**SECURITIES AND EXCHANGE COMMISSION**Washington,D.C. 20549

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**FORM 10-Q**
| **x**                                                                                                                | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                                                                                           | ** ** | ** **                                                                                              |
| **For the  quarterly period ended June 30, 2006**                                                               |
| ** **                                                                                                           | ** ** | ** **                                                                                              |
| **OR**                                                                                                               |
| ** **                                                                                                           | ** ** | ** **                                                                                              |
| **o**                                                                                                                | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                           | ** ** | ** **                                                                                              |
| **For the  transition period  from             to** |
| ** **                                                                                                           | ** ** | ** **                                                                                              |
| **Commission  file number 000-29335**                                                                                |

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**WITNESSSYSTEMS, INC.**(ExactName of Registrant as Specified in Its Charter)
| **Delaware**                                                              | ** ** | **23-2518693**       |
|---------------------------------------------------------------------------|------------|----------------------|
| (State or Other  Jurisdiction                                             |       | (I.R.S. Employer     |
| of Incorporation  or Organization)                                        |       | Identification  No.) |
| ** **                                                                | ** ** | ** **           |
| **300  Colonial Center Parkway**                                          | ** ** |                 |
| **Roswell,  Georgia**                                                     |       | **30076**            |
| (Address of  Principal Executive Offices)                                 | ** ** | (Zip Code)           |
| ** **                                                                | ** ** | ** **           |
| Registrant’s  telephone number, including area code **770-754-1900** |

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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                                         |

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes o  No x

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 x |   | Non-accelerated filer o |
|--------------------------------|--------|---------------------|--------|-------------------------|

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

As of January 31, 2007, 34,149,619 shares of theregistrant’s common stock were outstanding.

 

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**WITNESSSYSTEMS, INC.**

**FORM 10-Q**

**INDEX**
| PART I.  | FINANCIAL  INFORMATION                                                                                                 |   |
|---------------|------------------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                   |   |
| Item  1.      | Financial  Statements:                                                                                                 |   |
|          |                                                                                                                   |   |
|          | Condensed Consolidated Balance Sheets at June 30,  2006 (unaudited) and December 31, 2005                    | 3      |
|          |                                                                                                                   |   |
|          | Condensed Consolidated Statements of Operations for  the three and six months ended June 30, 2006 and 2005 (unaudited) | 4      |
|          |                                                                                                                   |   |
|          | Condensed Consolidated Statements of Cash Flows for  the six months ended June 30, 2006 and 2005 (unaudited)      | 5      |
|          |                                                                                                                   |   |
|          | Notes to the Condensed Consolidated Financial  Statements (unaudited)                                                  | 6      |
|          |                                                                                                                   |   |
| Item 2.       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                            | 15     |
|          |                                                                                                                   |   |
| Item 3.       | Quantitative and Qualitative Disclosures About Market  Risk                                                            | 25     |
|          |                                                                                                                   |   |
| Item 4.       | Controls and Procedures                                                                                                | 25     |
|          |                                                                                                                   |   |
| PART II. | OTHER  INFORMATION                                                                                                     | 25     |
|          |                                                                                                                   |   |
| Item  1.      | Legal  Proceedings                                                                                                     | 25     |
|          |                                                                                                                   |   |
| Item 1A       | Risk Factors                                                                                                           | 27     |
|          |                                                                                                                   |   |
| Item 6.       | Exhibits                                                                                                               | 36     |
|          |                                                                                                                   |   |
| SIGNATURES    |                                                                                                                   | 37     |

 

 

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**PART I.FINANCIAL INFORMATION**

**Item 1.   Financial Statements**

**WITNESSSYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(In thousands, except share data)**
| ** **                                                                                                                                                                                             | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                             | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                             | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                        |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                             |       | $                       | 93,261     |                        | $          | 111,751 |   |
| Investments, at  fair market value                                                                                                                                                                     |       | 70,054                  |       | 14,886                      |       |
| Restricted cash  held in escrow                                                                                                                                                                        |       | —                  |       | 4,000                       |       |
| Accounts  receivable, net of allowance of $3,111 at June 30, 2006 and $3,283 at  December 31, 2005                                                                                           |       | 46,944                  |       | 40,218                      |       |
| Prepaid and  other current assets                                                                                                                                                                      |       | 7,127                   |       | 5,462                       |       |
| Total current  assets                                                                                                                                                                                  |       | 217,386                 |       | 176,317                     |       |
| Intangible assets, net  of accumulated amortization of $34,592 at June 30, 2006 and $26,874 at  December 31, 2005.                                                                                     |       | 29,994                  |       | 36,389                      |       |
| Goodwill                                                                                                                                                                                               |       | 40,137                  |       | 40,319                      |       |
| Property and equipment,  net of accumulated depreciation of $16,273 at June 30, 2006 and $13,715 at  December 31, 2005                                                                                 |       | 9,459                   |       | 7,796                       |       |
| Other assets                                                                                                                                                                                           |       | 4,505                   |       | 3,573                       |       |
|                                                                                                                                                                                                   |       | $                       | 301,481    |                        | $          | 264,394 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                   |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                       |       | $                       | 8,967      |                        | $          | 3,795 |   |
| Accrued expenses                                                                                                                                                                                       |       | 20,625                  |       | 29,651                      |       |
| Deferred revenue                                                                                                                                                                                       |       | 35,901                  |       | 23,756                      |       |
| Total current  liabilities                                                                                                                                                                             |       | 65,493                  |       | 57,202                      |       |
| Other long-term  liabilities                                                                                                                                                                           |       | 5,297                   |       | 4,165                       |       |
| Deferred income tax  liabilities                                                                                                                                                                       |       | 620                     |       | 743                         |       |
| Total  liabilities                                                                                                                                                                                     |       | 71,410                  |       | 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; 33,955,685 and 32,822,193  shares issued and outstanding at June 30, 2006 and December 31,  2005, respectively                  |       | 340                     |       | 326                         |       |
| Additional  paid-in capital                                                                                                                                                                            |       | 272,013                 |       | 251,712                     |       |
| Accumulated  deficit                                                                                                                                                                                   |       | (47,454                 | )          | (52,830                     | )          |
| Accumulated  other comprehensive income                                                                                                                                                                |       | 5,172                   |       | 3,076                       |       |
| Total  stockholders’ equity                                                                                                                                                                       |       | 230,071                 |       | 202,284                     |       |
|                                                                                                                                                                                                   |       | $                       | 301,481    |                        | $          | 264,394 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

3

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)(unaudited)**
| ** **                                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                        |       |                                                |       |                                              |       |   |   |   |   |
| Product                                         |       | $                                                   | 22,063     |                                              | $          | 18,918 |   | $ | 41,902 |   | $ | 35,286 |   |
| Services                                        |       | 32,765                                              |       | 27,253                                            |       | 64,392 |   | 52,044 |   |
| Total revenue                                   |       | 54,828                                              |       | 46,171                                            |       | 106,294 |   | 87,330 |   |
| Cost of revenue:                                |       |                                                |       |                                              |       |   |   |   |   |
| Product                                         |       | 5,209                                               |       | 4,928                                             |       | 9,787 |   | 9,260 |   |
| Services                                        |       | 12,799                                              |       | 10,793                                            |       | 24,554 |   | 20,329 |   |
| Total cost of revenue                           |       | 18,008                                              |       | 15,721                                            |       | 34,341 |   | 29,589 |   |
| Gross profit                                    |       | 36,820                                              |       | 30,450                                            |       | 71,953 |   | 57,741 |   |
| Operating  expenses:                            |       |                                                |       |                                              |       |   |   |   |   |
| Selling, general and administrative             |       | 25,874                                              |       | 21,577                                            |       | 51,082 |   | 41,575 |   |
| Research and development                        |       | 8,080                                               |       | 6,894                                             |       | 16,058 |   | 13,092 |   |
| Merger-related and integration costs            |       | 131                                                 |       | 925                                               |       | 2,222 |   | 2,584 |   |
| Acquired in-process research and development    |       | —                                              |       | —                                            |       | — |   | 9,000 |   |
| Operating income (loss)                         |       | 2,735                                               |       | 1,053                                             |       | 2,591 |   | (8,510 | ) |
| Interest and  other income, net                 |       | 1,472                                               |       | 56                                                |       | 2,743 |   | 194 |   |
| Income (loss) before provision for income taxes |       | 4,207                                               |       | 1,109                                             |       | 5,334 |   | (8,316 | ) |
| Provision for  income taxes (benefit)           |       | (218                                                | )          | 617                                               |       | (42 | ) | 650 |   |
| Net income (loss)                               |       | $                                                   | 4,425      |                                              | $          | 492 |   | $ | 5,376 |   | $ | (8,966 | ) |
|                                            |       |                                                |       |                                              |       |   |   |   |   |
| Net income  (loss) per share:                   |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                           |       | $                                                   | 0.13       |                                              | $          | 0.02 |   | $ | 0.16 |   | $ | (0.34 | ) |
| Diluted                                         |       | $                                                   | 0.12       |                                              | $          | 0.02 |   | $ | 0.15 |   | $ | (0.34 | ) |
| Weighted-average  common shares outstanding:    |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                           |       | 33,652                                              |       | 26,868                                            |       | 33,262 |   | 26,483 |   |
| Diluted                                         |       | 36,776                                              |       | 29,513                                            |       | 36,712 |   | 26,483 |   |

 

 

See accompanyingnotes to condensed consolidated financial statements.

4

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(unaudited)**
| ** **                                                                                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                                                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                              |       |                                              |       |   |   |
| Net income (loss)                                                                                   |       | $                                                 | 5,375      |   | $ | (8,966 | ) |
| 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                                                                   |       | 7,108                                             |       | 7,239 |   |
| Stock-based compensation expense                                                                    |       | 6,504                                             |       | 212 |   |
| Depreciation and amortization of property and  equipment                                            |       | 2,522                                             |       | 1,895 |   |
| Provision for accounts receivable                                                                   |       | 1,269                                             |       | 1,977 |   |
| Deferred income taxes                                                                               |       | (862                                              | )          | — |   |
| Other non-cash items, net                                                                           |       | 1,039                                             |       | 130 |   |
| Excess tax benefits from stock-based compensation                                                   |       | (180                                              | )          | — |   |
| Changes in operating assets and liabilities:                                                        |       |                                              |       |   |   |
| Accounts receivable                                                                                 |       | (7,381                                            | )          | (8,988 | ) |
| Prepaid and other assets                                                                            |       | (3,085                                            | )          | 294 |   |
| Accounts payable                                                                                    |       | 5,118                                             |       | (641 | ) |
| Accrued expenses                                                                                    |       | 1,592                                             |       | (4,637 | ) |
| Deferred revenue                                                                                    |       | 11,821                                            |       | 515 |   |
| Net cash provided by (used in) operating activities                                                 |       | 30,840                                            |       | (1,970 | ) |
| Cash flows from  investing activities:                                                              |       |                                              |       |   |   |
| Capital expenditures                                                                                |       | (4,244                                            | )          | (2,608 | ) |
| Purchases of investments                                                                            |       | (78,384                                           | )          | — |   |
| Proceeds from sales of investments                                                                  |       | 23,659                                            |       | 32,968 |   |
| Acquisition of Blue Pumpkin Software, Inc., net of  cash acquired of $3,900                         |       | (8,921                                            | )          | (37,241 | ) |
| Acquisition of Optimis, net of cash acquired of  $1,300                                             |       | —                                            |       | (4,341 | ) |
| Increase in restricted cash                                                                         |       | 4,000                                             |       | (4,000 | ) |
| Purchase of other business assets                                                                   |       | (673                                              | )          | — |   |
| Net cash used in investing activities                                                               |       | (64,563                                           | )          | (15,222 | ) |
| Cash flows from  financing activities:                                                              |       |                                              |       |   |   |
| Proceeds from exercise of stock options and Employee  Stock Purchase Plan                           |       | 10,546                                            |       | 4,974 |   |
| Proceeds from sale of common stock, net                                                             |       | 3,723                                             |       | — |   |
| Excess tax benefits from stock-based compensation                                                   |       | 180                                               |       | — |   |
| Other                                                                                               |       | (106                                              | )          | (128 | ) |
| Net cash provided by financing activities                                                           |       | 14,343                                            |       | 4,846 |   |
| Effect of exchange rate changes on cash                                                             |       | 890                                               |       | (313 | ) |
| Net decrease in cash and cash equivalents                                                           |       | (18,490                                           | )          | (12,659 | ) |
| Cash and cash  equivalents at beginning of period                                                   |       | 111,751                                           |       | 42,641 |   |
| Cash and cash  equivalents at end of period                                                         |       | $                                                 | 93,261     |   | $ | 29,982 |   |
| Supplemental  cash flow information:                                                                |       |                                              |       |   |   |
| Cash paid for interest                                                                              |       | $                                                 | 5          |   | $ | 13 |   |
| Cash paid for  income taxes                                                                         |       | $                                                 | 302        |   | $ | 358 |   |

 

 

See accompanying notes to condensed consolidatedfinancial statements.

5

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2006(unaudited)**

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

***Business***- ***Witness***Systems, Inc. (“Witness”) is a publicly traded company thatprovides workforce optimization software and services enabling companies toimprove workforce performance and capture customer intelligence in theircustomer service operations. Our Impact 360 solution consists of softwareproducts and services designed to optimize the workforce, processes andtechnology involved in the customer service function and gain valuable insightfrom customer interactions that can be used throughout the enterprise. Ourquality monitoring products record multimedia interactions, includingtraditional voice, Web chat and email, based on user-defined businessrules to enable our customers to evaluate the performance of theircustomer service representatives, or CSRs, wherever they may be located inthe enterprise. Our high-volume compliance applications are designed to record highvolume, full-time performance of the voice conversations between CSRs andcustomers for purposes such as compliance recording and sales verification. Ourworkforce management products enable our customers to develop strategicstaffing plans, deploy skilled resources and evaluate productivity of CSRs. Ourperformance management applications provide comprehensive analytics, includingperformance scorecards, and reports of customer interaction and CSRperformance. Our e-learning applications deliver ongoing training tailored toCSR needs and competencies. We also provide consulting and implementationservices, training and support to customers that use our software products.

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

***Principles of Consolidation and Reclassifications*** - The unaudited interim condensedconsolidated financial statements include the financial statements of WitnessSystems, Inc. and its wholly-owned subsidiaries. All significantintercompany balances and transactions have been eliminated in consolidation.Certain prior year amounts have been reclassified to conform to thecurrent presentation.

The financial statementsherein have been prepared in accordance with the requirements of Form 10-Qand, therefore, do not include all information and footnotes required byaccounting principles generally accepted in the United States of America.However, in the opinion of management, all adjustments necessary for a fairpresentation of the results of operations for the relevant periods have beenmade. Results for the interim periods are not necessarily indicative of theresults to be expected for the year. These financial statements should be readin conjunction with the summary of significant accounting policies and thenotes to the consolidated financial statements included in our Annual Report onForm 10-K for the fiscal year ended December 31, 2005, filed with theU.S. Securities and Exchange Commission.

***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 and Deferred Revenue**

***We***recognizerevenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) 97-2, *Software Revenue Recognition*, and SOP 98-9, *Modification of* SOP 97-2, *Software Revenue Recognition, With Respect to Certain**Transactions.* Revenue is primarilyderived from licensing software and providing related services includingmaintenance. Product revenue, which can include software and hardware, isrecognized when persuasive evidence of an agreement exists, delivery of theproduct has occurred, the fee is fixed or determinable, collection is probableand vendor specific objective evidence of fair value (“VSOE”) exists toallocate revenue to the undelivered elements of the arrangement. The Companyreports hardware revenue gross in accordance with Emerging Issues Task Force “EITF”No. 99-19, *Reporting Revenue Gross as aPrincipal versus Net as an Agent,* because the factors indicatinggross reporting outweigh the factors indicating net reporting. We recognizerevenue using the residual method of accounting when customer orders containmultiple element arrangements, including the sale of licensed software,hardware, maintenance, and professional services. We generally have VSOE formaintenance and professional services, but not for the software and hardwareelements of the order. Under the residual method, services revenue, includingmaintenance and professional services, is deferred at an amount equal to VSOEuntil 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.

6

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Services revenue includesinstallation, training, consulting, maintenance and reimbursable travelexpenses. Revenue from installation, training and consulting services isrecognized upon completion or performance of the related services and isoffered and billed as separate elements of contracts. Reimbursable travelexpenses revenue is recognized upon incurrence of the related expenses. Thefunctionality of the software and any hardware sold is not dependent oninstallation and training services and customization is not required to enableour customers to use our products. Maintenance is offered as a separate elementand the majority of contracts include the right to unspecified upgrades on awhen-and-if available basis. Maintenance revenue is deferred and recognizedratably over the term of the related maintenance contract.

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

Deferred revenue consists primarilyof amounts collected fromcustomers for products and services that have not met the criteria for revenuerecognition.

**3.****             Restatement of Condensed Consolidated FinancialStatements**

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 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 dateswas lower than the fair market value on the redetermined measurement dates, 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 notpreviously accounted for in our previously issued financial statements.

As a result of thefindings described above, our restated Consolidated Financial Statements as ofDecember 31, 2005 reflected a cumulative decrease in net income ofapproximately $9.5 million for the years 2000 to 2005 due to non-cashadjustments to stock-based compensation expense. The stock-based compensationexpense is primarily based on APB No. 25 which are intrinsic value basedcharges that are amortized over the vesting terms of the stock options. Inconnection with the restatement, we identified additional adjustments thatneeded to be recorded to our historical Consolidated Financial Statements.These adjustments consisted primarily of purchase accounting, income taxes andmiscellaneous other items. The cumulative effect of the restatement adjustmentson our Consolidated Balance Sheet as of December 31, 2005 resulted in an increasein the accumulated deficit of $10.5 million, an increase in additional paid-incapital of $5.8 million and increases in assets and liabilities of $2.8 millionand $7.5 million, respectively. Although there were no option measurementdating issues, our 2006 Condensed Consolidated Financial Statements areimpacted by option grants in prior years where the measurement dates have beenadjusted.

 

**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 directorsand a number of our current officers as defendants.  Miller v. Gould, etal., Civil Action No. 1:06-CV-2039 (N.D. Ga.).  The complaint allegespurported violations of federal and state law, including breaches of fiduciaryduty, abuse of control, constructive fraud, corporate waste, unjust enrichment,gross mismanagement 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,rescission of stock option grants, imposition of a constructive trust over thedefendants’ stock options and proceeds derived therefrom, punitive damages,reimbursement of attorneys’ fees and other costs and expenses, an orderdirecting the Company to adopt or put to a stockholder vote various proposalsrelating to corporate governance, and other relief as determined by thecourt.  On November 15, 2006, the Company and the other defendants filed amotion to dismiss the complaint 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 filed an Amended Complaint.  The Company and its directors intend to reviewthe allegations of the Amended Complaint and respond when appropriate.

A class action securities lawsuit has been filedby an individual  on August 14,2006 claiming to be a stockholder of the Company naming the Companyand certain of its directors and officers as defendants in connection withcertain stock option grants made by the Company.  Rosenberg v. Gould, etal., Civil Action No. 1:06-CV-1894 (N.D. Ga.).  The complaint, filed inthe United States District Court for the Northern District of Georgia, allegesviolations of Section 10(b) of the Securities Exchange Act of 1934 and Rule10b-5 thereunder and seeks unspecified damages, attorneys’ fees and other costsand expenses, unspecified extraordinary, equitable and injunctive relief, andother relief as determined by the court.  Neither a lead plaintiff norlead counsel has been appointed, nor has any response to the complaint yet beenrequired. The Company and the other defendants will respond to the complaintwhen appropriate.

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

Our common stock trades on the Nasdaq Stock Marketunder the symbol “WITS”.  We delayed thefiling of our quarterly reports on Form 10-Q for the quarters ended June30,2006 and September 30, 2006 until after the Special Committee completed itsreview of our past stock option practices and grants. As a result, we have notbeen in compliance with the NASDAQ filing requirements for continued listing asset forth in Marketplace Rule 4310(c) (14).  We have received a letterfrom Nasdaq Listing Qualification Panel advising us that we have received anextension of time through February 7, 2007 to file our Quarterly Reports onForm 10-Q for the quarters ended June 30, 2006 and September 30, 2006. The Panel advised us that if we are unable to meet the extension deadline, thePanel will issue a final determination to delist our shares and there can be noassurance that Nasdaq Listing and Hearing Review Council will grant anadditional extension of time to meet such requirements or that our common stockwill remain listed on the Nasdaq Stock Market.

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

On January 24, 2005, we acquired Blue PumpkinSoftware, Inc. (“Blue Pumpkin”), a privately held California corporation. Withthis 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“Merger Agreement”), we paid $36 million in cash which was funded from ourexisting cash and investments and issued 1.9 million shares of Witness’ commonstock valued at $33.5 million (measured based on the date the stock considerationbecame fixed pursuant to the application of a formula specified in the mergeragreement). On May 24, 2005, the shares issued in connection with theacquisition were registered for resale with the Securities and ExchangeCommission. 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 andPayables”,*werecorded a $0.7 million discount representing the difference between the facevalue and the present value of the $3.0 million. The escrow fund was releasedto Witness during March 2006 in satisfaction and settlement of claims thatWitness brought against the escrow fund, including claims for losses resultingfrom the settlement of the IEX litigation. As part of the agreement to releasethe escrow Witness issued shares of common stock for proceeds of approximately$3.1 million. These shares were issued at a discount of approximately $1.35million, which was recorded as a charge to earnings in the Company’sconsolidated statement of operations for the three months 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.  

We commenced consolidationof Blue Pumpkin on January 25, 2005 and the acquisition was accounted forusing the purchase method of accounting in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 141,*Business Combinations*. The following summarizes the totalpurchase price for Blue 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 ofaccounting, the total purchase price was allocated to Blue Pumpkin’s nettangible and intangible assets based upon their estimated fair value as of thedate of the acquisition with any amount paid in excess of the fair value of thenet assets recorded as goodwill. Based upon the purchase price and review ofthe net assets acquired and liabilities assumed, the purchase price allocationwas as follows (in thousands):

7

----

 

| Cash and investments                 |   | $       | 3,900  |   |
|--------------------------------------|--------|---------|--------|--------|
| Other current  assets                |   | 5,900   |   |
| Property and  equipment, net         |   | 700     |   |
| Acquired  technology                 |   | 21,000  |   |
| Customer  relationships              |   | 17,000  |   |
| Goodwill                             |   | 35,200  |   |
| 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 ofidentifiable intangible assets were determined with the assistance of TaylorConsulting Group, Inc., an independent third-party appraiser using both anincome and a cost approach taking into consideration the nature, risks,historical patterns, economic characteristics, and future considerations of theassets. As of the closing date of the merger, technological feasibility of thein-process research and development (“IPR&D”) had not been established andthe technology had no alternative future use. Accordingly, we charged the valueof the IPR&D at the date of the acquisition to expense. The amount of thepurchase price allocated to IPR&D was based on established valuationtechniques used in the software industry. The fair value assigned to theacquired IPR&D was determined using a discounted cash flow methodology,which discounts expected future cash flows to present value.

The key assumptions used inthe valuation include, among others, expected completion date of the in-processprojects identified as of the acquisition date, estimated cost to complete theprojects, revenue contributions and expense projections assuming the resultingproduct has entered the market, and discount rates based on the risks associatedwith the development life cycle of the in-process technology acquired. Thediscount rates used in the present value calculations are obtained from aweighted-average cost of capital analysis, adjusted upward to account for theinherent uncertainties surrounding the successful development of the IPR&D,the expected profitability levels of such technology, and the uncertainty oftechnological advances that could potentially impact the estimates. We assumethe pricing model for the resulting product of the acquired IPR&D to bestandard within its industry. We did not take into consideration anyconsequential amount of expense reductions from integrating the acquiredIPR&D with other existing in process or completed technology.

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

Goodwill of $35.3 millionwas recorded and represented the excess of the purchase price over the fairvalue of the tangible and other intangible assets acquired less the liabilitiesassumed. In accordance with SFAS No. 142,*Goodwill 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):

|                                    | ** ** | **Six months  Ended June 30,  2005** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|
| Total revenues                     |       | $                                                   | 88,405     |   |
| Net loss                           |       | $                                                   | (2,340     | ) |
| Net loss per  share - basic        |       | $                                                   | (0.09      | ) |
| Net loss per  share - diluted      |       | $                                                   | (0.09      | ) |
| Weighted average  shares - basic   |       | 26,634                                              |       |
| Weighted average shares  - diluted |       | 26,634                                              |       |

 

 

8

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**5.****                    ****Optimis Acquisition**

On May 23, 2005, we acquired Optimis GroupLimited (“Optimis”), a UK-based provider of workforce optimization softwaresolutions. Blue Pumpkin owned a minority interest in an operating subsidiary ofOptimis, the balance of which was acquired through the Optimis acquisition. Wepaid $5.0 million in cash and other consideration, which was financed fromour existing cash and investments. Ten percent of the aggregate mergerconsideration was held in escrow and was released in August 2006. 

We commenced theconsolidation of Optimis on May 24, 2005 and the acquisition was accountedfor using the purchase method of accounting in accordance with SFASNo. 141,*Business Combinations*.The following summarizes the total purchase price for Optimis (in thousands): 
| Cash and other consideration |   | $   | 5,000  |   |
|------------------------------|--------|-----|--------|--------|
| Direct  acquisition costs    |   | 700 |   |
|                         |   | $   | 5,700  |   |

 

Under the purchasemethod of accounting, the total purchase price is allocated to Optimis’ nettangible and intangible assets based upon their estimated fair value as of thedate of the acquisition with any amount paid in excess of the fair value of thenet assets recorded as goodwill. Based upon the purchase price and review ofthe net assets acquired and liabilities assumed, the purchase price allocationwas as follows (in thousands):
| Cash and investments      |   | $      | 1,300  |   |
|---------------------------|--------|--------|--------|--------|
| Other current  assets     |   | 1,500  |   |
| Customer  relationships   |   | 2,500  |   |
| Goodwill                  |   | 5,800  |   |
| Other long term  assets   |   | 100    |   |
| Total assets acquired     |   | 11,200 |   |
| Current  liabilities      |   | (3,100 | )      |
| Deferred revenue          |   | (1,400 | )      |
| Restructuring  accruals   |   | (1,000 | )      |
| Total liabilities assumed |   | (5,500 | )      |
|                      |   | $      | 5,700  |   |

 

The fair values of identifiable intangible assets weredetermined using both an income and a cost approach taking into considerationthe nature, risks, historical patterns, economic characteristics, and futureconsiderations of the asset.

**6.****                    ****Acquisition-RelatedRestructuring Accruals and Merger-Related and Integration Costs**

As a result of our Eyretelacquisition in 2003, we recorded an acquisition-related restructuring accrualrelated to the closing of certain Eyretel facilities and the accrual of expenserelating to abandoned leased premises. All such costs met the criteria foraccrual as outlined in EITF No. 95-3,*Recognition of Liabilities in Connection with a Purchase Business Combination,*and were included in the assets acquired and liabilities assumed in thepurchase of Eyretel. The following table summarizes the restructuring accrual(in thousands):
|                                        | ** ** | **Facilities** | ** ** |
|----------------------------------------|------------|----------------|------------|
| Accrual at  December 31, 2005     |       | $              | 2,073      |   |
| Amounts credited to rent expenses      |       | (251           | )          |
| Foreign exchange translation           |       | 76             |       |
| Accrual at  June 30, 2006         |       | 1,898          |       |
| Less: Long-term portion                |       | (1,462         | )          |
| Current portion at  June 30, 2006 |       | $              | 436        |   |

 

9

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The following table summarizes all merger-related andintegration costs that were charged to expense during the three and six-monthsended June 30, 2006 and 2005 (in thousands):
|                                      | ** ** | **Three months ended June** | ** ** | **Six months ended June** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                   | ** ** | **2005**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Blue Pumpkin and  Optimis:           |       |                                       |       |                                     |       |   |   |   |   |
| Merger-related and integration costs |       | 131                                        |       | 925                                      |       | 2,222 |   | 2,485 |   |
| Eyretel:                             |       |                                       |       |                                     |       |   |   |   |   |
| Bonus expense                        |       | —                                     |       | —                                   |       | — |   | 155 |   |
| Merger-related and integration costs |       | —                                     |       | —                                   |       | — |   | (56 | ) |
|                                 |       | $                                          | 131        |                                     | $          | 925 |   | $ | 2,222 |   | $ | 2,584 |   |
|                                      |            |                                            |            |                                          |            |  |  |  |  |  |  |  |  |

 

During the first half of 2006, we incurredmerger-related and integration costs in the amount of $2.2 million pertainingto the acquisition of Blue Pumpkin and Optimis. These expenses were primarilyassociated with legal,professional fees and a discount on shares sold to the Blue Pumpkinshareholders.

During the first half of2005, we incurred merger-related and integration costs of $2.6 millionpertaining to the acquisitions of Blue Pumpkin and Optimis that closed in 2005and the Eyretel acquisition in 2003. The $2.6 million included $2.5 million ofintegration expenses comprised primarily of costs of transitional Blue Pumpkinand Optimis employees and other contractors, travel costs and advertisingcosts.

**7.****                     Net Income (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):
| ** **                                                                         | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                         | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                               |       |                                            |       |                                          |       |   |   |   |   |
| Net income  (loss)                                                                 |       | $                                               | 4,425      |                                          | $          | 492 |   | $ | 5,376 |   | $ | (8,966 | ) |
| Weighted average  shares of common stock and common stock equivalents outstanding: |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                              |       | 33,652                                          |       | 26,868                                        |       | 33,262 |   | 26,483 |   |
| Dilutive effect of stock options computed using the  treasury stock method         |       | 3,124                                           |       | 2,808                                         |       | 3,450 |   | — |   |
| Diluted common  shares and share equivalents outstanding                           |       | 36,776                                          |       | 29,513                                        |       | 36,712 |   | 26,483 |   |
| Net income  (loss) per share:                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                              |       | $                                               | 0.13       |                                          | $          | 0.02 |   | $ | 0.16 |   | $ | (0.34 | ) |
| Diluted                                                                            |       | $                                               | 0.12       |                                          | $          | 0.02 |   | $ | 0.15 |   | $ | (0.34 | ) |

 

 

We have excluded all outstanding stock options fromthe calculation of diluted net loss per common share for the six month periodended June 30, 2005 because we reported a loss in this period and all suchsecurities are anti-dilutive.  The total number of share equivalentsexcluded from the calculation of historical diluted net loss per common share forthe six month period ended June 30, 2005 was 2,730,424 calculated using thetreasury stock method.  For the three and six months ended June 30, 2006,stock options of 1,593,612 and 1,338,458, respectively, were excluded from thecomputation of diluted earnings per share compared to 398,948  and 41,283, respectively for the same yearago periods because their inclusion would be anti-dilutive.

**8.****                    ****Stock-Based Compensation**

Effective January 1,2006, we adopted SFAS No. 123(R), *Share-BasedPayment,*(“SFAS 123(R)”) usingthe 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 the intrinsicvalue method in accordance with APB 25 as allowed under SFAS No. 123, *“Accounting for Stock-Based Compensation”*. Other than asnoted in Note 3, “Restatement of Condensed Consolidated Financial 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.

10

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Our net income for the threeand six months ended June 30, 2006 includes $3.3 million and $6.5 million,respectively, of stock-option compensation expense and $0.1 million and $0.2million, respectively, of related income tax benefits recorded to additionalpaid-in-capital.

Cash received from stock option exercises for the sixmonths ended June 30, 2006 and 2005 was $10.2 million and $4.5 million,respectively. The income tax benefits from stock option exercises totaled $0.2million, for the six months ended June 30, 2006 and 2005, respectively.

A summary of all stockoption plans activity for the three and six months ended June 30, 2006 is asfollows:
| ** **                                         | ** ** | **Number  of Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value (a)  000’s** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|-----------------------------------------------------|------------|------------------------------------------------------|------------|
| Outstanding as  of December 31, 2005          |       | 8,570,696                  |       | $                                       | 10.98      |                                                |       |                                                 |       |   |
| Granted                                            |       | 1,182,800                  |       | 20.55                                   |       |                                                |       |                                                 |       |
| Exercised                                          |       | (563,174                   | )          | 8.99                                    |       |                                                |       |                                                 |       |
| Forfeited                                          |       | (69,384                    | )          | 14.98                                   |       |                                                |       |                                                 |       |
| Outstanding as  of March 31, 2006             |       | 9,120,938                  |       | 12.31                                   |       |                                                |       |                                                 |       |
| Granted                                            |       | 234,525                    |       | 22.20                                   |       |                                                |       |                                                 |       |
| Exercised                                          |       | (583,426                   | )          | 8.83                                    |       |                                                |       |                                                 |       |
| Forfeited                                          |       | (135,197                   | )          | 14.40                                   |       |                                                |       |                                                 |       |
| Expired                                            |       | (10,382                    | )          | 7.22                                    |       |                                                |       |                                                 |       |
| Outstanding as  of June 30, 2006              |       | 8,626,458                  |       | 12.79                                   |       | 4.9 years                                           |       | $                                                    | 64,735     |   |
|                                               |       |                       |       |                                    |       |                                                |       |                                                 |       |
| Vested +  Expected to vest as of June 30, 2006 (b) |       | 7,639,596                  |       | 12.26                                   |       | 5.0 years                                           |       | 61,239                                               |       |
|                                               |       |                       |       |                                    |       |                                                |       |                                                 |       |
| Exercisable as of  June 30, 2006              |       | 3,402,904                  |       | $                                       | 9.00       |                                                | 5.3 years  |                                                 | $          | 38,061 |   |

 

----

(a) Theaggregate intrinsic values were computed by applying the following formula =(fair market value of an option as of end of the quarter - the exercise priceat which the option was granted) x the number of  common stock options.

(b)The number of shares vested and expected to vest as of June 30, 2006 iscomputed by applying the following formula

= Number of shares vested as of June 30, 2006+ {sharesnot vested as of June 30, 2006*[100%-forfeiture rate]}

As of June 30, 2006, there was $14.7 million oftotal unrecognized compensation expense related to unvested share-basedcompensation arrangements granted under all stock option plans. That cost isexpected to be recognized over a weighted-average period of 1.3 years.

The followingtable summarizes information about stock options outstanding and exercisable asof June 30, 2006
| **Outstanding**                             | ** ** | **Exercisable**         | ** ** |
|---------------------------------------------|------------|-------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual Term** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
| $1.42 - $6.56                               |       | 2,185,243               |       | 5.8 years |   | $ | 4.26 |   | 1,272,739 |   | $ | 3.74 |   |
| $7.13 - $13.93                              |       | 2,217,681               |       | 5.5 years |   | 10.18 |   | 1,438,409 |   | 10.01 |   |
| $14.07 - $18.89                             |       | 2,548,934               |       | 3.8 years |   | 17.17 |   | 679,856 |   | 16.43 |   |
| $19.00 - $34.00                             |       | 1,674,600               |       | 4.6 years |   | 20.69 |   | 11,900 |   | 24.18 |   |
|                                        |       | 8,626,458               |       | 4.9 years |   | $ | 12.79 |   | 3,402,904 |   | $ | 9.00 |   |

 

During the threeand six months ended June 30, 2006 and 2005, the total intrinsic value ofstock options exercised is as follows (in thousands):

|                                                   | ** ** | **Three months ended June** | ** ** | **Six months ended June** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                   | ** ** | **2005**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Total intrinsic  value of stock options exercised |       | $                                          | 8,243      |                                     | $          | 3,154 |   | $ | 16,568 |   | $ | 7,627 |   |
|                                                   |            |                                            |            |                                          |            |  |  |  |  |  |  |  |  |

 

11

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The weighted-average grant date fair value of stockoptions granted during the three months ended June 30, 2006 and 2005 was $8.82per share and $7.64 per share, respectively. The weighted-average grant date fair value of stock options grantedduring the six months ended June 30, 2006 and 2005 was $8.18 per share and$7.63 per share, respectively.  Theweighted-average grant date fair values were determined using the Black-Scholesoption-pricing model with the following weighted-average assumptions:
|                              | ** ** | **Three months ended June** | ** ** | **Six months ended June** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                   | ** ** | **2005**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term of  option (1) |       | 3.3 years                                  |       | 3.5 years                                |       | 3.3 years |   | 3.5 years |   |
| Volatility (2)               |       | 52                                         | %          | 60                                       | %          | 54 | % | 60 | % |
| Forfeiture (3)               |       | 16.2                                       | %          | 0                                        | %          | 16.2 | % | 0 | % |
| Risk-free  interest rate (4) |       | 4.9                                        | %          | 3.6                                      | %          | 4.5 | % | 3.6 | % |
| Expected dividend yield      |       | 0                                          | %          | 0                                        | %          | 0 | % | 0 | % |

 

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(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 using theBlack-Scholes model:

·                  The vesting period of the awards

·                  Employees’ past exercise and post-vestingemployment departure behavior

·                  Expected volatility of the price of theunderlying share

(2) Weused a 3.3 year historical stock-price volatility as the expected volatilityassumption which aligns with the expected term of the options granted duringthe three and six months ended June 30, 2006. We believe that historicalvolatility reflects our current assessment of implied volatility. Prior to2006, we used historical stock price volatility in accordance with SFAS No. 123for purposes of our pro forma disclosure.

(3) Theforfeiture rates are computed taking into consideration historical forfeiturerates. SFAS123(R) requires forfeitures be estimated at the time of optiongrants and revised, if necessary, in subsequent periods if actual forfeituresdiffer from 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 assumptions are based on the rate currentlyavailable on zero-coupon U.S. Treasury instruments with a remaining term equalto the expected term of the share option.

The table below reflectspro forma net income and basic and diluted net income per share for the threeand six months ended June 30, 2005 (in thousands, except per share data):
|                                                                              | ** ** | **Three months  ended  June 30, 2005** | ** ** | **Six months  ended  June 30, 2 005** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **Pro forma (1)**                           | ** ** | **Pro forma (1)**                               | ** ** |
| ** **                                                                   | ** ** | ** **                                            | ** ** | ** **                                                | ** ** |
| Net income  (loss) before the effect of stock-based compensation expense     |       | $                                                     | 492        |                                                      | $          | (8,966 | ) |
| Stock-based employee compensation expense related to  employee stock options |       | (3,397                                                | )          | (6,323                                                    | )          |
| Net loss  including the effect of stock-based compensation expense           |       | $                                                     | (2,905     | )                                                         | $          | (15,289 | ) |
|                                                                         |       |                                                  |       |                                                      |       |
| Net loss per share:                                                          |       |                                                  |       |                                                      |       |
| Pro forma basic                                                              |       | $                                                     | (0.11      | )                                                         | $          | (0.57 | ) |
| Pro forma diluted                                                            |       | $                                                     | (0.11      | )                                                         | $          | (0.57 | ) |
|                                                                         |       |                                                  |       |                                                      |       |
|                                                                         |       | Actual                                                |       | Actual                                                    |       |
| Reported net income (loss) per share:                                        |       |                                                  |       |                                                      |       |
| Reported basic                                                               |       | $                                                     | 0.02       |                                                      | $          | (0.34 | ) |
| Reported diluted                                                             |       | $                                                     | 0.02       |                                                      | $          | (0.34 | ) |

 

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(1) Netincome (loss), stock-based compensation expense and basic and diluted earningsper share in 2005  represent pro formainformation based on SFAS No.123.

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***Stock******Incentive******Plans—******We***have three stock incentive plans:(i) the 1999 Stock Incentive Plan (the “1999 Plan”); (ii) the 2003Broad Based Option Plan (the “2003 Plan”); and (iii) the 2003 Non-employeeDirector 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. As of June 30, 2006, there were 12.9 million shares authorizedfor issuance, of which 2.3 million 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. Asof June 30, 2006, there were 1.6 million****sharesauthorized for issuance, of which 0.4 million shares remain available forfuture grant. We do not anticipate increasing the number of shares availablefor issuance 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. As of June 30, 2006, there were 0.5 million sharesauthorized for issuance, of which 0.4 million shares remain available forfuture 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 Statments.” 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. Ourpolicy is to issue new shares upon share option exercise.

**9.****                    ****Comprehensive Income (Loss)**

Totalcomprehensive income(loss) and accumulated other comprehensive income consisted of the following(in thousands):
| ** **                                                   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss)                                           |       | $                                               | 4,425      |                                          | $          | 492 |   | $ | 5,375 |   | $ | (8,966 | ) |
| Other  comprehensive income (loss):                          |       |                                            |       |                                          |       |   |   |   |   |
| Foreign currency translation adjustments                     |       | 977                                             |       | (403                                          | )          | 2,218 |   | (298 | ) |
| Change in net unrealized holding (loss) gain on  investments |       | (38                                             | )          | 14                                            |       | (121 | ) | 15 |   |
| Total comprehensive  income (loss)                           |       | $                                               | 5,364      |                                          | $          | 103 |   | $ | 7,472 |   | $ | (9,249 | ) |

 

|                                                      | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                 |       |                    |       |                        |       |
| Cumulative  foreign currency translation adjustments |       | $                       | 5,295      |                        | $          | 3,078 |   |
| Unrealized net  holding loss on investments          |       | (123                    | )          | (2                          | )          |
| Total accumulated other  comprehensive income        |       | $                       | 5,172      |                        | $          | 3,076 |   |

 

 

**10.****                 ****Line of Credit**

In March 2006, we extended the maturity date onour $15.0 million line of credit to March 2007. At our election,borrowings under the line of credit bear interest at the bank’s prime rate,which was 8.25 % on June 30, 2006, or LIBOR plus 300 basis points. Borrowingsunder the revolving line of credit 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 ofJune 30, 2006, we were in compliance with our bank covenants.

As of June 30, 2006, wehad no amounts outstanding under the line of credit and the amount availablefor borrowing was $13.2 million, which was net of outstanding letters of creditof $1.8 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.

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**11.****                 ****Segment and Geographic Information**

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   June 30,** | ** ** | **Six months ended   June 30,** | ** ** |
|----------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|           |       |                                                  |       |                                                |       |   |   |   |   |
| United States  |       | $                                                     | 28,399     |                                                | $          | 23,360 |   | $ | 56,068 |   | $ | 46,398 |   |
| United Kingdom |       | 16,193                                                |       | 13,879                                              |       | 29,490 |   | 23,670 |   |
| Rest of World  |       | 10,236                                                |       | 8,932                                               |       | 20,736 |   | 17,262 |   |
|           |       | $                                                     | 54,828     |                                                | $          | 46,171 |   | $ | 106,294 |   | $ | 87,330 |   |

 

The rest of world revenuewas derived primarily from customers located in Australia, Canada, India, Japanand the Netherlands. No individual customer accounted for more than 10% ofconsolidated revenue during the three and six months ended June 30, 2006or 2005.

Long-lived assets, includinggoodwill and intangible assets, by geography are as follows (in thousands):
|                | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| United States  |       | $                       | 67,743     |                        | $          | 71,430 |   |
| United Kingdom |       | 9,840                   |       | 10,824                      |       |
| Rest of world  |       | 2,007                   |       | 2,250                       |       |
| Total          |       | $                       | 79,590     |                        | $          | 84,504 |   |

 

**12.****                  Recent Accounting 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 alsoincludes accounting 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 periods beginningafter December 15, 2005. The adoption of this FSP had no materialimpact to our financial statements.

In June 2006, the FASB issued InterpretationNo. 48, *“Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109.”* This Interpretationprescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return, and provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. This Interpretation is effective for our fiscal year 2007. We arecurrently assessing the impact of the Interpretation on our results ofoperations and financial position.

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 our fiscal year 2007. We are currently assessing the impact ofthe EITF on our results of operations and financial position.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 108 (“SAB 108”) *Financial Statements—Considering the Effects of PriorYear Misstatements 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 it mustrecognize the cumulative effect of applying SAB 108 in fiscal 2006 beginningbalances of the affected assets and liabilities with a corresponding adjustmentto the fiscal 2006 opening balance in retained earnings. We are currentlyevaluating the impact of adopting SAB 108.

InSeptember 2006, the FASB issued SFAS No. 157, *“Fair ValueMeasurements”*, which becomes effective beginning on January 1, 2008.SFAS No.157 addresses the definition of fair value, the methods used to measurefair value and the expanded disclosures about fair value measurement of acompany’s assets and liabilities. SFAS No.157 requires that the fair valuemeasurement should be determined based on the assumptions that marketparticipants would use in pricing the asset or liability. We are currentlyassessing the impact of the SFAS No. 157 on our results of operations andfinancial position.

 

**13.****                  Subsequent Events**

*Acquisition of Exametric, Inc.*

On October 2, 2006, weacquired Exametric, Inc. (“Exametric”), a leading software solutions companyspecializing in workforce management and optimization for the financial serviceindustry.  The acquisition was structured as a merger of Exametric with anewly-formed, wholly-owned subsidiary of Witness (Witness EnterpriseSolutions).  The total consideration 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 available to indemnify Witness for lossesresulting from, among other things, breaches of representations, warranties,covenants and certain transaction costs.

*Acquisitionof 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 acquisitionwas structured as a merger of Demos with a newly-formed, wholly-ownedsubsidiary of Witness (Witness Enterprise Solutions).  The totalconsideration paid for Demos was approximately $6 million plus the potentialfor an earn-out of up to $18 million based on the growth of the business overthe next several years.  Ten percent (10%) of the initial considerationplus ten percent (10%) of any earn-out earned will be held in escrow untilOctober 2, 2007, or longer, if claims are brought against the escrow fund andremain pending on that date.  The escrow fund will be available toindemnify Witness for losses resulting from, among other things, breaches ofrepresentations, warranties and covenants. 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.

***Legal Proceedings***

On August 29, 2006, A.Edward Miller filed a shareholder derivative lawsuit in the United StatesDistrict Court for the Northern District of Georgia (Atlanta Division) namingWitness Systems, Inc. (the “Company”) as a nominal defendant and naming all ofour current directors and 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.

A class action securitieslawsuit has been filed by an individual on August 14, 2006 claiming to be astockholder of the Company naming the Company and certain of its directors andofficers as defendants in connection with certain stock option grants made bythe Company.  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 plaintiffnor lead counsel has been appointed, nor has any response to the complaint yetbeen required. The Company and the other defendants will respond to thecomplaint when appropriate.

On October 27, 2006, theCompany received a notice of informal nonpublic inquiry from the Securities andExchange Commission requesting certain documents and information relating tothe company’s stock option grant practices from February 2000 to the present.Witness Systems intends to cooperate fully with all matters related to thisrequest.

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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 28. The following will be discussed and analyzed:

·                  Overview

·                  Stock Option Practices andRestatement of Condensed Consolidated Financial Statement

·                  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 compliance recording,workforce management, performance management and electronic learning, ore-learning. Our quality monitoring products record multimedia interactions,including traditional voice, Web chat and email, based on user-defined businessrules to enable our customers to evaluate the performance of theircustomer service representatives,(“CSR”s), wherever they may be located inthe enterprise. Our high-volume compliance applications are designed to record highvolume, full-time performance of the voice conversations between CSRs andcustomers for purposes such as compliance recording and sales verification. Ourworkforce management products enable our customers to develop strategicstaffing plans, deploy skilled resources and evaluate productivity of CSRs. Ourperformance management applications provide comprehensive analytics, includingperformance scorecards, and reports of customer interaction and CSRperformance. Our e-learning applications deliver ongoing training tailored toCSR needs and competencies. We also provide consulting and implementationservices, training and support to customers that use our software products.

We derive product revenue by licensing software andderive services revenue by providing related installation, training,consulting, and maintenance services. We also derive a relatively small portionof product revenue by selling hardware to customers. The majority of ourproduct revenue is derived from quality monitoring (“QM”) and workforcemanagement (“WFM”) software. We sell our products through our direct salesforce and through our indirect sales channels. Our indirect sales channelsconsist of distributors, resellers, systems integrators and Original EquipmentManufacturers (“OEM”). Distributors and resellers purchase product from us at adiscount and then resell our products to end-users (or, in the case ofdistributors, to other resellers) and referral partners are paid a fee forreferring sales leads to us or for assisting us in a sales order. Systemsintegrators are information technology 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 sales channels byentering into new reseller, distributor, OEM and similar arrangements with keyvendors in the contact center workforce optimization market. During the threeand six months ended June 30,  2006,approximately 52% and 39%, respectively**,**of ourlicense revenue was derived from the indirect sales channel compared to 37% and39% , respectively, in 2005.

We plan to grow our product revenue and maintain ourcompetitive position from a technology perspective through the timelyintroduction of new products, such as pre-packaged solutions, which addcapabilities such as performance analysis and e-learning management to our corequality monitoring and workforce management solutions. We also believe themarket shift from traditional hardware based recording to VoIP represents asignificant growth opportunity, and our software solutions support both ofthese recording environments. In addition, we believe our product offerings canbe marketed toward branch-office and back-office initiatives for businessprocess monitoring, which represents a new market for us. Factors thatmay impact our ability to grow our product revenue, however, include ourability to remain competitive from a technology perspective; market acceptanceof our new products; our ability to maintain our product pricing integrity; andour ability to manage and expand our global sales channels.

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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.

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“Merger Agreement”), we paid $36 million in cash which was funded from ourexisting cash and investments and issued 1.9 million shares of Witness’ commonstock valued 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 and210,000 shares of common stock valued at approximately $3.7 million on the dateof acquisition 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, weacquired Optimis Group Limited (“Optimis”), a UK-based provider of workforceoptimization software solutions. Blue Pumpkin owned a minority interest in anoperating subsidiary of Optimis, the balance of which was acquired through theOptimis acquisition. We paid $5.0 million in cash and other considerationthat was financed from our existing cash and investments. Ten percent ofthe aggregate acquisition consideration was held in escrow and was released inAugust 2006. 

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 and six months endedJune 30, 2006 was $3.3 million and $6.5 million, respectively. 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.

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We are headquartered in Roswell, Georgia withoperations in the United States, Australia, Brazil, Canada, China, Germany,India, Japan, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom. During the three and six months ended June 30, 2006,approximately 48% and 47%, respectively, of our revenue was derived fromoperations outside the United States. During three and six months endedJune 30, 2005, 49% and 47%, respectively, of our revenue was derived fromcustomers outside the United States.  Asof June 30, 2006, we had 746 full-time employees, excluding approximately 90contractors located in the Asia-Pacific region, compared to 604 employees as ofJune 30, 2005.  As of June 30, 2006, 301 of the 746 full-time employeeswere located outside the United States.

**Stock Option Practices and Restatement ofConsolidated 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 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 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 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 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 dateswas lower than the fair market value on the redetermined measurement dates, inaccordance with Accounting Principles Board No. 25, “Accounting for StockIssued to Employees” (“APB No. 25”) and related interpretations, we concludedthat we should have recorded material stock-based compensation expense whichwas not previously accounted for in our previously issued 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 accounting,income taxes and miscellaneous other items. The cumulative effect of therestatement adjustments on our Consolidated Balance Sheet as of December 31,2005 resulted in an increase in the accumulated deficit of $10.5 million, anincrease in additional paid-in capital of $5.8 million and increases in assetsand liabilities of $2.8 million and $7.5 million, respectively.

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We delayed the filing of our quarterly reports on Form10-Q for the quarters ended June 30, 2006 and September 30, 2006 until afterthe Special Committee completed its review of our past stock option practicesand grants. As a result, we have not been in compliance with the Nasdaq filingrequirements for continued listing as set forth in Marketplace Rule 4310(c)(14). We have received a letter from Nasdaq Listing Qualification Paneladvising us that we have received an extension of time through February 7, 2007to file our Quarterly Reports on Form 10-Q for the quarters ended June 30, 2006and September 30, 2006.  The Panel advised us that if we are unable tomeet the extension deadline, the Panel will issue a final determination todelist our shares and there can be no assurance that Nasdaq Listing and HearingReview Council will grant an additional extension of time to meet suchrequirements or that our common stock will remain listed on the Nasdaq StockMarket.

**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 U.S Generally Accepted Accounting Principles (“GAAP”). We base ourestimates on historical experience and on various assumptions that we believeto be reasonable under the circumstances. However, because future events andtheir effects cannot be determined with certainty, actual resultsmay differ from these estimates under different assumptions or conditionsand such differences 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 of Directors.

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

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

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.

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

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*Accountingfor Acquisitions.*Accountingfor acquisitions requires management to make judgments and estimates indetermining the purchase price, the fair value of the assets and liabilitiesacquired and merger-related and integration costs. In recording acquisitions,significant judgment is required in estimating:

·                  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.

*Impairmentof Long-Lived Assets.*  Long-livedassets, such as property and equipment and amortizable intangible assets, areaccounted for in accordance with SFAS No. 144*, Accounting for Impairment or Disposal of Long-livedAssets* and are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. All of our identifiable intangible assets are amortized using thestraight-line method. Useful lives of amortizable intangible assets arereviewed annually with any changes in estimated useful lives being accountedfor prospectively over the revised remaining useful life. Recoverability ofassets to be held and used would be measured by a comparison of the carryingamount of an asset to the estimated undiscounted future cash flows expected tobe generated by the asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized in the amountby which the carrying amount of the asset exceeds the fair value of the asset.The determination of estimated future cash flows, however, requires managementto make estimates. Future events and changes in circumstances may requireus to record a significant impairment charge in the period in which such eventsor changes occur. Impairment testing requires considerable analysis andjudgment in determining the results. If other assumptions and estimates wereused in our evaluations, the results could differ significantly.

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

If we were to recognize the tax benefitassociated with our net operating loss carryforwards, we would expect ourprovision for income tax expense in future periods to reflect an effective taxrate that would be significantly higher than in past periods. Furthermore, theutilization of deferred tax assets, primarily net operating loss carryforwardsarising from acquisitions, results in a reduction in goodwill and therecognition of tax expense associated with the purchased deferred tax assets.

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. Under FAS 123(R), future excess tax deductions will result inan increase to additional-paid-in-capital. Under FAS 123(R), the Company willcontinue to follow the with-and-without approach and consider the impact ofexcess stock option deductions last when computing its income tax provision. Wehave utilized $4.7 million of income tax benefits originating from stock optiondeductions that have not been recorded in accordance with FAS 123(R).

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

*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 employees includingemployee stock options and employee stock purchase plan based on the grant datefair value of those awards. We determine the fair value of share-based paymentawards on the date of grant using Black-Scholes option-pricing model. The fairvalue of share-based awards is affected by stock price as well as assumptionsregarding a number of highly complex and subjective variables. These variablesinclude, but are not limited to, our expected stock price volatility over theterm of the awards, and actual and projected employee stock option exercisebehavior. SFAS 123(R) also requires that forfeitures be estimated over thevesting period of an award, rather than being recognized as a reduction ofcompensation expense when the forfeiture actually occurs. We adopted SFAS123(R) using the modified prospective transition method.  Our Condensed Consolidated FinancialStatements as of and for the three and six months ended June 30, 2006reflect the impact of SFAS 123(R).

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In accordance with themodified prospective transition method, our Condensed Consolidated FinancialStatements for prior periods have not been restated to reflect, and do notinclude, the impact of SFAS 123(R). This statement requires us to estimate thefair value of share-based payment awards on the date of grant using anoption-pricing model. The value of the portion of the award that is ultimatelyexpected to vest is recognized as expense over the requisite service periods inour Consolidated Statement of Operations. Stock-based compensation expenserecognized under SFAS 123(R) for the three and six months ended June 30,2006 was $3.3 million and $6.5 million, respectively. 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 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.  See Note 8to the Condensed Consolidated Financials Statement included elsewhere in thisreport for additional information on stock-based compensation expense.

On November 10,2005, the Financial Accounting Standards Board (“FASB”) issued FASB StaffPosition No. FSP123(R)-3, *Transition ElectionRelated 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).

**Results of Operations**

The followingtable sets forth the results of operations for the three and six months endedJune 30, 2006 and 2005 expressed as a percentage of total revenue.

|                                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                |       |                                            |       |                                          |       |   |   |   |   |
| Product                                                 |       | 40                                              | %          | 41                                            | %          | 39 | % | 40 | % |
| Services                                                |       | 60                                              | %          | 59                                            | %          | 61 | % | 60 | % |
| Total revenue                                           |       | 100                                             | %          | 100                                           | %          | 100 | % | 100 | % |
| Cost of revenue:                                        |       |                                            |       |                                          |       |   |   |   |   |
| Product                                                 |       | 10                                              | %          | 11                                            | %          | 9 | % | 11 | % |
| Services                                                |       | 23                                              | %          | 23                                            | %          | 23 | % | 23 | % |
| Total cost of revenue                                   |       | 33                                              | %          | 34                                            | %          | 32 | % | 34 | % |
| Gross profit                                            |       | 67                                              | %          | 66                                            | %          | 68 | % | 66 | % |
| Operating  expenses:                                    |       |                                            |       |                                          |       |   |   |   |   |
| Selling, general and administrative                     |       | 46                                              | %          | 47                                            | %          | 48 | % | 48 | % |
| Research and development                                |       | 15                                              | %          | 15                                            | %          | 15 | % | 15 | % |
| Merger-related and integration costs                    |       | —                                          | %          | 2                                             | %          | 2 | % | 3 | % |
| Acquired in-process research and development            |       | —                                          | %          | —                                        | %          | — | % | 10 | % |
| Operating income (loss)                                 |       | 6                                               | %          | 2                                             | %          | 3 | % | (10 | )% |
| Interest and  other income, net                         |       | 3                                               | %          | 0                                             | %          | 3 | % | 0 | % |
| Income (loss) income before provision for income  taxes |       | 9                                               | %          | 2                                             | %          | 6 | % | (10 | )% |
| Provision for  income taxes                             |       | 1                                               | %          | 1                                             | %          | 1 | % | — | % |
| Net income (loss)                                       |       | 8                                               | %          | 1                                             | %          | 5 | % | (10 | )% |

 

 

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*Total revenue*

Total revenueincreased 19% to $54.8 million, in the three months ended June 30, 2006,compared to the same period in 2005.  Theincrease in total revenue in the period can be attributed to both continuedgrowth of our business and sales and related services derived from our May 2005acquisition of Optimis, which expanded our workforce optimization solution.Total revenue in the first half of 2006 increased 22% compared to the sameperiod in 2005 due to increases in product and services revenue.  The strengthening of the U.S. dollar againstcertain foreign currencies reduced revenue by approximately 1% and 2%,respectively, for the three and six months period ended June 30, 2006, comparedto the same periods in 2005. Our historical revenue recognition practice withrespect to revenue received through the OEM channel has generally been torecognize revenue upon receipt of royalty reports from the OEM partner becauseuntil that time, pricing was deemed not to be fixed or determinable.  However, effective April 1, 2006, the Companybegan recognizing revenue from one OEM partner upon receipt of a valid purchaseorder because it was determined, based on the Company’s historical experiencewith this particular partner, that fixed and determinable pricing now exists atthe time the order is placed by the partner. As a result of this change, the Company recognized an additional $1.0million in license revenue in the second quarter 2006.  The number of installed customer sites grewto 4,453 as of June 30, 2006 from 3,979 sites as of June 30, 2005.

*Productrevenue*

The table belowprovides a detailed breakdown of the product revenue for the three and sixmonths ended June 30, 2006 and 2005 as follows (in thousands):
|            | ** ** | **Three months ended June 30,** | ** ** | ** ** | ** ** |
|------------|------------|---------------------------------|------------|------------|------------|
| ** ** | ** ** | **2006**                        | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:   |       |                            |       |       |       |   |   |
| Software   |       | $19,211                         |       | $17,035    |       | 13 | % |
| Hardware   |       | 2,852                           |       | 1,883      |       | 51 | % |
|       |       | $22,063                         |       | $18,918    |       | 17 | % |

 
|            | ** ** | **Six months ended June 30,** | ** ** | ** ** | ** ** |
|------------|------------|---------------------------------------------------|------------|------------|------------|
| ** ** | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:   | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software   |       | $                                                 | 37,475     |       | $          | 32,102 |   | 17 | % |
| Hardware   |       | 4,427                                             |       | 3,184      |       | 39 | % |
|       |       | $                                                 | 41,902     |       | $          | 35,286 |   | 19 | % |

 

Product revenueincludes software revenue and hardware revenue. Software revenue for the threeand six months ended June 30, 2006 increased 13% and 17%, respectively,compared to the three and six months ended June 30, 2005.  Our product pricing has remained reasonablyconsistent over the previous three years. The increase in softwarerevenue growth in 2006 is largely attributed to our expanded product line,particularly Impact 360, as well as additional revenue recognized from theindirect sales channel. Our Impact 360 solution consists of software productsand services designed to optimize the workforce, processes and technologyinvolved in the customer service function. We periodically review our revenuerecognition policy with regard to our indirect sales channel inorder to account for current trends surrounding collectability.

Hardware revenuefor the three and six months ended June 30, 2006 increased $1.0 million and$1.2 million, respectively, compared to the three and six months ended June 30,2005. The increase in hardware revenue in 2006 is attributed to a few largehardware orders in 2006. However, hardware sales are incidental to ourbusiness, and we expect hardware revenue to decline in the future.

New customers accountedfor 25% and 18%, respectively, of software revenue, during the three monthsended June 30, 2006 and 2005.  New customers accounted for 20% and 19%,respectively, of software revenue, during the six months ended June 30, 2006and 2005. We receive follow-on revenue from our existing customers whenthey purchase additional user licenses or license additional applications atexisting sites and when they license our products at new sites.  We expectto continue receiving the majority of our product revenue from existingcustomers during 2006.

*Servicesrevenue*

Services revenue,consisting of installation, training, consulting, maintenance support andreimbursable travel expenses, increased 20% and 24% in the three and six monthsended June 30, 2006, respectively, compared to the same periods in2005.   The increases in 2006 were due to the installation andtraining services related to new product sales and due to customers renewingtheir maintenance contracts with us thereby increasing our recurring maintenancerevenue stream.  The percentage of Witness customers that have renewedtheir maintenance contracts with us has historically exceeded 90%.  Webelieve that maintenance contracts will be renewed at a comparable rate during2006.  We expect services revenue, in absolute dollars, to increase overtime due to the compounding effect of renewals of annual maintenance contractsfrom existing customer sites and to remain relatively constant as a percentageof total revenue, excluding hardware revenue, throughout 2006.

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*Total cost of revenue*

Total cost ofrevenue increased 15% and 16% in the three and six months ended June 30, 2006,respectively, compared to the same year ago periods. Expressed as apercent of revenue, gross profit margins increased slightly to 67% for thethree months ended June 30, 2006, compared to 66% for the same year agoperiod. Expressed as a percent of revenue, gross profit margins increasedslightly to 68% for the six months ended June 30, 2006 compared to 66% for thesame year ago period. The increases in 2006 resulted primarily fromproductivity gains achieved in the professional services organization,partially offset by an increase in stock —based compensation expense of  $0.7 million and $0.9 million, respectively,for the three and  six months ended June30, 2006 compared to the same periods in 2005,   Excluding hardware costof revenue, stock-based compensation expense and the amortization of intangibleassets resulting from acquisitions, gross profit margins have remained fairlystable at 75% and 74% in the first half of 2006 and 2005, respectively. We expect our gross profit margin, excluding hardware, stock-based compensationexpense and amortization of intangible assets, to continue to remain relativelyconstant throughout 2006.

* Cost of product revenue*

The table belowprovides a detailed breakdown of the cost of product revenue for the three and sixmonths ended June 30, 2006 and 2005 as follows (in thousands):
|                             | ** ** | **Three months ended June 30,** | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:                    |       |                                                |       |       |       |   |   |
| Software                    |       | $                                                   | 923        |       | $          | 632 |   | 46 | % |
| Hardware                    |       | 2,803                                               |       | 1,912      |       | 47 | % |
| Amortization of intangibles |       | 1,483                                               |       | 2,384      |       | (38 | )% |
|                        |       | $                                                   | 5,209      |       | $          | 4,928 |   | 6 | % |

 
|                             | ** ** | **Six months ended ended June 30,** | ** ** | ** ** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                                     | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:                    | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software                    |       | $                                                            | 1,577      |       | $          | 1,574 |   | 0 | % |
| Hardware                    |       | 4,462                                                        |       | 3,230      |       | 38 | % |
| Amortization of intangibles |       | 3,748                                                        |       | 4,456      |       | (16 | )% |
|                        |       | $                                                            | 9,787      |       | $          | 9,260 |   | 6 | % |

 

Cost of productrevenue consists of amortization of acquired technology, capitalized softwaredevelopment costs, hardware costs acquired from third parties, royalties due tothird parties for software components that are embedded in some of our softwareapplications and packaging costs.  For the three and six months ended June30, 2006, amortization of intangibles decreased 38% and 16%, respectively,  compared to the same year ago periods. Asignificant portion of the cost of acquired technology associated with theEyretel acquisition has been fully amortized as of June 30, 2006.

For the three and six months ended June 30, 2006, costof hardware revenue increased by $0.9 million and $1.2 million, respectively,compared to the same year ago periods. This increase corresponds to theincrease in hardware revenue in 2006.

For the three andsix months ended June 30, 2006, cost of software increased 46% and 0%,respectively, compared to the same year ago periods.  The increase was dueto higher royalties expense during the three months ended June 30, 2006compared to the same period of 2005. Royalties expense relate to third partiesfor software components that are embedded in some of our software applications.Such royalties vary period-over-period in proportion to the sales of certainproducts.   For the three and six months endedJune 30, 2006, expressed as a percentage of software revenue, the cost ofsoftware revenue was 5% and 4%, respectively, compared to 4% and 5%,respectively, for the same year ago periods.  As we develop upgrades ofour existing products and add new offerings to our product suite, wemay embed third-party technology into some of our software, which couldincrease the cost of software revenue in the future.

*Cost of services revenue*

Cost of servicesrevenue for installation, training, consulting and maintenance services includepersonnel costs and related expenses and allocated overhead.  Personnelcosts include salaries, bonuses and benefits and allocated overhead.  Costof services revenue increased 19% and 21% in the three and six months endedJune 30, 2006, respectively, compared to the same periods in 2005. Theincreases in 2006 are due primarily to an increase in the number of employeesengaged in customer support services and stock-based compensation expenses.Stock-based compensation expense for the three and six months ended June 30, 2006was $0.7 million and $0.9 million, respectively.

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Cost of servicesrevenue, as a percentage of services revenue, was 39% in the second quarter of2006, compared to 40% in the second quarter of 2005.  Cost of servicesrevenue, as a percentage of services revenue, for the six months ended June 30,2006 and 2005, was 38% and 39%, respectively. We anticipate that our servicesmargins will remain relatively stable throughout 2006.  We expect ourcustomer service organization to continue to grow over time and, therefore, weanticipate that our cost of services revenue, in absolute dollars, willincrease as we grow our customer base.

*OperatingExpenses*

*Selling, General and Administrative. *Selling, general and administrative expense (‘‘SG&A’’)consists primarily of personnel costs, sales commissions, marketing programs,professional fees, the amortization of certain intangible assets and provisionsfor bad debt expense. For the three and six months ended June 30, 2006,SG&A expense of $25.9 million and $51.1 million, respectively, increased 20%and 23%, respectively compared to the same year ago periods.  Theseincreases are due primarily to theincrease in stock-based compensation expense,****legaland professional fees, and personnel costs incurred during the three and sixmonths ended June 30, 2006.  For thethree and six months ended June 30, 2006, stock-based compensation expense was$1.9 million and $4.5 million, respectively. Certain increases in SG&Acosts, especially personnel, during 2006 resulted from the Blue Pumpkin andOptimis acquisitions during the first half of 2005. We expect SG&A expenseto increase in absolute dollars throughout 2006, but decrease as a percentageof total revenue, due to anticipated revenue growth.

*Researchand Development.*  Research and development (‘‘R&D’’)expenses consist primarily of personnel and consulting costs to support productdevelopment and allocated overhead.  R&D costs are generally expensedas incurred and include software development costs incurred prior to theestablishment of technological feasibility. Costs incurred subsequent toestablishing technological feasibility are capitalized and amortized over theirestimated useful lives to cost of product revenue.  For the three and sixmonths ended  June 30, 2006, totalamortization of software development costs amounted to $0.1 million and $0.3million, respectively compared to $0.1 million and $0.3 million, respectively,for the same  year ago periods. As ofJune 30, 2006 and 2005, we had $1.2 million and $0.2 million, respectively, incapitalized but unamortized software development costs. R&D expensesincreased 17% and 22% in the three and six months ended June 30, 2006,respectively, compared to the same year ago periods due to the increased numberof employees engaged in research and development activities. In addition, stock—based compensation expense in the amount of $ 0.6 million and $0.9 million wasincurred during the three and six months period ended June 30, 2006.  We expect total R&D expense to increasein absolute dollars but decrease as a percentage of total revenue during theremainder of 2006.

*Merger-related and Integration Costs*.We incurred merger-related and integration costs of $2.2 million in the firsthalf of 2006, pertaining to the acquisitions of Blue Pumpkin and Optimis. These costs primarily related to legal andprofessional fees. During the first half of 2005, we incurred $2.6 million inmerger-related and integration costs, comprised primarily of costs oftransitional Blue Pumpkin and Optimis employees and other contractors, travelcosts and advertising costs.

*AcquiredIn-Process Research and Development Charges.*  During thefirst quarter of 2005, we estimated that $9.0 million of the purchase price ofBlue Pumpkin represented acquired in-process research and development (‘‘IPR&D’’)that had not yet reached technological feasibility as defined by SFAS No. 86,*  Accountingfor the Cost of Computer Software to Be Sold, Leased or Otherwise Marketed,*  and had no alternative future use. Accordingly, these amounts were immediately charged to expense uponconsummation of the acquisition.  The value of the IPR&D wascalculated with the assistance of an independent third-party appraiser byutilizing a discounted cash flow methodology, focusing on the income-producingcapabilities of the in-process technologies and taking into consideration:stage of completion; complexity of work to date and to complete; anticipatedproduct development and introduction schedules; forecasted product salescycles; 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 and sixmonths ended June 30, 2006 and 2005, respectively is as follows (inthousands):
| ** **            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** | ** ** |
|-----------------------|------------|--------------------------------------|------------|------------------------------------|------------|------------|
| ** **            | ** ** | **2006**                             | ** ** | **2005**                           | ** ** | **2006**   | ** ** | **2005** | ** ** | ** ** |
| Interest income, net  |       | $                                    | 1,695      |                               | $          | 182        |   | $ | 3,103 |   | $ | 473 |   |   |
| Foreign currency loss |       | (223                                 | )          | (126                               | )          | (360       | ) | (279 | ) |   |
|                  |       | $                                    | 1,472      |                               | $          | 56         |   | $ | 2,743 |   | $ | 194 |   |   |

 

We expect that interest income will continue to  higher in 2006 than in 2005 due to highercash and investment balances resulting from our common stock offering inDecember 2005 and expected increases in cash flows from operations during2006, and higher interest rates.

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*Provisionfor Income Taxes*

We recorded a provision for federal alternativeminimum tax, deferred taxes and foreign income tax, net of federal taxbenefits, for the three and six months ended June 30, 2006 and 2005.  Of the $42,000 and $0.7 million provision,respectively, for the six months ended June 30, 2006 and 2005, $0.2 million and$0.2 million, respectively, related to the utilization of a portion of theof deferred income tax assets, primarily net operating loss carry-forwards, acquiredin the 2005 acquisition of Blue Pumpkin. Because a full valuation allowance was recorded against these assets,the benefit from the utilization of these deferred income tax assets in 2006and 2005 was credited as a reduction to goodwill.

The provision for income taxes for the sixmonths ended June 30, 2006 and 2005, benefited from the utilization of netoperating loss carryforwards from prior years. We had net operating losscarryforwards aggregating $81.3 million for U.S. income tax purposes and 38.1 millionfor foreign income tax purposes remaining as of December 31, 2005.  We expect that the provision for income taxesin 2006 will continue to benefit from the utilization of these net operatingloss carryforwards.  However, theutilization of certain net operating loss carryforwards arising fromacquisitions will result in a reduction of the valuation allowance for deferredincome tax assets and goodwill or intangible assets and the recognition ofdeferred income tax expense.

**Liquidity and Capital Resources**

At June 30, 2006, we had$13.2 million available for borrowing under our line of credit. At ourelection, borrowings under the line of credit bear interest at the bank’s primerate, which was 8.25% on June 30, 2006, or LIBOR plus 300 basis points,and are limited to 85% of eligible accounts receivable, as defined by theagreement. The revolving line of credit is secured by all of our assets andrequires compliance with various covenants, including liquidity ratios andEBITDA requirements, among others. As of June 30, 2006, we were incompliance 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 $6.0million in 2006. We believe that our capital expendituresmay increase over the next several years as we expand our facilities andacquire equipment to support the expansion of our research and developmentactivities and internal management 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, theavailability under our line of credit may be used to fund working capitalrequirements or 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 exchange rates because we translateforeign currencies into U.S. dollars for reporting purposes. Historically,these risks have been minimal, but as our international operations continue togrow, adverse currency fluctuations could have a material adverse impact on ourfinancial results. Net foreign exchange losses were $0.2 million and $ 0.4million in the three and six months ended June 30, 2006, respectively,compared to $0.1 million and $0.3 million, respectively, in the same periods inthe prior year.

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.

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

Information concerningmarket risk is included in Management’s Discussion and Analysis of FinancialCondition and Results of Operations, Item 2 of Part I of this report.

**Item 4.Controls and Procedures**

***Evaluation ofDisclosure Controls and Procedures***

We conducted an evaluation ofthe 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 June 30, 2006, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures are not effective due to the material weaknesses discussed below.

Our policies and procedures over accountreconciliations and management’s review of estimates and account balances werenot designed to a sufficient level of precision to prevent or detectmisstatements that could have a material effect on the consolidated financialstatements. As a result, there were errors to the consolidated financialstatements that were not identified or recorded by management. This deficiencyresulted in more than a remote likelihood that a material misstatement to theconsolidated financial statements would not be prevented or detected.

Since the Company’s original 2005 Form 10-K was filedon March 17, 2006, an additional material weakness in the Company’s internalcontrol over financial reporting as of December 31, 2005 has beenidentified.  At December 31, 2005, theCompany did not have effective policies and procedures to determine the cost ofan acquired enterprise in a business combination in accordance with U.S.generally accepted accounting principles. Specifically, the Company’s polices and procedures did not provide forappropriate consideration of funds held in escrow for pre-acquisitioncontingencies.  This material weaknessresulted in errors in restricted cash, accrued liabilities, and stockholders’equity as of December 31, 2005. 

In the first half of 2006,management made significant progress in remediating the material weakness by:

·                  Revising our policies and procedures relatedto the capitalization and depreciation of property and equipment including theaddition of control procedures over the review of information input into ouraccounting system;

·                  Revising our control procedures through theaddition of more effective controls to ensure the accrual of certain period-endoperating expenses;

·                  Implementing formal policies, includingquantitative and qualitative analysis, over the documentation and evaluation ofunsubstantiated differences that individually or in the aggregate should betimely recorded; and

Management believes theabove new policies and procedures, when fully implemented, will be effective inremediating this material weakness.

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.

*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 Special Committeeundertook its investigation with the assistance of independent counsel andaccounting experts retained by its counsel. The Special Committee reviewed all5.7 million stock options granted throughout the period covered by itsinvestigation. In December 2006, the Special Committee completed its review andreported its findings and recommendations to our full Board of Directors. TheSpecial Committee did not find fraud or intentional misrepresentation in thefinancial 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 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 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 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 dateswas lower than the fair market value on the redetermined measurement dates, inaccordance with Accounting Principles Board No. 25, “Accounting for StockIssued to Employees” (“APB No. 25”) and related interpretations, we concludedthat we should have recorded material stock-based compensation expense whichwas not previously accounted for in our previously issued 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 accounting,income taxes and miscellaneous other items. The cumulative effect of therestatement adjustments on our Consolidated Balance Sheet as ofDecember 31, 2005 resulted in an increase in the accumulated deficit of$10.5 million, an increase in additional paid-in capital of $5.8 million andincreases in assets and liabilities of $2.8 million and $7.5 million,respectively.

As described in Note 3, “Restatement of CondensedConsolidated Financial Statements,” of the Notes to Condensed ConsolidatedFinancial Statements, our  condensedconsolidated financial statements has been restated to correct errors in therecognition of stock-based compensation expense for previously granted stockoptions. Although there were no option measurement dating issues, our 2006Condensed Consolidated Financial Statements are impacted by option grants inprior years where the measurement dates have been adjusted.

Following the SpecialCommittee’s findings and recommendations, and in an effort to strengthen ourcorporate governance mechanisms, the Board voted to separate the positions ofChairman of the Board and CEO and elected Mr. Dan Lautenbach, a member of theCompany’s Board since 2002 and a member of the Special Committee, as Chairmanof the Board, effective December 6, 2006. Mr. Lautenbach succeeded Mr. David Gould, who voluntarily agreed to stepdown as Chairman of the Board of Directors.

In addition,following the Special Committee’s findings and recommendations, Mr. Gouldvoluntarily agreed to resign from his positions as CEO and as a member of theCompany’s Board of Directors effective January 3, 2007.  The Board appointed Mr. Nicholas Discombe,the Company’s former President and Chief Operating Officer, as the Company’snew CEO and as a member of the company’s Board effective January 3, 2007.

In furtherresponse to the Special Committee’s recommendations, and in a further effort tostrengthen our management and controls and corporate governance mechanisms, weplan in the future to realign certain responsibilities in financial reportingareas. Management believes that the above measures will address the findings bythe Special Committee and strengthen the company’s management and controls andcorporate governance mechanism.

We believe thatour current practices for granting stock options and determining measurementdates are appropriate and that adequate controls are in place.  Most of the material exceptions resultingfrom the use of inaccurate measurement dates occurred during 2000 and2001.  Since 2001, the Company hasimplemented improvements in its processes, personnel and practices to enhanceits internal controls over the issuance of stock option grants.  Examples of these improvements include:

i)                 Changein process:  Beginning in 2002, theCompany enhanced its internal controls over stock option grant practices andreduced the risk of using inaccurate measurement dates by complying with thenew SEC requirement of filing Form 4s within two days of the date of grant.

ii)              Changein personnel:  A number of people withprior public company experience joined the Company after 2001 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)           Changein practices:  The internal process 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.

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, 

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including Blue Pumpkin’s Prime Time Skills and PrimeTime Enterprise products. IEX’s lawsuit sought 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 sought aninjunction and money damages for IEX’s infringement of the ‘732 Patent.

 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 IEX’s parent company, in April 2006 and agreed to makesix annual payments of $0.5 million ($3.0 million in total) fromApril 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 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 on July 29,2005, collectively, through which we deny infringement of any valid claim ofthe STS patents and seek a declaration to that effect. The case has been set ona discovery calendar and is at a preliminary stage.

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.

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 preliminary stage.

On May 10, 2006, NICESystems, Inc. and NICE Systems Ltd. (collectively “NICE”), filed a patentinfringement suit seeking monetary damages and injunctive relief in the U.S.District Court for the District of Delaware against us (“Delaware Action”).  The Delaware Action asserts that our products,including ContactStore, ContactStore for IP, ContactStore for CommunicationsManager, Quality for Communications Manager, and eQuality Balance, infringe oneor more claims of ten U.S. Patents:  U.S.Patent 

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Nos. 5,274,738; 5,396,371; 5,819,005; 6,249,570;6,728,345; 6,775,372; 6,785,370; 6,870,920; 6,959,079; and 7,010,109 (“theDelaware Patents”).  We answered NICE’scomplaint on June 30, 2006, through which we deny infringement of any validclaim of any of the Delaware Patents. The case is at a preliminary stage and the Court has set a schedulingconference for September 7, 2006.

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, etal., Civil Action No. 1:06-CV-2039 (N.D. Ga.).  The complaint allegespurported violations of federal and state law, including breaches of fiduciaryduty, abuse of control, constructive fraud, corporate waste, unjust enrichment,gross mismanagement and violations of certain antifraud provisions of thefederal securities laws (including Sections 10(b) and 14(a) of the SecuritiesExchange Act of 1934 and Rules 10b-5 and 14a-9 thereunder) in connection withcertain stock option grants made by the Company.  The complaint seeksmonetary damages in unspecified amounts, disgorgement of profits, anaccounting, rescission of stock option grants, imposition of a constructivetrust over the defendants’ stock options and proceeds derived therefrom,punitive damages, reimbursement of attorneys’ fees and other costs andexpenses, an order directing the Company to adopt or put to a stockholder votevarious proposals relating to corporate governance, and other relief asdetermined by the court.  On November 15, 2006, the Company and the otherdefendants filed a motion to dismiss the complaint in its entirety on a varietyof grounds, including plaintiffs’ failure to allege demand futility.  Rather than respond to that Motion,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.

A class action securities lawsuit has been filedby an individual  on August 14,2006 claiming to be a stockholder of the Company naming the Companyand certain of its directors and officers as defendants in connection withcertain stock option grants made by the Company.  Rosenberg v. Gould, etal., Civil Action No. 1:06-CV-1894 (N.D. Ga.).  The complaint, filed inthe United States District Court for the Northern District of Georgia, allegesviolations of Section 10(b) of the Securities Exchange Act of 1934 and Rule10b-5 thereunder and seeks unspecified damages, attorneys’ fees and other costsand expenses, unspecified extraordinary, equitable and injunctive relief, andother relief as determined by the court.  Neither a lead plaintiff norlead counsel has been appointed, nor has any response to the complaint yet beenrequired. The Company and the other defendants will respond to the complaintwhen appropriate.

On October 27, 2006, theCompany received a notice of informal nonpublic inquiry from the Securities andExchange Commission requesting certain documents and information relating tothe company’s stock option grant practices from February 2000 to the present.Witness Systems intends to cooperate fully with all matters related to thisrequest.

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 Stock Market,our common stock could be delisted, which could, among other things, reduce theprice of our common stock and the levels of liquidity available to ourstockholders.*

In connection with the Special Committee’s review andthe restatement of our  consolidatedfinancial statements, we did not timely file certain of our periodicreports with the SEC.  As a result, we were not in compliance with thelisting requirements under the Nasdaq Rules. Following a review and hearing process with the Nasdaq, theNasdaq has permitted our securities to remain listed.However, our securitiescould be delisted in the future if we do not maintain compliance withapplicable listing requirements. If our securities are delisted from theNasdaq, they would subsequently be transferred to the National QuotationService Bureau, or “Pink Sheets”. The trading of our common stock throughthe Pink Sheets may reduce the price of our common stock and the levels ofliquidity available to our stockholders. In addition, the trading of our commonstock through the Pink Sheets could materially and adverselyaffect our access to the capital markets and our ability to raise capitalthrough alternative financing sources on terms acceptable to us, or toraise capital at all. Securities that trade through the Pink Sheets are nolonger eligible for margin loans, and a company trading through the PinkSheets cannot avail itself of federal preemption of state securities or “bluesky” laws, which adds substantial compliance costs to securities issuances,including pursuant to employee option plans, stock purchase plans and privateor public offerings of securities. If we are delisted in the future from theNasdaq and transferred to the Pink Sheets, there could also be othernegative implications, including the potential loss of confidence by suppliers,customers and employees and the loss of institutional investor interest in ourCompany.

*Because our products have along sales cycle, it is more difficult to plan our expenses and forecast our results;and our operating results may fail to meet investor expectations andmay fluctuate materially from period to period, which may adverselyaffect 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 morelarge orders or a significant number of small orders, it would delay the timingof our revenue, but not the timing of most of our corresponding expenses.Lengthening of our sales cycle could also increase the total cost of a sale dueto additional employee time and costs associated with the sale. Material changesin our sales cycle could cause our quarterly revenue or operating results to bebelow the expectations of investors, and the price of our common stock couldfall substantially.

Our customers’ decision process regarding 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 requiredbefore purchasing 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.

*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 ofrelatively large orders. The delay or failure to close anticipated sales in aparticular quarter could reduce our revenue in that quarter and subsequentquarters over which revenue for the sale could be recognized. In addition,because our revenue from installation and training services largely correlateswith our product revenue, a decline in product revenue could also cause adecline in our professional services revenue in the same quarter or insubsequent quarters. Our quarterly revenue is difficult to forecast for severalreasons, including the following:

·                  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 $50.2 million and $40.9****million in the first six months of 2006 and 2005,respectively, from customers located outside the United States. Our operationsoutside of the United States at June 30, 2006, consisted of operationslocated in Australia, 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 additional acquisitions,internal business expansion and strategic business relationships. These effortsrequire significant management attention and financial resources. Wemay not be able to successfully penetrate international markets or, if wedo, we may not be able to grow or to maintain adequate profit margins inthese markets. Because of the complex nature of our international expansion, it

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may adversely affect our business and operatingresults. International expansion and sales are subject to many risks, includingthe following:

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

·                  expandingand training our international sales force and support operations;

·                  highercosts of employment in certain international locations;

·                  difficultiesin producing localized versions of our products;

·                  politicaland economic instability;

·                  potentiallyadverse tax consequences of operating in foreign countries;

·                  international Laws and regulations, including trade restrictions, local labor ordinances,changes in tarriffs, rates and import and export Licensing requirements;

·                  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 on maintaininga productive direct sales force. Historically, it has taken us up to six monthsto train new sales personnel before they reach an acceptable level ofproductivity. We have also experienced difficulty in recruiting sales personnelwith experience in computer and telephone integration technologies. We cannotassure you that we will be able to continue to manage turnover and hire newsales personnel to meet our needs. If the personnel we hire are less qualifiedthan we expect, it may take us more time to train them before they reachan acceptable level of productivity, which could increase our costs and reduceour 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 39% of totalproduct revenue in the first six months 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.

Someresellers with which we do business have similar, and often more established,relationships with our competitors, and may recommend the products andservices of our competitors to customers instead of our software and services.We cannot provide assurance that these distribution partners will devoteadequate resources to selling our software and services or that our resellersmay not learn about our products and the market for our software andservices and develop and sell competing products and services. As a result, ourrelationships with resellers could lead to increased competition for 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, butare 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 recording, quality monitoring and workforce management software exposesus to risks of obsolescence due to changes in competitive product offerings.*

We have derived a substantial portion of our productrevenues from sales of our recording, quality monitoring and workforcemanagement software products. We expect revenue from these products to continueto account for a significant portion of our revenue for the foreseeable future.As a result, any factors affecting the markets for these products couldmaterially and adversely affect our business, financial condition and resultsof operations. We cannot assure you that the market will continue to demand ourcurrent products or that we will be successful in marketing any new or enhancedproducts. If our competitors release new products that are superior to ourproducts in performance or price, demand for our products may decline. Adecline in demand for our products as a result of competition, technologicalchange or other factors would reduce our total revenues and adversely affectprofitability.

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

The markets for our products are characterized byrapidly changing technology, frequent new product introductions andenhancements, changes in customer demands and evolving industry standards. Ourexisting products could be rendered obsolete if we fail to continue to advanceour technology. We have also found that the technological life cycles of ourproducts are difficult to estimate, partially because of changing demands ofour customers. We believe that our future success will depend on our ability tocontinue to enhance our current product line while we concurrently develop andintroduce new products that keep pace with competitive and technologicaldevelopments. These developments require us to 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 

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risk that the ‘environment’ will fail or that it willnot achieve the compatibility with our product that we and the OEM seek. Ifthis happens, our software might not function properly, or the OEM might sellless of it, or both, which could have a material adverse effect on ourrevenues, 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-time performance ofour customers’ interactions or our customers are unable to retrieve therecordings when necessary, we may be subject to liability and ourreputation may be harmed.

*If we are unable to 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 ourcustomers. While we have internal policies and procedures for employeesperforming these functions, the perception that we have improperly handledsensitive, confidential information could have a negative effect on ourbusiness. If, in handling this information, we fail to comply with privacy orsecurity laws, we could incur civil liability to government agencies, customersand individuals whose privacy is compromised. If personal information isreceived or used from sources outside the U.S., we could be subject to civil,administrative or criminal liability under the laws of other countries. Inaddition, while we implement sophisticated security measures, third partiesmay attempt to breach our security or inappropriately use our productsthrough computer viruses, electronic break-ins and other disruptions. Ifsuccessful, confidential information may be improperly obtained and wemay be subject to lawsuits and other liability. Any internal or externalsecurity breaches could harm our reputation, and even the perception ofsecurity risks, whether or not valid, 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 June 30, 2006, we had eleven 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. trademark registrations,and U.S. trademark applications for our “eQuality” trademark and its variationsthat predate our use, and the April 2002 issuance of the U.S. registrationfor our trademark eQuality®. It is possible that an owner of legal rightsresulting from prior use, registrations, or applications will bring legalaction to challenge our registration of and/or our use of the trademarkeQuality®, and may also seek compensation for damages resulting from ouruse this trademark. As a result, we cannot assure you that our registration ofthis trademark will be undisturbed, or that this use will not result inliability for trademark infringement, trademark dilution, and/or unfaircompetition.

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.*

Ourcustomers ordinarily purchase installation, training and maintenance servicestogether with our products. The functionality of our products is not dependenton our installation and training services. We believe that the speed andquality of installation services are competitive factors in our industry. Ifour installation services are not satisfactory to our customers, the customersmay choose not to use our installation services or they may notlicense our software in the future. As a result, we would lose licensing andservices revenue, and it could harm our reputation. In addition, our revenuesrealized from the performance of maintenance services are 

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materialto our operating results, and a failure to provide adequate maintenance supportto our customers would result in reduced maintenance revenues and have anadverse effect on our operating results.

*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 limited experiencein making acquisitions and investments. As a result, our ability to identifyand 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:

·                  identifying suitable candidates, performingappropriate due diligence, identifying potential liabilities and negotiatingacceptable terms;

·                  reducing our working capital and hinderingour ability to expand or maintain our business, if we make acquisitions usingcash;

·                  the potential distraction of our management,diversion of our resources and disruption of our business;

·                  retaining and motivating key employees of theacquired companies;

·                  managing operations that are distant from ourcurrent headquarters and operations;

·                  entering into geographic markets in which wehave little or no prior experience;

·                  competing for acquisition opportunities withcompetitors that are larger than we are or have greater financial and otherresources than we have;

·                  accurately forecasting the financial impactof a transaction;

·                  assuming liabilities of acquired companies,including litigation related to the operation of the business prior to theacquisition;

·                  maintaining good relations with the customersand suppliers of the acquired company;

·                  potentially dilutive issuances of securitiesas consideration for an acquisition;

·                  effectively integrating acquired companiesand achieving expected synergies; and

·                  the impairment of the value of the assetsacquired in any corporate acquisition.

*If we need additionalfinancing to maintain or expand our business, it may not be available onfavorable terms, 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:

·                  develop and enhance our software to remaincompetitive;

·                  take advantage of future opportunities, suchas acquisitions;

·                  respond to changing customer needs and ourcompetitors’ innovations; or

·                  attract and retain qualified key personnel.

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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:

·                  cancellations of orders due to unavailabilityof hardware;

·                  increased hardware prices, whichmay make our products less attractive; and

·                  additional development expense to modify ourproducts to work with new hardware configurations.

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 a material weakness 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.*

Themarket price of our common stock has been subject to significant fluctuationsin response to variations in quarterly operating results and other factors. Inaddition, the stock market has experienced significant volatility that hasparticularly affected the market prices of equity securities of many technologycompanies and that often has been unrelated or disproportionate to theoperating performance of these companies. Any announcement with respect to anyadverse variance in revenue or earnings from levels generally expected bysecurities analysts or investors could have a significant adverse effect on thetrading price of our common stock. In addition, factors such as announcementsof technological innovations or new products by us, our competitors or thirdparties, changing conditions in the customer relationship management softwaremarket, changes in the market valuations of similar companies, loss of a majorcustomer, additions or departures of key personnel, changes in estimates bysecurities analysts, announcements of extraordinary events, such asacquisitions or litigation, or general economic conditions may have anadverse effect on the market price of 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 our software, services and hardware, deferrals by customers of serviceengagements previously scheduled and pressure by our customers and competitorsto discount our offerings. If the improvements recently 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.*

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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 oftelecommunications and telephone and Internet monitoring and recordingproducts, such as our software. We believe that increases in regulation couldcome in a number of different forms, including regulations regarding privacy,protection of personal information such as Social Security numbers, credit cardinformation and employment. For example, the State of California enacted theDatabase Security Breach Act, which requires any business that suffers acomputer security breach to immediately notify customers in California ifpersonal information has been compromised, and the payment card industry hasadopted regulations that require additional security regarding the storage ofconsumers’ credit card numbers. The adoption of any new regulations or changesto existing regulations could cause a decline in the use of our software andcould result in increased expense for us as we modify our software toaccommodate these regulations. Moreover, these regulations could subject ourcustomers or us to liability. Whether or not these regulations are adopted, ifwe do not adequately address the privacy concerns of consumers, companiesmay be hesitant to use our software. If any of these events occur, itcould 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 significantcompetition for individuals with the skills required to perform theservices we offer. If we are unable to attract and retain qualified personnelor if we experience high personnel turnover, it could prevent us fromeffectively managing and expanding our business.

Our success also depends upon the 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.

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

Throughout much of our history, we have experiencedlosses. As a result of our prior operating losses, we had a significantaccumulated deficit as of June 30, 2006. We need to generate sufficient revenueto achieve sustained profitability and avoid incurring losses again in thefuture.

**Item 6.Exhibits**
| **(a)** | ** ** | **Exhibits**                                                                   |
|---------|------------|--------------------------------------------------------------------------------|
|    |       |                                                                           |
| 23.1*   |       | Consent of Independent Business Valuation Experts                              |
| 31.1*   |       | Certification of Chief Executive Officer                                       |
| 31.2*   |       | Certification of Chief Financial Officer                                       |
| 32.1*   |       | Certifications Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

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* Filed herewith

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** **

**(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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