** **

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

** **
| **ý**                                                                                                                                                                                         | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                         |
| **For  the quarterly period ended March 31, 2006**                                                                                                                                            |
| ** **                                                                                                                                                                                         | ** ** |
| **OR**                                                                                                                                                                                             |
| ** **                                                                                                                                                                                         | ** ** |
| **o**                                                                                                                                                                                              | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                         |
| **For  the transition period  from             to             ** |
| ** **                                                                                                                                                                                         |
| **Commission  file number 000-29335**                                                                                                                                                              |

 

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**WITNESSSYSTEMS, INC.**

(ExactName of Registrant as Specified in Its Charter)

** **

| **Delaware**                                                             | ** ** | **23-2518693**      |
|--------------------------------------------------------------------------|------------|---------------------|
| (State or Other Jurisdiction                                             |       | (I.R.S. Employer    |
| of Incorporation or Organization)                                        |       | 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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| Securities registered pursuant to Section 12(b) of the Act:**None** |
|-------------------------------------------------------------------------------|
|                                                                          |   |   |
| Securities registered pursuant to Section 12(g) of the Act:         |

 

| **Title of each class**                | ** ** | **Name of each exchange on which registered** |
|----------------------------------------|------------|-----------------------------------------------|
| Common Stock, par value $.01 per share | ** ** | NASDAQ                                        |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes ý  No o

 

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

 

| Large  accelerated filer o |   | Accelerated filer ý |   | Non-accelerated filer o |
|---------------------------------|--------|--------------------------|--------|-------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No ý

 

As of April 30, 2006, 33,499,777 shares of theregistrant’s common stock were outstanding.

 

 

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**WITNESSSYSTEMS, INC.**

 

**FORM 10-Q**

 

**INDEX**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                | 3      |
|---------------|----------------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                 |   |
| Item 1.       | Financial Statements:                                                                                                | 3      |
|          |                                                                                                                 |   |
|          | Condensed Consolidated Balance Sheets at March 31, 2006 and December 31,  2005 (unaudited)                 | 3      |
|          |                                                                                                                 |   |
|          | Condensed Consolidated Statements of Operations for the three months  ended March 31, 2006 and 2005 (unaudited) | 4      |
|          |                                                                                                                 |   |
|          | Condensed Consolidated Statements of Cash Flows for the three months  ended March 31, 2006 and 2005 (unaudited) | 5      |
|          |                                                                                                                 |   |
|          | Notes to the Condensed Consolidated Financial Statements (unaudited)                                                 | 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                                                          | 28     |
|          |                                                                                                                 |   |
| Item 4.       | Controls and Procedures                                                                                              | 28     |
|          |                                                                                                                 |   |
| PART II. | OTHER INFORMATION                                                                                                    | 29     |
|          |                                                                                                                 |   |
| Item 1.       | Legal Proceedings                                                                                                    | 29     |
|          |                                                                                                                 |   |
| Item 1A       | Risk factors                                                                                                         | 30     |
|          |                                                                                                                 |   |
| Item 6.       | Exhibits                                                                                                             | 42     |
|          |                                                                                                                 |   |
| SIGNATURES    |                                                                                                                 | 43     |

 

2

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**PART I.FINANCIAL INFORMATION**

 

**Item 1.   Financial Statements**

 

**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Inthousands, except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                             | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                             | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current  assets:                                                                                                                                                                                       |       |                     |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                                             |       | $                        | 85,510     |                        | $          | 111,751 |   |
| Investments                                                                                                                                                                                            |       | 70,996                   |       | 14,886                      |       |
| Accounts  receivable, net of allowance of $3,204 at March 31, 2006 and $3,283 at December 31,  2005                                                                                          |       | 43,525                   |       | 40,218                      |       |
| Prepaid and  other current assets                                                                                                                                                                      |       | 7,191                    |       | 5,462                       |       |
| Total  current assets                                                                                                                                                                                  |       | 207,222                  |       | 172,317                     |       |
| Intangible  assets, net                                                                                                                                                                                |       | 32,658                   |       | 36,389                      |       |
| Goodwill                                                                                                                                                                                               |       | 41,096                   |       | 40,697                      |       |
| Property and  equipment, net                                                                                                                                                                           |       | 8,306                    |       | 7,796                       |       |
| Other assets                                                                                                                                                                                           |       | 3,505                    |       | 4,387                       |       |
|                                                                                                                                                                                                   |       | $                        | 292,787    |                        | $          | 261,586 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current  liabilities:                                                                                                                                                                                  |       |                     |       |                        |       |
| Accounts  payable                                                                                                                                                                                      |       | $                        | 6,327      |                        | $          | 3,795 |   |
| Accrued  expenses                                                                                                                                                                                      |       | 27,256                   |       | 21,891                      |       |
| Deferred  revenue                                                                                                                                                                                      |       | 34,158                   |       | 23,778                      |       |
| Total  current liabilities                                                                                                                                                                             |       | 67,741                   |       | 49,464                      |       |
| Other  long-term liabilities                                                                                                                                                                           |       | 5,993                    |       | 4,409                       |       |
| Deferred  income tax liabilities                                                                                                                                                                       |       | 675                      |       | 743                         |       |
| Total  liabilities                                                                                                                                                                                     |       | 74,409                   |       | 54,616                      |       |
| 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; 33,366,163 and  32,822,193 shares issued and outstanding at March 31, 2006 and December 31,  2005, respectively                 |       | 334                      |       | 328                         |       |
| Additional  paid-in capital                                                                                                                                                                            |       | 253,956                  |       | 245,889                     |       |
| Accumulated  deficit                                                                                                                                                                                   |       | (40,146                  | )          | (42,323                     | )          |
| Accumulated  other comprehensive income                                                                                                                                                                |       | 4,234                    |       | 3,076                       |       |
| Total  stockholders’ equity                                                                                                                                                                       |       | 218,378                  |       | 206,970                     |       |
|                                                                                                                                                                                                   |       | $                        | 292,787    |                        | $          | 261,586 |   |
|                                                                                                                                                                                                        |            |                          |            |                             |            |  |  |  |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands, except per share data)**

**(unaudited)**

 
| ** **                                       | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Revenue:                                         |       |                                  |       |   |   |
| Product                                          |       | $                                     | 19,839     |   | $ | 16,368 |   |
| Services                                         |       | 31,627                                |       | 24,791 |   |
| Total  revenue                                   |       | 51,466                                |       | 41,159 |   |
| Cost of revenue:                                 |       |                                  |       |   |   |
| Product                                          |       | 4,578                                 |       | 4,332 |   |
| Services                                         |       | 11,745                                |       | 9,525 |   |
| Total cost  of revenue                           |       | 16,323                                |       | 13,857 |   |
| Gross profit                                     |       | 35,143                                |       | 27,302 |   |
| Operating expenses:                              |       |                                  |       |   |   |
| Selling,  general and administrative             |       | 25,129                                |       | 19,913 |   |
| Research and  development                        |       | 7,956                                 |       | 6,195 |   |
| Merger-related  and integration costs            |       | 740                                   |       | 1,659 |   |
| Acquired  in-process research and development    |       | —                                |       | 9,000 |   |
| Operating  income (loss)                         |       | 1,318                                 |       | (9,465 | ) |
| Interest and other income, net                   |       | 1,271                                 |       | 138 |   |
| Income  (loss) before provision for income taxes |       | 2,589                                 |       | (9,327 | ) |
| Provision for income taxes                       |       | 412                                   |       | 33 |   |
| Net income  (loss)                               |       | $                                     | 2,177      |   | $ | (9,360 | ) |
| Net income (loss) per share:                     |       |                                  |       |   |   |
| Basic                                            |       | $                                     | 0.07       |   | $ | (0.36 | ) |
| Diluted                                          |       | $                                     | 0.06       |   | $ | (0.36 | ) |
| Weighted-average common shares outstanding:      |       |                                  |       |   |   |
| Basic                                            |       | 33,059                                |       | 26,261 |   |
| Diluted                                          |       | 36,648                                |       | 26,261 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

4

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(unaudited)**

 
| ** **                                                                                           | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Cash flows  from operating activities:                                                               |       |                                                 |       |   |   |
| Net income  (loss)                                                                                   |       | $                                                    | 2,177      |   | $ | (9,360 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                                 |       |   |   |
| In-process  research and development                                                                 |       | —                                               |       | 9,000 |   |
| Amortization  of intangible assets                                                                   |       | 3,964                                                |       | 3,284 |   |
| Stock-based  compensation expense                                                                    |       | 3,034                                                |       | — |   |
| Depreciation  and amortization of property and equipment                                             |       | 1,134                                                |       | 911 |   |
| Provision for  accounts receivable                                                                   |       | 747                                                  |       | 358 |   |
| Deferred  income taxes                                                                               |       | 205                                                  |       | — |   |
| Other  non-cash items, net                                                                           |       | (159                                                 | )          | 131 |   |
| Changes in  operating assets and liabilities:                                                        |       |                                                 |       |   |   |
| Accounts  receivable                                                                                 |       | (3,960                                               | )          | (5,581 | ) |
| Prepaid and  other assets                                                                            |       | (1,416                                               | )          | 510 |   |
| Accounts payable                                                                                     |       | 2,545                                                |       | 631 |   |
| Accrued  expenses                                                                                    |       | 456                                                  |       | (5,551 | ) |
| Deferred  revenue                                                                                    |       | 10,416                                               |       | (2,974 | ) |
| Net cash  provided by (used in) operating activities                                                 |       | 19,143                                               |       | (8,641 | ) |
| Cash flows  from investing activities:                                                               |       |                                                 |       |   |   |
| Capital  expenditures                                                                                |       | (1,973                                               | )          | (1,547 | ) |
| Purchases of  investments                                                                            |       | (62,557                                              | )          | — |   |
| Proceeds  from sales of investments                                                                  |       | 6,668                                                |       | 30,885 |   |
| Acquisition  of Blue Pumpkin Software, Inc., net of cash acquired of $3,900                          |       | 7,052                                                |       | (36,272 | ) |
| Net cash  used in investing activities                                                               |       | (50,810                                              | )          | (6,934 | ) |
| Cash flows  from financing activities:                                                               |       |                                                 |       |   |   |
| Proceeds  from exercise of stock options and Employee Stock Purchase Plan                            |       | 5,251                                                |       | 2,226 |   |
| Others                                                                                               |       | (105                                                 | )          | — |   |
| Excess tax  benefits from stock-based compensation                                                   |       | 84                                                   |       | — |   |
| Net cash  provided by financing activities                                                           |       | 5,230                                                |       | 2,226 |   |
| Effect of  exchange rate changes on cash                                                             |       | 196                                                  |       | (272 | ) |
| Net decrease  in cash and cash equivalents                                                           |       | (26,241                                              | )          | (13,621 | ) |
| Cash and  cash equivalents at beginning of period                                                    |       | 111,751                                              |       | 42,641 |   |
| Cash and  cash equivalents at end of period                                                          |       | $                                                    | 85,510     |   | $ | 29,020 |   |
| Supplemental  cash flow information:                                                                 |       |                                                 |       |   |   |
| Cash paid  for interest                                                                              |       | $                                                    | 5          |   | $ | 1 |   |
| Cash paid  for income taxes                                                                          |       | $                                                    | 95         |   | $ | 216 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

5

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**March 31,2006**

**(unaudited)**

 

**1.****                    ****Basis of Presentation**

 

***Business***- ***Witness***Systems, Inc. (“Witness”) is a publicly traded company thatprovides workforce optimization software and services that enable companies toimprove workforce performance and capture customer intelligence in theircustomer service operations. Our Impact 360 solution consists of softwareproducts and services designed to optimize the workforce, processes andtechnology involved in the customer service function and gain valuable insightfrom customer interactions that can be used throughout the enterprise. Ourquality monitoring products record multimedia interactions, includingtraditional voice, Web chat and email, based on user-defined business rules toenable our customers to evaluate the performance of their customer servicerepresentatives, or CSRs, wherever they may be located in the enterprise.Our high-volume compliance applications are designed to record 100% of thevoice conversations between CSRs and customers for purposes such as compliancerecording and sales verification. Our workforce management products enable ourcustomers to develop strategic staffing plans, deploy skilled resources and evaluateproductivity of CSRs. Our performance management applications providecomprehensive analytics, including performance scorecards, and reports ofcustomer interaction and CSR performance. Our e-learning applications deliverongoing training tailored to CSR needs and competencies. We also provideconsulting and implementation services, training and support to customers thatuse our software products.

 

We are headquartered in Roswell, Georgia withoperations in the United States, Australia, Brazil, Canada, China, Germany,India, Japan, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom. We were originally incorporated in 1988 in Georgia and werereincorporated in Delaware in 1997.

 

***Principles ofConsolidation and Reclassifications***- The unaudited interim condensed consolidated financial statements include thefinancial 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 presentation.

 

The financial statements herein have beenprepared in accordance with the requirements of Form 10-Q and, therefore,do not include all information and footnotes required by accounting principlesgenerally accepted in the United States of America. However, in the opinion ofmanagement, all adjustments necessary for a fair presentation of the results ofoperations for the relevant periods have been made. Results for the interimperiods are not necessarily indicative of the results to be expected for theyear. These financial statements should be read in conjunction with the summaryof significant accounting policies and the notes to the consolidated financialstatements included in our Annual Report on Form 10-K for the fiscal yearended December 31, 2005, filed with the U.S. Securities and ExchangeCommission.

 

***Use of Estimates*** - Thepreparation of these financial statements requires us to make certain estimatesand judgments that affect our reported assets,liabilities, revenues and expenses, and our related disclosure of contingentassets and liabilities. We base our estimates on historical experience and on

 

6

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various assumptions that we believe to bereasonable under the circumstances. Actual results may differ fromthese estimates under different assumptions or conditions.

 

**2.****                    ****Revenue Recognition and Deferred Revenue**

 

***We***recognizerevenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) 97-2, *Software Revenue Recognition*, and SOP 98-9, *Modification of* SOP 97-2, *Software Revenue Recognition, With Respect to Certain*Transactions. Revenue is primarily derived from licensing softwareand providing related services including maintenance. Product revenue, whichcan include software and hardware, is recognized when persuasive evidence of anagreement exists, delivery of the product has occurred, the fee is fixed ordeterminable, collection is probable and vendor specific objective evidence offair value (“VSOE”) exists to allocate revenue to the undelivered elements ofthe arrangement. The Company reports hardware revenue gross in accordance withEmerging Issues Task Force No. 99-19, *ReportingRevenue Gross as a Principal versus Net as an Agent,* because thefactors indicating gross reporting outweigh the factors indicating netreporting. We recognize revenue using the residual method of accounting whencustomer orders contain multiple element arrangements, including the sale oflicensed software, hardware, maintenance, and professional services. Wegenerally have VSOE for maintenance and professional services, but not for thesoftware and hardware elements of the order. Under the residual method,services revenue, including maintenance and professional services, is deferredat an amount equal to VSOE until those elements are delivered. Consequently,product revenue for the software and hardware is 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 includes installation,training, consulting, maintenance and reimbursable travel expenses. Revenuefrom installation, training and consulting services is recognized uponcompletion or performance of the related services and is offered and billed asseparate elements of contracts. Reimbursable travel expenses revenue isrecognized upon incurrence of the related expenses. The functionality of thesoftware and any hardware sold is not dependent on installation and trainingservices and customization 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.

 

Our revenue recognition policy is significantbecause our revenues are a key component of our results of operations. Wefollow very specific and detailed guidelines in measuring revenues; however,certain judgments and estimates affect the application of our revenue policydescribed above. Further, assessment of collectibility is particularly criticalin determining whether or not revenues should be recognized. We also recordprovisions 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 creditand 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.

 

Deferred revenue consists of amounts collectedfrom customers for products and services that have not met the criteria forrevenue recognition.

 

7

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**3.****                    ****Blue Pumpkin Acquisition**

 

On January 24, 2005, we acquired BluePumpkin Software, Inc. (“Blue Pumpkin”), a privately held Californiacorporation. With this acquisition, we expanded our workforce optimizationsolution to include advanced workforce management software and servicessolutions including forecasting, scheduling, adherence and planningapplications. Pursuant to the Merger Agreement and Plan of Reorganization,dated December 16, 2004 (the “Merger Agreement”), we paid $40 million incash which was funded from our existing cash and investments and issued 2.1million shares of Witness’ common stock valued at $37.2 million (measuredat the date the stock consideration became fixed pursuant to the application ofa formula specified in the Merger Agreement). Approximately ten percent of theaggregate merger consideration had been placed into escrow fund. On May 24,2005, the shares issued in connection with the acquisition were registered forresale with the Securities and Exchange Commission.

 

On December 15, 2005, Tekelec, IEX’s parentcompany, and Blue Pumpkin reached a tentative agreement to settle all claimsasserted between them. As part of the final settlement entered into in April 2006,Witness has made payment of $8.25 million to Tekelec, and agreed to make sixannual payments of $0.5 million ($3.0 million in total) from April 2007through 2012. In accordance with Accounting Principles Board (“APB”) 21 *“Interest on Receivables and Payables”,* we recorded a $0.7 million discountrepresenting the difference between the face value and the present value of the$3.0 million. The escrow fund was released to Witness during March 2006 insatisfaction and settlement of claims that Witness brought against the escrowfund, including claims for losses resulting from the settlement of the Tekeleclitigation.

 

We commenced consolidation of Blue Pumpkin on January 25,2005 and the acquisition was accounted for using the purchase method ofaccounting in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 141,*Business Combinations*.The following summarizes the total purchase price for Blue Pumpkin (inthousands):

 
| Value of  Witness Systems, Inc. common stock issued |   | $      | 33,700 |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Cash consideration                                       |   | 36,000 |   |
| Cash initially held in escrow                            |   | 4,000  |   |
| Value of common stock initially held in  escrow          |   | 3,500  |   |
| Direct acquisition costs                                 |   | 5,400  |   |
|                                                     |   | $      | 82,600 |   |

 

8

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Under the purchase method of accounting, thetotal purchase price was allocated to Blue Pumpkin’s net tangible andintangible assets based upon their estimated fair value as of the date of theacquisition with any amount paid in excess of the fair value of the net assetsrecorded as goodwill. Based upon the purchase price and review of the netassets acquired and liabilities assumed, the purchase price allocation, is asfollows (in thousands):

 
| Cash and  investments               |   | $       | 3,900  |   |
|-------------------------------------|--------|---------|--------|--------|
| Other current assets                |   | 7,200   |   |
| Property and equipment, net         |   | 700     |   |
| Acquired technology                 |   | 21,000  |   |
| Customer relationships              |   | 17,000  |   |
| Goodwill                            |   | 35,300  |   |
| In-process research and development |   | 9,000   |   |
| Other long term assets              |   | 100     |   |
| Total assets  acquired              |   | 94,200  |   |
| Current liabilities                 |   | (4,300  | )      |
| Litigation accrual                  |   | (4,200  | )      |
| Deferred revenue                    |   | (1,700  | )      |
| Restructuring accruals              |   | (1,400  | )      |
| Total  liabilities assumed          |   | (11,600 | )      |
|                                |   | $       | 82,600 |   |

 

The fair values of identifiable intangibleassets were 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 and development(“IPR&D”) had not been established and the technology had no alternativefuture use. Accordingly, we charged the value of the IPR&D at the date ofthe acquisition to expense. The amount of the purchase price allocated toIPR&D was based on established valuation techniques used in the softwareindustry. The fair value assigned to the acquired IPR&D was determinedusing a discounted cash flow methodology, which discounts expected future cashflows 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 theinherent uncertainties surrounding the successful development of the IPR&D,the expected 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 considerations underlying the valuationof acquired in-process research and development from Blue Pumpkin are asfollows: a) guidance from the Financial Accounting Standards Board (“FASB”)SFAS No. 2,*Accounting for Research andDevelopment Costs* and FASB Interpretation No. 4,*Applicability of FASB Statement No. 2 toBusiness Combinations Accounted for by the Purchase Method;* b)percent completed as of the acquisition date; c) estimated costs to date, aswell as costs to complete the technology; and d) the numerous technical, cost,market, and timing risks we face before the technology becomes technologicallyfeasible.

 

Goodwill of $35.3 million has been recorded andrepresents the excess of the purchase price over the fair value of the tangibleand other intangible assets acquired less the liabilities assumed. In

 

9

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accordance with SFAS No. 142,*Goodwill and Other Intangible Assets*,goodwill and intangible assets with indefinite useful lives are not amortized,but are tested for impairment at least annually or as circumstances indicatetheir value may no longer be recoverable.

 

Supplemental unaudited pro forma informationreflecting the acquisition of Blue Pumpkin as if it occurred on January 1,2005 is as follows (in thousands, except per share amounts):

 
| ** **                                  | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|
| Total revenues                              |       | $                                            | 42,234     |   |
| Net loss                                    |       | $                                            | (11,734    | ) |
| Net loss per share – basic and diluted |       | $                                            | (0.45      | ) |
| Weighted average shares - basic and diluted |       | 26,261                                       |       |

 

**4.****                    ****Acquisition-Related Restructuring Accruals and Merger-Related andIntegration Costs**

 

As a result of Eyretel acquisition in 2003, werecorded an acquisition-related restructuring accrual related to the closing ofcertain Eyretel facilities and the accrual of expense relating to abandonedleased premises. All such costs met the criteria for accrual as outlined inEITF No. 95-3,*Recognition ofLiabilities in Connection with a Purchase Business Combination,* andwere included in the assets acquired and liabilities assumed in the purchase ofEyretel. The following table summarizes the restructuring accrual (inthousands):

 
| ** **                             | ** ** | **Facilities** | ** ** |
|----------------------------------------|------------|----------------|------------|
| Accrual at December 31, 2005      |       | $              | 2,073      |   |
| Amounts  credited to rent expenses     |       | (123           | )          |
| Foreign  exchange translation          |       | (9             | )          |
| Accrual at March 31, 2006         |       | 1,941          |       |
| Less:  Long-term portion               |       | (1,449         | )          |
| Current portion at March 31, 2006 |       | $              | 492        |   |

 

The following table summarizes allmerger-related and integration costs that were charged to expense during thethree months ended March 31, 2006 and 2005 (in thousands):

 
| ** **                            | ** ** | **March 31,** | ** ** |
|---------------------------------------|------------|--------------------|------------|
| ** **                            | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Blue Pumpkin:                         |       |               |       |   |   |
| Merger-related  and integration costs |       | $                  | 740        |   | $ | 1,561 |   |
| Eyretel:                              |       |               |       |   |   |
| Bonus  expense                        |       | —             |       | 154 |   |
| Merger-related  and integration costs |       | —             |       | (56 | ) |
|                                  |       | $                  | 740        |   | $ | 1,659 |   |

 

During the first quarter of 2006, we incurredmerger-related and integration costs in the amount of $0.7 million pertainingto the acquisition of Blue Pumpkin. These expenses were primarily associatedwith

 

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legaland professional fees.

 

During the three months ended March 31, 2005, we incurredmerger-related and integration costs of $1.7 million pertaining to theacquisitions of Blue Pumpkin and Eyretel. The $1.7 million included $1.6million of integration expenses comprised primarily of costs of transitionalBlue Pumpkin employees and other contractors, travel costs and advertisingcosts.

 

**5.****             NetIncome (Loss) Per Share**

 

The following is a reconciliation of the numeratorand denominator used in the calculation of basic and diluted net income (loss)per share (in thousands, except per share data):

 
| ** **                                                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                                                               |       |                                             |       |   |   |
| Net income  (loss)                                                                 |       | $                                                | 2,177      |   | $ | (9,360 | ) |
| Weighted  average shares of common stock and common stock equivalents outstanding: |       |                                             |       |   |   |
| Basic                                                                              |       | 33,059                                           |       | 26,261 |   |
| Dilutive  effect of stock options computed using the treasury stock method         |       | 3,589                                            |       | — |   |
| Diluted  common shares and share equivalents outstanding                           |       | 36,648                                           |       | 26,261 |   |
| Net income  (loss) per share:                                                      |       |                                             |       |   |   |
| Basic                                                                              |       | $                                                | 0.07       |   | $ | (0.36 | ) |
| Diluted                                                                            |       | $                                                | 0.06       |   | $ | (0.36 | ) |

 

We have excluded all outstanding stock options fromthe calculation of diluted net loss per common share for the three months endedMarch 31, 2005 because we reported a loss in this period and all suchsecurities are anti-dilutive. The total number of share equivalents excludedfrom the calculation of historical diluted net loss per common share for thethree months ended March 31, 2005 was 2,862,491, calculated using thetreasury stock method. In the first quarter of 2006 and 2005**,**4,200****and 41,283stock options, respectively, were excluded from the computation of dilutedearnings per share because they had exercise prices that exceeded the averagefair market value of our common stock for those periods, and therefore, had ananti-dilutive effect.

 

**6.****            ****Stock-Based Compensation**

 

Effective January 1, 2006, we adopted SFAS No. 123(R),*Share-Based Payment,*using themodified prospective application transition method. SFAS 123(R) requires us to estimate thefair value of share-based payment awards on the date of grant using anoption-pricing model. The value of the portion of the award that is ultimatelyexpected to vest is recognized as expense over the requisite service period.

 

Prior to the adoption of SFAS 123(R), we accountedfor stock-based awards to employees using the intrinsic value method inaccordance with APB 25 as allowed under SFAS No. 123, *“Accountingfor Stock-Based Compensation”*. Under the intrinsic value method, wehave generally not recorded compensation 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.

 

11

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Our net income for the three months ended March 31,2006 includes $3.0 million of stock-option compensation expense and $0.1million of related income tax benefits recorded to additional paid-in-capital.

 

A summary of all stock option plans activity for thethree months ended March 31, 2006 is as follows:

 
| ** **                             | ** ** | **Number  of shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value (a)  $000’s** | ** ** |
|----------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------|------------|
| Outstanding as of January 1, 2006 |       | 8,574,446                  |       | $                                      | 10.98      |                                                |       |                                                  |       |   |
| Granted                                |       | 1,182,800                  |       | 20.55                                  |       |                                                |       |                                                  |       |
| Exercised                              |       | (563,174                   | )          | 8.99                                   |       |                                                |       |                                                  |       |
| Forfeited                              |       | (69,384                    | )          | 14.98                                  |       |                                                |       |                                                  |       |
| Expired                                |       | —                     |       | —                                 |       |                                                |       |                                                  |       |
| Outstanding as of March 31, 2006  |       | 9,124,688                  |       | 12.31                                  |       | 5.2 years                                           |       | 119,441                                               |       |
|                                   |       |                       |       |                                   |       |                                                |       |                                                  |       |
| Exercisable as of March 31, 2006  |       | 3,538,923                  |       | 8.71                                   |       | 5.6 years                                           |       | 59,069                                                |       |
|                                        |            |                            |            |                                        |            |                                                     |            |                                                       |            |  |

 

----

(a) The aggregate intrinsic values werecomputed by applying the following formula = (fair market value of an option asof 3/31/06 - the exercise price at which the option was granted) x the numberof options.

 

As of March 31, 2006, there was $16.5million of total unrecognized compensation costs related to unvestedshare-based compensation arrangements granted under all stock option plans. Thatcost is expected to be recognized over a weighted-average period of 1.4 years.

 

The total intrinsic value of share options exercisedduring the three months ended March 31, 2006 and 2005 was approximately$7.9 million and $4.5 million, respectively. The weighted-average grant datefair value of stock options granted during the three months ended March 31,2006 and 2005, was $8.06 and $7.63, respectively, using the Black-Scholesoption-pricing model with the following weighted-average assumptions:

 
| ** **                  | ** ** | **Three Months Ended March 31, 2006** | ** ** | **Three Months Ended March 31, 2005** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| Expected term of option (1) |       | 3.3 years                                  |       | 3.5 years                                  |       |
| Volatility (2)              |       | 54                                         | %          | 60                                         | %          |
| Forfeiture (3)              |       | 16.2                                       | %          | —                                     | %          |
| Risk-free interest rate (4) |       | 4.4                                        | %          | 3.6                                        | %          |
| Expected dividend yield     |       | 0                                          | %          | 0                                          | %          |

 

----

(1) The expected term of employee stock options represents theweighted-average period the stock options are expected to remain outstanding.The following factors were considered in estimating the expected term usingBlack-Scholes model:

 

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•      The vesting period of the awards

 

•      Employee’s past exercise and post-vestingemployment departure behavior

 

•      Expected volatility of the price of theunderlying share

 

(2) We used a 3-yearhistorical stock-price volatility as the expected volatility assumption which alignswith the expected life term of the options granted during the three monthsended March 31, 2006. We believe that historical volatility reflects ourcurrent assessment of implied volatility. Prior to 2006, we used historicalstock price volatility in accordance with SFAS No. 123 for purposes of ourpro forma disclosure.

 

(3) Forfeiture rate wascomputed taking into consideration the historical forfeiture rates. SFAS123(R)requires forfeitures to be estimated at the time of option grants and revised,if necessary, in subsequent periods if actual forfeiture differs from thoseestimates. Prior to adoption of SFAS 123(R), our pro forma disclosuresaccounted for actual forfeitures as they occurred.

 

(4)  The risk-freeinterest rate assumption is based on the rate currently available onzero-coupon U.S. Treasury instruments with a remaining term equal to theexpected term of the share option.

 

Cash received from stockoption exercises for the three months ended March 31, 2006 and 2005 was $5.1 million and$2.2 million, respectively. The income tax benefits from stock option exercisestotaled $ 0.1 million for thethree months ended March 31, 2006 and 2005, respectively.

 

The tablebelow reflects net income and diluted net income per share for the three monthsended March 31, 2006 compared with the pro forma information for the threemonths ended March 31, 2005:

 
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **Actual**                                       | ** ** | **Pro forma (1)** | ** ** |
| Net income (loss) before the effect of  stock-based compensation Expense     |       | $                                                | 5,211      |   | $ | (9,360 | ) |
| Stock-based  employee compensation expense related to employee stock options |       | —                                           |       | 15 |   |
| Stock-based  employee compensation expense related to employee stock options |       | (3,034                                           | )          | (2,863 | ) |
| Net income (loss), including the effect of  stock-based compensation expense |       | $                                                | 2,177      |   | $ | (12,208 | ) |
|                                                                         |       |                                             |       |   |   |
| Basic  earnings per share                                                    |       | $                                                | 0.07       |   | $ | (0.46 | ) |
| Diluted  earnings per share                                                  |       | $                                                | 0.06       |   | $ | (0.46 | ) |

 

----

(1) Net loss,stock-based compensation expense, basic and diluted earnings per share prior to2006 represents pro forma information based on SFAS No.123.

 

***Stock******Incentive******Plans—******We***have three stock incentive plans: (i) the1999 Stock Incentive Plan (the “1999 Plan”); (ii) the 2003 Broad BasedOption Plan (the “2003 Plan”); and (iii) the 2003 Non-employee DirectorStock Option Global Plan (the “Director Plan”).

 

*1999**Plan**—**Under*the 1999 Plan, we may grant shares ofcommon stock in the form of stock options, restricted stock awards, orstock appreciation rights to employees and key persons affiliated with

 

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Witness, as defined. At March 31, 2006, therewere 12.9 million shares authorized for issuance, of which 2,411,228 sharesremain available for future grant

 

*2003 Plan—**In***connection with the Eyretel acquisition, we established the 2003 Planfor former Eyretel employees. The 2003 Plan became effective in June 2003,allowing us to grant options exercisable to acquire shares of common stock. .At March 31, 2006, there were 1.6 million****sharesauthorized for issuance, of which 399,613 shares remain available for futuregrant. We do not anticipate increasing the number of shares available forissuance under the 2003 Plan.

 

*Director Plan—**under****the***Director Plan we may grant continuing non-employee members of theBoard of Directors non-qualified options to purchase shares of our common stock pursuant to aformula award. At March 31, 2006, there were 500,000 shares authorized forissuance, of which 388,000 shares remain available for future grant.

 

Each planremains in effect until the earlier of the tenth anniversary of its effectivedate or the date on which all reserved shares have been issued or are no longeravailable for use. Options granted under our stock option plans arenon-qualified stock options that were granted at a price greater than or equalto the fair value of the stock on the grant date. Option vesting termstypically range from two to four years. Options granted since July 1,2004, have five-year terms from the date of grant. Options granted prior to July 1,2004 have ten-year terms from the date of the grant. These plans provide foraccelerated option vesting terms in connection with a change in control.

 

**7.****                    ****Comprehensive Income (Loss)**

 

Total comprehensive income (loss) and accumulated othercomprehensive income consisted of the following (in thousands):

 
| ** **                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                                         |       |                                             |       |   |   |
| Net income (loss)                                            |       | $                                                | 2,177      |   | $ | (9,360 | ) |
| Other comprehensive income (loss):                           |       |                                             |       |   |   |
| Foreign  currency translation adjustments                    |       | 1,241                                            |       | 105 |   |
| Change in  unrealized net holding (loss) gain on investments |       | (83                                              | )          | 1 |   |
| Total comprehensive income (loss)                            |       | $                                                | 3,335      |   | $ | (9,254 | ) |

 
| ** **                                           | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                 |       |                     |       |                        |       |
| Cumulative foreign currency translation  adjustments |       | $                        | 4,319      |                        | $          | 3,078 |   |
| Unrealized net holding loss on investments           |       | (85                      | )          | (2                          | )          |
| Total accumulated other comprehensive  income        |       | $                        | 4,234      |                        | $          | 3,076 |   |

 

**8.****                    ****Line of Credit**

 

In March 2006, we extended the maturity date onour $15.0 million line of credit to March 2007. At our election,borrowings under the line of credit bear interest at the bank’s prime rate,which was 7.75 % on March 31, 2006 or LIBOR plus 300 basis points. Borrowingsunder the revolving line of credit are

 

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limitedto 85% of eligible accounts receivable, as defined by the agreement. Therevolving line of credit is secured by all of our assets and requirescompliance with various covenants, including liquidity ratios and EBITDArequirements, among others. As of March 31, 2006, we were in compliancewith our bank covenants.

 

As of March 31, 2006, we had no amountsoutstanding under the line of credit and the amount available for borrowing was$12.8 million, which was net of outstanding letters of credit of $2.2 million. Theletters of credit secure the lease on the corporate headquarters facility andhave decreasing schedules that ultimately expire in 2007. In addition, we havea £0.3 million letter of credit securing our lease obligations for our premisesin the United Kingdom.

 

**9.****                    ****Segment and Geographic Information**

 

We consider ourselves to be in a single industrysegment, specifically licensing and servicing of software applications to thecustomer interaction recording and analysis market. Our chief operatingdecision maker receives financial information by geographic region; however,our operating segments are aggregated into one reportable segment based uponsimilar economic characteristics, products, services and delivery methods.

 

World-wide revenue based on customer location is asfollows (in thousands):

 
| ** **     | ** ** | **Three months ended  March 31,** | ** ** |
|----------------|------------|--------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|           |       |                                             |       |   |   |
| United States  |       | $                                                | 27,669     |   | $ | 23,038 |   |
| United Kingdom |       | 13,297                                           |       | 9,791 |   |
| Rest of world  |       | 10,500                                           |       | 8,330 |   |
| Total          |       | $                                                | 51,466     |   | $ | 41,159 |   |

 

The rest of world revenue was derived primarily fromcustomers located in Australia, Canada, China, India and Japan. No individualcustomer accounted for more than 10% of consolidated revenue during the threemonths ended March 31, 2006 or 2005.

 

Long-lived assets, including goodwill and intangibleassets, by geography are as follows (in thousands):

 
| ** **     | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | ** **               | ** ** | ** **                  | ** ** |
| United States  |       | $                        | 70,236     |                        | $          | 71,808 |   |
| United Kingdom |       | 9,619                    |       | 10,824                      |       |
| Rest of world  |       | 2,205                    |       | 2,250                       |       |
| Total          |       | $                        | 82,060     |                        | $          | 84,882 |   |

 

**10.****                  Recent Accounting Pronouncements**

 

In November 2005, the FASB issued StaffPosition (“FSP”) FAS115-1/124-1, *The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments,*which addresses the determination as to when an investment is consideredimpaired, whether that impairment is other than temporary, and the measurementof an impairment loss. This FSP also includes accounting considerations

 

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subsequentto the recognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. The guidance in this FSP amends FASBStatements No. 115, *Accounting forCertain Investments in Debt and Equity Securities, and No. 124, Accountingfor Certain Investments Held by Not-for-Profit Organizations*, andAPB Opinion No. 18*, The Equity Methodof Accounting for Investments in Common Stock*. This FSP iseffective for reporting periods beginning after December 15,2005. The adoption of this FSP had no material impact to our financialstatements.

 

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

 

The following Management’s Discussion and Analysisof Financial Condition and Results of Operations should be read in conjunctionwith the Condensed Consolidated Financial Statements and Notes thereto includedelsewhere in this report. Investors should carefully review the informationcontained in this report under the caption “Risk Factors” beginning on page 30.The following will be discussed and analyzed:

 

•      Overview

 

•      CriticalAccounting Policies and Estimates

 

•      Results ofOperations

 

•      Liquidity andCapital Resources

 

**Overview**

 

We are a leading provider of workforce performanceimprovement software and services that enable companies to optimize workforceperformance and capture customer intelligence in their customer serviceoperations. Our Impact 360 solution consists of software products and servicesdesigned to optimize the workforce, processes and technology involved in thecustomer service function and gain valuable insight from customer interactionsthat can be used throughout the enterprise. These solutions may bedeployed

 

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throughout a customer’s enterprise—including in contact centers, backoffices and branch offices—to enable the customer to capture informationderived from contacts with its customers, analyze the information in relationto key performance indicators, act upon the information to improve the overallcustomer experience, and manage the staffing, training and performancemeasurement of its personnel involved in all aspects of customer service.

 

Our Impact 360 solution is an integratedoffering of software products that provide comprehensive workforce optimizationfunctionality, including quality monitoring and high-volume compliancerecording, workforce management, performance management and electroniclearning, or e-learning. Our quality monitoring products record multimediainteractions, including traditional voice, Web chat and email, based onuser-defined business rules to enable our customers to evaluate theperformance of their customer service representatives, or “CSR”s, wherever theymay be located in the enterprise. Our high-volume compliance applicationsare designed to record 100% of the voice conversations between CSRs andcustomers for purposes such as compliance recording and sales verification. Ourworkforce management products enable our customers to develop strategicstaffing plans, deploy skilled resources and evaluate productivity of CSRs. Ourperformance management applications provide comprehensive analytics, includingperformance scorecards, and reports of customer interaction and CSRperformance. Our e-learning applications deliver ongoing training tailored toCSR needs and competencies. We also provide consulting and implementationservices, training and support to customers that use our software products.

 

We derive product revenue by licensingsoftware and derive services revenue by providing related installation,training, consulting, and maintenance services. We also derive a relativelysmall portion of product revenue by selling hardware to customers. The majorityof our product 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, weco-develop products, which are sold by the OEM as part of their portfolioof products.

 

We intend to continue to expand our globalsales channels by entering into new reseller, distributor, OEM and similararrangements with key vendors in the contact center workforce optimizationmarket. During first quarter of 2006 and 2005, approximately 31% and 42%,respectively**,**of our license revenue has beenderived from the indirect sales channel.

 

We plan to grow our product revenue andmaintain our competitive position from a technology perspective through thetimely introduction 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, as our software solutions support both of theserecording environments. In addition, we believe our product offerings can bemarketed toward branch-office and back-office initiatives for business processmonitoring, which represents a new market for us. Factors that may impactour ability to grow our product revenue, however, include our ability to remaincompetitive from a technology perspective; market acceptance of our newproducts; our ability to maintain our product pricing integrity; and ourability to expand our global sales channels.

 

We also plan to grow our services revenue inconcert with 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 servicesrevenue. In addition, our customers generally renew their maintenance contractswith us each year. Therefore, our maintenance revenue increases as our customerbase increases. Factors that may influence our ability to grow ourservices revenue, however, include our ability to continue to increase productrevenues, provide services

 

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that enable and enhance our customers’ ability to improve theefficiency and effectiveness of their customer service operations and ourability to maintain a high level of customer success and satisfaction.

 

On January 24, 2005, we acquired BluePumpkin Software, Inc. (“Blue Pumpkin”), a privately held Californiacorporation. With this acquisition, we have extended our workforce optimizationsolution to include advanced workforce management software and servicessolutions including forecasting, scheduling, adherence and planningapplications. Pursuant to the Acquisition Agreement and Plan of Reorganization,dated December 16, 2004 (the “Acquisition Agreement”), we paid $40 millionin cash which was funded from our existing cash and investments and issued 2.1million shares of Witness’ common stock valued at $37.2 million (measuredat the date the stock consideration became fixed pursuant to the application ofa formula specified in the Merger Agreement). On May 24, 2005, the sharesissued in connection with the acquisition were registered for resale with theSecurities and Exchange Commission. Approximately ten percent of the aggregateacquisition consideration was placed into escrow and was released to Witness duringthe month of March, 2006 in satisfaction and settlement of claims that Witnessbrought against the escrow fund, including claims from the settlement of IEXlitigation. On April 6, 2006, Blue Pumpkin and IEX reached an agreement tosettle all claims asserted between them. As part of the final settlement,Witness made payment of $8.25 million to Tekelec, IEX’s parent company, in April 2006and agreed to make six annual payments of $0.5 million ($3.0 million in total)from April 2007 through 2012.

 

On May 23, 2005, we acquired OptimisGroup Limited (“Optimis”), a UK-based provider of workforce optimizationsoftware solutions. Blue Pumpkin owned a minority interest in an operatingsubsidiary of Optimis, the balance of which was acquired through the Optimisacquisition. We paid $5.0 million in cash and other consideration that wasfinanced from our existing cash and investments. Ten percent of theaggregate acquisition consideration is being held in escrow until May 23,2006. 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.

 

On January 1, 2006, we adopted SFAS No. 123(R),*Share-Based Payment*, which requires themeasurement and recognition of compensation expense for all share-based paymentawards made to employees including employee stock options and employee stockpurchase plan based on the grant date fair value of those awards. We determinethe fair value of share-based payment awards on the date of grant using theBlack-Scholes option-pricing model. We adopted SFAS 123(R) using the modifiedprospective transition method, which requires the application of SFAS 123(R) asof January 1, 2006. Stock-based compensation expense recognized under SFAS123(R) for the three months ended March 31, 2006 was $ 3.0 million, whichconsisted of stock-based compensation expense related to employee stock optionsgranted during the last four years (vesting period).

 

The table below reflects net income anddiluted net income per share for the three months ended March 31, 2006compared with the pro forma information for the three months ended March 31,2005:

 
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **Actual**                                       | ** ** | **Pro forma (1)** | ** ** |
| Net income (loss) before the effect of  stock-based compensation Expense     |       | $                                                | 5,211      |   | $ | (9,360 | ) |
| Stock-based  employee compensation expense related to employee stock options |       | —                                           |       | 15 |   |
| Stock-based  employee compensation expense related to employee stock options |       | (3,034                                           | )          | (2,863 | ) |
| Net income (loss), including the effect of  stock-based compensation expense |       | $                                                | 2,177      |   | $ | (12,208 | ) |
|                                                                         |       |                                             |       |   |   |
| Basic  earnings per share                                                    |       | $                                                | 0.07       |   | $ | (0.46 | ) |
| Diluted  earnings per share                                                  |       | $                                                | 0.06       |   | $ | (0.46 | ) |
|                                                                              |            |                                                  |            |  |  |  |  |  |  |

 

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(1)           Net loss, stock-basedcompensation expense, basic and diluted earnings per share prior to 2006represents pro forma information based on SFAS No. 123.

 

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We are headquartered in Roswell, Georgia withoperations in the United States, Australia, Brazil, Canada, China, Germany,India, Japan, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom. During the three months ended March 31, 2006, approximately 46%of our revenue was derived from operations outside the United States. Duringthree months ended March 31,2005 and 2004, 44% and 43%, respectively, ofour revenue was derived from customers outside the United States. We had****668****full-timeemployees**,** excluding approximately 164****contractors located in the Asia-Pacific region, at March 31,2006, compared to 595 employees, excluding approximately 159 contractors, at March 31,2005. As of March 31, 2006, 229 of the 668 full-time employees werelocated outside the United States compared to 195 employees, excludingcontractors, at March 31, 2005.

 

**Critical Accounting Policies and Estimates**

 

The discussion and analysis of our financialcondition and results of operations is based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America. The preparation of thesefinancial statements requires us to make certain estimates and judgments thataffect our reported assets, liabilities, revenue and expenses, and our relateddisclosure of contingent assets and liabilities. On an on-going basis, we re-evaluateour estimates, accounting policies and judgments including those related torevenue recognition, the collectibility of receivables, accounting foracquisitions, impairment of long-lived assets, income taxes and stock-basedcompensation to ensure that our financial statements are presented fairly andin accordance with Generally Accepted Accounting Principles (“GAAP”). We baseour estimates on historical experience and on various assumptions that webelieve to be reasonable under the circumstances. However, because futureevents and their effects cannot be determined with certainty, actual results may differfrom these estimates under different assumptions or conditions and suchdifferences could be material. Management believes that the following accountingpolicies and estimates are critical to understanding and evaluating ourreported financial results. Management has reviewed these critical accountingpolicies and estimates with the Audit Committee of our Board of Directors.

 

*Revenue Recognition.* Werecognize revenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) No. 97-2,*Software Revenue Recognition,* andSOP No. 98-9*, Modification of SOP97-2, Software Revenue Recognition, With Respect to Certain Transactions*.Revenue is primarily derived from licensing software and providing relatedservices including maintenance. We also derive a relatively small portion ofproduct revenue by selling hardware to customers. Product revenue, whichincludes software and hardware, is recognized when persuasive evidence of anarrangement exists, delivery of the product has occurred, the fee is fixed ordeterminable, collection is probable and vendor specific objective evidence offair value (“VSOE”) exists to allocate revenue to the undelivered elements ofthe arrangement. We report hardware revenue gross in accordance with EmergingIssues Task Force (“EITF”) No. 99-19,*Reporting Revenue Gross as a Principal versus Net as an Agent,*because the factors indicating gross reporting outweigh the factors indicatingnet reporting. We recognize revenue using the residual method of accountingsince we generally have VSOE for maintenance and professional services, but notfor the software and hardware elements of the order. 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

 

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the software and hardware is 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 includes installation,training, consulting, maintenance and reimbursable travel expenses. Revenuefrom 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 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.

 

Our revenue recognition policy is significantbecause our revenues are a key component of our results of operations. Wefollow very specific and detailed guidelines, discussed above, in measuringrevenues, however, certain judgments and estimates affect the application ofour revenue policy described above. Further, assessment of collectibility isparticularly critical in determining whether or not revenues should berecognized. We also record provisions for estimated sales allowances on productand service related revenues at the time the related revenues are recorded.These estimates are based on historical sales and services allowances, analysisof customer credits and other known factors. If future sales credits prove tobe greater than the historical data and the estimates we used to calculatethese provisions, our revenues could be overstated.

 

*Allowance for DoubtfulAccounts.*We perform ongoingevaluations of our customers and continuously monitor collections and paymentsand estimate an allowance for doubtful accounts based on the aging of theunderlying receivables, our historical experience with write-offs and anyspecific customer collection issues that we have identified. While such creditlosses have historically been within our expectations and we believeappropriate reserves have been established, we cannot assure that we willcontinue to experience the same credit loss rates that we have experienced inthe past or adequately predict future credit losses. If the financial conditionof our customers were to deteriorate and result in an impairment of theirability to make payments, additional allowances may be required whichwould result in an additional selling, general and administrative expense inthe period such determination is made.

 

*Accounting for Acquisitions.*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 costs. In recording acquisitions,significant judgment is required in estimating:

 

•      valuation ofdeferred revenue,

 

•      valuation ofintangible assets and acquired in-process research and development,

 

•      otherliabilities existing at the time of acquisition.

 

Changes to estimates of acquired identifiableassets and liabilities are reflected as adjustments to goodwill or intangibles tothe extent such changes were based on conditions that existed at theacquisition date but the information was subsequently received and evaluated. Otheradjustments are reflected in our results of operations. In accordance with SFASNo. 142,*Goodwill and Other IntangibleAssets*, goodwill and intangible assets with indefinite useful livesare not amortized, but are tested for impairment annually or more frequently ifcircumstances indicate their value may no longer be recoverable.

 

*Impairment of Long-LivedAssets.*  Long-lived assets, such asproperty and equipment and amortizable intangible assets, are accounted for inaccordance with SFAS No. 144*,Accounting for Impairment or Disposal of Long-lived Assets* and arereviewed for impairment whenever events or

 

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changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. All of ouridentifiable intangible assets are amortized using the straight-line method.Useful lives of amortizable intangible assets are reviewed annually with anychanges in estimated useful lives being accounted for prospectively over therevised remaining useful life. Recoverability of assets to be held and usedwould be measured by a comparison of the carrying amount of an asset to theestimated undiscounted future cash flows expected to be generated by the asset.If the carrying 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, requires 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.

 

*Accounting for Income Taxes.* Weaccount for income taxes in accordance with SFAS No. 109,*Accounting for Income Taxes*, whichrequires recognition  of deferred incometax assets and liabilities for temporary differences between the financialreporting and tax bases of recorded assets and liabilities and the expectedbenefits of net operating loss and credit carryforwards. SFAS No. 109requires that deferred income tax assets be reduced by a valuation allowance ifit is more likely than not that some portion or all of the deferred income taxassets will not be realized. We evaluate the realizability of our deferredincome tax assets, primarily resulting from net operating loss and creditcarryforwards, and adjust our valuation allowance, if necessary.

 

If we were to recognize the tax benefitassociated with our net operating loss carryforwards, we would expect ourprovision for income tax expense in future periods to reflect an effective taxrate that would be significantly higher than in past periods. Furthermore, theutilization of deferred tax assets, primarily net operating loss carryforwardsarising from acquisitions, has resulted and will continue to result in areduction in goodwill and the recognition of tax expense associated with thepurchased deferred tax assets. Additionally, the utilization of net operatingloss carryforwards generated by the tax deduction for stock option exercisesresults in an increase to Additional-Paid-in-Capital and the recognition of taxexpense.

 

Also under FAS 123(R),future excess tax deductions will result in an increase to Additional-Paid-in-Capital.Under this new standard, the Company will continue to follow thewith-and-without approach and consider the impact of excess stock optiondeductions last when computing its income tax provision. We have utilized $2.2million of income tax benefits originating from stock optiondeductions that have not been recorded in accordance with FAS 123(R).

 

Estimates and judgments are required indetermining our worldwide income tax expense. In the ordinary course ofconducting business globally, there are many transactions and calculationswhose ultimate tax outcome cannot be certain. Although we believe our estimatesand judgments are reasonable, no assurance can be given that the final taxoutcome of these matters will not be different from what is reflected in ourhistorical income tax provisions and accruals. Such differences could have amaterial impact on our income tax provision and operating results in the periodin which such a determination is made.

 

*Stock-Based Compensation.*  On January 1, 2006, weadopted SFAS No.123(R), *Share-Based Payment*,which requires the measurement and recognition of compensation expense for allshare-based payment awards made to employees including employee stock optionsand employee stock purchase plan based on the grant date fair value of thoseawards. We determine the fair value of share-based payment awards on the dateof grant using Black-Scholes option-pricing model. The fair value ofshare-based awards is affected by stock price as well as assumptions regardinga number of highly complex and subjective variables. These variables include,but are not limited to, our expected stock price volatility

 

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overthe term of the awards, and actual and projected employee stock option exercisebehavior. SFAS 123(R) also requires that forfeitures be estimated over thevesting period of an award, rather than being recognized as a reduction ofcompensation expense when the forfeiture actually occurs. We adopted SFAS123(R) using the modified prospective transition method, which requires theapplication of SFAS123(R) as of January 1, 2006. Our CondensedConsolidated Financial Statements as of and for the three months ended March 31,2006 reflect the impact of SFAS 123(R).

 

In accordance with the modified prospectivetransition method, our Condensed Consolidated Financial Statements for priorperiods have not been restated to reflect, and do not include, the impact ofSFAS 123(R). This statement requires us to estimate the fair value ofshare-based payment awards on the date of grant using an option-pricing model.The value of the portion of the award that is ultimately expected to vest isrecognized as expense over the requisite service periods in our ConsolidatedStatement of Operations. Stock-based compensation expense recognized under SFAS123(R) for the three months ended March 31, 2006 was $3.0 million whichconsisted of stock-based compensation expense related to employee stock optionsgranted during the last four years (vesting period). Prior to the adoption ofSFAS 123(R), we accounted for stock-based awards to employees using theintrinsic value method in accordance with APB 25 as allowed under SFAS No. 123,*Accounting for Stock-Based Compensation*(“SFAS123”). Under the intrinsic value method, we have generally not recordedcompensation 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.

 

On November 10, 2005,the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FSP123(R)-3,*Transition Election Related to Accounting for TaxEffects of Share-Based Payment Awards.* We elected to adopt the alternativetransition method provided in the FSP for calculating the tax effects ofstock-based compensation pursuant to SFAS 123(R). The alternative transitionmethod includes simplified methods to establish the beginning balance of theadditional paid-in capital pool (“APIC pool”) related to the tax effects ofemployee stock-based compensation, and to determine the subsequent impact onthe APIC pool and Condensed Consolidated Statement of Cash Flows of the taxeffects of employee stock-based compensation awards that are outstanding uponadoption of SFAS 123(R).

 

The weighted-average grant date fair value ofstock options granted during the three months ended March 31, 2006 and2005, was $8.06 and $7.63, respectively, using the Black-Scholes option-pricingmodel with the following weighted-average assumptions:

 
| ** **                  | ** ** | **Three Months  Ended March 31,  2006** | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|-----------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Expected term of option (1) |       | 3.3 years                                    |       | 3.5 years                                    |       |
| Volatility (2)              |       | 54                                           | %          | 60                                           | %          |
| Forfeiture (3)              |       | 16.2                                         | %          | —                                       | %          |
| Risk-free interest rate (4) |       | 4.4                                          | %          | 3.6                                          | %          |
| Expected dividend yield     |       | 0                                            | %          | 0                                            | %          |

 

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(1) The expected term of employee stockoptions represents the weighted-average period the stock options are expectedto remain outstanding. The following factors were considered in estimating theexpected term using Black-Scholes model:

 

•      The vesting period of the awards

 

•      Employee’s past exercise and post-vestingemployment departure behavior

 

•      Expected volatility of the price of theunderlying share

 

(2) We used a 3-yearhistorical stock-price volatility as the expected volatility assumption whichaligns with the expected term of the options granted during the three monthsended March 31, 2006. We

 

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believe that historical volatility reflects ourcurrent assessment of implied volatility. Prior to 2006, we used historicalstock price volatility in accordance with SFAS No. 123 for purposes of ourpro forma disclosure.

 

(3) Forfeiture rate wascomputed taking into consideration the historical forfeiture rates. SFASNo.123(R) requires forfeitures to be estimated at the time of option grants andrevised, if necessary, in subsequent periods if actual forfeiture differs fromthose estimates. Prior to adoption of SFAS No.123(R), our pro forma disclosuresaccounted for actual forfeitures as they occurred.

 

(4) The risk-freeinterest rate assumption is based on the rate currently available onzero-coupon U.S. Treasury instruments with a remaining term equal to theexpected term of the share option.

 

See Note 6 to the Condensed ConsolidatedFinancials Statement included elsewhere in this report for discussion on stock-based compensation.

 

**Results of Operations**

 

The table below shows operating data as a percentageof total revenue for the three months ended March 31, 2006 and 2005.

 
| ** **                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Revenue:                                         |       |                                   |       |   |   |
| Product                                          |       | 39                                     | %          | 40 | % |
| Services                                         |       | 61                                     |       | 60 |   |
| Total  revenue                                   |       | 100                                    |       | 100 |   |
| Cost of revenue:                                 |       |                                   |       |   |   |
| Product                                          |       | 9                                      |       | 11 |   |
| Services                                         |       | 23                                     |       | 23 |   |
| Total cost  of revenue                           |       | 32                                     |       | 34 |   |
| Gross profit                                     |       | 68                                     |       | 66 |   |
| Operating expenses:                              |       |                                   |       |   |   |
| Selling,  general and administrative             |       | 49                                     |       | 48 |   |
| Research and  development                        |       | 15                                     |       | 15 |   |
| Merger-related  and integration costs            |       | 1                                      |       | 4 |   |
| Acquired  in-process research and development    |       | —                                 |       | 22 |   |
| Operating income  (loss)                         |       | 3                                      |       | (23 | ) |
| Interest and other income, net                   |       | 2                                      |       | 0 |   |
| Income  (loss) before provision for income taxes |       | 5                                      |       | (23 | ) |
| Provision for income taxes                       |       | 1                                      |       | 0 |   |
| Net income  (loss)                               |       | 4                                      | %          | (23% | ) |

 

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*Revenue*

 

Total revenue increased 25%in the first quarter of 2006, as compared to the first quarter of 2005, to$51.5 million. The increase in total revenue can be attributed to bothcontinued growth of our business and sales and related services derived fromour Blue Pumpkin acquisition, which expanded our workforce optimizationsolution. The number of installed customer sites grew to 4,330 as at March 31,2006 from 3,846 sites as at March 31, 2005.

 

Product revenue includes software revenue andhardware revenue. Hardware sales are incidental to our business, and weare working toward transitioning our customers to third-party hardwaresuppliers. We expect hardware revenue to decline in the future. Product revenueof $18.3 million, excluding hardware revenue of $1.6 million in the firstquarter of 2006 (and $1.3 million in the same period in 2005), increased $3.2million, or 21% in the first quarter of 2006. The increase in software revenuegrowth in 2006 is largely attributed to our expanded product line, especiallyImpact 360. Our Impact 360 solution consists of software products and servicesdesigned to optimize the workforce, processes and technology involved in thecustomer service function.

 

Product revenue as a percentage of total revenue hasbeen decreasing slightly over the past three years due to increased servicesrevenue, as discussed below. Our product pricing has remained reasonablyconsistent over the previous three years.

 

New customers accounted for 15% and 21%,respectively, of product revenue, excluding hardware revenue, during the firstquarters of 2006 and 2005. We receive follow-on revenue from our existingcustomers when they purchase additional user licenses or license additionalapplications at existing sites and when they license our products at new sites.We expect to continue receiving the majority of our product revenue fromexisting customers during 2006.

 

Services revenue, consisting of installation,training, consulting, maintenance support and reimbursable travel expenses,increased 28% to $31.6 million in the first quarter of 2006 compared to thefirst quarter of 2005. The increase was due to installation and trainingservices related to new product sales, customers renewing their maintenancecontracts with us thereby increasing our recurring maintenance revenue streamand the lesser impact of the fair value adjustment on service revenues acquiredin conjunction with the Blue Pumpkin and Optimis acquisition. The percentage ofWitness customers that have renewed their maintenance contracts with us hashistorically exceeded 90%. We believe that maintenance contracts will berenewed at a comparable rate during 2006. 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, throughout 2006.

 

*Cost of Revenue*

 

Total cost of revenue increased 18% to $16.3 millionin the first quarter of 2006 compared to the first quarter of 2005. Expressedas a percent of revenue, gross profit margin has increased to 68% in the firstquarter of 2006 compared to 66% in the same period in 2005**.**Thisincrease resulted primarily from an increase in service revenue gross margins.Excluding hardware cost of revenue and the amortization of

 

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intangibleassets resulting from acquisitions, gross profit margins increased slightly to75% in the first quarter of 2006 from 74% in the first quarter of 2005. Weexpect our gross profit margin, excluding hardware and amortization ofintangible assets, to remain relatively constant throughout 2006.

 

Cost of product revenue consists of amortization ofacquired technology, hardware costs, royalties due to third parties forsoftware components that are embedded in our software applications,amortization of capitalized software development costs and packaging costs. Amortizationof acquired technology was $2.3 million in the first quarter of 2006 comparedto $1.9 million in the same period in 2005. Cost of hardware revenue was $1.7million in the first quarter of 2006 and $1.3 million in the same period of2005. We will continue to incur amortization expense, but expect the cost ofhardware to decline as we work towards reducing the amount of hardware sales inthe future. Cost of product revenue, excluding amortization of acquiredtechnology and hardware costs, decreased 31% in the first quarter of 2006compared to the same period in 2005. This decrease was due to lowerroyalties expense during the first three months of 2006 compared to the sameperiod of 2005. Royalties expense relate to third parties for softwarecomponents that are embedded in our software applications. Such royalties varyperiod-over-period in proportion to the sales of certain products. The cost ofproduct revenue expressed as a percentage of product revenue, excludinghardware and amortization of intangible assets, was 4% and 6% in the firstquarter of 2006 and 2005, respectively. As we develop upgrades of our existingproducts and add new offerings to our product suite, we may embedthird-party technology into our software, which could increase the cost ofproduct revenue in the future.

 

Cost of services revenue for installation, training,consulting and maintenance services include personnel costs and relatedexpenses and allocated overhead. Personnel costs include salaries, bonuses andbenefits. Cost of services revenue increased 23% to $11.7 million in the firstquarter of 2006 compared to the same period in 2005, due primarily to anincrease in the number of employees engaged in customer support services. Costof services revenue as a percentage of services revenue decreased to 37% oftotal services revenue in the first quarter of 2006 from 38% in the same periodin 2005 due to productivity improvements in the professional services group. Weanticipate that our services margins will remain relatively consistentthroughout 2006. We expect our customer service organization to continue togrow over time and, therefore, we anticipate that our cost of services revenue,in absolute dollars, will increase as we grow our customer base.

 

*Operating Expenses*

 

*Selling, General andAdministrative.*Selling,general and administrative (“SG&A”) expense consists primarily of personnelcosts, sales commissions, marketing programs, professional fees, theamortization of certain intangible assets and provisions for bad debt expense. SG&Aexpense increased 26% to $25.1 million in the first quarter of 2006 compared tothe same period in 2005 due primarily to $2.5 million in stock compensationexpense and $2.3 million in legal, professional and personnel costs. Certainincreases in SG&A costs, especially personnel, during 2006 were effected bythe Blue Pumpkin and Optimis acquisitions during 2005. We expect SG&Aexpense to increase quarterly in 2006 in absolute dollars but decrease as apercentage of total revenue due to anticipated revenue growth.

 

*Research and Development.* Research and development (“R&D”) expensesconsist primarily of personnel and consulting costs to support productdevelopment, and allocated overhead. R&D costs are expensed as incurred andinclude software development costs incurred prior to the establishment oftechnological feasibility. Costs incurred subsequent to establishingtechnological feasibility are capitalized and amortized over the asset’sestimated useful life to cost of product revenue.  Software development capitalization increasedto $1.2 million as of March 31, 2006 from $0.9 million as of March 31,2005. Cost of product revenue during the three months ended March 31, 2006and 2005 includes amortization of capitalized software development costs of$0.9 million and $0.1 million, respectively. R&D expenses increased28% to $8.0 million in the first quarter of 2006 compared to the same period in

 

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2005,primarily due to the increased number of employees engaged in research anddevelopment activities. We expect total R&D expense to increase quarterlyin absolute dollars but decrease as a percentage of total revenue during 2006.

 

*Merger-related and IntegrationCosts*. During thefirst quarter of 2006, we incurred merger-related and integration costs in theamount of $0.7 million pertaining to the acquisition of Blue Pumpkin. Theseexpenses were primarily incurred for legal and professional fees. During thefirst quarter of 2005 we incurred $1.7 million in merger-related andintegration costs due to the January 2005 acquisition of Blue Pumpkin.

 

*Acquired In-Process Research andDevelopment.*Duringthe first quarter of 2005, we estimated that $9.0 million of the purchase priceof Blue Pumpkin represented acquired in-process research and development (“IPR&D”)that had not 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 for the threemonths ended March 31, 2006 and 2005, respectively is as follows (inthousands):

 
| ** **            | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------|------------|----------------------------------------|------------|
| ** **            | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Interest income, net  |       | $                                      | 1,408      |   | $ | 291 |   |
| Foreign currency loss |       | (137                                   | )          | (153 | ) |
|                  |       | 1,271                                  |       | 138 |   |
|                       |            |                                        |            |  |  |  |  |

 

We expect that interest income will increasein 2006 compared to 2005 due to higher cash and investment balances resultingfrom our common stock offering in December 2005.

 

*Provision for Income Taxes*

 

We recorded a provision for income tax of$0.4 million and $33 thousand, respectively, in the first quarter of 2006 and2005. As of December 31, 2005, we had net operating loss carryforwardsaggregating $82.2 million for U.S. tax purposes and $37.8. million for foreigntax purposes. We expect that the provision for income taxes in 2006 willbenefit from the utilization of these net operating loss carryforwards.However, the utilization of certain net operating loss carryforwards arisingfrom

 

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acquisitions will result in a reduction of the valuation allowance fordeferred income tax assets and goodwill or intangible assets, and therecognition of deferred income tax expense.

 

**Liquidity and Capital Resources**

 

At March 31, 2006, 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 corporateheadquarters facility and have decreasing schedules that ultimately expire in2007. At our election, borrowings under the line of credit bear interest at thebank’s prime rate, which was 7.75% on March 31, 2006, or LIBOR plus 300basis points, and are limited to 85% of eligible accounts receivable, asdefined by the agreement. The revolving line of credit is secured by all of ourassets and requires compliance with various covenants, including liquidityratios and EBITDA requirements, among others. As of March 31, 2006, wewere in compliance with all bank covenants.

 

We anticipate that operating expenses andcapital expenditures will continue to be a material use of our cash resources. Wecurrently expect to have total capital expenditures of approximately $5.5million in 2006. We believe that our capital expenditures may increaseover the next several years as we expand our facilities and acquire equipmentto support the expansion of our research and development activities andinternal management and 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 mergeror acquisition transactions.

 

*Market Risk*

 

Market risk represents the risk of loss that may affectus due to adverse changes in financial market prices and rates. Our market riskexposure primarily relates to fluctuations in foreign exchange rates andinterest rates. We have not entered into derivative or hedging transactions tomanage risk in connection with foreign exchange fluctuations and have notengaged in any interest rate hedging transactions.

 

Within our foreign-based operations, wheretransactions may be denominated in foreign currencies, we are subject tomarket risk with respect to fluctuations in the relative value of currencies. Currently,we have foreign-based operations in Australia, Brazil, Canada, China, Germany,India, Japan, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom that conduct transactions in either the local currency of the locationor the U.S. dollar. We are exposed to adverse movements in foreign currencyexchange rates because we translate foreign currencies into U.S. dollars forreporting purposes. Historically, these risks have been minimal, but as ourinternational operations continue to grow, adverse currency fluctuations couldhave a material adverse impact on our financial results. Net foreign exchangelosses were $0.1 million and $0.2 million in the three months ended March 31,2006 and 2005, respectively.

 

Exposure to market rate risk for changes ininterest rates relates to our investment portfolio and any potential borrowing.Our investments are made with capital preservation and liquidity as our primaryobjectives. We generally hold only high-grade investments such as commercialpaper, corporate bonds, auction rate securities and U.S. government agencysecurities. To reduce our balance sheet exposure to variations in asset values,our investment policy guidelines specify that we invest in the highestinvestment grade securities and maintain a weighted average maturity of ninemonths or less for our entire

 

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portfolio. Our investment portfolio may contain securities withmaturities of up to three years. While this minimizes our interest rate risk toasset values, our results are exposed to fluctuations in interest income due tochanges in market rates.

 

**Item 3. Quantitative and QualitativeDisclosures About Market Risk**

 

Informationconcerning market risk is included in Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, Item 2 of Part I of thisReport.

 

**Item 4. Controls and Procedures**

 

***Evaluation of Disclosure Controlsand Procedures***

 

We conducted an evaluation of the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-14 and15d-14 under the Securities Exchange Act of 1934), as of the end of the periodcovered by this quarterly report. This evaluation was conducted under thesupervision and with the participation of our management, including the ChiefExecutive Officer and Chief Financial Officer. Based on this evaluation, as ofthe quarter ended March 31, 2006, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures are noteffective due to the material weakness discussed below.

 

The following was the material weakness, asoriginally reported in our Annual Report on Form 10-K for the year ended December 31,2005:

 

Our policiesand procedures over account reconciliations and management’s review ofestimates and account balances were not designed to a sufficient level ofprecision to prevent or detect misstatements that could have a material effecton the consolidated financial statements. As a result, there were errors to theconsolidated financial statements that were not identified or recorded bymanagement. This deficiency resulted in more than a remote likelihood that a materialmisstatement to the consolidated financial statements would not be prevented ordetected.

 

In the quarter ended March 31,2006, management made significant progress in remediating the material weaknessby:

 

•      Revising ourpolicies and procedures related to the capitalization and depreciation ofproperty and equipment including the addition of control procedures over thereview of information input into our accounting system;

 

•      Revising ourcontrol procedures through the addition of more effective controls to ensurethe accrual of certain period-end operating expenses; and

 

•      Implementingformal policies, including quantitative and qualitative analysis, over thedocumentation and evaluation of unsubstantiated differences that individuallyor in the aggregate should be timely recorded.

 

Since this is the firstquarter of remediation, it is too early to conclude that the material weaknesshas been remediated. Management believes the above new policies and procedures,when fully implemented, will be effective in remediating this materialweakness.

 

A material weakness ininternal control over financial reporting is defined by the Public CompanyAccounting Oversight Board (“PCAOB”) Auditing Standard No. 2 as asignificant deficiency, or

 

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combination of significant deficiencies, that resultin a more than remote likelihood that a material misstatement of the annual orinterim financial statements will not be prevented or detected.

 

There were no changes, other than as discussedabove, in our internal controls over financial reporting that occurred duringthe period covered by this quarterly report that have materially affected, orthat are reasonably likely to materially affect, our internal controls over financialreporting.

 

**PART II. OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

In January 2001, IEX Corporation filed alawsuit against Blue Pumpkin in the United States District Court for theEastern District of Texas, Sherman Division (“Texas IEX action”), alleging thatBlue Pumpkin 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’s lawsuit seeks actual damages, an award oftreble damages pursuant to 35 U.S.C. § 284, and an award of prejudgmentinterest, costs, and attorney’s fees, and an injunction against Blue Pumpkin’smaking or selling the products that IEX claims infringe its ‘355 Patent.

 

On October 4, 2005, Blue Pumpkin filedin the United States District Court for the Northern District of Georgia,Atlanta Division, a lawsuit against IEX Corporation alleging patentinfringement(“Georgia IEX Action”). Specifically, Blue Pumpkin has alleged thatIEX products infringe claims of U.S. Patent No. 6,952,732 (“the ‘732Patent”), entitled “Method and apparatus for multi-contact scheduling.” BluePumpkin’s lawsuit seeks an injunction and money damages for IEX’s infringementof the ‘732 Patent.

 

On December 15, 2005, IEX and BluePumpkin reached a tentative agreement to settle all claims asserted betweenthem. On April 6, 2006, Blue Pumpkin and IEX reached an agreement tosettle all claims asserted between. As part of the final settlement,Witness paid $8.25 million to Tekelec, IEX’s parent company, in April 2006 and agreed to make six annualpayments of $0.5 million ($3.0 million in total) from April 2007 through2012.

 

On December 11, 2002, we filed in theUnited States District Court for the Northern District of Georgia, AtlantaDivision, a lawsuit against Knowlagent, Inc. (“Knowlagent”), which is theassignee of United States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2.Knowlagent has accused our eQuality Now software of infringing the abovepatents. We filed suit seeking a declaration that we did not and do notinfringe either of the two patents listed above, as well as a declaration thatthe 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 requestedmonetary damages in an amount equal to the amount that Knowlagent has receivedfrom its use of the above patents. On December 31, 2002, Knowlagent filedits answer to our complaint as well as two counterclaims, alleging that weinfringe and contribute to the infringement by others of the above patents;Knowlagent seeks 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. The case is nowproceeding to expert discovery and summary judgment phases.

 

On July 20, 2004, STS Software SystemsLtd. (“STS Software”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICELtd.”), filed a patent infringement suit in the U.S. District Court for theSouthern District of New York against us (“New York Action”). The New YorkAction 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

 

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Georgia (“Georgia Action”). We seek a declaration from the court thatwe have not infringed any valid claim of the ‘665 patent. By Order entered December 16,2004, Judge Koeltl of the U.S. District Court for the Southern District of NewYork granted our motion to transfer the New York Action to the NorthernDistrict of Georgia, which has now consolidated the former New York Action withthe Georgia Action. On July 7, 2005, the Court also granted STS leave toamend its complaint to add three patents to the dispute, namely: U.S. PatentNos. 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”), againseeking solely injunctive relief. We answered the first amended complaint andasserted counterclaims on July 29, 2005, collectively, through which wedeny infringement of any valid claim of the STS patents and seek a declarationto that effect. The case has been set on a discovery calendar and is at apreliminary stage.

 

On August 30, 2004, we filed in theUnited States District Court for the Northern District of Georgia, AtlantaDivision, 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 NiceUniverseproducts that include screen capture and synchronized screen and voice capturetechnologies, 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 forSimultaneously Monitoring Computer User Screen and Telephone Activity from aRemote Location.” We have sought an injunction and money damages for NICE’sinfringement of these two patents. NICE Inc. has answered and counterclaimedfor declaratory judgments 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, the court has consolidatedthe NICE Inc. and NICE Ltd. actions. The case has been set on a modifieddiscovery calendar after consolidation and is at a preliminary stage.

 

On January 19, 2006, we filed in the UnitedStates District Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. and NICE Systems, Ltd. (collectively “NICE”),alleging patent infringement. Specifically, we have alleged that NICE products,including NicePerform and related products that include the ability tomonitor communications to detect the presence of at least one predeterminedparameter, infringe claims of U.S. Patent No. 6,404,857 B1 (“the ‘857Patent”), entitled “Signal Monitoring Apparatus for Analyzing Communications.”We have sought an injunction and money damages for NICE’s infringement of the ‘857patent. On March 6, 2006, NICE filed its answer  to the complaint and a counterclaim, allegingthat the ‘857 patent is not infringed and is invalid, and this case is at apreliminary stage.

 

We are not party to any significantlitigation or legal proceedings, including those summarized above, that webelieve could have a material adverse effect on our financial position, resultsof operations or cash flows.

 

**Item 1A Risk Factors**

 

Our future operating results may varysubstantially from period to period. The price of our common stock will fluctuatein the future, and an investment in our common stock is subject to a variety ofrisks, including, but not limited to, the specific risks identified below.Inevitably, some investors in our securities will experience gains while otherswill experience losses depending on the prices at which they purchase and sellour securities. Prospective and existing investors should consider thefollowing factors in evaluating our business or an investment in oursecurities. If any of the following or other risks actually occurs, ourbusiness, financial condition and results of operations could be adverselyaffected. In that case, the trading price of our common stock could decline.

 

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*Because our products have a long salescycle, it is more difficult to plan our expenses and forecast our results; andour operating results may fail to meet investor expectations and may fluctuatematerially from period to period, which may adversely affect our stockprice.*

* *

It typically takes three to nine months fromthe time we qualify a sales lead until we sign a sales contract with thecustomer. As a result, it is difficult for us to predict the quarter in which aparticular sale will occur. If our sales cycle unexpectedly lengthens for oneor more large orders or a significant number of small orders, it would delaythe timing of our revenue, but not the timing of most of our correspondingexpenses. Lengthening of our sales cycle could also increase the total cost ofa sale due to additional employee time and costs associated with the sale.Material changes in our sales cycle could cause our quarterly revenue oroperating results to be below the expectations of investors, and the price ofour common stock could fall substantially.

 

Our customers’ decision process regardingtheir purchase of our products and services is relatively long due to severalfactors, including:

 

•      the complexnature of our products, requiring our need to educate potential customers aboutthe uses and benefits of our products;

 

•      competition forthe corporate resources necessary to finance the purchase and implementation ofour products;

 

•      customers’budgeting and purchasing cycles;

 

•      economicfactors;

 

•      the extent ofcustomers’ evaluation and internal approval process often required beforepurchasing our products and services; and

 

•      delayedpurchases due to announcements of new products or enhancements by ourcompetitors or us.

 

*If our products and services are not usedand accepted by existing and prospective customers, our business and results ofoperations will be adversely affected.*

* *

The market for workforce optimizationsoftware, including software that records and analyzes customer interactionsand that forecast and schedules employees, is still developing. Our successdepends on the use and acceptance of our software and services by existing andprospective customers. In addition, demand for our software remains uncertainbecause our existing and potential customers may:

 

•      not understandthe benefits of using workforce optimization software generally or, morespecifically, software which records and analyzes the interactions between abusiness and its customers or which optimizes the forecasting and scheduling ofemployees;

 

•      not achievefavorable results using our software;

 

•      experiencetechnical difficulty in implementing our software;

 

•      use alternativemethods such as online self-help to solve the same business problems oursoftware is intended to address; or

 

•      close contactcenters.

 

*If we experience losses in the future,the market price of our common stock may be materially and adverselyaffected.*

* *

Throughout much of our history, we haveexperienced losses. As a result of our prior operating losses, we had anaccumulated deficit of $40.1 million as of March 31, 2006. We need togenerate sufficient revenue to achieve sustained profitability and avoidincurring losses again in the future.

 

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*Our quarterly results are difficult topredict and adverse fluctuations in operating results could cause our stockprice to fall.*

* *

Our quarterly revenue and operating resultsare difficult to predict and could fluctuate significantly from period toperiod. In particular, we typically derive a significant portion of oursoftware product revenue toward the end of each quarter and from a small numberof relatively large orders. The delay or failure to close anticipated sales ina particular quarter could reduce our revenue in that quarter and subsequentquarters over which revenue for the sale could be recognized. In addition,because our revenue from installation and training services largely correlateswith our product revenue, a decline in product revenue could also cause adecline in our professional services revenue in the same quarter or insubsequent quarters. Our quarterly revenue is difficult to forecast for severalreasons, including the following:

 

•      changes indemand for our products and services;

 

•      the tendency ofcustomers to delay software purchases until the end of the fiscal quarter;

 

•      lengthening ofour customers’ budgeting and purchasing cycles;

 

•      timing of anyacquisitions and related costs;

 

•      delays ininstallations of our software;

 

•      varying salesand implementation cycles for our products and services from customer tocustomer;

 

•      the failure ofour customers to renew their maintenance service agreements;

 

•      the timing ofhiring new services employees and the rate at which these employees becomeproductive; and

 

•      the developmentand performance of our distribution channels.

 

As a result of these and other factors, webelieve that quarter-to-quarter comparisons of our operating results may notbe a good indicator of our future performance, and you should not rely on themto predict our future performance or the performance of our stock price. If ourrevenue or operating results fall below the expectations of investors orsecurities analysts, the price of our common stock would likely decline.

 

*We may be unable to manage andexpand our international operations, which may adversely affect ourbusiness and operating results.*

* *

We derived revenues of $23.8 million and$18.1 million in the first quarter of 2006 and 2005, respectively, fromcustomers located outside the United States. Our operations outside of theUnited States at March 31, 2006, consisted of operations located inAustralia, Brazil, Canada, China, Germany, India, Japan, Mexico, theNetherlands, Singapore, South Africa and the United Kingdom. We have alsoestablished relationships with a number of international resellers.

 

With our acquisitions of Blue Pumpkin in January 2005and Optimis in May 2005 both of which have sales outside of North America,we have expanded our international operations, and we intend to continue toexpand our international operations through additional acquisitions, internalbusiness expansion and strategic business relationships. These efforts requiresignificant management attention and financial resources. We may not beable to successfully penetrate international markets or, if we do, we may notbe able to grow or to maintain adequate profit margins in these markets.Because of the complex nature of our international expansion, it may adverselyaffect our business and operating results. International expansion and salesare subject to many risks, including the following:

 

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

 

•      expanding andtraining our international sales force and support operations;

 

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•      higher costs ofemployment in certain international locations;

 

•      difficulties inproducing localized versions of our products;

 

•      political andeconomic instability;

 

•      potentiallyadverse tax consequences of operating in foreign countries;

 

•      import andexport restrictions and tariffs;

 

•      longer paymentcycles 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 our operations outsidethe United States, we will also face new competitors and competitiveenvironments. In addition to the risks associated with our domesticcompetitors, foreign competitors may pose an even greater risk, becausethey may possess a better understanding of their local markets and havebetter working relationships with local infrastructure providers and others. Inparticular, because telephone protocols and standards are unique to eachcountry, local competitors will have more experience with, and may have acompetitive advantage in, these markets. We may not be able to obtainsimilar levels of knowledge, which could place us at a significant competitivedisadvantage. In addition, we have limited experience in developing locallanguage versions of our products or in marketing our products to internationalcustomers. We may not be able to successfully translate, market, sell, anddeliver our products internationally.

 

*If we are unable to maintain a productivedirect sales force, our business and operating results could be adverselyaffected.*

* *

We believe that our future success willdepend on maintaining a productive direct sales force. Historically, it hastaken us up to six months to train new sales personnel before they reach anacceptable level of productivity. We have also experienced difficulty inrecruiting sales personnel with experience in computer and telephoneintegration technologies. We cannot assure you that we will be able to continueto manage turnover and hire new sales personnel to meet our needs. If thepersonnel 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 reduce our revenue.

 

*If we are unable to expand thedistribution of our products through indirect sales channels, our business andoperating results could be materially adversely affected.*

* *

Our strategy is to continue to increase theproportion of customers served through indirect sales channels, such as selectresellers and a variety of strategic marketing alliances. Product revenue,excluding hardware revenue, from our indirect sales channel represented 31% and42% of total product revenue in the first quarter of 2006 and 2005,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 which we do business havesimilar, and often more established, relationships with our competitors, and may recommendthe products and services of our competitors to customers instead of oursoftware and services. We cannot provide assurance that these distributionpartners will devote adequate resources to selling our software and services orthat our resellers may not learn about

 

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our products and the market for our software and services and developand sell competing products and services. As a result, our relationships withresellers could lead to increased competition for us.

 

*Competition in our business couldadversely affect our revenue, profitability and market share.*

* *

The market for products that record customerinteractions, forecast and schedule employees, analyze performance and/orprovide electronic learning is intensely competitive, evolving and is subjectto rapid changes in technology. We believe our 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;

 

•      large telecomsolution providers;

 

•      enterprisesoftware vendors;

 

•      systemsintegrators and consulting firms; and

 

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

 

Many of our current and potential competitorshave longer operating histories, more established business relationships,larger customer 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 more aggressivepricing 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 markettheir products through resellers and companies that integrate their technologyand products with those of the competitor. These resellers and technologypartners often have strong business relationships with our customers andpotential customers. For example, some of our competitors have better and morelong standing 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 moreof our competitors, which would further solidify their business relationships.

 

We expect that competition will increase asother established and emerging companies enter our market and as new products,services and technologies are introduced. Increased competition may resultin price reductions, lower gross margins and loss of market share, any of whichcould materially and adversely affect our business, financial condition andresults of operations.

 

*Our heavy reliance on sales of ourquality monitoring and workforce management software exposes us to risks ofobsolescence due to changes in competitive product offerings.*

* *

We have derived a substantial portion of ourproduct revenues from sales of our quality monitoring and workforce managementsoftware products. We expect revenue from these products to continue to accountfor a significant portion of our revenue for the foreseeable future. As aresult, any factors affecting the markets for these products could materiallyand adversely affect our business, financial

 

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condition and results of operations. We cannot assure you that themarket will continue to demand our current products or that we will besuccessful in marketing any new or enhanced products. If our competitorsrelease new products that are superior to our products in performance or price,demand for our products may decline. A decline in demand for our products asa result of competition, technological change or other factors would reduce ourtotal revenues and adversely affect profitability.

 

*If we fail to develop new software orimprove our existing software, we may not be able to remain competitive.*

* *

The markets for our products arecharacterized by rapidly changing technology, frequent new productintroductions and enhancements, changes in customer demands and evolvingindustry standards. Our existing products could be rendered obsolete if we failto continue to advance our technology. We have also found that thetechnological life cycles of our products are difficult to estimate, partiallybecause of changing demands of our customers. We believe that our futuresuccess will depend on our ability to continue to enhance our current productline while we concurrently develop and introduce new products that keep pacewith competitive and technological developments. These developments require usto anticipate customers’ future needs and 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 will be completed on a timely basis or gain customer acceptance.In addition, failure to develop new software or improve existing softwareproducts may adversely affect our ability to maintain our maintenancerenewal rate which could adversely affect our revenue.

 

We have recently introduced Impact 360, whichcombines a new software architecture with new combinations of our products. Ourbusiness concept in doing so is to create incremental value for our customersand to win business away from competitors whose product offerings are morelimited and require the customer to make additional hardware purchases toobtain the solutions that our Impact 360 product offering provides in anintegrated suite. While we plan and expect that this lower total cost ofownership will be well received in the marketplace, we can offer no assurancethat our new Impact 360 offering will be successful. If our Impact 360 productofferings do not meet with commercial success, our business would be materiallyand adversely affected.

 

*If our softwaredevelopment activities in the Asia-Pacific region are not successful, we may notbe able to meet our development schedules.*

* *

During 2004, we expanded our softwaredevelopment capabilities in the Asia-Pacific region in order to optimizeavailable research and development resources and better meet developmenttimeframes. We have limited experience with remote software developmentactivities. Accordingly, there are a number of risks associated with thisactivity, including:

 

•      delays orproduct errors due to miscommunication between our local developmentorganization and our Atlanta- based R&D management;

 

•      developmentpersonnel affected by time, distance and 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;

 

•      high voluntarypersonnel turnover; and

 

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

 

Our inability to meet development schedulesbecause of our reliance on developers in the Asia-Pacific region may affectour ability to enhance our current product line or introduce new products,which would have a material adverse affect on our financial results and couldharm our reputation. The loss of

 

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key development personnel could have a material adverse effect on ourproduct development process and adversely affect future product revenues.

 

*Our liability to customers may besubstantial if our products fail to perform properly.*

 

Our software is used in a complex operatingenvironment that requires its integration with computer and telephone networksand other business software applications. If our products fail to function asrequired, we may be subject to claims for substantial damages. Courts may notenforce provisions in our contracts that would limit our liability or otherwiseprotect us from liability for damages. Although we maintain general liabilityinsurance coverage, including coverage for errors or omissions, this coverage may notcontinue to be available on reasonable terms or in sufficient amounts to coverclaims against us. In addition, our insurer may disclaim coverage as toany future claim. If claims exceeding the available insurance coverage aresuccessfully asserted against us, or our insurer imposes premium increases,large deductibles or co-insurance requirements on us, our business, financialposition, and results of operations could be adversely affected.

 

*If an original equipment manufacturerthat is part of our indirect sales channel experiences technicaldifficulties, our product sales through that channel may be adverselyaffected.*

* *

When we sell our software through an originalequipment manufacturer, or OEM, our software is embedded in the OEM’s product,which we sometimes refer to as the ‘environment’ for our software. When the OEM’sproduct uses our software, there is a risk that the ‘environment’ will fail orthat it will not achieve the compatibility with our product that we and the OEMseek. If this happens, our software might not function properly, or the OEMmight sell less of it, or both, which could have a material adverse effecton our revenues, operating cash flows and the growth of our business.

 

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

* *

Software products as complex as those offeredby us might contain undetected errors or failures when first introduced or whennew versions are released. We cannot assure you, despite testing by us and bycurrent and prospective customers, that errors will not be found in newproducts or product enhancements after commercial release. Any errors found may causesubstantial harm to our reputation and result in a loss in revenue andadditional unplanned expenses to remedy any defects.

 

*If our advanced compliance recordingapplications fail to record 100% of our customers’ interactions, we may besubject to liability and our reputation may be harmed.*

* *

Many of our customers use our advancedcompliance recording applications to record and store interactions withcustomers to provide back-up and verification of transactions and to guardagainst risks posed by lost or misinterpreted voice communications. Thesecustomers rely on our applications to record, store and retrieve voice data ina timely, reliable and efficient manner. If our applications fail to record100% of our customers’ interactions or our customers are unable to retrieve therecordings when necessary, we may be subject to liability and ourreputation may be harmed.

 

*If we are unable to maintain the securityof our systems, our business, financial condition and operating results couldbe harmed.*

* *

The occurrence or perception of securitybreaches in the operation of our business or suffered by third parties usingour products could harm our business, financial condition and operatingresults. Our customers use our products to compile and analyze highly sensitiveor confidential information. We may come into contact with suchinformation or data when we perform support or maintenance functions forour customers. 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 orsecurity laws,

 

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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 may attemptto breach our security or inappropriately use our products through computerviruses, electronic break-ins and other disruptions. If successful,confidential information may be improperly obtained and we may besubject to lawsuits and other liability. Any internal or external securitybreaches could harm our reputation, and even the perception of security risks,whether or not valid, could inhibit market acceptance of our products.

 

*Fluctuations in foreign currency exchangerates could affect our financial results.*

* *

We may experience gains and lossesresulting from fluctuations in currency exchange rates. Moreover, in locationswhere we price our products in U.S. dollars, our sales could be affectedadversely by declines in foreign currencies relative to the dollar, therebymaking our products more expensive in local currencies. In locations where wesell our products in local currencies, we could be competitively unable toincrease our prices to reflect fluctuations in exchange rates. We do not usederivative instruments to manage our foreign exchange risk, and we cannotpredict the impact that future exchange rate fluctuations may have on ourresults.

 

*Certain provisions in agreements that wehave entered into may expose us to liability for breach that is notlimited in amount by the terms of the contract.*

* *

Certain contract provisions, principallyconfidentiality and indemnification obligations in certain of our licenseagreements, could expose us to risks of loss that, in some cases, are notlimited by contract to a specified maximum amount. If we fail to perform tothe standards required by these contracts, we could be subject to additionalliability and our business, financial condition and results of operations couldbe materially and adversely affected.

 

*If we fail to protect our intellectualproperty, third parties may use our technology for their own benefit.*

* *

Our success and ability to compete depends toa significant degree upon our proprietary technology. We rely on a combinationof patent, 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 negativelyaffect our future operating results.

 

As of March 31, 2006, we had nineregistered trademarks in the U.S. and nine U.S. and three internationalpatents. We cannot assure you that we will file new patent or trademarkapplications, that any future applications will be approved, that any existingor future patents, trademarks or copyrights will adequately protect ourintellectual property or that any existing or future patents, trademarks orcopyrights 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 that an owner oflegal rights resulting from prior use, registrations, or applications willbring legal action to challenge our registration of and/or our use of thetrademark eQuality®, and may also seek compensation for damages resultingfrom our use this trademark. As a result, we cannot assure you that ourregistration of this trademark will be undisturbed, or that this use will notresult in liability for trademark infringement, trademark dilution, and/orunfair competition.

 

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Moreover, the laws of certain foreigncountries do not protect our intellectual property rights to the same extent asdo the laws of the United States. Furthermore, policing the unauthorized use ofour products is difficult, and litigation may be necessary in the futureto enforce our intellectual property rights, to protect our trade secrets or todetermine the validity and scope of the proprietary rights of others. Litigationcould result in substantial costs and diversion of resources and couldnegatively affect our future operating results.

 

*Claims by other companies that oursoftware infringes their intellectual property could require us to incursubstantial costs or prevent us from selling our software or services.*

* *

It is possible that third parties will claimthat we have infringed their current or future products. We expect that we andother participants 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 affect our operating results. Anyefforts to reengineer our software or obtain licenses from third parties may notbe successful, could be extremely costly and would likely divert valuablemanagement and product development resources.

 

For example, claims have been assertedagainst us in lawsuits involving Knowlagent, STS and NICE (as described in Item1, “Legal Proceedings”, of Part II). We cannot assure you that we will besuccessful in defending against the claims that have been asserted or any otherclaims that may be asserted. We also cannot assure you that such claimswill not have a material adverse effect on our business, financial condition,or operations. Defending infringement claims or other claims involvessubstantial costs and diversion of management resources. In addition, to theextent we are not successful in defending such claims, we may be subjectto injunctions with respect to the use or sale of certain of our products or toliabilities for damages to the claimants or to customers to whom we haveindemnification commitments, and we may be required to obtain licenseswhich 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 rights of others. These software users couldattempt to hold us responsible for these claims and any resulting harm theysuffer. If a patent claim against us were to be successful and we could notobtain a license on acceptable terms or license a substitute technology orredesign to avoid infringement, we may be prevented from distributing oursoftware or required to incur significant expense and delay in developingnon-infringing software. Such a result could have a material adverse effect onour business, financial condition and results of operations.

 

*If we are unable to maintain thecompatibility of our software with certain other products and technologies, ourfuture business would be adversely affected.*

* *

Our software must integrate with software andhardware solutions provided by a number of our existing and potentialcompetitors. For example, our products must integrate with phone switches madeby the telephone switch vendors and computer telephony software applicationsoffered by other software providers. These competitors or their businesspartners could alter their products so that our software no longer integrateswell with them, or they could delay or deny our access to software releasesthat allow us to timely adapt our software to integrate with their products. Ifwe cannot adapt our software to changes in necessary technology, it may significantlyimpair our ability to compete effectively, particularly if our software must integratewith the software and hardware solutions of our competitors.

 

*If our professional services employees donot provide installation services effectively and efficiently, our customers may notuse our installation services or may stop using our software.*

* *

Our customers ordinarily purchaseinstallation, training and maintenance services together with our products. Thefunctionality of our products is not dependent on our installation and trainingservices. We

 

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believe that the speed and quality of installation services arecompetitive factors in our industry. If our installation services are notsatisfactory to our customers, the customers may choose not to use ourinstallation services or they may not license our software in the future.As a result, we would lose licensing and services revenue, and it could harmour reputation. 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 effect on our operatingresults.

 

*We may make acquisitions orinvestments that are not successful and that adversely affect our ongoingoperations.*

* *

We may acquire or make investments incompanies, products, services and technologies that we believe complement ourbusiness and assist us in quickly bringing new products to market. We havelimited experience in making acquisitions and investments. As a result, ourability to identify and evaluate prospects, complete acquisitions and properlymanage the integration of businesses is relatively unproven. If we fail toproperly evaluate and execute acquisitions or investments, it may have amaterial adverse effect on our business and operating results. In making orattempting to make acquisitions or investments, we face a number of risks,including:

 

•      identifyingsuitable candidates, performing appropriate due diligence, identifying potentialliabilities and negotiating acceptable terms;

 

•      reducing ourworking capital and hindering our ability to expand or maintain our business,if we make acquisitions using cash;

 

•      the potentialdistraction of our management, diversion of our resources and disruption of ourbusiness;

 

•      retaining andmotivating key employees of the acquired companies;

 

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

 

•      entering intogeographic markets in which we have little or no prior experience;

 

•      competing foracquisition opportunities with competitors that are larger than we are or havegreater 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 impairmentof the value of the assets acquired in any corporate acquisition.

 

*If we need additional financing tomaintain or expand our business, it may not be available on favorableterms, if at all.*

* *

Although we believe our current cash andborrowing capacity will be sufficient to meet our anticipated cash needs for atleast the next 12 months and the foreseeable future, we may needadditional funds to expand or meet all of our operating needs. If we needadditional financing, we cannot be certain that it will be available to us onfavorable terms, or at all. If we raise additional funds by issuing equitysecurities or convertible debt, the ownership interest of our stockholderscould be significantly diluted, and any additional equity securities we issue may haverights, preferences or privileges senior to the rights of our stockholders.Also, the terms of any additional financing we obtain may significantlylimit

 

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our future financing and operating activities. If we need funds andcannot obtain them on acceptable terms, we may be unable to:

 

•      develop andenhance our software to remain competitive;

 

•      take advantageof future opportunities, such as acquisitions;

 

•      respond tochanging customer needs and our competitors’ innovations; or

 

•      attract andretain qualified key personnel.

 

Any of these events could significantly harmour business and financial condition and limit our growth.

 

*Our inability to source hardware couldharm our business.*

* *

A number of customers expect us to sourcehardware to support the implementation of our software. We seek to reduce theamount of hardware sales in the future and have transferred the fulfillment ofhardware orders to third-party distributors. Thus, we are largely dependent onthird parties for the supply of hardware components to our customers. If thesehardware distributors experience financial, operational or quality assurancedifficulties, or if there is any other disruption in our relationships, we may berequired to locate alternative hardware sources. We are subject to thefollowing risks due to our hardware distribution 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 our distributors aresuccessful in locating alternative sources of supply, alternative supplierscould increase prices significantly. In addition, alternative components may malfunctionor interact with existing components in unexpected ways. The use of newsuppliers and the modification of our products to function with new systemswould require testing and may require further modifications, which may resultin additional expense, diversion of management attention and other resources,inability to fulfill customer orders or delay in fulfillment, reduction inquality and reliability, customer dissatisfaction, and other adverse effects onour reputation, business and operating results.

 

*Failure to maintain effective internalcontrols in accordance with Section 404 of the Sarbanes-Oxley Actof 2002 could have a material adverse effect on our business, operatingresults and stock price.*

* *

The Sarbanes-Oxley Act of 2002 imposescertain duties on us and our executives, directors and attorneys. Our effortsto comply with the requirements of Section 404 have resulted in increasedgeneral and administrative expense and a diversion of management time andattention from revenue-generating activities to compliance activities, and weexpect these efforts to require the continued commitment of significantresources. We have reported a material weakness in internal control overfinancial reporting which we found in connection with our evaluation ofcontrols and procedures as of December 31, 2005. If we fail to maintainthe adequacy of our internal controls, we may not be able to ensure thatwe can conclude on an ongoing basis that we have effective internal controlsover financial reporting. Failure to maintain effective internal controls overfinancial reporting could result in investigation and/or sanctions byregulatory authorities, and could have a material adverse effect on ourbusiness and operating results, investor confidence in our reported financialinformation, and the market price of our common stock.

 

*Our stock price has been volatile.*

* *

The market price of our common stock has beensubject to significant fluctuations in response to variations in quarterlyoperating results and other factors. In addition, the stock market hasexperienced

 

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significant volatility that has particularly affected the market pricesof equity securities of many technology companies and that often has beenunrelated or disproportionate to the operating performance of these companies.Any announcement with respect to any adverse variance in revenue or earningsfrom levels generally expected by securities analysts or investors could have asignificant adverse effect on the trading price of our common stock. Inaddition, factors such as announcements of technological innovations or newproducts by us, our competitors or third parties, changing conditions in thecustomer relationship management software market, changes in the marketvaluations of similar companies, loss of a major customer, additions ordepartures of key personnel, changes in estimates by securities analysts,announcements of extraordinary events, such as acquisitions or litigation, orgeneral economic conditions may have an adverse effect on the market priceof our common stock.

 

*Our performance may be negativelyaffected by macro-economic or other external influences.*

* *

Beginning in 2000, a declining United Stateseconomy adversely affected the performance of many businesses, especiallywithin the technology sector. Reductions in the capital budgets of ourcustomers and prospective customers have an adverse impact on our ability tosell our solutions. Until late in 2003, we continued to experience effects froma weak spending environment for information technology in both the UnitedStates and Europe, in the form of delayed and cancelled buying decisionsby customers for our software, services and hardware, deferrals by customers ofservice engagements previously scheduled and pressure by our customers andcompetitors to discount our offerings. If the current improvements now beingseen in the general business climate do not continue, this would likely have amaterial adverse effect on our business.

 

*Government regulation of telephone andInternet monitoring 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 telecommunications industry continuesto evolve, state, federal and foreign governments (including supranationalgovernmental organizations such as the European Union) and industryassociations may increasingly regulate the monitoring oftelecommunications and telephone and Internet monitoring and recordingproducts, such as our software. We believe that increases in regulation couldcome in the form of a number of different kinds of regulations, includingregulations regarding privacy, protection of personal information such asSocial Security numbers, credit card information and employment. For example,the State of California enacted the Database Security Breach Act, whichrequires any business that suffers a computer security breach to immediatelynotify customers in California if personal information has been compromised,and the Payment Card industry has adopted regulations that require additionalsecurity regarding the storage of consumers’ credit card numbers. The adoptionof any new regulations or changes to existing regulations could cause a declinein the use of our software and could result in increased expense for us as wemodify our software to accommodate these regulations. Moreover, theseregulations could subject our customers or us to liability. Whether or notthese regulations are adopted, if we do not adequately address the privacyconcerns of consumers, companies may be hesitant to use our software. Ifany of these events occur, it could materially and adversely affect ourbusiness.

 

*If we are unable to attract and retainkey personnel, our ability to effectively manage and grow our business wouldsuffer.*

* *

Our success greatly depends on our ability tohire, 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 theservices we offer. If we are unable to attract and retain qualified personnelor if we experience high personnel turnover, it could prevent us fromeffectively managing and expanding our business.

 

Our success also depends upon the continuedservice of our executive officers, particularly our Chairman and ChiefExecutive Officer, David Gould, and our President and Chief Operating Officer,Nick Discombe. We have employment agreements with Mr. Gould and Mr. Discombeand limited non-

 

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compete agreements with most of our other executive officers. However,any of our executive officers and other employees could terminate his or herrelationship with us at any time. The loss of the services of our executiveofficers or other key personnel, particularly if lost to competitors, couldmaterially and adversely affect our business.

 

*Our certificate of incorporation andbylaws, as well as Delaware law, may inhibit a takeover of our company,which could limit the price investors might be willing to pay for oursecurities.*

* *

Our amended and restated certificate ofincorporation and bylaws, as well as Delaware law, contain provisions thatmight enable our management to resist a takeover of our company. For example,our stockholders cannot take action by written consent or call a specialmeeting to remove our board of directors. In addition, our directors serve forstaggered terms, which makes it difficult to remove all our directors at once.Further, in October 2002, our board of directors approved, and we haveimplemented, a stockholder rights plan which has the effect of causingsubstantial dilution to a person or group that attempts to acquire us on termsnot approved by the board of directors.

 

These anti-takeover provisions mightdiscourage, delay or prevent a change in the control of our company or a changein our management. These provisions could also discourage proxy contests andmake it more difficult for you and other shareholders to elect directors andtake other corporate actions. The existence of these provisions could alsolimit the price that investors might be willing to pay in the future for oursecurities.

 

**Item 6. Exhibits**

 
| **(a)** |   |                                                                                                      | **Exhibits** |
|---------|--------|-----------------------------------------------------------------------------------------------------------|--------------|
|    |   |                                                                                                      |
| 10.1*   |   | Ninth Loan  Modification Agreement between the Company and Silicon Valley Bank dated March 9,  2006. |
| 10.2*   |   | First  amendment to employee change of control agreement                                                  |
| 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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**(1) ****  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: May 9, 2006 | 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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