**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q/A**
| **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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**WITNESS SYSTEMS, INC.**

(Exact Name 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 telephonenumber, including area code **770-754-1900**

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Securitiesregistered pursuant to Section 12(b) of the Act:**None**

Securitiesregistered 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 ActRule 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 inRule 12b-2 of 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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**EXPLANATORYNOTE**

We are amending our Quarterly Report on Form 10-Qfor the quarter ended March 31, 2006 filed on May 9, 2006 (the “OriginalFiling”) to restate our Condensed Consolidated Financial Statements for thequarter ended March 31, 2006 and the related disclosures.  For more information on the restatement ofthe Condensed Consolidated Financials Statements, please refer to Note 3 of theNotes to the Condensed Consolidated Financial Statements, Item 2, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”, andItem 4, “Controls and Procedures”.

Beginning in late May 2006, the Company’s managementinitiated a preliminary internal review of the Company’s historical stockoption practices and related accounting treatment in response to general mediaattention concerning stock option grants at various public companies andshareholder interest with respect to this particular issue. On August 8, 2006,in response to the results of management’s preliminary internal review, ourBoard of Directors voluntarily formed a Special Committee of independentdirectors to review our stock option practices and grants during the periodbetween the date of the Company’s initial public offering on February 10, 2000and August 31, 2002.  The SpecialCommittee undertook its investigation with the assistance of independentcounsel and accounting experts retained by its counsel. The Special Committeereviewed all 5.7 million stock options granted throughout the period covered byits investigation. In December 2006, the Special Committee completed its reviewand reported its findings and recommendations to our full Board of Directors.The Special Committee did not find fraud or intentional misrepresentation inthe financial reporting of the option grants that it analyzed but found inaccuraciesin the determination of measurement dates for certain stock option grantsaffecting the Company’s accounting and disclosures. For a number of thesegrants, the Special Committee found that it was likely that the stated grantdate was selected in hindsight based on price given the lack of supportingdocumentation and that the option price was the low price in a given month orquarter. Such grants were found to be present during 2000 and throughapproximately mid-year 2001. The Special Committee concluded that it was notnecessary to expand the investigation to cover periods after August 31, 2002.Among the various key considerations in reaching this conclusion were: 1) asnoted above, the Special Committee did not find fraud or intentional misrepresentationin the financial reporting of the option grants that it analyzed; 2) theSpecial Committee’s investigation found that the last instance of likely grantdate selection based on stock price occurred in mid-2001; and 3) the Special Committee observed that theoption granting practices of the Company became more formal and regularizedduring the latter phase of the period subject to its review. 

In addition to the Special Committee investigation,the Company, with the assistance of outside legal counsel, reviewed theCompany’s stock option practices and grants for the periods subsequent toAugust 31, 2002. This review evaluated 90 percent of the 11.1 million optionsgranted after August 31, 2002. The review was designed not only to provide ahigh degree of grant review coverage, but also to appropriately assess thepropriety of measurement dates for each of the various types of options grantedduring this period.  Among others, optiongrant types covered included: 1) new employee grants in connection with theacquisition of businesses; 2) semi-annual employee ranking grants; 3) routinenon-officer grants for such events as new hires, promotions, sales achievement,etc; and 4) officer grants, including grants to the Company’s then CEO. Thisreview did not find fraud or intentional misrepresentation in the financialreporting relating to option grants but identified errors in the determinationof measurement dates. However, such errors were relatively immaterial and didnot exhibit evidence of selection of a favorable grant date and price inhindsight.  

In those instances during the two review periods wherethe fair market value of our common stock at the originally stated grant datewas lower than the fair market value on the redetermined measurement date, inaccordance with Accounting Principles Board No. 25, “Accounting for StockIssued to Employees” (“APB No. 25”) and related interpretations, we concludedthat we should have recorded stock-based compensation expense which was notaccounted for in our previously issued Consolidated Financial Statements.

As a result of the findings of the Special Committeeas well as our internal review, we amended our Annual Report on Form 10-Kfor the year ended December 31, 2005, originally filed on March 16,2006, to restate our Consolidated Financial Statements for the years endedDecember 31, 2005, 2004 and 2003 and the related disclosures as ofDecember 31, 2005. The Annual Report on Form 10-K/ A also includedthe restatement of selected consolidated financial data as of and for the yearsended December 31, 2005, 2004, 2003, 2002 and 2001, and the unauditedquarterly financial data for each of the quarters in the years endedDecember 31, 2005 and 2004. We also concluded that we needed to amend theQuarterly Report on Form 10-Q for the quarter ended March 31, 2006,originally filed on May 9, 2006, to restate our Condensed ConsolidatedFinancial Statements for the quarter ended March 31, 2006 and the relateddisclosures. Witness reached an agreement with the former shareholders of BluePumpkin (“BP shareholders”) in February 2006 whereby Witness issued the sharesof common stock originally placed in escrow as a part of the Merger Agreementto the BP shareholders for proceeds of approximately $3.1 million. Theseshares were issued at a discount of approximately $1.35 million, which wasinitially accounted for as additional consideration paid in the acquisition ofBlue Pumpkin (based on the difference between the fair value at the date ofissuance in February 2006 and the price at which the shares were sold to the BPshareholders). We determined that the discount was granted to facilitate therelease of the funds in escrow as a part of this agreement with the BPshareholders. Accordingly, we have recorded a $1.35 million charge to earningsin the Company’s Consolidated Statement of Operations for the three monthsended March 31, 2006.

Except for the sections of this Form 10-Q/A entitled “StockOption Practices and Restatement of Condensed Consolidated Financial Statements”included in Item 2, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations”, Item 4, “Controls and Procedures,”and Note 3 (unaudited) of the Notes to Condensed Consolidated FinancialStatements, all of the information in this amended Quarterly Report on Form10-Q/A is as of March 31, 2006 and does not reflect events occurring afterthe Original Filing, other than the restatement, or modify or updatedisclosures (including the exhibits to the Original Filing, except for theupdated Exhibits 31.1, 31.2 and  32.1)affected by subsequent events. Accordingly, this amended Quarterly Report onForm 10-Q/A should be read in conjunction with our periodic filings made withthe Securities Exchange Commission.

For the convenience of the reader, this amendedQuarterly Report on Form 10-Q/A sets forth the Original Filing in its entirety,as amended by, and to reflect, the restatement. The following items have beenamended principally as a result of, and to reflect, the restatement, and noother information in the Original Filing is amended hereby as a result of therestatement:

Part I—Item 1—Financial Information (unaudited);

Part I—Item 2— Management’s Discussion and Analysis ofFinancial Condition and Results of Operations;

Part I—Item 4— Controls and Procedures;

Part II—Item 1— Legal Proceedings as to legalproceedings related to the stock option investigation;

Part II—Item 1A— Risk factors; and

Part II—Item 6—Exhibits

2

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**WITNESS SYSTEMS, INC.**

**FORM 10-Q/A**

**INDEX**
| PART I.  | FINANCIAL INFORMATION                                                                                                               |   |
|---------------|-------------------------------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                                |   |
| Item 1.       | Financial Statements:                                                                                                               |   |
|          |                                                                                                                                |   |
|          | Condensed  Consolidated Balance Sheets at March 31, 2006 (as restated) and  December 31, 2005 (unaudited)                 |   |
|          |                                                                                                                                |   |
|          | Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2006 (as restated) and 2005 (unaudited) |   |
|          |                                                                                                                                |   |
|          | Condensed  Consolidated Statements of Cash Flows for the three months ended  March 31, 2006 (as restated) and 2005 (unaudited) |   |
|          |                                                                                                                                |   |
|          | Notes to the  Condensed Consolidated Financial Statements (unaudited)                                                               |   |
|          |                                                                                                                                |   |
| Item 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                         |   |
|          |                                                                                                                                |   |
| Item 3.       | Quantitative  and Qualitative Disclosures About Market Risk                                                                         |   |
|          |                                                                                                                                |   |
| Item 4.       | Controls and  Procedures                                                                                                            |   |
|          |                                                                                                                                |   |
| PART II. | OTHER INFORMATION                                                                                                                   |   |
|          |                                                                                                                                |   |
| Item  1.      | Legal  Proceedings                                                                                                                  |   |
|          |                                                                                                                                |   |
| Item  1A      | Risk  factors                                                                                                                       |   |
|          |                                                                                                                                |   |
| Item  6.      | Exhibits                                                                                                                            |   |
|          |                                                                                                                                |   |
| SIGNATURES    |                                                                                                                                |

 

3

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**PART I.FINANCIAL INFORMATION**

**Item 1.   Financial Statements**

**WITNESS SYSTEMS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(In thousands, except share data)**
| ** **                                                                                                                                                                                             | ** ** | **March 31,  2006**      | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                             | ** ** | **As Restated (1)** | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                             | ** ** | **(unaudited)**               | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                                                             | ** ** | ** **                    | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                        |       |                          |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                             |       | $                             | 85,510     |                  | $          | 111,751 |   |
| Investments, at fair  market value                                                                                                                                                                     |       | 70,996                        |       | 14,886                |       |
| Restricted cash held in  escrow                                                                                                                                                                        |       | —                        |       | 4,000                 |       |
| 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                       |       | 176,317               |       |
| Intangible assets, net of accumulated amortization of $30,901 at  March 31, 2006 and $26,874 at December 31, 2005                                                                                      |       | 32,658                        |       | 36,389                |       |
| Goodwill                                                                                                                                                                                               |       | 39,582                        |       | 40,319                |       |
| Property and equipment, net of accumulated depreciation of $14,825 at  March 31, 2006 and $13,715 at December 31, 2005                                                                                 |       | 8,306                         |       | 7,796                 |       |
| Other assets                                                                                                                                                                                           |       | 3,151                         |       | 3,573                 |       |
|                                                                                                                                                                                                   |       | $                             | 290,919    |                  | $          | 264,394 |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                         | ** ** | ** **                    | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                                   |       |                          |       |                  |       |
| Accounts payable                                                                                                                                                                                       |       | $                             | 6,327      |                  | $          | 3,795 |   |
| Accrued expenses                                                                                                                                                                                       |       | 27,427                        |       | 29,651                |       |
| Deferred revenue                                                                                                                                                                                       |       | 34,136                        |       | 23,756                |       |
| Total current  liabilities                                                                                                                                                                             |       | 67,890                        |       | 57,202                |       |
| Other long-term liabilities                                                                                                                                                                            |       | 6,055                         |       | 4,165                 |       |
| Deferred income tax liabilities                                                                                                                                                                        |       | 675                           |       | 743                   |       |
| Total liabilities                                                                                                                                                                                      |       | 74,620                        |       | 62,110                |       |
| 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                           |       | 326                   |       |
| Additional paid-in  capital                                                                                                                                                                            |       | 263,612                       |       | 251,712               |       |
| Accumulated deficit                                                                                                                                                                                    |       | (51,881                       | )          | (52,830               | )          |
| Accumulated other  comprehensive income                                                                                                                                                                |       | 4,234                         |       | 3,076                 |       |
| Total stockholders’  equity                                                                                                                                                                       |       | 216,299                       |       | 202,284               |       |
|                                                                                                                                                                                                   |       | $                             | 290,919    |                  | $          | 264,394 |   |

 

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**(1) See Note 3, “Restatement of CondensedConsolidated Financial Statements,” of the Notes to the Condensed ConsolidatedFinancial Statements**.

See accompanying notes to condensed consolidatedfinancial statements.

4

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**WITNESS SYSTEMS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(In thousands, except per share data)**

**(unaudited)**
| ** **                                       | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                             | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **As Restated (1)**                        | ** ** | **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                                         |       | 11,755                                               |       | 9,535 |   |
| Total cost of  revenue                           |       | 16,333                                               |       | 13,867 |   |
| Gross profit                                     |       | 35,133                                               |       | 27,292 |   |
| Operating expenses:                              |       |                                                 |       |   |   |
| Selling, general  and administrative             |       | 25,209                                               |       | 19,998 |   |
| Research and  development                        |       | 7,978                                                |       | 6,198 |   |
| Merger-related  and integration costs            |       | 2,091                                                |       | 1,659 |   |
| Acquired  in-process research and development    |       | —                                               |       | 9,000 |   |
| Operating loss                                   |       | (145                                                 | )          | (9,563 | ) |
| Interest and other  income, net                  |       | 1,271                                                |       | 138 |   |
| Income (loss)  before provision for income taxes |       | 1,126                                                |       | (9,425 | ) |
| Provision for income  taxes                      |       | 177                                                  |       | 33 |   |
| Net income  (loss)                               |       | $                                                    | 949        |   | $ | (9,458 | ) |
| Net income (loss) per  share:                    |       |                                                 |       |   |   |
| Basic                                            |       | $                                                    | 0.03       |   | $ | (0.36 | ) |
| Diluted                                          |       | $                                                    | 0.03       |   | $ | (0.36 | ) |
| Weighted-average common  shares outstanding:     |       |                                                 |       |   |   |
| Basic                                            |       | 32,871                                               |       | 26,098 |   |
| Diluted                                          |       | 36,648                                               |       | 26,098 |   |

 

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**(1) See Note 3, “Restatement of CondensedConsolidated Financial Statements,” of the Notes to the Condensed ConsolidatedFinancial Statements**.

See accompanying notes to condensed consolidatedfinancial statements.

5

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**WITNESS SYSTEMS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(In thousands)**

**(unaudited)**
| ** **                                                                                           | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                             | ** ** | ** ** | ** ** |
| ** **                                                                                           | ** ** | **As  Restated (1)**                            | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                                               |       |                                                 |       |   |   |
| Net income  (loss)                                                                                   |       | $                                                    | 949        |   | $ | (9,458 | ) |
| 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                                                                    |       | 3,146                                                |       | 113 |   |
| Depreciation and  amortization of property and equipment                                             |       | 1,134                                                |       | 911 |   |
| Provision for  accounts receivable                                                                   |       | 747                                                  |       | 358 |   |
| Deferred income  taxes                                                                               |       | (11                                                  | )          | — |   |
| Other non-cash  items, net                                                                           |       | 1,200                                                |       | 116 |   |
| Changes in  operating assets and liabilities:                                                        |       |                                                 |       |   |   |
| Accounts  receivable                                                                                 |       | (3,960                                               | )          | (5,581 | ) |
| Prepaid and  other assets                                                                            |       | (1,875                                               | )          | 510 |   |
| Accounts payable                                                                                     |       | 2,545                                                |       | 631 |   |
| Accrued expenses                                                                                     |       | 225                                                  |       | (5,551 | ) |
| Deferred revenue                                                                                     |       | 10,416                                               |       | (2,974 | ) |
| Net cash  provided by (used in) operating activities                                                 |       | 18,480                                               |       | (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                          |       | —                                               |       | (32,272 | ) |
| Restricted cash  held in escrow                                                                      |       | 4,000                                                |       | (4,000 | ) |
| Net cash used in  investing activities                                                               |       | (53,862                                              | )          | (6,934 | ) |
| Cash flows from  financing activities:                                                               |       |                                                 |       |   |   |
| Proceeds from  exercise of stock options and Employee Stock Purchase Plan                            |       | 5,251                                                |       | 2,226 |   |
| Others                                                                                               |       | (105                                                 | )          | — |   |
| Proceeds from sale  of common stock, net                                                             |       | 3,723                                                |       | — |   |
| Excess tax  benefits from stock-based compensation                                                   |       | 76                                                   |       | — |   |
| Net cash  provided by financing activities                                                           |       | 8,945                                                |       | 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 |   |

 

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**(1) See Note 3, “Restatement of CondensedConsolidated Financial Statements,” of the Notes to the Condensed ConsolidatedFinancial Statements**.

See accompanying notes to condensed consolidatedfinancial statements.

6

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**WITNESS SYSTEMS, INC. ANDSUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**March 31, 2006**

**(unaudited)**

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

***Business*** - ***Witness***Systems, Inc.(“Witness”) is a publicly traded company that provides workforce optimization softwareand services that enable companies to improve workforce performance and capturecustomer intelligence in their customer service operations. Our Impact 360solution consists of software products and services designed to optimize theworkforce, processes and technology involved in the customer service functionand gain valuable insight from customer interactions that can be usedthroughout the enterprise. 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 CSRs, wherever theymay be located in the enterprise. Our high-volume compliance applicationsare designed to record high volume, full-time performance of the voiceconversations 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 andevaluate productivity 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 with operations in the UnitedStates, Australia, Brazil, Canada, China, Germany, India, Japan, Mexico, theNetherlands, Singapore, South Africa and the United Kingdom. We were originallyincorporated in 1988 in Georgia and were reincorporated in Delawarein 1997.

***Principles of Consolidation andReclassifications***- 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 been preparedin accordance with the requirements of Form 10-Q and, therefore, do notinclude 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/A for the fiscalyear ended December 31, 2005, filed with the U.S. Securities and ExchangeCommission.

***Use of Estimates*** -The preparation of these financial statements requires us to make certainestimates and judgments that affect our reportedassets, liabilities, revenues and expenses, and our related disclosure ofcontingent assets and liabilities. We base our estimates on historicalexperience and on various assumptionsthat we believe to be reasonable under the circumstances. Actual resultsmay differ from these estimates under different assumptions or conditions.

**2.****                                                             ****Revenue Recognition andDeferred Revenue**

***We***recognize revenue in accordance with theAmerican Institute of Certified Public Accountants’ Statement of Position (“SOP”)97-2, *Software Revenue Recognition*,and SOP 98-9, *Modification of* SOP97-2, *Software Revenue Recognition, WithRespect to Certain*Transactions. Revenue is primarily derived fromlicensing software and providing related services including maintenance.Product revenue, which can include software and hardware, is recognized whenpersuasive evidence of an agreement exists, delivery of the product hasoccurred, the fee is fixed or determinable, collection is probable and vendorspecific objective evidence of fair value (“VSOE”) exists to allocate revenueto the undelivered elements of the arrangement. The Company reports hardwarerevenue gross in accordance with Emerging Issues Task Force No. 99-19, *Reporting Revenue Gross as a Principal versus Net asan Agent,* because the factors indicating gross reporting outweighthe factors indicating net reporting. We recognize revenue using the residualmethod of accounting when customer orders contain multiple element arrangements,including the sale of licensed software, hardware, maintenance, andprofessional services. We generally have VSOE for maintenance and professionalservices, but not for the software and hardware elements of the order. Underthe residual method, services revenue, including maintenance and professionalservices, is deferred at an amount equal to VSOE until those elements aredelivered. Consequently, product revenue for the software and hardware isrecognized (i) upon delivery of those products when we have VSOE for therelated maintenance and professional services sold and (ii) at an amountrepresenting the difference between the total order amount and the amountdeferred.

7

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

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 primarily of amountscollected from customers for products and services that have not met thecriteria for revenue recognition.

**3.****                                                              Restatementof Condensed Consolidated Financial Statements**

Beginning in late May 2006, the Company’s managementinitiated a preliminary internal review of the Company’s historical stockoption practices and related accounting treatment in response to general mediaattention concerning stock option grants at various public companies and shareholderinterest with respect to this particular issue. On August 8, 2006, in responseto the results of management’s preliminary internal review, our Board ofDirectors voluntarily formed a Special Committee of independent directors toreview our stock option practices and grants during the period between the dateof the Company’s initial public offering on February 10, 2000 and August 31,2002.  The Special Committee undertookits investigation with the assistance of independent counsel and accounting expertsretained by its counsel. The Special Committee reviewed all 5.7 million stockoptions granted throughout the period covered by its investigation. In December2006, the Special Committee completed its review and reported its findings andrecommendations to our full Board of Directors. The Special Committee did notfind fraud or intentional misrepresentation in the financial reporting of theoption grants that it analyzed but found inaccuracies in the determination ofmeasurement dates for certain stock option grants affecting the Company’saccounting and disclosures. For a number of these grants, the Special Committeefound that it was likely that the stated grant date was selected in hindsightbased on price given the lack of supporting documentation and that the optionprice was the low price in a given month or quarter. Such grants were found tobe present during 2000 and through approximately mid-year 2001. The SpecialCommittee concluded that it was not necessary to expand the investigation tocover periods after August 31, 2002. Among the various key considerations inreaching this conclusion were: 1) as noted above, the Special Committee did notfind fraud or intentional misrepresentation in the financial reporting of theoption grants that it analyzed; 2) the Special Committee’s investigation foundthat the last instance of likely grant date selection based on stock price  occurred in mid-2001; and 3) the SpecialCommittee observed that the option granting practices of the Company becamemore formal and regularized during the latter phase of the period subject toits review. 

In addition to theSpecial Committee investigation, the Company, with the assistance of outsidelegal counsel, reviewed the Company’s stock option practices and grants for theperiods subsequent to August 31, 2002. This review evaluated 90 percent of the11.1 million options granted after August 31, 2002. The review was designed notonly to provide a high degree of grant review coverage, but also toappropriately assess the propriety of measurement dates for each of the varioustypes of options granted during this period. Among others, option grant types covered included: 1) new employeegrants in connection with the acquisition of businesses; 2) semi-annualemployee ranking grants; 3) routine non-officer grants for such events as newhires, promotions, sales achievement, etc; and 4) officer grants, includinggrants to the Company’s then CEO. This review did not find fraud or intentionalmisrepresentation in the financial reporting relating to option grants butidentified errors in the determination of measurement dates. However, sucherrors were relatively immaterial and did not exhibit evidence of selection ofa favorable grant date and price in hindsight. 

In those instancesduring the two review periods where the fair market value of our common stockat the originally stated grant date was lower than the fair market value on theredetermined measurement date, in accordance with Accounting Principles BoardNo. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and relatedinterpretations, we concluded that we should have recorded stock-basedcompensation expense which was not accounted for in our previously issuedConsolidated Financial Statements.

As a result of thefindings described above, our restated Consolidated Financial Statements as ofDecember 31, 2005 included in our Form 10-K/A reflected a cumulativedecrease in net income of approximately $9.5 million for the years 2000 to 2005due to non-cash adjustments for stock-based compensation expense. Thestock-based compensation expense is based on APB No. 25 which are intrinsicvalue based charges that are amortized over the vesting terms of the stockoptions. In connection with the restatement, we identified additionaladjustments that needed to be recorded to our historical Consolidated FinancialStatements. These adjustments consisted primarily of purchase accountingrelating to the acquisition of Blue Pumpkin Inc., income taxes andmiscellaneous other items. The cumulative effect of the restatement adjustmentson our Consolidated Balance Sheet as of December 31, 2005 resulted in anincrease in the accumulated deficit of $10.5 million, an increase in additionalpaid-in capital of $5.8 million and increases in assets and liabilities of $2.8million and $7.5 million, respectively. Although there were no optionmeasurement dating issues, our 2006 Condensed Consolidated Financial Statementsare impacted by option grants in prior years where the measurement dates havebeen adjusted. The additional stock-based compensation adjustment reduced ournet income for the three month period ended March 31, 2006 by $71,000.

We determinedthat, at the date of the acquisition of Blue Pumpkin Software, Inc. (“BluePumpkin”), it was not beyond a reasonable doubt that the cash and common stockheld in escrow pursuant to the Merger Agreement and Plan of Reorganizationwould be issued to the former shareholders of Blue Pumpkin.  Therefore, in accordance with SFAS No. 141, *Business Combinations*, we have adjusted the considerationpaid in the acquisition of Blue Pumpkin Software, Inc. (“Blue Pumpkin”) from$77.2 million to $69.5 million to properly reduce the purchase price for the $4million in cash and 210,000 shares of common stock that were held inescrow.  As a result, the December 31,2005 balance sheet reflects a reduction in equity by approximately $3.7 millionand the recognition of $4 million in restricted cash.  In addition, we adjusted accrued expenses byapproximately $7.7 million to reflect the $11.2 million estimated cost tosettle all claims with IEX.  

Witness reached an agreement with the formershareholders of Blue Pumpkin (“BP shareholders”) in February 2006 wherebyWitness issued the shares of common stock originally placed in escrow as a partof the Merger Agreement to the BP shareholders for proceeds of approximately$3.1 million.  These shares were issuedat a discount of approximately $1.35 million, which was initially accounted foras additional consideration paid in the acquisition of Blue Pumpkin (based onthe difference between the fair value at the date of issuance in February 2006and the price at which the shares were sold to the BP shareholders).  We subsequently determined that the discountwas granted to facilitate the release of the funds in escrow as a part of thisagreement with the BP shareholders. Accordingly, we have recorded a $1.35 million charge to restate earningsin the Company’s Consolidated Statement of Operations for the three monthsended March 31, 2006.  See Note 4, “BluePumpkin Acquisition” for additional discussion related to the acquisition.

8

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**Impact ofthe Financial Statement Adjustments on the Condensed Consolidated Statements ofOperations (unaudited)**

The table below presents the impact of the financialstatements adjustments related to restatement of our previously reportedCondensed of Consolidated Statement of Operations for the three months endedMarch 31, 2006 (in thousands, except per share data):
| ** **                                      | ** ** | **Three months ended March 31, 2006** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                      | ** ** | **As  Previously  Reported**                                   | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
| Revenue:                                        |       |                                                           |       |   |   |   |   |
| Product                                         |       | $                                                              | 19,839     |   | — |   | $ | 19,839 |   |
| Services                                        |       | 31,627                                                         |       | — |   | 31,627 |   |
| Total revenue                                   |       | 51,466                                                         |       | — |   | 51,466 |   |
| Cost of revenue:                                |       |                                                           |       |   |   |   |   |
| Product                                         |       | 4,578                                                          |       | — |   | 4,578 |   |
| Services                                        |       | 11,745                                                         |       | $ | 10 |   | 11,755 |   |
| Total cost of  revenue                          |       | 16,323                                                         |       | 10 |   | 16,333 |   |
| Gross profit                                    |       | 35,143                                                         |       | (10 | ) | 35,133 |   |
| Operating expenses:                             |       |                                                           |       |   |   |   |   |
| Selling, general  and administrative            |       | 25,129                                                         |       | 80 |   | 25,209 |   |
| Research and  development                       |       | 7,956                                                          |       | 22 |   | 7,978 |   |
|                                            |       |                                                           |       |   |   |   |   |
| Merger-related  and integration costs           |       | 740                                                            |       | 1,351 |   | 2,091 |   |
| Acquired  in-process research and development   |       | —                                                         |       | — |   | — |   |
| Operating income  (loss)                        |       | 1,318                                                          |       | (1,463 | ) | (145 | ) |
| Interest and other  income, net                 |       | 1,271                                                          |       | — |   | 1,271 |   |
| Income(loss)  before provision for income taxes |       | 2,589                                                          |       | (1,463 | ) | 1,126 |   |
| Provision for income  taxes                     |       | 412                                                            |       | (235 | ) | 177 |   |
| Net income  (loss)                              |       | $                                                              | 2,177      |   | $ | (1,228 | ) | $ | 949 |   |
| Net income (loss) per  share:                   |       |                                                           |       |   |   |   |   |
| Basic                                           |       | $                                                              | 0.07       |   | $ | (0.04 | ) | $ | 0.03 |   |
| Diluted                                         |       | $                                                              | 0.06       |   | $ | (0.03 | ) | $ | 0.03 |   |
| Weighted-average common  shares outstanding:    |       |                                                           |       |   |   |   |   |
| Basic                                           |       | 33,059                                                         |       | (188 | ) | 32,871 |   |
| Diluted                                         |       | 36,648                                                         |       | (188 | ) | 36,460 |   |

9

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**Impact ofthe Financial Statement Adjustments on the Condensed Consolidated Statements ofCash Flows (unaudited)**

The restatement of the Condensed ConsolidatedStatement of Cash Flows for the three months ended March 31, 2006 did notaffect on our cash flows from financing or investing activities. The tablebelow reflects adjustments to our cash flows from operating activities (inthousands):
| ** **                                                                                           | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **As  Previously  Reported**                              | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| Cash flows from  operating activities:                                                               | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                                   |       | $                                                         | 2,177      |   | $ | (1,228 | ) | $ | 949 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                                      |       |   |   |   |   |
| In-process  research and development                                                                 |       | —                                                    |       | — |   | — |   |
| Amortization of  intangible assets                                                                   |       | 3,964                                                     |       | — |   | 3,964 |   |
| Stock-based  compensation expense                                                                    |       | 3,034                                                     |       | 112 |   | 3,146 |   |
| Depreciation and  amortization of property and equipment                                             |       | 1,134                                                     |       | — |   | 1,134 |   |
| Provision for  accounts receivable                                                                   |       | 747                                                       |       | — |   | 747 |   |
| Deferred income  taxes                                                                               |       | 205                                                       |       | (216 | ) | (11 | ) |
| Other non-cash  items, net                                                                           |       | (159                                                      | )          | 1,359 |   | 1,200 |   |
| Changes in  operating assets and liabilities:                                                        |       |                                                      |       |   |   |   |   |
| Accounts  receivable                                                                                 |       | (3,960                                                    | )          | — |   | (3,960 | ) |
| Prepaid and  other assets                                                                            |       | (1,416                                                    | )          | (459 | ) | (1,875 | ) |
| Accounts payable                                                                                     |       | 2,545                                                     |       | — |   | 2,545 |   |
| Accrued expenses                                                                                     |       | 456                                                       |       | 440 |   | 896 |   |
| Deferred revenue                                                                                     |       | 10,416                                                    |       | — |   | 10,416 |   |
| Net cash  provided by (used in) operating activities                                                 |       | $                                                         | 19,143     |   | $ | 8 |   | $ | 19,151 |   |

10

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***Impact of the Financial StatementAdjustments on the Consolidated Balance Sheet***

***The table below presents the impact ofthe financial statement adjustments related to restatement of our previouslyreported Consolidated Balance Sheet as of March 31, 2006 (in thousands):***
| ** **                                                                                                                                                                                            | ** ** | **March 31, 2006 (unaudited)** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **As  Previously  Reported**             | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
| **ASSETS**                                                                                                                                                                                            |       |                                     |       |   |   |   |   |
| Current assets:                                                                                                                                                                                       |       |                                     |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                             |       | $                                        | 85,510     |   | — |   | $ | 85,510 |   |
| Investments                                                                                                                                                                                           |       | 70,996                                   |       | — |   | 70,996 |   |
| Restricted cash                                                                                                                                                                                       |       | —                                   |       | — |   | — |   |
| Accounts receivable, net of allowance of $3,204 at  March 31, 2006                                                                                                                               |       | 43,525                                   |       | — |   | 43,525 |   |
| Prepaid and other current assets                                                                                                                                                                      |       | 7,191                                    |       |   |   | 7,191 |   |
| Total current assets                                                                                                                                                                                  |       | 207,222                                  |       |   |   | 207,222 |   |
| Intangible  assets, net                                                                                                                                                                               |       | 32,658                                   |       | — |   | 32,658 |   |
| Goodwill(1)                                                                                                                                                                                           |       | 41,096                                   |       | (1,514 | ) | 39,582 |   |
| Property and  equipment, net                                                                                                                                                                          |       | 8,306                                    |       | — |   | 8,306 |   |
| Other assets(2)                                                                                                                                                                                       |       | 3,505                                    |       | (354 | ) | 3,151 |   |
|                                                                                                                                                                                                  |       |                                     |       |   |   |   |   |
|                                                                                                                                                                                                  |       | $                                        | 292,787    |   | $ | (1,868 | ) | $ | 290,919 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        |       |                                     |       |   |   |   |   |
| Current  liabilities:                                                                                                                                                                                 |       |                                     |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                      |       | $                                        | 6,327      |   | — |   | $ | 6,327 |   |
| Accrued expenses(3)                                                                                                                                                                                   |       | 27,256                                   |       | $ | 171 |   | 27,427 |   |
|                                                                                                                                                                                                  |       |                                     |       |   |   |   |   |
| Deferred revenue                                                                                                                                                                                      |       | 34,158                                   |       | (22 | ) | 34,136 |   |
|                                                                                                                                                                                                  |       |                                     |       |   |   |   |   |
| Total current liabilities                                                                                                                                                                             |       | 67,741                                   |       | 149 |   | 67,890 |   |
| Other long-term  liabilities(3)                                                                                                                                                                       |       | 5,993                                    |       | 62 |   | 6,055 |   |
| Deferred income  tax liabilities                                                                                                                                                                      |       | 675                                      |       | — |   | 675 |   |
|                                                                                                                                                                                                  |       |                                     |       |   |   |   |   |
| Total liabilities                                                                                                                                                                                     |       | 74,409                                   |       | 211 |   | 74,620 |   |
| 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 shares issued and outstanding at March 31, 2006                                                                          |       | 334                                      |       | — |   | 334 |   |
| Additional paid-in capital                                                                                                                                                                            |       | 253,956                                  |       | 9,656 |   | 263,612 |   |
| Accumulated deficit                                                                                                                                                                                   |       | (40,146                                  | )          | (11,735 | ) | (51,881 | ) |
| Accumulated other comprehensive income                                                                                                                                                                |       | 4,234                                    |       | — |   | 4,234 |   |
| Total stockholders’ equity                                                                                                                                                                       |       | 218,378                                  |       | (2,079 | ) | 216,299 |   |
|                                                                                                                                                                                                  |       | $                                        | 292,787    |   | $ | (1,868 | ) | $ | 290,919 |   |

 

(1)    Adjustmentto recognize deferred tax assets acquired in the acquisition of Blue Pumpkinand to reflect the $1.35 million discount on common stock issued as acharge to earnings rather than an adjustment to goodwill.

(2)    Adjustmentto reflect the discount on long term obligation related to purchased softwarelicenses.

(3)    Adjustmentto reflect the accrual of costs associated with vacated leases in accordancewith SFAS No. 146 and offsetting adjustment to reflect the discount on longterm obligations.

11

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**Legal Proceedings**

On August 29, 2006, A. Edward Miller filed ashareholder derivative lawsuit in the United States District Court for theNorthern District of Georgia (Atlanta Division) naming Witness Systems, Inc. (the“Company”) as a nominal defendant and naming all of our current directors and anumber of our current officers as defendants.  Miller v. Gould, et al.,Civil Action No. 1:06-CV-2039 (N.D. Ga.).  The complaint alleges purportedviolations of federal and state law, including breaches of fiduciary duty,abuse of control, constructive fraud, corporate waste, unjust enrichment, grossmismanagement and violations of certain antifraud provisions of the federalsecurities laws (including Sections 10(b) and 14(a) of the Securities ExchangeAct of 1934 and Rules 10b-5 and 14a-9 thereunder) in connection with certainstock option grants made by the Company.  The complaint seeks monetarydamages in unspecified amounts, disgorgement of profits, an accounting, rescissionof stock option grants, imposition of a constructive trust over the defendants’stock options and proceeds derived therefrom, punitive damages, reimbursementof attorneys’ fees and other costs and expenses, an order directing the Companyto adopt or put to a stockholder vote various proposals relating to corporategovernance, and other relief as determined by the court.  On November 15,2006, the Company and the other defendants filed a motion to dismiss thecomplaint in its entirety on a variety of grounds, including plaintiffs’failure to allege demand futility. Rather than respond to that Motion, plaintiffs on January 9, 2007 filedan Amended Complaint.  The Company andits directors intend to review the allegations of the Amended Complaint andrespond when appropriate.

A class action securities lawsuit was filedby an individual on August 14, 2006 claiming tobe a stockholder of the Company naming the Company and certain of itsdirectors and officers as defendants in connection with certain stock optiongrants made by the Company.  Rosenberg v. Gould, et al., Civil Action No.1:06-CV-1894 (N.D. Ga.).  The complaint, filed in the United StatesDistrict Court for the Northern District of Georgia, alleges violations ofSection 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunderand seeks unspecified damages, attorneys’ fees and other costs and expenses,unspecified extraordinary, equitable and injunctive relief, and other relief asdetermined by the court.  Neither a lead plaintiff nor lead counsel hasbeen appointed, nor has no response to the complaint yet been required. TheCompany and the other defendants will respond to the complaint whenappropriate.

**CommonStock- Listing on the Nasdaq Stock Market**

We delayed the filing of our quarterly reports on Form10-Q for the quarters ended June 30, 2006 and September 30, 2006 until we wereable to complete restatement of previously issued Consolidated FinancialStatements. As a result, we have not been in compliance with the Nasdaq Stock Marketfiling requirements for continued listing as set forth in Marketplace Rule4310(c) (14).  We have received a letter from Nasdaq Listing QualificationPanel advising us that we have received an extension of time through February7, 2007 to file our Quarterly Reports on Form 10-Q for the quarters ended June30, 2006 and September 30, 2006.  The Panel advised us that if we areunable to meet the extension deadline, the Panel will issue a finaldetermination to delist our shares and there can be no assurance that NasdaqListing and Hearing Review Council will grant an additional extension of timeto meet such requirements or that our common stock will remain listed on theNasdaq Stock Market.

**4.****                                                             ****Blue Pumpkin Acquisition**

OnJanuary 24, 2005, we acquired Blue Pumpkin Software, Inc. (“BluePumpkin”), a privately held California corporation. With this acquisition, wehave expanded our workforce optimization solution to include advanced workforcemanagement software and services solutions including forecasting, scheduling,adherence and planning applications. Pursuant to the Merger Agreement and Planof Reorganization, dated December 16, 2004 (the “Merger Agreement”), wepaid $36 million in cash which was funded from our existing cash andinvestments and issued 1.9 million shares of Witness’ common stock valued at$33.5 million (measured based on the date the stock consideration becamefixed pursuant to the application of a formula specified in the mergeragreement). On May 24, 2005, the shares issued in connection with theacquisition were registered for resale with the Securities and ExchangeCommission. Pursuant to the Merger Agreement, cash of $4 million and 210,000shares of common stock valued at approximately $3.7 million on the date ofacquisition were placed into escrow fund to compensate Witness, subject tocertain limitations, for potential losses that could result from, among otherthings, the IEX litigation and other specified litigations, and breaches ofBlue Pumpkin’s representations, warranties or covenants in the Merger Agreement

On December 15, 2005, Tekelec, IEX’s parentcompany, and Witness reached a tentative agreement to settle all claimsasserted between them. As part of the final settlement entered into inApril 2006, Witness has made payment of $8.25 million to Tekelec, andagreed to make six annual payments of $0.5 million ($3.0 million in total) fromApril 2007 through 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 IEX litigation.As part of the agreement to release the escrow Witness issued shares of commonstock for proceeds of approximately $3.1 million. These shares were issued at adiscount of approximately $1.35 million, which was recorded as a charge toearnings in the Company’s consolidated statement of operations for the threemonths ended March 31, 2006.

Wedetermined that, at the date of the acquisition of Blue Pumpkin Software, Inc.(“Blue Pumpkin”), it was not beyond a reasonable doubt that the cash and commonstock held in escrow pursuant to the Merger Agreement and Plan ofReorganization would be issued to the former shareholders of Blue Pumpkin.  Therefore, in accordance with SFAS No. 141, *Business Combination*, we have adjusted the considerationpaid in the acquisition of Blue Pumpkin Software, Inc. (“Blue Pumpkin”) from$77.2 million to $69.5 million to properly reduce the purchase price for the $4million in cash and 210,000 shares of common stock that were held inescrow.  As a result, the December 31,2005 balance sheet reflects a reduction in equity by approximately $3.7 millionand the recognition of $4 million in restricted cash.  In addition, we adjusted accrued expenses byapproximately $7.7 million to reflect the $11.2 million estimated cost tosettle all claims with IEX.  

12

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We commenced consolidation of Blue Pumpkin onJanuary 25, 2005 and the acquisition was accounted for using the purchasemethod of accounting in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 141,*BusinessCombinations*. The following summarizes the total purchase price forBlue Pumpkin (in thousands):
| Value of Witness  Systems, Inc. common stock issued |   | $      | 33,500 |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Cash  consideration                                      |   | 36,000 |   |
| Direct  acquisition costs                                |   | 5,400  |   |
|                                                     |   | $      | 74,900 |   |

 

Under the purchase method of accounting, the totalpurchase price was allocated to Blue Pumpkin’s net tangible and intangibleassets based upon their estimated fair value as of the date of the acquisitionwith any amount paid in excess of the fair value of the net assets recorded asgoodwill. Based upon the purchase price and review of the net assets acquiredand liabilities assumed, the purchase price allocation, is as follows (inthousands):
| Cash and investments                 |   | $       | 3,900  |   |
|--------------------------------------|--------|---------|--------|--------|
| Other current  assets                |   | 6,400   |   |
| Property and  equipment, net         |   | 700     |   |
| Acquired  technology                 |   | 21,000  |   |
| Customer  relationships              |   | 17,000  |   |
| Goodwill                             |   | 34,700  |   |
| In-process  research and development |   | 9,000   |   |
| Other long term  assets              |   | 100     |   |
| Total assets acquired                |   | 92,800  |   |
| Current  liabilities                 |   | (3,600  | )      |
| Litigation  accrual                  |   | (11,200 | )      |
| Deferred revenue                     |   | (1,700  | )      |
| Restructuring  accruals              |   | (1,400  | )      |
| Total liabilities assumed            |   | (17,900 | )      |
|                                 |   | $       | 74,900 |   |

 

The fair values of identifiable intangible assetswere determined with the assistance of Taylor Consulting Group, Inc., anindependent third-party appraiser using both an income and a cost approachtaking into consideration the nature, risks, historical patterns, economiccharacteristics, and future considerations of the assets. As of the closingdate of the merger, technological feasibility of the in-process research anddevelopment (“IPR&D”) had not been established and the technology had noalternative future use. Accordingly, we charged the value of the IPR&D atthe date of the acquisition to expense. The amount of the purchase priceallocated to IPR&D was based on established valuation techniques used inthe software industry. The fair value assigned to the acquired IPR&D wasdetermined using a discounted cash flow methodology, which discounts expectedfuture cash flows to present value.

The key assumptions used in the valuation include,among others, expected completion date of the in-process projects identified asof the acquisition date, estimated cost to complete the projects, revenuecontributions and expense projections assuming the resulting product hasentered the market, and discount rates based on the risks associated with thedevelopment life cycle of the in-process technology acquired. The discountrates used in the present value calculations are obtained from a weighted-averagecost of capital analysis, adjusted upward to account for the inherentuncertainties surrounding the successful development of the IPR&D, theexpected profitability levels of such technology, and the uncertainty oftechnological advances that could potentially impact the estimates. We assumethe pricing model for the resulting product of the acquired IPR&D to bestandard within its industry. We did not take into consideration anyconsequential amount of expense reductions from integrating the acquiredIPR&D with other existing in process or completed technology.

The key considerations underlying the valuation ofacquired in-process research and development from Blue Pumpkin are as follows:a) guidance from the Financial Accounting Standards Board (“FASB”) SFASNo. 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.

13

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Goodwillof $35.3 million has been recorded and represents the excess of the purchaseprice over the fair value of the tangible and other intangible assets acquiredless the liabilities assumed. In accordance with SFAS No. 142,*Goodwill and Other Intangible Assets*, goodwill and intangible assetswith indefinite useful lives are not amortized, but are tested for impairmentat least annually or as circumstances indicate their value may no longerbe 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                                     |       | $                                                      | (11,832    | ) |
| Net loss per  share – basic and diluted |       | $                                                      | (0.45      | ) |
| Weighted average shares  - basic and diluted |       | 26,051                                                 |       |

 

**5.****                                                             ****Acquisition-Related RestructuringAccruals and Merger-Related and Integration 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 all merger-related andintegration costs that were charged to expense during the three months endedMarch 31, 2006 and 2005 (in thousands):

|                                      | ** ** | **March 31,**                  | ** ** |
|--------------------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **2006  As Restated (1)** | ** ** | **2005** | ** ** |
| Blue Pumpkin:                        |       |                                |       |   |   |
| Merger-related and integration costs |       | $                                   | 2,091      |   | $ | 1,561 |   |
| Eyretel:                             |       |                                |       |   |   |
| Bonus expense                        |       | —                              |       | 154 |   |
| Merger-related and integration costs |       | —                              |       | (56 | ) |
|                                 |       | $                                   | 2,091      |   | $ | 1,659 |   |

----

**(1) See Note 3, “Restatement ofCondensed Consolidated Financial Statements.”**

 

During the first quarter of 2006, we incurred merger-related and integrationcosts in the amount of $2.1 million pertaining to the acquisition of BluePumpkin. These expenses were primarily associated with legal, professional fees and a discount on shares sold to the BluePumpkin Shareholders.

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 $1.6 millionof integration expenses comprised primarily of costs of transitional BluePumpkin employees and other contractors, travel costs and advertising costs.

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

The following is areconciliation of the numerator and denominator used in the calculation ofbasic and diluted net income (loss) per share (in thousands, except per sharedata):

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|                                                                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                             | ** ** | ** ** | ** ** |
| ** **                                                                         | ** ** | **As  Restated (1)**                            | ** ** | **2005** | ** ** |
| Net income  (loss)                                                                 |       | $                                                    | 949        |   | $ | (9,458 | ) |
| Weighted average shares  of common stock and common stock equivalents outstanding: |       |                                                 |       |   |   |
| Basic                                                                              |       | 32,871                                               |       | 26,098 |   |
| Dilutive effect  of stock options computed using the treasury stock method         |       | 3,777                                                |       | — |   |
| Diluted common  shares and share equivalents outstanding                           |       | 36,648                                               |       | 26,098 |   |
| Net income per share  (loss):                                                      |       |                                                 |       |   |   |
| Basic                                                                              |       | $                                                    | 0.03       |   | $ | (0.36 | ) |
| Diluted                                                                            |       | $                                                    | 0.03       |   | $ | (0.36 | ) |

 

----

**(1) See Note 3, “Restatement of CondensedConsolidated Financial Statements**.”

We have excluded alloutstanding stock options from the calculation of diluted net loss per commonshare for the three months ended March 31, 2005 because we reported a lossin this period and all such securities are anti-dilutive. The total number ofshare equivalents excluded from the calculation of historical diluted net lossper common share for the three months ended March 31, 2005 was 2,862,491,calculated using the treasury stock method. In the first quarter of 2006and 2005, 4, 200** **and 41,283 stock options,respectively, were excluded from the computation of diluted earnings per sharebecause they had exercise prices that exceeded the average fair market value ofour common stock for those periods, and therefore, had an anti-dilutive effect.

**7.****                                                             ****Stock-Based Compensation**

Effective January 1,2006, we adopted SFAS No. 123(R), *Share-BasedPayment,*using the modified prospective application transition method. The cumulative effect of the adoption ofSFAS No. 123(R) was not material. SFAS 123(R) requires us to estimate the fairvalue 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 ofSFAS 123(R), we accounted for stock-based awards to employees using theintrinsic value method in accordance with APB 25 as allowed under SFASNo. 123, *“Accounting for Stock-Based Compensation”*.Other than as noted in Note 3, “Restatement of Condensed ConsolidatedFinancial Statements”, we have generally not recorded compensation expense for options granted to our employeesbecause all options granted under our stock option plans have an exercise priceequal to the market value of the underlying common stock on the date of grant.

Our net income for the threemonths ended March 31, 2006 includes $3.1 million of stock-option compensationexpense and $0.1 million of related income tax benefits recorded to additionalpaid-in-capital.

A summary of all stockoption plans activity for the three months ended March 31, 2006 is asfollows:
| ** **                                         | ** ** | **Number  of shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value (a)  $000’s** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------|------------|
| Outstanding as of  January 1, 2006            |       | 8,570,696                  |       | $                                      | 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             |       | 9,120,938                  |       | 12.31                                  |       | 5.2 years                                           |       | 119,413                                               |       |
|                                               |       |                       |       |                                   |       |                                                |       |                                                  |       |
| Vested+ Expected to  vest as of March 31, 2006 (b) |       | 7,983,878                  |       | 11.76                                  |       | 5.3 years                                           |       | 108,935                                               |       |
|                                               |       |                       |       |                                   |       |                                                |       |                                                  |       |
| Exercisable as of March 31, 2006              |       | 3,537,849                  |       | 8.71                                   |       | 5.6 years                                           |       | 59,061                                                |       |
|                                                    |            |                            |            |                                        |            |                                                     |            |                                                       |            |  |

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(a)                 Theaggregate intrinsic values were computed by applying the following formula =(fair market value of an option as of 3/31/06 - the exercise price at which theoption was granted) x the number of options.

(b)                 Thenumber of shares vested+ expected to vest as of March 31, 2006 is computed byapplying the following Formula = Number of shares vested as of March 31, 2006 +(shares not vested as of March 31, 2006*[100%-forfeiture rate]).

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As of March 31, 2006, there was $16.5 million oftotal unrecognized compensation costs related to unvested share-basedcompensation arrangements granted under all stock option plans. That cost isexpected to be recognized over a weighted-average period of 1.4 years.

The total intrinsic value ofshare options exercised during the three months ended March 31, 2006 and2005 was approximately $8.3 million and $4.5 million, respectively. Theweighted-average grant date fair value of stock options granted during thethree months ended March 31, 2006 and 2005, was $8.06 and $7.63,respectively, using the Black-Scholes option-pricing model with the followingweighted-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:

·                  The vesting period of the awards

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

·                  Expected volatility of the price of theunderlying share

(2) Weused a 3-year historical stock-price volatility as the expected volatilityassumption which aligns with the expected life term of the options grantedduring the three months ended March 31, 2006. We believe that historicalvolatility reflects our current assessment of implied volatility. Prior to2006, we used historical stock price volatility in accordance with SFASNo. 123 for purposes of our pro forma disclosure.

(3) Forfeiturerate was computed taking into consideration the historical forfeiture rates.SFAS123(R) requires forfeitures to be estimated at the time of option grantsand revised, if necessary, in subsequent periods if actual forfeiture differsfrom those estimates. Prior to adoption of SFAS 123(R), our pro formadisclosures accounted for actual forfeitures as they occurred.

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

Cashreceived from stock option exercises for the three months ended March 31, 2006 and 2005 was $5.3 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 table below reflectspro forma net income and diluted net income per share for the three monthsended March 31, 2005:

 
| ** **                                                                                               | ** ** | **Three Months  Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                                     | ** ** |
| ** **                                                                                               | ** ** | **Pro forma (1)**                  | ** ** |
| Net income (loss)  before the effect of stock-based compensation expense                                 |       | $                                            | (9,458     | ) |
| Add: Stock-based  compensation expense related to stock options included in reported income,  net of tax |       | 113                                          |       |
| Deduct:  Stock-based compensation determined under fair value based method                               |       | (3,039                                       | )          |
| Net income (loss)  including the effect of stock-based compensation expense                              |       | $                                            | (12,384    | ) |
|                                                                                                     |       |                                         |       |
| Basic earnings  per share                                                                                |       | $                                            | (0.47      | ) |
| Diluted earnings per  share                                                                              |       | $                                            | (0.47      | ) |

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

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***Stock******Incentive******Plans—******We****have* three stock incentiveplans: (i) the 1999 Stock Incentive Plan (the “1999 Plan”); (ii) the2003 Broad Based Option Plan (the “2003 Plan”); and (iii) the 2003Non-employee Director Stock 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 Witness,as defined. At March 31, 2006, there were 12.9 million shares authorizedfor issuance, of which 2,411,228 shares remain available for future grant

*2003Plan—**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.

*DirectorPlan—**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 plan remains ineffect until the earlier of the tenth anniversary of its effective date or thedate on which all reserved shares have been issued or are no longer availablefor use. Options granted under our stock option plans are non-qualified stockoptions that were granted at a price greater than or equal to the fair value ofthe stock on the grant date, other than as noted in Note 3, “Restatement ofCondensed Consolidated Financial Statements.” Option vesting terms typicallyrange from two to four years. Options granted since July 1, 2004, havefive-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.

**8.****                                                             ****Comprehensive Income (Loss)**

Totalcomprehensive income(loss) and accumulated other comprehensive income consisted of the following(in thousands):
|                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                         | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **As Restated (1)**                    | ** ** | **2005** | ** ** |
|                                                         |       |                                             |       |   |   |
| Net income  (loss)                                           |       | $                                                | 949        |   | $ | (9,458 | ) |
| 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)                           |       | $                                                | 2,107      |   | $ | (9,352 | ) |

 
|                                                      | ** ** | **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 |   |

----

**(1) See Note 3, “Restatement of CondensedConsolidated Financial Statements”.**

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**9.****                                                             ****Line of Credit**

In March 2006, weextended the maturity date on our $15.0 million line of credit toMarch 2007. At our election, borrowings under the line of credit bearinterest at the bank’s prime rate, which was 7.75% on March 31, 2006, orLIBOR plus 300 basis points. Borrowings under the revolving line of credit arelimited to 85% of eligible accounts receivable, as defined by the agreement.The revolving line of credit is secured by all of our assets and requirescompliance with various covenants, including liquidity ratios and EBITDArequirements, among others. As of March 31, 2006, we were in compliancewith our bank covenants.

As of March 31, 2006,we had no amounts outstanding under the line of credit and the amount availablefor borrowing was $12.8 million, which was net of outstanding letters of creditof $2.2 million. The letters of credit secure the lease on the corporateheadquarters facility and have decreasing schedules that ultimately expire in2007. In addition, we have a £0.3 million letter of credit securing our leaseobligations for our premises in the United Kingdom.

**10.****                                                      ****Segment and GeographicInformation**

We consider ourselves to bein a single industry segment, specifically licensing and servicing of softwareapplications to the customer interaction recording and analysis market. Ourchief operating decision maker receives financial information by geographicregion; however, our operating segments are aggregated into one reportablesegment based upon similar economic characteristics, products, services anddelivery methods.

World-wide revenue based oncustomer location is as follows (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 revenuewas derived primarily from customers located in Australia, Canada, China, Indiaand Japan. No individual customer accounted for more than 10% of consolidatedrevenue during the three months ended March 31, 2006 or 2005.

Long-lived assets, includinggoodwill and intangible assets, by geography are as follows (in thousands):
| ** **     | ** ** | **March 31,**      | ** ** | ** **                  | ** ** |
|----------------|------------|-------------------------|------------|-----------------------------|------------|
|                | ** ** | **2006  (As restated)** | ** ** | **December 31,  2005** | ** ** |
| ** **     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| United States  |       | $                       | 68,722     |                        | $          | 71,430 |   |
| United Kingdom |       | 9,619                   |       | 10,824                      |       |
| Rest of world  |       | 2,205                   |       | 2,250                       |       |
| Total          |       | $                       | 80,546     |                        | $          | 84,504 |   |

 

**11.****                                                       RecentAccounting Pronouncements**

In November 2005, theFASB issued Staff Position (“FSP”) FAS115-1/124-1, *The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments,* which addresses the determination as to when aninvestment is considered impaired, whether that impairment is other thantemporary, and the measurement of an impairment loss. This FSP also includesaccounting considerations subsequent to the recognition of another-than-temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporaryimpairments. The guidance in this FSP amends FASB Statements No. 115,*Accounting for Certain Investments in Debtand Equity Securities, and No. 124, Accounting for Certain InvestmentsHeld by Not-for-Profit Organizations*, and APB Opinion No. 18*, The Equity Method of Accounting for Investments inCommon Stock*. This FSP is effective for reporting periodsbeginning after December 15, 2005. The adoption of this FSP had nomaterial impact to our financial statements.

In June 2006, the FASB issued Interpretation No. 48, “*Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109*.” This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return, andprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition. This Interpretationis effective for us as of January 1, 2007. We are currently assessing theimpact of the Interpretation on our results of operations and financialposition.

In June 2006, the FASB issued EITF No. 06-3, “*How Taxes Collected from Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement (That is, Gross versusNet Presentation)*”. This EITF requires disclosure of the accountingpolicy of any tax assessed by a governmental authority that is directly imposedon a revenue-producing transaction (i.e., sales, use, value added) on a gross(included in revenue and costs) or net (excluded from revenue) basis. This EITFis effective for us as of January 1, 2007. We are currently assessing theimpact of the EITF on our results of operations and financial position.

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In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 108 (“SAB 108”) *Financial Statements—Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements*”, which becomes effective beginning on January 1, 2007.SAB 108 requires a utilization of a dual-approach to assessing the quantitativeeffects of financial misstatements. This dual approach includes both an incomestatement assessment and a balance sheet assessment. If a misstatement ismaterial to the current year financial statements under either assessment, theprior year financial statements should also be corrected, even though suchrevision was, and continues to be, immaterial to the prior year financialstatements. Correcting prior year financial statements for immaterial errorswould not require previously filed reports to be amended. Such correctionshould be made in the current period filings. If the Company determines that anadjustment to prior year financial statements is required upon adoption of SAB108 and does not elect to restate its previous financial statements, then itmust recognize the cumulative effect of applying SAB 108 in fiscal 2006beginning balances of the affected assets and liabilities with a correspondingadjustment to the fiscal 2006 opening balance in retained earnings. We arecurrently evaluating the impact of adopting SAB 108.

In September 2006, the FASB issued SFAS No. 157, “*Fair Value Measurements*”, which becomes effective beginningon January 1, 2008. SFAS No.157 addresses the definition of fair value, themethods used to measure fair value and the expanded disclosures about fairvalue measurement of a company’s assets and liabilities. SFAS No.157 requiresthat the fair value measurement should be determined based on the assumptionsthat market participants would use in pricing the asset or liability. We arecurrently assessing the impact of the SFAS No. 157 on our results of operationsand financial position.

**12.                  SubsequentEvents**

*Acquisition of Exametric, Inc.*

On October 2, 2006, we acquired Exametric, Inc.(“Exametric”), a leading software solutions company specializing in workforcemanagement and optimization for the financial service industry.  The acquisition was structured as a merger ofExametric with a newly-formed, wholly-owned subsidiary of Witness (WitnessEnterprise Solutions).  The totalconsideration paid for Exametric was approximately $23 million.  Approximately $2.4 million of the aggregateconsideration will be held in escrow until October 2, 2007, or longer, ifclaims are brought against the escrow fund and remain pending on thatdate.  The escrow fund will be availableto indemnify Witness for losses resulting from, among other things, breaches ofrepresentations, warranties, covenants and certain transaction costs.

*Acquisition of Demos Consulting Group Ltd.*

Also on October 2, 2006, we acquired Demos ConsultingGroup Ltd. also known as Demos Solutions (“Demos”), a leading productivitysolution provider for the financial services industry.  The acquisition was structured as Demos witha newly-formed, wholly-owned subsidiary of Witness (Witness EnterpriseSolutions).  The total consideration paidfor Demos was approximately $6 million plus the potential for an earn-out of upto $18 million based on the growth of the business over the next severalyears.  Ten percent (10%) of the initialconsideration plus ten percent (10%) of any earn-out earned will be held inescrow until October 2, 2007, or longer, if claims are brought against theescrow fund and remain pending on that date. The escrow fund will be available to indemnify Witness for lossesresulting from, among other things, breaches of representations, warranties andcovenants. 

**LegalProceedings**

On August 29, 2006, A. Edward Miller filed ashareholder derivative lawsuit in the United States District Court for theNorthern District of Georgia (Atlanta Division) naming Witness Systems, Inc.(the “Company”) as a nominal defendant and naming all of our current directorsand a number of our current officers as defendants.  Miller v. Gould, et al., Civil Action No.1:06-CV-2039 (N.D. Ga.).  The complaintalleges purported violations of federal and state law, including breaches offiduciary duty, abuse of control, constructive fraud, corporate waste, unjustenrichment, gross mismanagement and violations of certain antifraud provisionsof the federal securities laws (including Sections 10(b) and 14(a) of theSecurities Exchange Act of 1934 and Rules 10b-5 and 14a-9 thereunder) inconnection with certain stock option grants made by the Company.  The complaint seeks monetary damages inunspecified amounts, disgorgement of profits, an accounting, rescission ofstock option grants, imposition of a constructive trust over the defendants’stock options and proceeds derived therefrom, punitive damages, reimbursementof attorneys’ fees and other costs and expenses, an order directing the Companyto adopt or put to a stockholder vote various proposals relating to corporategovernance, and other relief as determined by the court.  On November 15, 2006, the Company and theother defendants filed a motion to dismiss the complaint in its entirety on avariety of grounds, including plaintiffs’ failure to allege demandfutility.  Rather than respond to thatMotion, plaintiffs on January 9, 2007 filed an Amended Complaint.  The Company and its directors intend toreview the allegations of the Amended Complaint and respond when appropriate.

In addition, a class action securities lawsuit hasbeen filed by an individual  on August14, 2006 claiming to be a stockholder of the Company naming the Company andcertain of its directors and officers as defendants in connection with certainstock option grants made by the Company. Rosenberg v. Gould, et al., Civil Action No. 1:06-CV-1894 (N.D.Ga.).  The complaint, filed in the UnitedStates District Court for the Northern District of Georgia, alleges violationsof Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5thereunder and seeks unspecified damages, attorneys’ fees and other costs andexpenses, unspecified extraordinary, equitable and injunctive relief, and otherrelief as determined by the court. Neither a lead plaintiff nor lead counsel has been appointed, nor has anyresponse to the complaint yet been required. The Company and the other defendantswill respond to the complaint when appropriate.

On October 27, 2006, the Company received a notice ofinformal nonpublic inquiry from the Securities and Exchange Commissionrequesting certain documents and information relating to the company’s stockoption grant practices from February 2000 to the present. Witness Systemsintends to cooperate fully with all matters related to this request.

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**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

The following Management’sDiscussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with the Condensed Consolidated Financial Statements andNotes thereto included elsewhere in this report. Investors should carefullyreview the information contained in this report under the caption “Risk Factors”beginning on page 30. The following will be discussed and analyzed:

·                  Overview

·                  Stock OptionPractices and Restatement of Condensed Consolidated Financial Statements

·                  CriticalAccounting Policies and Estimates

·                  Resultsof Operations

·                  Liquidityand Capital 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 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 integrated offering ofsoftware 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 the performanceof their customer service representatives, or “CSR”s, wherever they may belocated in the enterprise. Our high-volume compliance applications are designedto record high volume, full-time performance of the voice conversations betweenCSRs and customers for purposes such as compliance recording and salesverification. Our workforce management products enable our customers to developstrategic staffing plans, deploy skilled resources and evaluate productivity ofCSRs. Our performance management applications provide comprehensive analytics,including performance 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 licensing software andderive services revenue by providing related installation, training,consulting, and maintenance services. We also derive a relatively small portionof product revenue by selling hardware to customers. The majority of ourproduct revenue is derived from quality monitoring (“QM”) and workforcemanagement (“WFM”) software. We sell our products through our direct sales forceand through our indirect sales channels. Our indirect sales channels consist ofdistributors, 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 global saleschannels 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 and maintain ourcompetitive position from a technology perspective through the timelyintroduction of new products, such as pre-packaged solutions, which addcapabilities such as performance analysis and e-learning management to ourcore quality 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 in concertwith our product revenue. When our customers license our products, theygenerally purchase installation, training and one year of support services.Therefore, as we generate product revenue, we also generate related 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 that enable and enhance our customers’ ability toimprove the efficiency and effectiveness of their customer service operationsand our ability to maintain a high level of customer success and satisfaction.

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On January 24, 2005, we acquired Blue PumpkinSoftware, Inc. (“Blue Pumpkin”), a privately held California corporation.With this acquisition, we have expanded our workforce optimization solution toinclude advanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications. Pursuant to theMerger Agreement and Plan of Reorganization, dated December 16, 2004 (the “MergerAgreement”), we paid $36 million in cash which was funded from our existingcash and investments and issued 1.9 million shares of Witness’ common stockvalued at $33.5 million (measured based on the date the stockconsideration became fixed pursuant to the application of a formula specifiedin the merger agreement). On May 24, 2005, the shares issued in connectionwith the acquisition were registered for resale with the Securities andExchange Commission. Pursuant to the Merger Agreement, cash of $4 million and 210,000shares of common stock valued at approximately $3.7 million on the date ofacquisition were placed into escrow and was released to Witness during themonth 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, inApril 2006 and agreed to make six annual payments of $0.5 million ($3.0million in total) from April 2007 through 2012.

On May 23, 2005, we acquired Optimis GroupLimited (“Optimis”), a UK-based provider of workforce optimization software solutions.Blue Pumpkin owned a minority interest in an operating subsidiary of Optimis,the balance of which was acquired through the Optimis acquisition. We paid$5.0 million in cash and other consideration that was financed from ourexisting cash and investments. Ten percent of the aggregate acquisitionconsideration is being held in escrow until May 23, 2006. The escrowperiod may be extended in the event that there are pending claims that arebrought against the escrow fund within such period. The escrow fund isavailable to compensate Witness, subject to certain limitations, for lossesresulting from, among other things, breaches of representations, warranties orcovenants in the purchase agreement and certain pending and potential claims.

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 the Black-Scholes option-pricing model. We adopted SFAS 123(R)using the modified prospective transition method, which requires theapplication of SFAS 123(R) as of January 1, 2006. Stock-based compensationexpense recognized under SFAS 123(R) for the three months ended March 31,2006 was $3.1 million, which consisted of stock-based compensation expenserelated to employee stock options granted during the last four years (vestingperiod).

The table below reflects pro forma net income anddiluted net income per share for the three months ended March 31, 2005:
| ** **                                                                                               | ** ** | **Three Months  Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                                     | ** ** |
| ** **                                                                                               | ** ** | **Pro forma (1)**                  | ** ** |
| Net income (loss)  before the effect of stock-based compensation expense                                 |       | $                                            | (9,458     | ) |
| Add: Stock-based  compensation expense related to stock options included in reported income,  net of tax |       | 113                                          |       |
| Deduct:  Stock-based compensation determined under fair value based method                               |       | (3,039                                       | )          |
| Net income (loss)  including the effect of stock-based compensation expense                              |       | $                                            | (12,384    | ) |
|                                                                                                     |       |                                         |       |
| Basic earnings  per share                                                                                |       | $                                            | (0.47      | ) |
| Diluted earnings per  share                                                                              |       | $                                            | (0.47      | ) |

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

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, atMarch 31, 2006, compared to 595 employees, excluding approximately 159contractors, at March 31, 2005. As of March 31, 2006, 229 of the 668full-time employees were located outside the United States compared to 195employees, excluding contractors, at March 31, 2005.

**Stock Option Practices and Restatement ofCondensed Consolidated Financial Statements**

Beginning in lateMay 2006, the Company’s management initiated a preliminary internal review ofthe Company’s historical stock option practices and related accountingtreatment in response to general media attention concerning stock option grantsat various public companies and shareholder interest with respect to this particularissue. On August 8, 2006, in response to the results of management’spreliminary internal review, our Board of Directors voluntarily formed aSpecial Committee of independent directors to review our stock option practicesand grants during the period between the date of the Company’s initial publicoffering on February 10, 2000 and August 31, 2002.  The Special Committee undertook itsinvestigation with the assistance of independent counsel and accounting expertsretained by its counsel. The Special Committee reviewed all 5.7 million stockoptions granted throughout the period covered by its investigation. In December2006, the Special Committee completed its review and reported its findings andrecommendations to our full Board of Directors. The Special Committee did notfind fraud or intentional misrepresentation in the financial reporting of theoption grants that it analyzed but found inaccuracies in the determination ofmeasurement dates for certain stock option grants affecting the Company’s accountingand disclosures. For a number of these grants, the Special Committee found thatit was likely that the stated grant date was selected in hindsight based onprice given the lack of supporting documentation and that  

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the option price was thelow price in a given month or quarter. Such grants were found to be presentduring 2000 and through approximately mid-year 2001. The Special Committeeconcluded that it was not necessary to expand the investigation to coverperiods after August 31, 2002. Among the various key considerations in reachingthis conclusion were: 1) as noted above, the Special Committee did not findfraud or intentional misrepresentation in the financial reporting of the optiongrants that it analyzed; 2) the Special Committee’s investigation found thatthe last instance of likely grant date selection based on stock price  occurred in mid-2001; and 3) the SpecialCommittee observed that the option granting practices of the Company becamemore formal and regularized during the latter phase of the period subject toits review.

In addition to the Special Committee investigation,the Company, with the assistance of outside legal counsel, reviewed theCompany’s stock option practices and grants for the periods subsequent toAugust 31, 2002. This review evaluated 90 percent of the 11.1 million optionsgranted after August 31, 2002. The review was designed not only to provide ahigh degree of grant review coverage, but also to appropriately assess thepropriety of measurement dates for each of the various types of options grantedduring this period.  Among others, optiongrant types covered included: 1) new employee grants in connection with theacquisition of businesses; 2) semi-annual employee ranking grants; 3) routinenon-officer grants for such events as new hires, promotions, sales achievement,etc; and 4) officer grants, including grants to the Company’s then CEO. Thisreview did not find fraud or intentional misrepresentation in the financialreporting relating to option grants but identified errors in the determinationof measurement dates. However, such errors were relatively immaterial and didnot exhibit evidence of selection of a favorable grant date and price in hindsight.

In those instances during the two review periods wherethe fair market value of our common stock at the originally stated grant datewas lower than the fair market value on the redetermined measurement date, inaccordance with Accounting Principles Board No. 25, “Accounting for StockIssued to Employees” (“APB No. 25”) and related interpretations, we concluded thatwe should have recorded stock-based compensation expense which was notaccounted for in our previously issued Consolidated Financial Statements.

As a result of the findings described above, ourrestated Consolidated Financial Statements as of December 31, 2005 reflected acumulative decrease in net income of approximately $9.5 million for the years2000 to 2005 due to non-cash adjustments to stock-based compensation expense.The stock-based compensation expense is primarily based on APB No. 25 which areintrinsic value based charges that are amortized over the vesting terms of thestock options. In connection with the restatement, we identified additionaladjustments that needed to be recorded to our historical Consolidated FinancialStatements. These adjustments consisted primarily of purchase accountingrelating to acquisition of Blue Pumpkin, income taxes and miscellaneous otheritems. The cumulative effect of the restatement adjustments on our ConsolidatedBalance Sheet as of December 31, 2005 resulted in an increase in theaccumulated deficit of $10.5 million, an increase in additional paid-in capitalof $5.8 million and increases in assets and liabilities of $2.8 million and$7.5 million, respectively. Although there were no option measurement datingissues, our 2006 Condensed Consolidated Financial Statements are impacted byoption grants in prior years where the measurement dates have been adjusted.The additional stock-based compensation adjustment reduced our net income forthe three months period ended March 31, 2006 by $71,000.

In October, 2006, we received a notice of informalnonpublic inquiry from the Securities and Exchange Commission requestingcertain documents and information relating to the Company’s stock option grantpractices from February 2000 to the present. We are cooperating fully with allmatters related to this request.

We delayed the filing of our quarterly reports on Form10-Q for the quarters ended June 30, 2006 and September 30, 2006 until the  Company was able to complete restatement of previouslyissued Consolidated Financial Statements. As a result, we have not been incompliance with the Nasdaq Stock Market filing requirements for continuedlisting as set forth in Marketplace Rule 4310(c) (14). We havereceived a letter from Nasdaq Listing Qualification Panel advising us that wehave received an extension of time through February 7, 2007 to file ourQuarterly Reports on Form 10-Q for the quarters ended June 30, 2006 andSeptember 30, 2006.  The Panel advised us that if we are unable to meetthe extension deadline, the Panel will issue a final determination to delistour shares and there can be no assurance that Nasdaq Listing and Hearing ReviewCouncil will grant an additional extension of time to meet such requirements orthat our common stock will remain listed on the Nasdaq Stock Market.

**Critical Accounting Policies andEstimates**

The discussion and analysis of our financial conditionand results of operations is based upon our Consolidated Financial Statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financialstatements requires us to make certain estimates and judgments that affect ourreported assets, liabilities, revenue and expenses, and our related disclosureof contingent assets and liabilities. On an on-going basis, we re-evaluate ourestimates, accounting policies and judgments including those related to revenuerecognition, the collectibility of receivables, accounting for acquisitions,impairment of long-lived assets, income taxes and stock-based compensation toensure that our financial statements are presented fairly and in accordancewith Generally Accepted Accounting Principles (“GAAP”). We base our estimateson historical experience and on various assumptions that we believe to bereasonable under the circumstances. However, because future events and theireffects 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 followingaccounting policies and estimates are critical to understanding and evaluatingour reported financial results. Management has reviewed these criticalaccounting policies and estimates with the Audit Committee of our Board ofDirectors.

*RevenueRecognition.* We recognize revenue in accordance withthe American Institute of Certified Public Accountants’ Statement of Position (“SOP”)No. 97-2,*Software Revenue Recognition,*and SOP No. 98-9*, Modification ofSOP 97-2, 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 thesoftware and hardware is recognized (i) upon delivery of those productswhen we have VSOE for the related maintenance and professional services soldand (ii) at an amount representing the difference between the total orderamount and the amount deferred.

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Services revenueincludes installation, training, consulting, maintenance and reimbursabletravel expenses. Revenue from installation, training and consulting services isrecognized upon performance of the related services and is offered and billedas separate 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 ourproducts. Maintenance is offered as a separate element and the majority ofcontracts include the right to unspecified upgrades on a when-and-if availablebasis. Maintenance revenue is deferred and recognized ratably over the term ofthe related contract.

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

*Allowance for Doubtful Accounts.*We perform ongoing evaluations of ourcustomers and continuously monitor collections and payments and estimate anallowance for doubtful accounts based on the aging of the underlyingreceivables, our historical experience with write-offs and any specificcustomer collection issues that we have identified. While such credit losseshave historically been within our expectations and we believe appropriatereserves have been established, we cannot assure that we will continue toexperience the same credit loss rates that we have experienced in the past oradequately predict future credit losses. If the financial condition of ourcustomers were to deteriorate and result in an impairment of their ability tomake payments, additional allowances may be required which would result inan additional selling, general and administrative expense in the period suchdetermination is made.

*Accounting for Acquisitions.*Accounting for acquisitions requiresmanagement to make judgments and estimates in determining the purchase price,the fair value of the assets and liabilities acquired and merger-related andintegration costs. In recording acquisitions, significant judgment is requiredin estimating:

·                  valuationof deferred revenue,

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

·                  otherliabilities existing at the time of acquisition.

Changes to estimates of acquired identifiable assetsand liabilities are reflected as adjustments to goodwill or intangibles to theextent such changes were based on conditions that existed at the acquisitiondate 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-Lived Assets.*  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 changes in circumstances indicatethat the carrying 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.* We account for income taxes inaccordance with SFAS No. 109,*Accounting for Income Taxes*, which requires recognition of deferredincome tax assets and liabilities for temporary differences between thefinancial reporting and tax bases of recorded assets and liabilities and theexpected benefits 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 benefit associated with our netoperating loss carryforwards, we would expect our provision for income taxexpense in future periods to reflect an effective tax rate that would besignificantly higher than in past periods. Furthermore, the utilization ofdeferred tax assets, primarily net operating loss carryforwards arising fromacquisitions, has resulted and will continue to result in a reduction ingoodwill and the recognition of tax expense associated with the purchaseddeferred tax assets. Additionally, the utilization of net operating losscarryforwards generated by the tax deduction for stock option exercises resultsin an increase to Additional-Paid-in-Capital and the recognition of taxexpense.

Alsounder FAS 123(R), future excess tax deductions will result in an increase toAdditional-Paid-in-Capital. Under this new standard, the Company will continueto follow the with-and-without approach and consider the impact of excess stockoption deductions last when computing its income tax provision. We haveutilized $2.5 million of income tax benefits originating from stock optiondeductions that have not been recorded in accordance with FAS 123(R).

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Estimates and judgmentsare required in determining our worldwide income tax expense. In the ordinarycourse of conducting business globally, there are many transactions andcalculations whose ultimate tax outcome cannot be certain. Although we believeour estimates and judgments are reasonable, no assurance can be given that thefinal tax outcome of these matters will not be different from what is reflectedin our historical income tax provisions and accruals. Such differences couldhave a material impact on our income tax provision and operating results in theperiod in which such a determination is made.

*Stock-BasedCompensation.* OnJanuary 1, 2006, we adopted SFAS No.123(R), *Share-BasedPayment*, which requires the measurement and recognition ofcompensation expense for all share-based payment awards made to employeesincluding employee stock options and employee stock purchase plan based on thegrant date fair value of those awards. We determine the fair value ofshare-based payment awards on the date of grant using Black-Scholesoption-pricing model. The fair value of share-based awards is affected by stockprice as well as assumptions regarding a number of highly complex andsubjective variables. These variables include, but are not limited to, ourexpected stock price volatility over the term of the awards, and actual andprojected employee stock option exercise behavior. SFAS 123(R) also requiresthat forfeitures be estimated over the vesting period of an award, rather thanbeing recognized as a reduction of compensation expense when the forfeitureactually occurs. We adopted SFAS 123(R) using the modified prospectivetransition method, which requires the application of SFAS123(R) as ofJanuary 1, 2006. Our Condensed Consolidated Financial Statements as of andfor the three months ended March 31, 2006 reflect the impact of SFAS123(R).

In accordance with the modified prospective transition method, ourCondensed Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). Thisstatement requires us to estimate the fair value of share-based payment awardson the date of grant using an option-pricing model. The value of the portion ofthe award that is ultimately expected to vest is recognized as expense over therequisite service periods in our Consolidated Statement of Operations.Stock-based compensation expense recognized under SFAS 123(R) for the threemonths ended March 31, 2006 was $3.1 million which consisted ofstock-based compensation expense related to employee stock options grantedduring the last four years (vesting period). Prior to the adoption of SFAS123(R), we accounted for stock-based awards to employees using the intrinsicvalue method in accordance with APB 25 as allowed under SFAS No. 123, *Accounting for Stock-Based Compensation*(“SFAS 123”). Otherthan noted in Note 3, “Restatement of Condensed Consolidated FinancialStatements”, we have generally not recorded compensation expense for optionsgranted to our employees because all options granted under our stock optionplans have an exercise price equal to the market value of the underlying commonstock on the date of grant.

OnNovember 10, 2005, the Financial Accounting Standards Board (“FASB”)issued FASB Staff Position No. FSP123(R)-3, *TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards.*We elected to adopt the alternative transition method provided in the FSP forcalculating the tax effects of stock-based compensation pursuant to SFAS123(R). The alternative transition method includes simplified methods toestablish the beginning balance of the additional paid-in capital pool (“APICpool”) related to the tax effects of employee stock-based compensation, and todetermine the subsequent impact on the APIC pool and Condensed ConsolidatedStatement of Cash Flows of the tax effects of employee stock-based compensationawards that are outstanding upon adoption of SFAS 123(R).

The weighted-average grant date fair value of stockoptions granted during the three months ended March 31, 2006 and 2005, was$8.06 and $7.63, respectively, using the Black-Scholes option-pricing modelwith 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 stock optionsrepresents the weighted-average period the stock options are expected to remainoutstanding. The following factors were considered in estimating the expectedterm 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) Weused a 3-year historical stock-price volatility as the expected volatilityassumption which aligns with the expected term of the options granted duringthe three months ended March 31, 2006. We believe that historicalvolatility reflects our current assessment of implied volatility. Prior to2006, we used historical stock price volatility in accordance with SFASNo. 123 for purposes of our pro forma disclosure.

(3) Forfeiturerate was computed taking into consideration the historical forfeiture rates.SFAS No.123(R) requires forfeitures to be estimated at the time of optiongrants and revised, if necessary, in subsequent periods if actual forfeiturediffers from those estimates. Prior to adoption of SFAS No.123(R), our proforma disclosures accounted for actual forfeitures as they occurred.

(4) Therisk-free interest 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 7 to the Condensed Consolidated Financials Statement includedelsewhere in this report for discussion on stock- based compensation.

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**Results of Operations**

The table below showsoperating data as a percentage of total revenue for the three months endedMarch 31, 2006 and 2005.
| ** **                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                         | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **As Restated (1)**                    | ** ** | **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            |       | 4                                                |       | 4 |   |
| Acquired in-process  research and development    |       | —                                           |       | 22 |   |
| Operating income (loss)                          |       | 0                                                |       | (23 | ) |
| Interest and other income, net                   |       | 2                                                |       | 0 |   |
| Income (loss) before  provision for income taxes |       | 2                                                |       | (23 | ) |
| Provision for income taxes                       |       | 0                                                |       | 0 |   |
| Net income (loss)                                |       | 2                                                | %          | (23 | )% |

 

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(1)See Note 3, “Restatement of Condensed Consolidated Financial Statements,” ofthe Notes to the Condensed Consolidated Financial Statements included elsewherein this report.

*Revenue*

Totalrevenue increased 25% in the first quarter of 2006, as compared to the firstquarter of 2005, to $51.5 million. The increase in total revenue can beattributed to both continued growth of our business and sales and relatedservices derived from our Blue Pumpkin acquisition, which expanded ourworkforce optimization solution. The number of installed customer sites grew to4,330 as at March 31, 2006 from 3,846 sites as at March 31, 2005.

Product revenue includessoftware revenue and hardware revenue. Hardware sales are incidental toour business, and we are working toward transitioning our customers tothird-party hardware suppliers. We expect hardware revenue to decline in thefuture. Product revenue of $18.3 million, excluding hardware revenue of $1.6million in the first quarter of 2006 (and $1.3 million in the same period in2005), increased $3.2 million, or 21% in the first quarter of 2006. Theincrease in software revenue growth in 2006 is largely attributed to ourexpanded product line, especially Impact 360. Our Impact 360 solution consistsof software products and services designed to optimize the workforce, processesand technology involved in the customer service function.

Product revenue as apercentage of total revenue has been decreasing slightly over the past threeyears due to increased services revenue, as discussed below. Our productpricing has remained reasonably consistent over the previous three years.

New customers accounted for15% and 21%, respectively, of product revenue, excluding hardware revenue,during the first quarters of 2006 and 2005. We receive follow-on revenue fromour existing customers when they purchase additional user licenses or licenseadditional applications at existing sites and when they license our products atnew sites. We expect to continue receiving the majority of our product revenuefrom existing customers during 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 has historicallyexceeded 90%. We believe that maintenance contracts will be renewed at acomparable rate during 2006. Our services pricing has remained consistent overthe past three years. We expect services revenue, in absolute dollars, toincrease over

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timedue to the compounding effect of renewals of annual maintenance contracts fromexisting customer sites and to remain relatively constant as a percentage oftotal revenue, excluding hardware revenue, throughout 2006.

*Cost of Revenue*

Total cost of revenueincreased 18% to $16.3 million in the first quarter of 2006 compared to thefirst quarter of 2005. Expressed as a percent of revenue, gross profit marginhas increased to 68% in the first quarter of 2006 compared to 66% in the sameperiod in 2005**.**This increase resulted primarilyfrom an increase in service revenue gross margins. Excluding hardware cost ofrevenue and the amortization of intangible assets resulting from acquisitions,gross profit margins increased slightly to 75% in the first quarter of 2006from 74% in the first quarter of 2005. We expect our gross profit margin,excluding hardware and amortization of intangible assets, to remain relativelyconstant throughout 2006.

Cost of product revenueconsists of amortization of acquired technology, hardware costs, royalties dueto third parties for software components that are embedded in our softwareapplications, amortization of capitalized software development costs andpackaging costs. Amortization of acquired technology was $2.3 million in the firstquarter of 2006 compared to $1.9 million in the same period in 2005. Cost ofhardware revenue was $1.7 million in the first quarter of 2006 and $1.3 millionin the same period of 2005. We will continue to incur amortization expense, butexpect the cost of hardware to decline as we work towards reducing the amountof hardware sales in the future. Cost of product revenue, excludingamortization of acquired technology and hardware costs, decreased 31% in thefirst quarter of 2006 compared to the same period in 2005. This decreasewas due to lower royalties expense during the first three months of 2006compared to the same period of 2005. Royalties expense relate to third partiesfor software components that are embedded in our software applications. Such royaltiesvary period-over-period in proportion to the sales of certain products. Thecost of product 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 forinstallation, training, consulting and maintenance services include personnelcosts and related expenses and allocated overhead. Personnel costs includesalaries, bonuses and benefits. Cost of services revenue increased 23% to $11.8million in the first quarter of 2006 compared to the same period in 2005, dueprimarily to an increase in the number of employees engaged in customer supportservices. Cost of services revenue as a percentage of services revenuedecreased to 37% of total services revenue in the first quarter of 2006 from38% in the same period in 2005 due to productivity improvements in theprofessional services group. We anticipate that our services margins willremain relatively consistent throughout 2006. We expect our customer service organizationto continue to grow over time and, therefore, we anticipate that our cost ofservices revenue, in absolute dollars, will increase as we grow our customerbase.

*Operating Expenses*

*Selling,General and Administrative.*Selling, general and administrative (“SG&A”) expense consistsprimarily of personnel costs, sales commissions, marketing programs,professional fees, the amortization of certain intangible assets and provisionsfor bad debt expense. SG&A expense increased 26% to $25.2 million in thefirst quarter of 2006 compared to the same period in 2005 due primarily to $2.5million in stock compensation expense and $2.3 million in legal, professionaland personnel costs. Certain increases in SG&A costs, especially personnel,during 2006 were affected by the Blue Pumpkin and Optimis acquisitions during2005. We expect SG&A expense to increase quarterly in 2006 in absolutedollars but decrease as a percentage of total revenue due to anticipatedrevenue growth.

*Researchand Development.*Research and development (“R&D”) expenses consist primarily of personneland consulting costs to support product development, and allocated overhead.R&D costs are expensed as incurred and include software development costsincurred prior to the establishment of technological feasibility. Costsincurred subsequent to establishing technological feasibility are capitalizedand amortized over the asset’s estimated useful life to cost of productrevenue.  Software developmentcapitalization increased to $1.2 million as of March 31, 2006 from $0.9million as of March 31, 2005. Cost of product revenue during the threemonths ended March 31, 2006 and 2005 includes amortization of capitalizedsoftware development costs of $0.9 million and $0.1 million, respectively.R&D expenses increased 29% to $8.0 million in the first quarter of 2006compared to the same period in 2005, primarily due to the increased number ofemployees engaged in research and development activities. We expect totalR&D expense to increase quarterly in absolute dollars but decrease as apercentage of total revenue during 2006.

*Merger-relatedand Integration Costs*.During the first quarter of 2006, we incurred merger-related and integrationcosts in the amount of $2.1 million pertaining to the acquisition of BluePumpkin. These expenses were primarily incurred for legal, professional feesand a discount on shares sold to the Blue Pumpkin Shareholders. During thefirst quarter of 2005 we incurred $1.7 million in merger-related andintegration costs due to the January 2005 acquisition of Blue Pumpkin.

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*AcquiredIn-Process Research and Development.*During the first quarter of 2005, we estimated that $9.0 million of thepurchase price of Blue Pumpkin represented acquired in-process research anddevelopment (“IPR&D”) that had not yet reached technological feasibility asdefined by SFAS No. 86,*Accounting forthe Cost of Computer Software to Be Sold, Leased or Otherwise Marketed,*and had no alternative future use. Accordingly, these amounts were immediatelycharged to expense upon consummation of the acquisition. The value of theIPR&D was determined with the assistance of an independent third-partyappraiser by utilizing a discounted cash flow methodology, focusing on theincome-producing capabilities of the in-process technologies and taking intoconsideration: stage of completion; complexity of work to date and to complete;anticipated product development and introduction schedules; forecasted productsales cycles; internal and external risk factors; revenue and operating expenseestimates; contributory asset charges, and costs already incurred and theexpected costs to complete.

*Interest and Other Income, Net*

Interest and other income, net for the three monthsended March 31, 2006 and 2005, respectively is as follows (in thousands):
| ** **            | ** ** | **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 increase in 2006compared to 2005 due to higher cash and investment balances resulting from ourcommon stock offering in December 2005.

*Provision for Income Taxes*

We recorded a provision for income tax of $0.2 millionand $33 thousand, respectively, in the first quarter of 2006 and 2005. As ofDecember 31, 2005, we had net operating loss carryforwards aggregating$82.2 million for U.S. tax purposes and $37.8. million for foreign taxpurposes. 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 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, wehad $12.8 million available under a line of credit, which was net ofoutstanding letters of credit of $2.2 million. The letters of credit secure thelease on the corporate headquarters facility and have decreasing schedules thatultimately expire in 2007. At our election, borrowings under the line of creditbear interest at the bank’s prime rate, which was 7.75% on March 31, 2006,or LIBOR plus 300 basis points, and are limited to 85% of eligible accountsreceivable, as defined by the agreement. The revolving line of credit issecured by all of our assets and requires compliance with various covenants,including liquidity ratios and EBITDA requirements, among others. As of March 31,2006, we were in compliance with all bank covenants.

We anticipate that operating expenses and capitalexpenditures will continue to be a material use of our cash resources. Wecurrently expect to have total capital expenditures of approximately $5.5 millionin 2006. We believe that our capital expenditures may increase overthe next several years as we expand our facilities and acquire equipment tosupport the expansion of our research and development activities and internalmanagement and information systems.

We believe that our existingcash and investment balances, together with our anticipated cash flows fromoperations, will be sufficient to meet our working capital and capitalexpenditures for at least the next twelve months. In addition, the availabilityunder our line of credit may be used to fund working capital requirementsor future merger or acquisition transactions.

*Market Risk*

Market risk represents therisk of loss that may affect us due to adverse changes in financial marketprices and rates. Our market risk exposure primarily relates to fluctuations inforeign exchange rates and interest rates. We have not entered into derivativeor hedging transactions to manage risk in connection with foreign exchangefluctuations and have not engaged in any interest rate hedging transactions.

Within our foreign-basedoperations, where transactions may be denominated in foreign currencies,we are subject to market risk with respect to fluctuations in the relativevalue of currencies. Currently, we have foreign-based operations in Australia,Brazil, Canada, China, Germany, India, Japan, Mexico, the Netherlands,Singapore, South Africa and the United Kingdom that conduct transactions ineither the local currency of the location or the U.S. dollar. We are exposed toadverse movements in foreign currency

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exchange rates because we translate foreigncurrencies into U.S. dollars for reporting purposes. Historically, these riskshave been minimal, but as our international operations continue to grow,adverse currency fluctuations could have a material adverse impact on ourfinancial results. Net foreign exchange losses were $0.1 million and $0.2million in the three months ended March 31, 2006 and 2005, respectively.

Exposure to market rate risk for changes in interestrates relates to our investment portfolio and any potential borrowing. Ourinvestments 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 portfolio. Our investment portfoliomay contain securities with maturities of up to three years. While thisminimizes our interest rate risk to asset values, our results are exposed tofluctuations in interest income due to changes in market rates.

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

Information concerning market risk is included inManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, Item 2 of Part I of this Report.

**Item 4.Controls and Procedures**

***Evaluation ofDisclosure Controls and Procedures***

We conducted an evaluationof the effectiveness of our disclosure controls and procedures (as defined inRules 13a-14 and 15d-14 under the Securities Exchange Act of 1934), as ofthe end of the period covered by this quarterly report. This evaluation wasconducted under the supervision and with the participation of our management,including the Chief Executive Officer and Chief Financial Officer. Based onthis evaluation, as of the quarter ended March 31, 2006, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are not effective due to the material weaknessesdiscussed below.

(1)           Our policies and procedures over account reconciliationsand management’s review of estimates and account balances were not designed toa sufficient level of precision to prevent or detect misstatements that couldhave a material effect on the Consolidated Financial Statements. As a result,there were errors to the Consolidated Financial Statements that were notidentified or recorded by management. This deficiency resulted in more than aremote likelihood that a material misstatement to the Consolidated FinancialStatements would not be prevented or detected.

(2)           Sincethe Company’s original 2005 Form 10-K was filed on March 17, 2006, an additionalmaterial weakness in the Company’s internal control over financial reporting asof December 31, 2005 has been identified. At December 31, 2005, the Company did not have effective policies andprocedures to determine the cost of an acquired enterprise in a businesscombination in accordance with U.S. generally accepted accountingprinciples.  Specifically, the Company’spolices and procedures did not provide for appropriate consideration of fundsheld in escrow for pre-acquisition contingencies.  This material weakness resulted in errors inrestricted cash, accrued liabilities, and stockholders’ equity as of December31, 2005. 

In the quarter endedMarch 31, 2006, management made significant progress in remediating thematerial weakness by:

·                  Revisingour policies 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;

·                  Revisingour control procedures through the addition of more effective controls toensure the 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 materialweaknesses have been remediated. Management believes the above new policies andprocedures, when fully implemented, will be effective in remediating thesematerial weaknesses.

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 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.

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*Restatementof Condensed Consolidated Financial Statements, Special Committee and CompanyFindings*

Beginning in late May 2006, the Company’s managementinitiated a preliminary internal review of the Company’s historical stockoption practices and related accounting treatment in response to general mediaattention concerning stock option grants at various public companies andshareholder interest with respect to this particular issue. On August 8, 2006,in response to the results of management’s preliminary internal review, ourBoard of Directors voluntarily formed a Special Committee of independentdirectors to review our stock option practices and grants during the periodbetween the date of the Company’s initial public offering on February 10, 2000and August 31, 2002.  The SpecialCommittee undertook its investigation with the assistance of independentcounsel and accounting experts retained by its counsel. The Special Committeereviewed all 5.7 million stock options granted throughout the period covered byits investigation. In December 2006, the Special Committee completed its reviewand reported its findings and recommendations to our full Board of Directors.The Special Committee did not find fraud or intentional misrepresentation inthe financial reporting of the option grants that it analyzed but foundinaccuracies in the determination of measurement dates for certain stock optiongrants affecting the Company’s accounting and disclosures. For a number ofthese grants, the Special Committee found that it was likely that the statedgrant date was selected in hindsight based on price given the lack ofsupporting documentation and that the option price was the low price in a givenmonth or quarter. Such grants were found to be present during 2000 and throughapproximately mid-year 2001. The Special Committee concluded that it was notnecessary to expand the investigation to cover periods after August 31, 2002.Among the various key considerations in reaching this conclusion were: 1) asnoted above, the Special Committee did not find fraud or intentionalmisrepresentation in the financial reporting of the option grants that itanalyzed; 2) the Special Committee’s investigation found that the last instanceof likely grant date selection based on stock price  occurred in mid-2001; and 3) the SpecialCommittee observed that the option granting practices of the Company becamemore formal and regularized during the latter phase of the period subject toits review. 

In addition to theSpecial Committee investigation, the Company, with the assistance of outsidelegal counsel, reviewed the Company’s stock option practices and grants for theperiods subsequent to August 31, 2002. This review evaluated 90 percent of the11.1 million options granted after August 31, 2002. The review was designed notonly to provide a high degree of grant review coverage, but also toappropriately assess the propriety of measurement dates for each of the varioustypes of options granted during this period. Among others, option grant types covered included: 1) new employeegrants in connection with the acquisition of businesses; 2) semi-annualemployee ranking grants; 3) routine non-officer grants for such events as newhires, promotions, sales achievement, etc; and 4) officer grants, includinggrants to the Company’s then CEO. This review did not find fraud or intentionalmisrepresentation in the financial reporting relating to option grants butidentified errors in the determination of measurement dates. However, sucherrors were relatively immaterial and did not exhibit evidence of selection ofa favorable grant date and price in hindsight.  

In those instancesduring the two review periods where the fair market value of our common stockat the originally stated grant date was lower than the fair market value on theredetermined measurement date, in accordance with Accounting Principles BoardNo. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and relatedinterpretations, we concluded that we should have recorded stock-basedcompensation expense which was not accounted for in our previously issuedConsolidated Financial Statements.

As described in Note 3, “Restatementof Condensed Consolidated Financial Statements,” of the Notes to CondensedConsolidated Financial Statements, our Condensed Consolidated FinancialStatements has been restated to correct errors in the recognition ofstock-based compensation expense for previously granted stock options. Althoughthere were no option measurement dating issues, our 2006 Condensed ConsolidatedFinancial Statements are impacted by option grants in prior years where themeasurement dates have been adjusted.

Following the SpecialCommittee’s findings and recommendations, and in an effort to strengthen ourcorporate governance mechanisms, the Board of Directors voted to separate thepositions of Chairman of the Board and CEO and elected Mr. Dan Lautenbach, amember of the Company’s Board of Directors since 2002 and a member of theSpecial Committee, as Chairman of the Board, effective December 6, 2006.  Mr. Lautenbach succeeded Mr. David Gould, whovoluntarily agreed to step down as Chairman of the Board of Directors.

In addition, followingthe Special Committee’s findings and recommendations, Mr. Gould voluntarilyagreed to resign from his position as CEO and as a member of the Company’sBoard of Directors effective January 3, 2007. The Board of Directors appointed Mr. Nicholas Discombe, the Company’sformer President and Chief Operating Officer, as the Company’s new CEO and as amember of the Company’s Board of Directors effective January 3, 2007.

In further response tothe Special Committee’s recommendations, and in a further effort to strengthenour management and controls and corporate governance mechanisms, we have nameda new General Counsel and plan to realign certain responsibilities in financialreporting areas. Management believes that the above measures will address thefindings and recommendations of the Special Committee and strengthen ourmanagement and controls and corporate governance mechanism.

We believe that ourcurrent practices for granting stock options and determining measurement datesare appropriate and that adequate controls are in place. Most of the $9.5million additional stock-based compensation reflected in our restatedConsolidated Financial Statements resulted from the use of inaccuratemeasurement dates during 2000 and 2001. Since 2001, the Company has implemented improvements in its processes,personnel and practices to enhance its internal controls over the issuance ofstock option grants.  Examples of theseimprovements include:

i)                 Change inprocess:  Beginning in 2002, the Companyenhanced its internal controls over stock option grant practices and reducedthe risk of using inaccurate measurement dates by complying with the new SECrequirement of filing Form 4s within two days of the date of grant.

ii)              Change inpersonnel:  A number of people with priorpublic Company experience joined the Company in 2001and 2002 and becameresponsible for key elements of the stock option process.  New additions included the Chief FinancialOfficer, the Chairman of the Compensation Committee of the Board of Directorsand the Director of Human Resources.

iii)           Change inpractices:  The internal practices ofdocumenting, approving, recording and reporting stock options grants have beenenhanced and become more formalized, especially since 2004, when the processbecame subject to internal control assessments pursuant to the Sarbanes OxleyAct.

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There were no changes, otherthan as discussed above, in our internal controls over financial reporting thatoccurred during the period covered by this quarterly report that havematerially affected, or that are reasonably likely to materially affect, ourinternal controls over financial reporting.

**PART II.OTHER INFORMATION**

**Item 1.Legal Proceedings**

In January 2001, IEX Corporation filed a lawsuitagainst Blue Pumpkin in the United States District Court for the EasternDistrict of Texas, Sherman Division (“Texas IEX action”), alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the‘355 Patent”) by making and selling certain workforce management and callrouting software products, including Blue Pumpkin’s Prime Time Skills and PrimeTime Enterprise products. IEX’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 filed in theUnited States District Court for the Northern District of Georgia, AtlantaDivision, a lawsuit against IEX Corporation alleging patent infringement(“GeorgiaIEX Action”). Specifically, Blue Pumpkin has alleged that IEX products infringeclaims of U.S. Patent No. 6,952,732 (“the ‘732 Patent”), entitled “Methodand apparatus for multi-contact scheduling.” Blue Pumpkin’s lawsuit seeks aninjunction and money damages for IEX’s infringement of the ‘732 Patent.

On December 15, 2005, IEX and Blue Pumpkinreached a tentative agreement to settle all claims asserted between them. OnApril 6, 2006, Blue Pumpkin and IEX reached an agreement to settle allclaims asserted between. As part of the final settlement, Witness paid$8.25 million to Tekelec,  IEX’s parentcompany, in April 2006 and agreed to make six annual payments of $0.5million ($3.0 million in total) from April 2007 through 2012.

On December 11, 2002, we filed in the UnitedStates District Court for the Northern District of Georgia, Atlanta Division, alawsuit against Knowlagent, Inc. (“Knowlagent”), which is the assignee ofUnited States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagenthas accused our eQuality Now software of infringing the above patents. We filedsuit seeking a declaration that we did not and do not infringe either of thetwo patents listed above, as well as a declaration that the above patents areinvalid and unenforceable. We also filed a claim requesting that if the patentsare found to be valid, that one of our own employees be named the rightfulinventor of the patents. We also requested monetary damages in an amount equalto the amount that Knowlagent has received from its use of the above patents.On December 31, 2002, Knowlagent filed its answer to our complaint as wellas two counterclaims, alleging that we infringe and contribute to theinfringement by others of the above patents; Knowlagent seeks both monetarydamages and an injunction in connection with its counterclaim. On June 6,2005, the Court held a claim construction hearing and issued a claimconstruction order on June 8, 2005. The case is now proceeding to expertdiscovery and summary judgment phases.

On July 20, 2004, STS Software Systems Ltd. (“STSSoftware”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICE Ltd.”),filed a patent infringement suit in the U.S. District Court for the SouthernDistrict of New York against us (“New York Action”). The New York Actionasserts that our products, including eQuality ContactStore for IP, infringeUnited States (“U.S.”). Patent No. 6,122,665 (“the ‘665 patent”) and seeksonly injunctive, not monetary, relief. On the same day, we filed a declaratoryjudgment action against STS Software in the U.S. District Court for theNorthern District of Georgia (“Georgia Action”). We seek a declaration from thecourt that we have not infringed any valid claim of the ‘665 patent. By Orderentered December 16, 2004, Judge Koeltl of the U.S. District Court for theSouthern District of New York granted our motion to transfer the New YorkAction to the Northern District of Georgia, which has now consolidated theformer New York Action with the Georgia Action. On July 7, 2005, the Courtalso granted STS leave to amend its complaint to add three patents to thedispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and 6,880,004(respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004 patent”;collectively, “the STS patents”), again seeking solely injunctive relief. Weanswered the first amended complaint and asserted counterclaims onJuly 29, 2005, collectively, through which we deny infringement of anyvalid claim of the STS patents and seek a declaration to that effect. The casehas been set on a discovery calendar and is at a preliminary stage.

On August 30, 2004, we filed in the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. (“NICE Inc.”), a wholly-ownedsubsidiary of NICE Ltd., alleging patent infringement. Specifically, wehave alleged that NICE products, including the NiceUniverse products thatinclude screen capture and synchronized screen and voice capture technologies,infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220(“the ‘220 Patent”), both entitled “Method and Apparatus for SimultaneouslyMonitoring Computer User Screen and Telephone Activity from a Remote Location.”We have sought an injunction and money damages for NICE’s infringement of thesetwo patents. NICE Inc. has answered and counterclaimed for declaratoryjudgments of non-infringement and invalidity. Since then, on February 24,2005, we filed suit against NICE Ltd. because of its infringing activitiesin violation of the ‘798 and ‘220 patents, including importation of the accusedNICE products. By order dated April 5, 2005, 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.

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On January 19, 2006, wefiled in the United States District Court for the Northern District of Georgia,Atlanta Division, a lawsuit against NICE Systems, Inc. and NICE Systems,Ltd. (collectively “NICE”), alleging patent infringement. Specifically, we havealleged that NICE products, including NicePerform and related productsthat include the ability to monitor communications to detect the presence of atleast one predetermined parameter, infringe claims of U.S. PatentNo. 6,404,857 B1 (“the ‘857 Patent”), entitled “Signal MonitoringApparatus for Analyzing Communications.” We have sought an injunction and moneydamages for NICE’s infringement of the ‘857 patent. On March 6, 2006, NICEfiled its answer to the complaint and a counterclaim, alleging that the ‘857patent is not infringed and is invalid, and this case is at a preliminarystage.

On August 29, 2006, A. Edward Miller filed ashareholder derivative lawsuit in the United States District Court for theNorthern District of Georgia (Atlanta Division) naming Witness Systems, Inc. asa nominal defendant and naming all of our current directors and a number of ourcurrent officers as defendants.  Miller v. Gould, et al., Civil Action No.1:06-CV-2039 (N.D. Ga.).  The complaint alleges purported violations offederal and state law, including breaches of fiduciary duty, abuse of control,constructive fraud, corporate waste, unjust enrichment, gross mismanagement andviolations of certain antifraud provisions of the federal securities laws(including Sections 10(b) and 14(a) of the Securities Exchange Act of 1934 andRules 10b-5 and 14a-9 thereunder) in connection with certain stock optiongrants made by the Company.  The complaint seeks monetary damages inunspecified amounts, disgorgement of profits, an accounting, rescission ofstock option grants, imposition of a constructive trust over the defendants’ stockoptions and proceeds derived therefrom, punitive damages, reimbursement ofattorneys’ fees and other costs and expenses, an order directing the Company toadopt or put to a stockholder vote various proposals relating to corporategovernance, and other relief as determined by the court.  On November 15,2006, the Company and the other defendants filed a motion to dismiss thecomplaint in its entirety on a variety of grounds, including plaintiffs’failure to allege demand futility. Rather than respond to that Motion, plaintiffs on January 9, 2007 filedan Amended Complaint.  The Company andits directors intend to review the allegations of the Amended Complaint andrespond when appropriate.

A class action securities lawsuit was filed onAugust 14, 2006, by an individual claiming to be a stockholderof the Company naming the Company and certain of its directors and officers asdefendants in connection with certain stock option grants made by theCompany.  Rosenberg v. Gould, et al., Civil Action No. 1:06-CV-1894 (N.D.Ga.).  The complaint, filed in the United States District Court for theNorthern District of Georgia, alleges violations of Section 10(b) of theSecurities Exchange Act of 1934 and Rule 10b-5 thereunder and seeks unspecifieddamages, attorneys’ fees and other costs and expenses, unspecifiedextraordinary, equitable and injunctive relief, and other relief as determinedby the court.  Neither a lead plaintiff nor lead counsel has beenappointed, nor has a response to the complaint yet been required. The Companyand the other defendants will respond to the complaint when appropriate.

On October 27, 2006, the Company received a notice ofinformal nonpublic inquiry from the SEC requesting certain documents andinformation relating to the Company’s stock option grant practices fromFebruary 2000 to the present. The Company intends to cooperate fully with allmatters related to this request.

From time to time we may be involved in other legalproceedings and/or litigation arising in the ordinary course of our businessthat might impact on our financial position, our results of operations, or ourcash flows.

**Item 1A Risk Factors**

Our future operating results may varysubstantially from period to period. The price of our common stock willfluctuate in the future, and an investment in our common stock is subject to avariety of risks, including, but not limited to, the specific risks identifiedbelow. Inevitably, some investors in our securities will experience gains whileothers will experience losses depending on the prices at which they purchaseand sell our 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.

*SECInquiry and Litigation Relating to Stock Options.*

Although a SpecialCommittee of our independent directors has completed its review of our stockoption grants and practices in the period between February 10, 2000 and August31, 2002 and management has completed its review of our option grants afterthat period, an informal inquiry by the SEC relating to our stock optiongranting practices remains pending, as does derivative and class actionlitigation against the company and certain of its directors and officers.Although we believe that we have made appropriate corrections to the financialstatements set forth in this report for matters relating to stock options, wecannot rule out the possibility that these proceedings may require furtheradjustments to the financial results and other disclosures set forth in thisreport. In addition, these proceedings are likely to result in additional legalexpense that may affect our results in future periods, and may also result indiversion of management attention and other resources, as well as fines,penalties, damages and other sanctions.

*If wedo not maintain compliance with the listing requirements of the Nasdaq StockMarket, our common stock could be delisted,*

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*whichcould, among other things, reduce the price of our common stock and the levelsof liquidity available to our stockholders.*

In connection with the Special Committee’s review andthe restatement of our Consolidated Financial Statements, we did nottimely file certain of our periodic reports with the SEC.  As a result, wewere not in compliance with the listing requirements under the Nasdaq  Rules. Following a review and hearingprocess with the Nasdaq, the Nasdaq has permitted our securities to remainlisted. However, our securities could be delisted in the future if we do notmaintain compliance with applicable listing requirements. If our securities aredelisted from the Nasdaq, they would subsequently be transferred to theNational Quotation Service Bureau, or “Pink Sheets”. The trading of our commonstock through the Pink Sheets may reduce the price of our common stock andthe levels of liquidity available to our stockholders. In addition, the tradingof our common stock through the Pink Sheets could materially andadversely affect our access to the capital markets and our ability to raisecapital through alternative financing sources on terms acceptable to us,or to raise capital at all. Securities that trade through the PinkSheets are no longer eligible for margin loans, and a companytrading through the Pink Sheets cannot avail itself of federal preemptionof state securities or “blue sky” laws, which adds substantial compliance coststo securities issuances, including pursuant to employee option plans, stockpurchase plans and private or public offerings of securities. If we aredelisted in the future from the Nasdaq and transferred to the Pink Sheets,there could also be other negative implications, including the potentialloss of confidence by suppliers, customers and employees and the loss ofinstitutional investor interest in our Company.

*Because our products have along sales cycle, it is more difficult to plan our expenses and forecast ourresults; and our operating results may fail to meet investor expectationsand may fluctuate materially from period to period, whichmay adversely affect our stock price.*

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

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

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

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

·                  customers’budgeting and purchasing cycles;

·                  economicfactors;

·                  theextent of customers’ 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 servicesare not used and accepted by existing and prospective customers, our businessand results of operations will be adversely affected.*

The market for workforce optimization software,including software that records and analyzes customer interactions and thatforecast and schedules employees, is still developing. Our success depends onthe use and acceptance of our software and services by existing and prospectivecustomers. In addition, demand for our software remains uncertain because ourexisting and potential customers may:

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

·                  notachieve favorable results using our software;

·                  experiencetechnical difficulty in implementing our software;

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

·                  closecontact centers.

*If we experience losses inthe future, the market price of our common stock may be materially andadversely affected.*

Throughout much of our history, we have experiencedlosses. As a result of our prior operating losses, we had an accumulateddeficit of $51.9 million as of March 31, 2006. We need to generatesufficient revenue to achieve sustained profitability and avoid incurringlosses again in the future.

*Our quarterly results aredifficult to predict and adverse fluctuations in operating results could causeour stock price to fall.*

Our quarterly revenue and operating results aredifficult to predict and could fluctuate significantly from period to period.In particular, we typically derive a significant portion of our softwareproduct revenue toward the end of each quarter and from a small number of relativelylarge orders. The delay or failure to close anticipated sales in a particularquarter could reduce our revenue in that quarter and subsequent quarters overwhich revenue for the sale could be recognized. In addition, because ourrevenue from installation and training services largely correlates with ourproduct revenue, a decline in product revenue could also cause a decline in ourprofessional services revenue in the same quarter or in subsequent quarters.Our quarterly revenue is difficult to forecast for several reasons, includingthe following:

·                  changesin demand for our products and services;

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

·                  lengtheningof our customers’ budgeting and purchasing cycles;

·                  timingof any acquisitions and related costs;

·                  delaysin installations of our software;

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

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

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

·                  thedevelopment and performance of our distribution channels.

As a result of these and other factors, we believethat quarter-to-quarter comparisons of our operating results may not be agood indicator of our future performance, and you should not rely on them topredict 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 tomanage and expand our international operations, which may adversely affectour business 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 inJanuary 2005 and Optimis in May 2005 both of which have sales outsideof North America, we have expanded our international operations, and we intendto continue to expand our international operations through additionalacquisitions, internal business expansion and strategic business relationships.These efforts require significant management attention and financial resources.We may not be able to successfully penetrate international markets or, ifwe do, we may not be able to grow or to maintain adequate profit margins inthese markets. Because of the complex nature of our international expansion, itmay adversely affect our business and operating results. Internationalexpansion and sales are subject to many risks,

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includingthe following:

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

·                  expandingand training our international sales force and support operations;

·                  highercosts of employment in certain international locations;

·                  difficultiesin producing localized versions of our products;

·                  politicaland economic instability;

·                  potentiallyadverse tax consequences of operating in foreign countries;

·                  import and export restrictions andtariffs;

·                  longerpayment cycles and difficulties in collecting accounts receivable;

·                  currencyfluctuations;

·                  culturaldifferences which may affect workforce performance and sales processes;

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

·                  unexpectedchanges in regulatory requirements.

As we further expand our operations outside the UnitedStates, we will also face new competitors and competitive environments. Inaddition to the risks associated with our domestic competitors, foreigncompetitors may pose an even greater risk, because they may possess abetter understanding of their local markets and have better workingrelationships with local infrastructure providers and others. In particular,because telephone protocols and standards are unique to each country, localcompetitors will have more experience with, and may have a competitiveadvantage in, these markets. We may not be able to obtain similar levelsof knowledge, which could place us at a significant competitive disadvantage.In addition, we have limited experience in developing local language versionsof our products or in marketing our products to international customers. Wemay not be able to successfully translate, market, sell, and deliver ourproducts internationally.

*If we are unable to maintaina productive direct sales force, our business and operating results could beadversely affected.*

We believe that our future success will depend onmaintaining a productive direct sales force. Historically, it has taken us upto six months to train new sales personnel before they reach an acceptablelevel of productivity. We have also experienced difficulty in recruiting salespersonnel with experience in computer and telephone integration technologies.We cannot assure you that we will be able to continue to manage turnover andhire new sales personnel to meet our needs. If the personnel we hire are lessqualified than we expect, it may take us more time to train them beforethey reach an acceptable level of productivity, which could increase our costsand reduce our revenue.

*If we are unable to expandthe distribution of our products through indirect sales channels, our businessand operating results could be materially adversely affected.*

Our strategy is to continue to increase the proportionof customers served through indirect sales channels, such as select resellersand a variety of strategic marketing alliances. Product revenue, excludinghardware revenue, from our indirect sales channel represented 31% and 42% oftotal product revenue in the first quarter of 2006 and 2005, respectively. Weexpect revenue from our indirect sales channel and, accordingly, our dependenceon distribution partners, to increase as we establish relationships withcompanies to resell our software worldwide. We cannot assure you that we willbe able to maintain productive relationships with our current partners, or thatwe will be able to establish similar relationships with additional resellers ona timely basis, if at all.

Some resellers with which we do business have similar,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 our products and the market for oursoftware and services and develop and sell competing products and services. Asa result, our relationships with resellers could lead to increased competitionfor us.

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*Competition in our businesscould adversely 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;

·                  largetelecom solution providers;

·                  enterprisesoftware vendors;

·                  systemsintegrators and consulting firms; and

·                  new,larger and more established entities that may acquire, invest in orform joint ventures with providers of recording or performance enhancingsoftware solutions.

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

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

We expect that competition will increase as otherestablished 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 salesof our quality monitoring and workforce management software exposes us to risksof obsolescence due to changes in competitive product offerings.*

We have derived a substantial portion of our productrevenues from sales of our quality monitoring and workforce management softwareproducts. We expect revenue from these products to continue to account for asignificant portion of our revenue for the foreseeable future. As a result, anyfactors affecting the markets for these products could materially and adverselyaffect our business, financial condition and results of operations. We cannotassure you that the market will continue to demand our current products or thatwe will be successful in marketing any new or enhanced products. If ourcompetitors release new products that are superior to our products inperformance or price, demand for our products may decline. A decline indemand for our products as a result of competition, technological change orother factors would reduce our total revenues and adversely affectprofitability.

*If we fail to develop newsoftware or improve our existing software, we may not be able to remaincompetitive.*

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The markets for our products are characterized byrapidly changing technology, frequent new product introductions andenhancements, changes in customer demands and evolving industry standards. Ourexisting products could be rendered obsolete if we fail to continue to advance ourtechnology. We have also found that the technological life cycles of ourproducts are difficult to estimate, partially because of changing demands ofour customers. We believe that our future success will depend on our ability tocontinue to enhance our current product line while we concurrently develop andintroduce new products that keep pace with competitive and technologicaldevelopments. These developments require us to anticipate customers’ futureneeds and to continue to make substantial product development investments.Although we are presently developing a number of product enhancements to ourproduct suites, we cannot assure you that these enhancements will be completedon a timely basis or gain customer acceptance. In addition, failure to developnew software or improve existing software products may adversely affectour ability to maintain our maintenance renewal rate which could adverselyaffect our revenue.

We have recently introduced Impact 360, which combinesa new software architecture with new combinations of our products. Our businessconcept in doing so is to create incremental value for our customers and to winbusiness away from competitors whose product offerings are more limited andrequire the customer to make additional hardware purchases to obtain thesolutions that our Impact 360 product offering provides in an integrated suite.While we plan and expect that this lower total cost of ownership will be wellreceived in the marketplace, we can offer no assurance that our new Impact 360offering will be successful. If our Impact 360 product offerings do not meetwith commercial success, our business would be materially and adverselyaffected.

*If our software development activities in the Asia-Pacific region arenot successful, we may not be able to meet our development schedules.*

We have expanded our software development capabilitiesin the Asia-Pacific region in order to optimize available research anddevelopment resources and better meet development timeframes. We have limitedexperience with remote software development activities. Accordingly, there area number of risks associated with this activity, including:

·                  delaysor product 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;

·                  highvoluntary personnel turnover; and

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

Our inability to meet development schedules because ofour reliance on developers in the Asia-Pacific region may affect ourability to enhance our current product line or introduce new products, whichwould have a material adverse affect on our financial results and could harmour reputation. The loss of key development personnel could have a materialadverse effect on our product development process and adversely affect futureproduct revenues.

*Our liability to customersmay be substantial 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. Courtsmay not enforce provisions in our contracts that would limit our liabilityor otherwise protect us from liability for damages. Although we maintaingeneral liability insurance coverage, including coverage for errors oromissions, this coverage may not continue to be available on reasonableterms or in sufficient amounts to cover claims against us. In addition, ourinsurer may disclaim coverage as to any future claim. If claims exceedingthe available insurance coverage are successfully asserted against us, or ourinsurer imposes premium increases, large deductibles or co-insurancerequirements on us, our business, financial position, and results of operationscould be adversely affected.

*If an original equipmentmanufacturer that is part of our indirect sales channel experiencestechnical difficulties, our product sales through that channel may beadversely affected.*

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

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happens,our software might not function properly, or the OEM might sell less of it, orboth, which could have a material adverse effect on our revenues,operating cash flows and the growth of our business.

*Our softwaremay contain undetected errors or “bugs,” resulting in harm to ourreputation and operating results.*

Software products as complex as those offered by usmight contain undetected errors or failures when first introduced or when newversions 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 foundmay cause substantial harm to our reputation and result in a loss inrevenue and additional unplanned expenses to remedy any defects.

*If our advanced compliancerecording applications fail to record high volume, full-time performance of ourcustomers’ interactions, we may be subject to liability and our reputationmay be harmed.*

Many of our customers use our advanced compliancerecording applications to record and store interactions with customers toprovide back-up and verification of transactions and to guard against risksposed by lost or misinterpreted voice communications. These customers rely onour applications to record, store and retrieve voice data in a timely, reliableand efficient manner. If our applications fail to record high volume, full-timeperformance of our customers’ interactions or our customers are unable toretrieve the recordings when necessary, we may be subject to liability andour reputation may be harmed.

*If we are unable to maintainthe security of our systems, our business, financial condition and operatingresults could be harmed.*

The occurrence or perception of security breaches inthe operation of our business or suffered by third parties using our productscould harm our business, financial condition and operating results. Ourcustomers use our products to compile and analyze highly sensitive orconfidential information. We may come into contact with such informationor data when we perform support or maintenance functions for our customers.While we have internal policies and procedures for employees performing thesefunctions, the perception that we have improperly handled sensitive,confidential information could have a negative effect on our business. If, inhandling this information, we fail to comply with privacy or security laws, wecould incur civil liability to government agencies, customers and individualswhose privacy is compromised. If personal information is received or used fromsources outside the U.S., we could be subject to civil, administrative orcriminal liability under the laws of other countries. In addition, while weimplement sophisticated security measures, third parties may attempt tobreach our security or inappropriately use our products through computer viruses,electronic break-ins and other disruptions. If successful, confidentialinformation may be improperly obtained and we may be subject tolawsuits and other liability. Any internal or external security breaches couldharm our reputation, and even the perception of security risks, whether or notvalid, could inhibit market acceptance of our products.

*Fluctuations in foreigncurrency exchange rates could affect our financial results.*

We may experience gains and losses resulting fromfluctuations in currency exchange rates. Moreover, in locations where we priceour products in U.S. dollars, our sales could be affected adversely by declinesin foreign currencies relative to the dollar, thereby making our products moreexpensive in local currencies. In locations where we sell our products in localcurrencies, we could be competitively unable to increase our prices to reflectfluctuations in exchange rates. We do not use derivative instruments to manageour foreign exchange risk, and we cannot predict the impact that futureexchange rate fluctuations may have on our results.

*Certain provisions inagreements that we have entered into may expose us to liability for breachthat is not limited 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 toperform to the standards required by these contracts, we could be subjectto additional liability and our business, financial condition and results ofoperations could be materially and adversely affected.

*If we fail to protect ourintellectual property, third parties may use our technology for their ownbenefit.*

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

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As of March 31, 2006, we had nine registeredtrademarks in the U.S. and nine U.S. and three international patents. We cannotassure you that we will file new patent or trademark applications, that anyfuture applications will be approved, that any existing or future patents,trademarks or copyrights will adequately protect our intellectual property orthat any existing or future patents, trademarks or copyrights will not bechallenged 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.

Moreover, the laws of certain foreign countries do notprotect our intellectual property rights to the same extent as do the laws ofthe United States. Furthermore, policing the unauthorized use of our productsis difficult, and litigation may be necessary in the future to enforce ourintellectual property rights, to protect our trade secrets or to determine thevalidity and scope of the proprietary rights of others. Litigation could resultin substantial costs and diversion of resources and could negatively affect ourfuture operating results.

*Claims by other companiesthat our software infringes their intellectual property could require us toincur substantial costs or prevent us from selling our software or services.*

It is possible that third parties will claim that wehave infringed their current or future products. We expect that we and otherparticipants in our industry will be increasingly subject to infringementclaims as the number of competitors and products grows. Any claims, with orwithout merit, which are generally uninsurable, could be time-consuming, resultin costly litigation, require us to reengineer or redevelop our software, causeproduct shipment delays or require us to enter into royalty or licensingagreements, any of which could negatively affect our operating results. Anyefforts to reengineer our software or obtain licenses from third partiesmay not be successful, could be extremely costly and would likely divertvaluable management and product development resources.

For example, claims have been asserted against us inlawsuits involving Knowlagent, STS and NICE (as described in Item 1, “LegalProceedings”, of Part II). We cannot assure you that we will be successfulin defending against the claims that have been asserted or any other claimsthat may be asserted. We also cannot assure you that such claims will nothave a material adverse effect on our business, financial condition, oroperations. Defending infringement claims or other claims involves substantialcosts and diversion of management resources. In addition, to the extent we arenot successful in defending such claims, we may be subject to injunctionswith respect to the use or sale of certain of our products or to liabilitiesfor damages to the claimants or to customers to whom we have indemnificationcommitments, and we may be required to obtain licenses which may notbe available on reasonable terms. In addition, we cannot assure you that legalaction claiming patent infringement will not be commenced against us, or thatwe would prevail in litigation given the complex technical issues and inherentuncertainties in patent litigation. In addition, users of our softwaremay become subject to claims if our software is alleged to infringe theintellectual property rights of others. These software users could attempt tohold us responsible for these claims and any resulting harm they suffer. If apatent claim against us were to be successful and we could not obtain a licenseon acceptable terms or license a substitute technology or redesign to avoidinfringement, we may be prevented from distributing our software orrequired to incur significant expense and delay in developing non-infringingsoftware. Such a result could have a material adverse effect on our business,financial condition and results of operations.

*If we are unable to maintainthe compatibility of our software with certain other products and technologies,our future business would be adversely affected.*

Our software must integrate with software and hardwaresolutions provided by a number of our existing and potential competitors. Forexample, our products must integrate with phone switches made by the telephoneswitch vendors and computer telephony software applications offered by othersoftware providers. These competitors or their business partners could altertheir products so that our software no longer integrates well with them, orthey could delay or deny our access to software releases that allow us totimely adapt our software to integrate with their products. If we cannot adaptour software to changes in necessary technology, it may significantlyimpair our ability to compete effectively, particularly if our software mustintegrate with the software and hardware solutions of our competitors.

*If our professional servicesemployees do not provide installation services effectively and efficiently, ourcustomers may not use our installation services or may stop using oursoftware.*

Our customers ordinarily purchase installation,training and maintenance services together with our products. The functionalityof our products is not dependent on our installation and training services. Webelieve that the speed and quality of

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installationservices are competitive factors in our industry. If our installation servicesare not satisfactory to our customers, the customers may choose not to useour installation services or they may not license our software in thefuture. As a result, we would lose licensing and services revenue, and it couldharm our 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 makeacquisitions or investments that are not successful and that adversely affectour ongoing operations.*

We may acquire or make investments in companies,products, services and technologies that we believe complement our business andassist us in quickly bringing new products to market. We have limitedexperience in making acquisitions and investments. As a result, our ability toidentify and evaluate prospects, complete acquisitions and properly manage theintegration of businesses is relatively unproven. If we fail to properlyevaluate and execute acquisitions or investments, it may have a materialadverse effect on our business and operating results. In making or attemptingto make acquisitions or investments, we face a number of risks, including:

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

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

·                  thepotential distraction of our management, diversion of our resources anddisruption of our business;

·                  retainingand motivating key employees of the acquired companies;

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

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

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

·                  accuratelyforecasting the financial impact of a transaction;

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

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

·                  potentiallydilutive issuances of securities as consideration for an acquisition;

·                  effectivelyintegrating acquired companies and achieving expected synergies; and

·                  theimpairment of the value of the assets acquired in any corporate acquisition.

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

Although we believe our current cash and borrowingcapacity will be sufficient to meet our anticipated cash needs for at least thenext 12 months and the foreseeable future, we may need additionalfunds to expand or meet all of our operating needs. If we need additionalfinancing, we cannot be certain that it will be available to us on favorableterms, or at all. If we raise additional funds by issuing equity securities orconvertible debt, the ownership interest of our stockholders could besignificantly diluted, and any additional equity securities we issuemay have rights, preferences or privileges senior to the rights of ourstockholders. Also, the terms of any additional financing we obtainmay significantly limit our future financing and operating activities. Ifwe need funds and cannot obtain them on acceptable terms, we may be unableto:

·                  developand enhance our software to remain competitive;

·                  takeadvantage of future opportunities, such as acquisitions;

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

·                  attractand retain qualified key personnel.

Any of these events could significantly harm ourbusiness and financial condition and limit our growth.

*Our inability to sourcehardware could harm our business.*

A number of customers expect us to source hardware tosupport the implementation of our software. We seek to reduce the amount ofhardware sales in the future and have transferred the fulfillment of hardwareorders to third-party distributors. Thus, we are largely dependent on thirdparties 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, wemay be required to locate alternative hardware sources. We are subject tothe following 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 are successful inlocating alternative sources of supply, alternative suppliers could increaseprices 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, whichmay result in additional expense, diversion of management attention andother resources, inability to fulfill customer orders or delay in fulfillment,reduction in quality and reliability, customer dissatisfaction, and otheradverse effects on our reputation, business and operating results.

*Failure to maintaineffective internal controls in accordance with Section 404 of theSarbanes-Oxley Act of 2002 could have a material adverse effect on ourbusiness, operating results and stock price.*

The Sarbanes-Oxley Act of 2002 imposes certain dutieson us and our executives, directors and attorneys. Our efforts to comply withthe requirements of Section 404 have resulted in increased general andadministrative expense and a diversion of management time and attention fromrevenue-generating activities to compliance activities, and we expect theseefforts to require the continued commitment of significant resources. We havereported material weaknesses in internal control over financial reporting whichwe found in connection with our evaluation of controls and procedures as ofDecember 31, 2005. If we fail to maintain the adequacy of our internalcontrols, we may not be able to ensure that we can conclude on an ongoingbasis that we have effective internal controls over financial reporting.Failure to maintain effective internal controls over financial reporting couldresult in investigation and/or sanctions by regulatory authorities, and couldhave a material adverse effect on our business and operating results, investorconfidence in our reported financial information, and the market price of ourcommon stock.

*Our stock price has beenvolatile.*

The market price of our common stock has been subjectto significant fluctuations in response to variations in quarterly operatingresults and other factors. In addition, the stock market has experiencedsignificant volatility that has particularly affected the market prices of equitysecurities of many technology companies and that often has been unrelated ordisproportionate to the operating performance of these companies. Anyannouncement with respect to any adverse variance in revenue or earnings fromlevels 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 benegatively affected by macro-economic or other external influences.*

Beginning in 2000, a declining United States economyadversely affected the performance of many businesses, especially within thetechnology sector. Reductions in the capital budgets of our customers andprospective customers have an adverse impact on our ability to sell oursolutions. Until late in 2003, we continued to experience effects from a weakspending environment for information technology in both the United States andEurope, in the form of delayed and cancelled buying decisions by customersfor

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oursoftware, services and hardware, deferrals by customers of service engagementspreviously scheduled and pressure by our customers and competitors to discountour offerings. If the current improvements now being seen in the generalbusiness climate do not continue, this would likely have a material adverseeffect on our business.

*Government regulation oftelephone and Internet monitoring could cause a decline in the use of oursoftware, result in increased expenses for us or subject our customers and usto liability.*

As the telecommunications industry continues toevolve, state, federal and foreign governments (including supranationalgovernmental organizations such as the European Union) and industryassociations may increasingly regulate the monitoring of telecommunicationsand telephone and Internet monitoring and recording products, such as oursoftware. We believe that increases in regulation could come in theform of a number of different kinds of regulations, including regulationsregarding privacy, protection of personal information such as Social Securitynumbers, credit card information and employment. For example, the State ofCalifornia enacted the Database Security Breach Act, which requires anybusiness that suffers a computer security breach to immediately notifycustomers in California if personal information has been compromised, and thePayment Card industry has adopted regulations that require additional securityregarding the storage of consumers’ credit card numbers. The adoption of anynew regulations or changes to existing regulations could cause a decline in theuse of our software and could result in increased expense for us as we modifyour software to accommodate these regulations. Moreover, these regulationscould subject our customers or us to liability. Whether or not theseregulations are adopted, if we do not adequately address the privacy concernsof consumers, companies may be hesitant to use our software. If any ofthese events occur, it could materially and adversely affect our business.

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

Our success greatly depends on our ability to hire,train, retain and motivate qualified personnel, particularly in sales, marketing,research and development, service and support. We face significant competitionfor individuals with the skills required to perform the services we offer.If we are unable to attract and retain qualified personnel or if we experiencehigh personnel turnover, it could prevent us from effectively managing andexpanding our business.

Our success also depends upon the continued service ofour executive officers. Any of our executive officers and other employees couldterminate his or her relationship with us at any time. The loss of the servicesof our executive officers or other key personnel, particularly if lost tocompetitors, could materially and adversely affect our business.

*Our certificate ofincorporation and bylaws, as well as Delaware law, may inhibit a takeoverof our company, which could limit the price investors might be willing to payfor our securities.*

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

These anti-takeover provisions might discourage, delayor prevent a change in the control of our company or a change in ourmanagement. These provisions could also discourage proxy contests and make itmore difficult for you and other shareholders to elect directors and take othercorporate actions. The existence of these provisions could also limit the pricethat investors might be willing to pay in the future for our securities.

**Item 6.Exhibits**
| (a)   | ** ** | **Exhibits**                                                                   |
|-------|------------|--------------------------------------------------------------------------------|
| 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**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| Dated: February 7, 2007 | WITNESS SYSTEMS, INC. |
|-------------------------|----------------------------|
|                    |                       |   |
|                    |                       |   |
|                    | BY:                        | /s/   Nicholas Discombe |   |
|                    |                       | NICHOLAS DISCOMBE |
|                    |                       | 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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