance. Product revenue, which can include software andhardware, is recognized when persuasive evidence of an agreement exists,delivery of the product has occurred, the fee is fixed or determinable,collection is probable and vendor specific objective evidence of fair value (“VSOE”)exists to allocate revenue to the undelivered elements of the arrangement. Wereport hardware revenue gross in accordance with Emerging Issues Task Force No. 99-19,*Reporting Revenue Gross as a Principal versus Netas an Agent*, because the factors indicating gross reporting outweighthe factors indicating net reporting. We recognize revenue using the residualmethod of accounting since we generally have VSOE for maintenance andprofessional services, but not for the software and hardware elements of theorder. Under the residual method,services revenue, including maintenance and professional services, is deferredat an amount equal to its fair value until those elements are delivered.Consequently, product revenue for the software and hardware may be recognized (i) upondelivery of those products when we have VSOE for the related maintenance andprofessional services sold and (ii) at an amount representing thedifference between the total order amount and the amount deferred.

Services revenue includesinstallation, training, consulting, maintenance and reimbursable travel expenses.Revenue from installation, training and consulting services is recognized uponperformance of the related services and is offered and billed as separateelements of contracts. Reimbursable travel expenses revenue is recognized uponincurrence of the related expenses. The functionality of the software and anyhardware sold is not dependent on installation and training services andcustomization is not required to enable our customers to use our products.Maintenance is offered as a separate element and the majority of contractsinclude the right to unspecified upgrades on a when-and-if available basis.Maintenance revenue is deferred and recognized ratably over the term of therelated maintenance contract.

Deferredrevenue consists of amounts collected from customers for products and servicesthat have not met the criteria for revenue recognition.

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**3.**   Blue PumpkinAcquisition

On January 24, 2005, we acquired Blue PumpkinSoftware, Inc. (“Blue Pumpkin”), a privately held California corporation. Withthis acquisition, we have extended our workforce optimization solution toinclude advanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications. Pursuant to theMerger Agreement and Plan of Reorganization, dated December 16, 2004 (the “MergerAgreement”), we paid $40 million in cash which was funded from our existingcash and investments and issued 2.1 million shares of Witness’ common stockvalued at $37.2 million (measured at the date the stock considerationbecame fixed pursuant to the application of a formula specified in the mergeragreement). On May 24, 2005, the shares issued in connection with theacquisition were registered for resale with the Securities and ExchangeCommission. Ten percent of the aggregate merger consideration is being held inescrow until January 24, 2006, one year after the closing date of theMerger. The escrow period may be extended in the event that there are pendingclaims that are brought against the escrow fund within such one-year period. Theescrow fund is available to compensate Witness, subject to certain limitations,for losses resulting from, among other things, breaches of representations,warranties or covenants in the Merger Agreement and certain pending andpotential claims.

In January 2001, IEXCorporation filed a lawsuit against Blue Pumpkin in the United States DistrictCourt for the Eastern District of Texas, Sherman Division, alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the‘355 Patent”) by making and selling certain workforce management and call routingsoftware products, including Blue Pumpkin’s Prime Time Skills and Prime TimeEnterprise products. IEX is seeking to recover actual damages, an award oftreble damages pursuant to 35 U.S.C. § 284, and an award of prejudgmentinterest, costs, and attorney’s fees. IEX is also seeking an injunction againstBlue Pumpkin’s making or selling the products that IEX claims infringe its ‘355Patent. On October 10, 2003, the District Court granted Blue Pumpkinsummary judgment of non-infringement and dismissed the remainder of the case.IEX then appealed the District Court’s summary judgment ruling to the Court ofAppeals for the Federal Circuit. On February 2, 2005, the Federal Circuitreversed, in part, the district court’s summary judgment ruling and remanded theaction to the district court for further proceedings consistent with theFederal Circuit’s analysis. Blue Pumpkin is on a schedule before the districtcourt that is likely to result in a January 2006 trial, unless the case isresolved on summary judgment. We are unable to assess what impact, if any, anadverse result in this matter might have on our financial position, results ofoperations or cash flows.

On October 4, 2005, BluePumpkin filed in the United States District Court for the Northern District ofGeorgia, Atlanta Division, a lawsuit against IEX Corporation alleging patentinfringement. Specifically, Blue Pumpkin has alleged that IEX products infringeclaims of U.S. Patent No. 6,952,732 (“the ‘732 Patent”), entitled “Methodand apparatus for multi-contact scheduling.” Blue Pumpkin has sought aninjunction and money damages for IEX’s infringement of the ‘732 Patent. Thiscase is in a preliminary stage.

Wecommenced consolidating Blue Pumpkin on January 24, 2005 and the acquisitionwas accounted for using the purchase method of accounting in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 141, *Business Combinations*. The followingsummarizes the total purchase price for Blue Pumpkin (in thousands):

| Value of Witness  Systems, Inc. common stock issued |   | $      | 37,200 |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Cash  consideration                                      |   | 40,000 |   |
| Direct  acquisition costs                                |   | 5,500  |   |
|                                                     |   | $      | 82,700 |   |

 

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Underthe purchase method of accounting, the total purchase price is allocated toBlue Pumpkin’s net tangible and intangible assets based upon their estimatedfair value as of the date of the acquisition with any amount paid in excess ofthe fair value of the net assets recorded as goodwill. Based upon the purchaseprice and review of the net assets acquired and liabilities assumed, thepurchase price allocation, is as follows (in thousands):

| Cash and  investments                |   | $      | 3,700  |   |
|--------------------------------------|--------|--------|--------|--------|
| Other current  assets                |   | 6,100  |   |
| Property and  equipment, net         |   | 700    |   |
| Acquired  technology                 |   | 21,000 |   |
| Customer  relationships              |   | 17,000 |   |
| Goodwill                             |   | 31,700 |   |
| In-process  research and development |   | 9,000  |   |
| Total assets acquired                |   | 89,200 |   |
| Current  liabilities                 |   | (3,400 | )      |
| Deferred revenue                     |   | (1,700 | )      |
| Restructuring  accruals              |   | (1,400 | )      |
| Total liabilities assumed            |   | (6,500 | )      |
|                                 |   | $      | 82,700 |   |

 

The fair values of identifiableintangible assets was determined with the assistance of Taylor Consulting Group, Inc.,an independent third-party appraiser using both an income and a cost approachtaking into consideration the nature, risks, historical patterns, economiccharacteristics, and future considerations of the assets. As of the closingdate of the merger, technological feasibility of the in-process research anddevelopment (“IPR&D”) had not been established and the technology had noalternative future use. Accordingly, we charged the value of the IPR&D atthe date of the acquisition to expense. The amount of the purchase priceallocated to IPR&D was based on established valuation techniques used inthe software industry. The fair value assigned to the acquired IPR&D wasdetermined using a discounted cash flow methodology, which discounts expectedfuture cash flows to present value. The key assumptions used in the valuationinclude, among others, expected completion date of the in-process projectsidentified as of the acquisition date, estimated cost to complete the projects,revenue contributions and expense projections assuming the resulting producthas entered the market, and discount rates based on the risks associated withthe development life cycle of the in-process technology acquired. The discountrates used in the present value calculations are obtained from aweighted-average cost of capital analysis, adjusted upward to account for the inherentuncertainties surrounding the successful development of the IPR&D, theexpected profitability levels of such technology, and the uncertainty oftechnological advances that could potentially impact the estimates. We assumethe pricing model for the resulting product of the acquired IPR&D to bestandard within its industry. We did not take into consideration anyconsequential amount of expense reductions from integrating the acquiredIPR&D with other existing in process or completed technology.

The key considerationsunderlying the valuation of acquired in-process research and development fromBlue Pumpkin are as follows: a) guidance from the Financial AccountingStandards Board (“FASB”) SFAS No. 2, *Accounting for Researchand Development Costs* and FASB Interpretation No. 4, *Applicability of FASB Statement No. 2 to Business CombinationsAccounted for by the Purchase Method*; b) percent completed as of theacquisition date; c) estimated costs to date, as well as costs to complete thetechnology; and d) the numerous technical, cost, market, and timing risks weface before the technology becomes technologically feasible.

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Goodwill of $31.7 million hasbeen recorded and represents the excess of the purchase price over the fairvalue of the tangible and other intangible assets acquired less the liabilitiesassumed. In accordance with SFAS No. 142, *Goodwill andOther Intangible Assets*, goodwill and intangible assets withindefinite useful lives are not amortized, but are tested for impairment annuallyor more frequently as circumstances indicate their value may no longer berecoverable.

The acquisition of Blue Pumpkinresulted in the acquisition of $41.8 million of net deferred tax assets. Thesepurchased deferred tax assets are primarily net operating losses, capitalizedresearch and development costs and capitalized acquisition expenses. A fullvaluation allowance has been recorded against these assets. As of September 30,2005, $1.8 million has been recorded as income tax expense with the offset as areduction to goodwill during the current year due to the utilization of thesepurchased deferred tax assets.

Supplemental unaudited pro forma information reflectingthe acquisition of Blue Pumpkin as if it occurred on January 1, 2004 is asfollows (in thousands, except per share amounts):

| ** **                                | ** ** | **Three months ended** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **September 30, 2004** | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| Total revenues                            |       |                             | $          | 43,133                                              |       |   | $ | 135,554 |   | $ | 129,590 |   |
| Net income (loss)                         |       |                             | $          | 745                                                 |       |   | $ | (1,528 | ) | $ | (3,737 | ) |
| Net income (loss)  per share—basic   |       |                             | $          | 0.03                                                |       |   | $ | (0.06 | ) | $ | (0.15 | ) |
| Net income (loss)  per share—diluted |       |                             | $          | 0.03                                                |       |   | $ | (0.06 | ) | $ | (0.15 | ) |
| Weighted average  shares—basic       |       |                             | 25,731     |                                                |       | 27,113 |   | 25,135 |   |
| Weighted average shares—diluted      |       |                             | 28,302     |                                                |       | 27,113 |   | 25,135 |   |

 

The pro forma resultsinclude adjustments for the amortization expense of intangible assets arisingfrom the acquisition and the reversal of interest income assuming the cashportion of the purchase was paid from available cash. In addition, the proforma results do not reflect any adjustments for IPR&D charges, because oftheir non-recurring nature, and cost savings and synergies that we believewould have resulted had the acquisition occurred on January 1, 2004.

**4.**   Optimis Acquisition

On May 23, 2005, we acquired Optimis GroupLimited (“Optimis”), a UK-based provider of workforce optimization softwaresolutions. Blue Pumpkin owned a minority interest in an operating subsidiary ofOptimis, the balance of which was acquired through the Optimis acquisition. Wepaid $5.0 million in cash and other consideration, which was financed fromour existing cash and investments. Ten percent of the aggregate mergerconsideration is being held in escrow until May 23, 2006, one year afterthe closing date of the Merger. The escrow period may be extended in the eventthat there are pending claims that are brought against the escrow fund withinsuch one-year period. The escrow fund is available to compensate Witness,subject to certain limitations, for losses resulting from, among other things,breaches of representations, warranties or covenants in the Merger Agreementand certain pending and potential claims.

Wecommenced the consolidation of Optimis on May 23, 2005 and the acquisitionwas accounted for using the purchase method of accounting in accordance withSFAS No. 141, *Business Combinations*.The following summarizes the total purchase price for Optimis (in thousands):

| Cash and other  consideration |   | $   | 5,000  |   |
|-------------------------------|--------|-----|--------|--------|
| Direct  acquisition costs     |   | 700 |   |
|                          |   | $   | 5,700  |   |

 

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Underthe purchase method of accounting, the total purchase price is allocated toOptimis’ net tangible and intangible assets based upon their estimated fairvalue as of the date of the acquisition with any amount paid in excess of thefair value of the net assets recorded as goodwill. Based upon the purchaseprice and review of the net assets acquired and liabilities assumed, the purchaseprice allocation, is as follows (in thousands):

| Cash and  investments     |   | $      | 1,300  |   |
|---------------------------|--------|--------|--------|--------|
| Other current  assets     |   | 1,400  |   |
| Customer  relationships   |   | 2,500  |   |
| Goodwill                  |   | 5,900  |   |
| Other long term  assets   |   | 100    |   |
| Total assets acquired     |   | 11,200 |   |
| Current  liabilities      |   | (3,400 | )      |
| Deferred revenue          |   | (1,100 | )      |
| Restructuring  accruals   |   | (1,000 | )      |
| Total liabilities assumed |   | (5,500 | )      |
|                      |   | $      | 5,700  |   |

 

Thefair values of identifiable intangible assets was determined using both anincome and a cost approach taking into consideration the nature, risks,historical patterns, economic characteristics, and future considerations of theassets.

**5.**   Acquisition-Related Restructuring Accruals andMerger-Related and Integration Costs

As a result of the Blue Pumpkin and Optimis acquisitionsduring the first nine months of 2005, we recorded $2.4 million in certainacquisition-related restructuring accruals primarily related to personnelreductions. All such costs met the criteria for accrual as outlined in EITF No. 95-3,*Recognition of Liabilities in Connection with aPurchase Business Combination*, and were included in the assetsacquired and liabilities assumed in the purchases of Blue Pumpkin and Optimis. Thefollowing table summarizes restructuring accrual activities related to allacquisitions (in thousands):

| ** **                                  | ** ** | **Severance  and Benefits** | ** ** | **Facilities** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|----------------|------------|-----------|------------|
| Accrual at  December 31, 2004          |       |                             | $          | —         |       |      |       | $ | 2,044 |   |   | $ | 2,044 |   |
| Acquisition-related restructuring provision |       |                             | 1,972      |           |       |      | 462        |   |   | 2,434 |   |
| Cash payments                               |       |                             | (1,893     | )              |       |      | (151       | ) |   | (2,044 | ) |
| Foreign exchange translation                |       |                             | (5         | )              |       |      | (106       | ) |   | (111 | ) |
| Accrual at  September 30, 2005         |       |                             | 74         |           |       |      | 2,249      |   |   | 2,323 |   |
| Less: Long-term portion                     |       |                             | —     |           |       |      | (1,747     | ) |   | (1,747 | ) |
| Current portion at  September 30, 2005 |       |                             | $          | 74             |       |      |       | $ | 502 |   |   | $ | 576 |   |

 

Thefollowing table summarizes all merger-related and integration costs (inthousands):

| ** **                           | ** ** | **Three months ended  September**  | ** ** | **Nine months ended  September**   | ** ** |
|--------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                           | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| Eyretel:                             |       |                                         |       |                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Bonus expense, net                   |       |                                         | $          | —                                       |       |   |   | $ | 152 |   |   |   | $ | 99 |   |   |   | $ | 675 |   |   |
| Blue Pumpkin and  Optimis:           |       |                                         |       |                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Merger-related and integration costs |       |                                         | 1,059      |                                         |       |   | — |   |   |   | 3,544 |   |   |   | — |   |   |
|                                 |       |                                         | $          | 1,059                                        |       |   |   | $ | 152 |   |   |   | $ | 3,643 |   |   |   | $ | 675 |   |   |

 

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During 2005 and 2004, weincurred merger-related and integration costs pertaining to the acquisitions ofBlue Pumpkin and Optimis that closed in 2005 and the Eyretel acquisition thatclosed in 2003. Merger-related and integration costs totaled $3.6 millionduring the nine months ended September 30, 2005 and included $3.5 million ofintegration expenses comprised primarily of legal costs, transitional employeesand other contractors, travel costs and advertising costs. Merger-related andintegration costs incurred in the same period a year ago totaled $0.7 millionand related to the partial accrual of a bonus payable to Eyretel’s former ChiefExecutive Officer, now our Chief Operating Officer (“COO”). Our Board ofDirectors agreed to pay a bonus of £1.0 million to our COO in connection withthe Eyretel acquisition and subsequent integration. In March 2004, £0.4million of this bonus was paid and the remaining balance of £0.6 million (or$1.1 million as of March 31, 2005) was paid in March 2005.

**6.**   Net Income(Loss) Per Share

The following is a summary of the calculation of basicand diluted net income (loss) per share (in thousands, except per share data):

| ** **                                                                         | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss)                                                                  |       | $                                                    | 630        |                                                | $          | 2,943 |   | $ | (8,154 | ) | $ | 4,927 |   |
| Weighted average shares  of common stock and common stock equivalents outstanding: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                              |       | 27,475                                               |       | 23,631                                              |       | 26,938 |   | 23,035 |   |
| Dilutive effect of stock options computed using the  treasury stock method         |       | 2,622                                                |       | 2,571                                               |       | — |   | 2,710 |   |
| Diluted common  shares and share equivalents outstanding                           |       | 30,097                                               |       | 26,202                                              |       | 26,938 |   | 25,745 |   |
| Net income (loss) per  share:                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                              |       | $                                                    | 0.02       |                                                | $          | 0.12 |   | $ | (0.30 | ) | $ | 0.21 |   |
| Diluted                                                                            |       | $                                                    | 0.02       |                                                | $          | 0.11 |   | $ | (0.30 | ) | $ | 0.19 |   |

 

Wehave excluded all outstanding stock options from the calculation of diluted netloss per common share for the nine month period ended September 30, 2005because we reported a loss in this period and all such securities areanti-dilutive. The total number of share equivalents excluded from thecalculation of historical diluted net loss per common share for the nine monthperiod ended September 30, 2005 was 2,694,262 calculated using thetreasury stock method. For the three and nine months ended September 30,2005, stock options of 508,834 and 222,328, respectively, were excluded fromthe computation of diluted earnings per share compared to 843,659 and1,027,343, respectively for the same year ago periods because they had exerciseprices that exceeded the average fair market value of our common stock forthose periods, and therefore had an anti-dilutive effect.

**7.**   Stock-BasedCompensation

Wegenerally do not record compensation expense for options granted to ouremployees because all options granted under our stock option plans have anexercise price equal to the market value of the underlying common stock on thedate of grant. As permitted under SFAS No. 148, *Accounting for Stock-Based Compensation—Transition and Disclosure*,and SFAS No. 123, *Accounting forStock-Based Compensation*, we have elected to continue to apply theprovisions of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees,*and have adopted the disclosure requirements of SFAS No. 123. Thefollowing table illustrates the effect on net income (loss) and net income(loss) per 

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share if we hadapplied the fair value method as prescribed by SFAS No. 123 (in thousands,except per share data):

| ** **                                                                                              | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reported net  income (loss)                                                                             |       | $                                                    | 630        |                                                | $          | 2,943 |   | $ | (8,154 | ) | $ | 4,927 |   |
| Add back: Stock-based employee compensation expense  included in reported net income (loss)             |       | 15                                                   |       | 44                                                  |       | 45 |   | 44 |   |
| Deduct: Total stock-based compensation expense  determined under fair value based method for all awards |       | (3,280                                               | )          | (2,458                                              | )          | (9,528 | ) | (6,082 | ) |
| Pro forma net  (loss) income                                                                            |       | $                                                    | (2,635     | )                                                   | $          | 529 |   | $ | (17,638 | ) | $ | (1,111 | ) |
| Net income (loss)  per share:                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Reported basic                                                                                          |       | $                                                    | 0.02       |                                                | $          | 0.12 |   | $ | (0.30 | ) | $ | 0.21 |   |
| Pro forma basic                                                                                         |       | $                                                    | (0.10      | )                                                   | $          | 0.02 |   | $ | (0.65 | ) | $ | (0.05 | ) |
| Reported diluted                                                                                        |       | $                                                    | 0.02       |                                                | $          | 0.11 |   | $ | (0.30 | ) | $ | 0.19 |   |
| Pro forma diluted                                                                                       |       | $                                                    | (0.10      | )                                                   | $          | 0.02 |   | $ | (0.65 | ) | $ | (0.05 | ) |

 

As of September 30, 2005,there were 0.2 million shares available for future grants under our stockoption plans.

**8.**   ComprehensiveIncome (Loss)

Totalcomprehensive income (loss) and accumulated other comprehensive incomeconsisted of the following (in thousands):

| ** **                                                   | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                   | ** ** | **   2005   **         | ** ** | **   2004   **        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss)                                            |       |                                                 | 630        |                                                |       |   | 2,943 |   |   | $ | (8,154 | ) | $ | 4,927 |   |
| Other comprehensive  income (loss):                          |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Change in net unrealized holding gain (loss) on  investments |       |                                                 | —     |                                                |       |   | 70 |   |   | 15 |   | (96 | ) |
| Foreign currency translation adjustments                     |       |                                                 | (706       | )                                                   |       |   | (164 | ) |   | (1,004 | ) | 278 |   |
| Total comprehensive  income (loss)                           |       |                                                 | $          | (76                                                 | )          |   |   | $ | 2,849 |   |   | $ | (9,143 | ) | $ | 5,109 |   |
|                                                              |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                           | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Cumulative  foreign currency translation adjustments |       |                         | $          | 3,949                       |       |   |   | $ | 4,953 |   |   |
| Unrealized net  holding gain (loss) on investments   |       |                         | 4          |                        |       |   | (11 | ) |   |
| Total accumulated other  comprehensive income        |       |                         | $          | 3,953                       |       |   |   | $ | 4,942 |   |   |

 

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**9.**   Intangible Assets

The following tables present the components ofintangible assets (in thousands):

| ** **                 | ** ** | **September 30, 2005** | ** ** |
|----------------------------|------------|----------------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**                | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Acquired  technology       |       | $                                | 35,542     |   |   | $ | (15,675 | ) |   | $ | 19,867 |   |
| Customer  relationships    |       | 21,616                           |       |   | (4,279 | ) |   | $ | 17,337 |   |
| Distribution  arrangements |       | 4,279                            |       |   | (2,165 | ) |   | $ | 2,114 |   |
| Trademarks                 |       | 1,150                            |       |   | (973 | ) |   | $ | 177 |   |
| Patents                    |       | 351                              |       |   | (135 | ) |   | $ | 216 |   |
|                       |       | $                                | 62,938     |   |   | $ | (23,227 | ) |   | $ | 39,711 |   |

 

| ** **                 | ** ** | **December 31, 2004** | ** ** |
|----------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**               | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Acquired  technology       |       | $                               | 15,588     |   |   | $ | (9,664 | ) |   | $ | 5,924 |   |
| Customer  relationships    |       | 2,336                           |       |   | (915 | ) |   | 1,421 |   |
| Distribution  arrangements |       | 4,343                           |       |   | (1,536 | ) |   | 2,807 |   |
| Trademarks                 |       | 1,237                           |       |   | (789 | ) |   | 448 |   |
| Patents                    |       | 295                             |       |   | (93 | ) |   | 202 |   |
|                       |       | $                               | 23,799     |   |   | $ | (12,997 | ) |   | $ | 10,802 |   |

 

Portionsof intangible assets and amortization expenses are subject to foreign currencytranslation adjustments. Amortization ofintangible assets included in the accompanying condensed consolidatedstatements of operations is as follows (in thousands):

| ** **                          | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                          | ** ** | **   2005   **         | ** ** | **   2004   **        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Included in:                        |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Cost of product revenue             |       |                                                 | $          | 2,348                                               |       |   |   | $ | 1,054 |   |   | $ | 6,804 |   | $ | 3,813 |   |
| Selling, general and administrative |       |                                                 | 1,633      |                                                |       |   | 405 |   |   | 4,416 |   | 1,215 |   |
|                                |       |                                                 | $          | 3,981                                               |       |   |   | $ | 1,459 |   |   | $ | 11,220 |   | $ | 5,028 |   |

 

**10.**   Line of Credit

In March 2005, we extended the maturity date onour $15.0 million line of credit to March 2006. At our election,borrowings under the line of credit bear interest at the bank’s prime rate orLIBOR plus 300 basis points. Borrowings under the revolving line of creditare limited to 85% of eligible accounts receivable, as defined by the agreement.The revolving line of credit is secured by all of our assets and requirescompliance with various covenants, including liquidity ratios and EBITDArequirements, among others. As of September 30, 2005, we were incompliance with our bank covenants.

As of September 30,2005, we had no amounts outstanding under the line of credit and the amountavailable for borrowing was $12.8 million, which was net of outstanding lettersof credit of $2.2 million. The letters of credit secure the leases on thecorporate headquarters facility and have decreasing schedules that ultimatelyexpire in 2007. In addition, we have a £0.3 million letter of credit securingour premises in the United Kingdom.

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**11.**   Segment and Geographic Information

We consider ourselves to be in a single industrysegment, specifically licensing and servicing of software applications to the customer interaction recording andanalysis market. Our chief operating decision maker receives financialinformation by geographic region; however, our operating segments areaggregated into one reportable segment based upon similar economiccharacteristics, products, services and delivery methods.

World-wideannual revenue based on customer location is as follows (in thousands):

| ** **     | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States  |       | $                                                    | 26,837     |                                                | $          | 17,489 |   | $ | 73,236 |   | $ | 53,332 |   |
| United Kingdom |       | 11,513                                               |       | 10,369                                              |       | 35,182 |   | 27,888 |   |
| Rest of World  |       | 8,799                                                |       | 7,399                                               |       | 26,061 |   | 21,407 |   |
|           |       | $                                                    | 47,149     |                                                | $          | 35,257 |   | $ | 134,479 |   | $ | 102,627 |   |

 

The rest of world revenue was derived primarily fromcustomers located in Canada, Australia, India, Japan, China, and othercountries**.**No individual customer accounted for more than 10%of consolidated revenue during the three and nine months ended September 30,2005 or 2004.

Long-lived assets, including intangible assets andgoodwill, by geography are as follows (in thousands):

| ** **     | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------|------------|------------------------------|------------|-----------------------------|------------|
| United States  |       |                         | $          | 70,298                      |       |   |   | $ | 5,518 |   |   |
| United Kingdom |       |                         | 12,372     |                        |       |   | 8,533 |   |   |
| Rest of world  |       |                         | 2,333      |                        |       |   | 2,948 |   |   |
| Total          |       |                         | $          | 85,003                      |       |   |   | $ | 16,999 |   |   |

 

**12.**   Recent Accounting Pronouncements

In December 2004, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 123R(Revised 2004), *Share-Based Payment*, whichrequires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements based on alternative fairvalue models. The share-based compensation cost will be measured based on thefair value of the equity or liability instruments issued. We currently disclosepro forma compensation expense quarterly and annually by calculating the stockoption grants’ fair value using the Black-Scholes model. Upon adoption, proforma disclosure will no longer be an alternative. SFAS No. 123R iseffective for fiscal years that begin after June 15, 2005, or January 1,2006. We are evaluating the requirements under SFAS 123R and expect theadoption to have a significant adverse impact on our results of operations, butwill not impact our cash flows.

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

This quarterly report on Form 10-Q containsforward-looking statements that are not historical facts but rather are basedon current expectations, estimates and projections about our business andindustry, and our beliefs and assumptions. Words such as “anticipates”, “expects”,“intends”, “plans”, “believes”, “seeks”, “estimates” and variations of thesewords and similar expressions are intended to identify forward-lookingstatements. These statements are not guarantees of future performance and aresubject to risks, uncertainties and other factors, some of which are beyond ourcontrol, are difficult to predict and could cause actual results to differmaterially from those expressed or forecasted in the forward-looking statements.Forward-looking statements that were true at the time made may ultimately proveto be incorrect or false. Readers are cautioned not to place undue reliance onforward-looking statements, which reflect our management’s view only as of thedate of this report. Except as required by law, we undertake no obligation toupdate any forward-looking statement, whether as a result of new information,future events or otherwise.

The following Management’sDiscussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with the Condensed Consolidated Financial Statements andNotes thereto included elsewhere in this report. Investors should carefullyreview the information contained in this report under the caption “Factors ThatMay Affect Our Future Results and Market Price of Our Stock” beginning on page27.

**Overview**

We provide the contact center market with a completeworkforce optimization software and services solution that enables globalenterprises to capture customer intelligence and improve workforce performance.Witness Systems, Inc. (“Witness”) software is comprised of qualitymonitoring, compliance, high-volume and IP Telephony recording solutions,as well as workforce management, actionable learning and performance managementapplications. These solutions play astrategic role in the customer interaction centers of Global 2000 and small-and medium-sized businesses (“SMBs”) as well as back office environments, andthroughout the extended enterprise, including branch offices. Thesolutions enable organizations to optimize their people, processes andtechnology throughout the enterprise. Customers benefit from an integratedbusiness consulting, implementation and training methodology that supports arapid deployment, enabling them to drive revenue, reduce operational costs, andachieve greater customer retention and loyalty. Our solutions frameworksupports local and enterprise traditional time division multiplexing (“TDM”)switch environments and Internet Protocol (“IP”) Telephony environments andleverages standard operating systems and hardware platforms.

Our solution set is designed to enhance the quality ofcustomer interactions across multiple communications media, including thetelephone, e-mail and the Internet, and are used primarily in the organization’scontact center(s). Our enterprise collaboration architecture allows contactcenter management to share information gathered in the contact center withother departments that service the customer, as well as throughout theorganization. The result is a proactive management tool for optimizing customerrelationship management (“CRM”), improving communication among departments, andfine-tuning workflow, processes and quality of service from within thecontact center and throughout the enterprise. As a result, we believe ourcustomers are able to generate additional revenue opportunities, improveprofitability, enhance customer retention, reduce employee turnover and improvetheir overall customer service and intelligence. Using an integrated businessconsulting, installation and training methodology, we provide services tosupport an effective and rapid deployment of our software that enablesorganizations to maximize their return on an investment in our products andservices. Our software is designed to integrate with a variety of third-partysoftware applications, such as CRM and enterprise resource planning (“ERP”)applications, and with existing telephony and computer network hardware andsoftware. Many of our customers are companies with an international presenceand one or 

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more contact centers thathandle voice and data customer interactions for outbound sales and marketingoperations, inbound service/support lines, or both.

We derive product revenue by licensing software andderive services revenue by providing related installation, training,consulting, and maintenance services. We also derive a relatively small portionof product revenue by selling hardware to customers. The majority of ourproduct revenue is derived from quality monitoring (“QM”) and workforcemanagement (“WFM”) software. We sell our products through our direct salesforce and through our indirect sales channels. Our indirect sales channelsconsist of distributors, resellers, systems integrators and Original EquipmentManufacturers (“OEM”). Distributors and resellers purchase product from us at adiscount and then resell our products to end-users (or, in the case ofdistributors, to other resellers) and referral partners are paid a fee forreferring sales leads to us or for assisting us in a sales order. Systemsintegrators are information technology (“IT”) consulting service companies whorecommend our products during client engagements. Through OEM agreements, we co-developproducts, which are sold by the OEM as part of their portfolio of products.

We intend to continue to expand our global saleschannels by entering into new reseller, distributor, OEM and similararrangements with key vendors in the contact center workforce optimizationmarket. This year approximately 42% of our license revenue has been derivedfrom the indirect sales channel.

We plan to grow our product revenue and maintain ourcompetitive position from a technology perspective through the timelyintroduction of new products, such as pre-packaged solutions, which addcapabilities such as performance analysis and e-learning management to our corequality monitoring and workforce management solutions. We also believe themarket shift from traditional hardware based recording to VoIP represents asignificant growth opportunity and our software solutions support both of theserecording environments. Sales of our pre-packaged solutions and VoIP productshave not been material to date. In addition, we believe our product offeringscan be marketed toward back-office initiatives for business process monitoring,which represents a new market for us. Factors that may impact our ability togrow our product revenue, however, include our ability to remain competitivefrom a technology perspective; market acceptance of our new products; ourability to maintain our product pricing integrity; and our ability to expandour global sales channels.

We also plan to grow our services revenue in concertwith our product revenue. When our customers license our products, theygenerally purchase installation, training and one year of support services. Therefore,as we generate product revenue, we also generate related services revenue. Inaddition, our customers generally renew their maintenance contracts with useach year. Therefore, our maintenance revenue increases as our customer baseincreases. Factors that may influence our ability to grow our services revenue,however, include our ability to continue to increase product revenues, provideservices that enable and enhance our customers’ ability to improve theefficiency and effectiveness of their call center operations and our ability tomaintain a high level of customer satisfaction.

On January 24, 2005, we acquired Blue PumpkinSoftware, Inc. (“Blue Pumpkin”), a privately held California corporation. Withthis acquisition, we have extended our workforce optimization solution toinclude advanced WFM software and services solutions including forecasting,scheduling, adherence and planning applications. Pursuant to the MergerAgreement and Plan of Reorganization, dated December 16, 2004 (the “MergerAgreement”), we paid $40 million in cash which was funded from our existingcash and investments and issued 2.1 million shares of Witness’ common stockvalued at $37.2 million (measured at the date the stock considerationbecame fixed pursuant to the application of a formula specified in the mergeragreement). On May 24, 2005, the shares issued in connection with theacquisition were registered for resale with the Securities and ExchangeCommission. Ten percent of the aggregate merger consideration is being held inescrow until January 24, 2006, one year after the closing date of theMerger. The escrow period may be extended in the event that there are pendingclaims that are brought against the escrow fund within such one-year period. Theescrow fund is available to compensate 

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Witness, subject tocertain limitations, for losses resulting from, among other things, breaches ofrepresentations, warranties or covenants in the purchase agreement and certainpending and potential claims.

On May 23, 2005, we acquired Optimis GroupLimited (“Optimis”), a UK-based provider of workforce optimization softwaresolutions. Blue Pumpkin owned a minority interest in an operating subsidiary ofOptimis, the balance of which was acquired through the Optimis acquisition. Wepaid $5.0 million in cash and other consideration that was financed fromour existing cash and investments. Ten percent of the aggregate mergerconsideration is being held in escrow for one year after the closing date ofthe Merger. The escrow period may be extended in the event that there arepending claims that are brought against the escrow fund within such period. Theescrow fund is available to compensate Witness, subject to certain limitations,for losses resulting from, among other things, breaches of representations,warranties or covenants in the purchase agreement and certain pending andpotential claims.

In 2005, the Compensation Committee of our Boardof Directors approved stock option awards for approximately 650,000 shares ofWitness common stock to certain Blue Pumpkin and Optimis employees as aninducement to join Witness. These inducement options have an exercise priceequal to the market value on the date of the grant, subject to standardprovisions for termination, forfeiture and acceleration, and are exercisablefor five years from the date of grant. The inducement options will first becomeexercisable, as to 25 percent of the total amount, after one year from thedate of grant, and commencing 13 months after grant and until the end ofthe 47th month following grant, the options will become exercisable as to anadditional two percent per month and the balance upon the 48th month followinggrant.

We are headquartered inRoswell, Georgia and have other offices throughout the United States. Wedeliver our products and services internationally through our offices inAustralia, Brazil, Canada, China, Germany, India, Japan, Mexico, theNetherlands, Singapore, South Africa and the United Kingdom. This yearapproximately 38% of our revenue was derived from operations outside of Northand South America (“the Americas.”) During 2004 and 2003, 41% and 34%,respectively, of our revenue was derived from customers outside the Americas. AtSeptember 30, 2005, we had 615 full-time employees, excludingapproximately 175 contractors located in the Asia-Pacific region, compared to486 employees at September 30, 2004. As of September 30, 2005, 204 ofthe 615 full-time employees were located outside the United States.

**CriticalAccounting Policies and Estimates**

The discussion and analysis of our financial conditionand results of operations is based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financialstatements requires us to make certain estimates and judgments that affect ourreported assets, liabilities, revenue and expenses, and our related disclosureof contingent assets and liabilities. On an on-going basis, we re-evaluateour estimates, including those related to revenue recognition, thecollectibility of receivables, accounting for acquisitions, impairment oflong-lived assets, income taxes and stock-based compensation. We base ourestimates on historical experience and on various assumptions that we believeto be reasonable under the circumstances. Actual results may differ from theseestimates. A summary of our critical accounting policies follows.

*RevenueRecognition.**  *Werecognize revenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) No. 97-2, *Software Revenue Recognition,* and SOP No. 98-9*, Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions*. Revenue isprimarily derived from licensing software and providing related servicesincluding maintenance. We also derive a relatively small portion of productrevenue by selling hardware to 

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customers since ouracquisition of Eyretel. Product revenue, which includes software and hardware,is recognized when persuasive evidence of an arrangement exists, delivery ofthe product has occurred, the fee is fixed or determinable, collection isprobable and vendor specific objective evidence of fair value (“VSOE”) existsto allocate revenue to the undelivered elements of the arrangement. We reporthardware revenue gross in accordance with Emerging Issues Task Force (“EITF”) No. 99-19,*Reporting Revenue Gross as a Principalversus Net as an Agent,* because the factors indicating grossreporting outweigh the factors indicating net reporting. We recognize revenueusing the residual method of accounting since we generally have VSOE formaintenance and professional services, but not for the software and hardwareelements of the order. Under the residual method, services revenue, includingmaintenance and professional services, is deferred at an amount equal to itsfair value until those elements are delivered. Consequently, product revenuefor the software and hardware may be recognized (i) upon delivery of thoseproducts when we have VSOE on the related maintenance and professional servicessold and (ii) at an amount representing the difference between the totalorder amount and the amount deferred.

Services revenue includes installation, training,consulting, maintenance and reimbursable travel expenses. Revenue frominstallation, training and consulting services is recognized upon performanceof the related services and is offered and billed as separate elements ofcontracts. Reimbursable travel expenses revenue is recognized upon incurrenceof the related expenses. The functionality of the software and any hardwaresold is not dependent on installation and training services and customizationis not required to enable our customers to use our products. Maintenance isoffered as a separate element and the majority of contracts include the rightto unspecified upgrades on a when-and-if available basis. Maintenance revenueis deferred and recognized ratably over the term of the related contract.

*Allowancefor Doubtful Accounts.**  *Weperform ongoing evaluations of our customers and continuously monitorcollections and payments and estimate an allowance for doubtful accounts basedon the aging of the underlying receivables, our historical experience withwrite-offs and any specific customer collection issues that we have identified.While such credit losses have historically been within our expectations and webelieve appropriate reserves have been established, we cannot assure that wewill continue to experience the same credit loss rates that we have experiencedin the past or adequately predict future credit losses. If the financialcondition of our customers were to deteriorate and resulted in an impairment oftheir ability to make payments, additional allowances may be required whichwould result in an additionalselling, general and administrative expense in the period such determination ismade.

Our revenue recognition policy is significant becauseour revenues are a key component of our results of operations. We follow veryspecific and detailed guidelines, discussed above, in measuring revenues;however, certain judgments and estimates affect the application of our revenuepolicy described above. Further, assessment of collectibility is particularlycritical in determining whether or not revenues should be recognized. We alsorecord provisions for estimated sales allowances on product and service relatedrevenues at the time the related revenues are recorded. These estimates arebased on historical sales and services allowances, analysis of customer creditsand other known factors. If future sales credits prove to be greater than thehistorical data and the estimates we used to calculate these provisions, ourrevenues could be overstated.

*Accounting forAcquisitions.**  *Accountingfor acquisitions requires management to make judgments and estimates indetermining the purchase price, the fair value of the assets and liabilitiesacquired and merger-related and integration expenses. In recording the BluePumpkin and Optimis acquisitions in 2005, significant judgment was required inestimating:

·       valuationof deferred revenue,

·       valuationof intangible assets and acquired in-process research and development,

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·       otherliabilities existing at the time of acquisition.

Changes to purchase price estimates, prior to thecompletion of the final purchase price allocation, are reflected as adjustmentsto goodwill and/or other acquired assets. Subsequent adjustments are reflectedin our results of operations. In accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 142, *Goodwilland Other Intangible Assets*, goodwill and intangible assets withindefinite useful lives are not amortized, but are tested for impairmentannually or more frequently if circumstances indicate their value may no longerbe recoverable.

*Impairmentof Long-Lived Assets.**  *Long-livedassets, such as property and equipment and intangible assets, are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. All of our identifiableintangible assets are amortized using the straight-line method. Useful lives ofamortizable intangible assets are reviewed annually with any changes inestimated useful lives being accounted for prospectively over the revisedremaining useful life. Recoverability of assets to be held and used would bemeasured by a comparison of the carrying amount of an asset to the estimatedundiscounted future cash flows expected to be generated by the asset. If thecarrying amount of an asset exceeds its estimated future cash flows, animpairment charge is recognized in the amount by which the carrying amount ofthe asset exceeds the fair value of the asset. The determination of estimatedfuture cash flows, however, would require management to make estimates. Futureevents and changes in circumstances may require us to record a significantimpairment charge in the period in which such events or changes occur.Impairment testing requires considerable analysis and judgment in determiningthe results. If other assumptions and estimates were used in our evaluations,the results could differ significantly.

*Accountingfor Income Taxes.**  *Weaccount for income taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*, whichrequires companies to recognize deferred income tax assets and liabilities fortemporary differences between the financial reporting and tax bases of recordedassets and liabilities and the expected benefits of net operating loss andcredit carryforwards. SFAS No. 109 requires that deferred income taxassets be reduced by a valuation allowance if it is more likely than not thatsome portion or all of the deferred income tax assets will not be realized. Weevaluate the realizability of our deferredincome tax assets, primarily resulting from net operating loss and credit carryforwards,and adjust our valuation allowance, if necessary.

The utilization of deferred tax assets, primarily netoperating loss carryforwards, arising from acquisitions has resulted in areduction of the valuation allowance for the deferred income tax assets, areduction in goodwill, and the recognition of tax expense associated with thepurchased deferred tax assets.

Once we utilize our net operating loss carryforwards,we would expect our provision for income tax expense in future periods toreflect an effective tax rate that will be significantly higher than pastperiods. The utilization of certain net operating loss carryforwards arisingfrom acquisitions will result in a reduction of the valuation allowance for thedeferred income tax assets and intangible assets. Furthermore, the adoption ofSFAS 123R, as noted below, will potentially result in tax benefits that arecurrently difficult to predict.

Estimates and judgments are required in determiningour worldwide income tax expense. In the ordinary course of conducting businessglobally, there are many transactions and calculations whose ultimate taxoutcome cannot be certain. Although we believe our estimates and judgments arereasonable, no assurance can be given that the final tax outcome of thesematters will not be different from what is reflected in our historical incometax provisions and accruals. Such differences could have a material impact onour income tax provision and operating results in the period in which such adetermination is made.

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In December 2004, the Financial AccountingStandards Board (“FASB”) issued Staff Position No. FAS 109-2, *Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provision within the American Jobs Creations Act of 2004*. Corporations are allowed an 85%dividends received deduction in 2004 and 2005 on the repatriation of certainforeign earnings to a U.S. taxpayer, provided certain criteria are met.Management does not believe it will repatriate any material amount of earningsin 2005. The range of possible amounts that are currently being considered forrepatriation is between $0 and $0.4 million and the tax effects of theseamounts are insignificant.

*Stock-Based Compensation.**  *We generally do not recordcompensation expense for options granted to our employees because all optionsgranted under our stock option plans have an exercise price equal to the marketvalue of the underlying common stock on the date of grant. As permitted underSFAS No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure*, and SFAS No. 123,*Accounting for Stock-Based Compensation*,we have elected to continue to apply the provisions of Accounting PrinciplesBoard Opinion No. 25, *Accounting forStock Issued to Employees,* and have adopted the disclosure requirementsof SFAS No. 123. The pro forma disclosures of stock-based compensationinclude the use of certain input factors in calculating the fair value of stockoption grants, some of which require management to make estimates and usejudgment. In December 2004, the FASB issued SFAS No. 123R (Revised2004), *Share-Based Payment*, whichrequires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements based on alternative fairvalue models. The share-based compensation cost will be measured based on thefair value of the equity or liability instruments issued. Upon adoption, proforma disclosure will no longer be an alternative. We will begin to apply SFAS No. 123Rusing the most appropriate fair value model beginning January 1, 2006. Weare evaluating the requirements under SFAS 123R and expect the adoption tohave a significant adverse impact on our results of operations, but not on ourcash flows.

**Results of Operations**

The following table sets forth the results of operationsfor the three and nine months ended September 30, 2005 and 2004 expressedas a percentage of total revenue.

| ** **                                              | ** ** | **Three Months Ended  September 30,**     | ** ** | **Nine Months Ended  September 30,**      | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                              | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                                |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                                 |       |                                                     | 39         | %                                                        |       |   | 39 | % |   |   | 40 | % |   |   | 41 | % |   |
| Services                                                |       |                                                     | 61         | %                                                        |       |   | 61 | % |   |   | 60 | % |   |   | 59 | % |   |
| Total revenue                                           |       |                                                     | 100        | %                                                        |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |
| Cost of revenue:                                        |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                                 |       |                                                     | 10         | %                                                        |       |   | 8 | % |   |   | 10 | % |   |   | 10 | % |   |
| Services                                                |       |                                                     | 23         | %                                                        |       |   | 23 | % |   |   | 24 | % |   |   | 24 | % |   |
| Total cost of revenue                                   |       |                                                     | 33         | %                                                        |       |   | 31 | % |   |   | 34 | % |   |   | 34 | % |   |
| Gross profit                                            |       |                                                     | 67         | %                                                        |       |   | 69 | % |   |   | 66 | % |   |   | 66 | % |   |
| Operating expenses:                                     |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and  administrative                    |       |                                                     | 46         | %                                                        |       |   | 46 | % |   |   | 47 | % |   |   | 46 | % |   |
| Research and development                                |       |                                                     | 15         | %                                                        |       |   | 16 | % |   |   | 15 | % |   |   | 15 | % |   |
| Merger-related and  integration costs                   |       |                                                     | 2          | %                                                        |       |   | 0 | % |   |   | 3 | % |   |   | 1 | % |   |
| Acquired in-process  research and development           |       |                                                     | 0          | %                                                        |       |   | 0 | % |   |   | 7 | % |   |   | 0 | % |   |
| Operating income (loss)                                 |       |                                                     | 5          | %                                                        |       |   | 7 | % |   |   | (5 | )% |   |   | 4 | % |   |
| Interest and other  income, net                         |       |                                                     | 1          | %                                                        |       |   | 1 | % |   |   | 0 | % |   |   | 1 | % |   |
| Income (loss) income  before provision for income taxes |       |                                                     | 5          | %                                                        |       |   | 8 | % |   |   | (4 | )% |   |   | 5 | % |   |
| Provision for income  taxes                             |       |                                                     | 4          | %                                                        |       |   | 0 | % |   |   | 2 | % |   |   | 0 | % |   |
| Net income (loss)                                       |       |                                                     | 1          | %                                                        |       |   | 8 | % |   |   | (6 | )% |   |   | 5 | % |   |

 

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*Impact of BluePumpkin and Optimis Acquisitions*

The acquisition of BluePumpkin and Optimis in 2005 increased our reported revenues in the nine monthsended September 30, 2005 by an estimated $17 million compared to the sameperiod in 2004. Operating expenses, expressed as a percentage of total revenue,also increased in the nine months ended September 30, 2005 compared to thesame period in 2004 due to a non-recurring charge of $9.0 million in acquiredin-process research and development costs, an increase of $3.0 million in merger-relatedand integration costs and additional intangible asset amortization of $6.7million.

*Revenue*

Total revenue increased 34% in the third quarter of2005, as compared to the third quarter of 2004, to $47.1 million. The increasein total revenue can be attributed to both continued growth of our business andsales and related services derived from our Blue Pumpkin acquisition, whichexpanded our workforce optimization solution. Total revenue increased 31% inthe nine months ended September 30, 2005 as compared to the same year agoperiod due to increases in product and services revenue.

Product revenue includes software revenue and hardwarerevenue. Because hardware sales are incidental to our business, we are workingtowards transitioning our customers to third-party hardware suppliers and, as aresult, expect hardware revenue to decline in the future. For the three andnine months ended September 30, 2005, hardwarerevenue was $0.8 million and $4.0 million, respectively, compared to $1.2million and $5.5 million, respectively, during 2004. Software revenue for thethree and nine months ended September 30, 2005 increased 38% and 36%,respectively, as compared to the same year ago periods. More than halfof the increase in software revenue growth in 2005 is attributed to our expandedproduct line resulting from our acquisitions of Blue Pumpkin and Optimis whichwe began consolidating upon acquisition in 2005.

Product revenue as a percentage of total revenue hasdecreased over the past three years due to lower hardware sales and increasedservices revenue, as discussed below. Our product pricing has remainedrelatively consistent over the previous three years.

New customers accounted for 41%and 30%, respectively, of product revenue, excluding hardware revenue, duringthe third quarters of 2005 and 2004. We receive follow-on revenue from ourexisting customers when they purchase additional user licenses or licenseadditional applications at existing sites and when they license our products atnew sites. We expect to continue receiving the majority of our product revenuefrom existing customers during 2005.

Services revenue,consisting of installation, training, consulting, maintenance support andreimbursable travel expenses, increased 35% and 33% in the three and ninemonths ended September 30, 2005, respectively, as compared to the sameyear ago periods. This increase was due to the installation and trainingservices related to new product sales and due to customers renewing theirmaintenance contracts with us thereby increasing our recurring maintenancerevenue stream. The Blue Pumpkin and Optimis acquisitions during 2005 accountedfor approximately half of the increase in services revenue in 2005. Thepercentage of Witness customers that have renewed their maintenance contracts withus has historically exceeded 90%. We believe that maintenance contracts will berenewed at a comparable rate during 2005. Our services pricing has remainedconsistent over the past three years. We expect services revenue, in absolutedollars, to increase over time due to the compounding effect of renewals ofannual maintenance contracts from existing customer sites and to remainrelatively constant as a percentage of total revenue, excluding hardwarerevenue, for the remainder of 2005.

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*Cost of Revenue*

Total cost of revenue increased 42% and 29% in thethree and nine months ended September 30, 2005, respectively, as comparedto the same year ago periods. Expressed as a percent of revenue, gross profitmargins decreased to 67% from 69% for the three months ended September 30,2005 as compared to the same year ago period and remained constant at 66% forthe nine months ended September 30, 2005 as compared to the same year agoperiod. The third quarter decrease is due to an increase in royalties due tothird parties resulting from changes in product mix during the quarter. Excludinghardware cost of revenue and the amortization of intangible assets resultingfrom acquisitions, gross profit margins have remained consistent at 74% in thenine months ended September 30, 2005 and 2004. We expect our gross profitmargin, excluding hardware and amortization of intangible assets, to continueto remain relatively constant for the remainder of 2005.

Cost of product revenueconsists of amortization of acquired technology, hardware costs, royalties dueto third parties for software components that are embedded in our softwareapplications, amortization of capitalized software development costs andpackaging costs. For the three and ninemonths ended September 30, 2005, amortization of acquired technology of$2.3 million and $6.8 million, respectively, increased 109% and 79%,respectively as compared to the same year ago periods due to the acquisition ofBlue Pumpkin. For the three and nine months ended September 30, 2005, costof hardware revenue of $0.8 million and $4.1 million, respectively, decreased27% and 20%, respectively, as compared to the same year ago periods. Wewill continue to incur amortization expense, but expect the cost of hardware todecline as we work towards reducing the amount of hardware sales in the future.For the three and nine months ended September 30, 2005, cost of product revenue of $1.3 million and$2.9 million, respectively, excluding amortization of acquired technology and hardware costs, increased 117% and 93%, respectively, as compared to the same year agoperiods. This increase was due to increased royalties due to thirdparties for software components that are embedded in our software applications.Such royalties increased as a result of an increase in sales of softwareapplications containing third party software components. For the three and ninemonths ended September 30, 2005, expressed as a percentage of productrevenue and excluding hardware and amortization of intangible assets, the costof product revenue, was 7% and 5%, respectively, as compared to 4% and 3% forthe same year ago periods. As we develop upgrades of our existing products and addnew offerings to our product suite, we may embed additional third-partytechnology into our software, which would increase the cost of product revenuein the future.

Cost of services revenuefor installation, training, consulting and maintenance services includepersonnel costs and related expenses and allocated overhead. Personnel costsinclude salaries, bonuses and benefits and allocated overhead. Cost of servicesrevenue increased 34% and 27% in the three and nine months ended September 30,2005, respectively, as compared to the same year ago periods due primarily toan increase in the number of employees engaged in customer support servicesmainly as a result of the Blue Pumpkin and Optimis acquisitions. Cost ofservices revenue as a percentage of services revenue was 37% in the thirdquarter of 2005, compared to 38% in the third quarter of 2004. We anticipatethat our services margins will remain relatively constant for the remainder of2005. We expect our customer service organization to continue to grow over timeand, therefore, we anticipate that our cost of services revenue, in absolute dollars,will increase as we grow our customer base.

*Operating Expenses*

*Selling,General and Administrative.**  *Selling, general and administrative expense (“SG&A”)consists primarily of personnel costs, sales commissions, marketing programs,professional fees, the amortization of certain intangible assets and provisionsfor bad debt expense. For the three andnine months ended September 30, 2005, SG&A expense of $21.6 millionand $63.0 million, respectively, was an increase of 32% as compared to the sameyear ago periods. This increase is due primarily to higher amortizationexpenses and the increased size of our Company due to acquisitions of BluePumpkin and Optimis. In 

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2005, we expect SG&Aexpense to increase in absolute dollars but decrease as a percentage of totalrevenue due to anticipated revenue growth as compared to the same period in2004.

*Researchand Development.**  *Researchand development (“R&D”) expenses consist primarily of personnel andconsulting costs to support product development and allocated overhead. R&Dcosts are generally expensed as incurred and include software development costsincurred prior to the establishment of technological feasibility. Costsincurred subsequent to establishing technological feasibility are capitalizedand amortized over their estimated useful lives to cost of product revenue. Asof September 30, 2005, we reported $0.3 million in unamortized softwaredevelopment costs. R&D expenses increased 27% and 31% in the three and ninemonths ended September 30, 2005, respectively, as compared to the sameyear ago periods due to the increased number of employees engaged in researchand development activities as a result of the Blue Pumpkin acquisition. Weexpect total R&D expense to increase in absolute dollars but decrease as apercentage of total revenue during 2005 as compared to 2004.

*Merger-relatedand Integration Costs.*   Merger-related andintegration costs during the three months ended September 30, 2005 were $1.1million and related primarily to legal costs and costs associated withtransitional employees and other contractors. Merger-related and integrationcosts incurred in the same year ago period were less than $0.2 million. Weincurred merger-related and integration costs of $3.6 million during thenine months ended September 30, 2005, primarily due to Blue Pumpkin andOptimis integration expenses. Merger-related and integration costs incurred inthe same period a year ago totaled $0.7 million and related to the final accrual of a bonus payable to Eyretel’s former ChiefExecutive Officer. Merger-related and integration costs are comprised primarilyof costs of transitional employees and other contractors, travel costs, legalcosts and advertising costs.

*Acquired In-ProcessResearch and Development Charges.**  *During the first quarter of 2005,we estimated that $9.0 million of the purchase price of Blue Pumpkinrepresented acquired in-process research and development (“IPR&D”) that hadnot yet reached technological feasibility as defined by SFAS No. 86, *Accounting for the Cost of Computer Software to BeSold, Leased or Otherwise Marketed,*and had no alternative futureuse. Accordingly, these amounts were immediately charged to expense uponconsummation of the acquisition. The value of the IPR&D was determined withthe assistance of an independent third-party appraiser by utilizing adiscounted cash flow methodology, focusing on the income-producing capabilitiesof the in-process technologies and taking into consideration: stage ofcompletion; complexity of work to date and to complete; anticipated productdevelopment and introduction schedules; forecasted product sales cycles;internal and external risk factors; revenue and operating expense estimates;contributory asset charges, and costs already incurred and the expected coststo complete.

*Interest and Other Income, Net*

Interest and other income,net consists primarily of interest earned on funds available for investment andforeign currency transaction gains and losses on settlement of contracts denominatedin currencies other than the local currency. Interest and other income, netdecreased 43% and 41% in the three and nine months ended September 30,2005, respectively, as compared to the same year ago periods due primarily todecreased interest income resulting from lower investment balances as a resultof the acquisitions of Blue Pumpkin and Optimis. We expect that interest andother income, net will decrease in 2005 compared to 2004 due to lower cash andinvestment balances.

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*Provision for Income Taxes*

We recorded a provision for income tax of $1.8 millionand $2.5 million, respectively, during the three months and nine months endedSeptember 30, 2005. Of the total provision during the three months andnine months ended September 30, 2005, $1.6 million and $1.7 million,respectively, related to the utilization of deferred tax assets,primarily net operating loss carry-forwards, acquired during the 2005acquisition of Blue Pumpkin Software, Inc. The utilization of thesedeferred tax assets in 2005 also reduced goodwill. The remainder of theprovision is primarily comprised of U.S. federal alternative minimumincome tax expense and foreign income tax, primarily from withholding. For thesame periods during 2004, the tax expense was a benefit of $(0.1)millionand an expense of $0.1 million due primarily to U.S.federal alternative minimum tax expense.

At September 30,2005, we had net operating loss carryforwards aggregating to $78.1million forU.S. tax purposes and $41.8 million for foreign tax purposes. Theprovision for income taxes prior to 2005 generally benefited from therecognition of deferred tax assets for which we had previously provided avaluation allowance in prior years. However, when the net operating loss carry forwardsbeing utilized arise from acquisitions, this results in a modification of thepurchase price allocated to intangible assets and a recognition of income taxexpense.

**Liquidity and Capital Resources**

At September 30, 2005, we had $34.6 million in totalcash and cash equivalents and investments, compared to $76.5 million atDecember 31, 2004. Working capital also decreased by $30.8 million from$60.5 million at December 31, 2004 to $29.7 million at September 30,2005. These decreases in cash and working capital were primarily due to theacquisitions of Blue Pumpkin and Optimis in 2005.

Cash flows provided by operating activities during thenine months ended September 30, 2005 were $0.7 million compared to $12.3million in cash provided by operating activities in the same year-ago period. Thecash flows provided by operations during the nine months ended September 30,2005 were significantly impacted by payments of merger-related andrestructuring costs and an increase in accounts receivable. We made cashpayments of $4.1 million and $3.6 million in accrued restructuringand integration costs during the nine months ended September 30, 2005 and2004, respectively. We also incurred $3.6 million in merger-related andintegration costs during the nine months ended September 30, 2005 and$0.7 million in the same year-ago period. We expect to pay approximately $0.9million in additional accrued restructuring and integration costs throughoutthe remainder of 2005. Our accounts receivables days sales outstanding (“DSO”)at September 30, 2005 was 72 days, an increase of 6 days from December 31,2004 due primarily to timing differences in payments received from customers. Weexpect our DSO to remain in the 70 day range throughout the remainder of theyear.

Cash flows used in investing activities increasedduring the nine months ended September 30, 2005 to $17.4 million comparedto $14.8 million in the same year-ago period, due to the acquisitions of BluePumpkin and Optimis. The cash portion of the Blue Pumpkin acquisition ($40.0million or $36.3 million net of cash and cash equivalents acquired) was fundedin part through the sale of investment securities totaling $30.9 million. Wepaid $5.0 million for Optimis (or $3.7 million net of cash and cash equivalentsacquired). Capital expenditures during the nine months ended September 30,2005 were $4.0 million, compared to $2.2 million in the same year-ago period.

Cash flows provided by financing activities during thenine months ended September 30, 2005 were $8.3 million as compared to$11.4 million during the same period last year and represent proceeds from theexercise of stock options.

At September 30, 2005, we had $12.8 millionavailable under a line of credit, which was net of outstanding letters ofcredit of $2.2 million. The letters of credit secure the lease on the corporate

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headquarters facility andhave decreasing schedules that ultimately expire in 2007. At our election,borrowings under the line of credit bear interest at the bank’s prime rate, orLIBOR plus 300 basis points and are limited to 85% of eligible accountsreceivable, as defined by the agreement. The revolving line of credit issecured by all of our assets and requires compliance with various covenants,including liquidity ratios and tangible net worth requirements, among others. Asof September 30, 2005, we were in compliance with all bank covenants.

We anticipate that operating expenses and capitalexpenditures will continue to be the major use of our cash resources. Wecurrently expect to have total capital expenditures of approximately $5.0 millionin 2005, primarily consisting of purchases of computer equipment and software. Weanticipate that our capital expenditures may increase over the next severalyears as we expand our facilities and acquire equipment to support theexpansion of our research and development activities and internal managementand information systems. We believe that our existing cash and investmentbalances, together with our anticipated cash flows from operations, will besufficient to meet our working capital and capital expenditures for at leastthe next twelve months. In addition, the availability under our line ofcredit may be used to fund working capital requirements or future merger oracquisition transactions.

Our shelf registrationstatement on Form S-3 (including subsequent amendments) filed withthe Securities and Exchange Commission (“SEC”) became effective in August 2004.The shelf registration allows us to register up to $80 million of securities,which may consist of common stock, warrants to purchase our common stock, orboth. The shelfregistration statement provides us the ability to raise equity capitalif and when appropriate for our business.The sale of additional equity securities could result in additionaldilution to our stockholders. If cash generated from operations is insufficientto satisfy our liquidity requirements and we are unable or choose not to raiseadditional equity capital or borrow under our line of credit, we may seek toestablish new financing arrangements. We cannot assure that any financingarrangements will be available in sufficient amounts or on acceptable terms. Inaddition, we registered 2.1 million shares of our common stock issued to theBlue Pumpkin shareholders in the second quarter of 2005.

*Market Risk*

Market risk represents the risk of loss that mayaffect us due to adverse changes in financial market prices and rates. Ourmarket risk exposure primarily relates to fluctuations in foreign exchangerates and interest rates. Except for the hedge transaction entered into in connectionwith the Eyretel acquisition during 2003, we have not entered into derivativeor hedging transactions to manage risk in connection with foreign exchangefluctuations and have not engaged in any interest rate hedging transactions.

We are exposed to adverse movements in foreigncurrency exchange rates because we translate foreign currencies into U.S.dollars for reporting purposes. Foreign currency translations did notcontribute significantly to our September 30, 2005 operating resultscompared to those in the same period in 2004. However, due to the relativestrengthening of the US dollar compared to the British pound Sterling andcertain other currencies compared to 2004, we currently expect that revenuereported in the fourth quarter of 2005 may be negatively impacted byapproximately $0.5 million.

Within our foreign-based operations, wheretransactions may be denominated in foreign currencies, we are also subject tomarket risk, especially when those operations conduct transactions incurrencies other than the local currency. As our international operationscontinue to grow, adverse currency fluctuations could have a material adverseimpact on our financial results. Net foreign exchange gains and (losses) were$(0.2) million and $0.1 million during thenine months ended September 30, 2005 and 2004, respectively.

Exposure to market raterisk for changes in interest rates relates to our investment portfolio. Ourinvestments are made with capital preservation and liquidity as our primaryobjectives. We generally hold 

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onlyhigh-grade investments such as commercial paper, corporate bonds and U.S.government agency securities. To reduce our balance sheet exposure tovariations in asset values, our investment policy guidelines specify that weinvest in the highest investment grade securities and maintain a weightedaverage maturity of nine months for our entire portfolio. Our investmentportfolio may contain securities with maturities of up to three years. Whilethis minimizes our interest rate risk to asset values, our results are exposedto fluctuations in interest income due to changes in market rates.

**FactorsThat May Affect Our Future Results and Market Price of Our Stock**

Our future operatingresults may vary substantially from period to period. The price of our commonstock will fluctuate in the future, and an investment in our common stock issubject to a variety of risks, including, but not limited to, the specificrisks identified below. Inevitably, some investors in our securities willexperience gains while others will experience losses depending on the prices atwhich they purchase and sell our securities. Prospective and existing investorsshould consider the following factors in evaluating our business or aninvestment in our securities. If any of the following or other risks actuallyoccurs, our business, financial condition and results of operations could beadversely affected. In that case, the trading price of our common stock coulddecline.

*Because our products have a long sales cycle, it is moredifficult to plan our expenses and forecast our results; and our operatingresults may fail to meet investor expectations, which may adversely affect ourstock price.*

It typically takes three to nine months from the timewe qualify a sales lead until we sign a sales contract with the customer. As aresult, it is difficult for us to predict the quarter in which a particularsale will occur. If our sales cycle unexpectedly lengthens for one or morelarge orders or a significant number of small orders, it would delay the timingof our revenue, but not the timing of most of our corresponding expenses.Lengthening of our sales cycle could also increase the total cost of a sale dueto additional employee time and costs associated with the sale. Material changesin our sales cycle could cause our quarterly revenue or operating results to bebelow the expectations of investors, and the price of our common stock couldfall substantially.

Our customers’decision process regarding their purchase of our products and services isrelatively long due to several factors, including:

·       thecomplex nature of our products, requiring our need to educate potentialcustomers about the uses and benefits of our products;

·       competitionfor the corporate resources necessary to finance the purchase andimplementation of our products;

·       customers’budgeting and purchasing cycles;

·       theextent of customers’ evaluation and internal approval process often requiredbefore purchasing our products and services; and

·       delayed purchases due toannouncements of new products or enhancements by our competitors or us.

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*If our products and services are not used and acceptedby existing and prospective customers, our business and results of operationswill be adversely affected.*

The market forworkforce optimization software, including software that records and analyzescustomer interactions and that forecasts and schedules employees, is stilldeveloping. Our success depends on the use and acceptance of our software andservices by existing and prospective customers. In addition, demand for oursoftware remains uncertain because our existing and potential customers may:

·       notunderstand the benefits of using workforce optimization software generally or,more specifically, software which records and analyzes the interactions betweena business and its customers or which optimizes the forecasting and schedulingof employees;

·       notachieve favorable results using our software;

·       experiencetechnical difficulty in implementing our software;

·       usealternative methods such as online self-help to solve the same businessproblems our software is intended to address; or

·       close contact centers.

*If we experience losses in the future, the marketprice of our common stock may be materially and adversely affected.*

Throughout much of ourhistory, we have experienced losses . As a result of our prior operatinglosses, we had an accumulated deficit of $47.2 million as of September 30,2005. We need to generate sufficient revenue to achieve sustained profitabilityand avoid incurring losses again in the future.

*Our quarterly results are difficult to predict andadverse fluctuations in operating results could cause our stock price to fall.*

Our quarterlyrevenue and operating results are difficult to predict and could fluctuatesignificantly from period to period. In particular, we typically derive asignificant portion of our software product revenue toward the end of eachquarter and from a small number of relatively large orders. The delay orfailure to close anticipated sales in a particular quarter could reduce ourrevenue in that quarter and subsequent quarters over which revenue for the salecould be recognized. In addition, because our revenue from installation andtraining services largely correlates with our product revenue, a decline inproduct revenue could also cause a decline in our professional services revenuein the same quarter or in subsequent quarters. Our quarterly revenue isdifficult to forecast for several reasons, including the following:

·       changesin demand for our products and services;

·       thetendency of customers to delay software purchases until the end of the fiscalquarter;

·       lengtheningof our customers’ budgeting and purchasing cycles;

·       timingof any acquisitions and related costs;

·       delaysin installations of our software;

·       varyingsales and implementation cycles for our products and services from customer tocustomer;

·       thefailure of our customers to renew their maintenance service agreements;

·       thetiming of hiring new services employees and the rate at which these employeesbecome productive; and

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·       thedevelopment and performance of our distribution channels.

As a result of these andother factors, we believe that quarter-to-quarter comparisons of our operatingresults may not be a good indicator of our future performance, and you shouldnot rely on them to predict our future performance or the performance of ourstock price. If our revenue or operating results fall below the expectations ofinvestors or securities analysts, the price of our common stock would likelydecline.

*We may be unable to manage and expand ourinternational operations, which may adversely affect our business and operatingresults.*

We derived revenues of $61.2 million and $49.3 millionduring the nine months ended September 30, 2005 and 2004, respectively,from customers located outside the United States. Our operations outside of theUnited States at September 30, 2005, consisted of offices located inAustralia, Brazil, Canada, China, Germany, India, Japan, Malaysia, Mexico, theNetherlands, Singapore, South Africa and the United Kingdom. We have alsoestablished relationships with a number of international resellers.

With ouracquisitions of Optimis in May 2005 and Blue Pumpkin in January 2005,both of which have sales outside of North America, we have expanded ourinternational operations, and we intend to continue to expand our internationaloperations through additional acquisitions, internal business expansion andstrategic business relationships. These efforts require significant managementattention and financial resources. We may not be able to successfully penetrateinternational markets or, if we do, we may not be able to grow or to maintainadequate profit margins in these markets. Because of the complex nature of ourinternational expansion, it may adversely affect our business and operatingresults. International expansion and sales are subject to many risks, includingthe following:

·       limiteddevelopment of an international market for our software and services;

·       expandingand training our international sales force and support operations;

·       highercosts of employment in certain international geographies;

·       difficultiesin producing localized versions of our products;

·       politicaland economic instability;

·       potentiallyadverse tax consequences of operating in foreign countries;

·       importand export restrictions and tariffs;

·       longerpayment cycles and difficulties in collecting accounts receivable;

·       currencyfluctuations;

·       culturaldifferences which may affect workforce performance and sales processes;

·       difficultiesand expenses associated with complying with a variety of foreign laws; and

·       unexpectedchanges in regulatory requirements.

As we further expand ouroperations outside the United States, we will also face new competitors andcompetitive environments. In addition to the risks associated with our domesticcompetitors, foreign competitors may pose an even greater risk, because theymay possess a better understanding of their local markets and have better workingrelationships with local infrastructure providers and others. In particular,because telephone protocols and standards are unique to each country, localcompetitors will have more experience with, and may have a competitiveadvantage in, these markets. We may not be able to obtain similar levels ofknowledge, which could place us at a significant competitive disadvantage. Inaddition, we 

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havelimited experience in developing local language versions of our products or inmarketing our products to international customers. We may not be able tosuccessfully translate, market, sell, and deliver our products internationally.

*If we are unable to maintain a productive direct salesforce, our business and operating results could be adversely affected.*

We believe that our futuresuccess will depend on maintaining a productive direct sales force.Historically, it has taken us up to six months to train new sales personnelbefore they reach an acceptable level of productivity. We have also experienceddifficulty in recruiting sales personnel with experience in computer andtelephone integration technologies. We cannot assure you that we will be ableto continue to manage turnover and hire new sales personnel to meet our needs.If the personnel we hire are less qualified than we expect, it may take us moretime to train them before they reach an acceptable level of productivity, whichcould increase our costs and impact our revenue.

*If we are unable to expand the distribution of ourproducts through indirect sales channels, our business and operating resultscould be materially adversely affected.*

Our strategy is to continue to increase the proportionof customers served through indirect sales channels, such as select resellersand a variety of strategic marketing alliances. Product revenue from ourindirect sales channel represented approximately 42% and 32% of total productrevenue during the nine months ended September 30, 2005 and 2004,respectively. We expect revenue from our indirect sales channel and,accordingly, our dependence on distribution partners, to increase as weestablish relationships with companies to resell our software worldwide. Wecannot assure you that we will be able to maintain productive relationshipswith our current partners, or that we will be able to establish similarrelationships with additional resellers on a timely basis, if at all.

Some resellers with whichwe do business have similar, and often more established, relationships with ourcompetitors, and may recommend the products and services of our competitors tocustomers instead of our software and services. We cannot provide assurancethat these distribution partners will devote adequate resources to selling oursoftware and services or that our resellers may not learn about our productsand the market for our software and services and develop and sell competingproducts and services. As a result, our relationships with resellers could leadto increased competition for us.

*Competition in our business could adversely affect ourrevenue, profitability and market share.*

The market forproducts that record customer interactions, forecast and schedule employees,analyze performance and/or provide electronic learning is intenselycompetitive, evolving and is subject to rapid changes in technology. We believeour principal competitors include, but are not limited to:

·       traditionalcall-logging vendors;

·       qualitymonitoring suppliers to the contact center industry;

·       workforcemanagement, forecasting and scheduling vendors to the call center industry;

·       electroniclearning vendors;

·       businessanalytics vendors;

·       largetelecom solution providers;

·       enterprisesoftware vendors;

·       systemsintegrators and consulting firms; and

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·       new,larger and more established entities that may acquire, invest in or form jointventures with providers of recording or performance enhancing softwaresolutions.

Many of our current and potential competitors havelonger operating histories, more established business relationships, largercustomer bases, a broader range of products and services, greater namerecognition and substantially greater financial, technical, marketing,personnel, management, service, support and other resources than we do. As aresult, our current and potential competitors may be able to respond morequickly to new or emerging technologies and changes in customer requirements,take better advantage of acquisitions and other opportunities, devote greaterresources to marketing and selling their products and services and adopt moreaggressive pricing policies. We cannot assure you that our current or potentialcompetitors will not develop products comparable or superior in terms of priceand performance features to those developed by us.

In addition, many of our competitors market theirproducts through resellers and companies that integrate their technology andproducts with those of the competitor. These resellers and technology partnersoften have strong business relationships with our customers and potentialcustomers. For example, some of our competitors have better and more longstanding relationships than we do with telephone switch vendors. Ourcompetitors may use these business relationships to market and sell theirproducts and compete for potential customers. It is also possible thatresellers or technology partners may acquire or be acquired by one or more ofour competitors, which would further solidify their business relationships.

We expect that competitionwill increase as other established and emerging companies enter our market andas new products, services and technologies are introduced. Increasedcompetition may result in price reductions, lower gross margins and loss ofmarket share, any of which could materially and adversely affect our business,financial condition and results of operations.

*Our heavy reliance on sales of our Balance,ContactStore and Workforce Management products exposes us to risks ofobsolescence due to changes in competitive product offerings.*

We have derived asubstantial portion of our product revenues from sales of our Balance,ContactStore and Workforce Management software products. We expect revenue fromthese products to continue to account for a significant portion of our revenuefor the foreseeable future. As a result, any factors affecting the markets forthese products could materially and adversely affect our business, financialcondition and results of operations. We cannot assure you that the market willcontinue to demand our current products or that we will be successful in marketingany new or enhanced products. If our competitors release new products that aresuperior to our products in performance or price, demand for our products maydecline. A decline in demand for our products as a result of competition,technological change or other factors would reduce our total revenues and harmour ability to maintain profitability.

*If we fail to develop new software or improve ourexisting software, we may not be able to remain competitive.*

The markets for our products are characterized byrapidly changing technology, frequent new product introductions andenhancements, changes in customer demands and evolving industry standards. Ourexisting products could be rendered obsolete if we fail to continue to advanceour technology. We have also found that the technological life cycles of ourproducts are difficult to estimate, partially because of changing demands ofour customers. We believe that our future success will depend on our ability tocontinue to enhance our current product line while we concurrently develop andintroduce new products that keep pace with competitive and technologicaldevelopments. These developments require us to continue to make substantialproduct development investments. Although we are presently developing a numberof product enhancements to our product suites, we cannot assure you that theseenhancements 

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will be completed on atimely basis or gain customer acceptance. In addition, failure to develop newsoftware or improve existing software products may impact our ability tomaintain our maintenance renewal rate which could have a material impact on ourrevenue.

We have recentlyintroduced Impact 360, which combines a new software architecture with newcombinations of our products. Our business concept in doing so is to createincremental value for our customers and to win business away from competitorswhose product offerings are more limited and require the customer to makeadditional hardware purchases to obtain the solutions that our Impact 360 productoffering provides in an integrated suite. While the company plans and expectsthat this lower total cost of ownership will be well received in themarketplace, we can offer no assurance that our new Impact 360 offering will besuccessful. If our Impact 360 product offerings do not meet with commercialsuccess, our business would be materially and adversely affected.

*If our software development activities in theAsia-Pacific region are not successful, we may not be able to meet ourdevelopment schedules.*

During 2004, weexpanded our software development capabilities in the Asia-Pacific region inorder to optimize available research and development resources and better meetdevelopment timeframes. We have limited experience with remote softwaredevelopment activities. Accordingly, there are a number of risks associatedwith this activity, including:

·       delaysor product errors due to miscommunication between our local developmentorganization and the remote development personnel affected by time, distanceand language differences;

·       schedulingdelays due to lengthy ramp-up time for our new development personnel;

·       productsproduced in the Asia-Pacific region that fail to meet our quality requirements;

·       highvoluntary personnel turnover; and

·       foreignemployment and labor laws with which we are not familiar.

Our inability to meetdevelopment schedules because of our reliance on developers in the Asia-Pacificregion may affect our ability to enhance our current product line or introducenew products, which would have a material adverse affect on our financialresults and could harm our reputation. The loss of key development personnelcould have a material adverse effect on our product development process andadversely affect future product revenues.

*Our liability tocustomers may be substantial if our products fail to perform properly.*

Our software is used in acomplex operating environment that requires its integration with computer andtelephone networks and other business software applications. If our productsfail to function as required, we may be subject to claims for substantialdamages. Courts may not enforce provisions in our contracts that would limitour liability or otherwise protect us from liability for damages. Although wemaintain general liability insurance coverage, including coverage for errors oromissions, this coverage may not continue to be available on reasonable termsor in sufficient amounts to cover claims against us. In addition, our insurermay disclaim coverage as to any future claim. If claims exceeding the availableinsurance coverage are successfully asserted against us, or our insurer imposespremium increases, large deductibles or co-insurance requirements on us, ourbusiness and results of operations could be adversely affected.

*Our software may contain undetected errors or “bugs,”resulting in harm to our reputation and operating results.*

Software products ascomplex as those offered by us might contain undetected errors or failures whenfirst introduced or when new versions are released. We cannot assure you,despite testing by us and by 

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currentand prospective customers, that errors will not be found in new products orproduct enhancements after commercial release. Any errors found may causesubstantial harm to our reputation and result in additional unplanned expensesto remedy any defects as well as a loss in revenue.

*If our advanced compliance recording applications failto record 100% of our customers’ interactions, we may be subject to liabilityand our reputation may be harmed.*

Through our acquisition ofEyretel, we have extended our product line to include advanced compliancerecording applications and related services. Many of our Eyretel customers usethese applications to record and store interactions with customers to provideback-up and verification of transactions and to guard against risks posed bylost or misinterpreted voice communications. These customers rely on ourapplications to record, store and retrieve voice data in a timely, reliable andefficient manner. If our applications fail to record 100% of our customers’interactionsor our customers are unable to retrieve the recordings when necessary, we maybe subject to liability and our reputation may be harmed.

*If we are unable to maintain the security of oursystems, our business, financial condition and operating results could beharmed.*

The occurrence orperception of security breaches in the operation of our business or by thirdparties using our products could harm our business, financial condition andoperating results. Our customers use our products to compile and analyze highlysensitive or confidential information. We may come into contact with suchinformation or data when we perform support or maintenance functions for ourcustomers. While we have internal policies and procedures for employeesperforming these functions, the perception that we have improperly handledsensitive, confidential information could have a negative effect on ourbusiness. If, in handling this information, we fail to comply with privacy or securitylaws, we could incur civil liability to government agencies, customers andindividuals whose privacy is compromised. If personal information is receivedor used from sources outside the U.S., we could be subject to civil,administrative or criminal liability under the laws of other countries. Inaddition, while we implement sophisticated security measures, third parties mayattempt to breach our security or inappropriately use our products throughcomputer viruses, electronic break-ins and other disruptions. If successful,confidential information may be improperly obtained and we may be subject tolawsuits and other liability. Any internal or external security breaches couldharm our reputation, and even the perception of security risks, whether or notvalid, could inhibit market acceptance of our products.

*Fluctuations in foreign currency exchange rates couldaffect our financial results.*

We may experience gainsand losses resulting from fluctuations in currency exchange rates. Moreover, inlocations where we price our products in U.S. dollars, our sales could beaffected adversely by declines in foreign currencies relative to the dollar,thereby making our products more expensive in local currencies. In locationswhere we sell our products in local currencies, we could be competitivelyunable to increase our prices to reflect fluctuations in exchange rates. We donot use derivative instruments to manage our foreign exchange risk, and wecannot predict the impact that future exchange rate fluctuations may have onour results.

*Certain provisions in agreements that we have enteredinto may expose us to liability for breach that is not limited in amount by theterms of the contract.*

Certain contractprovisions, principally confidentiality and indemnification obligations incertain of our license agreements, could expose us to risks of loss that, insome cases, are not limited by contract to a specified maximum amount. If wefail to perform to the standards required by these contracts, we could besubject to additional liability and our business, financial condition andresults of operations could be 

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materiallyand adversely affected. There have been no material losses to date as a resultof any such contractual provisions.

*If we fail to protect our intellectual property, thirdparties may use our technology for their own benefit.*

Our success and ability to compete depends to asignificant degree upon our proprietary technology. We rely on a combination ofpatent, trade secret, copyright and trademark laws and confidentialityagreements with employees and third parties to establish and protect ourproprietary rights. These measures may not be sufficient to protect ourproprietary rights, and we cannot be certain that third parties will notmisappropriate our technology and use it for their own benefit. Also, most ofthese protections do not preclude our competitors from independently developingproducts with functionality or features substantially equivalent or superior toour software. Any infringement of our proprietary rights could negativelyimpact our future operating results.

As of September 30, 2005, we had eight registeredtrademarks, three trademark applications pending in the U.S., eight patents andnineteen patent applications pending in the U.S. and nine patent applicationspending internationally. There is no guarantee that our pending applicationswill result in issued trademarks or patents or, if issued, that they willprovide us with any competitive advantage. We cannot assure you that we will filefurther patent or trademark applications, that any future applications will beapproved, that any existing or future patents, trademarks or copyrights willadequately protect our intellectual property or that any existing or futurepatents, trademarks or copyrights will not be challenged by third parties.

We are aware of certain uses, U.S. trademarkregistrations, and U.S. trademark applications for our “eQuality” trademark andits variations that predate our use, and the April 2002 issuance of theU.S. registration for our trademark eQuality®. It is possible thatan owner of legal rights resulting from prior use, registrations, orapplications will bring legal action to challenge our registration of and/orour use of the trademark eQuality®, and may also seek compensationfor damages resulting from our use this trademark. As a result, we cannotassure you that our registration of this trademark will be undisturbed, or thatthis use will not result in liability for trademark infringement, trademarkdilution, and/or unfair competition.

Moreover, the laws ofcertain foreign countries do not protect our intellectual property rights tothe same extent as do the laws of the United States. Furthermore, policing theunauthorized use of our products is difficult, and litigation may be necessaryin the future to enforce our intellectual property rights, to protect our tradesecrets or to determine the validity and scope of the proprietary rights ofothers. Litigation could result in substantial costs and diversion of resourcesand could negatively impact our future operating results.

*Claims by other companies that our software infringestheir intellectual property could require us to incur substantial costs orprevent us from selling our software or services.*

It is possible that third parties will claim that wehave infringed their current or future products. We expect that we and otherparticipants in our industry will be increasingly subject to infringementclaims as the number of competitors and products grows. Any claims, with orwithout merit, which are generally uninsurable could be time-consuming, resultin costly litigation, require us to reengineer or redevelop our software, causeproduct shipment delays or require us to enter into royalty or licensingagreements, any of which could negatively impact our operating results. Anyefforts to reengineer our software or obtain licenses from third parties maynot be successful, could be extremely costly and would likely divert valuablemanagement and product development resources.

For example, claims havebeen asserted against us in lawsuits involving Knowlagent, IEX, STS and NICE(as described in Item 1, “Legal Proceedings”, of Part II). We believe thatnone of these cases has 

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merit.We cannot assure you, however, that we will be successful in defending againstthe claims that have been asserted or any other claims that may be asserted. Wealso cannot assure you that such claims will not have a material adverse effecton our business, financial condition, or operations. Defending infringementclaims or other claims involves substantial costs and diversion of managementresources. In addition, to the extent we are not successful in defending suchclaims, we may be subject to injunctions with respect to the use or sale of certainof our products or to liabilities for damages to the claimants or to customersto whom we have indemnification commitments, and we may be required to obtainlicenses which may not be available on reasonable terms. In addition, we cannotassure you that legal action claiming patent infringement will not be commencedagainst us, or that we would prevail in litigation given the complex technicalissues and inherent uncertainties in patent litigation. In addition, users ofour software may become subject to claims if our software is alleged toinfringe the intellectual property of others. These software users couldattempt to hold us responsible for these claims and any resulting harm theysuffer. If a patent claim against us was successful and we could not obtain alicense on acceptable terms or license a substitute technology or redesign toavoid infringement, we may be prevented from distributing our software orrequired to incur significant expense and delay in developing non-infringingsoftware. Such a result could have a material adverse effect on our business,financial condition and results of operations.

*If we are unable to maintain the compatibility of oursoftware with certain other products and technologies, our future businesswould be adversely affected.*

Our software mustintegrate with software and hardware solutions provided by a number of ourexisting and potential competitors. For example, our products must integratewith phone switches made by the telephone switch vendors and computer telephonysoftware applications offered by other software providers. These competitors ortheir business partners could alter their products so that our software nolonger integrates well with them, or they could delay or deny our access tosoftware releases that allow us to timely adapt our software to integrate withtheir products. If we cannot adapt our software to changes in necessarytechnology, it may significantly impair our ability to compete effectively,particularly if our software must integrate with the software and hardwaresolutions of our competitors.

*If our professional services employees do not provideinstallation services effectively and efficiently, our customers may not useour installation services or may stop using our software.*

Our customers ordinarilypurchase installation, training and maintenance services together with ourproducts. The functionality of our products is not dependent on ourinstallation and training services. We generate a material part of our revenuesfrom these services. We believe that the speed and quality of installationservices are competitive factors in our industry. If our installation servicesare not satisfactory to our customers, the customers may choose not to use ourinstallation services or they may not license our software in the future. As aresult, we would lose licensing and services revenue, and it could harm ourreputation. In addition, our revenues realized from the performance ofmaintenance services are material to our operating results, and a failureto provide adequate maintenance support to our customers would result inreduced maintenance revenues and have an adverse impact on our operatingresults.

*We may make acquisitions or investments that are notsuccessful and that adversely affect our ongoing operations.*

We may acquire ormake investments in companies, products, services and technologies that webelieve complement our business and assist us in quickly bringing new productsto market. We have limited experience in making acquisitions and investments.As a result, our ability to identify and evaluate prospects, completeacquisitions and properly manage the integration of businesses is relativelyunproven. If we fail to properly evaluate and execute acquisitions orinvestments, it may have a material adverse 

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effecton our business and operating results. In making or attempting to makeacquisitions or investments, we face a number of risks, including:

·       identifyingsuitable candidates, performing appropriate due diligence, identifyingpotential liabilities and negotiating acceptable terms;

·       reducingour working capital and hindering our ability to expand or maintain ourbusiness, if we make acquisitions using cash;

·       thepotential distraction of our management, diversion of our resources and disruptionof our business;

·       retainingand motivating key employees of the acquired companies;

·       managingoperations that are distant from our current headquarters and operations;

·       enteringinto geographic markets in which we have little or no prior experience;

·       competingfor acquisition opportunities with competitors that are larger than we are orhave greater financial and other resources than we have;

·       accuratelyforecasting the financial impact of a transaction;

·       assumingliabilities of acquired companies, including litigation related to theoperation of the business prior to the acquisition;

·       maintaininggood relations with the customers and suppliers of the acquired company;

·       potentiallydilutive issuances of securities as consideration for an acquisition;

·       effectivelyintegrating acquired companies and achieving expected synergies; and

·       the impairment of the valueof the assets acquired in any corporate acquisition.

*If we need additional financing to maintain or expandour business, it may not be available on favorable terms, if at all.*

Although we believeour current cash and borrowing capacity will be sufficient to meet ouranticipated cash needs for at least the next 12 months and the foreseeablefuture, we may need additional funds to expand or meet all of our operatingneeds. If we need additional financing, we cannot be certain that it will beavailable to us on favorable terms, or at all. If we raise additional funds byissuing equity securities or convertible debt, the ownership interest of ourstockholders could be significantly diluted, and any additional equitysecurities we issue may have rights, preferences or privileges senior to therights of our stockholders. Also, the terms of any additional financing weobtain may significantly limit our future financing and operating activities.If we need funds and cannot obtain them on acceptable terms, we may be unableto:

·       developand enhance our software to remain competitive;

·       takeadvantage of future opportunities, such as acquisitions;

·       respondto changing customer needs and our competitors’ innovations; or

·       attractand retain qualified key personnel.

Any of these events couldsignificantly harm our business and financial condition and limit our growth.

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*Our inability to source hardware could harm ourbusiness.*

A number ofcustomers expect us to source hardware to support the implementation of oursoftware. We are working towards reducing the amount of hardware sales in thefuture and have transferred the fulfillment of hardware orders to third-partydistributors. Thus, we are largely dependent on third parties for the supply ofhardware components to our customers. If these hardware distributors experiencefinancial, operational or quality assurance difficulties, or if there is anyother disruption in our relationships, we may be required to locate alternativehardware sources. We are subject to the following risks due to our hardwaredistribution system:

·       cancellationsof orders due to unavailability of hardware;

·       increasedhardware prices, which may make our products less attractive; and

·       additionaldevelopment expense to modify our products to work with new hardwareconfigurations.

Even if we and/or ourdistributors are successful in locating alternative sources of supply,alternative suppliers could increase prices significantly. In addition,alternative components may malfunction or interact with existing components inunexpected ways. The use of new suppliers and the modification of our productsto function with new systems would require testing and may require furthermodifications, which may result in additional expense, diversion of managementattention and other resources, inability to fulfill customer orders or delay infulfillment, reduction in quality and reliability, customer dissatisfaction,and other adverse effects on our reputation, business and operating results.

*Failure to maintain effective internal controls inaccordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have amaterial adverse effect on our business, operating results and stock price.*

The Sarbanes-Oxley Act of2002 imposes new duties on us and our executives, directors, attorneys andindependent registered public accountants. Our efforts to comply with therequirements of Section 404 have resulted in increased general andadministrative expense and a diversion of management time and attention fromrevenue-generating activities to compliance activities, and we expect theseefforts to require the continued commitment of significant resources. We completedthe initial implementation of Section 404 during the year ended December 31,2004 and reported no material weaknesses in internal controls. However, if wefail to maintain the adequacy of our internal controls, we may not be able toensure that we can conclude on an ongoing basis that we have effective internalcontrols over financial reporting. Failure to maintain effective internalcontrols over financial reporting could result in investigation and/orsanctions by regulatory authorities, and could have a material adverse effecton our business and operating results, investor confidence in our reportedfinancial information, and the market price of our common stock.

*Our stock price has been volatile.*

The market price of ourcommon stock has been subject to significant fluctuations in response tovariations in quarterly operating results and other factors. In addition, thestock market has experienced significant volatility that has particularlyaffected the market prices of equity securities of many technology companiesand that often has been unrelated or disproportionate to the operatingperformance of these companies. Any announcement with respect to any adversevariance in revenue or earnings from levels generally expected by securitiesanalysts or investors could have a significant adverse effect on the tradingprice of our common stock. In addition, factors such as announcements oftechnological innovations or new products by us, our competitors or thirdparties, changing conditions in the customer relationship management softwaremarket, changes in the market valuations of similar companies, loss of a majorcustomer, additions or departures of key personnel, changes in estimates bysecurities analysts, 

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announcementsof extraordinary events, such as acquisitions or litigation, or generaleconomic conditions may have an adverse effect on the market price of ourcommon stock.

*We issued 2.1 million new shares and grantedapproximately 650,000 options to purchase shares of our common stock inconnection with acquisitions in 2005, which will result in dilution to ourexisting stockholders and may cause our stock price to decline.*

As part of the mergerconsideration in our acquisition of Blue Pumpkin in January 2005, weissued a total of 2.1 million shares of common stock to Blue Pumpkinshareholders, which increased our total outstanding common stock byapproximately 8%; we also issued employee stock options to purchaseapproximately 650,000 shares of common stock in connection with thisacquisition and the acquisition of Optimis in May 2005. The issuance of asignificant amount of additional shares of common stock results in dilution toour existing shareholders and reduces our earnings per share, which couldnegatively affect the market price of our common stock. A significant amount ofcommon stock coming on the market at any given time could result in a declinein the price of our common stock or increased volatility.

*Our performance may be negatively affected bymacro-economic or other external influences.*

Beginning in 2000, adeclining United States economy began to adversely affect the performance ofmany businesses, especially within the technology sector. Reductions in thecapital budgets of our customers and prospective customers have an adverseimpact on our ability to sell our solutions. Until late in 2003, we continuedto experience effects from a weak spending environment for informationtechnology in both the United States and Europe, in the form of delayed andcancelled buying decisions by customers for our software, services andhardware, deferrals by customers of service engagements previously scheduledand pressure by our customers and competitors to discount our offerings. If thecurrent improvements now being seen in the general business climate do notcontinue, this would likely have a material adverse effect on our business.

*Government regulation of telephone and Internetmonitoring could cause a decline in the use of our software, result inincreased expenses for us or subject our customers and us to liability.*

As the telecommunicationsindustry continues to evolve, state, federal and foreign governments (includingsupranational governmental organizations such as the European Union) mayincreasingly regulate the monitoring of telecommunications and telephone andInternet monitoring and recording products, such as our software. We believethat increases in regulation could come in the form of a number of differentkinds of regulations, including regulations regarding privacy, protection ofpersonal information and employment. For example, the State of Californiarecently enacted the Database Security Breach Act, which requires any businessthat suffers a computer security breach to immediately notify customers inCalifornia if personal information has been compromised. The adoption of anynew regulations or changes to existing regulations could cause a decline in theuse of our software and could result in increased expense for us, particularlyif we are required to modify our software to accommodate these regulations.Moreover, these regulations could subject our customers or us to liability.Whether or not these regulations are adopted, if we do not adequately address theprivacy concerns of consumers, companies may be hesitant to use our software.If any of these events occur, it could materially and adversely affect ourbusiness.

*If we are unable to attract and retain key personnel,our ability to effectively manage and grow our business would suffer.*

Our success greatly depends on our ability to hire,train, retain and motivate qualified personnel, particularly in sales,marketing, research and development, service and support. We face significantcompetition for individuals with the skills required to perform the services weoffer. If we are unable to 

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attract and retainqualified personnel or if we experience high personnel turnover, it couldprevent us from effectively managing and expanding our business.

Our success also dependsupon the continued service of our executive officers, particularly our Chairmanand Chief Executive Officer, David Gould, and our President and Chief OperatingOfficer, Nick Discombe. We have employment agreements with Mr. Gould and Mr. Discombeand limited non-compete agreements with most of our other executive officers.However, any of our executive officers and other employees could terminate hisor her relationship with us at any time. The loss of the services of ourexecutive officers or other key personnel, particularly if lost to competitors,could materially and adversely affect our business.

*Our certificate of incorporation and bylaws, as wellas Delaware law, may inhibit a takeover of our company, which could limit theprice investors might be willing to pay for our securities.*

Our amended and restated certificate of incorporationand bylaws, as well as Delaware law, contain provisions that might enable ourmanagement to resist a takeover of our company. For example, our stockholderscannot take action by written consent or call a special meeting to remove ourboard of directors. In addition, our directors serve for staggered terms, whichmakes it difficult to remove all our directors at once. Further, in October 2002,our board of directors approved, and we have implemented, a stockholder rightsplan which has the effect of causing substantial dilution to a person or groupthat attempts to acquire us on terms not approved by the board of directors.

These anti-takeoverprovisions might discourage, delay or prevent a change in the control of ourcompany or a change in our management. These provisions could also discourageproxy contests and make it more difficult for you and other shareholders toelect directors and take other corporate actions. The existence of theseprovisions could also limit the price that investors might be willing to pay inthe future for our securities.

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk

Information concerningmarket risk is included in the Management’sDiscussion and Analysis of Financial Condition and Results of Operations,Item 2 of Part I of this Report.

**Item 4.**                        Controlsand Procedures

***Evaluation of Disclosure Controls and Procedures***

The Company conducted an evaluation of the effectivenessof the Company’s disclosure controls and procedures (as defined in Rules 13a-15and 15d-15 under the Securities Exchange Act of 1934), as of the end ofthe period covered by this quarterly report. This evaluation was conductedunder the supervision and with the participation of the Company’s management,including the Chief Executive Officer and Chief Financial Officer. Based onthis evaluation, as of the quarter ended September 30, 2005, the Company’sChief Executive Officer and Chief Financial Officer have concluded the Company’sdisclosure controls and procedures are effective. There were no changes ininternal controls over financial reporting that occurred during the periodcovered by this quarterly report that have materially affected, or that are reasonablylikely to materially affect, our internal controls over financial reporting.

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**PART II. OTHERINFORMATION**

**Item 1.   LegalProceedings**

On December 11, 2002, wefiled in the United States District Court for the Northern District of Georgia,Atlanta Division, a lawsuit against Knowlagent, Inc. (“Knowlagent”), whichis the assignee of United States (“U.S.”) Patent Nos. 6,324,282 B1 and6,459,787 B2. Knowlagent has accused our eQuality Now software of infringingthe above patents. We filed suit seeking a declaration that we did not and donot infringe either of the two patents listed above, as well as a declarationthat the above patents are invalid and unenforceable. We also filed a claimrequesting that if the patents are found to be valid, that one of our ownemployees be named the rightful inventor of the patents. We also requested monetarydamages in an amount equal to the amount that Knowlagent has received from itsuse of the above patents. On December 31, 2002, Knowlagent filed itsanswer to our complaint as well as two counterclaims, alleging that we infringeand contribute to the infringement by others of the above patents; Knowlagentseeks both monetary damages and an injunction in connection with itscounterclaim. On June 6, 2005, the Court held a claim construction hearingand issued a claim construction order on June 8, 2005. We are currently inthe discovery phase of the lawsuit and believe that any adverse outcome wouldnot have a material impact on our financial position, results of operations andcash flows.

On July 20, 2004, STSSoftware Systems Ltd. (“STS Software”), a wholly-owned subsidiary of NICE Systems,Ltd. (“NICE Ltd.”), filed a patent infringement suit in the U.S. District Courtfor the Southern District of New York against us (“New York Action”). The NewYork Action asserts that our products, including eQuality ContactStore for IP,infringe United States (“U.S.). Patent No. 6,122,665 (“the ‘665 patent”)and seeks only injunctive, not monetary, relief. On the same day, we filed adeclaratory judgment action against STS Software in the U.S. District Court forthe Northern District of Georgia (“Georgia Action”). We seek a declaration fromthe court that we have not infringed any valid claim of the ‘665 patent. ByOrder entered December 16, 2004, Judge Koeltl of the U.S. District Courtfor the Southern District of New York granted our motion to transfer the NewYork Action to the Northern District of Georgia, which has now consolidated theformer New York Action with the Georgia Action. On July 7, 2005, the Courtalso granted STS leave to amend its complaint to add three patents to thedispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and 6,880,004(respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004 patent”;collectively, “the STS patents”), again seeking solely injunctive relief. Weanswered the first amended complaint and asserted counterclaims on July 29,2005, collectively, through which we deny infringement of any valid claim ofthe STS patents and seek a declaration to that effect. The case has been set ona discovery calendar and is at a preliminary stage. We continue to believe thatthis case will not have a material impact on our financial position, results ofoperations and cash flows.

On August 30, 2004, wefiled in the United States District Court for the Northern District of Georgia,Atlanta Division, a lawsuit against NICE Systems, Inc. (“NICE Inc.”), awholly-owned subsidiary of NICE Ltd., alleging patent infringement. Specifically,we have alleged that NICE products, including the NiceUniverse products thatinclude screen capture and synchronized screen and voice capture technologies,infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220(“the ‘220 Patent”), both entitled “Method and Apparatus for SimultaneouslyMonitoring Computer User Screen and Telephone Activity from a Remote Location.”We have sought an injunction and money damages for NICE’s infringement of thesetwo patents. NICE Inc. has answered and counterclaimed for declaratoryjudgments of non-infringement and invalidity. Since then, on February 24,2005, we filed suit against NICE Ltd. because of its infringing activitiesin violation of the ‘798 and ‘220 patents, including importation of the accusedNICE products. By order dated April 5, 2005, Judge Pannell hasconsolidated the NICE Inc. and NICE Ltd. actions. The case has been set on amodified discovery calendar after consolidation and is at a preliminary stage.

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In January 2001, IEXCorporation filed a lawsuit against Blue Pumpkin in the United States DistrictCourt for the Eastern District of Texas, Sherman Division, alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the‘355 Patent”) by making and selling certain workforce management and callrouting software products, including Blue Pumpkin’s Prime Time Skills and PrimeTime Enterprise products. IEX is seeking to recover actual damages, an award oftreble damages pursuant to 35 U.S.C. § 284, and an award of prejudgmentinterest, costs, and attorney’s fees. IEX is also seeking an injunction againstBlue Pumpkin’s making or selling the products that IEX claims infringe its ‘355Patent. On October 10, 2003, the District Court granted Blue Pumpkinsummary judgment of non-infringement and dismissed the remainder of the case.IEX then appealed the District Court’s summary judgment ruling to the Court ofAppeals for the Federal Circuit. On February 2, 2005, the Federal Circuitreversed-in-part the district court’s summary judgment ruling and remanded theaction to the district court for further proceedings consistent with theFederal Circuit’s analysis. Blue Pumpkin is on a schedule before the districtcourt that is likely to result in a January 2006 trial, unless the case isresolved on summary judgment. We are unable to assess what impact, if any, anadverse result in this matter might have on our financial position, results ofoperations or cash flows.

On October 4,2005, Blue Pumpkin filed in the United States District Court for the NorthernDistrict of Georgia, Atlanta Division, a lawsuit against IEX Corporationalleging patent infringement. Specifically, Blue Pumpkin has alleged that IEXproducts infringe claims of U.S. Patent No. 6,952,732 (“the ‘732 Patent”),entitled “Method and apparatus for multi-contact scheduling.” Blue Pumpkin hassought an injunction and money damages for IEX’s infringement of the ‘732Patent. IEX has not yet answered, and this case is at a preliminary stage.

**Item 6.   Exhibits**

**Exhibits**
| 23.1* |   | Consent of Independent  Business Valuation Experts                             |   |
|-------|--------|--------------------------------------------------------------------------------|--------|
| 31.1* |   | Certification  of Chief Executive Officer                                      |   |
| 31.2* |   | Certification  of Chief Financial Officer                                      |   |
| 32.1* |   | Certifications  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |   |

 

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*Filed herewith

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| Dated: November 7, 2005 | WITNESS SYSTEMS, INC. |
|------------------------------|-----------------------|
|                         | BY:                   | /s/  DAVID B. GOULD |
|                         |                  | DAVID B. GOULD |
|                         |                  | *Chairman of the Board and* |
|                         |                  | *Chief Executive Officer* |
|                         | * *              | *(Principal Executive Officer)* |
|                         | BY:                   | /s/  WILLIAM F. EVANS |
|                         |                  | WILLIAM F. EVANS |
|                         |                  | *Executive Vice President and* |
|                         |                  | *Chief Financial Officer* |
|                         | * *              | *(Principal Financial and Accounting Officer)* |

 

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