UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington, D.C.
20549
  FORM
10-K
  (mark
one)
 
 Annual
Report Pursuant To Section 13 or 15(d) of the Securities Exchange Act of
1934
  For
the fiscal year ended September 30, 2009
  or
  Transition
Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
  For the
transition period from _______________ to _______________
  Commission
file number 000-26285
  CNS
RESPONSE, INC.
 (Exact
name of registrant as specified in its charter)
  Delaware
              87-0419387(State
      or other jurisdiction
              (I.R.S.
      Employerof
      incorporation or organization)
              Identification
      No.)
  2755
Bristol St., Suite 285
 Costa
Mesa, CA 92626
 (Address
of Principal Executive Offices)(Zip Code)
  (714)
545-3288
 (Registrant’s
telephone number, including area code)
  Securities
registered pursuant to Section 12(b) of the Act:
 None
  Securities
registered under Section 12(g) of the Exchange Act:
 Common
Stock, $0.001 par value
  (Title of
Class)
  Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.
 Yes     ̈No     x
  Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.
 Yes     ̈No     x
  Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
 Yes    xNo      ̈
  Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).
 Yes     ̈No     x
  Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§229.405 of this chapter) is not contained herein, and will not
be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K.
  ̈
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.
 Large
      accelerated filer       ̈
                Accelerated
      filer  ̈Non-accelerated
      filer      ̈(Do
      not check if smaller reporting company)
                Smaller
      reporting company x
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act.)
 Yes     ̈No     x
  The
aggregate market value of the registrant's common stock held by non-affiliates
of the registrant on March 31, 2009, the last business day of the registrant's
most recently completed second fiscal quarter was $13,555,818 (based on the
closing sales price of the registrant's common stock on that date).
 
 At
December 28, 2009, the registrant had 51,747,729 shares of Common Stock, $0.001
par value, issued and outstanding.
  DOCUMENTS
INCORPORATED BY REFERENCE
  Portions
of the issuer’s Proxy Statement for its 2010 Annual Meeting of Stockholders are
incorporated by reference into Part III of this Annual Report.
  
 
 CNS
RESPONSE, INC.
  2009
FORM 10-K ANNUAL REPORT
 
 TABLE OF
CONTENTS
 
 PART
      I
                  
                  3ITEM
      1.
                  Business
                  4ITEM
      1A.
                  Risk
      Factors
                  17ITEM
      1B.
                  Unresolved
      Staff Comments
                  32ITEM
      2.
                  Properties
                  33ITEM
      3.
                  Legal
      Proceedings
                  33ITEM
      4.
                  Submission
      of Matters to a Vote of Security Holders
                  37PART
      II
                  
                  37ITEM
      5.
                  Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                  37ITEM
      6.
                  Selected
      Financial Data
                  42ITEM
      7.
                  Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                  42ITEM
      7A.
                  Quantitative
      and Qualitative Disclosures about Market Risk
                  55ITEM
      8.
                  Financial
      Statements and Supplementary Data
                  56ITEM
      9.
                  Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                  80ITEM 9A(T).
                  Controls
      and Procedures
                  80ITEM
      9B.
                  Other
      Information
                  81PART
      III
                  
                  82ITEM
      10.
                  Directors,
      Executive Officers and Corporate Governance
                  82ITEM
      11.
                  Executive
      Compensation
                  82ITEM
      12.
                  Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                  82ITEM
      13.
                  Certain
      Relationships and Related Transactions, and Director
      Independence
                  82ITEM
      14.
                  Principal
      Accounting Fees and Services
                  82PART
      IV
                  
                  83ITEM
      15.
                  Exhibits,
      Financial Statement Schedules
                  83
 
 2
  PART
I
  CAUTIONARY
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
  This 2009
Annual Report on Form 10-K, including the sections entitled “Risk Factors,”
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” and “Business,” contains “forward-looking statements” that include
information relating to future events, future financial performance, strategies,
expectations, competitive environment, regulation and availability of
resources.  These forward-looking statements include, without
limitation, statements regarding: proposed new products or services; our
statements concerning litigation or other matters; statements concerning
projections, predictions, expectations, estimates or forecasts for our business,
financial and operating results and future economic performance; statements of
management’s goals and objectives; trends affecting our financial condition,
results of operations or future prospects; our financing plans or growth
strategies; and other similar expressions concerning matters that are not
historical facts.  Words such as “may,” “will,” “should,” “could,”
“would,” “predicts,” “potential,” “continue,” “expects,” “anticipates,”
“future,” “intends,” “plans,” “believes” and “estimates,” and similar
expressions, as well as statements in future tense, identify forward-looking
statements.
  Forward-looking
statements should not be read as a guarantee of future performance or results,
and will not necessarily be accurate indications of the times at, or by which,
that performance or those results will be achieved. Forward-looking statements
are based on information available at the time they are made and/or management’s
good faith belief as of that time with respect to future events, and are subject
to risks and uncertainties that could cause actual performance or results to
differ materially from those expressed in or suggested by the forward-looking
statements. Important factors that could cause these differences include, but
are not limited to:
  ·
              our
      inability to raise additional funds to support operations and capital
      expenditures;
  ·
              our
      inability to achieve greater and broader market acceptance of our products
      and services in existing and new market
  segments;
  ·
              our
      inability to successfully compete against existing and future
      competitors;
  ·
              our
      inability to manage and maintain the growth of our
    business;
  ·
              our
      inability to protect our intellectual property rights;
  and
  ·
              other
      factors discussed under the headings “Risk Factors,” “Management’s
      Discussion and Analysis of Financial Condition and Results of Operations”
      and “Business.”
  Forward-looking
statements speak only as of the date they are made. You should not put undue
reliance on any forward-looking statements. We assume no obligation to update
forward-looking statements to reflect actual results, changes in assumptions or
changes in other factors affecting forward-looking information, except to the
extent required by applicable securities laws.  If we do update one or
more forward-looking statements, no inference should be drawn that we will make
additional updates with respect to those or other forward-looking
statements.
  3
  ITEM
      1.
              Business
  With
respect to this discussion, the terms “we” “us” “our” “CNS” and the “Company”
refer to CNS Response, Inc., a Delaware corporation and its wholly-owned
subsidiaries CNS Response, Inc., a California corporation (“CNS California”),
Colorado CNS Response, Inc., a Colorado corporation (“CNS Colorado”) and
Neuro-Therapy Clinic, Inc., a Colorado professional medical corporation and a
wholly-owned subsidiary of CNS Colorado (“NTC”).
  Background
  CNS
Response, Inc. was incorporated in Delaware on July 10, 1984, under the name
Mammon Oil & Gas, Inc.  Prior to January 16, 2007, CNS Response,
Inc. (then called Strativation, Inc.) existed as a “shell company” with nominal
assets whose sole business was to identify, evaluate and investigate various
companies to acquire or with which to merge.  On January 16, 2007, we
entered into an Agreement and Plan of Merger (the “Merger Agreement”) with CNS
Response, Inc., a California corporation formed on January 11, 2000 (“CNS
California”), and CNS Merger Corporation, a California corporation and our
wholly-owned subsidiary (“MergerCo”) pursuant to which we agreed to acquire CNS
California in a merger transaction wherein MergerCo would merge with and into
CNS California, with CNS California being the surviving corporation (the
“Merger”). On March 7, 2007, the Merger closed, CNS California became our
wholly-owned subsidiary, and on the same date we changed our corporate name from
Strativation, Inc. to CNS Response, Inc.
  Overview
  CNS
Response is a life sciences company with two distinct business segments. Our
Laboratory Information Services business operated by CNS California, which we
consider our primary business, is focused on the research, development, and
commercialization of a patented system that guides psychiatrists and other
physicians/prescribers to determine a proper treatment for patients with
behavioral (psychiatric and/or addictive) disorders. Our Clinical Services
business operated by NTC is a full service psychiatric clinic.
  Laboratory
Information Services
  Traditionally,
prescription of medication for the treatment of behavioral disorders (such as
depression, bipolar disorders, eating disorders, addiction, anxiety disorders,
ADHD and schizophrenia) has been primarily based on symptomatic factors, while
the underlying physiology and pathology of the disorder is rarely able to be
analyzed, often resulting in multiple ineffective, costly, and often lengthy,
courses of treatment before effective medications are
identified.  Some patients never find effective
medications.
  We
believe that our technology offers an improvement upon traditional methods for
determining a course of medication for patients suffering from nonpsychotic
behavioral disorders because our technology is designed to correlate the success
of courses of medication, with the neurophysiological characteristics of a
particular patient. Our technology provides medical professionals with
medication sensitivity data for a subject patient based upon the identification
and correlation of treatment outcome information from other patients with
similar neurophysiologic characteristics.   This treatment
outcome information is contained in a proprietary outcomes database that
consists of over 17,000 medication trials for patients with psychiatric or
addictive problems (the “CNS
Database”).  For each patient in the CNS Database, we have
compiled electroencephalographic (“EEG”)
scans, symptoms and outcomes often across multiple treatments from multiple
psychiatrists and physicians.  This patented technology, called
“Referenced-EEG®” or “rEEG®” represents an innovative approach to identifying
effective medications for patients suffering from debilitating behavioral
disorders.
  4
  With
rEEG®, physicians order a digital EEG for a patient, which is then evaluated
with reference to the CNS Database.  By providing this reference
correlation, an attending physician can choose a treatment strategy with the
knowledge of how other patients having similar brain function have previously
responded to a myriad of treatment alternatives.  Analysis of this
complete data set yielded a platform of 74 quantitative biomarkers that have
shown utility in characterizing patient response to diverse
medications.  This platform then allows a new patient to be
characterized, based on these 74 biomarkers, and the database to be queried to
understand the statistical probability of how patients with similar brain
patterns have previously responded to the medications currently in the database.
This technology allows us to create and provide simple reports (“rEEG
Reports”) to the prescriber that summarizes historical treatment success
of specific medications for those patients with similar brain
patterns.   It provides neither a diagnosis nor specific
treatment, but like all lab results, objective, evidenced-based information to
help the prescriber in their decision-making.
 
 Our Laboratory Information Services
business is focused on increasing the demand for our rEEG Reports. We believe
the key factors that will drive broader adoption of our rEEG Reports will be
acceptance by healthcare providers and patients of their benefit, demonstration
of the cost-effectiveness of using our technology, reimbursement by third-party
payers, expansion of our sales force and increased marketing
efforts.
  In
addition to its utility in providing psychiatrists and other
physicians/prescribers with medication sensitivity guidance, rEEG provides us
with significant opportunities in the area of pharmaceutical development. 
rEEG, in combination with the information contained in the CNS Database, has the
potential to be able to identify novel uses for neuropsychiatric medications
currently on the market and in late stages of clinical development, as well as
aid in the identification of neurophysiologic characteristics of clinical
subjects that may be successfully treated with neuropsychiatric medications in
the clinical testing stage. We intend to enter into relationships with
established drug and biotechnology companies to further explore these
opportunities, although no relationships are currently
contemplated.  The development of biomarkers as the new method for
identifying the correct patient population to research is being encouraged by
both The National Institute of Mental Health (NIMH) and The Food and Drug
Administration (FDA).
  Clinical
Services
  In
January 2008, we acquired our largest customer, NTC, located in Colorado. Upon
the completion of the transaction, NTC became our wholly-owned subsidiary. At
the time, NTC operated one of the largest psychiatric medication management
practices in the state of Colorado, under contracts with national health
plans.  Daniel A. Hoffman, M.D. is the medical director at NTC, and,
after the acquisition, became our Chief Medical Officer and more recently, our
President.
  NTC,
having performed a significant number of rEEG’s, serves as an important resource
in our product development, the expansion of our CNS Database, production system
development and implementation, along with the integration of our rEEG services
into a medical practice.  Through NTC, we also expect to successfully
develop marketing and patient acquisition strategies for our Laboratory
Information Services business. Specifically, NTC is learning how to best
communicate the advantages of rEEG to patients and referring physicians in the
local market. We will share this knowledge and develop communication programs
which can be generalized to physicians using our services throughout the
country, which we believe will help drive market acceptance of our
services.  In addition, we plan to use NTC to train practitioners
across the country in the uses of rEEG technology.
  5
  We view
our Clinical Services business as secondary to our Laboratory Information
Services business, and we have no current plans to significantly expand this
business.
  Laboratory
Information Services
  The
Challenge and the Opportunity
  The 1990’s were known as “the Decade of
the Brain,” a period in which basic neuroscience yielded major advances in drug
discovery and neurotherapy.  Several trends have emerged which may
propel significant adoption of these advances over the next decade:
  ·
              Comparative
      Effectiveness Research is incorporated into the Obama health plan. The
      cost to treat Americans under care for depression and other mental
      illnesses rose by nearly two-thirds from $35 billion to $58 billion in the
      last 10 years, according to a recent report from the Agency for Healthcare
      Research and Quality.  Finding more cost-effective treatment
      modalities in mental disorders will be critical to successful health care
      reform;
  ·
              Mental
      Health Parity Act (Parity Act) requires payers, beginning in 2010, to pay
      for behavioral medications and treatments using the same standards for
      evidence and coverage as they currently use for medical/surgical
      treatments;
  ·
              According
      to a recent RAND report, 275,000 returning military personnel from the
      Iraq and Afghanistan theatres suffer from Major Depression, Post Traumatic
      Stress Disorder (PTSD), traumatic brain injury;
  and
  ·
              Consumers
      have emerged as active decision makers in behavioral treatment, driven by
      over $4.8 billion in annual Pharma direct-to-consumer advertising and the
      internet.  At the same time, media costs for reaching those
      consumers are at historic lows.
  Today,
there are over 100 prescription drugs available to patients suffering from a
behavioral disorder, representing one of the largest and fastest-growing drug
classes.  Unfortunately, psychotropic drugs often do not work, or lose
their effect over time, and over 17 million Americans who have failed two or
more medication treatments are now considered “treatment
resistant”.  For these patients, the conventional “trial and error”
method of prescribing psychotropic drugs has resulted in low efficacy, high
relapse and treatment discontinuation rates, significant patient suffering and
billions in additional cost to payers.
  We
believe we are the first company to create a biomarker database that correlates a
patient’s response to major drug classes and specific medications with their
individual brain physiology.  We developed this tool to improve
pharmacotherapy outcomes, particularly in treatment resistant patients, a
particularly expensive patient population with profound unmet clinical
needs.  Our rEEG technology has been used by physicians to guide
prescribing in behavioral disorders such as depression, anxiety, anorexia, OCD,
bipolar, ADHD, addiction and others.
  rEEG® was
developed by a pathologist/psychiatrist who recognized that correlation of a
patient’s unique brain patterns to known long-term medication outcomes in
similar patients might significantly improve therapeutic
performance.  This approach — commonly referred to as Personalized
Medicine, and exemplified by biomarker companies such as Genomic Health (GHDX) —
is in the process of transforming both clinical practice and the pharmaceutical
industry.  CNS Response brings this science to behavioral medicine,
where the unmet clinical need is well-documented, expensive, and
growing.
  6
  The
rEEG® Method
  rEEG® reports are offered as a service,
much like a reference lab, in which standard electroencephalogram (EEG) readings
are referenced to a biomarker database to suggest patient-specific probabilities
of response to different medications.  EEG recording devices are
widely available, inexpensive to lease, and are available in most cities by
independent mobile EEG providers.
  The
service works as follows:
  ·
              Patients
      are directed to a national rEEG® provider, who performs a standard digital
      EEG.
  ·
              EEG
      data is uploaded over the web to our central analytical
      laboratory.
  ·
              We
      analyze the data against the CNS Database for patients with similar brain
      patterns.
  ·
              We
      provide a report describing the probability of patient success with
      different medication options (much like an antibiotic sensitivity report
      commonly used in medicine).
  ·
              The
      rEEG® report is sent back to the doctor, typically the next
      day.
 
 Treatment
Decisions Made by Licensed Professionals
  With the
exception of our subsidiary, the Neuro-Therapy Clinic based in Denver, CO, we do
not currently operate our own healthcare facilities, employ our own treating
physicians or provide medical advice or treatment to
patients.  Physicians who contract for our rEEG Reports own their own
facilities or professional licenses, and control and are responsible for the
clinical activities provided on their premises.  Patients receive
medical care in accordance with orders from their attending physicians or
providers.  Physicians who contract for rEEG Reports are responsible
for exercising their independent medical judgment in determining the specific
application of the information contained in the rEEG Reports, and the
appropriate course of care for each patient.  Following the
prescription of any medication, Physicians are presumed to administer and
provide continuing care treatment.
  Estimated
Market for rEEG Reports
  Currently,
the wholesale (direct to physician) price for standard rEEG testing is $400 per
test, and the retail (payer and consumer) price is approximately
$800.  Thus far, payments have typically been from psychiatrists whose
patients pay privately for the rEEG® report.  The National Institute
of Mental Health (NIMH) estimates that only 12.7% of patients get minimally
effective treatment, with over 17 million Americans now classified as “treatment
resistant”, meaning they’ve failed to find relief after trying two or more
medications.
  We
therefore estimate the potential market for our rEEG reports at $1.7 billion
annually, based on an addressable market of 17 million Treatment Resistant
patients, with only 12.5% of patients seeking care and complying with
treatment.  Now that we have completed our clinical trial (please see
page 11 Laboratory Services Accomplishments for further information on our
clinical trial), we intend to place greater emphasis on the marketing of our
rEEG technology to physicians, consumers and payers.
  7
  Path
to Adoption
  Several
biomarker firms have successfully commercialized products that predict
medication response, including Genomic Health’s OncotypeDx which predicts
response to chemotherapy, and Roche/Affymetrix Cytochrome P450 test which shows
how each patient is likely to metabolize a given antidepressant.  We
are following the paths to adoption used by these successful biomarker firms by
focusing on growth in three stages:
  (1)          Private
pay market.
  Consumers
and private-pay psychiatrists drive over 33% of the market for psychiatric
visits, and a significant proportion of all licensed psychiatrists now describe
themselves as private pay only.  We believe consumers who have
experienced treatment failure will seek out our network of physicians once they
become aware of the successful outcomes demonstrated in our clinical
trial.
  During
2008, the recruiting for our Depression Efficacy Trial (the Depression Efficacy
Trial is further described under the heading Laboratory Services Accomplishments
on page 11) generated many important lessons about integrated marketing for our
rEEG® service.  By using a media mix of web, radio and TV, interested
patients were delivered into the trial at an average cost of $40-$68 per
contact.  We will continue to pursue integrated consumer marketing as
a means to introduce interested patients to our rEEG® provider
network.
  To drive
growth in private pay, consumer-driven rEEG testing, we plan to do the
following:
  ·
              Grow
      our focused physician network:  We currently have 51 active
      practicing physicians utilizing rEEG in their practices, defined as having
      paid for testing within the last 12 months.   An additional
      52 physicians are currently involved in training or clinical trials
      utilizing rEEG.  Physicians who become “power users” (which we
      define as physicians who conduct several tests per month) report
      significantly better results than casual users of rEEG technology, and
      have certain economies of scale in using the test in their
      practices.  Similar to the adoption of LASIK technology in
      consumer-driven opthalmology, successful practices using rEEG have
      reported that as their word-of-mouth referrals increase, their procedure
      billings increase, and their average patient visits decrease (as patients
      improve).  Accordingly, their patient turnover may increase over
      time, requiring additional marketing efforts to grow their practice
      volume.
  We plan
to focus on supporting these power users through direct marketing, clinical
practice support (patient intake, scheduling, washout support and reporting),
and technical support.  This focused network approach has been
successful in other specialties (for example, in organ transplant networks and
in disease management) because it is easier to sell to payers, facilitates data
collection, and is more cost-effective in delivering care even at higher
provider margins.
  ·
              Increase
      unit pricing:  Currently, the wholesale (direct-to-physician)
      price for standard rEEG testing is $400 per test, and the retail (payer
      and consumer) is approximately $800.   We anticipate that
      our pricing will be increased over time with greater acceptance of the
      test as a standard of care, rewarding power users for committed volume and
      affording improvement in test margins
overall.
  8
  ·
              Utilize
      our product laboratory:  In 2008, we purchased the psychiatric
      clinic in Denver, CO founded by our Chief Medical Officer, Daniel Hoffman,
      MD.  The clinic currently serves as a platform for perfecting
      rEEG workflow, information systems, product development and
      research.  We also test local marketing strategies in Denver
      which can then be generalized to other rEEG® network
      clinics.  The Denver clinic may ultimately become a national
      Center of Excellence for neuropsychiatry, where insurers may direct
      certain treatment-resistant
patients.
  ·
              Scalable
      platform for delivery:  During 2008, significant development
      effort was focused on production systems and lab infrastructure to
      accommodate potential growth in the production volume of our rEEG
      Reports.  Our current production application is able to
      accommodate up to 100 tests per day without additional
      manpower.  In addition to providing scalable capacity, the
      production system provides for online delivery of tests and delivery of
      test data to physicians’ desktops.  Currently, we are investing
      in projects to reduce or eliminate the remaining manual processes in test
      production:  “artifacting” of EEG data and Neurologist review of
      each case.  It is estimated that these processes will, over
      time, be replaced with validated algorithms and/or post-facto sampling for
      quality assurance.
  (2)         Payer
economic trials.
  Health
plans currently spend over $30 billion on psychotropic medications each year
according to the Substance Abuse and Mental Health Services Administration
(SAMHSA), and most are aware that these agents only work on about 30% of
patients who take them.  The lack of medication adherence and poor
treatment outcomes in behavioral health have been longstanding issues for
payers, but they’ve lacked a targeted, cost-efficient approach to solve the
problem.
  Presently,
rEEG is not a reimbursable procedure for most health care
payers.  Initially, payer  response to most new technologies
is a reflexive denial of coverage, regardless of the superiority of evidence or
economics.  Over time, however, certain payers may adopt technologies
which confer a clear marketing or underwriting advantage, or which protect them
from legal claims for reimbursement under new legislation (e.g.
Parity).  Because of this, it is possible that with sufficient
marketing efforts, we may shift payer “fear of adoption” to “fear of not
adopting” and increase the number of payers that approve our rEEG Reports as a
reimbursable expense.
  We intend
to prove that our rEEG reports are a compelling value for payers through
independent research, budget impact models, and payer pilots (economic
trials):
  ·
              Evidence
      for payers:  We will share well-designed research on
      rEEG® efficacy, showing the weight of superior evidence in controlled and
      real-world clinical trials and case
series.
  For
example, in 2008, the Center for Health Economics, Epidemiology, and Science
Policy of United BioSource evaluated current evidence supporting the utility of
rEEG® in guiding treatment of treatment-resistant depression vs. other
guidelines commonly used by insurance companies and managed care
payers.   They reported:
  “Referenced-EEG®
was associated with relatively high remission rates in Treatment Resistant
Depression with reasonable levels of evidence.  ... In conclusion, the
evidence supporting rEEG® appears superior
to that supporting American Psychiatric Association (APA) or Texas Medication
Algorithm Project (TMAP) treatment guidelines for TRD and certainly the results
of the Sequenced Treatment Alternatives to Relieve Depression (STAR*D) Level 3
and Level 4 studies that are commonly used by payers.”
  9
  ·
              Parity:In 2010, Mental Health
      Parity Act (Parity Act) will change all payers’ coverage criteria,
      requiring equal coverage for behavioral and medical therapies, using the
      same coverage criteria and evidence.  Milliman Global Actuarial
      Services estimates a 1-3% increase in overall health costs resulting from
      a significant increase in behavioral health expenditures driven by the
      Parity Act.  Of particular interest to us, however, is the
      specific language in the Parity Act which requires that coverage of a
      scope-of-service for one type of diagnosis (for example: a Neurologist
      performing a diagnostic EEG for Epilepsy) be applied equally as the use of
      an EEG by a Psychiatrist for medication
  management.
  ·
              Budget Impact Model:A
      Budget Impact Model for rEEG® has been developed by Analysis Group
      Economics based on the published research of Kessler, Russell, and others
      covering the cost of treatment failure in mental
      disorders.  Modeling the economic impact of rEEG® in a health
      plan with five million members, we estimate that full utilization of rEEG®
      in treatment-resistant depression, anxiety, bipolar and ADHD could save
      $8,500 per treatment resistant member for a savings of $45 million per
      year.
  ·
              Economic
      Trials: Economic Trials are intended to demonstrate the comparative
      effectiveness of rEEG versus prevailing Trial & Error medication
      management through pilot programs within a payer’s own
      population.  Although no payer is currently reimbursing
      physicians for the use of rEEG technology, we are currently negotiating
      pilot programs for reimbursement coverage with several of the nation’s
      largest payers, representing over 80 million covered
  lives.
  One
example of the payer appeal was outlined in an advisory issued last year by the
actuarial firm Milliman Global:
  “One
innovative company has come up with an interesting method to help doctors treat
patients who have previously been defined as treatment-resistant. Instead of
using the trial and error method to find an appropriate medication for these
patients, a form of digital electroencephalography (EEG) is used to identify
abnormal patient physiology. The results of this EEG are then used in
combination with a database containing over 1,600 patients and 13,000 medication
trials to select the most efficacious drug(s). Initial outcomes indicate a high
success rate (75%) for participants in this program.
  Quality
initiatives to increase effective treatment of behavioral disorders with
psychotropic drugs will result in preferred outcomes for all involved. If
patients are using the "correct" drug and doing so in accordance with
established medical guidelines, their all around health will improve. Payers who
implement similar quality initiatives will also benefit by getting greater value
in their healthcare spending, and hopefully, reducing total healthcare costs
down the road as members get healthier and stay healthier.  Even
employers will benefit with reduced healthcare costs, fewer sick days and
disability days, and increased productivity.”
  Milliman
Global Client Advisory, August 2008.
  10
  (3)        
Full payer coverage.
  Full
reimbursement of referenced-EEG is likely to follow successful
direct-to-consumer adoption of the rEEG test, along with continued release of
confirmatory rEEG research in peer-reviewed publications.  Following
the example of the biomarker firms discussed above, it appears possible to
accelerate the effect of these initiatives in the following ways:
  ·
              Patient
      Advocacy:  we believe that some components of the rEEG
      test may be billable to payers under Mental Health Parity
      Act.  Historically, patients of our physician network providers,
      and those in our own clinic in Colorado, have paid out of pocket for rEEG
      testing and then sought reimbursement from their insurance
      carrier.  Although these providers frequently furnish
      information to support these claims, the success of their prosecution by
      patients is unclear.
  Accordingly,
we intend to follow the example of biomarker firms such as Genomic Health, which
developed Patient Advocacy services where patient claims were documented and
tracked, and the company helped organize the advocacy of each claim with third
party payers.  Using this approach, Genomic Health was able to win a
retrospective reversal of claim denials for its test from Medicare (the Centers
for Medicare and Medicaid Services) in 2006.
  ·
              Guideline
      development:  we intend to continue internal
      and externally-sponsored clinical research to prove the efficacy of our
      technology to professional associations, such as the American Psychiatric
      Association.  We believe that with strong clinical results,
      professional associations may endorse rEEG in their treatment guidelines,
      which may drive full payer
coverage.
  We also
believe that the inclusion of historical and new rEEG research in Comparative
Effectiveness studies conducted under the Agency for Healthcare Research and
Quality (AHRQ) would be a significant milestone.  As a consequence of
this recent focus on cost-effective treatment, an unprecedented level of funding
has been made available under the Economic Recovery Act, the budgets for NIH and
AHRQ, and earmarked budgets for Defense and the Veterans Association
(VA).  We intend to pursue research opportunities with several
external sponsors of research, including:
  ·
              the
      National
      Institutes of Mental Health, focusing on the cost-effectiveness of
      rEEG as a more deployable version of brain imaging to guide
      prescribing;
  ·
              the
      Department
      of Defense and the Veterans Administration, to address the
      potential for rEEG in treating returning soldiers with PTSD and Major
      Depression; and
  ·
              the
      Centers
      for Medicare and Medicaid Services (CMS), as a mechanism for
      improving quality and cost performance in programs that spend billions on
      psychotropic medications.
  Laboratory
Services Accomplishments
 
 Over the
last few years, we have been primarily focused on proving the efficacy of
rEEG-guided treatments through multiple clinical trials.  The largest
of these — the Depression Efficacy Trial — was a multi-center, randomized,
parallel controlled trial completed this year at 12 medical centers,
including Harvard, Stanford, Cornell, UCI and Rush.  The study began
in late 2007 and was completed in September of this year, screening 465
potential subjects with Treatment Resistant Depression and ultimately
randomizing 114 participants to a 12-week course of treatment utilizing rEEG in
the experimental group, and a modified STAR*D algorithm in the control group
(STAR*D, or Sequenced Alternatives to Relieve Depression, was a large,
seven-year study sponsored by the National Institute of Mental Health and
completed in 2006).   Top-line results were consistent with
previous clinical trials of rEEG:
  11
 
 ·           The
study found that rEEG significantly outperformed the modified STAR*D treatment
algorithm from the beginning.  The difference, or separation, between
rEEG and the STAR*D control group was 50 and 100 percent for the study’s
two primary endpoints.  By contrast, separation between a new
treatment and a control group often averages less than 10 percent in
antidepressant studies.  Interestingly, separation was achieved early
(week 2) and durable, continuing to grow through week 12.
 
 ·           The
control group in this case, STAR*D, was a particularly tough comparator,
representing a level of evidence-based depression care that is available to only
10% of the US population, according to one of the study’s authors.
 
 ·           Statistical
significance (p < .05) was achieved on all primary and most secondary
endpoints.
 
 In the course of undertaking the study,
we also gained insights into marketing of the rEEG technology, highlighting
aspects of marketing which proved to be more successful than
others.  Furthermore, we also developed a foundation for
commercialization of the rEEG technology with insurance companies, and signing a
payer group, Cal Optima (a Southern California health plan for Medicare/Medicaid
enrollees), to run a pilot study with us.  A second large insurer is
in the process of negotiating a pilot study.  Additionally, over the
course of the last few years, much time has been spent securing sufficient
financing to continue our operations and ensure that the clinical trial was
completed.
  Going forward, we plan to continue
expanding the CNS Database with the addition of more pharmaceuticals and their
respective outcomes.  Additionally, we plan on improving the
functionality and clinical utility of our rEEG reports, in order to improve
adoption and compress the training period necessary for physicians to become
proficient with the report.  Finally, we plan to increase and refine
our marketing efforts to consumers and psychiatrists, and expand our effort to
obtain regular insurance reimbursement for rEEG-guided therapies.
  Use
of rEEG Technology in Pharmaceutical Development
  In
addition to its utility in providing psychiatrists and other physicians with
medication sensitivity guidance, rEEG provides us with significant opportunities
in the area of pharmaceutical development.  In the future, we aim to
use our propriety data and processes to advance central nervous system (CNS)
pharmaceutical development and economics, in one or more of the following
ways:
  ·
              Enrichment: selecting
      patients for clinical trial who not only have the symptoms of interest,
      but are shown by rEEG® screening to likely respond to the developer’s
      drug.  An oft-cited example is the antidepressant Prozac, which
      failed several clinical trials before it achieved success in two separate
      trials.  The ability to design trials in which exclusion
      criteria identify and exclude patients who are clearly resistant, as
      determined by rEEG, has the potential to sharpen patient focus and
      productivity in clinical trials of psychotropic
    medications.
  12
  ·
              Repositioning:
      rEEG® may suggest new applications/indications of existing
      medications.  For example, Selective Serotonin Reuptake
      Inhibitors Antidepressants (SSRI’s) are now commonly given by primary care
      physicians for depression and other complaints, but often produce unwanted
      side effects or inadequate results.  The ability to biomarker
      patients who respond better to tricyclics (TCA’s), or combinations of
      TCA’s and stimulants, offers the potential for new indications for
      existing compounds.
  ·
              Salvage:  resuscitation
      of medications that failed phase II or III studies.   One
      example of this opportunity is Sanofi-Aventis’ unsuccessful PMA filing for
      Rimonabant, a promising  anti-obesity/cardiometabolic compound
      which was denied approval in the U.S. due to CNS side-effects in their
      clinical trial populations.  Being able to screen out trial
      participants with resistance to a certain medication is an application for
      rEEG, and could create “theranostic” products (where an indication for use
      is combined with rEEG) for compounds which have failed  to
      receive broader approval.
  ·
              New
      Combinations:  unwanted adverse effects occur with
      medications in fields from cancer to hepatitis. The ability to improve
      these medications, in combination with psychotropics, may improve safety,
      compliance, and, sometimes, patient
outcomes.
  ·
              Decision
      Support:  improved understanding supports improved
      decision making at all levels of  pharmaceutical
      development.
  Competition
  Comparable Biomarker Companies
  Although there are no companies
offering a service directly comparable to rEEG, the following companies might be
noted as pursuing similar strategies:
  ·
              GENOMIC
      HEALTH (Nasdaq: GHDX)  Genomic Health, Inc. is a life science
      company focused on the development and commercialization of genomic-based
      clinical laboratory services for cancer that allow physicians and patients
      to make individualized treatment decisions. The company was founded in
      2000 and is based in Redwood City, California.  In 2004, the
      company launched the Oncotype DX breast cancer test, which has been shown
      to predict the likelihood of chemotherapy benefit, as well as recurrence
      in early-stage breast cancer.  By the end of 2008, the company
      reported that over 90% of health plans were reimbursing use of this
      test.  In addition to its adopted Oncotype DX breast cancer
      test, Genomic Health is preparing to launch its Oncotype DX colon cancer
      test in early 2010.
  ·
              ASPECT
      MEDICAL SYSTEMS, INC. (Nasdaq: ASPM), an EEG anesthesia monitoring
      company, is developing a specific EEG measurement system that indicates a
      patient's likely response to some antidepressant medications. Its
      biomarker, based on research from the UCLA Neuropsychiatric Institute, is
      called Cordance.
  A
375-subject multi-site clinical trial on the efficacy of this biomarker in
guiding treatment of treatment resistant depression — the BRITE trial —
demonstrated positive predictive outcomes for a single antidepressant,
escitalopram  (Lexapro).  Patients in the trial were
measured prior to and after taking medication.  Publicly available
data suggests that the technology may validate a patient's treatment but does
not guide specific treatment. Initial trials have shown efficacy in correlating
a patient's ultimate response to antidepressants. The revenue model may involve
sale of  equipment and a per-patient charge, but the company does not
currently appear to be close to a commercial release of its
product.  The company is now conducting trials.
  13
  ·
              BRAIN
      RESOURCE COMPANY (Aust: BRRZF) (www.brainresource.com), is an Australian
      Clinical Research Organization (CRO) and biomarker company focused on
      personalized medicine solutions for patients, clinicians, pharmaceutical
      trials and discovery research.  As a CRO, its main focus has
      been iSPOT, an $18 million international biomarker study with a private
      biotechnology company.  Their revenue model includes physician
      services and sale of systems and services to pharmaceutical development
      companies in the CNS discovery field.  As a biomarker provider,
      it signed a $6 million agreement last year with Optum (United Healthcare)
      to provide screening for plan
members.
  We believe that we have a competitive
advantage with respect to the behavioral biomarker firms such as Aspect Medical
or Brain Resource Company as we offer more comprehensive testing (e.g. to cover
the full range of CNS medications, not just certain antidepressants in the case
of Aspect Medical) and have conducted studies to validate the efficacy of our
service.  We also believe that we offer greater clinical utility (ease
of use, rapid results) in day-to-day clinical practice than our
competitors.
  Emerging Medical Device Technologies.
  The field of neuropsychiatry is
undergoing dramatic change as a result of the introduction of new technologies.
Many of these technologies are focused on the same treatment-resistant patient
populations which are the focus of rEEG, and are priced from $10,000 to over
$50,000 for a full course of treatment. Two of the three examples presented here
are invasive, implantable devices.
  ·
              CYBERONICS,  INC.
      (Nasdaq: CYBX) is a neuromodulation company, engages in the design,
      development, manufacture, and marketing of implantable medical devices
      that provide vagus nerve stimulation (VNS) therapy for the treatment of
      epilepsy and treatment-resistant depression. The VNS therapy system
      consists of an implantable generator that delivers an electrical signal to
      an implantable lead attached to the left vagus nerve, as well as a bipolar
      lead, a programming wand and software, and a tunneling
    tool.
  Cyberonics
has developed an implantable Vagus Nerve Stimulation device approved for
treatment-resistant depression.  This device has received pre-market
approval from the Food and  Drug Agency for patients and is believed
to be under reimbursement review by insurance payers.
  ·
              MEDTRONIC,
      INC. (NYSE: MDT). Medtronic has an implantable deep brain stimulation
      device (DBS) in development which is similar to their device approved for
      Parkinson's treatment. Deep brain stimulation uses an implanted electrode
      – essentially a pacemaker for the brain — to deliver electrical
      stimulation to specific structures within the brain. The Food and Drug
      Administration (FDA) approved DBS as a treatment for essential tremor in
      1997, for Parkinson's disease in 2002, and dystonia in 2003. DBS is also
      routinely used to treat chronic pain and has been used to treat various
      affective disorders, including major depression. While DBS has proven
      helpful for some patients, there is potential for serious complications
      and side effects.
  ·
              NEURONETICS
      (Privately held) (www.neuronetics.com).  Neuronetics has
      pioneered and refined the NeuroStar TMS Therapy system for non-invasive,
      non-systemic treatment for depression using a focused, pulsed magnetic
      field to stimulate function in targeted brain
      regions.  NeuroStar TMS Therapy stimulates nerve cells in an
      area of the brain that is linked to depression by delivering highly
      focused MRI-strength magnetic field
pulses.
  14




TMS is
performed in a physician's office with each treatment lasting about 40 minutes
daily for four to six weeks.  In an open-label clinical trial, which
is most like real world clinical practice, approximately one in two patients
experienced significant improvement in symptoms, and one in three experienced
complete symptom resolution. NeuroStar TMS Therapy was cleared by the FDA in
October 2008 for patients who have not adequately benefited from prior
antidepressant medication. TMS Therapy is currently available at over 25
treatment locations in 15 states.
 
 From a competitive standpoint, we view
these emerging treatment options as expensive augmentations to existing
therapies for treatment-resistant patients, and as competitive therapeutic
options to medications. To the best of our knowledge, rEEG-guided therapy
provides a higher probability of treatment success at a significantly lower cost
than device-based solutions, which gives us a competitive advantage in the
marketplace.
  Intellectual
Property
  rEEG
Patents
  We have
three issued U.S. Patents which we believe provide us with the right to exclude
others from using our rEEG technology.  In addition, we believe these
patents cover the analytical methodology we use with any form of neurophysiology
measurement including SPECT (Single Photon Emission Computed Tomography), fMRI
(Functional Magnetic Resonance Imaging), PET (Positron Emission Tomography), CAT
(Computerized Axial Tomography), and MEG
(Magnetoencephalography)).  We do not currently have data on the
utility of such alternate measurements, but we believe they may, in the future,
prove to be useful to guide therapy in a manner similar to rEEG.  We
have also filed patent applications for our technology in various foreign
jurisdictions, and have issued patents in Australia and Israel.
  rEEG
Trademarks
  “Referenced-EEG”
and “rEEG” are registered trademarks of CNS California in the United
States.  We will continue to expand our brand names and our
proprietary trademarks worldwide as our operations expand.
  CNS
Database
  The CNS
Database consists of over 17,000 medication trials across over 2,000 patients
who had psychiatric or addictive problems. The CNS Database is maintained in two
parts:
  1.           The
QEEG Database
  The QEEG
Database includes EEG recordings and neurometric data derived from analysis of
these recordings.  This data is collectively known as the QEEG Data.
QEEG or “Quantitative EEG” is a standard measure that adds modern computer and
statistical analyses to traditional EEG studies.  The Company utilizes
two separate, FDA-approved external QEEG databases which provide statistical and
normative information in the rEEG process.
  2.           The
Clinical Outcomes Database
  The
Clinical Outcomes Database consists of physician provided assessments of the
clinical long-term outcomes (average of 405 days) of patients and their
associated medications. The clinical outcomes of patients are recorded using an
industry-standard outcome rating scale, the Clinical Global Impression Global
Improvement scale (“CGI-I”).  The CGI-I requires a clinician to rate
how much the patient's illness has improved or worsened relative to a baseline
state. A patient's illness is compared to change over time and rated as: very
much improved, much improved, minimally improved, no change, minimally worse,
much worse, or very much worse.
  15
  The
format of the data is standardized and that standard is enforced at the time of
capture by a software application.  Outcome data is input into the
database by the treating physician or in some cases, their office
staff.  Each Physician has access to his/her own patient data through
the software tool that captures clinical outcome data.
  We
consider the information contained in the CNS Database to be a valuable trade
secret and are diligent about protecting such information.  The CNS
Database is stored on a secure server and only a limited number of employees
have access to it.
  Research
and Development
  In 2010,
we plan to continue to enhance, refine and improve the accuracy of our CNS
Database and rEEG through expansion of the number of medications covered by our
rEEG Reports, expansion of our biomarkers, refinement of our biomarker system,
and by reducing the time to turnaround a report to the physician.
  Government
Regulation
  We do not
believe that sales of our Laboratory Information Services, including our rEEG
Reports, are subject to regulatory pre-market approval. However, on April 10,
2008 we received a “warning letter” from the FDA in which the FDA indicated it
believed, based in part on the combination of certain marketing statements it
read on our website, together with the delivery of our rEEG Reports, that we
were selling a software product to aid in diagnosis, which constituted a
“medical device” requiring pre-market approval or clearance by the FDA pursuant
to the Federal Food, Drug and Cosmetic Act (the "Act"). We responded to the FDA
on April 24, 2008 indicating that we believed it had incorrectly understood our
product offering, and clarified that the Laboratory Information Services
were not diagnostic and thus did not constitute a medical device.  On
December 14, 2008, the FDA again contacted us and indicated that, based upon its
review of our description of our intended use of the rEEG Reports on our
website, it continued to maintain that the rEEG Reports met its definition of
medical devices. In response to of the FDA communications, we made a number of
changes to our website and other marketing documents to reflect that rEEG is a
service to aid in medication  selection  and is not a
diagnosis  aid.  On September 4, 2009, through our
regulatory counsel, we responded to the December 14, 2008 FDA letter explaining
our position in more detail.
  On
December 28, 2009, the Company and Regulatory counsel received a response from
the FDA indicating that it still believes referenced-EEG constitutes a “medical
device” under the Act.  In response to the most recent letter, we will
request a meeting with FDA to discuss the scope of and requirements
for  510(k) clearance, that they might require, if any.  In any
event, we will continue our ongoing dialogue with the FDA regarding our
Laboratory Information Services, and we will take all action necessary and
appropriate to support our position.
  We cannot
provide any assurance that additional FDA regulation, including PMA, will not be
required in the future for referenced-EEG.  It is also possible that
legislation will be enacted into law and may result in increased regulatory
burdens for us to continue to offer referenced-EEG testing.
  If
pre-market review is required, our business could be negatively impacted until
such review is completed and clearance to market or approval is obtained, and
FDA could require that we stop selling our test pending pre-market clearance or
approval.  If our test is allowed to remain on the market but there is
uncertainty about our test, if it is labeled investigational by FDA, or if
labeling claims FDA allows us to make are very limited, orders may decline. The
regulatory approval process may involve, among other things, successfully
completing additional clinical trials and submitting a pre-market clearance
notice or filing a PMA application with the FDA.  If pre-market review
is required by FDA, there can be no assurance that our test will be cleared
or approved on a timely basis, if at all.   Ongoing compliance
with FDA regulations would increase the cost of conducting our business, and
subject us to inspection by FDA and to the requirements of FDA and penalties for
failure to comply with these requirements.
 16
 Even if
the sale of our Laboratory Information Services are not subject to regulatory
approval, federal and state laws and regulations relating to the sale of our
Laboratory Information Services are subject to future changes, as are
administrative interpretations of regulatory agencies. In the event that we do
not resolve the status of our Laboratory Information Services with the FDA, or
in the event that federal and state laws and regulations change, we may need to
incur additional costs to seek government approvals for the sale of our
Laboratory Information Services.
  In the
future, we intend to seek approval for medications or combinations of
medications for new indications, either with corporate partners, or potentially,
on our own. The development and commercialization of medications for new
indications is subject to extensive regulation by the U.S. Federal government,
principally through the FDA and other federal, state and governmental
authorities elsewhere. Prior to marketing any central nervous system medication,
and in many cases prior to being able to successfully partner a central nervous
system medication, we will have to conduct extensive clinical trials at our own
expense to determine safety and efficacy of the indication that we are
pursuing.
 ITEM
      1A.
                Risk
      Factors
  INVESTING
IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK.  YOU SHOULD
CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION
CONTAINED IN THIS REPORT BEFORE PURCHASING OUR COMMON STOCK. THE RISKS AND
UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING US. ADDITIONAL RISKS
AND UNCERTAINTIES THAT WE ARE UNAWARE OF, OR THAT WE CURRENTLY DEEM IMMATERIAL,
ALSO MAY BECOME IMPORTANT FACTORS THAT AFFECT US. IF ANY OF THE FOLLOWING RISKS
OCCUR, OUR BUSINESS, FINANCIAL CONDITION OR RESULTS OF OPERATIONS COULD BE
MATERIALLY AND ADVERSELY AFFECTED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON
STOCK COULD DECLINE, AND YOU MAY LOSE SOME OR ALL OF THE MONEY YOU PAID TO
PURCHASE OUR COMMON STOCK.
  Risks
Related to Our Company
  Our
core Laboratory Information Services business has a limited operating history,
making it difficult to evaluate our future performance.
  Our
operating subsidiary which conducts our core Laboratory Information Services
business, CNS Response, Inc., a corporation formed under the law of the State of
California (“CNS California”), was incorporated in 2000 and therefore has a
limited operating history.  Investors therefore have limited substantive
financial information relating to our core business to evaluate an investment in
our company. Our potential must be viewed in light of the problems, expenses,
difficulties, delays and complications often encountered in the operation of a
new business. We will be subject to the risks inherent in the ownership and
operation of a company with a limited operating history such as fluctuations in
expenses, competition, the general strength of regional and national economies,
and governmental regulation. Any failure to successfully address these risks and
uncertainties could seriously harm our business and prospects.
  17
  If
our rEEG reports do not gain widespread market acceptance, then our revenues may
not exceed our expenses.
  We have
developed a methodology that aids psychiatrists and other physicians in
selecting appropriate and effective medications for patients with certain
behavioral or addictive disorders based on physiological traits of the patient’s
brain and information contained in a proprietary database that has been
developed over the last twenty years.  We began selling reports,
referred to as rEEGReports,
based on our methodology in 2000.  To date, we have not received
widespread market acceptance of the usefulness of our rEEG Reports in helping
psychiatrists and physicians inform their treatment strategies for patients
suffering from behavioral and/or addictive disorders.  If we fail to
achieve widespread market acceptance for our rEEG Reports, we will not
be able to grow our revenues, which could negatively impact our stock
price.
  Our
Clinical Services Business generates the majority of our revenue, and adverse
developments in this business could negatively impact our operating
results.
  Our Clinical Services business, which we view as ancillary to our core
Laboratory Information Services business, currently generates the majority of
our revenue.  In the event that NTC is unable to sustain the current
demand for its services because, for instance, the company isunable to
maintain favorable and continuing relations with its clients and referring
psychiatrists and physicians or Daniel Hoffman, the Medical Director at NTC and
our Chief Medical Officer and President, is no longer associated with NTC, our
revenues could significantly decline, which could adversely impact
our operating results and our ability to implement our growth
strategy.
  Our
operating results may fluctuate significantly and our stock price could decline
or fluctuate if our results do not meet the expectation of analysts or
investors.
  Management
expects that we will experience substantial variations in our operating results
from quarter to quarter. We believe that the factors which influence this
variability of quarterly results include:
  ·
              the
      use of and demand for rEEG Reports and other products and/or services that
      we may offer in the future that are based on our patented
      methodology;
  ·
              the
      effectiveness of new marketing and sales
  programs;
  ·
              turnover
      among our employees;
  ·
              changes
      in management;
  ·
              the
      introduction of products or services that are viewed in the marketplace as
      substitutes for the services we
provide;
  ·
              communications
      published by industry organizations or other professional entities in the
      psychiatric and physician community that are unfavorable to our
      business;
  ·
              the
      introduction of regulations which impose additional costs on or impede our
      business; and
  ·
              the
      timing and amount of our expenses, particularly expenses associated with
      the marketing and promotion of our services, the training of physicians
      and psychiatrists in the use of our rEEG Reports, and research and
      development.
  As a
result of fluctuations in our revenue and operating expenses that may occur,
management believes that period-to-period comparisons of our results of
operations are not a good indication of our future performance. It is possible
that in some future quarter or quarters, our operating results will be below the
expectations of securities analysts or investors. In that case, our common stock
price could fluctuate significantly or decline.
  18
  We
have a history of operating losses.
  We are a
company with a limited operating history. Since our inception, we have incurred
significant operating losses. As of September 30, 2009, our net loss was
approximately $25 million. Our future capital requirements will depend on many
factors, such as the risk factors described in this section, including our
ability to maintain our existing cost structure and to execute our business and
strategic plans as currently conceived.  Even if we
achieve profitability, we may be unable to maintain or increase
profitability on a quarterly or annual basis.
  We
will need additional funding to support our operations and capital expenditures,
which may not be available to us and which lack of availability could adversely
affect our business.
  We have
not generated significant revenues or become profitable, may never do so, and
may not generate sufficient working capital to cover costs of
operations.  We intend to fund our operations and capital expenditures
from revenues, our cash on hand, from the proceeds of future financings and
potentially from strategic collaborations. As of September 30, 2009, we had
approximately $0.99 million in cash and cash equivalents at hand.  On
December 24, 2009 we closed on the second tranche of our Private Placement in
which we raised net proceeds of $2.65 million (please see Item 5, under the
heading “Recent Sales of Unregistered Securities—Private Placement Transactions”
for further information).  We plan to use these funds to pay-off debt
and provide working capital for our operations.  Despite the
completion of this financing, we believe that it will be necessary to raise
additional funds in 2010.
  The
amount of capital we will need to conduct our operations and the time at which
we will require such capital may vary significantly depending upon a number of
factors, such as:
  ·
              the
      amount and timing of costs we incur in connection with our research and
      product development activities, including enhancements to our CNS Database
      and costs we incur to further validate the efficacy of our rEEG
      technology;
  ·
              the
      amount and timing of costs we incur in connection with the expansion of
      our commercial operations, including our selling and marketing
      efforts;
  ·
              whether
      we incur additional legal fees in our litigation with Brandt in relation
      to his pending counterclaims in the United States District Court or any
      appeals that he may bring in
Delaware;
  ·
              revenues
      we generate from the sale of our services;
and
  ·
              if
      we expand our business by acquiring or investing in complimentary
      businesses.
  We do not
know whether additional funding will be available on acceptable terms, or at
all, especially given the economic conditions that currently prevail.  In
addition, any additional funding may result in significant dilution to existing
stockholders.  If we are not able to secure additional funding when
needed, we may have to delay, reduce the scope of or eliminate one or more
research and development programs or selling and marketing initiatives, and
implement other cost saving measures. Any of these actions could
substantially harm our business.
  19
  Our
industry is highly competitive, and we may not be able to compete successfully,
which could result in price reductions and decreased demand for our
products.
  The
healthcare business in general, and the behavioral health treatment business in
particular, are highly competitive. In the event that we are unable to convince
physicians, psychiatrists and patients of the efficacy of our products and
services, individuals seeking treatment for behavioral health disorders may seek
alternative treatment methods, which could negatively impact our sales and
profitability.
  Our
rEEG reports may not be as effective as we believe them to be, which could limit
or prevent us from growing our revenues.
  Our
belief in the efficacy of our rEEG technology is based on a limited number of
studies.  Such results may not be statistically significant, and may
not be indicative of the long-term future efficacy of the information we
provide. Controlled scientific studies, including those that have been announced
and that are planned for the future, may yield results that are unfavorable or
demonstrate that our services, including our rEEG Reports, are not clinically
useful. While we have not experienced such problems to date, if the initially
indicated results cannot be successfully replicated or maintained over time,
utilization of services based on our rEEG technology, including the delivery of
our rEEG Reports, may not increase as we anticipate, which would harm our
operating results and stock price.  In addition, if we fail to upgrade
our CNS Database to account for new medications that are now available on the
market, psychiatrists and other physicians may be less inclined to utilize our
services if they believe that our reports only provide information about older
treatment options, which would further harm our operating results and stock
price.
  If
we do not maintain and expand our relationships in the psychiatric and physician
community, our growth will be limited and our business could be
harmed.  If psychiatrists and other physicians do not recommend and
endorse our products and services, we may be unable to increase our sales, and
in such instances our profitability would be harmed.
  Our
relationships with psychiatrists and physicians are critical to the growth of
our Laboratory Information Services business.  We believe that these
relationships are based on the quality and ease of use of our rEEG Reports, our
commitment to the behavioral health market, our marketing efforts, and our
presence at tradeshows.  Any actual or perceived diminution in our
reputation or the quality of our rEEG Reports, or our failure or inability to
maintain our commitment to the behavioral health market and our other marketing
and product promotion efforts could damage our current relationships, or prevent
us from forming new relationships, with psychiatrists and other physicians and
cause our growth to be limited and our business to be harmed.
  To sell
our rEEG Reports, psychiatric professionals must recommend and endorse
them.  We may not obtain the necessary recommendations or endorsements
from this community. Acceptance of our rEEG Reports depends on educating
psychiatrists and physicians as to the benefits, clinical efficacy, ease of use,
revenue opportunity, and cost-effectiveness of our rEEG Reports and on training
the medical community to properly understand and utilize our rEEG
Reports.  If we are not successful in obtaining the recommendations or
endorsements of psychiatrists and other physicians for our rEEG Reports, we may
be unable to increase our sales and profitability.
  20
  Negative
publicity or unfavorable media coverage could damage our reputation and harm our
operations.
  In the
event that the marketplace perceives our rEEG Reports as not offering the
benefits which we believe they offer, we may receive significant negative
publicity.  This publicity may result in litigation and increased
regulation and governmental review.  If we were to receive such
negative publicity or unfavorable media attention, whether warranted or
unwarranted, our ability to market our rEEG Reports would be adversely affected,
pharmaceutical companies may be reluctant to pursue strategic initiatives with
us relating to the development of new products and services based on our rEEG
technology, we may be required to change our products and services and become
subject to increased regulatory burdens, and we may be required to pay large
judgments or fines and incur significant legal expenses.  Any
combination of these factors could further increase our cost of doing business
and adversely affect our financial position, results of operations and cash
flows.
  If
we do not successfully generate additional products and services from our
patented methodology and proprietary database, or if such products and services
are developed but not successfully commercialized, then we could lose revenue
opportunities.
  Our
primary business is the sale of rEEG Reports to psychiatrists and physicians
based on our rEEG methodology and proprietary database.  In the
future, we may utilize our patented methodology and proprietary database to
produce pharmaceutical advancements and developments.  For instance,
we may use our patented methodology and proprietary database to identify new
medications that are promising in the treatment of behavioral health disorders,
identify new uses of medications which have been previously approved, and
identify new patient populations that are responsive to medications in clinical
trials that have previously failed to show efficacy in United States Food &
Drug Administration (FDA) approved clinical trials.  The development
of new pharmaceutical applications that are based on our patented methodology
and proprietary database will be costly, since we will be subject to
additional regulations, including the need to conduct expensive and time
consuming clinical trials.
  In
addition, to successfully monetize our pharmaceutical opportunity, we will need
to enter into strategic alliances with biotechnology or pharmaceutical companies
that have the ability to bring to market a medication, an ability which we
currently do not have.  We maintain no pharmaceutical manufacturing,
marketing or sales organization, nor do we plan to build one in the foreseeable
future.  Therefore, we are reliant upon approaching and successfully
negotiating attractive terms with a partner who has these
capabilities.  No guarantee can be made that we can do this on
attractive terms.  If we are unable to find strategic partners for our
pharmaceutical opportunity, our revenues may not grow as quickly as we desire,
which could lower our stock price.
  In
the event that we pursue our pharmaceutical opportunities, we or any development
partners that we partner with will likely need to conduct clinical
trials.  If such clinical trials are delayed or unsuccessful, it could
have an adverse effect on our business.
  We have
no experience conducting clinical trials of psychiatric medications and in the
event we conduct clinical trials, we will rely on outside parties, including
academic investigators, outside consultants and contract research organizations
to conduct these trials on our behalf.  We will rely on these parties
to assist in the recruitment of sites for participation in clinical trials, to
maintain positive relations with these sites, and to ensure that these sites
conduct the trials in accordance with the protocol and our
instructions.  If these parties renege on their obligations to us, our
clinical trials may be delayed or unsuccessful.
  In the
event we conduct clinical trials, we cannot predict whether we will encounter
problems that will cause us or regulatory authorities to delay or suspend our
clinical trials or delay the analysis of data from our completed or ongoing
clinical trials. In addition, we cannot assure you that we will be successful in
reaching the endpoints in these trials, or if we do, that the FDA or other
regulatory agencies will accept the results.
  21
  Any of
the following could delay the completion of clinical trials, or result in a
failure of these trials to support our business, which would have an adverse
effect on our business:
  ·
              delays
      or the inability to obtain required approvals from institutional review
      boards or other governing entities at clinical sites selected for
      participation in our clinical
trials;
  ·
              delays
      in enrolling patients and volunteers into clinical
  trials;
  ·
              lower
      than anticipated retention rates of patients and volunteers in clinical
      trials;
  ·
              negative
      results from clinical trials for any of our potential products;
      and
  ·
              failure
      of our clinical trials to demonstrate the efficacy or clinical utility of
      our potential products.
  If we
determine that the costs associated with attaining regulatory approval of a
product exceed the potential financial benefits or if the projected development
timeline is inconsistent with our determination of when we need to get the
product to market, we may chose to stop a clinical trial and/or development of a
product.
  If
we do not develop and implement a successful sales and marketing strategy, we
may not expand our business sufficiently to cover our expenses.
  We
currently rely on a limited number of employees to market and promote our rEEG
Reports. To grow our business, we will need to develop and introduce new sales
and marketing programs and clinical education programs to promote the use of our
rEEG Reports by psychiatrists and physicians and higher additional employees for
this purpose. If we do not implement these new sales and marketing and education
programs in a timely and successful manner, we may not be able to achieve
the level of market awareness and sales required to expand our
business.
  We
may fail to successfully manage and maintain the growth of our business, which
could adversely affect our results of operations.
  As we
continue expanding our commercial operations, this expansion could place
significant strain on our management, operational, and financial
resources.  To manage future growth, we will need to continue to hire,
train, and manage additional employees, particularly a specially trained sales
force to market our rEEG Reports.
  In
addition, we have maintained a small financial and accounting staff, and our
reporting obligations as a public company, as well as our need to comply with
the requirements of the Sarbanes-Oxley Act of 2002, and the rules and
regulations of the SEC will continue to place significant demands on our
financial and accounting staff, on our financial, accounting and information
systems and on our internal controls. As we grow, we will need to add additional
accounting staff and continue to improve our financial, accounting and
information systems and internal controls in order to fulfill our reporting
responsibilities and to support expected growth in our business. Our current and
planned personnel, systems, procedures and controls may not be adequate to
support our anticipated growth or management may not be able to effectively
hire, train, retain, motivate and manage required personnel. Our failure to
manage growth effectively could limit our ability to achieve our marketing and
commercialization goals or to satisfy our reporting and other obligations as a
public company.
  22
  We
may not be able to adequately protect our intellectual property, which is the
core of our business.
  We
consider the protection of our intellectual property to be critical to our
business prospects.  We currently have three issued U.S. patents, as
well as issued patents in Australia and Israel, and we have filed separate
patent applications in multiple foreign jurisdictions.
  In the
future, if we fail to file patent applications in a timely manner, or in the
event we elect not to file a patent application because of the costs associated
with patent prosecution, we may lose patent protection that we may have
otherwise obtained. The loss of any proprietary rights which are obtainable
under patent laws may result in the loss of a competitive advantage over present
or potential competitors, with a resulting decrease in revenues and
profitability for us.
  With
respect to the applications we have filed, there is no guarantee that the
applications will result in issued patents, and further, any patents that do
issue may be too narrow in scope to adequately protect our intellectual property
and provide us with a competitive advantage.  Competitors and others
may design around aspects of our technology, or alternatively may independently
develop similar or more advanced technologies that fall outside the scope of our
claimed subject matter but that can be used in the treatment of behavioral
health disorders.
  In
addition, even if we are issued additional patents covering our products, we
cannot predict with certainty whether or not we will be able to enforce our
proprietary rights, and whether our patents will provide us with adequate
protection against competitors.  We may be forced to engage in costly
and time consuming litigation or reexamination proceedings to protect our
intellectual property rights, and our opponents in such proceedings may have and
be willing to expend, substantially greater resources than we are able
to.  In addition, the results of such proceedings may result in our
patents being invalidated or reduced in scope.  These developments
could cause a decrease in our operating income and reduce our available cash
flow, which could harm our business and cause our stock price to
decline.
  We also
utilize processes and technology that constitute trade secrets, such as our
outcomes database, and we must implement appropriate levels of security for
those trade secrets to secure the protection of applicable laws, which we may
not do effectively.  In addition, the laws of many foreign countries
do not protect proprietary rights as fully as the laws of the United
States.
  While we
have not had any significant issues to date, the loss of any of our trade
secrets or proprietary rights which may be protected under the foregoing
intellectual property safeguards may result in the loss of our competitive
advantage over present and potential competitors.
  Confidentiality
agreements with employees, licensees and others may not adequately prevent
disclosure of trade secrets and other proprietary information.
  In order
to protect our proprietary technology and processes, we rely in part on
confidentiality provisions in our agreements with employees, licensees, treating
physicians and psychiatrists and others. These agreements may not effectively
prevent disclosure of confidential information and may not provide an adequate
remedy in the event of unauthorized disclosure of confidential
information.  Moreover, policing compliance with our confidentiality
agreements and non-disclosure agreements, and detecting unauthorized use of our
technology is difficult, and we may be unable to determine whether piracy of our
technology has occurred.  In addition, others may independently
discover our trade secrets and proprietary information. Costly and
time-consuming litigation could be necessary to enforce and determine the scope
of our proprietary rights, and failure to obtain or maintain trade secret
protection could adversely affect our competitive business
position.
  23
  The
Liability of Our Directors Is Limited.
  The applicable provisions of the
Delaware General Corporate Law and our Certificate of Incorporation limit the
liability of our directors to the Company and our stockholders for monetary
damages for breaches of their fiduciary duties, with certain exceptions, and for
other specified acts or omissions of such persons. In addition, the applicable
provisions of the Delaware General Corporate Law and of our Certificate of
Incorporation and Bylaws provide for indemnification of such persons under
certain circumstances.  In the event we are required to indemnify any
of our directors, our financial strength may be harmed, which may in turn lower
our stock price.
  Although
we believe we are not currently subject to regulatory pre-market approval for
the sale of our rEEG Reports, regulations are constantly changing, and in the
future our business may be subject to regulation.
  As
further discussed in Item 1 of this report under the heading “Government
Regulation”, we do not believe that sales of our Laboratory Information
Services, including our rEEG Reports, are subject to regulatory pre-market
approval.  However, federal, state and foreign laws and regulations
relating to the sale of our rEEG Reports are subject to future changes, as are
administrative interpretations of regulatory agencies. In the event that we do
not resolve the status of our Laboratory Information Services with the FDA, or
in the event that federal, state or foreign laws and regulations change, we may
need to incur additional costs to seek governmental approvals for the sale of
our Laboratory Information Services. There is no guarantee that we will be able
to obtain such approvals in a timely manner or at all, and as a result, our
business would be significantly harmed. If we fail to comply with
applicable federal, state or foreign laws or regulations, we could be subject to
enforcement actions, including injunctions preventing us from conducting our
business, withdrawal of clearances or approvals and civil and criminal
penalties.
  If
we do not retain our senior management and other key employees, we may not be
able to successfully implement our business strategy.
  Our
future success depends on the ability, experience and performance of our senior
management and our key professional personnel.  Our success therefore
depends to a significant extent on retaining the services of George Carpenter,
our Chief Executive Officer, our senior product development and clinical
managers, and others.  Because of their ability and experience, if we
lose one or more of the members of our senior management or other key employees,
our ability to successfully implement our business strategy could be seriously
harmed.  While we believe our relationships with our executives are
good and do not anticipate any of them leaving in the near future, the loss of
the services of any of our senior management could have a material adverse
effect on our ability to manage our business.  We do not carry key man
life insurance on any of our key employees.
  If
we do not attract and retain skilled personnel, we may not be able to expand our
business.
  Our
products and services are based on a complex database of
information.  Accordingly, we require skilled medical, scientific and
administrative personnel to sell and support our products and services. Our
future success will depend largely on our ability to continue to hire, train,
retain and motivate additional skilled personnel, particularly sales
representatives who are responsible for customer education and training and
customer support.  In the future, if we pursue our pharmaceutical
opportunities, we will also likely need to hire personnel with experience in
clinical testing and matters relating to obtaining regulatory
approvals.  If we are not able to attract and retain skilled
personnel, we will not be able to continue our development and commercialization
activities.
  24
  In
the future we could be subject to personal injury claims, which could result in
substantial liabilities that may exceed our insurance coverage.
  All
significant medical treatments and procedures, including treatment that is
facilitated through the use of our rEEG Reports, involve the risk of serious
injury or death. While we have not been the subject of any personal injury
claims for patients treated by providers using our rEEG Reports, our business
entails an inherent risk of claims for personal injuries, which are subject to
the attendant risk of substantial damage awards. We cannot control whether
individual physicians and psychiatrists will properly select patients, apply the
appropriate standard of care, or conform to our procedures in determining how to
treat their patients. A significant source of potential liability is negligence
or alleged negligence by physicians treating patients with the aid of the rEEG
Reports that we provide. There can be no assurance that a future claim or claims
will not be successful or, including the cost of legal defense, will not exceed
the limits of available insurance coverage.
  We
currently have general liability and medical professional liability insurance
coverage for up to $5 million per year for personal injury claims. We may
not be able to maintain adequate liability insurance, in accordance with
standard industry practice, with appropriate coverage based on the nature and
risks of our business, at acceptable costs and on favorable terms. Insurance
carriers are often reluctant to provide liability insurance for new healthcare
services companies and products due to the limited claims history for such
companies and products. In addition, based on current insurance markets, we
expect that liability insurance will be more difficult to obtain and that
premiums will increase over time and as the volume of patients treated by
physicians that are guided by our rEEG Reports increases.  In the
event of litigation, regardless of its merit or eventual outcome, or an
award against us during a time when we have no available insurance or
insufficient insurance, we may sustain significant losses of our operating
capital which may substantially reduce stockholder equity in the
company.
  If
government and third-party payers fail to provide coverage and adequate payment
rates for treatments that are guided by our rEEG Reports, our revenue and
prospects for profitability will be harmed.
  Our
future revenue growth will depend in part upon the availability of reimbursement
from third-party payers for psychiatrists and physicians who use our rEEG
Reports to guide the treatment of their patients. Such third-party payers
include government health programs such as Medicare and Medicaid, managed care
providers, private health insurers and other organizations. These third-party
payers are increasingly attempting to contain healthcare costs by demanding
price discounts or rebates and limiting both coverage on which procedures they
will pay for and the amounts that they will pay for new procedures. As a result,
they may not cover or provide adequate payment for treatments that are guided by
our rEEG Reports, which will discourage psychiatrists and physicians from
utilizing the information services we provide.  We may need to conduct
studies in addition to those we have already announced to demonstrate the
cost-effectiveness of treatments that are guided by our products and services to
such payers’ satisfaction. Such studies might require us to commit a significant
amount of management time and financial and other resources. Adequate
third-party reimbursement might not be available to enable us to realize an
appropriate return on investment in research and product development, and the
lack of such reimbursement could have a material adverse effect on our
operations and could adversely affect our revenues and earnings.
  We
are subject to evolving and expensive corporate governance regulations and
requirements. Our failure to adequately adhere to these requirements or the
failure or circumvention of our controls and procedures could seriously harm our
business.
  Because
we are a publicly traded company we are subject to certain federal, state and
other rules and regulations, including applicable requirements of the
Sarbanes-Oxley Act of 2002. Compliance with these evolving regulations is costly
and requires a significant diversion of management time and attention,
particularly with regard to our disclosure controls and procedures and our
internal control over financial reporting.  Although we have reviewed
our disclosure and internal controls and procedures in order to determine
whether they are effective, our controls and procedures may not be able to
prevent errors or frauds in the future. Faulty judgments, simple errors or
mistakes, or the failure of our personnel to adhere to established controls and
procedures may make it difficult for us to ensure that the objectives of the
control system are met. A failure of our controls and procedures to detect other
than inconsequential errors or fraud could seriously harm our business and
results of operations.
  25
  Our
senior management’s limited recent experience managing a publicly traded company
may divert management’s attention from operations and harm our
business.
  Our
management team has relatively limited recent experience managing a publicly
traded company and complying with federal securities laws, including compliance
with recently adopted disclosure requirements on a timely basis.  Our
management will be required to design and implement appropriate programs
and policies in responding to increased legal, regulatory compliance and
reporting requirements, and any failure to do so could lead to the imposition of
fines and penalties and harm our business.
  We
are currently in litigation with our former Chief Executive Officer and former
director, Leonard Brandt, relating to his attempt to replace the Board of
Directors with his own nominees.
  Since
June of 2009, we have been involved in litigation against Leonard J. Brandt, a
stockholder, former director and our former Chief Executive Officer in the
Delaware Chancery Court and the United States District Court for the Central
District of California. We have expended substantial resources in
connection with this litigation.  As further described below under
“Item 3 Legal Proceedings”, on December 2, 2009, following a two day trial
before the Delaware Court of Chancery, we prevailed in certain actions that were
pending between the Company and Mr. Brandt.  As a result of the
victory in the Chancery Court, we are currently evaluating whether to continue
to pursue our pending action in the United States District Court against Mr.
Brandt.  Mr. Brandt has filed counterclaims in that action and
may choose to proceed with his counterclaims.  We believe these
counterclaims are without merit, and intend to vigorously defend against them if
necessary.  Although the December 2, 2009 post-trial ruling by the
Delaware Chancery Court appears to us to be definitive and dispositive, we do
not know whether Mr. Brandt will appeal the decision or attempt to
institute new claims against us.  The defense of any claims, whether
in the Delaware courts or the United States district court, could involve the
expenditure of additional resources by the Company.  If the litigation
continues, these costs could impact the expected use of proceeds of our recent
offering that closed on December 24, 2009, and could make it more difficult for
us to raise any additional funds needed to finance our corporate and working
capital needs.
  Risks
Related To Our Industry
  The
healthcare industry in which we operate is subject to substantial regulation by
state and federal authorities, which could hinder, delay or prevent us from
commercializing our products and services.
  Healthcare
companies are subject to extensive and complex federal, state and local laws,
regulations and judicial decisions governing various matters such as the
licensing and certification of facilities and personnel, the conduct of
operations, billing policies and practices, policies and practices with regard
to patient privacy and confidentiality, and prohibitions on payments for the
referral of business and self-referrals. There are federal and state laws,
regulations and judicial decisions that govern patient referrals, physician
financial relationships, submission of healthcare claims and inducement to
beneficiaries of federal healthcare programs. Many states prohibit business
corporations from practicing medicine, employing or maintaining control over
physicians who practice medicine, or engaging in certain business practices,
such as splitting fees with healthcare providers. Many healthcare laws and
regulations applicable to our business are complex, applied broadly and subject
to interpretation by courts and government agencies. Our failure, or the failure
of physicians and psychiatrists to whom we sell our rEEG Reports, to comply with
these healthcare laws and regulations could create liability for us and
negatively impact our business.
  26
  In
addition, the FDA regulates development, testing, labeling, manufacturing,
marketing, promotion, distribution, record-keeping and reporting requirements
for prescription drugs. Compliance with laws and regulations enforced by the FDA
and other regulatory agencies may be required in relation to future products or
services developed or used by us. Failure to comply with applicable laws and
regulations may result in various adverse consequences, including withdrawal of
our products and services from the market, or the imposition of civil or
criminal sanctions.
  We
believe that this industry will continue to be subject to increasing regulation,
political and legal action and pricing pressures, the scope and effect of which
we cannot predict. Legislation is continuously being proposed, enacted and
interpreted at the federal, state and local levels to regulate healthcare
delivery and relationships between and among participants in the healthcare
industry. Any such changes could prevent us from marketing some or all of our
products and services for a period of time or permanently.
  We
may be subject to regulatory and investigative proceedings, which may find that
our policies and procedures do not fully comply with complex and changing
healthcare regulations.
  While we
have established policies and procedures that we believe will be sufficient to
ensure that we operate in substantial compliance with applicable laws,
regulations and requirements, the criteria are often vague and subject to change
and interpretation. We may become the subject of regulatory or other
investigations or proceedings, and our interpretations of applicable laws and
regulations may be challenged. The defense of any such challenge could result in
substantial cost and a diversion of management’s time and attention.
Thus, any such challenge could have a material adverse effect on our
business, regardless of whether it ultimately is successful. If we fail to
comply with any applicable laws, or a determination is made that we have failed
to comply with these laws, our financial condition and results of operations
could be adversely affected.
  Failure
to comply with the Federal Trade Commission Act or similar state laws could
result in sanctions or limit the claims we can make.
  The
Company’s promotional activities and materials, including advertising to
consumers and physicians, and materials provided to third parties for their use
in promoting our products and services, are regulated by the Federal Trade
Commission (FTC) under the FTC Act, which prohibits unfair and deceptive
acts and practices, including claims which are false, misleading or inadequately
substantiated. The FTC typically requires competent and reliable scientific
tests or studies to substantiate express or implied claims that a product or
service is effective. If the FTC were to interpret our promotional materials as
making express or implied claims that our products and services are effective
for the treatment of mental illness, it may find that we do not have adequate
substantiation for such claims. Failure to comply with the FTC Act or similar
laws enforced by state attorneys general and other state and local officials
could result in administrative or judicial orders limiting or eliminating the
claims we can make about our products and services, and other sanctions
including fines.
  27
  Our
business practices may be found to constitute illegal fee-splitting or corporate
practice of medicine, which may lead to penalties and adversely affect our
business.
  Many
states, including California, in which our principal executive offices are
located, have laws that prohibit business corporations, such as us, from
practicing medicine, exercising control over medical judgments or decisions of
physicians, or engaging in certain arrangements, such as employment or
fee-splitting, with physicians. Courts, regulatory authorities or other parties,
including physicians, may assert that we are engaged in the unlawful corporate
practice of medicine through our ownership of the Neuro-Therapy Clinic or by
providing administrative and ancillary services in connection with our rEEG
Reports. These parties may also assert that selling our rEEG Reports for a
portion of the patient fees constitutes improper fee-splitting.  If
asserted, such claims could subject us to civil and criminal penalties and
substantial legal costs, could result in our contracts being found legally
invalid and unenforceable, in whole or in part, or could result in us being
required to restructure our contractual arrangements, all with potentially
adverse consequences to our business and our stockholders.
  Our
business practices may be found to violate anti-kickback, self-referral or false
claims laws, which may lead to penalties and adversely affect our
business.
  The
healthcare industry is subject to extensive federal and state regulation with
respect to financial relationships and “kickbacks” involving healthcare
providers, physician self-referral arrangements, filing of false claims and
other fraud and abuse issues. Federal anti-kickback laws and regulations
prohibit certain offers, payments or receipts of remuneration in return for
(i) referring patients covered by Medicare, Medicaid or other federal health
care program, or (ii) purchasing, leasing, ordering or arranging for or
recommending any service, good, item or facility for which payment may be made
by a federal health care program. In addition, federal physician self-referral
legislation, commonly known as the Stark law, generally prohibits a physician
from ordering certain services reimbursable by Medicare, Medicaid or other
federal healthcare program from any entity with which the physician has a
financial relationship. In addition, many states have similar laws, some of
which are not limited to services reimbursed by federal healthcare programs.
Other federal and state laws govern the submission of claims for reimbursement,
or false claims laws. One of the most prominent of these laws is the federal
False Claims Act, and violations of other laws, such as the anti-kickback laws
or the FDA prohibitions against promotion of off-label uses of medications,
may also be prosecuted as violations of the False Claims Act.
  While we
believe we have structured our relationships to comply with all applicable
requirements, federal or state authorities may claim that our fee arrangements,
agreements and relationships with contractors and physicians violate these
anti-kickback, self-referral or false claims laws and regulations. These laws
are broadly worded and have been broadly interpreted by courts. It is often
difficult to predict how these laws will be applied, and they potentially
subject many typical business arrangements to government investigation and
prosecution, which can be costly and time consuming. Violations of these laws
are punishable by monetary fines, civil and criminal penalties, exclusion from
participation in government-sponsored health care programs and forfeiture of
amounts collected in violation of such laws. Some states also have similar
anti-kickback and self-referral laws, imposing substantial penalties for
violations. If our business practices are found to violate any of these
provisions, we may be unable to continue with our relationships or implement our
business plans, which would have an adverse effect on our business and results
of operations.
  We
may be subject to healthcare anti-fraud initiatives, which may lead to penalties
and adversely affect our business.
  State and
federal governments are devoting increased attention and resources to anti-fraud
initiatives against healthcare providers, taking an expansive definition of
fraud that includes receiving fees in connection with a healthcare business that
is found to violate any of the complex regulations described above. While to our
knowledge we have not been the subject of any anti-fraud investigations, if such
a claim were made defending our business practices could be time consuming and
expensive, and an adverse finding could result in substantial penalties or
require us to restructure our operations, which we may not be able to do
successfully.
  28
  Our
use and disclosure of patient information is subject to privacy and security
regulations, which may result in increased costs.
  In
conducting research or providing administrative services to healthcare providers
in connection with the use of our rEEG Reports, as well as in our Clinical
Services business, we may collect, use, maintain and transmit patient
information in ways that will be subject to many of the numerous state, federal
and international laws and regulations governing the collection, dissemination,
use and confidentiality of patient-identifiable health information, including
the federal Health Insurance Portability and Accountability Act (HIPAA) and
related rules. The three rules that were promulgated pursuant to HIPAA that
could most significantly affect our business are the Standards for Electronic
Transactions, or Transactions Rule; the Standards for Privacy of Individually
Identifiable Health Information, or Privacy Rule; and the Health Insurance
Reform: Security Standards, or Security Rule.  HIPAA applies to
covered entities, which include most healthcare facilities and health plans that
may contract for the use of our services. The HIPAA rules require covered
entities to bind contractors like us to compliance with certain burdensome HIPAA
rule requirements.
  The HIPAA
Transactions Rule establishes format and data content standards for eight of the
most common healthcare transactions. If we perform billing and collection
services on behalf of psychiatrists and physicians, we may be engaging in one of
more of these standard transactions and will be required to conduct those
transactions in compliance with the required standards. The HIPAA Privacy Rule
restricts the use and disclosure of patient information, requires entities to
safeguard that information and to provide certain rights to individuals with
respect to that information. The HIPAA Security Rule establishes elaborate
requirements for safeguarding patient information transmitted or stored
electronically. We may be required to make costly system purchases and
modifications to comply with the HIPAA rule requirements that are imposed on us
and our failure to comply may result in liability and adversely affect our
business.
  Numerous
other federal and state laws protect the confidentiality of personal and patient
information. These laws in many cases are not preempted by the HIPAA rules and
may be subject to varying interpretations by courts and government agencies,
creating complex compliance issues for us and the psychiatrists and physicians
who purchase our services, and potentially exposing us to additional expense,
adverse publicity and liability.
  Risks
Relating To Investment In Our Common Stock
  We
have a limited trading volume and shares eligible for future sale by our current
stockholders may adversely affect our stock price.
   Bid and
ask prices for shares of our Common Stock are quoted on NASD’s Over-the-Counter
Bulletin Board under the symbol CNSO.OB. There is currently no broadly followed,
established trading market for our Common Stock and an established trading
market for our shares of Common Stock may never develop or be maintained. Active
trading markets generally result in lower price volatility and more efficient
execution of buy and sell orders. The absence of an active trading market
reduces the liquidity of our Common Stock. Also, as a result of this lack of
trading activity, the quoted price for our Common Stock on the Over-the-Counter
Bulletin Board is not necessarily a reliable indicator of its fair market value.
Further, if we cease to be quoted, holders would find it more difficult to
dispose of, or to obtain accurate quotations as to the market value of, our
Common Stock, and the market value of our Common Stock would likely
decline.
  29




If
and when a larger trading market for our Common Stock develops, the market price
of our Common Stock is likely to be highly volatile and subject to wide
fluctuations, and you may be unable to resell your shares at or above the price
at which you acquired them.




The
market price of our Common Stock is likely to be highly volatile and could be
subject to wide fluctuations in response to a number of factors that are beyond
our control, including:




·
            quarterly
      variations in our revenues and operating
  expenses;




·
            developments
      in the financial markets and worldwide or regional
    economies;




·
            announcements
      of innovations or new products or services by us or our
      competitors;




·
            announcements
      by the government relating to regulations that govern our
      industry;




·
            significant
      sales of our Common Stock or other securities in the open
      market;




·
            variations
      in interest rates;




·
            changes
      in the market valuations of other comparable companies;
  and




·
            changes
      in accounting principles.




In the
past, stockholders have often instituted securities class action litigation
after periods of volatility in the market price of a company’s
securities.  If a stockholder were to file any such class action suit
against us, we would incur substantial legal fees and our management’s attention
and resources would be diverted from operating our business to respond to the
litigation, which could harm our business.




Substantial
future sales of our Common Stock in the public market could cause our stock
price to fall.




In
connection with the closing of our private placement transaction in August 2009,
we entered into a Registration Rights Agreement, as amended, with the investors
in the private placement.  The Registration Rights Agreement obligates
us to file a Registration Statement on Form S-1 to register for resale the
common stock issued to the investors in the private placement, as well as the
common stock issuable upon the exercise of certain warrants issued to the
investors and placement agent.  The sale of these shares or other
shares eligible for resale pursuant to Rule 144 of the Securities Act of 1933,
as amended, could depress the market price of our Common Stock.  A
reduced market price for our Common Stock could make it more difficult to raise
funds through future offering of Common Stock.




The
sale of securities by us in any equity or debt financing could result in
dilution to our existing stockholders and have a material adverse effect on our
earnings.




Any sale
of Common Stock by us in a future private placement could result in dilution to
our existing stockholders as a direct result of our issuance of additional
shares of our capital stock.  In addition, our business strategy may
include expansion through internal growth, by acquiring complementary
businesses, by acquiring or licensing additional products and services, or by
establishing strategic relationships with targeted customers and suppliers. In
order to do so, or to finance the cost of our other activities, we may issue
additional equity securities that could dilute our stockholders' stock
ownership. We may also assume additional debt and incur impairment losses
related to goodwill and other tangible assets if we acquire another company and
this could negatively impact our earnings and results of
operations.


30


The
trading of our Common Stock on the Over-the-Counter Bulletin Board and the
potential designation of our Common Stock as a “penny stock” could impact the
trading market for our Common Stock.




Our
securities, as traded on the Over-the-Counter Bulletin Board, may be subject to
SEC rules that impose special sales practice requirements on broker-dealers who
sell these securities to persons other than established customers or accredited
investors.  For the purposes of the rule, the phrase “accredited
investors” means, in general terms, institutions with assets in excess of
$5,000,000, or individuals having a net worth in excess of $1,000,000 or having
an annual income that exceeds $200,000 (or that, when combined with a spouse’s
income, exceeds $300,000).  For transactions covered by the rule, the
broker-dealer must make a special suitability determination for the purchaser
and receive the purchaser’s written agreement to the transaction before the
sale.  Consequently, the rule may affect the ability of broker-dealers
to sell our securities and also may affect the ability of purchasers to sell
their securities in any market that might develop therefor.




In
addition, the SEC has adopted a number of rules to regulate “penny stock” that
restrict transactions involving these securities.  Such rules include
Rules 3a51-1, 15g-1, 15g-2, 15g-3, 15g-4, 15g-5, 15g-6, 15g-7, and 15g-9 under
the Securities and Exchange Act of 1934, as amended. These rules may have the
effect of reducing the liquidity of penny stocks.  “Penny stocks”
generally are equity securities with a price of less than $5.00 per share (other
than securities registered on certain national securities exchanges or quoted on
the NASDAQ Stock Market if current price and volume information with respect to
transactions in such securities is provided by the exchange or
system).  Because our securities may constitute “penny stock” within
the meaning of the rules, the rules would apply to us and to our
securities.  If our securities become subject to the penny stock
rules, our stockholders may find it more difficult to sell their
securities.




Stockholders
should be aware that, according to SEC, the market for penny stocks has suffered
in recent years from patterns of fraud and abuse.  Such patterns
include (i) control of the market for the security by one or a few
broker-dealers that are often related to the promoter or issuer; (ii)
manipulation of prices through prearranged matching of purchases and sales and
false and misleading press releases; (iii) “boiler room” practices involving
high-pressure sales tactics and unrealistic price projections by
inexperienced sales persons; (iv) excessive and undisclosed bid-ask
differentials and markups by selling broker-dealers; and (v) the wholesale
dumping of the same securities by promoters and broker-dealers after prices have
been manipulated to a desired level, resulting in investor
losses.  Our management is aware of the abuses that have occurred
historically in the penny stock market.  Although we do not expect to
be in a position to dictate the behavior of the market or of broker-dealers who
participate in the market, management will strive within the confines of
practical limitations to prevent the described patterns from being established
with respect to our securities.




We
have not paid dividends in the past and do not expect to pay dividends for the
foreseeable future, and any return on investment may be limited to potential
future appreciation on the value of our Common Stock.




We
currently intend to retain any future earnings to support the development and
expansion of our business and do not anticipate paying cash dividends in the
foreseeable future.  Our payment of any future dividends will be at
the discretion of our Board of Directors after taking into account various
factors, including without limitation, our financial condition, operating
results, cash needs, growth plans and the terms of any credit agreements that we
may be a party to at the time.  To the extent we do not pay dividends,
our stock may be less valuable because a return on investment will only occur if
and to the extent our stock price appreciates, which may never
occur.  In addition, investors must rely on sales of their Common
Stock after price appreciation as the only way to realize their investment, and
if the price of our stock does not appreciate, then there will be no return on
investment.  Investors seeking cash dividends should not purchase our
Common Stock.


31


Our
officers, directors and principal stockholders can exert significant influence
over us and may make decisions that are not in the best interests of all
stockholders.




Our
officers, directors and principal stockholders (greater than 5% stockholders)
collectively control approximately 53% of our issued and outstanding Common
Stock. As a result, these stockholders are able to affect the outcome of, or
exert significant influence over, all matters requiring stockholder approval,
including the election and removal of directors and any change in control. In
particular, this concentration of ownership of our Common Stock could have the
effect of delaying or preventing a change of control of us or otherwise
discouraging or preventing a potential acquirer from attempting to obtain
control of us. This, in turn, could have a negative effect on the market price
of our Common Stock. It could also prevent our stockholders from realizing a
premium over the market prices for their shares of Common Stock. Moreover, the
interests of this concentration of ownership may not always coincide with our
interests or the interests of other stockholders, and accordingly, they could
cause us to enter into transactions or agreements that we would not otherwise
consider.




Transactions
engaged in by our largest stockholders, our directors or executives involving
our common stock may have an adverse effect on the price of our
stock.




Our
officers, directors and principal stockholders (greater than 5% stockholders)
collectively control approximately 53% of our issued and outstanding Common
Stock. Subsequent sales of our shares by these stockholders could have the
effect of lowering our stock price. The perceived risk associated with the
possible sale of a large number of shares by these stockholders, or the adoption
of significant short positions by hedge funds or other significant investors,
could cause some of our stockholders to sell their stock, thus causing the price
of our stock to decline. In addition, actual or anticipated downward pressure on
our stock price due to actual or anticipated sales of stock by our directors or
officers could cause other institutions or individuals to engage in short sales
of our Common Stock, which may further cause the price of our stock to
decline.




From time
to time our directors and executive officers may sell shares of our common stock
on the open market. These sales will be publicly disclosed in filings made with
the SEC. In the future, our directors and executive officers may sell a
significant number of shares for a variety of reasons unrelated to the
performance of our business. Our stockholders may perceive these sales as a
reflection on management's view of the business and result in some stockholders
selling their shares of our common stock. These sales could cause the price of
our stock to drop.




Anti-takeover
provisions may limit the ability of another party to acquire us, which could
cause our stock price to decline.




Delaware
law contains provisions that could discourage, delay or prevent a third party
from acquiring us, even if doing so may be beneficial to our stockholders, which
could cause our stock price to decline. In addition, these provisions could
limit the price investors would be willing to pay in the future for shares of
our Common Stock.




ITEM 1B.
              Unresolved
      Staff Comments




Not applicable.


32





ITEM
      2.
              Properties




Our lease for our headquarters and
Laboratory Information Services business, located at 2755 Bristol St., Suite
285, Costa Mesa, California, expired in November 2009.  We
continue to lease this space on a month to month basis.




We lease space for our Clinical
Services operations under a lease which expires in February 2010. The facility
is approximately 3,500 square feet, and is located in Denver, Colorado. This
lease is currently in the process of being renegotiated.  In addition,
we sublease approximately 1,000 square feet of space at a site adjacent to the
primary suite on a month-to-month basis for our Clinical Services
business.




We believe that our current space is
adequate for our needs and that suitable additional or substitute space will be
available to accommodate the foreseeable expansion of our
operations.




ITEM
      3.
              Legal
      Proceedings




From time
to time, we may be involved in litigation relating to claims arising out of our
operations in the ordinary course of business. Other than as set forth below, we
are not currently party to any legal proceedings, the adverse outcome of which,
in our management’s opinion, individually or in the aggregate, would have a
material adverse effect on our results of operations or financial
position.




Since
June of 2009, we have been involved in litigation against Leonard J. Brandt, a
stockholder, former director and our former Chief Executive Officer (“Brandt”)
in the Delaware Chancery Court and the United States District Court for the
Central District of California.  At the conclusion of a two-day
trial that commenced December 1, the Chancery Court entered judgment
for the Company and dismissed with prejudice Brandt's action brought
pursuant to Section 225 of the Delaware General Corporation Law, which sought to
oust the incumbent directors other than Brandt.  The Chancery Court thereby
found that the purported special meeting of stockholders convened by Brandt on
September 4, 2009 was not valid and that the directors purportedly elected at
that meeting are not entitled to be seated.




The Chancery
Court also denied an injunction sought by Mr. Brandt to prevent the voting
of shares issued by the Company in connection with our bridge financing in
June 2009 and securities offering in August 2009, and dismissed
Brandt's claims regarding those financings and stock issuances. 
The Chancery Court also dismissed with prejudice another action brought by Mr.
Brandt, in which he claimed he had not been provided with information owed to
him.




An action
before the United States District Court for the Central District of California
remains outstanding.  We are evaluating our options in connection with
this lawsuit.




The
following is a summary of the litigation proceedings involving the Company and
Brandt:




Delaware Chancery Court–CNS Response, Inc. v.
Leonard Brandt,MeyerlenLLC, EAC Investment Limited
Partnership and "John Does 1-20" (Any CNS Stockholder Purporting
to be Among Holders of Shares Constituting 25% Of the Company's Stock As
Referenced In the June 20, 2009 Notice Of Special Meeting)–C.A. No.
4688-CC





On June
26, 2009, we commenced an action in the Delaware Court of Chancery against
Leonard Brandt and certain other parties in connection with Brandt’s efforts to
seize control of the Company by unseating the incumbent directors (other than
Brandt).  In our complaint, we alleged that Brandt’s actions in
connection with his purported special meeting notices and attempts to call and
hold a special meeting violate certain provisions of the Delaware General
Corporation Law (the “DGCL”), and we sought declaratory and injunctive relief to
invalidate a special meeting called by Brandt.


33




On June
26, 2009, we also moved for issuance of a temporary restraining order against
Brandt’s holding a special meeting.  Brandt opposed the motion, and on
June 29 the Chancery Court heard and denied our motion for a temporary
restraining order, on the grounds that we could seek relief from Brandt’s
actions after his special meeting occurred.





On August
12, 2009, Brandt and Defendant MeyerLen, LLC filed an answer and affirmative
defenses to our June 26, 2009 complaint.  In addition, Brandt filed a
counterclaim and third-party complaint against us, our other directors,
affiliates of one of the directors, and investors who are not employees,
officers or directors of the Company.  In his answer and the
counterclaims and third party claims, Brandt alleged, among other things, that
the other directors acted without authority in connection with his removal as
the CEO in April 2009 and violated their fiduciary duties in connection with
their consideration and approval of certain financings completed by us
subsequent to Brandt’s termination as CEO.  Brandt alleged that
certain defendants aided and abetted the directors in their breaches and
wrongful acts.  Brandt also asked the court to invalidate certain
bylaw changes adopted by our board of directors.





On August
24, 2009, Brandt filed a motion seeking an injunction against our issuance of
shares of our stock to John Pappajohn or Sail Ventures pursuant to existing
agreements between us and those investors, and against the implementation of our
previously-announced bylaw amendments.





On
October 22, 2009, Brandt and Defendant MeyerLen, LLC filed an amended answer and
affirmative defenses to our June 26, 2009 complaint and an amended counterclaim
and third-party complaint against us, our other directors, affiliates of one of
the directors, and investors who are not employees, officers or directors of the
Company.  On the same day, Brandt filed an amended motion for a
preliminary injunction, which sought to prevent the voting of shares issued by
the Company in connection with our bridge financings in May and June, 2009
and the securities offering in August, 2009.  On the same day, Brandt
moved to expedite proceedings in the action, coordinate discovery with his
Section 225 action described below, and have the motion for a preliminary
injunction argued at the conclusion of the trial of the Section 225
action.





On
October 30, 2009, the Delaware Chancery Court granted the motion to expedite
proceedings in the action, coordinate discovery with his Section 225 action
described below, and have the motion for a preliminary injunction argued at the
conclusion of the trial of the Section 225 action.





On
December 2, 2009, after full briefing, evidentiary submissions, and argument of
the motion for a preliminary injunction, the Chancery Court denied the
injunctive relief sought by Brandt to prevent the voting of shares issued by the
company in connection with our bridge financings in May and June and
securities offering in August.  Instead, the Court dismissed
Brandt's counterclaims regarding those financings and stock
issuances. On the same date, the Delaware Chancery Court dismissed the
underlying Section 211 action against Brandt as moot.





Delaware Chancery Court–Leonard J. Brandt v. CNS
Response, Inc., C.A.No,
4773-CC





On July
31, 2009, Brandt filed an action under Section 220 of the DGCL asking the
Chancery Court to require us to provide him with certain books and records,
including stockholder information.  On July 31, Brandt also requested
emergency injunctive relief against us compelling us to provide the records
immediately.  We opposed the motion.  On August 3, 2009 the
Chancery Court heard argument and denied the requested emergency
relief.  On August 24, 2009, we answered the complaint and asserted
affirmative defenses to it.  On December 2, 2009, the Chancery
Court dismissed Brandt’s action with prejudice.


34





Purported September 4
Stockholders Meeting and Subsequent Action Filed by Brandt Under DGCL 225—Leonard J. Brandt v. CNS
Response, Inc., George Carpenter, Henry T. Harbin, M.D., David B.
Jones, Jerome Vaccaro, M.D., John Pappajohn and Tommy Thompson, C.A.No.
4867-CC





Pursuant
to a notice dated August 25, Brandt purported to hold a special meeting of
stockholders on September 4, 2009.  In his proxy materials
accompanying the notice, Brandt claimed that the record date for the purported
meeting was August 24.  Brandt claimed that a quorum was present and
proceeded to call a vote on his proposal to elect himself and his nominees as
directors.  He then claimed that his own shares and the shares for
which he purportedly held proxies were sufficient to elect Brandt and the other
nominees.  We took the position that no valid stockholder action was
taken on September 4, that no changes to the board of directors occurred, and
that the election of the company’s directors would occur at the scheduled CNS
annual meeting of stockholders on September 29, 2009. While our bylaws permit
stockholders to call special meetings under certain circumstances, those
meetings (i) require the stockholders wishing to call the meeting to follow
certain procedures that Brandt did not follow and (ii) cannot involve the
election of directors.  In addition, Brandt’s purported record date of
August 24 was invalid because our board of directors had already established
August 27 as the record date and, as a result, not all of the stockholders
entitled to vote at his purported meeting were permitted to do so.





On
September 4, Brandt filed an action seeking relief under Section 225 of the DGCL
in the Delaware Court of Chancery against us and our directors George Carpenter,
Henry T. Harbin, M.D., David B. Jones, Jerome Vaccaro, M.D., John Pappajohn and
former Wisconsin Governor Tommy Thompson.  Section 225 provides a
statutory mechanism for review of contested elections. Brandt sought to have the
Court declare that his meeting and election were valid.




On
September 25, 2009, the Company and its incumbent directors answered the
complaint and asserted affirmative defenses.  On September 29, 2009,
the Chancery Court issued a “status quo” order, which maintained the Board of
Directors in place immediately prior to the purported September 4 meeting
(Messrs. Carpenter, Jones, Pappajohn, Thompson and Brandt, and Drs. Harbin and
Vaccaro).  The status quo order also placed certain restrictions on
certain corporate actions during the pendency of the Section 225
action.




Later on
September 29, the Company convened its Annual Meeting of Stockholders, which had
been duly noticed earlier in September.  At the meeting we submitted
certain matters to a vote of security holders through the solicitation of
proxies.   At the meeting, our stockholders elected George Carpenter,
Henry Harbin, M.D., David B. Jones, John Pappajohn, Tommy Thompson and Jerome
Vaccaro, M.D. to serve as Directors on our Board of Directors for one year
or until their respective successors have been elected.




Full
discovery in the action occurred in September, October and
November.  On December 1 and 2, 2009, the Chancery Court conducted a
trial of the matter.  At the close of the trial, the court granted
judgment to the Company on Brandt’s complaint and dismissed Brandt’s action with
prejudice.  The Chancery Court thereby found that the purported
special meeting of stockholders convened by Brandt on September 4, 2009 was not
valid and that the directors purportedly elected at that meeting are not
entitled to be seated.


35




Delaware Chancery Court–CNS Response, Inc. v.
Leonard Brandt, C.A. No. 4901-CC (Breach of Fiduciary Duty)





On September 16, 2009, we filed a
complaint in the Delaware Chancery Court against Brandt for violations of his
fiduciary duty of loyalty to the Company and its stockholders.  On
December 2, 2009, the Chancery Court dismissed the Company’s breach of fiduciary
duty claims without prejudice.





United States District Courtfor the Central
District of California-  CNS Response,
Inc. v. Leonard Brandt, EAC Investment Limited Partnership and EAC Investment,
Inc. (Case No. SACV 09-00756-CJC)





On July
2, 2009, we filed a complaint against Brandt, EAC Investment Limited Partnership
and EAC Investment, Inc. (collectively, “EAC”), another stockholder of the
Company.  In that complaint, we allege that Brandt has violated
sections 14(a) and 13(d) of the Securities Exchange Act of 1934, as amended, and
related SEC rules and regulations (the “Exchange Act”), in connection with his
ongoing campaign to seize control of the company by unseating the incumbent
directors (other than Brandt).  We allege that EAC violated Section
13(d) of the Exchange Act.  The Company sought injunctive and
declaratory relief to prevent the use of proxies and written consents that
Brandt or the other defendants obtained in violation of law, declaring the
proxies obtained by Brandt invalid, prohibiting any further unlawful
proxy solicitation and any further violations of Section 13(d) and 14(a) of
the Exchange Act, and requiring remedial disclosures.  The Company
also sought damages in an amount to be determined.





The
defendants responded to our complaint by filing motions to dismiss on July 27,
2009 pursuant to Federal Rule of Civil Procedure 12(b)(6), based on two primary
arguments: (i) that the defendants had filed preliminary proxy materials,
preliminary consent solicitation materials and/or amended Schedule 13Ds with the
SEC, and those filings cured any alleged violations, and (ii) that we faced
no imminent threat of irreparable injury and, therefore, were not entitled to
injunctive relief.  EAC also moved to dismiss the complaint against it
for improper venue.  We filed our oppositions to the motions to
dismiss on August 10, 2009.  On August 18, 2009, the court denied the
motions to dismiss, finding, among other things, that our complaint adequately
pled a basis for relief and that whether Brandt’s filings could cure the alleged
violations of sections 14(a) and 13(d) were questions of fact that could not be
resolved in a motion to dismiss.





On August
17, 2009, Brandt distributed to our stockholders by email preliminary proxy
materials with a proxy card.  On August 21, 2009, we filed a motion
for temporary restraining order to enjoin Brandt from using any invalidly
obtained proxies or consents, including any proxies or consents obtained in
response to his preliminary proxy statement distribution.  We
asserted, among other things, that the delivery of preliminary proxy
materials including a proxy card violated Rule 14a-4(f) of the Exchange Act and
that the disclosures contained in, or omitted from, the materials distributed by
Brandt violated Rule 14a-9 of the Exchange Act.  On August 25, 2009,
the court denied our motion for the temporary restraining order citing, among
other things, an affidavit provided by Brandt that he would not solicit proxies
until he has filed a definitive proxy statement with the Securities and Exchange
Commission.





On
September 17, 2009, the defendants in the case filed counterclaims against us,
our Chief Executive Officer and director George Carpenter, and "Roes 1 through
10," alleging violations of Section 14 of the Exchange Act in the solicitation
of proxies or the revocation of proxies.  Unspecified damages and
injunctive relief are sought.  On December 14, 2009, the company and
George Carpenter answered the counterclaims in the case.





Given our
victory in the Delaware Court of Chancery, we have not determined whether or how
we will pursue this action.  Mr. Brandt may choose to proceed
with his counterclaim.


36





We have
expended substantial resources to pursue the defense of legal proceedings
initiated by Mr. Brandt.  Although the ruling by the Delaware
Chancery Court appears to us to
be definitive and dispositive, we do not know whether Mr. Brandt
will appeal the decisions or institute new claims against us.  The
defense of any such claims could involve the expenditure of additional resources
by the Company.





ITEM
      4.
              Submission
      of Matters to a Vote of Security
Holders




At our
Annual Meeting of Stockholders held on September 29, 2009, we submitted certain
matters to a vote of security holders through the solicitation of
proxies.   At the meeting, our stockholders elected George Carpenter,
Henry Harbin, M.D., David B. Jones, John Pappajohn, Tommy Thompson and Jerome
Vaccaro, M.D. to serve as Directors on our Board of Directors for one year or
until their respective successors have been elected.




The
following table provides the number of votes cast for or withheld for each
director:




Name
                      
                      For
                      
                      WithheldGeorge
      Carpenter
                      
                      26,492,372
                      
                      11,015Henry
      Harbin, M.D.
                      
                      26,325,705
                      
                      177,682David
      Jones
                      
                      26,492,372
                      
                      11,015John
      Pappajohn
                      
                      26,492,370
                      
                      11,017Tommy
      Thompson
                      
                      26,492,372
                      
                      11,015Jerome
      Vaccaro, M.D.
                      
                      26,325,705
                      
                      177,682




As
discussed under Item 3, Mr. Brandt previously had purported to hold a special
meeting of stockholders on September 4, 2009.  Mr. Brandt claimed that
a quorum was present at his September 4 meeting and proceeded to call a vote on
his proposal to elect himself and his nominees as directors.  He then
claimed that his own shares and the shares for which he purportedly held proxies
were sufficient to elect Brandt and the other nominees.  On December
2, 2009, following a two day trial, the Delaware Chancery Court ruled that the
purported special meeting of stockholders convened by Brandt on September 4,
2009 was not valid and therefore the directors purportedly elected at that
meeting will not be seated.  Therefore it is now uncontested that the
directors elected at the CNS September 29, 2009 meeting are the validly elected
directors of the Company.




PART
II




ITEM
      5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity
Securities.




37


Common
Stock




Our
common stock is currently listed for trading on the OTC Bulletin Board under the
symbol CNSO.OB. The following table sets forth, for the periods indicated, the
high and low bid information for Common Stock as determined from sporadic
quotations on the OTC Bulletin Board. The following quotations reflect
inter-dealer prices, without retail mark-up, mark-down or commission and may not
represent actual transactions.




High*
                      
                      
                      Low*Year
      Ended September 30, 2008First
      Quarter
                      
                      $
                      0.90
                      
                      
                      $
                      0.75Second
      Quarter
                      
                      $
                      2.25
                      
                      
                      $
                      0.75Third
      Quarter
                      
                      $
                      3.00
                      
                      
                      $
                      0.55Fourth
      Quarter
                      
                      $
                      0.75
                      
                      
                      $
                      0.51Year
      Ended September 30, 2009First
      Quarter
                      
                      $
                      1.01
                      
                      
                      $
                      0.10Second
      Quarter
                      
                      $
                      0.90
                      
                      
                      $
                      0.05Third
      Quarter
                      
                      $
                      0.69
                      
                      
                      $
                      0.15Fourth
      Quarter
                      
                      $
                      0.72
                      
                      
                      $
                      0.20




On
December 28, 2009, the closing sales price of our common stock as reported on
the OTC Bulletin Board was $1.20 per share.  As of December 28,
2009, there were 374 record holders of our common stock.  The number
of holders of record is based on the actual number of holders registered on the
books of our transfer agent and does not reflect holders of shares in “street
name” or persons, partnerships, associations, corporations or other entities
identified in security position listings maintained by depository trust
companies.




Dividend
Rights




We have
not paid or declared cash distributions or dividends on our common stock and we
do not intend to pay cash dividends on our common stock in the foreseeable
future.  We currently intend to retain all earnings, if and when
generated, to finance our operations.  The declaration of cash
dividends in the future will be determined by the board of directors based upon
our earnings, financial condition, capital requirements and other relevant
factors.




Recent
Sales of Unregistered Securities—Private Placement Transactions




First
Tranche: August 26, 2009




On August
26, 2009, we received gross proceeds of approximately $2,000,000 in the first
closing of our private placement transaction (the “Private Placement”) from six
accredited investors.  Pursuant to Subscription Agreements entered
into with the investors, we sold approximately 38 Investment Units at $54,000
per Investment Unit.  Each “Investment Unit” consists of 180,000
shares of our Common Stock and a five year non-callable warrant to purchase
90,000 shares of our Common Stock at an exercise price of $0.30 per
share.  After commissions and expenses, we received net proceeds of
approximately $1,792,300 in the Private Placement.  These funds were
used to repay outstanding liabilities, fund the clinical trial and for working
capital.  A FINRA member firm acted as lead placement agent (the
“Placement Agent”) in connection with the Private Placement.  For its
services in connection with the Private Placement, the Placement Agent received
(i) a cash fee of $55,980, (ii) a cash expense allowance of $40,860, and (iii) a
five year non-callable warrant to purchase 274,867 shares of our Common Stock at
an exercise price of $0.33 per share, first exercisable no earlier than February
26, 2010.


38


Pursuant
to a Registration Rights Agreement entered into with each investor, we agreed to
file a registration statement covering the resale of the Common Stock and the
Common Stock underlying the warrants sold in the Private Placement, as well as
the Common Stock underlying the warrants issued to the Placement Agent by the
later of October 26, 2009 or the 20th calendar day after the termination of the
offering.  The Registration Rights agreement was subsequently amended
to allow the filing of the registration statement by the later of 10 business
days following the Company’s filing of its Annual Report on Form 10-K for its
September 30, 2009 year end or the 20th calendar
day after termination of the  offering.





In
addition, the Company agreed to use its best efforts to have the registration
statement declared effective no later than 180 days following the final closing
of the offering and maintain such effectiveness until the earlier of the second
anniversary of the date of such effectiveness or the date that all of the
securities covered by the registration statement may be sold without
restriction.




In
issuing the shares and warrants to the investors without registration under the
Securities Act of 1933, as amended (the “Securities Act”), we relied upon one or
more of the exemptions from registration contained in Sections 4(2) of the
Securities Act, and in Regulation D promulgated thereunder, as the shares and
warrants were issued to accredited investors, without a view to distribution,
and were not issued through any general solicitation or advertisement. We made
this determination based on the representations of each investor which included,
in pertinent part, that such investor is an “accredited investor” within the
meaning of Rule 501 of Regulation D promulgated under the Securities Act, that
such investor was acquiring the shares and the warrant for investment purposes
for its own account, and not with a view to, or for resale in connection with,
any distribution or public offering thereof within the meaning of the Securities
Act, and that such investor understood that the shares, the warrant and the
securities issuable upon exercise thereof may not be sold or otherwise disposed
of without registration under the Securities Act or an applicable exemption
therefrom.




Events Relating toFirst Closing
ofPrivate
Placement Transaction




(a)           Conversion
of March Notes




On March
30, 2009, we entered into two Senior Secured Convertible Promissory Notes, each
in the principal amount of $250,000 (each a “March Note” and, collectively, the
“March Notes”), with Brandt Ventures, GP (“Brandt”) and SAIL Venture Partners,
LP (“SAIL”). Leonard Brandt, a former member of our board of directors, is the
general partner of Brandt and David B. Jones, a current member of our board of
directors, is a managing member of Sail Venture Partners, LLC, which is the
general partner of SAIL. The terms of the March Notes provided that in the event
we consummate an equity financing transaction of at least $1,500,000 (excluding
any and all other debt that is converted), then the principal and all accrued,
but unpaid interest outstanding under the notes shall be automatically converted
into the securities issued in the equity financing by dividing such amount by
90% of the per share price paid by the investors in such
financing.  In accordance with the terms of the March Notes, at the
closing of the Private Placement, we issued to each of Brandt and SAIL 956,164
shares of common stock and a five year non-callable warrant to purchase
478,082 shares of our common stock at an exercise price of $0.30 per
share.


39


(b)           Conversion
of May SAIL Note




On May
14, 2009, we entered into a Bridge Note and Warrant Purchase Agreement (the
“SAIL Purchase Agreement”) with SAIL. Pursuant to the SAIL Purchase Agreement,
on May 14, 2009 SAIL purchased a Secured Promissory Note in the principal amount
of $200,000 from us (the “May SAIL Note”). In order to induce SAIL to purchase
the note, we issued to SAIL a warrant to purchase up to 100,000 shares of our
common stock at a purchase price equal to $0.25 per share.  The
warrant expires on the earlier to occur of May 31, 2016 or a change of control
of the company.  The terms of the May SAIL Note provided that in the
event we consummate an equity financing transaction of at least $1,500,000
(excluding any and all other debt that is converted), then the principal and all
accrued, but unpaid interest outstanding under the note shall be automatically
converted into the securities issued in the equity financing by dividing such
amount by 85% of the per share price paid by the investors in such
financing.  In accordance with the terms of the May SAIL Note, at the
closing of the Private Placement, we issued to SAIL 802,192 shares of our common
stock and a five year non-callable warrant to purchase 401,096 shares of our
common stock at an exercise price of $0.30 per share.




(c)           Conversion
of Pappajohn Note




On June
12, 2009, Mr. Pappajohn entered into a Bridge Note and Warrant Purchase
Agreement (the “Pappajohn Purchase Agreement”) with us.  Pursuant to
the Pappajohn Purchase Agreement, Mr. Pappajohn purchased a Secured Convertible
Promissory Note in the principal amount of $1,000,000 from us.  In
order to induce Mr. Pappajohn to purchase the note, we issued to Mr.
Pappajohn a warrant to purchase up to 3,333,333 shares of our common stock at a
purchase price equal to $0.30 per share.  The warrant expires on June
30, 2016.




The note
issued pursuant to the Pappajohn Purchase Agreement provided that the principal
amount of $1,000,000 together with a single payment of $90,000 (the “Premium
Payment”) would be due and payable, unless sooner converted into shares of our
common stock (as described below), upon the earlier to occur of: (i) a
declaration by Mr. Pappajohn on or after June 30, 2010 or (ii) an Event of
Default (as defined in the note).  The note was secured by a lien on
substantially all of our assets (including all of our intellectual
property).  In the event of a liquidation, dissolution or winding up
of the company, unless Mr. Pappajohn informed us otherwise, we were required to
pay Mr. Pappajohn an amount equal to the product of 250% multiplied by the then
outstanding principal amount of the note and the Premium Payment.




The
Pappajohn Purchase Agreement also provided that in the event we consummated an
equity financing transaction of at least $1,500,000 (excluding any and all other
debt that is converted), the then outstanding principal amount of the note (but
excluding the Premium Payment, which would be repaid in cash at the time of such
equity financing) would be automatically converted into the securities issued in
the equity financing by dividing such amount by the per share price paid by the
investors in such financing.  The note also provided that the
securities issued upon conversion of the note would be otherwise issued on the
same terms as such shares are issued to the lead investor that purchases shares
of the company in the qualified financing.




At the
closing of the Private Placement, we paid the Premium Payment to Mr. Pappajohn,
and the outstanding principal amount of Mr. Pappajohn’s note ($1,000,000 as of
August 26, 2009) converted into 3,333,334 shares of our common stock. In
addition, in accordance with the terms of his note, Mr. Pappajohn was issued a
five year non-callable warrant to purchase 1,666,667 shares of our common stock
at an exercise price of $0.30 per share.


40


In
issuing the shares and warrants described above without registration under the
Securities Act, we relied upon one or more of the exemptions from registration
contained in Sections 4(2) of the Securities Act, and in Regulation D
promulgated thereunder, as such shares and warrants were issued to accredited
investors, without a view to distribution, and were not issued through any
general solicitation or advertisement. We made this determination based on the
representations of each note holder which included, in pertinent part, that such
note holder is an “accredited investor” within the meaning of Rule 501 of
Regulation D promulgated under the Securities Act, that such note holder was
acquiring the shares and warrants for investment purposes for its own account,
and not with a view to, or for resale in connection with, any distribution or
public offering thereof within the meaning of the Securities Act, and that such
note holder understood that the shares, the warrants and the securities issuable
upon exercise thereof may not be sold or otherwise disposed of without
registration under the Securities Act or an applicable exemption
therefrom.




Second
Tranche: December 24, 2009




On
December 24, 2009, we completed a second closing of our Private Placement (as
described above, the first closing of our Private Placement occurred on August
26, 2009), resulting in additional gross proceeds to us of approximately $3.0
million.





Pursuant
to Subscription Agreements entered into with investors, we sold approximately 55
Investment Units at $54,000 per Investment Unit. Each “Investment Unit” consists
of 180,000 shares of our common stock and a five year non-callable warrant to
purchase 90,000 shares of our common stock at an exercise price of $0.30 per
share.





After
commissions and expenses, we received net proceeds of approximately $2.65
million in connection with the second closing of our Private
Placement.  We intend to use the proceeds from the second closing for
general corporate purposes, including clinical trial expenses, research and
development expenses, and general and administrative expenses, including the
payment of accrued legal expenses incurred in connection with successfully
defending the company from actions brought in the Delaware Court of Chancery by
Leonard Brandt.





A FINRA
member firm acted as lead placement agent in connection with the second closing
of our Private Placement.  For its services in connection with the
second closing, the Placement Agent received (i) a cash fee of $195,200, (ii) a
cash expense allowance of $59,920, and (iii) a five year non-callable warrant to
purchase 672,267 shares of our common stock at an exercise price of $0.33per share, first
exercisable no earlier than June 24, 2010.





In
connection with the second closing of our Private Placement, each investor who
participated in the financing became party to the Registration Rights agreement
described above and will receive the same rights and benefits as the investors
in the first closing of our Private Placement.





In
issuing the shares and warrants to the investors without registration under the
Securities Act of 1933, as amended (the “Securities Act”), we relied upon one or
more of the exemptions from registration contained in Sections 4(2) of the
Securities Act, and in Regulation D promulgated thereunder, as the shares and
warrants were issued to accredited investors, without a view to distribution,
and were not issued through any general solicitation or
advertisement.  We made this determination based on the
representations of each investor which included, in pertinent part, that such
investor is an “accredited investor” within the meaning of Rule 501 of
Regulation D promulgated under the Securities Act, that such investor was
acquiring the shares and the warrant for investment purposes for its own
account, and not with a view to, or for resale in connection with, any
distribution or public offering thereof within the meaning of the Securities
Act, and that such investor understood that the shares, the warrant and the
securities issuable upon exercise thereof may not be sold or otherwise disposed
of without registration under the Securities Act or an applicable exemption
therefrom.


41




ITEM
      6.
              Selected
      Financial Data.




Not applicable.





ITEM
      7.
                Management’sDiscussion and
      Analysis of Financial Condition and Results of Operations.




The
following discussion should be read in conjunction with the consolidated
financial statements and accompanying notes provided under Part II, Item 8 of
this annual report on Form 10-K.  This discussion summarizes the
significant factors affecting the condensed consolidated operating results,
financial condition and liquidity and cash flows of CNS Response, Inc. for the
fiscal years ended September 30, 2009 and 2008.  Except for historical
information, the matters discussed in this Management’s Discussion and Analysis
of Financial Condition and Results of Operations are “forward-looking
statements” within the meaning of the Private Securities Litigation Reform Act
of 1995. These statements are subject to risks and uncertainties and are based
on the beliefs and assumptions of our management as of the date hereof based on
information currently available to our management. Use of words such as
“believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “should,”
“forecasts,” “goal,” “likely” or similar expressions, indicate a
forward-looking statement. Forward-looking statements are not guarantees of
future performance and involve risks, uncertainties and assumptions. Actual
results may differ materially from the forward-looking statements we make. See
“Risk Factors” elsewhere in this annual report on Form 10-K for a discussion of
certain risks associated with our business.  We disclaim any
obligation to update forward-looking statements for any reason.




Overview




We are a
life sciences company with two distinct business segments. Our Laboratory
Information Services business operated by CNS California, which we consider our
primary business, is focused on the commercialization of a patented system that
guides psychiatrists and other physicians to determine a proper treatment for
patients with behavioral (psychiatric and/or addictive)
disorders.  Our Clinical Services business operated by Neuro-Therapy
Clinic,  ("NTC") is a full service psychiatric clinic.




Laboratory
Information Services




In
connection with our Laboratory Information Services business, we have developed
an extensive proprietary database (the “CNS Database”) consisting of over 17,000
clinical outcomes across more than 2,000 patients who had psychiatric or
addictive problems. For each patient, we have compiled electrocephalographic
(“EEG”) data, symptoms and outcomes, often across multiple treatments from
multiple psychiatrists and physicians. Using this database, our technology
compares a patient’s EEG  to the outcomes in the database and ranks
treatment options based on treatment success of patients having similar
neurophysiology.




Trademarked
as Referenced-EEG®
(“rEEG®”), this
patented technology allows us to create and provide simple reports (“rEEG
Reports”) that specifically guide physicians to treatment strategies based on
the patient’s own physiology. The vast majority of these patients were
considered long-term “treatment-resistant”, the most challenging, high-risk and
expensive category to treat.


42


rEEG
identifies relevant neurophysiology that is variant from the norm and identifies
medications that have successfully treated database patients having similar
aberrant physiology.  It does this by comparing a patient’s standard
digital EEG to an external normative database, which identifies the presence of
abnormalities. The rEEG process then identifies a set of patients having similar
abnormalities as recorded in our CNS Database and reports on historical relative
medication success for this stratified group. Upon completion, the physician is
provided the analysis in a report detailing and ranking classes of agents (and
specific agents within the class) by treatment success for patients having
similar abnormal electrophysiology.




Our
business is focused on increasing the demand for our rEEG
services.  We believe the key factors that will drive broader adoption
of rEEG will be acceptance by healthcare providers of its clinical benefits,
demonstration of the cost-effectiveness of using our test, reimbursement by
third-party payers, expansion of our sales force and increased marketing
efforts.




Clinical
Services




In
January 2008, we acquired our largest customer, the Neuro-Therapy Clinic,
Inc.  Upon the completion of the transaction, NTC became a
wholly-owned subsidiary of ours. NTC operates one of the largest psychiatric
medication management practices in the state of Colorado, with nine full time
and four part time employees including psychiatrists and clinical nurse
specialists with prescribing privileges.  Daniel A. Hoffman, M.D. is
the medical director at NTC, and, after the acquisition, became our Chief
Medical Officer and more recently, our President.





NTC,
having performed a significant number of rEEG’s, serves an important resource in
our product development, the expansion of our CNS Database, production system
development and implementation, along with the integration of our rEEG services
into a medical practice.  Through NTC, we also expect to successfully
develop marketing and patient acquisition strategies for our Laboratory
Information Services business. Specifically, NTC is learning how to best
communicate the advantages of rEEG to patients and referring physicians in the
local market.  We will share this knowledge and developed
communication programs learned through NTC with other physicians using our
services, which we believe will help drive market acceptance of our
services.  In addition, we plan to use NTC to train practitioners
across the country in the uses of rEEG technology.





We view
our Clinical Services business as secondary to our LaboratoryInformation Services business,
and we have no current plans to expand this business.





Business
operations




Since our
inception, we have generated significant net losses. As of September 30, 2009,
we had an accumulated deficit of $25.2 million. We incurred operating losses of
$8.5 million and $5.4 million for the fiscal years ended September 30, 2009 and
2008, respectively.  We expect our net losses to continue for at least
the next couple of years. We anticipate that a substantial portion of our
capital resources and efforts will be focused on research and development, scale
up of our commercial organization, and other general corporate purposes,
including the payment of legal fees associated with our
litigation.  Research and development projects include the completion
of more clinical trials which are necessary to further validate the efficacy of
our products and services relating to our rEEG technology across different type
of behavioral disorders, the enhancement of the CNS Database and, to a lesser
extent, the identification of new medication that are often combinations of
approved drugs.


43


Acquisition
of Neuro-Therapy Clinic




On
January 15, 2008, we acquired all of the outstanding common stock of NTC in
exchange for a non-interest bearing $300,000 note payable in equal monthly
installments over 36 months.  The acquisition was accounted under the
purchase method of accounting, and accordingly, the purchase price was allocated
to NTC’s net tangible assets based on their estimated fair values as of January
15, 2008.  The excess purchase price over the value of the net
tangible assets was recorded as goodwill.  The purchase price and the
allocation thereof are as follows:





Fair
      value of note payable issued
                            
                            $
                            265,900Direct
      transaction costs
                            
                            
                            43,700Purchase
      price
                            
                            
                            309,600Allocated
      to net tangible liabilities,including cash of $32,100
                            
                            
                            (10,600
                            )Allocated
      to goodwill
                            
                            $
                            320,200





The
acquisition was not material, and accordingly, no pro forma results are
presented.  As of September 30, 2009 the goodwill was determined to be
fully impaired and was consequently written off.




The
2009 Private Placement Transaction




As more fully described under Item 5
under the heading “Recent Sales of Unregistered Securities –Private Placement
Transaction”, on August 26, 2009, we received gross proceeds of approximately
$2,043,000 in the first closing of our private placement transaction with six
investors.  Pursuant to Subscription Agreements entered into with the
investors, we sold approximately 38 Investment Units at $54,000 per Investment
Unit.  Each “Investment Unit” consists of 180,000 shares of our common
stock and a five year non-callable warrant to purchase 90,000 shares of our
common stock at an exercise price of $0.30 per share.  After
commissions and expenses, we received net proceeds of approximately
$1,792,300 upon the first closing of our private placement.  In
connection with the first closing, and as more fully described under Item 5
under the heading “Events Related to Private Placement Transaction”, certain
promissory notes then outstanding were converted into shares of common stock and
we issued warrants to the investors in connection with the note
conversions.




On
December 24, 2009, we had a second closing of our private placement in which we
received additional gross proceeds of approximately $2,996,000 from
approximately 30 investors.  At the second closing, we sold
approximately 55 Investment Units on the same terms and conditions as the
Investment Units sold at the first closing. After commissions and expenses,
we received net proceeds of approximately $2,650,400 in connection with the
second closing of our private placement.




Prior to
our private placement, we raised aggregate proceeds of $1,700,000 in 2009
through the issuance of secured convertible promissory notes on each of March
30, May 14, and June 12.  Upon the first closing of our private
placement on August 26, 2009, these notes were converted into shares of our
common stock, as more fully described under Item 5 under the heading “Events
Relating to First Closing of Private Placement Transaction”.


44


Matters
Involving our Former Chief Executive Officer and Former Director, Leonard
Brandt
  On April
10, 2009, our Board of Directors voted to remove Len Brandt as the CEO of the
Company and appointed George Carpenter as our CEO. On the same date, Mr.
Brandt resigned as Chairman of the Board, but retained his seat on the Board of
Directors.  On June 19, 2009, Mr. Brandt informed us of his
intention to call a special meeting of Company stockholders in lieu of an annual
meeting, for the purpose of unseating the other members of the Board and
replacing them with his nominees.  Subsequently, Mr. Brandt made
multiple mailings to stockholders purporting to give notice of a meeting,
scheduled multiple dates for the meeting, attempted to call and adjourn meetings
on at least six occasions.  Mr. Brandt failed to convene a quorum
or take any action at any of these meetings.
 
 Mr. Brandt
finally attempted to call a special meeting of stockholders to be held on
September 4, 2009, and purportedly held a meeting on that date, at which he
claimed to have elected his own slate of directors.  Subsequent to
this purported meeting, Mr. Brandt filed an action under Section 225
of the Delaware General Corporation Law (“DGCL”) seeking to validate the results
of that purported meeting.  Mr. Brandt also filed several other
actions in the Delaware Chancery Court as further described under Item 3, Legal
Proceedings.  He filed claims for breach of fiduciary duty in
connection with the approval by our Board of the May 14, 2009 and June 18, 2009
bridge loans and the first closing of the private placement on August 26, 2009,
and made a motion to preliminarily enjoin the voting of certain shares of our
common stock and to prevent action by written consent by such
stockholders.  Mr. Brandt also sought a permanent injunction against
the voting of these shares and to rescind their issuance.  While these
actions were pending, we were operating under what is commonly referred to as a
“status quo” order, which maintained the Board of Directors in place immediately
prior to the purported September 4 meeting (Messrs. Carpenter, Jones, Pappajohn,
Thompson and Brandt, and Drs. Harbin and Vaccaro).  The status quo
order also placed certain restrictions on certain corporate actions during the
pendency of the Section 225 action described above.
 
 As
further described under Item 3, Legal Proceedings, on December 2, 2009,
following a two day trial, the Delaware Court of Chancery entered judgment for
the Company and its incumbent directors in the Section 225 action and dismissed
the action with prejudice.  The entry of Judgment for the Company in
the Section 225 action and dismissal of that action terminated the “status quo”
order, including its restrictions on the Company’s ability to engage in certain
corporate actions.  The Chancery Court also denied Brandt’s motion for
an injunction that sought to prevent the voting of shares issued by us in
connection with the our bridge financings in May and June of 2009 and the
securities offering in August 2009, dismissed Mr. Brandt's counterclaims
alleging breaches of duties in connection with those transactions, and dismissed
with prejudice another action brought by Mr. Brandt that claimed he had not
been provided with information owed to him.  Finally, the Court
dismissed the claims by us against Mr. Brandt, without prejudice.
 
 On
September 29, 2009, we held an annual meeting of Stockholders at which each of
George Carpenter, Henry Harbin, M.D., David Jones, John Pappajohn, Jerome
Vaccaro, M.D. and Tommy Thompson were elected.
 
 As
further described under Item 3, Legal Proceedings, we filed an action in the
United States District Court for the Central District of California against
Mr. Brandt and certain others in July 2009.  Our complaint
alleges a variety of violations of federal securities laws, including anti-fraud
based claims under Rule 14a-9, solicitation of proxies in violation of the
filing and disclosure dissemination requirements of Regulation 14A, and
material misstatements and omissions in and failures to promptly file amendments
to Schedule 13D.  Mr. Brandt and the other defendants have
filed counterclaims against us, alleging violations of federal securities laws
relating to alleged actions and statements taken or made by us or our officers
and directors in connection with Mr. Brandt’s proxy and consent
solicitations.  Given our victory in the Delaware Court of Chancery,
we have not determined whether or how we will pursue this
action.  Mr. Brandt may choose to proceed with his
counterclaim.
  45
 
 We have
expended substantial resources to pursue the defense of legal proceedings
initiated by Mr. Brandt.  Although the ruling by the Delaware
Chancery Court appeared to be demonstrative, we do not know whether
Mr. Brandt will appeal the decisions or institute new claims against
us.  The defense of any such claims could involve the expenditure of
additional resources by the Company.
  Publicly
Announced Results of Clinical Trial
 
 On
November 2, 2009, we reported the results of a landmark study presented by
Charles DeBattista, D.M.H, M.D., at the U.S. Psychiatric and Mental Health
Congress.  The poster presentation, titled Referenced-EEG® (rEEG)
Efficacy Compared to STAR*D For Patients With Depression Treatment
Failure:  First Look At Final Results, highlighted a dramatic
improvement in personalized medicine technology for use in treatment of patients
with depression.  In this study, our rEEG technology proved effective
at predicting medication response for treatment-resistant patients approximately
65 percent of the time.
 
 The study
included 114 patients in 12 medical centers, including Harvard,
Stanford, Cornell, UCI and Rush.  The 12-week study found that rEEG
significantly outperformed the modified STAR*D treatment
algorithm.  The difference, or separation, between rEEG and the
control group was 50 and 100 percent for the study’s two primary
endpoints.  Typically, separation between a new treatment and a
control group is less than 10 percent in antidepressant
studies.
 
 The
study, the largest in our history, was a randomized, blinded, controlled,
parallel group, multicenter study.  The patients in the study
experienced depression treatment failure of one or more SSRIs and/or had failure
with at least two classes of antidepressants.  The patients fell into
two groups:  1) those treated with rEEG medication guidance, and
2) those treated with the modified STAR*D treatment algorithm.
  Financial Operations
Overview
  Revenues
  Our LaboratoryInformationServices revenues are derived from the sale of rEEG Reports to physicians.
Physicians are generally billed upon delivery of a rEEG Report.  The
list prices of our rEEG Reports to physicians range from $200 to $800 with $400
being the most frequent charge.
  Patient service revenue is generated as a result of providing
services to patients on an outpatient basis. Patient service revenue is recorded
at our established billing rates less contractual adjustments. Generally,
collection in full is not expected on our established billing rates. Contractual
adjustments are recorded to state our patient service revenue at the amount we
expect to collect for the services provided based on amounts due from
third-party payors at contractually determined rates.
  Cost of
Revenues
  Cost of revenues are for LaboratoryInformationServices and represent the cost of direct labor,
costs associated with external processing, analysis and consulting review
necessary to render an individualized test result and miscellaneous support
expenses.  Costs associated with performing our tests are expensed as
the tests are performed.  We continually evaluate the feasibility of
hiring our own personnel to perform most of the processing and analysis
necessary to render an rEEG Report.
  46
  Cost of revenues for Clinical Services are not broken out
separately but are included in general and administrative
expenses.
  Research and
Development
  Research and development expenses are associated with our
LaboratoryInformationServices and
primarily represent costs incurred to design and conduct clinical studies, to
recruit patients into the studies, to improve rEEG processing, to add data to
the CNS Database, to improve analytical techniques and advance application of
the methodology to additional clinical diagnosis. We charge all research and
development expenses to operations as they are incurred.
  Sales and
Marketing
  For our LaboratoryInformationServices, our selling and marketing expenses consist primarily of
personnel and media cost to inform consumers of our products and
services.  Additional marketing expenses are the costs of educating
physicians, laboratory personnel, other healthcare professionals regarding our
products and services.
  For our Clinical Services, selling and marketing costs relate to
advertising to attract patients to the clinic.
  General and
Administrative
  Our general and administrative expenses consist primarily of
personnel, occupancy, legal, consulting and administrative and support costs for
both our LaboratoryInformationServices
and Clinical Services businesses.
  Critical Accounting Policies and
Significant Judgments and Estimates
  This discussion and analysis of our financial condition and results
of operations is based on our financial statements, which have been prepared in
accordance with U.S. generally accepted accounting principles. The preparation
of these consolidated financial statements requires management to make estimates
and judgments that affect the reported amounts of assets, liabilities and
expenses and the disclosure of contingent assets and liabilities at the date of
the financial statements, as well as revenues and expenses during the reporting
periods. We evaluate our estimates and judgments on an ongoing basis. We base
our estimates on historical experience and on various other factors we believe
are reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. Actual results could therefore differ
materially from those estimates under different assumptions or
conditions.
  Our significant accounting policies are described in Note 3 to our
consolidated financial statements included elsewhere in this report. We believe
the following critical accounting policies reflect our more significant
estimates and assumptions used in the preparation of our consolidated financial
statements.
  47
  Revenue
Recognition
  We have generated limited revenues since our inception. Revenues
for our Laboratory Service product are recognized when an rEEG Report is
delivered to a Client-Physician.  For our Clinical Services, revenues
are recognized when the services are performed.
  Stock-based Compensation
Expense
  Stock-based compensation expense, which is a non-cash charge,
results from stock option grants.  Compensation cost is measured at
the grant date based on the calculated fair value of the award.  We
recognize stock-based compensation expense on a straight-line basis over the
vesting period of the underlying option. The amount of stock-based compensation
expense expected to be amortized in future periods may decrease if unvested
options are subsequently cancelled or may increase if future option grants are
made.
  Results of Operations for the Years
Ended September 30, 2009 and 2008
  As earlier
described, weoperate in two business segments: LaboratoryInformationServices and Clinical
Services.  Our LaboratoryInformationServices business focuses on the delivery of reports ("rEEG
Reports") that assist physicians with treatment strategies for patients with
behavioral (psychiatric and/or addictive) disorders based on the patient's own
physiology. Our Clinical Services business operated through NTC provides full
service psychiatric services.  For comparative purposes below,
ourClinical Services business which represents the
operations of Neuro-Therapy Clinic are only included since its acquisition on
January 15, 2008.
  The following table presents consolidated statement of operations
data for each of the periods indicated as a percentage of
revenues.
  YearEnded
                          September30,
                          2009
                        
                        
                        YearEnded
                          September30,
                          2008Revenues
                        
                        
                        100
                        %
                        
                        
                        100
                        %Cost
      of revenues
                        
                        
                        19
                        
                        
                        
                        21Gross
      profit
                        
                        
                        81
                        
                        
                        
                        79Research
      and development
                        
                        
                        305
                        
                        
                        
                        271Sales
      and marketing
                        
                        
                        131
                        
                        
                        
                        114General
      and administrative expenses
                        
                        
                        555
                        
                        
                        
                        402Goodwill
      impairment
                        
                        
                        46
                        
                        
                        
                        -Operating
      loss
                        
                        
                        (956
                        )
                        
                        
                        (708
                        )Other
      income (expense), net
                        
                        
                        (261
                        )
                        
                        
                        13Net
      income (loss)
                        
                        
                        (1217
                        )%
                        
                        
                        (695
                        )%
  48
  Revenues
  YearEnded
                          September30,
                          2009
                        
                        
                        YearEnded
                          September30,
                          2008
                        
                        
                        Percent
                          ChangeLaboratory
      Service Revenues
                        
                        $
                        120,400
                        
                        
                        $
                        178,500
                        
                        
                        
                        (33
                        )%Clinical
      Service Revenues
                        
                        
                        579,700
                        
                        
                        
                        595,000
                        
                        
                        
                        ( 3
                        )%Total
      Revenues
                        
                        $
                        700,100
                        
                        
                        $
                        773,500
                        
                        
                        
                        ( 9
                        )%
 
 With respect to our LaboratoryInformationServices business, the number of paid rEEG
Reports delivered during the year ended September 30, 2009 decreased to 321 from
476 in 2008 while the price per report was approximately $375 in both 2009 and
2008.  The reduction in revenues from the sale of our rEEG Reports is
partly due to the acquisition of NTC, which was our largest customer prior to
its acquisition in January 2008.  Furthermore, the Company diverted
its limited resources to focus on conducting and completing its clinical
trial.  The clinical trial was completed in September 2009 with
top-line results announced in November 2009.  The Company is starting
to scale up its sales and marketing efforts and has entered into agreements with
two payer groups to pilot the use of rEEG Reports.  We expect to drive
broader adoption of our rEEG technology now that the clinical trial is complete
and accordingly, we anticipate that our Laboratory Service Revenues will
increase in fiscal 2010.
  Our Clinical Services Revenues are a result of patient billings for
psychiatric services rendered.  Revenues fell in 2009 compared to 2008
due to staff turnover and the focus by key staff members on the clinical
trial.  Currently, we anticipate that the Clinical Services business
will become self-sustaining and profitable, however, we do not anticipate a
significant increase in revenues generated by this business
segment.
  Cost of
Revenues
  YearEnded
                          September30,
                          2009
                        
                        
                        YearEnded
                          September30,
                          2008
                        
                        
                        Percent
                          ChangeCost
      of Laboratory Information Services revenues
                        
                        $
                        131,600
                        
                        
                        $
                        163,200
                        
                        
                        
                        (19
                        )%
 
 Cost of LaboratoryInformationServices revenues consists of payroll, consulting, and other
miscellaneous costs.  Consulting costs primarily represent external
costs associated with the processing and analysis of rEEG Reports and range
between $75 and $100 per rEEG Report.  For the year ended September
30, 2009, cost of revenues of $131,600 consist primarily of direct labor and
benefit costs of $99,600, which includes stock-based compensation and consulting
fees of $29,200.  For the year ended September 30, 2008, cost of
revenues of $163,200 consisted primarily of direct labor and benefit costs of
$108,400, including stock-based compensation and consulting fees of
$48,600.  We expect costs of revenues will increase as an absolute
number as more rEEG Reports are processed. However, we expect cost of revenues
to decrease as a percentage of revenues as we improve our operating
efficiency.
  49
  Research and
Development
  YearEnded
                        September30,
                        2009
                      
                      
                      YearEnded
                        September30,
                        2008
                      
                      
                      Percent
                        ChangeLaboratory
      Information Services research and development
                      
                      $
                      2,137,200
                      
                      
                      $
                      2,097,300
                      
                      
                      
                      2
                      %
 
 Research and development expenses consist of clinical study patient
expenses, payroll and benefit costs (including stock-based compensation),
patents costs, consulting fees, marketing and recruitment costs, database
enhancements and maintenance, travel and conference and other miscellaneous
costs.  Research and development costs for the year ended September
30, 2009 totaled $2,137,200 and were largely comprised of the following:
clinical study patient costs of $789,300, payroll and benefit costs of $792,100,
patent costs of $213,100, consulting costs of $105,700, marketing and recruiting
costs $161,100, database costs of $16,800 and travel and conference costs
of $15,600.  For the year ended September 30, 2008 research and
development costs totaled $2,097,300 and were largely comprised of the
following: clinical study patient costs of $579,100, payroll and benefit costs
of $855,600, patent costs of $108,800, consulting costs of $285,000, marketing
and recruiting costs $136,200, database costs of $36,400 and travel and
conference costs of $50,200.
  Clinical
study patient costs increased by $210,200 in fiscal 2009 as our clinical trial
was running for twelve months in fiscal 2009 compared to approximately nine
months in fiscal 2008.  Patent costs also increased in fiscal 2009 by
$104,300 as a result of filing patent applications in Western Europe and
marketing and recruitment expenses increased by $25,000 in fiscal 2009 as we
accelerated patient enrollment in our clinical study.  Conversely,
payroll and benefit costs declined in fiscal 2009 by $63,500 due to changes in
the staff-mix and reduced stock compensation and bonus expenses and
consulting expenses declined by $179,300 as expertise was brought in-house
and the clinical trial moved beyond the design stage which involved the use of
consultants.  In fiscal 2009, database costs fell by $19,600 compared
to fiscal 2008 as the company reduced development efforts relating to the CNS
Database.
  The level of research and development costs are anticipated to
remain at a high level as the Company will continue to conduct clinical studies
and plans to expand the pharmacological range and improve the functionality of
its CNS Database.  The Company is also applying for grants which, if
obtained, will help the Company accelerate its research and development
efforts.
  Sales and
marketing
  YearEnded
                        September30,
                        2009
                      
                      
                      YearEnded
                        September30,
                        2008
                      
                      
                      Percent
                        ChangeSales
      and MarketingLaboratory
      Information Services
                      
                      $
                      908,500
                      
                      
                      $
                      847,600
                      
                      
                      
                      7
                      %Clinical
      Services
                      
                      
                      7,300
                      
                      
                      
                      33,800
                      
                      
                      
                      (78
                      )%Total
      Sales and Marketing
                      
                      $
                      915,800
                      
                      
                      $
                      881,400
                      
                      
                      
                      4
                      %
 
 Sales and marketing expenses associated with our LaboratoryInformationServices business consist
primarily of payroll and benefit costs, consulting fees, marketing costs,
computer services, travel and conference costs and miscellaneous
costs.  Sales and marketing expenses for fiscal 2009 were comprised of
the following: payroll and benefit costs of $596,200, consulting fees of
$82,400, marketing costs of $147,600, computer services costs of $31,700, and
travel and conference costs of $40,600.  For fiscal 2008 the company
incurred: payroll and benefit costs of $403,000, consulting fees of $221,100,
marketing costs of $18,500, computer services costs of $25,000, and travel and
conference costs of $110,900.
  50
  In fiscal
2009, payroll and benefits increased by $193,200 principally as a result of the
hiring of a Vice President for commercial operations and additional sales and
support staff.  This increase was partially offset by a reduction in
consulting fees of $138,900 as marketing expertise was brought in
house.  Marketing expenses increased in fiscal 2009 by $129,100 in an
effort to advertise our rEEG technology to service providers and
consumers.  This was partly offset by a reduction in travel and
conference costs of $70,300.
  In fiscal
2010, we anticipate that sales and marketing expenses for Laboratory Information
Services will increase as we plan to increase our Direct-to-Consumer
marketing.  Additionally, with the successful completion of our
clinical trial, we plan to introduce our rEEG technology to additional
psychiatric providers and medical insurance payers in fiscal 2010, which will
also increase our sales and marketing costs.
  Clinical Services sales and marketing expenses consist of
advertising in various media so as to attract patients to our clinic in
Denver.  We do not anticipate materially increasing sales and
marketing expenses relating to our Clinical Services business in fiscal
2010.
  General and
administrative
  YearEnded
                        September30,
                        2009
                      
                      
                      YearEnded
                        September30,
                        2008
                      
                      
                      Percent
                        ChangeGeneral
      and administrativeLaboratory
      Information Services
                      
                      
                      3,217,800
                      
                      
                      $
                      2,349,000
                      
                      
                      
                      35
                      %Clinical
      Services
                      
                      
                      669,600
                      
                      
                      
                      756,700
                      
                      
                      
                      (12
                      )%Total
      General and administrative
                      
                      $
                      3,887,400
                      
                      
                      $
                      3,105,700
                      
                      
                      
                      25
                      %
 
 General and administrative expenses for our LaboratoryInformationServices business are primarily
related to salaries and benefits (including stock-based compensation), legal and
other professional fees, consulting services, general administration and
occupancy costs, dues and fees, marketing and investor relations, and travel and
conferences.  For the year ended September 30, 2009 these expenses
were as follows: Salaries and benefits $792,700, legal fees $1,362,000, other
professional fees $151,300, consulting costs $369,700, general administration
and occupancy costs $183,000, dues and fees $80,000, marketing and investor
relations $86,500, and travel and conference costs $69,800.  For the
year ended September 30, 2008 these expenses were: Salaries and benefits
$1,420,900, legal fees $193,900, other professional fees $157,800, consulting
costs $94,600, general administration and occupancy costs $189,300, dues and
fees $46,300, marketing and investor relations $112,800, and travel and
conference costs of $78,100.
  51
  Changes
in general and administrative expenditures in 2009 were as
follows:  Salaries and benefit costs decreased by $628,200 as a result
of staff reductions, including the termination of our former CEO Leonard Brandt
in April 2009, a non-recurring bonus expense of $69,900 declared in 2008 that
did not reoccur in 2009 and as a result of stock based compensation charges
falling $214,900 in fiscal 2009 compared to the prior year
period.  Partly offsetting the reduction in salaries and benefits was
an increase in consulting fees of $275,100 as a result of the hiring of
consultants to perform functions previous undertaken by salaried employees.
Legal fees increased by $1,168,100 in 2009 principally due to costs associated
with defending against lawsuits brought by our former CEO and Chairman of the
Board, Leonard Brandt, as well as our fund raising efforts.  Dues and
fees increased by $33,800 in 2009 as a result of the payment of Delaware
Franchise taxes for 2009, Blue Sky filings necessitated by our private
placement, and increased transfer agent fees associated with the holding of our
annual stockholders’ meeting.  Certain other costs categories
decreased in 2009 including marketing and investor relations costs which
decreased by $26,300.
  The
company incurred certain miscellaneous charges in 2009 which included Delaware
Franchise Tax assessments for fiscal 2007 and 2008 totaling $74,400;
additionally, the company accrued for a $34,800 payroll tax assessment which was
related to 2006, and a write-off of $22,600 of doubtful debts.  In
2008 the company wrote off $56,900 in costs associated with a financing effort
that did not materialize.
  General
and administrative expenses for our Clinical Services business for the year
ended September 30, 2009 were $669,600 which includes all costs associated with
running the clinic, including all payroll costs, medical supply costs, occupancy
costs and other general and administrative costs.  These costs
declined $87,100 from $756,700 in 2008 primarily due to lower patient
volume.
  Goodwill
impairment charges
  During
the fiscal year 2009, we conducted a goodwill impairment test and determined
that all of the goodwill related to the NTC acquisition was impaired.
Accordingly, we recorded a goodwill impairment charge of $320,200 for the year
ended September 30, 2009.
  Other income
(expense)
  Year Ended
                        September
      30,
                        2009
                      
                      
                      Year Ended
                        September
      30,
                        2008
                      
                      
                      Percent
                        ChangeLaboratory Information
      Services (Expense), net
                      
                      $
                      (1,822,700
                      )
                      
                      $
                      104,600
                      
                      
                      
                      *Clinical
      Services (Expense)
                      
                      
                      (200
                      )
                      
                      
                      (600
                      )
                      
                      
                      33
                      %Total
      interest income (expense)
                      
                      $
                      (1,822,900
                      )
                      
                      $
                      104,000
                      
                      
                      
                      **not meaningful
  With respect to our LaboratoryInformationServices business, we incurred a $90,000
financing fee in connection with the bridge note issued to Mr. Pappajohn on June
12, 2009, $20,900 in interest expenses on the bridge notes issued to Mr. Brandt
and Sail Venture Partners.  Additionally, $1,058,000 of expenses
associated with the valuation of bridge warrants and $642,000 associated with
the value of the beneficial conversion feature of the bridge notes were written
off to interest expense upon conversion of the bridge
notes.  Furthermore, $13,300 of interest expense was incurred on
long-term debt issued in connection with our acquisition of
NTC.  These expenses were offset by interest income of $9,500 for the
fiscal year ended September 30, 2009 from interest bearing
accounts.  For the fiscal year ended September 30, 2008, interest
income of $127,000 was earned on cash in interest bearing accounts. This was
offset by $22,000 of interest expense on long term debt.
  52
  Net Loss
  Year Ended
                        September
      30,
                        2009
                      
                      
                      Year Ended
                        September
      30,
                        2008
                      
                      
                      Percent
                        ChangeLaboratory
      Information Services net loss
                      
                      $
                      (8,451,300
                      )
                      
                      $
                      (5,166,200
                      )
                      
                      
                      64
                      %Clinical
      Services net loss
                      
                      
                      (70,900
                      )
                      
                      
                      (205,300
                      )
                      
                      
                      (35
                      )%Total
      Net Loss
                      
                      $
                      (8,522,200
                      )
                      
                      $
                      (5,371,500
                      )
                      
                      
                      59
                      %
 
  The increase in net loss for Laboratory Information Services of
$3.28 million for the year ended September 30, 2009 is due primarily to charges
associated with our bridge note financings of $1.83 million, including the
discount on bridge notes and the value of the beneficial conversion
features of the notes; and a $1.17 million increase in legal fees primarily
relating to costs incurred in defending against lawsuits brought by our former
CEO and Chairman of the Board, Leonard Brandt. The impairment write down of
goodwill associated with our acquisition of NTC added a further $320,200 to the
loss.
  The
decrease in the net loss for Clinical Services of $134,400 for the year ended
September 30, 2009 is primarily due to reduced marketing expenses and reduced
general and administrative expenses.
  We expect
to incur a net loss in fiscal 2010 as we continue improving our rEEG technology
and focus on the commercialization of our products.
  Liquidity and Capital
Resources
  Since our inception, we have incurred significant losses and, as of
September 30, 2009, we had an accumulated deficit of approximately $25.2
million. We have not yet achieved profitability and anticipate that we will
continue to incur net losses for the next year. We expect that our research and
development, selling and marketing and general and administrative expenses will
continue to grow and, as a result, we will need to generate significant product
revenues to achieve profitability. We may never achieve
profitability.
  As of September 30, 2009 we had approximately $0.99 million in cash
and cash equivalents and a working capital deficit of approximately$1.1 millioncompared to approximately $2.0
million in cash and cash equivalents and a working capital balance of
approximately$0.83 millionat September
30, 2008.
  Upon
closing of the second tranche of our private placement on December 24, 2009, we
raised a further $2.65 million net of closing costs.
  Sources of
Liquidity
  Since our inception substantially all of our operations have been
financed primarily from equity and debt financings.  Through September
30, 2009, we had received proceeds of $10.6 million from the sale of stock, $4.8
million from the issuance of convertible promissory notes and $220,000 from the
issuance of common stock to employees in connection with expenses paid by such
employees on behalf of the company.
  53
  Cash Flows
  Net cash used in operating activities was $4.6 million for the
fiscal year ended September 30, 2009 compared to $3.7 million for fiscal year
ended September 30, 2008.  The increase in cash used of $0.9 million
was primarily attributable to increased legal fees associated with the Brandt
litigation, our private placement and bridge financings, investigation of FDA
licensure issues and the filing of patent applications.
  Net cash
used in investing activities was $2,000 for the purchase of office equipment for
the fiscal year ended September 30, 2009 as compared to $74,600 for the fiscal
year ended September 30, 2008.  Our 2008 investing activities related
to the acquisition of the Neuro-Therapy Clinic and the purchase of furniture and
equipment for our office located in Costa Mesa, California.
  Net cash
proceeds from financing activities for the fiscal year ended September 30, 2009
were $1.8 million, net of offering costs, raised on August 26, 2009 in
connection with the first closing of our private placement transaction; $1.7
million raised in bridge financing transactions (which ultimately converted into
equity as further described under Item 5), and $295,500 due to the exercise of
options and warrants.  These proceeds were partly offset by the
repayment of a convertible promissory note, with accrued interest, totaling
$92,600 and the repayment of $86,700 on a promissory note issued to Daniel
Hoffman in connection with our acquisition of NTC.  Net cash used by
financing activities in 2008 primarily related to the payment of $60,600 on a
promissory note in connection with our NTC acquisition.
  Contractual Obligations and
Commercial Commitments
  As of September 30, 2009, we have a contractual obligation to pay
the remaining balance on a promissory note of $118,600 issued in connection with
our acquisition of NTC, which bears interest at a rate of 8% per
annum.  As our leases are expiring within the next few months (or have
expired in the case of the lease for our head office location), contractual
obligations associated with our leases are immaterial.  As of
September 30, 2008, the balance outstanding on the aforementioned promissory
note was $225,000 and our obligations for leased space were
$129,800.  Please see Note 10 to our Consolidated Financial Statements
included elsewhere in this report for further details.
  Operating Capital and Capital
Expenditure Requirements
  We expect to continue to incur operating losses in the future and
to make capital expenditures to expand our research and development programs
(including upgrading our CNS Database) and to scale up our commercial operations
and marketing efforts. We expect that our existing cash will be used to fund
working capital and for capital expenditures and other general corporate
purposes, including the repayment of debt incurred as a result of our litigation
with Brandt.Although we recently received net
proceeds of $2.65 million on December 24, 2009 upon the second closing
of our private placement, we anticipate that our cash on hand (including the
proceeds received from the second closing) and cash generated through our
operations will not be sufficient to fund our operations for at least the next
12 months.  We therefore anticipate raising additional funds in the
future.
  The
amount of capital we will need to conduct our operations and the time at which
we will require such capital may vary significantly depending upon a number of
factors, such as:
  54
  ·
              the
      amount and timing of costs we incur in connection with our research and
      product development activities, including enhancements to our CNS Database
      and costs we incur to further validate the efficacy of our rEEG
      technology;
  ·
              the
      amount and timing of costs we incur in connection with the expansion of
      our commercial operations, including our selling and marketing
      efforts;
  ·
              whether
      we incur additional legal fees in our litigation with Brandt in relation
      to his pending counterclaims in the United States District Court or any
      appeals that he may bring in Delaware;
and
  ·
              if
      we expand our business by acquiring or investing in complimentary
      businesses.
  Until we can generate a sufficient amount of revenues to finance
our cash requirements, which we may never do, we expect to finance future cash
needs primarily through public or private equity offerings, debt financings,
borrowings or strategic collaborations. The issuance of equity securities may
result in dilution to stockholders. We do not know whether additional funding
will be available on acceptable terms, or at all, especially given the economic
conditions that currently prevail. If we are not able to secure additional
funding when needed, we may have to delay, reduce the scope of or eliminate one
or more research and development programs or selling and marketing initiatives,
and implement other cost saving measures.
  Income
Taxes
  Since inception, we have incurred operating losses and,
accordingly, have not recorded a provision for federal income taxes for any
periods presented.  As of September 30, 2009, we had net operating
loss carryforwards for federal income tax purposes of $20.8 million. If not
utilized, the federal net operating loss carryforwards will expire beginning in
2028. Utilization of net operating loss and credit carryforwards may be subject
to a substantial annual limitation due to restrictions contained in the Internal
Revenue Code that are applicable if we experience an “ownership change”. The
annual limitation may result in the expiration of our net operating loss and tax
credit carryforwards before they can be used.
  Off-Balance Sheet
Arrangements
  We have no off-balance sheet arrangements or financing activities
with special purpose entities.
  ITEM
7A. Quantitative and Qualitative Disclosures about Market
Risk.
  Not applicable.
  55
 
 ITEM
8. Financial Statements and Supplementary Data
  
 Index to financial statements
 PageReport
      of Independent Registered Public Accounting Firm
                                    
                                    57Consolidated
      Balance Sheets as of September 30, 2009 and 2008
                                    
                                    58Consolidated
      Statements of Operations for the Years Ended September 30, 2009 and
      2008
                                    
                                    59Consolidated
      Statements of Changes in Stockholders’ Equity (Deficit) for the Years
      Ended September 30, 2009 and 2008
                                    
                                    60Consolidated
      Statements of Cash Flows for the Years Ended September 30, 2009 and
      2008
                                    
                                    61Notes
      to Consolidated Financial Statements for the Years
      Ended  September 30, 2009 and 2008
                                    
                                    62
  56
  REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
  To the
Board of Directors
 CNS
Response, Inc.
 2755
Bristol St., Suite 285
 Costa
Mesa, CA 92626
 
 We have
audited the accompanying consolidated balance sheets of CNS Response, Inc. (the
“Company”) and its subsidiaries as of September 30, 2009 and 2008, and the
related consolidated statements of operations, changes in stockholders’ equity
(deficit), and cash flows for each of the years in the two-year period ended
September 30, 2009. CNS Response, Inc.’s management is responsible for these
financial statements. Our responsibility is to express an opinion on these
financial statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the company’s internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as of September
30, 2009 and 2008, and the results of its operations and its cash flows for each
of the years in the two-year period ended September 30, 2009 in conformity with
accounting principles generally accepted in the United States of
America.
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 1
to the consolidated financial statements, the Company’s continued operating
losses and limited capital raise substantial doubt about its ability to continue
as a going concern.  Management’s plans in regard to this matter are
also described in Note 1.  The accompanying consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
 
 /s/
Cacciamatta Accountancy Corporation
 
 Santa
Ana, California
 December
29, 2009
  57
  CNS
RESPONSE, INC.
  CONSOLIDATED
BALANCE SHEETS AT SEPTEMBER 30, 2009 and 2008
 
 As
      at September 30,2009
                      
                      
                      2008ASSETSCURRENT
      ASSETS:Cash
                      
                      $
                      988,100
                      
                      
                      $
                      1,997,000Accounts
      receivable (net of allowance for doubtful accounts of $11,700 and $17,200
      in 2009 and 2008 respectively)
                      
                      
                      61,700
                      
                      
                      
                      98,200Prepaids
      and other
                      
                      
                      89,500
                      
                      
                      
                      189,400Total
      current assets
                      
                      
                      1,139,300
                      
                      
                      
                      2,284,600Other
      Assets
                      
                      
                      21,600
                      
                      
                      
                      28,700Goodwill
                      
                      
                      -
                      
                      
                      
                      320,200TOTAL
      ASSETS
                      
                      $
                      1,160,900
                      
                      
                      $
                      2,633,500LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIES:Accounts
      payable (including $7,000 and $6,800 to related parties in 2009 and 2008
      respectively)
                      
                      $
                      1,285,600
                      
                      
                      $
                      335,700Accrued
      liabilities
                      
                      
                      261,400
                      
                      
                      
                      207,500Deferred
      compensation (including $81,200 and $107,000 to related parties in
      2009 and  2008 respectively)
                      
                      
                      220,100
                      
                      
                      
                      264,900Accrued
      patient costs
                      
                      
                      305,500
                      
                      
                      
                      397,500Accrued
      consulting fees (including $18,000 and $0 to related parties in 2009 and
      2008, respectively)
                      
                      
                      72,100
                      
                      
                      
                      67,600Accrued
      interest
                      
                      
                      -
                      
                      
                      
                      42,600Convertible
      promissory notes
                      
                      
                      -
                      
                      
                      
                      50,000Current
      portion of long-term debt
                      
                      
                      95,900
                      
                      
                      
                      88,500Total
      current liabilities
                      
                      
                      2,240,600
                      
                      
                      
                      1,454,300LONG-TERM
      LIABILITIESNote
      payable to officer
                      
                      
                      24,800
                      
                      
                      
                      118,600Capital
      lease
                      
                      
                      5,600
                      
                      
                      
                      7,700Total
      long-term liabilities
                      
                      
                      30,400
                      
                      
                      
                      126,300TOTAL
      LIABILITIES
                      
                      
                      2,271,000
                      
                      
                      
                      1,580,600COMMITMENTS
      AND CONTINGENCIES
                      
                      
                      -
                      
                      
                      
                      -STOCKHOLDERS'
      EQUITY:Common
      stock, $0.001 par value; authorized 750,000,000 shares; 41,781,129
      and 25,299,547 shares outstanding as of September 30, 2009 and
      2008
                      
                      
                      41,800
                      
                      
                      
                      25,300Additional
      paid-in capital
                      
                      
                      24,044,000
                      
                      
                      
                      17,701,300Accumulated
      deficit
                      
                      
                      (25,195,900
                      )
                      
                      
                      (16,673,700
                      )Total
      stockholders' equity
                      
                      
                      (1,110,100
                      )
                      
                      
                      1,052,900TOTAL
      LIABILITIES AND STOCKHOLDERS'EQUITY
                      
                      $
                      1,160,900
                      
                      
                      $
                      2,633,500
 
 See
accompanying Notes to Consolidated Financial Statements
  58
  CNS
RESPONSE, INC.
 
 CONSOLIDATED
STATEMENTS OF OPERATIONS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
 
 YEARS
      ENDED
                            SEPTEMBER
      30,2009
                          
                          
                          2008REVENUESLaboratory
      Information Services
                          
                          
                          120,400
                          
                          
                          
                          178,500Clinical
      Services
                          
                          
                          579,700
                          
                          
                          
                          595,000$
                          700,100
                          
                          
                          $
                          773,500OPERATING
      EXPENSES:Cost
      of Laboratory Service revenues
                          
                          
                          131,600
                          
                          
                          
                          163,200Research
      and development
                          
                          
                          2,137,200
                          
                          
                          
                          2,097,300Sales
      and marketing
                          
                          
                          915,800
                          
                          
                          
                          881,400General
      and administrative
                          
                          
                          3,887,400
                          
                          
                          
                          3,105,700Goodwill
      impairment charges
                          
                          
                          320,200
                          
                          
                          
                          -Total
      operating expenses
                          
                          
                          7,392,200
                          
                          
                          
                          6,247,600OPERATING
      LOSS
                          
                          
                          (6,692,100
                          )
                          
                          
                          (5,474,100
                          )OTHER
      INCOME (EXPENSE):Interest
      income (expense), net
                          
                          
                          (1,732,900
                          )
                          
                          
                          104,000Financing
      premium
                          
                          
                          (90,000
                          )
                          
                          
                          -Total
      other income (expense)
                          
                          
                          (1,822,900
                          )
                          
                          
                          104,000LOSS
      BEFORE PROVISION FOR INCOME TAXES
                          
                          
                          (8,515,000
                          )
                          
                          
                          (5,370,100
                          )PROVISION
      FOR INCOME TAXES
                          
                          
                          7,200
                          
                          
                          
                          1,400NET
      LOSS
                          
                          $
                          (8,522,200
                          )
                          
                          $
                          (5,371,500
                          )BASIC
      NET LOSS PER SHARE
                          
                          $
                          (0.31
                          )
                          
                          $
                          (0.21
                          )DILUTED
      NET LOSS PER SHARE
                          
                          $
                          (0.31
                          )
                          
                          $
                          (0.21
                          )WEIGHTED
      AVERAGE SHARES OUTSTANDING:Basic
                          
                          
                          27,778,171
                          
                          
                          
                          25,299,547Diluted
                          
                          
                          27,778,171
                          
                          
                          
                          25,299,547
  See
accompanying Notes to Consolidated Financial Statements
  59


CNS
RESPONSE, INC.
  CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) FOR THE YEARS ENDED SEPTEMBER
30, 2009 AND 2008
  AdditionalCommon Stock
                      
                      
                      Paid-in
                      
                      
                      AccumulatedShares
                      
                      
                      Amount
                      
                      
                      Capital
                      
                      
                      Deficit
                      
                      
                      TotalBalance
      at October 1, 2007
                      
                      
                      25,299,547
                      
                      
                      $
                      25,300
                      
                      
                      $
                      16,630,000
                      
                      
                      $
                      (11,302,200
                      )
                      
                      $
                      5,353,100Stock-
      based compensation
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,071,300
                      
                      
                      
                      -
                      
                      
                      
                      1,071,300Net
      loss for the year ended September 30, 2008
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (5,371,500
                      )
                      
                      
                      (5,371,500
                      )Balance
      at September 30, 2008
                      
                      
                      25,299,547
                      
                      
                      $
                      25,300
                      
                      
                      $
                      17,701,300
                      
                      
                      $
                      (16,673,700
                      )
                      
                      $
                      1,052,900Stock-
      based compensation
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      850,500
                      
                      
                      
                      -
                      
                      
                      
                      850,500Issuance
      of 3,433,333 bridge warrants
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,058,000
                      
                      
                      
                      -
                      
                      
                      
                      1,058,000Exercise
      of 1,498,986 $0.01 warrants
                      
                      
                      1,498,986
                      
                      
                      
                      1,500
                      
                      
                      
                      13,500
                      
                      
                      
                      -
                      
                      
                      
                      15,000Exercise
      of 2,124,740 $0.132 options
                      
                      
                      2,124,740
                      
                      
                      
                      2,100
                      
                      
                      
                      278,400
                      
                      
                      
                      -
                      
                      
                      
                      280,500Issuance
      of stock in connection with the Maxim PIPE net of offering costs of
      $250,700
                      
                      
                      6,810,002
                      
                      
                      
                      6,800
                      
                      
                      
                      1,785,500
                      
                      
                      
                      -
                      
                      
                      
                      1,792,300Value
      of beneficial conversion feature of bridge notes
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      642,000
                      
                      
                      
                      -
                      
                      
                      
                      642,000Issuance
      of stock on conversion $1,720,900 of bridge notes and accrued
      interest
                      
                      
                      6,047,854
                      
                      
                      
                      6,100
                      
                      
                      
                      1,714,800
                      
                      
                      
                      -
                      
                      
                      
                      1,720,900Warrants
      issued in association with the Maxim PIPE
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,607,000
                      
                      
                      
                      -
                      
                      
                      
                      1,607,000Offering
      cost pertaining to the Maxim PIPE
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (1,607,000
                      )
                      
                      
                      -
                      
                      
                      
                      (1,607,000
                      )Net
      loss for the year ended September 30, 2009
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      
                      
                      
                      
                      (8,522,200
                      )
                      
                      
                      (8,522,200
                      )Balance
      at September 30, 2009
                      
                      
                      41,781,129
                      
                      
                      $
                      41,800
                      
                      
                      $
                      24,044,000
                      
                      
                      $
                      (25,195,900
                      )
                      
                      $
                      (1,110,100
                      )
  See
accompanying Notes to Consolidated Financial Statements
  60
  CNS
RESPONSE, INC.
  CONSOLIDATED
STATEMENTS OF CASH FLOWS FOR YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
 
 YEAR ENDED SEPTEMBER 30,2009
                                  
                                  
                                  2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                                  
                                  $
                                  (8,522,200
                                  )
                                  
                                  $
                                  (5,371,500
                                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      & amortization
                                  
                                  
                                  9,100
                                  
                                  
                                  
                                  6,300Discount
      on bridge notes issued
                                  
                                  
                                  1,058,000
                                  
                                  
                                  
                                  -Value
      of beneficial conversion feature of bridge notes
                                  
                                  
                                  642,000
                                  
                                  
                                  
                                  -Stock
      based compensation
                                  
                                  
                                  850,500
                                  
                                  
                                  
                                  1,071,300Non-cash
      interest expense
                                  
                                  
                                  20,900
                                  
                                  
                                  
                                  -Goodwill
      impairment
                                  
                                  
                                  320,200
                                  
                                  
                                  
                                  -Write-off
      of doubtful accounts
                                  
                                  
                                  22,700
                                  
                                  
                                  
                                  -Changes
      in operating assets and liabilities:Accounts
      receivable
                                  
                                  
                                  13,800
                                  
                                  
                                  
                                  (39,000
                                  )Prepaids
      and other
                                  
                                  
                                  99,900
                                  
                                  
                                  
                                  (30,400
                                  )Accounts
      payable and accrued liabilities
                                  
                                  
                                  1,003,800
                                  
                                  
                                  
                                  116,300Deferred
      compensation and others
                                  
                                  
                                  (40,300
                                  )
                                  
                                  
                                  192,600Accrued
      patient costs
                                  
                                  
                                  (92,000
                                  )
                                  
                                  
                                  397,500Net
      cash used in operating activities
                                  
                                  
                                  (4,613,600
                                  )
                                  
                                  
                                  (3,656,900
                                  )CASH
      FLOWS FROM INVESTING ACTIVITIES:Deferred
      offering relating to acquisition
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (43,700
                                  )Furniture
      & Fixtures
                                  
                                  
                                  (2,000
                                  )
                                  
                                  
                                  (30,900
                                  )Net
      cash used in investing activities
                                  
                                  
                                  (2,000
                                  )
                                  
                                  
                                  (74,600
                                  )CASH
      FLOWS FROM FINANCING ACTIVITIES:Repayment
      of  convertible debt with accrued interest
                                  
                                  
                                  (92,600
                                  )
                                  
                                  
                                  -Repayment
      of  debt
                                  
                                  
                                  (86,700
                                  )
                                  
                                  
                                  (60,600
                                  )Repayment
      of lease payable
                                  
                                  
                                  (1,800
                                  )
                                  
                                  
                                  (1,000
                                  )Proceeds
      from the sale of common stock, net of offering costs
                                  
                                  
                                  1,792,300
                                  
                                  
                                  
                                  -Proceeds
      from bridge notes
                                  
                                  
                                  1,700,000
                                  
                                  
                                  
                                  -Proceeds
      from exercise of warrants and options
                                  
                                  
                                  295,500
                                  
                                  
                                  
                                  -Net
      cash provided (used) by financing activities
                                  
                                  
                                  3,606,700
                                  
                                  
                                  
                                  (61,600
                                  )NET
      INCREASE (DECREASE) IN CASH
                                  
                                  
                                  (1,008,900
                                  )
                                  
                                  
                                  (3,793,100
                                  )CASH-
      BEGINNING OF YEAR
                                  
                                  
                                  1,997,000
                                  
                                  
                                  
                                  5,790,100CASH-
      END OF YEAR
                                  
                                  $
                                  988,100
                                  
                                  
                                  $
                                  1,997,000SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Cash  paid
      during the period for:Interest
                                  
                                  $
                                  64,100
                                  
                                  
                                  $
                                  22,440Income
      taxes
                                  
                                  $
                                  7,200
                                  
                                  
                                  $
                                  5,972Fair
      value of note payable to officer issued for acquisition
                                  
                                  $
                                  118,600
                                  
                                  
                                  $
                                  265,900Fair
      value of equipment acquired through lease
                                  
                                  $
                                  7,600
                                  
                                  
                                  $
                                  10,500Conversion
      of bridge notes and related accrued interest into common
    stock
                                  
                                  $
                                  1,720,900
                                  
                                  
                                  $
                                  -
  See
accompanying Notes to Consolidated Financial Statements
  61
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  1.
              NATURE
      OF OPERATIONS
  Organization
and Nature of Operations
  CNS
Response, Inc. (the “Company”) was incorporated in Delaware on July 10, 1984.
The Company utilizes a patented system that guides psychiatrists and other
physicians to determine a proper treatment for patients with mental, behavioral
and/or addictive disorders.  The Company also intends to identify,
develop and commercialize new indications of approved drugs and drug candidates
for this patient population.
  In
addition, as a result of its acquisition of Neuro-Therapy Clinic, Inc. (“NTC”)
on January 15, 2008, the Company provides behavioral health care
services.  NTC is a center for highly-advanced testing and treatment
of neuropsychiatric problems, including learning, attentional and behavioral
challenges, mild head injuries, as well as depression, anxiety, bipolar and all
other common psychiatric disorders. Through this acquisition, the Company
expects to advance neurophysiology data collection, beta-test planned
technological advances in rEEG, advance physician training in rEEG and
investigate practice development strategies associated with
rEEG.
  Going
Concern Uncertainty
  The
Company has a limited operating history and its operations are subject to
certain problems, expenses, difficulties, delays, complications, risks and
uncertainties frequently encountered in the operation of a new business. These
risks include the failure to develop or supply technology or services to meet
the demands of the marketplace, the ability to obtain adequate financing on a
timely basis, the failure to attract and retain qualified personnel, competition
within the industry, government regulation and the general strength of regional
and national economies.
  To date,
the Company has financed its cash requirements primarily from debt and equity
financings.  It will be necessary for the Company to raise additional
funds.  The Company’s liquidity and capital requirements depend on
several factors, including the rate of market acceptance of its services, the
future profitability of the Company, the rate of growth of the Company’s
business and other factors described elsewhere in this Annual
Report.  The Company is currently exploring additional sources of
capital but there can be no assurances that any financing arrangement will be
available in amounts and terms acceptable to the Company.
  2.
              CONVERTIBLE
      DEBT AND EQUITY FINANCINGS
  Prior to
September 30, 2006, CNS California issued convertible promissory notes with
detachable warrants from time to time to fund its operations.  The
notes bear interest at 8% per year, compounded annually, and are payable on
demand.  The terms of the notes provide for the (i) conversion of
principal and accrued interest into the same type of securities issued by CNS
California upon a qualified institutional financing, the amount of which
financing varies between notes and ranges from $1 to $4 million, and (ii)
conversion price to be equal to the same price as the shares sold in the
financing.  The notes provide for an aggregate of $2,196,000 in
principal to convert automatically and $920,700 to convert at the note holders’
options based upon certain financing requirements (as defined).
  62
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
 
 In
October 2006, CNS California and the note holders of certain convertible
promissory notes converted notes with an aggregate outstanding balance of
$3,061,700 and related accrued and unpaid interest of $1,005,300 at September
30, 2006 into 5,993,515 shares of CNS California Series A Preferred
Stock.  In addition, the exercise price of warrants to purchase
1,062,116 shares of the CNS California common stock issued to such note holders
was changed to $0.59 per share.  Upon completion of the reverse merger
pursuant to which CNS California became a subsidiary of the Company, the
preferred shares were converted into 5,993,515 shares of the Company’s
common stock and the warrants were converted into warrants to purchase 1,062,116
shares of the Company’s common stock at an exercise price of $0.59 per
share.  The consolidated financial statements of the Company presented
reflect the issuance of these shares as common stock.
  As of
September 30, 2008, one note issued by CNS California with a principal
balance of $49,950 was outstanding. In May 2009, the Company entered into a
settlement and release agreement with this note holder and fully repaid the
promissory note with accrued interest on June 30, 2009.
  Between
March 30 and June 12, 2009 the Company entered into three rounds of bridge
financings in the form of secured convertible promissory notes.  These
three rounds are referred to as:
 
 (a)
              the
      March 30, 2009 SAIL/Brandt Notes
 (b)
              the
      May 14, 2009 SAIL Note
 (c)
              the
      June 12, 2009 Pappajohn Note
 
 All these
notes were converted to equity as a result of the private placement transaction
that closed on August 26, 2009 and are fully described in the section
below.
 
 The
Private Placement Transaction
  On August 26, 2009, CNS Response, Inc.
(the “Company”) received gross proceeds of approximately $2,043,000 in a private
placement transaction (the “Private Placement”) with six
investors.  Pursuant to Subscription Agreements entered into with the
investors, the Company sold approximately 38 Investment Units at $54,000 per
Investment Unit.  Each “Investment Unit” consists of 180,000 shares of
the Company’s common stock and a five year non-callable warrant to purchase
90,000 shares of the Company’s common stock at an exercise price of $0.30 per
share.  After commissions and expenses, the Company received net
proceeds of approximately $1,792,300 in the Private Placement.  These
funds were used to repay outstanding liabilities, fund the Company’s recent
clinical trial and for general working capital purposes.
 
 A FINRA member firm, the Maxim Group
LLC (“Maxim Group”), acted as lead placement agent in connection with the
Private Placement.  For its services in connection with the first
closing of the offering, Maxim Group received (i) a cash fee of $ 55,980, (ii) a
cash expense allowance of $40,860, and (iii) a five year non-callable warrant to
purchase 274,867 shares of the Company’s common stock at an exercise price of
$0.33 per share, first exercisable no earlier than February 26,
2010.
 
 Pursuant to a Registration Rights
agreement entered into with each investor, the Company agreed to file a
registration statement covering the resale of the common stock and the common
stock underlying the warrants sold in the Private Placement, as well as the
common stock underlying the warrants issued to Maxim Group by the later of
October 26, 2009 or the 20th calendar day after the termination of the
offering.  The Registration Rights agreement was subsequently amended
to permit the filing of the registration statement no later that 10
business days following the Company’s filing of its Annual Report on Form 10-K
for its September 30, 2009 year end, or the 20th
calendar day after termination of the private offering.
  63
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
 
 In
addition, the Company agreed to use its best efforts to have the registration
statement declared effective no later than 180 days following the final closing
of the offering and maintain such effectiveness until the earlier of the second
anniversary of the date of such effectiveness or the date that all of the
securities covered by the registration statement may be sold without
restriction.
 
 Events
Relating to Private Placement Transaction
 
 (a)
              Conversion
      of the March 30, 2009 SAIL/Brandt
Notes
 
 On March
30, 2009, the Company entered into two Senior Secured Convertible Promissory
Notes, each in the principal amount of $250,000 (each a “March Note” and,
collectively, the “March Notes”), with Brandt Ventures, GP (“Brandt”) and SAIL
Venture Partners, LP (“SAIL”). Leonard Brandt, a former member of the Company’s
board of directors, is the general partner of Brandt and David B. Jones, a
current member of the Company’s board of directors, is a managing member of Sail
Venture Partners, LLC, which is the general partner of SAIL. The terms of the
March Notes provided that in the event the Company consummates an equity
financing transaction of at least $1,500,000 (excluding any and all other debt
that is converted), then the principal and all accrued, but unpaid interest
outstanding under the notes shall be automatically converted into the securities
issued in the equity financing by dividing such amount by 90% of the per share
price paid by the investors in such financing.  In accordance with the
terms of the March Notes, at the closing of the Private Placement, the Company
issued to each of Brandt and SAIL 956,164 shares of common stock and a five year
non-callable warrant to purchase 478,082 shares of its common stock at an
exercise price of $0.30 per share.
 
 (b)
              Conversion
      of the May 14, 2009 SAIL Note
 
 On May 14, 2009, the Company entered
into a Bridge Note and Warrant Purchase Agreement (the “SAIL Purchase
Agreement”) with SAIL. Pursuant to the SAIL Purchase Agreement, on May 14, 2009
SAIL purchased a Secured Promissory Note in the principal amount of $200,000
from the Company (the “May SAIL Note”).  In order to induce SAIL to
purchase the note, the Company issued to SAIL a warrant to purchase up to
100,000 shares of the Company’s common stock at a purchase price equal to $0.25
per share.  The warrant expires on May 31, 2016.
 
 The terms
of the May SAIL Note provided that in the event the Company consummates an
equity financing transaction of at least $1,500,000 (excluding any and all other
debt that is converted), then the principal and all accrued, but unpaid interest
outstanding under the note shall be automatically converted into the securities
issued in the equity financing by dividing such amount by 85% of the per share
price paid by the investors in such financing.  In accordance with the
terms of the May SAIL Note, at the first closing of the Private Placement on
August 26, 2009, the Company issued to SAIL 802,192 shares of its common stock
and a five year non-callable warrant to purchase 401,096 shares of its common
stock at an exercise price of $0.30 per share.
  64
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
 
 (c)
              Conversion of
      the June 12, 2009 Pappajohn Note
 
 On June
12, 2009, John Pappajohn entered into a Bridge Note and Warrant Purchase
Agreement (the “Pappajohn Purchase Agreement”) with the
Company.  Pursuant to the Pappajohn Purchase Agreement, Mr. Pappajohn
purchased a Secured Convertible Promissory Note in the principal amount of
$1,000,000 from the Company.  In order to induce Mr. Pappajohn to
purchase the note, the Company issued to Mr. Pappajohn a warrant to
purchase up to 3,333,333 shares of the Company’s common stock at a purchase
price equal to $0.30 per share.  The warrant expires on June 30,
2016.
  The note
issued pursuant to the Pappajohn Purchase Agreement provided that the principal
amount of $1,000,000 together with a single payment of $90,000 (the “Premium
Payment”) would be due and payable, unless sooner converted into shares of the
Company’s common stock (as described below), upon the earlier to occur of: (i) a
declaration by Mr. Pappajohn on or after June 30, 2010 or (ii) an Event of
Default (as defined in the note).  The note was secured by a lien on
substantially all of the assets (including all intellectual property) of the
Company.  In the event of a liquidation, dissolution or winding
up of the Company, unless Mr. Pappajohn informed the Company otherwise, the
Company was required to pay Mr. Pappajohn an amount equal to the product of 250%
multiplied by the then outstanding principal amount of the note and the Premium
Payment.
  The
Pappajohn Purchase Agreement also provided that in the event the Company
consummated an equity financing transaction of at least $1,500,000 (excluding
any and all other debt that is converted), the then outstanding principal amount
of the note (but excluding the Premium Payment, which would be repaid in cash at
the time of such equity financing) would be automatically converted into the
securities issued in the equity financing by dividing such amount by the per
share price paid by the investors in such financing.  The note also
provided that the securities issued upon conversion of the note would be
otherwise issued on the same terms as such shares are issued to the lead
investor that purchases shares of the Company in the qualified
financing.
  On August
26, 2009, at the closing of the Private Placement, the Company paid the Premium
Payment to Mr. Pappajohn, and the outstanding principal amount of Mr.
Pappajohn’s note ($1,000,000 as of August 26, 2009) converted into 3,333,334
shares of the Company’s common stock. In addition, in accordance with the terms
of his note, Mr. Pappajohn was issued a five year non-callable warrant to
purchase 1,666,667 shares of the Company’s common stock at an exercise price of
$0.30 per share.
 
 Upon the
abovementioned conversions, the Company evaluated the terms and calculated the
fair value of the common stocks (by using the close market price at the
respective original issuance date of the convertible notes) and warrants (by
running the Black-Scholes Model) issued upon the conversions and so determined
that the notes were converted with a beneficial conversion feature amounting to
$642,000. As a result, for the year ended September 30, 2009, the Company
recorded $642,000 as interest expense.
 
 3.
              SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES
  Basis
of Consolidation
  The
consolidated financial statements include the accounts of CNS Response, Inc., an
inactive parent company, and its wholly owned subsidiaries CNS California and
NTC.  All significant intercompany transactions have been eliminated
in consolidation.
  65
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  Use
of Estimates
  The
preparation of the consolidated financial statements requires management to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenue and expense, and related disclosure of contingent assets and
liabilities. On an ongoing basis, the Company evaluates its estimates, including
those related to revenue recognition, doubtful accounts, intangible assets,
income taxes, valuation of equity instruments, contingencies and litigation. The
Company bases its estimates on historical experience and on various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ materially from these estimates.
  Cash
  The
Company deposits its cash with major financial institutions and may at times
exceed federally insured limit of $250,000.  At September 30, 2009
cash exceeded the federally insured limit by $819,600. The Company believes that
the risk of loss is minimal. To date, the Company has not experienced any losses
related to cash deposits with financial institutions.
  Fair
Value of Financial Instruments
  ASC
825-10 (formerly SFAS 107, “Disclosures about Fair Value of Financial
Instruments”) defines financial instruments and requires disclosure of the fair
value of financial instruments held by the Company. The Company considers the
carrying amount of cash, accounts receivable, other receivables, accounts
payable and accrued liabilities, to approximate their fair values because of the
short period of time between the origination of such instruments and their
expected realization.
 
 The
Company also analyzes all financial instruments with features of both
liabilities and equity under ASC 480-10 (formerly SFAS 150, “Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and
Equity”), ASC 815-10 (formerly SFAS No 133, “Accounting for Derivative
Instruments and Hedging Activities”) and ASC 815-40 (formerly EITF 00-19,
“Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company’s Own Stock”).
 
 The
Company adopted ASC 820-10 (formerly SFAS 157, “Fair Value Measurements”) on
January 1, 2008. ASC 820-10 defines fair value, establishes a three-level
valuation hierarchy for disclosures of fair value measurement and enhances
disclosure requirements for fair value measures. The three levels are defined as
follow:
 
 ·
              Level
      1   inputs to the valuation methodology are quoted prices
      (unadjusted) for identical assets or liabilities in  active
      markets.
 
 ·
              Level
      2   inputs to the valuation methodology include quoted
      prices for similar assets and liabilities in active markets, and inputs
      that are observable for the assets or liability, either directly or
      indirectly, for substantially the full term of the financial
      instruments.
 
 ·
              Level
      3   inputs to the valuation methodology are unobservable
      and significant to the fair value.
 
 As of
September 30, 2009 the Company did not identify any assets or liabilities that
are required to be presented on the balance sheet at fair value in accordance
with ASC 820-10.
  66
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  Accounts
Receivable
  The
Company estimates the collectability of customer receivables on an ongoing basis
by reviewing past-due invoices and assessing the current creditworthiness of
each customer.  Allowances are provided for specific receivables
deemed to be at risk for collection.
  Fixed
Assets
  Fixed assets, which are recorded at
cost, consist of office furniture and equipment and are depreciated over their
estimated useful life on a straight-line basis.  The useful life of
these assets is estimated to be from 3 to 5 years.  Depreciation and
accumulated depreciation for the years ended September 2009 and 2008 is $9,100
and $6,300 respectively.
  Goodwill
  In
accordance with ASC 350-20 (formerly Statement of Financial Accounting
Standards (“SFAS”)No. 142, Goodwill and Other Intangible
Assets) (“ASC
350-10”),goodwill is
not amortized but instead is measured for impairment at least annually, or
more frequently if certain indicators are present.
  The
Company measures for impairment by applying fair value-based tests at the
reporting unit level. If the fair value of the reporting unit exceeds the
carrying value of the net assets assigned to that unit, then goodwill is not
impaired and no further testing is performed. The Company, if necessary,
measures the amount of impairment by applying fair value-based tests to
individual assets and liabilities within each reporting unit. If the carrying
value of a reporting unit’s goodwill exceeds its implied fair value, the Company
records an impairment loss equal to the difference.
  To
determine the reporting unit’s fair values, the Company uses the income
approach. The income approach provides an estimate of fair value based on
discounted expected future cash flows (“DCF”). Estimates and assumptions with
respect to the determination of the fair value of the Company’s reporting units
using the income approach include the Company’s operating forecasts, revenue
growth rates and risk-commensurate discount rates.
  The
Company’s estimates of revenues and costs are based on historical data, various
internal estimates and a variety of external sources, and are developed by the
Company’s regular long-range planning process.
 
 During
the fourth quarter of fiscal year 2009, the Company conducted a goodwill
impairment test and determined that the amount of the recorded goodwill related
to the NTC acquisition was fully impaired. Accordingly, the Company
recorded a goodwill impairment charge of $320,200 for the year ended September
30, 2009.
  Long-Lived
Assets
  As
required by ASC 350-30 (formerly SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets) (“ASC 350-30”), the Company reviews the
carrying value of its long-lived assets whenever events or changes in
circumstances indicate that the historical cost-carrying value of an asset may
no longer be appropriate. The Company assesses recoverability of the carrying
value of the asset by estimating the future net cash flows expected to result
from the asset, including eventual disposition. If the future net cash flows are
less than the carrying value of the asset, an impairment loss is recorded equal
to the difference between the asset’s carrying value and fair value. No
impairment loss, apart from the abovementioned goodwill impairment, was recorded
for the years ended September 30, 2009 and 2008.
  67
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  Revenues
  The
Company recognizes revenue as the related services are delivered.
  Research
and Development Expenses
  The
Company charges all research and development expenses to operations as
incurred.
  Advertising
Expenses
  The
Company charges all advertising expenses to operations as incurred.
  Stock-Based
Compensation
  The
Company has adopted ASC 718-20 (formerly SFAS No. 123R, Share-Based Payment -revised
2004) (“ASC718-20”) and related interpretations which establish the accounting
for equity instruments exchanged for employee services. Under ASC 718-20,
share-based compensation cost is measured at the grant date based on the
calculated fair value of the award. The expense is recognized over the
employees’ requisite service period, generally the vesting period of the
award.
  Income
Taxes
  The
Company accounts for income taxes to conform to the requirements of ASC 740-20
(formerly SFAS No. 109, Accounting for Income Taxes)
(“ASC 740-20”). Under the provisions of ASC_740-20, an entity recognizes
deferred tax assets and liabilities for future tax consequences of events that
have already been recognized in the Company's financial statements or tax
returns. The measurement of deferred tax assets and liabilities is based on
provisions of the enacted tax law. The effects of future changes in tax laws or
rates are not anticipated. Valuation allowances are established when necessary
to reduce deferred tax assets to the amount expected to be
realized.
  Comprehensive
Income (Loss)
  ASC
220-10 (formerly, SFAS No. 130, Reporting Comprehensive
Income) (“ASC 220-10”), requires disclosure of all components of
comprehensive income (loss) on an annual and interim
basis.  Comprehensive income (loss) is defined as the change in equity
of a business enterprise during a period from transactions and other events and
circumstances from non-owner sources.  The Company’s comprehensive
income (loss) is the same as its reported net income (loss) for the years ended
September 30, 2009 and 2008.
  Income
(Loss) per Share
  Basic and
diluted net income (loss) per share has been computed using the weighted average
number of shares of common stock outstanding during the period.
  68
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  Segment
Information
  The
Company uses the management approach for determining which, if any, of its
products and services, locations, customers or management structures constitute
a reportable business segment. The management approach designates the internal
organization that is used by management for making operating decisions and
assessing performance as the source of any reportable segments. Management uses
two measurements of profitability and does disaggregate its business for
internal reporting and therefore operates two business segments which are
comprised of a reference laboratory and a clinic.  The Reference
Laboratory provides reports (“rEEG Reports”) that assist physicians with
treatment strategies for patients with behavioral (psychiatric and/or addictive)
disorders based on the patient’s own physiology.  The Clinic operates
NTC, a full service psychiatric practice.
  Reclassifications
  Certain
amounts in prior years have been reclassified to conform to current year
presentation.  These reclassifications had no effect on previously
reported operating loss or net income.
  Recent
Accounting Pronouncements
 
 In April
2009, the FASB issued ASC 825-10 (formerly FASB Staff Position
No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of
Financial Instruments) (“ASC 825”) , which requires that the fair value
disclosures required for all financial instruments within the scope of SFAS 107,
"Disclosures about Fair Value of Financial Instruments", be included in interim
financial statements. This FSP also requires entities to disclose the method and
significant assumptions used to estimate the fair value of financial instruments
on an interim and annual basis and to highlight any changes from prior periods.
FSP 107-1 was effective for interim periods ending after June 15, 2009, with
early adoption permitted. The adoption of FSP 107-1 did not have a material
impact on the Company’s consolidated financial statements.
  In May
2009, the FASB issued ASC 855-10 (formerly Statement No. 165, Subsequent
Events) (“ASC 855”). ASC 855 establishes general standards of accounting
for and disclosure of events that occur after the balance sheet date but before
financial statements are issued or are available to be issued. In accordance
with this Statement, entities should apply the requirements to interim or annual
financial periods ending after June 15, 2009.  The adoption of this
statement did not have a material impact on the Company’s consolidated
financial statements.
  In June
2009, the FASB approved its Accounting Standards Codification, or Codification,
as the single source of authoritative United States accounting and reporting
standards applicable for all non-governmental entities, with the exception of
the SEC and its staff. The Codification, which changes the referencing of
financial standards, is effective for interim or annual financial periods ending
after September 15, 2009. Therefore, starting from fiscal year end 2009,
all references made to US GAAP will use the new Codification numbering system
prescribed by the FASB. As the Codification is not intended to change or alter
existing US GAAP, it did not have any impact on the Company’s consolidated
financial statements.
  As a
result of the Company’s implementation of the Codification during the year ended
September 30, 2009, previous references to new accounting standards and
literature are no longer applicable. In the current annual financial statements,
the Company will provide reference to both new and old guidance to assist in
understanding the impact of recently adopted accounting literature, particularly
for guidance adopted since the beginning of the current fiscal year but prior to
the Codification.
  69
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
 
 In August
2009, the FASB issued Accounting Standards Update No. 2009-05 (ASU 2009-05),
“Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at
Fair Value.” ASU 2009-05 amends Subtopic 820-10, “Fair Value Measurements and
Disclosures – Overall,” and provides clarification for the fair value
measurement of liabilities. ASU 2009-05 is effective for the first reporting
period including interim period beginning after issuance. The Company does not
expect the adoption of ASU 2009-05 to have a material impact on its consolidated
financial statements.
  4.
              STOCKHOLDERS’
      EQUITY
  Common
and Preferred Stock
  As of
September 30, 2009 the Company is authorized to issue 750,000,000 shares of
common stock.
  As of
September 30, 2009, CNS California is authorized to issue 100,000,000 shares of
two classes of stock, 80,000,000 of which was designated as common shares and
20,000,000 of which was designated as preferred shares.
  As of
September 30, 2009, Colorado CNS Response, Inc. is authorized to issue 1,000,000
shares of common stock.
  As of
September 30, 2009, Neuro-Therapy Clinic, Inc., a wholly-owned subsidiary of
Colorado CNS Response, Inc., is authorized to issue ten thousand (10,000) shares
of common stock, no par value per share.
  Stock-Option
Plan
  On August
3, 2006, CNS California adopted the CNS California 2006 Stock Incentive Plan
(the “2006 Plan”). The 2006 Plan provides for the issuance of awards in the form
of restricted shares, stock options (which may constitute incentive stock
options(ISO) or non-statutory stock options (NSO)), stock appreciation rights
and stock unit grants to eligible employees, directors and consultants and is
administered by the board of directors. A total of 10 million shares of stock
are reserved for issuance under the 2006 Plan.  As of September 30,
2009, 2,124,740 options were exercised and there were 6,662,014 options and
183,937 restricted shares outstanding under the 2006 Plan and 1,029,309 shares
available for issuance of awards.
  The 2006
Plan provides that in any calendar year, no eligible employee or director shall
be granted an award to purchase more than 3 million shares of stock. The option
price for each share of stock subject to an option shall be (i) no less than the
fair market value of a share of stock on the date the option is granted, if the
option is an ISO, or (ii) no less than 85% of the fair market value of the stock
on the date the option is granted, if the option is a NSO; provided, however, if
the option is an ISO granted to an eligible employee who is a 10% shareholder,
the option price for each share of stock subject to such ISO shall be no less
than 110% of the fair market value of a share of stock on the date such ISO is
granted. Stock options have a maximum term of ten years from the date of grant,
except for ISOs granted to an eligible employee who is a 10% shareholder, in
which case the maximum term is five years from the date of grant. ISOs may be
granted only to eligible employees. The Company has adopted ASC 718-20
(formerly, SFAS No. 123R -revised 2004, “Share-Based Payment”), and related
interpretations. Under ASC 718-10, share-based compensation cost is measured at
the grant date based on the calculated fair value of the award. The Company
estimates the fair value of each option on the grant date using the
Black-Scholes model.  The following assumptions were made in
estimating the fair value:
  70
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  Optionsgrantedin:
                        
                        Dividend
                          Yield
                        
                        
                        Risk-free
                          interestrate
                        
                        
                        Expectedvolatility
                        
                        ExpectedlifeFiscal
      2006
                        
                        
                        0
                        %
                        
                        
                        5.46
                        %
                        
                        
                        100
                        %
                        5
      yearsNovember
      2006
                        
                        
                        0
                        %
                        
                        
                        5.00
                        %
                        
                        
                        100
                        %
                        10
      yearsAugust
      2007
                        
                        
                        0
                        %
                        
                        
                        4.72
                        %
                        
                        
                        91
                        %
                        5
      yearsOctober
      2007
                        
                        
                        0
                        %
                        
                        
                        4.60
                        %
                        
                        
                        105
                        %
                        5
      yearsDecember
      2007
                        
                        
                        0
                        %
                        
                        
                        4.00
                        %
                        
                        
                        113
                        %
                        5
      yearsApril
      2008
                        
                        
                        0
                        %
                        
                        
                        3.78
                        %
                        
                        
                        172
                        %
                        5
      yearsSeptember
      2008
                        
                        
                        0
                        %
                        
                        
                        3.41
                        %
                        
                        
                        211
                        %
                        5
      yearsOctober
      2008
                        
                        
                        0
                        %
                        
                        
                        3.77
                        %
                        
                        
                        211
                        %
                        5
      yearsMarch
      2009
                        
                        
                        0
                        %
                        
                        
                        3.00
                        %
                        
                        
                        385
                        %
                        5
      years
  The
expense is recognized over the employees’ requisite service period, generally
the vesting period of the award.  Stock-based compensation expense
included in the accompanying statements of operations for the years ended
September 30, 2009 and 2008 is as follows:
  For the fiscal year ended September 30,2009
                          
                          
                          2008Operations
                          
                          $
                          16,100
                          
                          
                          $
                          16,100Research
      and development
                          
                          
                          260,800
                          
                          
                          
                          321,100Sales
      and marketing
                          
                          
                          137,500
                          
                          
                          
                          83,100General
      and administrative
                          
                          
                          436,100
                          
                          
                          
                          651,000Total
                          
                          $
                          850,500
                          
                          
                          $
                          1,071,300
  Total
unrecognized compensation as of September 30, 2009 amounted to
$1,094,100.
  71
 
 CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  A summary
of stock option activity is as follows:
 
 Number of
                                  Shares
                                
                                
                                Weighted
                                  Average
                                  Exercise PriceOutstanding
      at September 30, 2007
                                
                                
                                7,436,703
                                
                                
                                $
                                0.57Granted
                                
                                
                                1,880,621
                                
                                
                                $
                                0.85Exercised
                                
                                
                                -
                                
                                
                                
                                -Forfeited
                                
                                
                                (352,757
                                )
                                
                                $
                                1.09Outstanding
      at September 30, 2008
                                
                                
                                8,964,567
                                
                                
                                $
                                0.60Granted
                                
                                
                                80,000
                                
                                
                                $
                                0.43Exercised
                                
                                
                                (2,124,740
                                )
                                
                                $
                                0.132Forfeited
                                
                                
                                (257,813
                                )
                                
                                $
                                0.51Outstanding
      at September 30, 2009
                                
                                
                                6,662,014
                                
                                
                                $
                                0.76Weighted
      average fair value of options granted during:Year
      ended September 30, 2008
                                
                                
                                
                                
                                
                                $
                                0.73Year
      ended September 30, 2009
                                
                                
                                
                                
                                
                                $
                                0.43
  Following
is a summary of the status of options outstanding at September 30,
2009:
  Exercise Price
                              
                              
                              Number of Shares
                              
                              Weighted Average
                                Contractual Life
                              
                              Weighted
                                Average
                                Exercise Price$
                              0.12
                              
                              
                              
                              859,270
                              
                              10
      years
                              
                              $
                              0.12$
                              0.132
                              
                              
                              
                              987,805
                              
                              7
      years
                              
                              $
                              0.132$
                              0.30
                              
                              
                              
                              135,700
                              
                              10
      years
                              
                              $
                              0.30$
                              0.59
                              
                              
                              
                              28,588
                              
                              10
      years
                              
                              $
                              0.59$
                              0.80
                              
                              
                              
                              140,000
                              
                              10
      years
                              
                              $
                              0.80$
                              0.89
                              
                              
                              
                              968,875
                              
                              10
      years
                              
                              $
                              0.89$
                              0.96
                              
                              
                              
                              496,746
                              
                              10
      years
                              
                              $
                              0.96$
                              1.09
                              
                              
                              
                              2,614,232
                              
                              10
      years
                              
                              $
                              1.09$
                              1.20
                              
                              
                              
                              333,611
                              
                              5
      years
                              
                              $
                              1.20$
                              0.51
                              
                              
                              
                              275,000
                              
                              10
      years
                              
                              $
                              0.51$
                              0.40
                              
                              
                              
                              56,000
                              
                              10
      years
                              
                              $
                              0.40Total
                              
                              
                              
                              6,662,014
                              
                              
                              
                              $
                              0.76
  Warrants
to Purchase Common Stock
  At
September 30, 2007, there were warrants outstanding to purchase 6,899,353 shares
of the Company’s common stock at exercise prices ranging from $0.01 to $1.812
with a weighted average exercise price of $1.04.  The warrants expire
at various times through 2017.  No warrants were issued or exercised
during the 12 months ended September 30, 2008.
  72
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  During
the year ended September 30, 2009, 1,498,986 warrants with an exercise price of
$0.01 were exercised.
  During
the year ended September 30, 2009, the following additional 10,137,118 warrants
were granted and are outstanding as of September 30, 2009:
  Warrants
      to Purchase
                                  
                                  Exercise
      Price
                                  
                                  Issued
      in Connection With:100,000
      shares
                                  
                                  $
                                  0.25
                                  
                                  A
      $200,000 bridge note with SAIL on May 14, 2009 as described in Note
      23,333,333
      shares
                                  
                                  $
                                  0.30
                                  
                                  A
      $1,000,000 bridge note with Pappajohn on June 12, 2009 as described
      in Note 23,404,991
      shares
                                  
                                  $
                                  0.30
                                  
                                  Associated
      with the private placement transaction of 6,810,002 shares at $0.30 with
      50% warrant coverage as described in Note 2956,164
      shares
                                  
                                  $
                                  0.27
                                  
                                  Associated
      with the automatic conversion of401,096
      shares
                                  
                                  $
                                  0.255
                                  
                                  $1,700,000
      of convertible promissory notes and1,666,667
      shares
                                  
                                  $
                                  0.30
                                  
                                  $20,900
      accrued interest upon completion an equityfinancing
      in excess of $1,500,000 as described  in Note
  2274,867
      shares
                                  
                                  $
                                  0.33
                                  
                                  The
      placement agent for private placement as described in Note
    2
  At
September 30, 2009, there were warrants outstanding to purchase 15,537,485
shares of the Company’s common stock at exercise prices ranging from $0.01 to
$1.812 with a weighted average exercise price of $0.65.  The warrants
expire at various times through 2017
  5.
              INCOME
      TAXES
  The
Company accounts for income taxes under the liability method. Deferred tax
assets and liabilities are determined based on differences between financial
reporting and tax bases of assets and liabilities, and are measured using the
enacted tax rates and laws that will be in effect when the differences are
expected to reverse. We provide a valuation allowance to reduce our deferred tax
assets to their estimated realizable value.
  Reconciliations
of the provision (benefit) for income taxes to the amount compiled by applying
the statutory federal income tax rate to profit (loss) before income taxes is as
follows for each of the years ended September 30:
  73
  CNS
RESPONSE, INC.
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
 SEPTEMBER
30, 2009 AND 2008
  2009
                  
                  
                  2008Federal
      income tax (benefit) at statutory rates
                  
                  
                  (34
                  )%
                  
                  
                  (34
                  )%Stock-based
      compensation
                  
                  
                  0
                  %
                  
                  
                  20
                  %Non
      deductible interest expense
                  
                  
                  0
                  %
                  
                  
                  0
                  %Change
      in valuation allowance
                  
                  
                  37
                  %
                  
                  
                  14
                  %Goodwill
      write off
                  
                  
                  (3
                  )%
                  
                  
                  0
                  %
  Temporary
differences between the financial statement carrying amounts and tax bases of
assets and liabilities that give rise to significant portions of deferred taxes
relate to the following at September 30, 2009 and 2008:
  2009
                    
                    
                    2008Deferred
      income tax assets:Net
      operating loss carryforward
                    
                    $
                    8,765,900
                    
                    
                    $
                    4,953,000Deferred
      interest, consulting and compensation liabilities
                    
                    
                    987,500
                    
                    
                    
                    17,000Amortization
                    
                    
                    (24,300
                    )
                    
                    
                    223,300Deferred
      income tax assets - other
                    
                    
                    7,800
                    
                    
                    
                    -9,736,900
                    
                    
                    
                    5,193,300Deferred
      income tax liabilities—other
                    
                    
                    -
                    
                    
                    
                    (12,300
                    )Deferred
      income tax asset—net before valuation allowance
                    
                    
                    9,736,900
                    
                    
                    
                    5,181,000Valuation
      allowance
                    
                    
                    (9,736,900
                    )
                    
                    
                    (5,181,000
                    )Deferred
      income tax asset—net
                    
                    $
                    -
                    
                    
                    $
                    -
  Current
and non-current deferred taxes have been recorded on a net basis in the
accompanying balance sheet. As of September 30, 2009, the Company has net
operating loss carryforwards of approximately $20.8 million. The net operating
loss carryforwards expire by 2028. Utilization of net operating losses and
capital loss carryforwards may be subject to the limitations imposed by Section
382 of the Internal Revenue Code. The Company has placed a valuation allowance
against the deferred tax assets in excess of deferred tax liabilities due to
the uncertainty surrounding the realization of such excess tax assets.
Management periodically evaluates the recoverability of the deferred tax assets
and the level of the valuation allowance. At such time as it is determined that
it is more likely than not that the deferred tax assets are realizable, the
valuation allowance will be reduced accordingly.
  6.ACQUISITION OF NEURO
THERAPY CLINIC, PC
 
 On
January 15, 2008, the Company, through its wholly owned subsidiary, Colorado CNS
Response, Inc., acquired all of the outstanding common stock of Neuro-Therapy
Clinic, PC (“NTC”) in exchange for a non-interest bearing note payable of
$300,000 payable in equal monthly installments over 36 months.  Upon
the completion of the acquisition, the sole shareholder of NTC was appointed
Chief Medical Officer of the Company.  Prior to the acquisition, NTC
was the Company’s largest customer.
  74




CNS
RESPONSE, INC.





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED


SEPTEMBER
30, 2009 AND 2008




The
acquisition was accounted under the purchase method of accounting, and
accordingly, the purchase price was allocated to NTC’s net tangible assets based
on their estimated fair values as of January 15, 2008. The excess purchase price
over the value of the net tangible assets was recorded as
goodwill.  The purchase price and the allocation thereof are as
follows:





Fair
      value of note payable issued
                  
                  $
                  265,900Direct
      transaction costs
                  
                  
                  43,700Purchase
      price
                  
                  
                  309,600Allocated
      to net tangible liabilities, including cash of
$32,100
                  
                  
                  (10,600
                  )Allocated
      to goodwill
                  
                  $
                  320,200





The
acquisition was not material, and accordingly, no pro forma results are
presented.  As of September 30, 2009, goodwill was measured and
determined to be fully impaired and consequently written off.





7.LONG-TERM DEBT





As
described in Note 6 above, during the year ended September 30, 2008 the Company
issued a note payable to an officer in connection with the acquisition of
NTC.  The note is non-interest bearing and the Company determined its
fair value by imputing interest at an annual rate of 8%.  As of
September 30, 2009 the note has an outstanding principal balance in the
amount of $118,600, of which $93,800 is current.





8.REPORTABLE
SEGMENTS





The
Company operates in two business segments:  reference laboratory and
clinic.  Reference laboratory provide reports (“rEEG Reports”) that
assist physicians with treatment strategies for patients with behavioral
(psychiatric and/or addictive) disorders based on the patient’s own
physiology.  Clinic operates NTC, a full service psychiatric
practice.





The
following tables show operating results for our reportable segments, along with
reconciliation from segment gross profit to (loss) from operations, the most
directly comparable measure in accordance with generally accepted accounting
principles in the United States, or GAAP:





Year ended September 30,2009Reference
                  Laboratory
                
                
                Clinic
                
                
                Eliminations
                
                
                TotalRevenues
                
                
                138,900
                
                
                
                628,200
                
                
                
                (67,000
                )
                
                
                700,100Operating
      expenses:Cost
      of revenues
                
                
                131,600
                
                
                
                18,500
                
                
                
                (18,500
                )
                
                
                131,600Research
      and development
                
                
                2,137,200
                
                
                
                -
                
                
                
                -
                
                
                
                2,137,200Sales
      and marketing
                
                
                908,500
                
                
                
                7,300
                
                
                
                -
                
                
                
                915,800General
      and administrative
                
                
                3,266,300
                
                
                
                669,600
                
                
                
                (48,500
                )
                
                
                3,887,400Goodwill impairment charges
                
                
                320,000
                
                
                
                -
                
                
                
                -
                
                
                
                320,000Total
      operating expenses
                
                
                6,763,800
                
                
                
                695,400
                
                
                
                (67,000
                )
                
                
                7,392,200Loss
      from operations
                
                $
                (6,624,900
                )
                
                $
                (67,200
                )
                
                $
                0
                
                
                $
                (6,692,100
                )




75


CNS
RESPONSE, INC.





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED


SEPTEMBER
30, 2009 AND 2008





The
following table includes selected segment financial information as of September
30, 2009, related to goodwill and total assets:





Reference
                    Laboratory
                  
                  
                  Clinic
                  
                  
                  TotalGoodwill
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Total
      assets
                  
                  $
                  1,118,000
                  
                  
                  $
                  42,900
                  
                  
                  $
                  1,160,900




9.
            EARNINGS
      PER SHARE




In
accordance with ASC 260-10 (formerly SFAS 128, “Computation of Earnings Per
Share”), basic net income (loss) per share is computed by dividing the net
income (loss) to common stockholders for the period by the weighted average
number of common shares outstanding during the period. Diluted net income (loss)
per share is computed by dividing the net income (loss) for the period by the
weighted average number of common and dilutive common equivalent shares
outstanding during the period.  For the years ended September 30, 2009
and 2008, the Company has excluded all common equivalent shares from the
calculation of diluted net loss per share as such securities are
anti-dilutive.




A summary
of the net income (loss) and shares used to compute net income (loss) per share
for the years ended September 30, 2009 and 2008 is as follows:




2009
                  
                  
                  2008Net
      loss for computation of basic net income (loss) per share
                  
                  $
                  (8,522,200
                  )
                  
                  $
                  (5,371,500
                  )Net
      income (loss) for computation of dilutive net income (loss) per
      share
                  
                  $
                  (8,522,200
                  )
                  
                  $
                  (5,371,500
                  )Basic
      net income (loss) per share
                  
                  $
                  (0.31
                  )
                  
                  $
                  (0.21
                  )Diluted
      net income (loss) per share
                  
                  $
                  (0.31
                  )
                  
                  $
                  (0.21
                  )Basic
      weighted average shares outstanding
                  
                  
                  27,778,171
                  
                  
                  
                  25,299,547Dilutive
      common equivalent shares
                  
                  
                  -
                  
                  
                  
                  -Diluted
      weighted average common shares
                  
                  
                  27,778,171
                  
                  
                  
                  25,299,547Anti-dilutive
      common equivalent shares not included in the
                    computation
      of dilutive net loss per share:Convertible
      debt
                  
                  
                  -
                  
                  
                  
                  4,995,000Warrants
                  
                  
                  8,318,310
                  
                  
                  
                  6,899,353Options
                  
                  
                  8,548,206
                  
                  
                  
                  8,767,212


76


CNS
RESPONSE, INC.





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED


SEPTEMBER
30, 2009 AND 2008




10.
            COMMITMENTS
      AND CONTINGENT LIABILITIES




Litigation




From time
to time, we may be involved in litigation relating to claims arising out of our
operations in the ordinary course of business. Other than as set forth above, we
are not currently party to any legal proceedings, the adverse outcome of which,
in our management’s opinion, individually or in the aggregate, would have a
material adverse effect on our results of operations or financial
position.




Since
June of 2009, the Company has been involved in litigation against Leonard J.
Brandt, a stockholder, former director and the Company’s former Chief
Executive Officer (“Brandt”) in both the Delaware Chancery Court and the United
States District Court for the Central District of California.  For a
full description of the events associated with the Brandt Litigation please
refer to Item 3, Legal Proceeding of Part I of this document which is
incorporated herein by reference.




Lease
Commitments




The Company’s lease for its
headquarters and Laboratory Information Services business, located at 2755
Bristol St., Suite 285, Costa Mesa, California, expired in November
2009.  The Company continues to lease this space on a month to month
basis at a cost of $4,410 per month.




The
Company leases space for its Clinical Services operations under an operating
lease. The base rental as of September 2009 is $6,021 per month.  This
lease terminates on February 28, 2010.




The
Company also sub-leases space for its Clinical Services operations on a
month-to-month basis for $1,075 per month.




The
Company leases a copier for $216 per month which it accounts for as a capital
lease with an interest rate of 9% per year. The lease terminates in February
2013 at which time the copier can be purchased at fair value.




Future
Minimum Lease Payment and Debt Maturities




At
September 30, 2009, the estimated future minimum lease payment under
non-cancelable operating and capital leases and debt maturities were as
follows:





Year
      ending September 30,
              
              Operating
                Leases
              
              
              Capital
                Lease
              
              
              Debt
                Maturities
              
              
              Total2010
              
              
              36,000
              
              
              
              2,600
              
              
              
              100,000
              
              
              
              138,6002011
              
              
              -
              
              
              
              2,600
              
              
              
              25,000
              
              
              
              27,6002012
              
              
              -
              
              
              
              2,600
              
              
              
              
              
              
              
              2,6002013
              
              
              -
              
              
              
              1,100
              
              
              
              
              
              
              
              1,100Total
              
              $
              36,000
              
              
              $
              8,900
              
              
              $
              125,000
              
              
              $
              169,900Less
      interest
              
              
              (700
              )
              
              
              (1,200
              )
              
              
              (6,400
              )
              
              
              (8,300
              )Net
      present value
              
              
              35,300
              
              
              
              7,700
              
              
              
              118,600
              
              
              
              161,600Less
      current portion
              
              
              (35,300
              )
              
              
              (2,100
              )
              
              
              (93,800
              )
              
              
              (131,200
              )Long-term
      debt and lease obligation
              
              $
              -
              
              
              $
              5,600
              
              
              $
              24,800
              
              
              $
              30,400


77


CNS
RESPONSE, INC.





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED


SEPTEMBER
30, 2009 AND 2008




11.
            SIGNIFICANT
      CUSTOMERS




For the
year ended September 30, 2009, three customers accounted for 39% of Laboratory
Information Services revenue and 45% of accounts receivable at September 30,
2009.




For the
year ended September 30, 2008, two customers accounted for 29% of Laboratory
Information Services revenue and 24% of accounts receivable at September 30,
2008.




12.
            SUBSEQUENT
      EVENTS




The
following key events occurred after the end of the fiscal year dated September
30, 2009:




Results
of Clinical Trial Announced





On
November 2, 2009, the Company reported the results of its landmark study
presented by Charles DeBattista, D.M.H, M.D., at the U.S. Psychiatric and Mental
Health Congress.  The poster presentation, titled Referenced-EEG®
(rEEG) Efficacy Compared to STAR*D For Patients With Depression Treatment
Failure:  First Look At Final Results, highlighted a dramatic
improvement in personalized medicine technology for use in treatment of patients
with depression.  In this study, rEEG proved effective at predicting
medication response for treatment-resistant patients approximately
65 percent of the time.





The study
included 114 patients in 12 medical centers, including Harvard,
Stanford, Cornell, UCI and Rush.  The 12-week study found that rEEG
significantly outperformed the modified STAR*D treatment
algorithm.  The difference, or separation, between rEEG and the
control group was 50 and 100 percent for the study’s two primary
endpoints.  Typically, separation between a new treatment and a
control group is less than 10 percent in antidepressant
studies.





The
study, the largest in the Company’s history, was a randomized, blinded,
controlled, parallel group, multicenter study.  The patients in the
study experienced depression treatment failure of one or more SSRIs and/or had
failure with at least two classes of antidepressants.  The patients
fell into two groups:  1) those treated with rEEG medication
guidance, and 2) those treated with the modified STAR*D treatment
algorithm.


78


CNS
RESPONSE, INC.





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED


SEPTEMBER
30, 2009 AND 2008




Ruling
from Delaware Chancery Court in Relation to Company’s Litigation with Leonard
Brandt




On
December 2, 2009, the Delaware Chancery Court dismissed complaints brought
against the Company by Brandt.  At the conclusion of a two-day
trial that commenced December 1, the Chancery Court entered judgment
for the Company and dismissed with prejudice Brandt's action brought pursuant to
Section 225 of the Delaware General Corporation Law.  The Chancery Court
thereby found that the purported special meeting of stockholders convened by
Brandt on September 4, 2009 was not valid and that the directors purportedly
elected at that meeting will not be seated.  For a full description of
the events associated with the Brandt Litigation please refer to Item 3, Legal
Proceeding of Part I of this document which is incorporated herein by
reference.




Completion
of Second Closing of Private Placement Transaction




On
December 24, 2009, the Company completed a second closing of its private
placement (the first closing having occurred on August 26, 2009), resulting in
additional gross proceeds to the Company of approximately $3.0 from accredited
investors.





Pursuant
to Subscription Agreements entered into with the investors, the Company sold
approximately 55 Investment Units at $54,000 per Investment Unit. Each
“Investment Unit” consists of 180,000 shares of the Company’s common stock and a
five year non-callable warrant to purchase 90,000 shares of the Company’s common
stock at an exercise price of $0.30 per share.





After
commissions and expenses, the Company received net proceeds of approximately
$2.65 million at the second closing.  The Company intends to use the
proceeds from the second closing of its private placement for general corporate
purposes, including clinical trial expenses, research and development expenses,
and general and administrative expenses, including the payment of accrued legal
expenses incurred in connection with the Company’s litigation with Leonard
Brandt.





A FINRA
member firm acted as lead placement agent (the “Placement Agent”) in connection
with the second closing of the private placement.  For its services in
connection with the second closing, the Placement Agent received (i) a cash fee
of $195,200, (ii) a cash expense allowance of $59,920, and (iii) a five year
non-callable warrant to purchase 672,267 shares of the Company’s common
stock at an exercise price of $0.33per share, first
exercisable no earlier than June 24, 2010.





In
connection with the second closing of the Company’s private placement, each
investor who participated in the financing became party to the Registration
Rights agreement described above under Note 2 and will receive the same rights
and benefits as the investors in the first closing of the Company’s Private
Placement on August 26, 2009.




Receipt
of letter from Food and Drug Administration




On
December 28, 2009, the Company's regulatory counsel received a letter (“the
Letter”) from the FDA in response to its prior correspondence relating to the
possible classification of the Company's rEEG, as a medical device. The Company
will continue its ongoing dialogue with the FDA regarding its rEEG (which may be
subject to pre-market review). If pre-market review is required the Company’s
revenue could be negatively impacted until such review is completed and
clearance to market or approval is obtained. The Letter does not have any impact
on the consolidated financial statements as of and for the years ended September
30, 2009 and 2008. See "Government Regulation" section for detailed
discussion.




79


ITEM
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure




None.




ITEM
      9A(T).
            Controls
      and Procedures




Disclosure
Controls and Procedures




Our
management, including our principal executive officer (PEO) and principal
financial officer (PFO), conducted an evaluation of the effectiveness of our
disclosure controls and procedures, as defined by paragraph (e) of Exchange Act
Rules 13a-15, as of September 30, 2009, the end of the period covered by
this report.  Based on this evaluation, our PEO and PFO concluded that
our disclosure controls and procedures were not effective as of September 30,
2009 for the reasons described below.




Management’s
Annual Report on Internal Control Over Financial Reporting




Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting.  As defined in Rule 13a-15(f) under
the Exchange Act, internal control over financial reporting is a process
designed by, or under the supervision of, our PEO and PFO and effected by our
board of directors, management, and other personnel, to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally
accepted accounting principles and procedures that:




1.           Pertain
to the maintenance of records that in reasonable detail accurately and fairly
reflect the transactions and dispositions of our assets;




2.           Provide
reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted
accounting principles, and that our receipts and expenditures are being made
only in accordance with authorization of our management and directors;
and




3.           Provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of our assets that could have a material effect
on the financial statements.




Management,
including our Chief Executive Officer (who is our Principal Executive Officer
and Principal Financial Officer), do not expect that our disclosure controls and
procedures or our internal control over financial reporting will prevent all
errors or all fraud. A control system, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Further, the design of a control
system must reflect the fact that there are resource constraints, and the
benefits of controls must be considered relative to their costs. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within our company have been detected. These inherent limitations include
the realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error or mistake.  Additionally,
controls can be circumvented by the individual acts of some persons, by
collusion of two or more people, or by management’s override of the control. The
design of any system of controls also is based in part upon certain assumptions
about the likelihood of future events, and there can be no assurance that any
design will succeed in achieving its stated goals under all potential future
conditions.  Also, over time, controls may become inadequate because
of changes in conditions, or the degree of compliance with the policies or
procedures may deteriorate.


80




Assessment
of Internal Controls Over Financial Reporting




Members
of our management, including George Carpenter our PEO and PFO, have evaluated
the effectiveness of our internal control over financial reporting as of
September 30, 2009, based on the framework and criteria established by the
Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), and
we concluded that our internal controls over financial reporting were not
effective.




The
following significant deficiencies (as defined below) were identified, which in
combination with other deficiencies may constitute a material weakness (as
defined below):




·
            We
      do not have proper segregation of duties within the accounting and finance
      function.




·
            We
      do not have a comprehensive and formalized accounting and procedures
      manual.




·
            We
      do not have personnel with sufficient financial expertise in the capacity
      of CFO.




A
“material weakness” is a deficiency, or combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of our annual or interim financial statements will
not be prevented or detected on a timely basis.




A
“significant deficiency” is a deficiency, or combination of deficiencies, in
internal control over financial reporting that is less severe than a material
weakness, yet important enough to merit attention by those responsible for
oversight of our financial reporting.




To the
knowledge of our management, including our PEO and PFO, none of the
aforementioned significant deficiencies led to a misstatement of our results of
operations for the year ended September 30, 2009, or statement of financial
position as of September 30, 2009.




This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
registered public accounting firm pursuant to temporary rules of the Securities
and Exchange Commission that permit us to provide only management’s report in
this annual report.




Changes
in Internal Control Over Financial Reporting




During
the quarterly period ending September 30, 2009, there were no changes in our
internal controls over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.




ITEM
      9B.
            Other
      Information




None.




81


PART
III




ITEM
      10.
            Directors,
      Executive Officers and Corporate
Governance.




Information regarding directors and executive officers
will appear in the definitive proxy statement for the 2010 annual meeting of CNS
Response stockholders, and is incorporated herein by
reference.




ITEM
      11.
            Executive
      Compensation




Information
regarding executive compensation will appear in the definitive proxy statement
for the 2010 annual meeting of CNS Response stockholders, and is incorporated
herein by reference.




ITEM
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters




Information regarding security
ownership of certain beneficial owners and management and related stockholder
matters will appear in the definitive proxy statement for the 2010 annual
meeting of CNS Response stockholders, and is incorporated herein by
reference.




ITEM
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence




Information regarding certain
relationships and related transactions will appear in the definitive
proxy statement for the
2010 annual meeting of CNS
Response stockholders, and is incorporated herein by
reference.




ITEM
      14.
            Principal
      Accounting Fees and Services




Information
regarding principal accounting fees and services will appear in the definitive
proxy statement for the 2010 annual meeting of CNS Response stockholders, and is
incorporated herein by reference.


82


PART IV




ITEM
      15.
            Exhibits,
      Financial Statement Schedules




(a)          1.           The
information required by this item is included in Item 8 of Part II of this
annual report.




2.           The
information required by this item is included in Item 8 of Part II of this
annual report.




3. Exhibits:
See Index to Exhibits, which is incorporated by reference in this Item. The
Exhibits listed in the accompanying Index to Exhibits are filed or incorporated
by reference as part of this annual report.




(b)
            Exhibits.
      See Index to Exhibits, which is incorporated by reference in this Item.
      The Exhibits listed in the accompanying Index to Exhibits are filed or
      incorporated by reference as part of this annual
  report.




(c)
            Not
      applicable.




83


SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.




CNS
      RESPONSE, INC.By:
              /s/ George CarpenterGeorge
      Carpenter
                Chief
      Executive OfficerDate:
      December 29, 2009




POWER OF
ATTORNEY




The
undersigned directors and officers of CNS Response, Inc. do hereby constitute
and appoint George Carpenter with full power of substitution and resubstitution,
as their true and lawful attorney and agent, to do any and all acts and things
in their name and behalf in their capacities as directors and officers and
to execute any and all instruments for them and in their names in the capacities
indicated below, which said attorney and agent, may deem necessary or advisable
to enable said corporation to comply with the Securities Exchange Act of 1934,
as amended and any rules, regulations and requirements of the Securities and
Exchange Commission, in connection with this Annual Report on Form 10-K,
including specifically but without limitation, power and authority to sign for
them or any of them in their names in the capacities indicated below, any and
all amendments hereto, and they do hereby ratify and confirm all that said
attorneys and agents, or either of them, shall do or cause to be done by virtue
hereof.




In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated.




Signature
              
              Title
              
              Date/s/ George Carpenter
              
              Chief
      Executive Officer, Director
              
              December
      29, 2009George
      Carpenter
              
              (Principal
      Executive, Financial and Accounting Officer)/s/ David B. Jones
              
              Director
              
              December
      29, 2009David
      B. Jones/s/ Jerome Vaccaro
              
              Director
              
              December
      29, 2009Jerome
      Vaccaro, M.D./s/ Henry Harbin
              
              Director
              
              December
      29, 2009Henry
      T. Harbin, M. D./s/ John Pappajohn
              
              Director
              
              December
      29, 2009John
      Pappajohn/s/ Tommy Thompson
              
              Director
              
              December
      29, 2009Tommy
      Thompson





INDEX TO
EXHIBITS




Exhibit
                    Number
                  
                  ExhibitTitle2.1
                  
                  Agreement
      and Plan of Merger between Strativation, Inc., CNS Merger Corporation and
      CNS Response, Inc. dated as of January 16, 2007.  Incorporated
      by reference to Exhibit No. 10.1 to the Registrant’s Current Report on
      Form 8-K (File No. 000-26285) filed with the Commission on January 22,
      2007.2.2
                  
                  Amendment
      No. 1 to Agreement and Plan of Merger by and among Strativation, Inc., CNS
      Merger Corporation, and CNS Response, Inc. dated as of February 28,
      2007.  Incorporated by reference to Exhibit No. 10.1 to the
      Registrant’s Current Report on Form 8-K (File No. 000-26285) filed with
      the Commission on March 1, 2007.3.1.1
                  
                  Certificate
      of Incorporation, dated March 17, 1987.  Incorporated by
      reference to Exhibit No. 3(i) to the Registrant’s Form 10-SB (File No.
      000-26285) filed with the Commission on June 7, 1999.3.1.2
                  
                  Certificate
      of Amendment of Certificate of Incorporation, dated June 1, 2004.
      Incorporated by reference to Exhibit 16 to the Registrant’s Current Report
      on Form 8-K (File No. 000-26285) filed with the Commission on June 8,
      2004.3.1.3
                  
                  Certificate
      of Amendment of Certificate of Incorporation, dated August 2, 2004.
      Incorporated by reference to Exhibit 16 to the Registrant’s Current Report
      on Form 8-K (File No. 000-26285) filed with the Commission on August 5,
      2004.3.1.4
                  
                  Certificate
      of Amendment of Certificate of Incorporation, dated September 7,
      2005.  Incorporated by reference to Exhibit 4.4 to the
      Registrant’s Registration Statement on Form S-8 (File No. 333-150398)
      filed with the Commission on April 23, 2008.3.1.5
                  
                  Certificate
      of Ownership and Merger Merging CNS Response, Inc., a Delaware
      corporation, with and into Strativation, Inc., a Delaware corporation,
      dated March 7, 2007.  Incorporated by reference to the
      Registrant’s Current Report on Form 8-K (File No. 000-26285) filed
      with the Commission on March 13, 2007.3.2.1
                  
                  Bylaws.  Incorporated
      by reference to Exhibit No. 3(ii) to the Registrant’s Form 10-SB (File No.
      000-26285) filed with the Commission on June 7, 1999.3.2.2
                  
                  Amendment
      No. 1 to Bylaws of CNS Response, Inc.  Incorporated by reference
      to Exhibit 3.2 to the Registrant’s Current Report on Form 8-K (File No.
      000-26285) filed with the Commission on July 2, 2009.3.2.3
                  
                  Amendment
      No. 2 to Bylaws of CNS Response, Inc.  Incorporated by reference
      to Exhibit 3.3 to the Registrant’s Current Report on Form 8-K (File No.
      000-26285) filed with the Commission on July 23, 2009.4.1
                  
                  2006
      CNS Response, Inc. Option Plan.  Incorporated by reference to
      Exhibit 4.1 to the Registrant’s Current Report on Form 10-QSB (File No.
      000-26285) filed with the Commission on May 15, 2007.*10.1
                  
                  Amended
      and Restated Registration Rights Agreement, dated January 16, 2007 by and
      among the Registrant and the stockholders signatory thereto. Incorporated
      by reference to Exhibit No. 10.2 to the Registrant’s Current Report on
      Form 8-K (File No. 000-26285) filed with the Commission on January 16,
      2007.10.2
                  
                  Form
      of Subscription Agreement between the Registrant and certain investors,
      dated March 7, 2007. Incorporated by reference to Exhibit 10.4 to the
      Registrant’s Current Report on Form 8-K (File No. 000-26285) filed with
      the Commission on March 13, 2007.10.3
                  
                  Form
      of Indemnification Agreement by and among the Registrant, CNS Response,
      Inc., a California corporation, and certain individuals, dated March 7,
      2007. Incorporated by reference to Exhibit 10.5 to the Registrant’s
      Current Report on Form 8-K (File No. 000-26285) filed with the Commission
      on March 13, 2007.10.4
                  
                  Form
      of Registration Rights Agreement by and among the Registrant and certain
      Investors signatory thereto dated March 7, 2007. Incorporated by reference
      to Exhibit 10.6 to the Registrant’s Current Report on Form 8-K (File No.
      000-26285) filed with the Commission on March 13,
  2007.










Exhibit
                    Number
                  
                  ExhibitTitle10.5
                  
                  Form
      of Registration Rights Agreement by and among the Registrant and certain
      stockholders of the Company signatory thereto dated March 7,
      2007.  Incorporated by reference to Exhibit 10.7 to the
      Registrant’s Current Report on Form 8-K (File No. 000-26285) filed with
      the Commission on March 13, 2007.10.6
                  
                  Employment
      Agreement by and between the Registrant and George Carpenter dated October
      1, 2007.  Incorporated by reference to Exhibit 10.1 to the
      Registrant’s Current Report on Form 8-K (File No. 000-26285) filed with
      the Commission on October 3, 2007.*10.7
                  
                  Employment
      Agreement by and between the Registrant and Daniel Hoffman dated January
      11, 2008. Incorporated by reference to Exhibit 10.1 to the Registrant's
      Current Report on Form 8-K (File No. 000-26285) filed with the Commission
      on January 17, 2008.*10.8
                  
                  Stock
      Purchase Agreement by and among Colorado CNS Response, Inc.,
      Neuro-Therapy, P.C. and Daniel A. Hoffman, M.D. dated January 11,
      2008.  Incorporated by reference to the Registrant’s Annual
      report on Form 10-K (File No. 000-26285) filed with the Commission on
      January 13, 2009.10.9
                  
                  Form
      of Warrant issued to Investors in Private
      Placement.  Incorporated by reference to Exhibit 4.1 to the
      Registrant’s Current Report on Form 8-K (File No. 000-26285) filed with
      the Commission on March 13, 2007.10.10
                  
                  Senior
      Secured Convertible Promissory Note, dated March 30, 2009, by and between
      the Company and Brandt Ventures, GP.  Incorporated by reference
      to Exhibit 10.1 to the Registrant's Current Report on Form 8-K (File No.
      000-26285) filed with the Commission on April 3, 2009.10.11
                  
                  Senior
      Secured Convertible Promissory Note, dated March 30, 2009, by and between
      the Company and SAIL Venture Partners, LP.  Incorporated by
      reference to Exhibit 10.2 to the Registrant's Current Report on Form 8-K
      (File No. 000-26285) filed with the Commission on April 3
      2009.10.12
                  
                  Bridge
      Note and Warrant Purchase Agreement, dated May 14, 2009 by and between the
      Company and SAIL Venture Partners, LP.  Incorporated by
      reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K
      (File Number 000-26285) filed with the Securities and Exchange
      Commission on May 20, 2009.10.13
                  
                  Form
      of Secured Convertible Promissory Note.  Incorporated by
      reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K
      (File Number 000-26285) filed with the Securities and Exchange
      Commission on May 20, 2009.10.14
                  
                  Form
      of Warrant to Purchase Shares.  Incorporated by reference to
      Exhibit 10.3 to the Registrant’s Current Report on Form 8-K (File Number
      000-26285) filed with the Securities and Exchange Commission on May
      20, 2009.10.15
                  
                  Bridge
      Note and Warrant Purchase Agreement, dated June 12, 2009, by and between
      the Company and John Pappajohn.  Incorporated by reference to
      Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File Number
      000-26285) filed with the Securities and Exchange Commission on June
      18, 2009.10.16
                  
                  Form
      of Secured Convertible Promissory Note.  Incorporated by
      reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K
      (File Number 000-26285) filed with the Securities and Exchange
      Commission on June 18, 2009.10.17
                  
                  Form
      of Warrant to Purchase Shares.  Incorporated by reference to
      Exhibit 10.3 to the Registrant’s Current Report on Form 8-K (File Number
      000-26285) filed with the Securities and Exchange Commission on June
      18, 2009.10.18
                  
                  Form
      of Subscription Agreement.10.19
                  
                  Form
      of Warrant.10.20
                  
                  Registration
      Rights Agreement.10.21
                  
                  Amendment
      No. 1 to Registration Rights
Agreement.










Exhibit
                    Number
                  
                  ExhibitTitle10.22
                  
                  Form
      of Indemnification Agreement.14.1
                  
                  Code
      of Ethics.  Incorporated by reference to Exhibit 14.1 to the
      Registrant’s Annual Report on Form 10-KSB/A (File No. 000-26285) filed
      with the Commission on January 24, 2008.21.1
                  
                  Subsidiaries
      of the Registrant.  Incorporated by reference to the
      Registrant’s Annual report on Form 10-K (File No. 000-26285) filed with
      the Commission on January 13, 2009.23.1
                  
                  Consent
      of Independent Registered Public Accounting Firm.24.1
                  
                  Power
      of Attorney (included as part of the Signature Page).31.1
                  
                  Certification
      by Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under
      the Securities Exchange Act of 1934, as amended.31.2
                  
                  Certification
      by Principal Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a)
      under the Securities Exchange Act of 1934, as amended.32.1
                  
                  Certification
      of Chief Executive Officer (Principal Accounting and Financial Officer)
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of
2002.


*           Management
contract or compensatory plan or arrangement.