**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 periodended September 30, 2006**

**OR**

| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

 

**For the transition periodfrom             to             **

**Commission file number 000-29335**

 

**WITNESS SYSTEMS, INC.**

(Exact Name of Registrant as Specified in Its Charter)

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

 

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

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

Securitiesregistered pursuant to Section 12(g) of the Act:
| Title of each class                     | ** ** | **Name of each exchange on which registered** |
|-----------------------------------------|------------|-----------------------------------------------|
| Common Stock,  par value $.01 per share |       | Nasdaq                                        |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes o  oNo ý

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     |
|--------------------------------|----------------------|-------------------------------------------------|

 

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

As ofJanuary 31, 2007, 34,149,619 shares of the registrant’s common stock wereoutstanding.

 

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**WITNESS SYSTEMS, INC.**

**FORM 10-Q**

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

 

2

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**PART I.FINANCIAL INFORMATION**

**Item 1.   Financial Statements**

**WITNESSSYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(In thousands, except share data)**
| ** **                                                                                                                                                                                             | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                             | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                             | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                        |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                             |       | $                            | 93,477     |                        | $          | 111,751 |   |
| Investments, at  fair market value                                                                                                                                                                     |       | 65,183                       |       | 14,886                      |       |
| Restricted cash  held in escrow                                                                                                                                                                        |       | —                       |       | 4,000                       |       |
| Accounts  receivable, net of allowance of $2,614 at September 30, 2006 and $3,283  at December 31, 2005                                                                                      |       | 50,528                       |       | 40,218                      |       |
| Prepaid and  other current assets                                                                                                                                                                      |       | 7,198                        |       | 5,462                       |       |
| Total current  assets                                                                                                                                                                                  |       | 216,386                      |       | 176,317                     |       |
| Intangible assets, net  of accumulated amortization of $38,001 at September 30, 2006 and $26,874 at  December 31, 2005                                                                                 |       | 26,473                       |       | 36,389                      |       |
| Goodwill                                                                                                                                                                                               |       | 41,156                       |       | 40,319                      |       |
| Property and equipment,  net of accumulated depreciation of $17,897 at September 30, 2006 and $13,715  at December 31, 2005                                                                            |       | 9,055                        |       | 7,796                       |       |
| Other assets                                                                                                                                                                                           |       | 10,274                       |       | 3,573                       |       |
|                                                                                                                                                                                                   |       | $                            | 303,344    |                        | $          | 264,394 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                   |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                       |       | $                            | 7,221      |                        | $          | 3,795 |   |
| Accrued expenses                                                                                                                                                                                       |       | 18,517                       |       | 29,651                      |       |
| Deferred revenue                                                                                                                                                                                       |       | 33,025                       |       | 23,756                      |       |
| Total current  liabilities                                                                                                                                                                             |       | 58,763                       |       | 57,202                      |       |
| Other long-term  liabilities                                                                                                                                                                           |       | 5,293                        |       | 4,165                       |       |
| Deferred income tax  liabilities                                                                                                                                                                       |       | 414                          |       | 743                         |       |
| Total  liabilities                                                                                                                                                                                     |       | 64,470                       |       | 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; 34,114,795 and 32,612,193  shares issued and outstanding at September 30, 2006 and  December 31, 2005, respectively             |       | 341                          |       | 326                         |       |
| Additional  paid-in capital                                                                                                                                                                            |       | 277,079                      |       | 251,712                     |       |
| Accumulated  deficit                                                                                                                                                                                   |       | (44,860                      | )          | (52,830                     | )          |
| Accumulated  other comprehensive income                                                                                                                                                                |       | 6,314                        |       | 3,076                       |       |
| Total  stockholders’ equity                                                                                                                                                                       |       | 238,874                      |       | 202,284                     |       |
|                                                                                                                                                                                                   |       | $                            | 303,344    |                        | $          | 264,394 |   |

 

See accompanying Notes to Condensed ConsolidatedFinancial Statements.

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)(Unaudited)**
| ** **                                      | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                        |       |                                                     |       |                                                    |       |   |   |   |   |
| Product                                         |       | $                                                        | 17,334     |                                                    | $          | 18,306 |   | $ | 59,236 |   | $ | 53,592 |   |
| Services                                        |       | 33,792                                                   |       | 28,843                                                  |       | 98,184 |   | 80,887 |   |
| Total revenue                                   |       | 51,126                                                   |       | 47,149                                                  |       | 157,420 |   | 134,479 |   |
| Cost of revenue:                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Product                                         |       | 3,578                                                    |       | 4,543                                                   |       | 13,365 |   | 13,803 |   |
| Services                                        |       | 12,951                                                   |       | 10,810                                                  |       | 37,505 |   | 31,139 |   |
| Total cost of revenue                           |       | 16,529                                                   |       | 15,353                                                  |       | 50,870 |   | 44,942 |   |
| Gross profit                                    |       | 34,597                                                   |       | 31,796                                                  |       | 106,550 |   | 89,537 |   |
| Operating  expenses:                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Selling, general and administrative             |       | 26,461                                                   |       | 21,667                                                  |       | 77,544 |   | 63,241 |   |
| Research and development                        |       | 8,142                                                    |       | 6,945                                                   |       | 24,201 |   | 20,038 |   |
| Merger-related and integration costs            |       | (31                                                      | )          | 1,059                                                   |       | 2,191 |   | 3,643 |   |
| Acquired in-process research and development    |       | 0                                                        |       | 0                                                       |       | 0 |   | 9,000 |   |
| Operating income (loss)                         |       | 25                                                       |       | 2,125                                                   |       | 2,614 |   | (6,385 | ) |
| Interest and  other income, net                 |       | 1,550                                                    |       | 245                                                     |       | 4,293 |   | 439 |   |
| Income (loss) before provision for income taxes |       | 1,575                                                    |       | 2,370                                                   |       | 6,907 |   | (5,946 | ) |
| Provision for  income taxes (benefit)           |       | (1,020                                                   | )          | 1,822                                                   |       | (1,061 | ) | 2,472 |   |
| Net income (loss)                               |       | $                                                        | 2,594      |                                                    | $          | 548 |   | $ | 7,968 |   | $ | (8,418 | ) |
|                                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income  (loss) per share:                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                           |       | $                                                        | 0.08       |                                                    | $          | 0.02 |   | $ | 0.24 |   | $ | (0.31 | ) |
| Diluted                                         |       | $                                                        | 0.07       |                                                    | $          | 0.02 |   | $ | 0.22 |   | $ | (0.31 | ) |
| Weighted-average  common shares outstanding:    |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                           |       | 34,021                                                   |       | 27,265                                                  |       | 33,515 |   | 26,743 |   |
| Diluted                                         |       | 36,282                                                   |       | 29,886                                                  |       | 36,569 |   | 26,743 |   |

 

See accompanyingNotes to Condensed Consolidated Financial Statements.

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**WITNESS SYSTEMS, INC. ANDSUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(Unaudited)**
| ** **                                                                                | ** ** | **Nine  Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                                      | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                                    |       |                                                          |       |   |   |
| Net income (loss)                                                                         |       | $                                                             | 7,968      |   | $ | (8,418 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                                          |       |   |   |
| In-process research and development                                                       |       | —                                                        |       | 9,000 |   |
| Amortization of intangible assets                                                         |       | 10,315                                                        |       | 11,220 |   |
| Stock-based compensation expense                                                          |       | 10,046                                                        |       | 309 |   |
| Depreciation and amortization of property and  equipment                                  |       | 4,116                                                         |       | 3,238 |   |
| Provision for accounts receivable                                                         |       | 1,488                                                         |       | 2,546 |   |
| Deferred income taxes                                                                     |       | (2,635                                                        | )          | 1,736 |   |
| Other non-cash items, net                                                                 |       | 948                                                           |       | 267 |   |
| Excess tax benefits from stock-based compensation                                         |       | (229                                                          | )          | — |   |
| Changes in operating assets and liabilities:                                              |       |                                                          |       |   |   |
| Accounts receivable                                                                       |       | (10,881                                                       | )          | (10,890 | ) |
| Prepaid and other assets                                                                  |       | (4,503                                                        | )          | (1,194 | ) |
| Accounts payable                                                                          |       | 3,269                                                         |       | (2,162 | ) |
| Accrued expenses                                                                          |       | (1,964                                                        | )          | 792 |   |
| Deferred revenue                                                                          |       | 8,661                                                         |       | (1,579 | ) |
| Accrued restructuring and integration costs                                               |       | (539                                                          | )          | (4,131 | ) |
| Net cash provided by operating activities                                                 |       | 26,060                                                        |       | 734 |   |
| Cash flows from  investing activities:                                                    |       |                                                          |       |   |   |
| Capital expenditures                                                                      |       | (5,348                                                        | )          | (3,976 | ) |
| Purchases of investments                                                                  |       | (114,537                                                      | )          | — |   |
| Proceeds from maturities of investments                                                   |       | 64,863                                                        |       | — |   |
| Proceeds from sales of investments                                                        |       | 184                                                           |       | 32,562 |   |
| Acquisition of Blue Pumpkin Software, Inc., net of  cash acquired of $3,900               |       | (8,250                                                        | )          | (37,637 | ) |
| Other acquisitions, net of cash acquired of $1,300                                        |       | (3,206                                                        | )          | (4,374 | ) |
| Restricted cash held in escrow                                                            |       | 4,000                                                         |       | (4,000 | ) |
| Net cash used in investing activities                                                     |       | (62,294                                                       | )          | (17,425 | ) |
| Cash flows from  financing activities:                                                    |       |                                                          |       |   |   |
| Proceeds from exercise of stock options and Employee  Stock Purchase Plan                 |       | 12,365                                                        |       | 8,495 |   |
| Proceeds from sale of common stock, net                                                   |       | 3,723                                                         |       | — |   |
| Excess tax benefits from stock-based compensation                                         |       | 229                                                           |       | — |   |
| Other                                                                                     |       | (105                                                          | )          | (151 | ) |
| Net cash provided by financing activities                                                 |       | 16,212                                                        |       | 8,344 |   |
| Effect of exchange rate changes on cash                                                   |       | 1,748                                                         |       | (1,204 | ) |
| Net decrease in cash and cash equivalents                                                 |       | (18,274                                                       | )          | (9,551 | ) |
| Cash and cash  equivalents at beginning of period                                         |       | 111,751                                                       |       | 42,641 |   |
| Cash and cash  equivalents at end of period                                               |       | $                                                             | 93,477     |   | $ | 33,090 |   |
| Supplemental  cash flow information:                                                      |       |                                                          |       |   |   |
| Cash paid for interest                                                                    |       | $                                                             | 5          |   | $ | 14 |   |
| Cash paid for  income taxes                                                               |       | $                                                             | 366        |   | $ | 428 |   |

 

See accompanying Notes to Condensed ConsolidatedFinancial Statements.

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSSeptember 30, 2006(Unaudited)**

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

***Business*** - ***Witness***Systems, Inc.(“Witness”) is a publicly traded company that provides workforce optimizationsoftware and services that help business capture customer intelligence andoptimize their work performance. Our Impact 360 solution features qualitymonitoring, compliance and IP recording, workforce management, performancemanagement and e-learning.  Our qualitymonitoring products record multimedia interactions, including traditionalvoice, Web chat and email, based on user-defined business rules to enableour customers to evaluate the performance of their customer servicerepresentatives, or CSRs, wherever they may be located in the enterprise.Our high-volume compliance applications are designed to record high volume,full-time performance of the voice conversations between CSRs and customers forpurposes such as compliance recording and sales verification. Our workforcemanagement products enable our customers to develop strategic staffing plans,deploy skilled resources and evaluate productivity of CSRs. Our performancemanagement applications provide comprehensive analytics, including performancescorecards, and reports of customer interaction and CSR performance. Oure-learning applications deliver ongoing training tailored to CSR needs andcompetencies. We also provide consulting and implementation services, trainingand support to customers that use our software products. Primarily deployed incontact centers-as well as the remote, branch and back offices of globalorganizations, the workforce optimization solution captures, analyzes andenables users to share and act on cross-functional information across theenterprise. With Impact 360, organizations can improve interactions and theunderlying back-office processes that enhance the customer experience and buildcustomer loyalty.

We are headquartered in Roswell, Georgia with operations in the UnitedStates, Australia, Brazil, Canada, China, Germany, India, Japan, Mexico, theNetherlands, Singapore, South Africa and the United Kingdom. We were originallyincorporated in 1988 in Georgia and were reincorporated in Delawarein 1997.

***Principles of Consolidation andReclassifications***- The unaudited interim condensed Consolidated Financial Statements include thefinancial statements of Witness Systems, Inc. and its wholly-ownedsubsidiaries. All significant intercompany balances and transactions have beeneliminated in consolidation. Certain prior period amounts have beenreclassified to conform to the current presentation.

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

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

**2.****                    ****Revenue Recognition 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 and EITF 00-21: Revenue Arrangementswith Multiple Deliverables.* Revenue is primarily derived fromlicensing software and providing related services including maintenance.Product revenue, which can include software and hardware, is recognized whenpersuasive evidence of an agreement exists, delivery of the product hasoccurred, the fee is fixed or determinable, collection is probable and vendorspecific objective evidence of fair value (“VSOE”) exists to allocate revenueto the undelivered elements of the arrangement. The Company reports hardwarerevenue gross in accordance with Emerging Issues Task Force (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 

6

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deferredat an amount equal to VSOE until those elements are delivered. Consequently,product revenue for the software and hardware is recognized (i) upondelivery of those products when we have VSOE for the related maintenance andprofessional services sold and (ii) at an amount representing thedifference between the total order amount and the amount deferred. For customerorders that include hardware, hardware revenue is accounted for as a separateunit of accounting in accordance with guidance provided in EITF 00-21.

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

Our revenue recognition policy is significantbecause our revenues are a key component of our results of operations. Wefollow very specific and detailed guidelines in measuring revenues; however,certain judgments and estimates affect the application of our revenue policydescribed above. Further, assessment of collectibility is particularly criticalin determining whether or not revenues should be recognized. We also recordprovisions for estimated sales allowances on product and service relatedrevenues at the time the related revenues are recorded. These estimates arebased on historical sales and services allowances, analysis of customer creditand other known factors. If future sales credits prove to be greater than thehistorical data and the estimates we used to calculate these provisions, ourrevenues could be overstated.

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

**3.                     Restatementof Condensed Consolidated Financial Statements**

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

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

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

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

 

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**Legal Proceedings**

On August 29, 2006, A. Edward Miller filed ashareholder derivative lawsuit in the United States District Court for theNorthern District of Georgia (Atlanta Division) naming Witness Systems, Inc.(the “Company”) as a nominal defendant and naming all of our current 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 was filedby an individual on August 14, 2006 claiming tobe a stockholder of the Company naming the Company and certain of itsdirectors and officers as defendants in connection with certain stock optiongrants made by the Company.  Rosenberg v. Gould, et al., Civil Action No.1:06-CV-1894 (N.D. Ga.).  The complaint, filed in the United StatesDistrict Court for the Northern District of Georgia, alleges violations ofSection 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunderand seeks unspecified damages, attorneys’ fees and other costs and expenses,unspecified extraordinary, equitable and injunctive relief, and other relief asdetermined by the court.  Neither a lead plaintiff nor lead counsel hasbeen appointed, nor has any response to the complaint yet been required. TheCompany and the other defendants will respond to the complaint whenappropriate.

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

We delayed the filing of our quarterly reports on Form10-Q for the quarters ended June 30, 2006 and September 30, 2006 until the  Company was able to complete restatement ofpreviously issued Consolidated Financial Statements. As a result, we have notbeen in compliance with the Nasdaq Stock Market filing requirements for continuedlisting as set forth in Marketplace Rule 4310(c) (14).  We have received aletter from Nasdaq Listing Qualification Panel advising us that we havereceived an extension of time through February 7, 2007 to file our QuarterlyReports on Form 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 extensiondeadline, the Panel will issue a final determination to delist our shares andthere can be no assurance that Nasdaq Listing and Hearing Review Council willgrant an additional extension of time to meet such requirements or that ourcommon stock will remain listed on the Nasdaq Stock Market.

**4.****                    ****Blue Pumpkin and Optimis Acquisitions**

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

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 $1.35 million,which was recorded as a charge to earnings in the Company’s consolidatedstatement 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.

8

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We commenced consolidation of Blue Pumpkin onJanuary 25, 2005 and the acquisition was accounted for using the purchasemethod of accounting in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 141,*BusinessCombinations*. The following summarizes the total purchase price forBlue Pumpkin (in thousands):

| Value of Witness  Systems, Inc. common stock issued |   | $      | 33,500 |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Cash  consideration                                      |   | 36,000 |   |
| Direct  acquisition costs                                |   | 5,400  |   |
|                                                     |   | $      | 74,900 |   |

 

Under the purchase method of accounting, the totalpurchase price was allocated to Blue Pumpkin’s net tangible and intangibleassets based upon their estimated fair value as of the date of the acquisitionwith any amount paid in excess of the fair value of the net assets recorded asgoodwill. Based upon the purchase price and review of the net assets acquiredand liabilities assumed, the purchase price allocation was as follows (inthousands):

 

| Cash and investments                 |   | $       | 3,900  |   |
|--------------------------------------|--------|---------|--------|--------|
| Other current  assets                |   | 4,800   |   |
| Property and  equipment, net         |   | 700     |   |
| Acquired  technology                 |   | 21,000  |   |
| Customer  relationships              |   | 17,000  |   |
| Goodwill                             |   | 36,300  |   |
| In-process  research and development |   | 9,000   |   |
| Other long term  assets              |   | 100     |   |
| Total assets acquired                |   | 92,800  |   |
| Current  liabilities                 |   | (3,600  | )      |
| Litigation  accrual                  |   | (11,200 | )      |
| Deferred revenue                     |   | (1,700  | )      |
| Restructuring  accruals              |   | (1,400  | )      |
| Total liabilities assumed            |   | (17,900 | )      |
|                                 |   | $       | 74,900 |   |

 

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

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

The key considerations underlying the valuation ofacquired in-process research and development from Blue Pumpkin are as follows:a) guidance from the Financial Accounting Standards Board (“FASB”) SFASNo. 2,*Accounting for Research andDevelopment Costs* and FASB Interpretation No. 4,*Applicability of FASB Statement No. 2 toBusiness Combinations Accounted for by the Purchase Method;* b)percent completed as of the acquisition date; c) estimated costs to date, aswell as costs to complete the technology; and d) the numerous technical, cost,market, and timing risks we face before the technology becomes technologicallyfeasible.

Goodwill of $35.3 million was recorded andrepresented the excess of the purchase price over the fair value of thetangible and other intangible assets acquired less the liabilities assumed. Inaccordance with SFAS No. 142,*Goodwilland Other Intangible Assets*, goodwill and intangible assets withindefinite useful lives are not amortized, but are tested for impairment atleast annually or as circumstances indicate their value may no longer berecoverable.

9

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Supplementalunaudited pro forma information reflecting the acquisition of Blue Pumpkin asif it occurred on January 1, 2005 is as follows (in thousands, except pershare amounts):

|                                         | ** ** | **Nine months  Ended  September  30,  2005** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------------------|------------|
| Total revenues                          |       | $                                                           | 135,554    |   |
| Net loss                                |       | $                                                           | (1,792     | ) |
| Net loss per  share – basic        |       | $                                                           | (0.07      | ) |
| Net loss per  share – diluted      |       | $                                                           | (0.07      | ) |
| Weighted average  shares – basic   |       | 26,903                                                      |       |
| Weighted average shares  – diluted |       | 26,903                                                      |       |

 

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.

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

As a result of our Eyretel acquisition in 2003, werecorded an acquisition-related restructuring accrual related to the closing ofcertain Eyretel facilities and the accrual of expense relating to abandonedleased premises. All such costs met the criteria for accrual as outlined inEITF No. 95-3,*Recognition ofLiabilities in Connection with a Purchase Business Combination,* andwere included in the assets acquired and liabilities assumed in the purchase ofEyretel. The following table summarizes the restructuring accrual (inthousands):
|                                             | ** ** | **Facilities** | ** ** |
|---------------------------------------------|------------|----------------|------------|
| Accrual at  December 31, 2005          |       | $              | 2,073      |   |
| Amounts credited to rent expenses           |       | (383           | )          |
| Foreign exchange translation                |       | 135            |       |
| Accrual at  September 30, 2006         |       | 1,825          |       |
| Less: Long-term portion                     |       | (1,456         | )          |
| Current portion at  September 30, 2006 |       | $              | 369        |   |

 

The following table summarizes all merger-related andintegration costs that were charged to expense during the three and nine-monthsended September 30, 2006 and 2005 (in thousands):
|                                      | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Blue Pumpkin and  Optimis:           |       |                                                     |       |                                                    |       |   |   |   |   |
| Merger-related and integration costs |       | $                                                        | (31        | )                                                       | $          | 1,059 |   | $ | 2,191 |   | $ | 3,544 |   |
| Eyretel:                             |       |                                                     |       |                                                    |       |   |   |   |   |
| Bonus expense                        |       | —                                                   |       | —                                                  |       | — |   | 99 |   |
|                                 |       | $                                                        | (31        | )                                                       | $          | 1,059 |   | $ | 2,191 |   | $ | 3,643 |   |

 

During the nine months ended September 30, 2006, weincurred merger-related and integration costs in the amount of $2.2 millionpertaining to the acquisitions of Blue Pumpkin and Optimis. These expenses wereprimarily associated with legal,professional fees and a discount on shares sold to the Blue Pumpkin shareholders.

During the nine months endedSeptember 30, 2005, we incurred merger-related and integration costs of $3.6million pertaining to the acquisitions of Blue Pumpkin and Optimis that closedin 2005 and the Eyretel acquisition in 2003. The $3.6 million included $3.5million of integration expenses comprised primarily of costs of transitionalBlue Pumpkin and Optimis employees and other contractors, travel costs andadvertising costs.

**6.****                    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  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Net income  (loss)                                                                 |       | $                                                    | 2,594      |                                                | $          | 548 |   | $ | 7,968 |   | $ | (8,418 | ) |
| Weighted average  shares of common stock and common stock equivalents outstanding: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                              |       | 34,021                                               |       | 27,265                                              |       | 33,515 |   | 26,743 |   |
| Dilutive effect of stock options computed using the  treasury stock method         |       | 2,261                                                |       | 2,832                                               |       | 3,054 |   | — |   |
| Diluted common  shares and share equivalents outstanding                           |       | 36,282                                               |       | 29,886                                              |       | 36,569 |   | 26,743 |   |
| Net income  (loss) per share:                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                              |       | $                                                    | 0.08       |                                                | $          | 0.02 |   | $ | 0.24 |   | $ | (0.31 | ) |
| Diluted                                                                            |       | $                                                    | 0.07       |                                                | $          | 0.02 |   | $ | 0.22 |   | $ | (0.31 | ) |

 

10

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We have excludedall outstanding stock options from the calculation of diluted net loss percommon share for the nine month period ended September 30, 2005 because wereported a loss in this period and all such securities are anti-dilutive. The total number of share equivalents excluded from the calculation of historicaldiluted net loss per common share for the nine month period ended September 30,2005 was 2,694,262 calculated using the treasury stock method.  For thethree and nine months ended September 30, 2006, stock options of 4,124,067 and2,261,175, respectively, were excluded from the computation of diluted earningsper share compared to 508,834 and 222,328, respectively for the same year agoperiods because their inclusion would be anti-dilutive.

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

Effective January 1,2006, we adopted SFAS No. 123(R) (“SFAS No. 123(R)”), *Share-Based Payment,*using the modifiedprospective application transition method. The cumulative effect of the adoption of SFAS No. 123(R) was notmaterial. SFAS 123(R) requires us to estimate the fair value of share-basedpayment awards on the date of grant using an option-pricing model. The value ofthe portion of the award that is ultimately expected to vest is recognized asexpense over the requisite service period.

Prior to the adoption ofSFAS 123(R), we accounted for stock-based awards to employees using theintrinsic value method in accordance with APB 25 as allowed under SFASNo. 123, *“Accounting for Stock-Based Compensation”*.Other than as noted in Note 3, “Restatement of Condensed ConsolidatedFinancial Statements,” we have generally not recorded compensation expense for options granted to our employeesbecause all options granted under our stock option plans have an exercise priceequal to the market value of the underlying common stock on the date of grant.

Our net income for the threeand nine months ended September 30, 2006 includes $3.6 million and $10.1million, respectively, of stock-option compensation expense and $0.1 millionand $0.3 million, respectively, of related income tax benefits recorded toadditional paid-in-capital.

Cash received from stockoption exercises for the nine months ended September 30, 2006 and 2005 was$11.6 million and $8.1 million, respectively. The income tax benefits fromstock option exercises totaled $0.3 million and $0.2 million, for the ninemonths ended September 30, 2006 and 2005, respectively.

A summary of all stockoption plans activity for the three months ended September 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 June 30, 2006                   |       | 8,626,458                  |       | $                                       | 12.79      |                                                |       |                                                 |       |   |
| Granted                                                 |       | 899,975                    |       | 16.70                                   |       |                                                |       |                                                 |       |
| Exercised                                               |       | (180,412                   | )          | 7.71                                    |       |                                                |       |                                                 |       |
| Forfeited                                               |       | (417,107                   | )          | 16.45                                   |       |                                                |       |                                                 |       |
| Expired                                                 |       | (16,463                    | )          | 17.53                                   |       |                                                |       |                                                 |       |
| Outstanding as  of September 30, 2006              |       | 8,912,451                  |       | $                                       | 13.11      |                                                | 4.7 years  |                                                 | $          | 45,097 |   |
|                                                    |       |                       |       |                                    |       |                                                |       |                                                 |       |
| Vested +  Expected to vest as of September 30, 2006 (b) |       | 7,923,979                  |       | $                                       | 12.60      |                                                | 4.7 years  |                                                 | $          | 43,537 |   |
|                                                    |       |                       |       |                                    |       |                                                |       |                                                 |       |
| Exercisable as of  September 30, 2006              |       | 3,727,985                  |       | $                                       | 9.59       |                                                | 5.0 years  |                                                 | $          | 29,985 |   |

 

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(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)  Thenumber of shares vested+ expected to vest as of September 30, 2006 is computedby applying the following

Formula = Numberof shares vested as of September 30, 2006 + (shares not vested as of September30, 2006*[100%-forfeiture rate])

As of September 30, 2006, there was $15.3 millionof total 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 following table summarizes information about stockoptions outstanding and exercisable as of September 30, 2006:
| **Outstanding**                             | ** ** | **Exercisable**            | ** ** |
|---------------------------------------------|------------|----------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number  of shares** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
| $1.42 - $6.56                               |       | 2,097,304                  |       | 5.5 years |   | $ | 4.23 |   | 1,332,265 |   | $ | 3.76 |   |
| $7.13 - $13.93                              |       | 2,034,159                  |       | 5.2 years |   | 10.20 |   | 1,437,718 |   | 10.02 |   |
| $14.07 - $18.89                             |       | 3,248,778                  |       | 3.9 years |   | 17.04 |   | 924,011 |   | 16.87 |   |
| $19.00 - $34.00                             |       | 1,532,210                  |       | 4.3 years |   | 20.72 |   | 33,991 |   | 21.85 |   |
|                                        |       | 8,912,451                  |       | 4.7 years |   | $ | 13.11 |   | 3,727,985 |   | $ | 9.59 |   |

 

During the threeand nine months ended September 30, 2006 and 2005, the total intrinsicvalue of stock options exercised is as follows (in thousands):
|                                                   | ** ** | **Three months ended September** | ** ** | **Nine months ended September** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                        | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Total intrinsic  value of stock options exercised |       | $                                               | 1,508      |                                           | $          | 5,670 |   | $ | 18,076 |   | $ | 13,296 |   |
|                                                   |            |                                                 |            |                                                |            |  |  |  |  |  |  |  |  |

 

11

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The weighted-average grant date fair value of stockoptions granted during the three months ended September 30, 2006 and 2005 was$6.63 per share and $6.38 per share, respectively.  The weighted-average grant date fair value ofstock options granted during the nine months ended September 30, 2006 and 2005was $7.58 per share and $7.31 per share, respectively.  The weighted-average grant date fair valueswere determined using the Black-Scholes option-pricing model with the followingweighted-average assumptions:
|                              | ** ** | **Three months ended September** | ** ** | **Nine months ended September** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                        | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term of  option (1) |       | 3.3 years                                       |       | 3.5 years                                      |       | 3.1 years |   | 3.5 years |   |
| Volatility (2)               |       | 51                                              | %          | 40                                             | %          | 52 | % | 55 | % |
| Forfeiture (3)               |       | 16.2                                            | %          | 0                                              | %          | 16.2 | % | 0 | % |
| Risk-free  interest rate (4) |       | 4.9                                             | %          | 3.9                                            | %          | 4.6 | % | 3.7 | % |
| Expected dividend yield      |       | 0                                               | %          | 0                                              | %          | 0 | % | 0 | % |

 

----

(1) The expected term of employee stock options represents theweighted-average period the stock options are expected to remain outstanding.The following factors were considered in estimating the expected term 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 3.3 year historical stock-price volatility as the expected volatilityassumption which aligns with the expected term of the options granted duringthe three and nine months ended September 30, 2006. We believe thathistorical volatility reflects our current assessment of expected volatility.Prior to 2006, we used historical stock price volatility in accordance withSFAS No. 123 for purposes of our pro forma disclosure.

(3) Theforfeiture rates are determined taking into consideration historical forfeiturerates. SFAS123(R) requires forfeitures be estimated at the time of optiongrants and revised, as 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 reflectsreported and pro forma net income (loss) and basic and diluted net income(loss) per share for the three and nine months ended September 30, 2005(in thousands, except per share data):

|                                                                                                         | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                             | ** ** | **2005**                                           | ** ** |
| Reported net  income (loss)                                                                             |       | $                                                    | 548        |                                               | $          | (8,418 | ) |
| Add back: Stock-based employee compensation expense  included in reported net income (loss)             |       | 97                                                   |       | 309                                                |       |
| Deduct: Total stock-based compensation expense  determined under fair value based method for all awards |       | (3,372                                               | )          | (9,909                                             | )          |
| Pro forma net loss                                                                                      |       | $                                                    | (2,727     | )                                                  | $          | (18,018 | ) |
| Net income  (loss) per share:                                                                           |       |                                                 |       |                                               |       |
| Reported basic                                                                                          |       | $                                                    | 0.02       |                                               | $          | (0.31 | ) |
| Pro forma basic                                                                                         |       | $                                                    | (0.10      | )                                                  | $          | (0.67 | ) |
| Reported diluted                                                                                        |       | $                                                    | 0.02       |                                               | $          | (0.31 | ) |
| Pro forma  diluted                                                                                      |       | $                                                    | (0.10      | )                                                  | $          | (0.67 | ) |

** **

***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, or stockappreciation rights to employees and key persons affiliated with Witness, asdefined. As of September 30, 2006, there were 12.9 million sharesauthorized for issuance, of which 2.0 million shares remain available forfuture 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 September 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 September 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 stock 

12

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options that were granted at a price greater than orequal to the fair value of the stock on the grant date, other than as noted in Note 3,“Restatement of Condensed Consolidated Financial Statements.” Optionvesting terms typically range from two to four years. Options granted sinceJuly 1, 2004, have five-year terms from the date of grant. Options grantedprior to July 1, 2004 had ten-year terms from the date of the grant. Theseplans provide for accelerated option vesting terms in connection with a changein control. Our policy is to issue new shares upon share option exercise.

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

Totalcomprehensive income(loss) and accumulated other comprehensive income consisted of the following(in thousands):
| ** **                                                   | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income (loss)                                            |       | $                                                    | 2,594      |                                                | $          | 548 |   | $ | 7,968 |   | $ | (8,418 | ) |
| Other comprehensive  income (loss):                          |       |                                                 |       |                                                |       |   |   |   |   |
| Foreign currency  translation adjustments                    |       | 1,048                                                |       | (706                                                | )          | 3,266 |   | (1,004 | ) |
| Change in net  unrealized holding (loss) gain on investments |       | 95                                                   |       | 0                                                   |       | (26 | ) | 15 |   |
| Total comprehensive income (loss)                            |       | $                                                    | 3,737      |                                                | $          | (158 | ) | $ | 11,208 |   | $ | (9,407 | ) |

 
|                                                      | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                           | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cumulative foreign  currency translation adjustments |       | $                            | 6,344      |                        | $          | 3,078 |   |
| Unrealized net holding  loss on investments          |       | (28                          | )          | (2                          | )          |
| Total accumulated other comprehensive income         |       | $                            | 6,316      |                        | $          | 3,076 |   |

 

**9.****                    ****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 September 30, 2006, or LIBOR plus 300 basis points.Borrowings under the revolving line of credit are limited to 85% of eligibleaccounts receivable, as defined by the agreement. The revolving line of creditis secured by all of our assets and requires compliance with various covenants,including liquidity ratios and EBITDA requirements, among others. As ofSeptember 30, 2006, we were in compliance with our bank covenants.

As of September 30,2006, we had no amounts outstanding under the line of credit and the amountavailable for borrowing was $13.3 million, which was net of outstanding lettersof credit of $1.7 million. The letters of credit secure the lease on thecorporate headquarters facility and have decreasing schedules that ultimatelyexpire in 2007. In addition, we have a £0.3 million letter of credit securingour lease obligations for our premises in the United Kingdom.

**10.****                 ****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  September  30,** | ** ** | **Nine months ended  September  30,** | ** ** |
|----------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                                   | ** ** | **2005**                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|           |       |                                                       |       |                                                      |       |   |   |   |   |
| United States  |       | $                                                          | 29,463     |                                                      | $          | 26,837 |   | $ | 85,531 |   | $ | 73,236 |   |
| United Kingdom |       | 12,096                                                     |       | 11,513                                                    |       | 41,586 |   | 35,182 |   |
| Rest of World  |       | 9,567                                                      |       | 8,799                                                     |       | 30,304 |   | 26,061 |   |
|           |       | $                                                          | 51,126     |                                                      | $          | 47,149 |   | $ | 157,421 |   | $ | 134,479 |   |

 

The rest of world revenuewas derived primarily from customers located in Australia, Canada, India andJapan. No individual customer accounted for more than 10% of consolidatedrevenue during the three and nine months ended September 30, 2006 or 2005.

Long-lived assets, includinggoodwill and intangible assets, by geography are as follows (in thousands):
|                | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| United States  |       | $                            | 64,766     |                        | $          | 71,430 |   |
| United Kingdom |       | 9,939                        |       | 10,824                      |       |
| Rest of world  |       | 1,979                        |       | 2,250                       |       |
|           |       | $                            | 76,684     |                        | $          | 84,504 |   |

 

**11.****                  Recent Accounting Pronouncements**

In June 2006, the FASB issued InterpretationNo. 48, *“Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109.”* ThisInterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return, and provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. This Interpretation is effective for us as ofJanuary 1, 2007. We are currently assessing the impact of the Interpretation onour results of operations and financial position.

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

InSeptember 2006, the Securities and Exchange Commission issued Staff AccountingBulletin No. 108 (“SAB 108”) *FinancialStatements—Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements”*, which becomeseffective beginning on January 1, 2007. SAB 108 requires a utilization of adual-approach to assessing the quantitative effects of financial misstatements.This dual approach includes both an income statement assessment and a balancesheet assessment. If a misstatement is material to the current year financialstatements under either assessment, the prior year financial statements shouldalso be corrected, even though such revision was, and continues to be,immaterial to the prior year financial statements. Correcting prior yearfinancial statements for immaterial errors would not require previously filedreports to be amended. Such correction should be made in the current periodfilings. If the Company determines that an adjustment to prior year financialstatements is required upon adoption of SAB 108 and does not elect to restateits previous financial statements, then it must recognize the cumulative effectof applying SAB 108 in fiscal 2006 beginning balances of the affected assetsand liabilities with a corresponding adjustment to the fiscal 2006 openingbalance in retained earnings. We are currently evaluating the impact ofadopting SAB 108.

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

**12.****                  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 that date. The escrow fund will be available to indemnify Witness for losses resultingfrom, among other things, breaches of representations, warranties, covenantsand certain transaction costs.

*Acquisitionof Demos Consulting Group Ltd.*

Also on October 2, 2006,we acquired Demos Consulting Group Ltd. also known as Demos Solutions (“Demos”),a leading productivity solution provider for the financial servicesindustry.  The acquisition was structured as Demos with a newly-formed,wholly-owned subsidiary of Witness (Witness Enterprise Solutions).  Thetotal consideration paid for Demos was approximately $6 million plus thepotential for an earn-out of up to $18 million based on the growth of thebusiness over the next several years.  Ten percent (10%) of the initialconsideration plus ten percent (10%) of any earn-out earned will be held inescrow until October 2, 2007, or longer, if claims are brought against theescrow fund and remain pending on that date.  The escrow fund will beavailable to indemnify Witness for losses resulting from, among other things,breaches of representations, warranties and covenants.

*Legalproceedings*

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.

In addition, a classaction securities lawsuit 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 32. The following will be discussed and analyzed:

·      Overview

·      Stock Option Practices and Restatement ofCondensed Consolidated Financial Statements

·      Critical Accounting Policies andEstimates

·      Results of Operations

·      Liquidity and Capital Resources

**Overview**

We are a leading providerof workforce optimizationsoftware and services that help businesses capture customer intelligence andoptimize their workforce performance. Our Impact 360 solution features quality monitoring, compliance and IPrecording, workforce management, performance management and e-learning.  Our quality monitoring products recordmultimedia interactions, including traditional voice, Web chat and email, basedon user-defined business rules to enable our customers to evaluate theperformance of their customer service representatives, or CSRs, wherever theymay be located in the enterprise. Our high-volume compliance applicationsare designed to record high volume full-time performance of the voice conversationsbetween CSRs and customers for purposes such as compliance recording and salesverification. Our workforce management products enable our customers to developstrategic staffing plans, deploy skilled resources and evaluate productivity ofCSRs. Our performance management applications provide comprehensive analytics,including performance scorecards, and reports of customer interaction and CSRperformance. Our e-learning applications deliver ongoing training tailored toCSR needs and competencies. We also provide consulting and implementationservices, training and support to customers that use our softwareproducts.  Primarily deployed in contactcenters – as well as the remote, branch and back offices of globalorganizations – the workforce optimization solution captures, analyzes andenables users to share and act on cross-functional information across theenterprise.  With Impact 360,organizations can improve interactions and the underlying back-office processesthat enhance the customer experience and build customer loyalty.

We derive product revenue by licensing software and derive servicesrevenue by providing related installation, training, consulting, andmaintenance services. We also derive a relatively small portion of productrevenue by selling hardware to customers. The majority of our product revenueis derived from quality monitoring (“QM”) and workforce management (“WFM”)software. We sell our products through our direct sales force and through ourindirect sales channels. Our indirect sales channels consist of distributors,resellers, systems integrators and Original Equipment Manufacturers (“OEM”).Distributors and resellers purchase product from us at a discount and thenresell our products to end-users (or, in the case of distributors, to otherresellers) and referral partners are paid a fee for referring sales leads to usor for assisting us in a sales order. Systems integrators are informationtechnology consulting service companies who recommend our products duringclient engagements. Through OEM agreements, we co-develop products, which aresold by the OEM as part of their portfolio of 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 and branch office markets.During the three and nine months ended September 30,  2006, approximately 49% and 42%, respectively**,**of our license revenue was derived from the indirect saleschannel compared to 48% and 42%, respectively, during the same periods 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 add capabilitiessuch as performance analysis and e-learning management to our core qualitymonitoring and workforce management solutions. We also believe the market shiftfrom traditional hardware based recording to VoIP represents a significantgrowth opportunity, and our software solutions support both of these recordingenvironments. In addition, we believe our product offerings can be marketedtoward retail bank branches and operations and other back-office initiativesfor business process monitoring, which represents a new market for us. Factorsthat may impact our ability to grow our product revenue, however, includesour ability to remain competitive from a technology perspective; marketacceptance of our new products; our ability to maintain our product pricingintegrity; and our ability to manage and expand our global sales channels.

We also plan to grow our services revenue in concertwith our product revenue. When our customers license our products, theygenerally purchase installation, training and one year of support services.Therefore, as we generate product revenue, we also generate related servicesrevenue. In addition, our customers generally renew their maintenance contractswith us each year. Therefore, our maintenance revenue increases as our customerbase increases. Factors that may influence our ability to grow ourservices revenue, however, include our ability to continue to increase productrevenues, provide services that enable and enhance our customers’ ability toimprove the efficiency and effectiveness of their customer service operationsand our ability to maintain a high level of customer success and satisfaction.

In October 2006,we acquired Demos Solutions Consulting Group Ltd. (also known as DemosSolutions) and Exametric, Inc., two leaders in supplying enterpriseproductivity and resource planning solutions to branch offices in the financialservices industry.  The acquisitions broaden our revenue opportunity,further extending the business value of workforce optimization (WFO) solutionsfrom contact centers to bank branches and ultimately to other areas in theenterprise. The aggregate purchase price for both transactions was $29 millionin cash plus a potential earn-out of up to $18 million based on the growth ofthe business over the next several years.  The acquisition was financedfrom our existing cash resources.  These acquisitions are expected to beaccretive (before amortization of intangibles and other acquisition-relatedcosts) and add $13 million to $15 million to our revenue in 2007.

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In January 2006, we adopted SFAS No. 123(R), *Share-BasedPayment*, which requires the measurement and recognition ofcompensation expense for all share-based payment awards made mainly toemployees including employee stock options and employee stock purchase planbased on the grant date fair value of those awards. We determine the fair valueof share-based payment awards on the date of grant using the Black-Scholesoption-pricing model. We adopted SFAS 123(R) using the modified prospectivetransition method, which requires the application of SFAS 123(R) as ofJanuary 1, 2006. Stock-based compensation expense recognized under SFAS123(R) for the three and nine months ended September 30, 2006 was $3.5 millionand $10.1 million, respectively.

In May 2005, we acquired Optimis Group Limited (“Optimis”),a UK-based provider of workforce optimization software solutions. Blue Pumpkinowned a minority interest in an operating subsidiary of Optimis, the balance ofwhich was acquired through the Optimis acquisition. We paid $5.0 millionin cash and other consideration that was financed from our existing cash andinvestments. Ten percent of the aggregate acquisition consideration was heldin escrow and was released in August 2006

OnJanuary 24, 2005, we acquired Blue Pumpkin Software, Inc. (“BluePumpkin”), a privately held California corporation. With this acquisition, wehave expanded our workforce optimization solution to include advanced workforcemanagement software and services solutions including forecasting, scheduling,adherence and planning applications. Pursuant to the Merger Agreement and Planof Reorganization, dated December 16, 2004 (the “Merger Agreement”), wepaid $36 million in cash which was funded from our existing cash andinvestments and issued 1.9 million shares of Witness’ common stock valued at$33.5 million (measured based on the date the stock consideration becamefixed pursuant to the application of a formula specified in the mergeragreement). On May 24, 2005, the shares issued in connection with theacquisition were registered for resale with the Securities and ExchangeCommission. Pursuant to the Merger Agreement, cash of $4 million and 210,000shares of common stock valued at approximately $3.7 million on the date ofacquisition were placed into escrow 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, in April 2006and agreed to make six annual payments of $0.5 million ($3.0 million in total)from April 2007 through 2012.

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 nine months periods ended September 30,2006, 42% and 46%, respectively, of our revenue was derived from operationsoutside the United States. During the three and nine month endedSeptember 30, 2005, 43% and 46%, respectively, of our revenue was derivedfrom customers outside the United States. As of September 30, 2006, we had 758 full-time employees, excludingapproximately 89 contractors located in the Asia-Pacific region, compared to615 employees as of September 30, 2005.  As of September 30, 2006, 306 ofthe 758 full-time employees were located outside the United States.

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

Beginning in late May 2006, the Company’s managementinitiated a preliminary internal review of the Company’s historical stockoption practices and related accounting treatment in response to general mediaattention concerning stock option grants at various public companies 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 through approximatelymid-year 2001. The Special Committee concluded that it was not necessary toexpand the investigation to cover periods after August 31, 2002. Among thevarious key considerations in reaching this conclusion were: 1) as noted above,the Special Committee did not find fraud or intentional misrepresentation inthe financial reporting of the option grants that it analyzed; 2) the SpecialCommittee’s investigation found that the last instance of likely grant dateselection based on stock price  occurredin mid-2001; and 3) the Special Committee observed that the option grantingpractices of the Company became more formal and regularized during the latterphase of the period subject to its review. 

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

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

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

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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 the  Company was able to complete restatement ofpreviously issued Consolidated Financial Statements. As a result, we have notbeen in compliance with the Nasdaq Stock Market filing requirements forcontinued listing as set forth in Marketplace Rule 4310(c) (14).  We havereceived a letter from Nasdaq Listing Qualification Panel advising us that wehave received an extension of time through February 7, 2007 to file ourQuarterly Reports on Form 10-Q for the quarters ended June 30, 2006 andSeptember 30, 2006.  The Panel advised us that if we are unable to meetthe extension deadline, the Panel will issue a final determination to delistour shares and there can be no assurance that Nasdaq Listing and Hearing ReviewCouncil will grant an additional extension of time to meet such requirements orthat our common stock will remain listed on the Nasdaq Stock Market.

**Critical Accounting Policies andEstimates**

The discussion and analysis of our financial conditionand results of operations is based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financialstatements requires us to make certain estimates and judgments that affect ourreported assets, liabilities, revenue and expenses, and our related disclosureof contingent assets and liabilities. On an on-going basis, we re-evaluate ourestimates, accounting policies and judgments including those related to revenuerecognition, the collectibility of receivables, accounting for acquisitions,impairment of long-lived assets, income taxes and stock-based compensation toensure that our financial statements are presented fairly and in accordancewith 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 and theireffects cannot be determined with certainty, actual results may differfrom these estimates under different assumptions or conditions and suchdifferences could be material. Management believes that the followingaccounting policies and estimates are critical to understanding and evaluatingour reported financial results. Management has reviewed these criticalaccounting policies and estimates with the Audit Committee of our Board ofDirectors.

*Revenue Recognition.* We recognize revenue in accordance withthe American Institute of Certified Public Accountants’ Statement of Position (“SOP”)No. 97-2,*Software Revenue Recognition,*and SOP No. 98-9*, Modification ofSOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions**and EITF 00-21: Revenue Arrangements with Multiple Deliverables*. Revenue is primarily derived from licensingsoftware and providing related services including maintenance. We also derive arelatively small portion of product revenue by selling hardware to customers.Product revenue, which includes software and hardware, is recognized whenpersuasive evidence of an arrangement exists, delivery of the product hasoccurred, the fee is fixed or determinable, collection is probable and vendorspecific objective evidence of fair value (“VSOE”) exists to allocate revenueto the undelivered elements of the arrangement. We report hardware revenuegross in accordance with Emerging Issues Task Force (“EITF”) No. 99-19,*Reporting Revenue Gross as a Principal versus Net asan Agent,* because the factors indicating gross reporting outweighthe factors indicating net reporting. We recognize revenue using the residualmethod of accounting since we generally have VSOE for maintenance andprofessional services, but not for the software and hardware elements of theorder. Under the residual method, services revenue, including maintenance andprofessional services, is deferred at an amount equal to its fair value untilthose elements are delivered. Consequently, product revenue for the softwareand hardware is recognized (i) upon delivery of those products when wehave VSOE for the related maintenance and professional services sold and(ii) at an amount representing the difference between the total orderamount and the amount deferred. For customer orders that includehardware, hardware revenue is accounted for as a separate unit of accounting inaccordance with guidance provided in EITF 00-21.

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.

*Allowance for Doubtful Accounts.*We perform ongoing evaluations of ourcustomers and continuously monitor collections and payments and estimate anallowance for doubtful accounts based on our historical experience with write-offsand any specific customer collection issues that we have identified. While suchcredit losses have historically been within our expectations, and we believeappropriate reserves have been established, we cannot assure that we willcontinue to experience the same credit loss rates that

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we have experienced in the past or adequatelypredict future credit losses. If the financial condition of our customers wereto deteriorate and result in an impairment of their ability to make payments,additional allowances may be required which would result in an additionalselling, general and administrative expense in the period such determinationis made.

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

·                  valuation of deferred revenue,

·                  valuation of intangible assets andacquired in-process research and development,

·                  other liabilities existing at thetime of acquisition.

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

*Impairment of Long-Lived Assets.*  Long-lived assets, such asproperty and equipment and amortizable intangible assets are accounted for inaccordance with SFAS No. 144*,Accounting for Impairment or Disposal of Long-lived Assets* and arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. All of ouridentifiable intangible assets are amortized using the straight-line method.Useful lives of amortizable intangible assets are reviewed annually with anychanges in estimated useful lives being accounted for prospectively over therevised remaining useful life. Recoverability of assets to be held and usedwould be measured by a comparison of the carrying amount of an asset to theestimated undiscounted future cash flows expected to be generated by the asset.If the carrying amount of an asset exceeds its estimated undiscounted futurecash flows, an impairment charge is recognized in the amount by which thecarrying amount of the asset exceeds the fair value of the asset. Thedetermination of estimated future cash flows, however, requires management tomake estimates. Future events and changes in circumstances may require usto record a significant impairment charge in the period in which such events orchanges occur. Impairment testing requires considerable analysis and judgmentin determining the results. If other assumptions and estimates were used in ourevaluations, the results could differ significantly.

*Accounting for Income Taxes.* We account for income taxes inaccordance with SFAS No. 109,*Accounting for Income Taxes*, which requires recognition of deferredincome tax assets and liabilities for temporary differences between thefinancial reporting and tax bases of recorded assets and liabilities and theexpected benefits of net operating loss and credit carry forwards. SFASNo. 109 requires that deferred income tax assets be reduced by a valuationallowance if it is more likely than not that some portion or all of thedeferred income tax assets will not be realized. Historically, we have provideda complete valuation allowance against the deferred income tax asset. Weevaluate the realizability of our deferred income tax assets, primarilyresulting from net operating loss and credit carry forwards, and will adjustour valuation allowance, if necessary.

If we were to reduce or eliminate the valuation allowance and recognizethe tax benefit associated with our net operating loss carry forwards, we wouldexpect our provision for income tax expense in future periods to reflect aneffective tax rate that would be significantly higher than in past periods.Furthermore, the utilization of deferred tax assets, primarily net operatingloss carry forwards arising from acquisitions, results in a reduction ingoodwill and the recognition of tax expense associated with the purchaseddeferred tax assets.

The utilization of net operating loss carry forwards generated by thetax deduction for stock option exercises results in an increase toadditional-paid-in-capital and the recognition of tax expense. Under FAS123(R), future excess tax deductions will result in an increase toadditional-paid-in-capital. Under FAS 123(R), the Company will continue tofollow the with-and-without approach and consider the impact of excess stock optiondeductions last when computing its income tax provision.  In 2006, we have utilized $5.1 million ofincome tax benefits originating from stock option deductions that have notbeen 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 are reasonable,no assurance can be given that the final tax outcome of these matters will notbe different from what is reflected in our historical income tax provisions andaccruals. Such differences could have a material impact on our income taxprovision and operating results in the period in which such a determinationis made.

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*Stock-BasedCompensation.*  OnJanuary 1, 2006, we adopted SFAS No.123(R), which requires the measurementand recognition of compensation expense for all share-based payment awards madeto employees including employee stock options and employee stock purchase planbased on the grant date fair value of those awards. We determine the fair valueof share-based payment awards on the date of grant using Black-Scholesoption-pricing model. The fair value of share-based awards is affected by stockprice as well as assumptions regarding a number of highly complex andsubjective variables. These variables include, but are not limited to, ourexpected stock price volatility over the term of the awards, and actual andprojected employee stock option exercise behavior. SFAS 123(R) also requiresthat forfeitures be estimated over the vesting period of an award, rather thanbeing recognized as a reduction of compensation expense when the forfeiture actuallyoccurs. We adopted SFAS 123(R) using the modified prospective transitionmethod.  Our Condensed ConsolidatedFinancial Statements as of and for the three and nine months endedSeptember 30, 2006 reflect the impact of SFAS 123(R).

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 Condensed Consolidated Statement of Operations. Stock-based compensationexpense recognized under SFAS 123(R) for the three and nine months endedSeptember 30, 2006 was $3.5 million and $10.1 million, respectively. Priorto the adoption of SFAS 123(R), we accounted for stock-based awards to employeesusing the intrinsic value method in accordance with APB 25 as allowed underSFAS No. 123, *Accounting for Stock-BasedCompensation*. Other than as noted in Note 3, “Restatement ofCondensed Consolidated Financial Statements,” we have generally not recordedcompensation expense for options granted to our employees because all optionsgranted under our stock option plans have an exercise price equal to the marketvalue of the underlying common stock on the date of grant.  See Note 7 to the Condensed ConsolidatedFinancials Statements included elsewhere in this report for additionalinformation on stock-based compensation expense.

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

**Results of Operations**

The followingtable sets forth the results of operations for the three and nine months endedSeptember 30, 2006 and 2005 expressed as a percentage of total revenue.
| ** **                                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                                 |       | 34                                                   | %          | 39                                                  | %          | 38 | % | 40 | % |
| Services                                                |       | 66                                                   | %          | 61                                                  | %          | 62 | % | 60 | % |
| Total revenue                                           |       | 100                                                  | %          | 100                                                 | %          | 100 | % | 100 | % |
| Cost of revenue:                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                                 |       | 7                                                    | %          | 10                                                  | %          | 8 | % | 10 | % |
| Services                                                |       | 25                                                   | %          | 23                                                  | %          | 24 | % | 23 | % |
| Total cost of revenue                                   |       | 32                                                   | %          | 33                                                  | %          | 32 | % | 33 | % |
| Gross profit                                            |       | 68                                                   | %          | 67                                                  | %          | 68 | % | 67 | % |
| Operating  expenses:                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative                     |       | 52                                                   | %          | 46                                                  | %          | 49 | % | 47 | % |
| Research and development                                |       | 16                                                   | %          | 15                                                  | %          | 15 | % | 15 | % |
| Merger-related and integration costs                    |       | —                                               | %          | 2                                                   | %          | 2 | % | 3 | % |
| Acquired in-process research and development            |       | —                                               | %          |                                                | %          | — | % | 7 | % |
| Operating income (loss)                                 |       | 0                                                    | %          | 4                                                   | %          | 2 | % | (5 | )% |
| Interest and  other income, net                         |       | 3                                                    | %          | 1                                                   | %          | 3 | % | 1 | % |
| Income (loss) income before provision for income  taxes |       | 3                                                    | %          | 5                                                   | %          | 5 | % | (4 | )% |
| Provision for  income taxes                             |       | 0                                                    | %          | 4                                                   | %          | 1 | % | 2 | % |
| Net income  (loss)                                      |       | 3                                                    | %          | 1                                                   | %          | 4 | % | (6 | )% |

 

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*Total revenue*

Total revenue increased 8% to $51.1 million, in thethree months ended September 30, 2006, compared to the same period in2005.  The increase in total revenue inthe period can be attributed to continued growth of our service revenues,particularly as a result of maintenance renewals. Total revenue in the ninemonths ended September 30, 2006 increased 17% compared to the same period in2005 due to increases in product and services revenue.  The weakening of the U.S. dollar againstcertain foreign currencies increased revenue by approximately 1% and 0%,respectively, for the three and nine months period ended September 30, 2006,compared to the same periods in 2005. Our historical revenue recognitionpractice with respect to revenue received through the OEM channel has generallybeen to recognize revenue upon receipt of royalty reports from the OEM partnerbecause until that time, pricing was deemed not to be fixed ordeterminable.  However, effective April1, 2006, the Company began recognizing revenue from one OEM partner uponreceipt of a valid purchase order because it was determined, based on theCompany’s historical experience with this particular partner, that fixed anddeterminable pricing now exists at the time the order is placed by thepartner.  The number of installedcustomer sites grew to 4,578 as of September 30, 2006 from 4,073 sites as ofSeptember 30, 2005.

*Productrevenue*

The table belowprovides a detailed breakdown of the productrevenue for the three and nine monthsended September 30, 2006 and 2005 as follows (in thousands):
|            | ** ** | **Three months ended September 30,** | ** ** | ** ** | ** ** |
|------------|------------|----------------------------------------------------------|------------|------------|------------|
| ** ** | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:   |       |                                                     |       |       |       |   |   |
| Software   |       | $                                                        | 16,174     |       | $          | 17,510 |   | (8 | )% |
| Hardware   |       | 1,160                                                    |       | 796        |       | 46 | % |
|       |       | $                                                        | 17,334     |       | $          | 18,306 |   | (5 | )% |

 
|            | ** ** | **Nine months ended September 30,** | ** ** | ** ** | ** ** |
|------------|------------|---------------------------------------------------------|------------|------------|------------|
| ** ** | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:   | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software   |       | $                                                       | 53,649     |       | $          | 49,611 |   | 8 | % |
| Hardware   |       | 5,587                                                   |       | 3,981      |       | 40 | % |
|       |       | $                                                       | 59,236     |       | $          | 53,592 |   | 11 | % |

 

Product revenueincludes software revenue and hardware revenue. Software revenue for the threemonths ended September 30, 2006 decreased 8% compared to the three months endedSeptember 30, 2005. The decrease is attributed to reduced software sales in ourinternational market due to a decrease in demand during the quarter. Softwarerevenue for the nine months ended September 30, 2006 increased 8% compared tothe nine months ended September 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 recognizedfrom the indirect sales channel. Our Impact 360 solution consists ofsoftware products and services designed to optimize the workforce, processesand technology involved in the customer service function. We periodicallyreview our revenue recognition policy with regard to our indirect saleschannel in order to account for current trends surroundingcollectability.  We expect softwarerevenue will increase in the fourth quarter due to normal seasonal patterns andexpanded offerings.

Hardware revenue forthe three and nine months ended September 30, 2006 increased $0.4 million and$1.6 million, respectively, compared to the three and nine months endedSeptember 30, 2005. The increase in hardware revenue in 2006 is attributed to afew large hardware orders. Although hardware sales are incidental to ourbusiness, we expect that we will continue to sell hardware to our existingcustomers as well as to our new customers whose preference is to make jointpurchases of our hardware and software. It is difficult to estimate futurehardware revenue due to its incidental nature.

New customersaccounted for 20% and 41%, respectively, of software revenue, during the threemonths ended September 30, 2006 and 2005.  New customers accounted for 20%and 25%, respectively, of software revenue, during the nine months ended 

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September 30, 2006 and2005. We receive follow-on revenue from our existing customers when theypurchase 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 for the remainder of 2006.

*Servicesrevenue*

Services revenue,consisting of installation, training, consulting, maintenance support andreimbursable travel expenses, increased 17% and 21% in the three and ninemonths ended September 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 recurringmaintenance revenue stream.  Historically over 90% of our customers renewtheir maintenance contracts every year.  We believe that maintenance contractswill be renewed at a comparable rate for the remainder of 2006.  We expectservices revenue, to increase over time due to the compounding effect ofmaintenance renewals as well as additional service revenues generated by newsales.

*Total cost of revenue*

Total cost ofrevenue increased 8% and 13% in the three and nine months ended September 30,2006, respectively, compared to the same year ago periods.  Expressed as apercent of revenue, gross profit margins increased slightly to 68% for thethree and nine months ended September 30, 2006 compared to 67% for the threeand nine months ended September 30, 2005. The increases in 2006 resultedprimarily from productivity gains achieved in the professional servicesorganization, offset by an inclusion of FAS 123(R) stock-based compensationexpense of $0.7 million and $1.6 million, respectively, for the three and ninemonths ended September 30, 2006. Excluding hardware cost of revenue,stock-based compensation expense and the amortization of intangible assetsresulting from acquisitions, gross profit margins have remained fairly stableat 75% and 74% in the nine months ended September 30, 2006 and 2005,respectively.  We expect our gross profit margin, excluding hardware,stock-based compensation expense and amortization of intangible assets, tocontinue to remain relatively constant for the remainder of 2006.

*Cost of product revenue*

The table belowprovides a detailed breakdown of the cost of productrevenue for the three and nine monthsended September 30, 2006 and 2005 as follows (in thousands):
|                             | ** ** | **Three months ended  September 30,** | ** ** | ** ** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                             | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:                    |       |                                                 |       |       |       |   |   |
| Software                    |       | $                                                    | 1,090      |       | $          | 1,349 |   | (19 | )% |
| Hardware                    |       | 1,120                                                |       | 846        |       | 32 | % |
| Amortization of intangibles |       | 1,368                                                |       | 2,348      |       | (42 | )% |
|                        |       | $                                                    | 3,578      |       | $          | 4,543 |   | (21 | )% |

 
|                             | ** ** | **Nine months ended September 30,** | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| ** **                  | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Product:                    | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software                    |       | $                                                       | 2,667      |       | $          | 2,923 |   | (9 | )% |
| Hardware                    |       | 5,583                                                   |       | 4,076      |       | 37 | % |
| Amortization of intangibles |       | 5,115                                                   |       | 6,804      |       | (25 | )% |
|                        |       | $                                                       | 13,365     |       | $          | 13,803 |   | (3 | )% |

 

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 nine months endedSeptember 30, 2006, amortization of intangibles decreased 42% and 25%,respectively, compared to the same year ago periods. A significant portion ofthe cost of acquired technology associated with the 2003 Eyretel acquisitionhas been fully amortized as of September 30, 2006.

For the three and nine months ended September 30,2006, cost of hardware revenue increased by $0.3 million and $1.5 million,respectively, compared to the same year ago periods. This increase correspondsto the increase in hardware product revenue in 2006.

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For the three and nine months ended September 30,2006, cost of software decreased 28% and 13%, respectively, compared to thesame year ago periods.  The decrease was due to lower royalty expenseduring the three and nine months ended September 30, 2006 compared to the sameperiod of 2005 due to lower software revenue in the third quarter and year todate in 2006. Royalties expense relate to third parties for software componentsthat are embedded in some of our software applications. Such royalties varyperiod-over-period in proportion to the sales of certain softwareproducts.   For the three and nine monthsended September 30, 2006, expressed as a percentage of software revenue, thecost of software revenue was 6% and 5%, respectively, compared to 8% and 6%,respectively, for the same year ago periods.  As we develop upgrades ofour existing products and add new offerings to our product suite, wemay embed additional third-party technologies into some of our software,which could increase 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 20% in the three and nine months endedSeptember 30, 2006, respectively, compared to the same periods in 2005. Theincreases in 2006 are consistent with the increases in services revenue and aredue primarily to an increase in the number of employees engaged in customersupport services and the inclusion of FAS123(R) stock-based compensationexpenses. Stock-based compensation expense for the three and nine months endedSeptember 30, 2006 was $0.7 million and $1.6 million, respectively.

Cost of servicesrevenue, excluding FAS123(R) stock-based compensation, as a percentage ofservices revenue, was 36% for the three months ended September 30, 2006 and2005.  Cost of services revenue, excluding FAS123(R) stock-basedcompensation, as a percentage of services revenue, for the nine months endedSeptember 30, 2006 and 2005, was 36% and 38%, respectively. We anticipate thatour services margins will remain relatively stable for the remainder of 2006.

*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 nine months ended September 30, 2006,SG&A expense of $26.5 million and $77.5million, respectively, increased 22%and 23%, respectively compared to the same year ago periods.  Theseincreases are due primarily to theinclusion of FAS123(R) stock-based compensation expense,****higher****legal and professional fees, and higher staffing levelsduring the three and nine months ended September 30, 2006.  For the three and nine months ended September30, 2006, stock-based compensation expense was $2.2 million and $6.6 million,respectively. Legal and professional fees, including fees related to the stockoptions review, increased by $2.5 million and $3.7 million, for the three andnine months period ended September 30, 2006, respectively. SG&A staffingincreased by 30 people from September 30, 2005 to September 30, 2006 as thecompany has continued to grow. We expect SG&A expense, to increase inabsolute dollars for the remainder of 2006 due to the continuation of thesefactors and our acquisition of Demos Solutions and Exametric in October of 2006

*Research and Development.* Research and development (‘‘R&D’’) expenses consist primarily of personneland consulting costs to support product development and allocatedoverhead.  R&D costs are generally expensed as incurred and includesoftware development costs incurred prior to the establishment of technologicalfeasibility. Costs incurred subsequent to establishing technologicalfeasibility are capitalized and amortized over their estimated useful lives tocost of product revenue.  For the three and nine months ended September30, 2006, total amortization of software development costs amounted to $0.2million and $0.4 million, respectively compared to $0.1 million and $0.4million, respectively, for the same year ago periods. As of September 30, 2006,we had $1.2 million in capitalized but unamortized software development costs.R&D expenses increased 14% and 20% in the three and nine months endedSeptember 30, 2006, respectively, compared to the same year ago periods due tothe increased number of employees engaged in research and development activities.In addition, FAS 123(R) stock-based compensation expense in the amount of $0.6million and $1.5 million was incurred during the three and nine months periodended September 30, 2006.  Weexpect total R&D expense to increase in absolute dollars but decrease as apercentage of total revenue during the remainder of 2006.

*Merger-related and Integration Costs*.We incurred merger-related and integration costs of $2.2 million in the ninemonths ended September 30, 2006, pertaining to the acquisitions of Blue Pumpkinand Optimis. These costs primarilyrelated to legal and professional fees. During the nine months ended September30, 2005, we incurred $3.6 million in merger-related and integration costs,comprised primarily of costs of transitional Blue Pumpkin and Optimis employeesand other contractors, travel costs and advertising costs. We expect to incurmerger-related & integration expenses during the fourth quarter of 2006 dueto our acquisitions of Demos Solutions and Exametric.

*Acquired In-Process Research andDevelopment Charges.*  During the first quarter of 2005,we estimated that $9.0 million of the purchase price of Blue Pumpkinrepresented acquired in-process research and development (‘‘IPR&D’’) thathad not yet reached technological feasibility as defined by SFAS No. 86,*  Accountingfor the Cost of Computer Software to Be Sold, Leased or Otherwise*

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*Marketed,* and had no alternative future use.  Accordingly, these amounts wereimmediately charged to expense upon consummation of the acquisition.  Thevalue of the IPR&D was calculated with the assistance of an independentthird-party appraiser by utilizing a discounted cash flow methodology, focusingon the income-producing capabilities of the in-process technologies and takinginto consideration: stage of completion; complexity of work to date and tocomplete; anticipated product development and introduction schedules;forecasted product sales cycles; internal and external risk factors; revenueand operating expense estimates; contributory asset charges, and costs alreadyincurred and the expected costs to complete.

*Interest and Other Income, Net*

Interest and other income, net for the three and ninemonths ended September 30, 2006 and 2005, respectively are as follows (inthousands):
| ** **                   | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Interest income,  net        |       | $                                                    | 1,854      |                                                | $          | 212 |   | $ | 4,956 |   | $ | 685 |   |
| Foreign currency  (loss)gain |       | (304                                                 | )          | 33                                                  |       | (663 | ) | (246 | ) |
|                         |       | $                                                    | 1,550      |                                                | $          | 245 |   | $ | 4,293 |   | $ | 439 |   |

 

We expect that interest income will continue to behigher in 2006 than in 2005 primarily due to higher cash and investmentbalances resulting from our common stock offering in December 2005.

*Provisionfor Income Taxes*

We recorded aprovision for federal alternative minimum tax, deferred taxes and foreignincome tax, net of federal tax benefits, for the nine months ended September30, 2006 and 2005.  Of the $(1.0) millionand $2.5 million provisions, respectively, for the nine months ended September30, 2006 and 2005, $0.3 million and $1.7 million, respectively, related tothe utilization of a portion of the of deferred income tax assets, primarilynet operating loss carry-forwards, acquired in the 2005 acquisition of BluePumpkin.  Because a full valuationallowance was recorded against these assets, the benefit from the utilizationof these deferred income tax assets in 2006 and 2005 was credited as areduction to goodwill.

The provisions for income taxes for the nine monthsended September 30, 2006 and 2005, benefited from the utilization of netoperating loss carry forwards from prior years. We had net operating loss carryforwards aggregating $81.3 million for U.S. income tax purposes and$38.1 million for foreign income tax purposes remaining as ofDecember 31, 2005.  We expect thatthe provision for income taxes in 2006 will continue to benefit from theutilization of these net operating loss carry forwards.  However, the utilization of certain netoperating loss carry forwards arising from acquisitions will result in areduction of the valuation allowance for deferred income tax assets andgoodwill or intangible assets and the recognition of deferred income taxexpense.

**Liquidity and Capital Resources**

At September 30, 2006, we had $13.3 million availablefor borrowing under our line of credit. At our election, borrowings under theline of credit bear interest at the bank’s prime rate, which was 8.25% onSeptember 30, 2006, or LIBOR plus 300 basis points, and are limited to 85%of eligible accounts receivable, as defined by the agreement. The revolvingline of credit is secured by all of our assets and requires compliance withvarious covenants, including liquidity ratios and EBITDA requirements, amongothers. As of September 30, 2006, we were in compliance with all bank covenants.

On October 2,2006, we paid $23 million to acquire Exametric, Inc. approximately $2.4million of the acquisition consideration will be held in escrow until October2, 2007, or longer, if claims are brought against the escrow fund and remainpending on that date.  The escrow fund will be available to indemnifyWitness for losses resulting from, among other things, breaches ofrepresentations, warranties, covenants and agreements in the ExametricAgreement and certain related agreements, and certain transaction costs.

Also on October 2,2006, we paid $6 million to acquire Demos Consulting Group Ltd, also known asDemos Solutions.  The acquisition consideration also includes a 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 $6 million plus tenpercent (10%) of any earn-out earned will held in escrow until October 2, 2007,or longer if claims are brought against the escrow fund and remain pending onthat date.  The escrow fund will be available to indemnify Witness forlosses resulting from, among other things, breaches of representations,warranties, covenants and agreements in the Demos Agreement.

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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 $7 millionin 2006. We believe that our capital expenditures may increase overthe next several years as we expand our facilities and acquire equipment tosupport the expansion of our research and development activities and internalmanagement and information systems.

We believe that our existingcash and investment balances, together with our anticipated cash flows fromoperations, will be sufficient to meet our working capital and capitalexpenditures for at least the next twelve months. In addition, 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 remeasureforeign 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 $0.3 million and $0.7million in the three and nine months ended September 30, 2006,respectively, compared to $0 million and $0.2 million, respectively, in thesame periods in the 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.

**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 evaluationof the effectiveness of our disclosure controls and procedures (as defined inRules 13a-14 and 15d-14 under the Securities Exchange Act of 1934), as ofthe end of the period covered by this quarterly report. This evaluation wasconducted under the supervision and with the participation of our management,including the Chief Executive Officer and Chief Financial Officer. Based onthis evaluation, as of the quarter ended September 30, 2006, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are not effective due to the material weaknessesdiscussed below.

Our policies and proceduresover account reconciliations and management’s review of estimates and accountbalances were not designed to a sufficient level of precision to prevent ordetect misstatements that could have a material effect on the ConsolidatedFinancial Statements. As a result, there were errors to the ConsolidatedFinancial Statements that were not identified or recorded by management. Thisdeficiency resulted in more than a remote likelihood that a materialmisstatement to the Consolidated Financial Statements would not be prevented ordetected.

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 nine months endedSeptember 30, of 2006, management made significant progress in remediating thematerial 

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weakness by:

·                  Revisingour policies and procedures related to the capitalization and depreciation ofproperty and equipment including the addition of control procedures over thereview of information input into our accounting system;

·                  Revisingour control procedures through the addition of more effective controls toensure the accrual of certain period-end operating expenses;

·                  Implementingformal policies, including quantitative and qualitative analysis, over thedocumentation and evaluation of unsubstantiated differences that individuallyor in the aggregate should be timely 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 SpecialCommittee undertook its investigation with the assistance of independentcounsel and accounting experts retained by its counsel. The Special Committeereviewed all 5.7 million stock options granted throughout the period covered byits investigation. In December 2006, the Special Committee completed its reviewand reported its findings and recommendations to our full Board of Directors.The Special Committee did not find fraud or intentional misrepresentation inthe financial reporting of the option grants that it analyzed but foundinaccuracies in the determination of measurement dates for certain stock optiongrants affecting the Company’s accounting and disclosures. For a number ofthese grants, the Special Committee found that it was likely that the statedgrant date was selected in hindsight based on price given the lack ofsupporting documentation and that the option price was the low price in a givenmonth or quarter. Such grants were found to be present during 2000 and throughapproximately mid-year 2001. The Special Committee concluded that it was notnecessary to expand the investigation to cover periods after August 31, 2002.Among the various key considerations in reaching this conclusion were: 1) asnoted above, the Special Committee did not find fraud or intentionalmisrepresentation in the financial reporting of the option grants that itanalyzed; 2) the Special Committee’s investigation found that the last instanceof likely grant date selection based on stock price  occurred in mid-2001; and 3) the SpecialCommittee observed that the option granting practices of the Company becamemore formal and regularized during the latter phase of the period subject toits review. 

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

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

As described in Note 3, “Restatement of CondensedConsolidated Financial Statements,” of the Notes to Condensed ConsolidatedFinancial Statements, our Condensed Consolidated Financial Statements has beenrestated to correct errors in the recognition of stock-based compensationexpense for previously granted stock options. 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.

Following the Special Committee’s findings andrecommendations, and in an effort to strengthen our corporate governancemechanisms, the Board of Directors voted to separate the positions of Chairmanof the Board and CEO and elected Mr. Dan Lautenbach, a member of the Company’sBoard of Directors since 2002 and a member of the Special Committee, asChairman of the Board, effective December 6, 2006.  Mr. Lautenbach succeeded Mr. David Gould, whovoluntarily agreed to step down as Chairman of the Board of Directors.

In addition,following the Special Committee’s findings and recommendations, Mr. Gouldvoluntarily agreed to resign from his position 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 of Directors effective January3, 2007.

In furtherresponse to the Special Committee’s recommendations, and in a further effort tostrengthen our management and controls and corporate governance mechanisms, wehave named a new General Counsel and plan to realign certain responsibilitiesin 

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financial reportingareas. Management believes that the above measures will address the findingsand recommendations of the Special Committee and strengthen our management andcontrols and corporate 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 $9.5million additional stock-based compensation reflected in our restatedConsolidated Financial Statements resulted from the use of inaccuratemeasurement dates during 2000 and 2001. Since 2001, the Company has implemented improvements in its processes,personnel and practices to enhance its internal controls over the issuance ofstock option grants.  Examples of theseimprovements include:

i)                 Change in process:  Beginning in 2002, the Company enhanced itsinternal controls over stock option grant practices and reduced the risk ofusing inaccurate measurement dates by complying with the new SEC requirement offiling Form 4s within two days of the date of grant.

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

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

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**

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 onJuly 29, 2005, collectively, through which we deny infringement of anyvalid claim of the STS patents and seek a declaration to that effect. The casehas been set on a discovery calendar and is at a preliminary stage.

On August 30, 2004, we filed in the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. (“NICE Inc.”), a wholly-owned subsidiaryof NICE Ltd., alleging patent infringement. Specifically, we have allegedthat NICE products, including the NiceUniverse products that include screencapture and synchronized screen and voice capture technologies, infringe claimsof U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220 (“the ‘220Patent”), both entitled “Method and Apparatus for Simultaneously MonitoringComputer User Screen and Telephone Activity from a 

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RemoteLocation.” We have sought an injunction and money damages for NICE’sinfringement of these two patents. NICE Inc. has answered and counterclaimedfor declaratory judgments of non-infringement and invalidity. Since then, onFebruary 24, 2005, we filed suit against NICE Ltd. because of itsinfringing activities in violation of the ‘798 and ‘220 patents, includingimportation of the accused NICE products. By order dated April 5, 2005,the court has consolidated the NICE Inc. and NICE Ltd. actions. The case hasbeen set on a modified discovery calendar after consolidation and is at apreliminary 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. Patent No. 6,404,857B1 (“the ‘857 Patent”), entitled “Signal Monitoring Apparatus for AnalyzingCommunications.” We have sought an injunction and money damages for NICE’sinfringement of the ‘857 patent. On March 6, 2006, NICE answered andcounterclaimed, alleging that the ‘857 patent is not infringed and isinvalid.  The case has been set ona discovery calendar and 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 ourproducts, including ContactStore, ContactStore for IP, ContactStore forCommunications Manager, Quality for Communications Manager, and eQualityBalance, infringe one or more claims of ten U.S. Patents:  U.S. Patent 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 (“the Delaware Patents”). We answered NICE’s complaint on June 30, 2006, through which we denyinfringement of any valid claim of any of the Delaware Patents.  The case has been set on a discoverycalendar and is at a preliminary stage.

On December 27, 2006, NICE Systems, Inc. and NICESystems Ltd. (collectively, “NICE”), filed a declaratory judgment actionagainst us in the U.S. District Court for the Northern District Georgia,relating to U.S. Patent No. 6,757,361 (“the ‘361 Patent”), entitled “SignalMonitoring Apparatus Analyzing Voice Communication Content.”  NICE seeks a declaration from the court thatthe claims of the ‘361 Patent are invalid, and that NICE has not infringed anyvalid claim of the ‘361 Patent.  We havenot yet responded to NICE’s complaint.

In January 2001, IEX Corporation filed a lawsuitagainst Blue Pumpkin in the United States District Court for the EasternDistrict of Texas, Sherman Division (“Texas IEX action”), alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the‘355 Patent”) by making and selling certain workforce management and callrouting software products, including Blue Pumpkin’s Prime Time Skills and PrimeTime Enterprise products.

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”). Blue Pumpkin’s lawsuit seeks an injunction and money damages forIEX’s infringement of the ‘732 Patent.

On April 6, 2006, Blue Pumpkin and IEX reached anagreement to settle all claims asserted between. As part of the finalsettlement, Witness paid $8.25 million to IEX’s parent company, inApril 2006 and agreed to make six annual payments of $0.5 million ($3.0 millionin total) from April 2007 through 2012.

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.

In addition, a class action securitieslawsuit has been filed by an individual  on August 14, 2006 claiming tobe a stockholder of the Company naming the Company and certain of itsdirectors and officers as defendants in connection with certain stock optiongrants made by the Company.  Rosenberg v. Gould, et al., Civil Action No.1:06-CV-1894 (N.D. Ga.).  The complaint, filed in the United StatesDistrict Court for the Northern District of Georgia, alleges violations ofSection 10(b) of the Securities Exchange Act of 

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1934and Rule 10b-5 thereunder and seeks unspecified damages, attorneys’ fees andother costs and expenses, unspecified extraordinary, equitable and injunctiverelief, and other relief as determined by 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, the Company received a notice of informal nonpublic inquiry from theSecurities and Exchange Commission requesting certain documents and informationrelating to the company’s stock option grant practices from February 2000 tothe present. Witness Systems intends to cooperate fully with all matters relatedto this request.

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

**Item 1A Risk Factors**

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

*SEC Inquiry and LitigationRelating 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 we do not maintain compliancewith the listing requirements of the Nasdaq Stockl Market, our common stockcould be delisted, which could, among other things, reduce the price of ourcommon stock and the levels of liquidity available to our stockholders.*

In connection withthe Special Committee’s review and the restatement of our  consolidated financial statements,we did not timely file certain of our periodic reports with the SEC. As a result, we were not in compliance with the listing requirements under theNasdaq  Rules. Following a reviewand hearing process with the Nasdaq, the Nasdaq has permitted oursecurities to remain listed. However, our securities could be delisted in thefuture if we do not maintain compliance with applicable listing requirements.If our securities are delisted from the Nasdaq, they would subsequently betransferred to the National Quotation Service Bureau, or “Pink Sheets”. Thetrading of our common stock through the Pink Sheets may reduce the priceof our common stock and the levels of liquidity available to our stockholders.In addition, the trading of our common stock through the PinkSheets could materially and adversely affect our access to thecapital markets and our ability to raise capital through alternative financingsources on terms acceptable to us, or to raise capital at all. Securitiesthat trade through the Pink Sheets are no longer eligible for marginloans, and a company trading through the Pink Sheets cannot avail itselfof federal preemption of state securities or “blue sky” laws, which addssubstantial compliance costs to securities issuances, including pursuant toemployee option plans, stock purchase plans and private or public offerings ofsecurities. If we are delisted in the future from the Nasdaq and transferred tothe Pink Sheets, there could also be other negative implications,including the potential loss of confidence by suppliers, customers andemployees and the loss of institutional investor interest in our Company.

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

It typically takes three to nine months from the timewe qualify a sales lead until we sign a sales contract with the customer. As aresult, it is difficult for us to predict the quarter in which a particularsale will occur. If our sales cycle unexpectedly lengthens for one or 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. Materialchanges in our sales cycle could cause our quarterly revenue or operating resultsto be 

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belowthe expectations of investors, and the price of our common stock could fallsubstantially.

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;

·                  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;

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·                  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 $71.9 million and $61.2 millionin the nine months ended September 30, 2006 and 2005, respectively, fromcustomers located outside the United States. Our operations outside of theUnited States at September 30, 2006, consisted of operations located inAustralia, Brazil, Canada, China, Germany, India, Japan, Mexico, theNetherlands, Singapore, South Africa and the United Kingdom. We have alsoestablished relationships with a number of international resellers.

With our acquisitions of Blue Pumpkin inJanuary 2005 and Optimis in May 2005 both of which have sales outsideof North America, we have expanded our international operations, and we intendto continue to expand our international operations through additionalacquisitions, internal business expansion and strategic business relationships.These efforts require significant management attention and financial resources.We may not be able to successfully penetrate international markets or, ifwe do, we may not be able to grow or to maintain adequate profit marginsin these markets. Because of the complex nature of our international expansion,it may adversely affect our business and operating results. Internationalexpansion and sales are subject to many risks, including the 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;

·                  internationallaws and regulations, including trade restrictions, local labor ordinances,changes in tariff 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.

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As we furtherexpand our operations outside the United States, we will also face newcompetitors and competitive environments. In addition to the risks associatedwith our domestic competitors, foreign competitors may pose an evengreater risk, because they may possess a better understanding of theirlocal markets and have better working relationships with local infrastructureproviders and others. In particular, because telephone protocols and standardsare unique to each country, local competitors will have more experience with,and may have a competitive advantage in, these markets. We may not beable to obtain similar levels of knowledge, which could place us at a significantcompetitive disadvantage. In addition, we have limited experience in developinglocal language versions of our products or in marketing our products tointernational customers. We may not be able to successfully translate,market, sell, and deliver our products internationally.

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

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

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

Our strategy is to continue to increase the proportionof customers served through indirect sales channels, such as select resellersand a variety of strategic marketing alliances. Product revenue, excludinghardware revenue, from our indirect sales channel represented 42% of totalproduct revenue in the nine months ended September 30, 2006 and 2005,respectively. We expect revenue from our indirect sales channel and,accordingly, our dependence on distribution partners, to increase as weestablish relationships with companies to resell our software worldwide. Wecannot assure you that we will be able to maintain productive relationshipswith our current partners, or that we will be able to establish similarrelationships with additional resellers on a timely basis, if at all.

Some resellers with which we do business have similar,and often more established, relationships with our competitors, andmay recommend the products and services of our competitors to customersinstead of our software and services. We cannot provide assurance that thesedistribution partners will devote adequate resources to selling our softwareand services or that our resellers may not learn about our products andthe market for our software and services and develop and sell competingproducts and services. As a result, our relationships with resellers could leadto increased competition for us.

*Competition in our businesscould adversely affect our revenue, profitability and market share.*

The market for products that record customerinteractions, forecast and schedule employees, analyze performance and/orprovide electronic learning is intensely competitive, evolving and is subjectto rapid changes in technology. We believe our principal competitors include,but are not limited to:

·                  traditionalcall-logging vendors;

·                  qualitymonitoring suppliers to the contact center industry;

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

·                  electroniclearning vendors;

·                  businessanalytics vendors;

·                  largetelecom solution providers;

·                  enterprisesoftware vendors;

·                  systemsintegrators and consulting firms; and

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·                  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 their productsand compete for potential customers. It is also possible that resellers ortechnology partners may acquire or be acquired by one or more of ourcompetitors, 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 those we will be successful in marketing any new orenhanced products. If our competitors release new products that are superior toour products in performance or price, demand for our products may decline.A decline in demand for our products as a result of competition, technologicalchange or other factors would reduce our total revenues and adversely affectprofitability.

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

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 combinesnew 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:

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·                  delaysor product errors due to miscommunication between our local developmentorganization and our Atlanta- based R&D management;

·                  development personnel affected by time,distance and language differences;

·                  scheduling delays due to lengthy ramp-up timefor our new development personnel;

·                  products produced in the Asia-Pacific regionthat fail to meet our quality requirements;

·                  high voluntary personnel turnover; and

·                  foreign employment and labor laws with whichwe are not familiar.

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

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

Our software is used in a complex operatingenvironment that requires its integration with computer and telephone networksand other business software applications. If our products fail to function asrequired, we may be subject to claims for substantial damages. Courtsmay not enforce provisions in our contracts that would limit our liabilityor otherwise protect us from liability for damages. Although we maintaingeneral liability insurance coverage, including coverage for errors oromissions, this coverage may not continue to be available on reasonableterms or in sufficient amounts to cover claims against us. In addition, ourinsurer may disclaim coverage as to any future claim. If claims exceedingthe available insurance coverage are successfully asserted against us, or ourinsurer imposes premium increases, large deductibles or co-insurancerequirements on us, our business, financial position, and results of operationscould be adversely affected.

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

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

*Our 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 new productsor 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 our customers’ interactions, wemay be subject to liability and our reputation may be harmed.*

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

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

The occurrence or perception of security breaches inthe operation of our business or suffered by third parties using our 

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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 ourproducts.

*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 to perform tothe standards required by these contracts, we could be subject to additionalliability and our business, financial condition and results of operations couldbe materially and adversely affected.

*If we fail to protect 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 confidentiality agreementswith employees and third parties to establish and protect our proprietaryrights. These measures may not be sufficient to protect our proprietaryrights, and we cannot be certain that third parties will not misappropriate ourtechnology and use it for their own benefit. Also, most of these protections donot preclude our competitors from independently developing products withfunctionality or features substantially equivalent or superior to our software.Any infringement of our proprietary rights could negatively affect our futureoperating results.

As of September 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 any futureapplications will be approved, that any existing or future patents, trademarksor copyrights will adequately protect our intellectual property or that anyexisting or future patents, trademarks or copyrights will not be challenged bythird parties.

We are aware of certain uses, U.S. trademarkregistrations, and U.S. trademark applications for our “eQuality” trademark andits variations that predate our use, and the April 2002 issuance of theU.S. registration for our trademark eQuality®. It is possible that an owner oflegal rights resulting from prior use, registrations, or applications willbring legal action to challenge our registration of and/or our use of thetrademark eQuality®, and may also seek compensation for damages resultingfrom our use this trademark. As a result, we cannot assure you that ourregistration of this trademark will be undisturbed, or that this use will notresult in liability for trademark infringement, trademark dilution, and/orunfair competition.

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

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

It is possible that third parties will claim that wehave infringed their current or future products. We expect that we and other 

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participantsin our industry will be increasingly subject to infringement claims as thenumber of competitors and products grows. Any claims, with or without merit,which are generally uninsurable, could be time-consuming, result in costlylitigation, require us to reengineer or redevelop our software, cause productshipment delays or require us to enter into royalty or licensing agreements,any of which could negatively affect our operating results. Any efforts toreengineer our software or obtain licenses from third parties may not besuccessful, could be extremely costly and would likely divert valuablemanagement 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 avoid infringement,we may be prevented from distributing our software or required to incursignificant expense and delay in developing non-infringing software. Such aresult could have a material adverse effect on our business, financialcondition and results of operations.

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

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

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

Our customers ordinarily purchase installation,training and maintenance services together with our products. The functionalityof our products is not dependent on our installation and training services. Webelieve that the speed and quality of installation services are competitivefactors in our industry. If our installation services are not satisfactory to ourcustomers, the customers may choose not to use our installation servicesor they may not license our software in the future. As a result, we wouldlose licensing and services revenue, and it could harm our reputation. Inaddition, our revenues realized from the performance of maintenanceservices are material to our operating results, and a failure to provideadequate maintenance support to our customers would result in reducedmaintenance revenues and have an adverse 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 limitedexperience in making acquisitions and investments. As a result, our ability toidentify and evaluate prospects, complete acquisitions and properly manage theintegration of businesses is relatively unproven. If we fail to properlyevaluate and execute acquisitions or investments, it may have a materialadverse effect on our business and operating results. In making or attemptingto make acquisitions or investments, we face a number of risks, including:

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

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

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

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·                  retainingand motivating key employees of the acquired companies;

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

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

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

·                  accuratelyforecasting the financial impact of a transaction;

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

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

·                  potentiallydilutive issuances of securities as consideration for an acquisition;

·                  effectivelyintegrating acquired companies and achieving expected synergies; and

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

*If we need 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:

·                  developand enhance our software to remain competitive;

·                  takeadvantage of future opportunities, such as acquisitions;

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

·                  attractand retain qualified key personnel.

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

*Our inability to sourcehardware could harm our business.*

A number of customers expect us to source hardware tosupport the implementation of our software. We seek to reduce the amount ofhardware sales in the future and have transferred the fulfillment of hardwareorders to third-party distributors. Thus, we are largely dependent on thirdparties for the supply of hardware components to our customers. If thesehardware distributors experience financial, operational or quality assurancedifficulties, or if there is any other disruption in our relationships, wemay be required to locate alternative hardware sources. We are subject tothe following risks due to our hardware distribution system:

·                  cancellationsof orders due to unavailability of hardware;

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

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

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Evenif we and/or our distributors are successful in locating alternative sources ofsupply, alternative suppliers could increase prices significantly. In addition,alternative components may malfunction or interact with existingcomponents in unexpected ways. The use of new suppliers and the modification ofour products to function with new systems would require testing andmay require further modifications, which may result in additionalexpense, diversion of management attention and other resources, inability tofulfill customer orders or delay in fulfillment, reduction in quality andreliability, customer dissatisfaction, and other adverse effects on ourreputation, 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 by securitiesanalysts, announcements of extraordinary events, such as acquisitions orlitigation, or general economic conditions may have an adverse effect onthe 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.*

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.

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*If we areunable to attract and retain key personnel, our ability to effectively manageand grow our business would suffer.*

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

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

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

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

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

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

Throughout much of our history, we have experiencedlosses. As a result of our prior operating losses, we had a significantaccumulated deficit as of September 30, 2006. We need to generate sufficientrevenue to achieve sustained profitability and avoid incurring losses again inthe future.

**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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