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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-K



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(Mark One)

|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------

For the fiscal year ended December 31, 2005

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: 0-21669



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Digital Lightwave, Inc.

(Exact name of Registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 95-4313013                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|15550 Lightwave Drive Clearwater, Florida                      |  | 33760                               
|(Address of principal executive offices)                       |  | (Zip Code)                          

Registrants telephone number, including area code: (727) 442-6677



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Securities registered pursuant
to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.0001 par value
per share



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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 of the Act.    Yes ̈No  x

Indicate by check mark whether 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 periods that Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.    Yes  x    No ̈

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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 Report or any amendment to this Form 10-K. ̈

Indicate by check mark whether the Registrant is a large
accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):



|                         |  |                    |  |                         
|------------------------ |  | ------------------ |  | ------------------------
|Large Accelerated Filer ̈ |  | Accelerated Filer ̈ |  | Non-Accelerated Filer  x

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act.    Yes ̈No  x

The aggregate market value of Registrants voting and non-voting common equity held by non-affiliates as of the last business day of the Registrants most
recently completed second fiscal quarter, June 30, 2005, was approximately $5,491,000 based on the last-sale price of $0.28 for shares of the Registrants Common Stock on such date as reported by the OTC Bulletin Board. Shares of Common
Stock held by each officer, director and holder of 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for
other purposes.

The number of shares of Registrants Common Stock issued and outstanding as of March 20, 2006,
was 35,207,075.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement for the Annual Meeting of Stockholders, which will be filed within 120 days after the close of the Registrants fiscal year ended December 31, 2005, are
incorporated by reference into Part III.



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##### Table of Contents

FORM 10-K

For the Year Ended December 31, 2005

Index



|         |  |                                                                                                             |  |     
|-------- |  | ----------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                             |  | Page
|PART I  
|Item 1.  |  | Business                                                                                                    |  | 1   
|         |  |                                                                                                            
|Item 1A. |  | Risk Factors                                                                                                |  | 10  
|         |  |                                                                                                            
|Item 1B. |  | Unresolved Staff Comments                                                                                   |  | 21  
|         |  |                                                                                                            
|Item 2.  |  | Properties                                                                                                  |  | 21  
|         |  |                                                                                                            
|Item 3.  |  | Legal Proceedings                                                                                           |  | 21  
|         |  |                                                                                                            
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                         |  | 21  
|        
|PART II 
|         |  |                                                                                                            
|Item 5.  |  | Market for Registrants Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 22  
|         |  |                                                                                                            
|Item 6.  |  | Selected Financial Data                                                                                     |  | 23  
|         |  |                                                                                                            
|Item 7.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                       |  | 24  
|         |  |                                                                                                            
|Item 7A. |  | Quantitative and Qualitative Disclosures about Market Risk                                                  |  | 36  
|         |  |                                                                                                            
|Item 8.  |  | Financial Statements and Supplementary Data                                                                 |  | 36  
|         |  |                                                                                                            
|Item 9.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosures                       |  | 36  
|         |  |                                                                                                            
|Item 9A. |  | Controls and Procedures                                                                                     |  | 36  
|         |  |                                                                                                            
|Item 9B. |  | Other Information                                                                                           |  | 36  
|        
|PART III
|         |  |                                                                                                            
|Item 10. |  | Directors and Executive Officers of the Registrant                                                          |  | 37  
|         |  |                                                                                                            
|Item 11. |  | Executive Compensation                                                                                      |  | 37  
|         |  |                                                                                                            
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters              |  | 37  
|         |  |                                                                                                            
|Item 13. |  | Certain Relationships and Related Transactions                                                              |  | 37  
|         |  |                                                                                                            
|Item 14. |  | Principal Accountant Fees and Services                                                                      |  | 37  
|        
|PART IV 
|         |  |                                                                                                            
|Item 15. |  | Exhibits and Financial Statement Schedules                                                                  |  | 38  



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PART I

This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may, will, should,
expect, plan, anticipate, believe, estimate, predict, potential or continue, the negative of terms like these or other comparable terminology. Additionally, statements concerning future matters such as the development of new products, enhancements
or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements. These statements are only predictions. These statements involve known and unknown risks and uncertainties
and other factors that may cause actual events or results to differ materially from the results and outcomes discussed in the forward-looking statements. All forward-looking statements included in this document are based on information available to
us on the date of filing, and we assume no obligation to update any such forward-looking statements, except as required by law. In evaluating these statements, you should specifically consider various factors, including the risks outlined under the
caption Risk Factors set forth in Item 1A and those contained from time to time in our other filings with the SEC. We caution you that our business and financial performance are subject to substantial risks and uncertainties.

Item 1.Business

Recent Developments

We continue to have insufficient short-term resources for the payment of our current liabilities. During the twelve months ended December 31, 2005, and continuing
into the first three months of 2006, we have addressed this shortfall by obtaining financing from Optel Capital, LLC (Optel), an entity controlled by our largest stockholder and current chairman of the board of directors,
Dr. Bryan J. Zwan. Our ability to meet cash requirements and maintain sufficient liquidity over the next 12 months is dependent on our ability to obtain additional financing from funding sources which may include, but may not be limited
to, Optel. If we are not able to obtain financing, we expect that we will not have sufficient cash to fund our working capital and capital expenditure requirements for the near term and that we will not have the resources required for the payment of
our current liabilities when they become due. Optel currently continues to be our principal source of financing. We have not identified any funding source other than Optel that would be prepared to provide current or future financing to the Company.

As of March 20, 2006, we owed Optel approximately $48.8 million in principal plus accrued interest thereon, which debt is secured by a first priority
security interest in substantially all of our assets and such debt accrues interest at a rate of 10% per annum. The maturity dates and corresponding payment schedules related to these obligations are as follows:



| |  |  | Secured Convertible Promissory Note. Pursuant to that certain secured convertible promissory note, dated as of September 16, 2004, we borrowed $27.0 million from Optel
on the following terms (the Secured Convertible Promissory Note):
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Accrued and unpaid interest as of September 16, 2004, plus interest that accrued on the $27.0 million outstanding principal that became due and payable on September 16,
2005, is now currently due and payable on demand at any time;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal is now currently due and payable on demand at any time.
| | - |  | ----------------------------------------------------------------------------------



| |  |  | Short-Term Notes. Pursuant to those several short-term secured promissory notes issued by the Company to Optel since September 30, 2004, we borrowed an additional $21.8
million from Optel on the following terms (the Short-Term Notes):
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $19.8 million in principal plus accrued interest is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $2.0 million in principal plus accrued interest payable on demand at any time after March 31, 2006;
| | - |  | -----------------------------------------------------------------------------------------------------------------



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On February 10, 2005, at a special meeting of our stockholders, the conversion feature of the Secured Convertible
Promissory Note was approved by our disinterested stockholders. Accordingly, all or any portion of such debt is convertible into our common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted average
trading price of our common stock during the five-day period preceding the date of any conversion. Further, as part of the conversion features approved by our disinterested stockholders, the Company is required to file a registration statement
covering the offer and sale by Optel of the shares of common stock issuable upon conversion and to keep the registration statement effective until the date that is two years after the date that such registration statement is declared effective.

All of the foregoing transactions with Optel were approved by the Companys board of directors, upon the recommendation of a special committee of the
board. The special committee is composed solely of independent directors.

On March 11, 2005, we issued 981,258 shares of common stock to Optel in
connection with Optels conversion of $1.0 million of the indebtedness outstanding under the Secured Convertible Promissory Note. As of March 20, 2006, the aggregate outstanding principal and accrued interest under the Secured Convertible
Promissory Note was approximately $32.2 million, and the applicable conversion price was approximately $0.43 per share. Accordingly, on March 20, 2006, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of
74,776,660 shares of common stock. Further, conversion by Optel of all or any portion of the Secured Convertible Promissory Note could significantly dilute the ownership interests of our other stockholders and give Optel and Dr. Zwan even
greater control over the Company. If Optel converted all of the indebtedness evidenced by the Secured Convertible Promissory Note, including principal and accrued interest into shares of common stock on March 20, 2006, at an applicable
conversion price of $0.43 per share, Optel and other entities controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 80.2% of
the then outstanding shares of common stock after giving effect to the conversion.

Overview

Digital Lightwave, Inc. provides the global fiber-optic communications industry with products and technology used to develop, install, maintain, monitor and manage
fiber-optic communication networks. Telecommunications service providers, owners of private networks (utilities, government and large enterprises) and equipment manufacturers deploy our products to provide quality assurance and ensure optimum
performance of advanced optical communications networks and network equipment. Our products are sold worldwide to telecommunications service providers, owners of private networks (utilities, government and large enterprises), telecommunications
equipment manufacturers, equipment leasing companies and international distributors.

Our revenue has been generated primarily from the sale of products
from our original product line, the Network Information Computers (NIC). NICs are portable instruments used for the installation and maintenance testing of advanced, high-speed networks and transmission equipment. The NIC product family provides
diagnostic capabilities for testing the performance of both optical and legacy electrical networks with an array of communications standards and transmission rates.

Our product lines also include the Network Access Agent (NAA), the Optical Wavelength Manager (OWM) and the Optical Test System (OTS). NAAs are unattended, software-controlled, performance monitoring and diagnostic
systems permanently installed within optical-based networks, allowing centralized remote network monitoring and management. The OWM remotely monitors up to eight optical fibers providing fast and highly accurate analysis of optical wavelengths. The
OWM also provides remote analysis and management via a web-enabled PC interface as well as software interfaces allowing for control by industry-standard network management systems. The OTS line includes a fully developed and widely deployed line of
precision optical test and measurement instruments used primarily by telecommunications equipment manufacturers in the research and development and manufacturing of new products.

Digital Lightwave, Inc. was incorporated in California in 1990 and reincorporated in Delaware in 1996. Unless the context indicates otherwise, the Company, we, our, and
Digital Lightwave, as used in this Report, refer to Digital Lightwave, Inc., a Delaware corporation, and its predecessor entity. Our principal executive offices are located at 15550 Lightwave Drive, Clearwater, Florida, 33760, and the
telephone number is (727) 442-6677. The Digital Lightwave web site address is www.lightwave.com.

Industry

The telecommunications industry is experiencing a modest stabilization after an abrupt halt of new investment and network expansion projects in 2002 through mid 2005.
Consolidation, mergers and acquisitions, and business failures have resulted in fewer service providers competing for global market share, resulting in a significantly more stable market environment into which the Company



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sells its products and technologies. Announcements by major local access providers in North America have provided a new catalyst for the fiber optic
networking industry through the planned expansion of fiber to the home (FTTH), fiber to the premise (FTTP) as well as a variety of combined fiber build outs matched to communities specific existing local loop infrastructure, collectively known
as (FTTx). Multi-year FTTx projects have begun in several regions of the United States. Whereas well-established network infrastructure exists in North America, leading to a slowdown in new development, aggressive network build outs in international
markets are ongoing and will facilitate the use and implementation of a group of loosely related technologies known as Next Generation (NextGen) technologies. NextGen typically applies to networks outside of the United States, designed specifically
for the existing infrastructure and fiber backbones of the international networks.

The Digital Lightwave Solution

Digital Lightwave provides products and technologies that are designed to support networking technologies in North America as well as the group of NextGen technologies
primarily used outside of the United States. The Company embraces the most advanced networking standards, and has designed its flagship product, the NIC, with a flexible architecture in anticipation of a continual upgrade path as new technologies
are developed, standardized and brought to market.

The Company designs and manufactures its products in portable and embedded form factors to serve its
varied customer types. Portable products are lightweight, self-contained test instruments that are used for field applications such as network diagnostics, maintenance and troubleshooting. The Company provides the same technologies in a rack
mountable product offering, designed for deployment at key points throughout the network, namely at central offices (CO), data centers, and co-location facilities. The rack-mounted equipment provides for remote monitoring from a centralized network
management console residing at the service providers network operations center (NOC). Having remotely-deployed equipment allows service providers to monitor and manage their network on a full-time basis, thereby optimizing labor resources and
minimizing time and expense of diagnosis and resolution of network emergencies and repairs.

Digital Lightwave products are also applicable to laboratory
and manufacturing applications. Network equipment manufacturers use our products during the research and development phase to ensure new equipment performs to designed specifications and conforms to international standards. Service providers and
private network operators use Digital Lightwave products in the laboratory environment to confirm network equipment functionality, compatibility and conformance to international standards. The Companys products are also used as part of the
manufacturing process for network equipment providers throughout the world.

Products and Services

Digital Lightwaves products are used to verify that telecommunications products and systems function and perform properly and to troubleshoot data signal
impairments in high-speed communication networks. Specific customer applications of the Companys diagnostic equipment include the testing of actual performance during the research and development of new network equipment by manufacturers, the
qualification of products during manufacturing, the verification of service during network installation and the monitoring and maintenance of deployed networks. In the third quarter of 2002, the Company organized products and services into four
categories to focus on specific market opportunities for its SONET/SDH, Gigabit Ethernet, T-Carrier, PDH, ATM, Packet Over SONET (POS), and DWDM test and measurement products and technologies.

Acquisitions

The Company expanded its product portfolio and customer
installed base in the second half of 2002 through the acquisition of assets of two individual product lines in an effort to complement our original products and provide core intellectual property rights to our business:

Optical Wavelength Manager (OWM) Acquired from LightChip - On October 11, 2002, the Company acquired certain assets related to the optical
network management product line from LightChip, Inc., a privately held company based in Salem, New Hampshire, in exchange for $1.0 million in cash. The acquired assets included inventory, patented technology and equipment. The acquired product
includes the Optical Wavelength Manager (OWM), which is installed by network service providers within the infrastructure of fiber-optic networks and is used primarily by operators of the network to monitor DWDM performance from a central location.
The OWM remotely monitors up to eight optical fibers and provides fast and highly accurate analysis of optical wavelengths. The OWM also provides remote analysis and management via a web-enabled PC interface as well as software interfaces allowing
for control by industry standard network management systems.

Optical Test System (OTS) Acquired from Tektronix - On November 5,
2002, the Company acquired the Optical Test System (OTS) product line of Tektronix, Inc. and assumed certain liabilities associated with the OTS product line, in exchange for



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$10.0 million in cash. The OTS product line includes a fully developed and widely deployed line of precision optical test and measurement instruments used
primarily by telecommunications equipment manufacturers in the research and development and manufacturing of new products. In connection with the acquisition agreement, the Company entered into (i) a license agreement with Tektronix pursuant to
which Tektronix licensed certain intellectual property to the Company related to the OTS product line, and (ii) a services agreement with Tektronix pursuant to which Tektronix performed certain manufacturing services for the Company related to
the OTS product line and the Company assumed certain warranty obligations of Tektronix related to the OTS product line.

The Company has
effectively integrated certain technology from the acquired products into its NIC and NAA product lines.

Network Installation and Maintenance Products

Comprised primarily of the Companys original product line of Network Information Computers (NIC), our Network Installation and Maintenance
Products include portable test devices used by network technicians. These devices provide a compact, lightweight, and easy-to-use product offering significant functionality.

The NIC (i) is an integrated test instrument that is capable of analyzing multiple protocols concurrently and independently; (ii) utilizes an intuitive Microsoft Windows-based graphical user interface (GUI)
with a touch sensor display to create an easy-to-use diagnostic tool; and (iii) is a software-based solution that can be easily upgraded and customized.

These products are based on modular and scalable hardware and software platforms and a flexible architecture that allow customers to easily upgrade existing systems to accommodate new technologies and thereby preserve the value of their
original investment. We are utilizing the core technology within our NIC product line to continue developing portable and embedded products that address the evolving needs of the optical networking industry. Current models and certain features of
the NIC include:



| |  |  | NIC® ASA-312®, which
analyzes North American optical networks (SONET rates: OC-1 through OC-48) and legacy electrical networks (T-carrier rates: DS0, DS1, DS3), operating at transmission rates ranging from 64Kbps to 2.5 Gbps and includes ATM analysis.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | NIC 2.5G®, which simultaneously and independently analyzes global optical networks (OTN/SONET/SDH rates: OC-1/STM-0 through OC-48/STM-16) and global electrical networks (T-carrier/PDH rates: DS0, DS1, DS3, E1, E3, E4),
operating at transmission rates ranging from 64 Kbps to 2.5 Gbps and includes ATM analysis.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | NIC 10G®, which verifies and qualifies the performance of global high-speed optical networks (SONET/SDH rates: OC-48/STM-16 and OC-192/STM-64), operating at transmission rates ranging from 2.6 Gbps to 10 Gbps and includes
Packet over SONET/SDH (POS) analysis.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | NIC Plus®, a scalable testing platform for global optical networks (OTN/SONET/SDH rates: OC-1/STM-0 through OC-192/STM-64) and global electrical networks (T-carrier/PDH rates: DS0, DS1, DS3, E1, E3, E4),
operating at transmission rates ranging from 64 Kbps to 10.7 Gbps and includes POS and ATM analysis. Jitter and Wander analysis is available up to 10.7 Gbps.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | NIC GigE is comprised of four fully independent optical GigE ports, eight 10/100/1000 BASE-T ports and one optional 10GigE port. This module enables packet-level testing as well as the more traditional bit-error testing on
Gigabit Ethernet traffic.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Sales of Network Installation and Maintenance Products generated approximately 68%, 74% and 71% of our net sales
for the years ended December 31, 2005, 2004 and 2003, respectively.

Network Management Systems

This product category is comprised of the Companys Network Access Agent (NAA) products and Optical Wavelength Manager (OWM) products. Using our products
analysis capabilities, a network operator is able to monitor signal degradation, diagnose and isolate network failures, and maintain a constant view of the network. This ensures fulfillment of service-level agreements (SLA) with the operators
customers and enables the operator to perform predictive analysis of certain situations in order to prevent potential network interruptions or failures.



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The first version NAA was introduced in 1998, utilizing the core technology of the NIC platform. NAAs are
software-controlled performance monitoring and diagnostic equipment that is permanently embedded at multiple access points within optical networks, providing real-time analysis and network management from a centralized location.

The OWM is a highly sophisticated DWDM analysis system that provides more functionality and reliability than traditional optical spectrum analyzers at a significantly
lower cost. The OWM is available in a compact rack-mountable form factor providing remote analysis and management via a web-enabled PC interface. The OWM remotely monitors up to eight optical fibers and provides fast and highly accurate analysis of
optical wavelengths.

Network Equipment Test and Measurement Products

The Network Equipment Test and Measurement Products category is comprised primarily of the Optical Test System (OTS). The OTS line employs patented Digital Phase Analysis technology, a test solution for optical jitter
and wander, both of which are critical network synchronization measurements. Products in the OTS line provide highly scalable and flexible platforms addressing both the network operator and network equipment manufacturer markets. These products are
capable of testing fiber-optic systems at rates from 155 megabits/second through 10 gigabits/second. By providing multi-channel support in a single system that is designed for ease of use and upgradeability with future product enhancements, the OTS
line decreases test time, time to market, and manufacturing and deployment costs.

Network Management Services

The Company provides engineering staff and consulting services for network installation and testing, capacity engineering, traffic optimization, and network planning, as
well as technical due diligence for the acquisition and integration of networks. The Company began offering these services in 2002.

Customers

Since inception and through December 31, 2005, the Company has sold over 5,800 units of the Network Information Computer and over 130 Network
Access Agents to over 500 customers. The Company has sold 12 units under the Optical Test Systems product line and 75 units under the Optical Wavelength Manager product line since October 2002. The Companys products are purchased and used by
domestic and international customers in the following industry segments:



| |  |  | Incumbent Local Exchange Carriers;
| | - |  | ----------------------------------



| |  |  | Inter-Exchange Carriers;
| | - |  | ------------------------



| |  |  | Competitive Local Exchange Carriers;
| | - |  | ------------------------------------



| |  |  | Internet Service Providers;
| | - |  | ---------------------------



| |  |  | Communications Equipment Manufacturers;
| | - |  | ---------------------------------------



| |  |  | Carriers Carriers;
| | - |  | -------------------



| |  |  | Utility Companies;
| | - |  | ------------------



| |  |  | Equipment Rental and Leasing Companies;
| | - |  | ---------------------------------------



| |  |  | Wireless Service Providers;
| | - |  | ---------------------------



| |  |  | Enterprise Network Operators; and
| | - |  | ---------------------------------



| |  |  | Government Agencies.
| | - |  | --------------------

The Company also sells its products to other
segments of the telecommunications industry, including independent telephone companies and private network operators.



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The Company involves key customers in the evaluation of products in development and continually solicits suggestions from
customers regarding additional desirable features of products that we have introduced or plan to develop. The Company has generally been able to satisfy requests for additional feature sets by providing software upgrades for loading into its
products in the field.

For the year ended December 31, 2005, three customers combined to account for approximately 32% of net sales. For the year
ended December 31, 2004, one customer accounted for approximately 21% of net sales. For the year ended December 31, 2003, two customers combined to account for approximately 27% of net sales. No other customer accounted for sales of 10% or
more during those years.

Sales, Marketing and Customer Support

Sales

The Company primarily sells its products in the United States through a direct sales force to telecommunications service providers
and network equipment manufacturers. The Company sells its products through a direct sales force in the United Kingdom and through a network of distributors located throughout Europe. The Company primarily sells its products in China through a
direct sales force and utilizes distributors throughout the Asia Pacific region. Sales of our products have tended to be concentrated with a few major customers, and we expect sales will continue to be concentrated with a few major customers in the
future. In the first quarter of 2003, the Company closed its sales offices in Brazil, Taiwan, Singapore, India and Australia and intends to utilize distributors for future sales in such regions. In the third quarter of 2005, the Company opened a
direct sales office in Dubai, managed by our Vice President of International Sales, to facilitate the Companys growing market penetration of the Middle East, India and Far East markets. Our direct sales force consisted of ten employees as of
March 20, 2006.

Marketing

The Company focuses
its marketing efforts for the Network Information Computer on the divisions of telecommunications service providers that are responsible for planning and installing extensions of the network and on the divisions of telecommunications equipment
manufacturers that are responsible for quality assurance. The Company has directed its marketing efforts for the Network Access Agent on the strategic planning divisions of telecommunications service providers and private network operators in order
to define customer requirements. The Company seeks to build awareness of its products through a variety of marketing channels and methodologies, including industry trade shows, conferences and internet-based marketing activities to targeted
customers and association groups.

Customer Support

The Company offers technical support to its customers 24 hours a day, seven days a week. The customer support organization is comprised of highly skilled employees with extensive experience across a broad range of fiber optics network
equipment and technologies. All service and repair work is performed at certified facilities in Florida, Massachusetts, Italy, Australia, Mexico, India and Thailand. The Company offers a warranty of one to three years depending on the product as
well as an extended warranty program.

Production

The
Companys NIC and NAA products are currently produced in Clearwater, Florida. The Company subcontracts the manufacture of computer systems boards, plastic molds and metal chassis and certain subassemblies and components for the NIC and NAA
products. The Company performs final assembly and programs the products with our software. The Company implements strict quality control procedures throughout each stage of the manufacturing process and tests the boards and subassemblies at various
stages in the process, including final test and qualification of the product.

In January 2002, we implemented our outsourcing strategy with Jabil Circuit,
Inc. (Jabil), to provide product assembly, direct order fulfillment, manufacturing design and product cost improvement services for all of our NIC and NAA products. Effective as of May 11, 2004, we entered into a Settlement
Agreement (the 2004 Settlement) with Jabil, which resolved and settled certain disputes between us and provided for Jabils continuing manufacturing services to us through December 31, 2004. On August 31, 2005, the Company
entered into a final Settlement Agreement and Mutual Release (the Settlement Agreement) relating to the 2004 Settlement that the Company and Jabil entered into effective May 11, 2004. In connection with the 2004 Settlement, the
Company executed and delivered to Jabil a purchase order, a promissory note in the original principal amount of approximately $3.0 million, and a second promissory note in the original principal amount of approximately $2.2 million (the Jabil
Notes).



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In view of the fact that the Companys current manufacturing needs have changed, Jabil and the Company have agreed
to amicably settle all outstanding principal and interest financial obligations between them relating to the 2004 Settlement. Under the terms of the Settlement Agreement, Jabil returned to the Company approximately $810,000 in parts inventory and
work-in-progress materials that have been purchased by the Company and warehoused at Jabil for Jabils use in the on-going manufacturing of the Companys finished goods. Additionally, the Company paid Jabil $1.9 million on August 31,
2005. The Company and Jabil exchanged mutual releases subject to specified exclusions and the Company obtained any remaining parts inventory and work-in-progress materials in Jabils possession on September 9, 2005.

Effective as of January 31, 2005, we entered into a letter agreement with MC Test Service, Inc. (MC) to also provide outsourced manufacturing services.
On March 15, 2005, Optel established an irrevocable letter of credit (LC) in the amount of $6.0 million on behalf of the Company and naming MC Test Service, Inc. as beneficiary. On December 16, 2005, Optel renewed the LC for
$2.0 million and extended the expiration date to December 30, 2006. With the LC in place, MC has extended to the Company regular payment terms to pay for purchased production material. (See Note 9 to the Consolidated Financial Statements 
Notes Payable, Line of Credit and Letter of Credit) In the future, any failure to maintain this manufacturing service agreement with MC, or to enter into a substitute manufacturing agreement in a timely fashion could interrupt our operations and
adversely impact our ability to manufacture our products, book sales and fulfill customer orders.

The Companys OWM and OTS products are currently
produced in Melbourne, Florida and Billerica, Massachusetts. The Company subcontracts the manufacture of computer systems boards, plastic molds and metal chassis and certain subassemblies and components for the OTS and OWM products. The Company
performs final assembly and programs the products with our software.

We currently utilize several key components in the manufacture of our products from
sole-source or limited-source suppliers. Certain laser and laser amplifier components, power supplies, touch-screen sensors, single-board computers and SONET overhead terminators used in our NIC and the NAA products are sourced from a single or a
limited number of suppliers. We purchase a filter, a controller board and an interface board from a single or limited number of suppliers for the NAA product. Certain oscillators, power supplies, single board computers, and other optical components
are key components in the manufacture of our OTS products and are sourced from a single or limited number of supplies. We use detectors, switches and an embedded operating system as key components in the manufacture of our OWM products that are
sourced from a single or limited number of suppliers. We are currently attempting to qualify certain additional suppliers for certain of the sole-sourced components. The loss of a supplier for any of these key components could seriously disrupt our
operations. The Company also obtains other equipment manufacturers products for resale to customers.

We forecast product sales on a quarterly basis
and order materials and components based on these forecasts. Lead times for materials and components that we order vary significantly and depend on factors such as the specific supplier, purchase terms and demand for a component at a given time.
There may be excess or inadequate inventory of certain materials and components if actual orders vary significantly from forecasts.

Engineering and
Development

The Company has organized its engineering and development efforts into product or project teams. These teams are organized around the
development of a particular product, and each team is responsible for all aspects of the development of that product and any enhanced features or upgrades. The Company has two research and development facilities: Clearwater, Florida and Billerica,
Massachusetts.

During fiscal years 2005, 2004, and 2003, the Company spent approximately $7.8 million, $5.1 million, and $5.5 million, respectively, on
engineering and development activities.

Intellectual Property

The Companys success and its ability to compete depends upon its proprietary technology that the Company protects through a combination of patent, copyright, trade secret and trademark law. As of March 20, 2006, we have six
issued patents relating to the NIC and NAA technology, and two issued patents relating to the DWDM technology in the United States. Currently we have 14 patents pending relating to our technology.

The Companys strategy includes a plan to expand its presence in international markets and the laws of some foreign countries may not protect the Companys
proprietary rights to the same extent as do the laws of the United States. In addition, the Company may either license its proprietary rights to third parties or license certain technologies from third parties for use in its products.



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##### Table of Contents

To further protect its proprietary information, the Company generally enters into non-disclosure agreements and
proprietary information and invention agreements with its employees and suppliers and limits access to and distribution of its proprietary information. However, it may be possible for third parties to copy or otherwise obtain and use the
Companys technology without authorization despite these precautions.

Backlog

We believe that backlog is not a meaningful indicator of future business prospects and financial results. Backlog, as we define it, generally represents cumulative outstanding orders that are scheduled for delivery
within a three-month period. We have not entered into long-term agreements or blanket purchase orders for the sale of our products and, accordingly, do not carry substantial backlog from quarter-to-quarter. Our sales during a particular quarter are
highly dependent upon orders placed by customers during that period. Consequently, sales may fluctuate significantly from quarter-to-quarter and year-to-year reflecting the timing and amount of our customers ordering trends. Because most of our
operating expenses are relatively fixed and cannot be easily reduced in response to decreased revenues, quarterly fluctuations in sales may have a significant effect on net income.

Seasonality

Our sales are generally seasonal with the largest portion of quarterly sales tied to telecommunications
industry purchasing patterns and tend to decrease during the first calendar quarter of each year.

Competition

The market for our products is competitive and is subject to rapid technological change, frequent product introductions with improved performance, competitive pricing and
changing industry standards. We believe that the principal factors on which we compete include:



| |  |  | product performance;
| | - |  | --------------------



| |  |  | product quality;
| | - |  | ----------------



| |  |  | product reliability;
| | - |  | --------------------



| |  |  | value;
| | - |  | ------



| |  |  | customer service and support; and
| | - |  | ---------------------------------



| |  |  | length of operating history, industry experience and name recognition.
| | - |  | ----------------------------------------------------------------------

We believe that the principal competitors for our Network Installation and Maintenance Products are Agilent Technologies, Anritsu, EXFO Electro-Optical Engineering, Inc., JDSU, and Sunrise Telecom. We believe the principal competitors for
our Network Management System and our Network Equipment Test and Measurement Products are Agilent, EXFO, and Spirent. Many of our competitors and certain prospective competitors have significantly longer operating histories, larger installed bases,
greater name recognition and significantly greater technical, financial, manufacturing and marketing resources. A number of these competitors have long-established relationships with our customers and potential customers.



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##### Table of Contents

Regulatory Matters

The Companys products must meet industry standards and regulations that are evolving as new technologies are deployed. In the United States, our products must comply with various regulations promulgated by the Federal Communications
Commission and Underwriters Laboratories as well as industry standards established by the American Standards Institute and other organizations. Internationally, our products must comply with standards established by the European Union and
communication authorities in other countries as well as with recommendations of the International Telecommunication Union. In addition, some of our planned products may be required to be certified by Telcordia in order to be commercially viable. The
failure of our products to comply, or delays in compliance, with the various existing and evolving standards and regulations could adversely affect our ability to sell products.

International

The Company sells its products in domestic and international markets. Our domestic sales represented
approximately 64%, 73% and 75% of our net sales for the years ending 2005, 2004, and 2003, respectively. The Companys international sales represented approximately 36%, 27% and 25% total net sales for the years ended 2005, 2004, and 2003,
respectively.

Employees

As of March 20, 2006, we
employed a full-time staff of 79 employees. None of the Companys employees are represented by labor unions, and we believe our relations with our employees are good.



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##### Table of Contents

Item 1A.Risk Factors

Our business is subject to various risks, including those described below. You
should carefully consider the following risks, together with all of the other information included in this document before deciding to invest in our securities. Any of these risks could materially adversely affect our business, operating results and
financial condition.

Our ability to continue as a going concern is uncertain.

Our consolidated financial statements have been prepared on the assumption that we will continue as a going concern, which contemplates the realization of assets and
liquidation of liabilities in the normal course of business. The independent registered public accounting firms report on our consolidated financial statements as of and for the fiscal year ended December 31, 2005, includes an explanatory
paragraph that states we have suffered recurring losses from operations and have a working capital deficiency that raise substantial doubt about our ability to continue as a going concern.

Beginning in the third quarter of 2001 and continuing through December 31, 2005, we incurred combined net losses of $149.4 million. For the years ended
December 31, 2005, and December 31, 2004, we reported net losses of approximately $21.1 million and $12.9 million, respectively, and cash flows used by operations of $13.6 million and $17.4 million, respectively. We anticipate that our
operating losses will continue in fiscal year 2006. Management has taken actions to reduce operating expenses and capital expenditures, including restructuring operations to more closely align operating costs with net sales.

Our ability to meet cash and future liquidity requirements is dependent on our ability to raise additional capital, successfully negotiate extended payment terms with
certain creditors, attain our business objectives, maintain tight controls over spending and release new products and product upgrades on a timely basis. If our cash requirements cannot be satisfied from cash flows from operations and the infusion
of additional capital, we may be forced to implement further expense reduction measures, including, but not limited to, workforce reductions, the sale of assets, the consolidation of operations or the delay, cancellation or reduction of certain
product development, marketing, licensing, or other operational programs.

We are unable to meet our current obligations.

As of December 31, 2005, we had approximately $499,000 of unrestricted cash and cash equivalents and a working capital deficit of approximately $48.8 million. In
addition to the unrestricted cash and cash equivalents, our current assets included approximately $2.7 million in net accounts receivable and approximately $4.8 million in net inventory. Our current liabilities included approximately $4.2 million in
accounts payable and accrued liabilities, $5.9 million in accrued interest and approximately $46.9 million in current notes payable. We are currently unable to pay our liabilities as they become due.

We need to raise additional capital.

From February 2003 through
September 17, 2004, we borrowed approximately $27.0 million from Optel and its affiliates. In September 2004, we restructured this debt and issued Optel a secured convertible promissory note having the following terms:



| |  |  | Interest rate of 10% per annum;
| | - |  | -------------------------------



| |  |  | Accrued and unpaid interest as of September 16, 2004, plus interest that accrued on the $27.0 million outstanding principal that became due and payable on September 16,
2005, is now currently due and payable on demand at any time;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, is now currently due and payable on demand at any time;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | Secured by a first priority security interest in substantially all of the assets of the Company.
| | - |  | ------------------------------------------------------------------------------------------------

On May 11, 2004, Jabil and the Company entered into a settlement agreement (the 2004 Settlement), which resolved and settled certain and all previous disputes between Jabil and the Company. During
2004, the Company made scheduled principal payments under the Jabil Notes, including the initial payments of approximately $1.8 million.

On
August 23, 2004, Optel entered into a guarantee agreement with Jabil Circuit, Inc., or Jabil, pursuant to which Optel guaranteed certain obligations of the Company owing to Jabil relating to purchase orders for production material issued by the
Company to Jabil after June 30, 2004. Optels maximum obligation under the guarantee agreement was $1.88 million. Prior to the completion of the guarantee agreement, the Company was required to prepay Jabil for all orders of production
material. With the guarantee agreement in place, the Company was able to pay for production material purchased from Jabil upon receipt of that material.



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##### Table of Contents

On August 31, 2005, the Company entered into a final Settlement Agreement and Mutual Release (the Settlement
Agreement) relating to the 2004 Settlement that the Company and Jabil entered into effective May 11, 2004. In connection with the 2004 Settlement, the Company executed and delivered to Jabil a purchase order, a promissory note
in the original principal amount of approximately $3.0 million, and a second promissory note in the original principal amount of approximately $2.2 million.

In view of the fact that the Companys current manufacturing needs have changed, Jabil and the Company have agreed to amicably settle all outstanding principal and interest financial obligations between them relating to the 2004
settlement. Under the terms of the Settlement Agreement, Jabil returned to the Company approximately $810,000 in parts inventory and work-in-progress materials that had been purchased by the Company and warehoused at Jabil for Jabils use in
the on-going manufacturing of the Companys finished goods and the Company paid Jabil $1.9 million on August 31, 2005. The Company and Jabil exchanged mutual releases subject to specified exclusions and the Company obtained any remaining
parts inventory and work-in-progress materials in Jabils possession on September 9, 2005.

On December 2, 2004, Optel established an
irrevocable standby letter of credit in the amount of approximately $1.4 million on our behalf and naming Lightwave Drive LLC, our landlord, as beneficiary. The letter of credit expires in December 2006. The letter of credit replaces a previous
letter of credit in the same amount, previously issued by us which had expired. The expired letter of credit had been secured by a restricted cash deposit of $1.4 million.

From September 30, 2004, through December 31, 2005, we borrowed approximately an additional $19.8 million from Optel pursuant to the Short-Term Notes. Since January 1, 2006 we borrowed an additional
$2.0 million from Optel pursuant to the Short-Term Notes. (See Note 9 to the Consolidated Financial Statements  Notes Payable, Line of Credit and Letter of Credit) The Short-Term Notes have the following terms:



| |  |  | Interest Rate of 10% per annum;
| | - |  | -------------------------------



| |  |  | Approximately $19.8 million in principal plus accrued interest is now currently due and payable on demand at any time;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $2.0 million in principal plus accrued interest payable on demand at any time after March 31, 2006; and,
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | Secured by a first priority security interest in substantially all of the assets of the Company.
| | - |  | ------------------------------------------------------------------------------------------------

On December 31, 2005, Optel notified us that it was not demanding payment of the approximately $46.8 million that was then and is currently payable upon demand by Optel, but that it reserved its right to do so in
the future.

On February 10, 2005, at a special meeting of our stockholders, the conversion feature of the Secured Convertible Promissory Note was
approved by our disinterested stockholders. Accordingly, all or any portion of such debt is convertible into our common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted average trading price of our
common stock during the five-day period preceding the date of any conversion. Further, as part of the conversion features approved by our disinterested stockholders, the Company is required to file a registration statement covering the offer and
sale by Optel of the shares of common stock issuable upon conversion and to keep the registration statement effective until the date that is two years after the date that such registration statement is declared effective.

On March 11, 2005, we issued 981,258 shares of common stock to Optel in connection with Optels conversion of $1.0 million of the indebtedness outstanding
under the Secured Convertible Promissory Note. As of March 20, 2006, the aggregate outstanding principal and accrued interest under the Secured Convertible Promissory Note was approximately $32.2 million, and the applicable conversion price was
approximately $0.43 per share. Accordingly, on March 20, 2006, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 74,776,660 shares of common stock. Further, conversion by Optel of all or any portion of
the Secured Convertible Promissory Note could significantly dilute the ownership interests of our other stockholders and give Optel and Dr. Zwan even greater control over the Company. If Optel converted all of the indebtedness evidenced by the
Secured Convertible Promissory Note, including principal and accrued interest into shares of common stock on March 20, 2006, at an applicable conversion price of $0.43 per share, Optel and other entities controlled by the Companys largest
stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 80.2% of the then outstanding shares of common stock after giving effect to the conversion.

On March 15, 2005, Optel established an irrevocable letter of credit in the amount of $6.0 million on our behalf and naming MC Test Service, Inc. as beneficiary. MC
Test Service, Inc. provides outsourced manufacturing services to us. With the letter of credit in place, MC Test Service, Inc. has extended to us regular payment terms to pay for purchased production material. On December 16, 2005, Optel
renewed the letter of credit for the amount of $2.0 million and extended the expiration date to December 30, 2006.



11



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##### Table of Contents

All of the foregoing transactions with Optel were approved by the Companys board of directors, upon the
recommendation of the special committee of the board. The special committee is composed solely of independent directors.

We have entered into discussions
with Optel to restructure the Short-Term Notes and the Secured Convertible Promissory Note by extending the maturity date of such debt, to arrange for additional short-term working capital and to continue guarantees through letters of credit to
secure vendor obligations. If we do not reach an agreement to restructure the Short-Term Notes and the Secured Convertible Promissory Note, continue its guarantees through letters of credit and obtain additional financing from Optel, we will be
unable to meet our obligations to Optel and our other creditors, and in an attempt to collect payment, our creditors, including Optel, may seek legal remedies, including filing a petition for involuntary bankruptcy, or we may elect to seek relief by
filing a voluntary bankruptcy petition.

While we have been exploring alternative financing to raise additional funding, we have not identified a funding
source other than Optel that would be willing to provide current or future financing. In the future, if we issue additional equity securities to raise funds, the ownership percentage of the existing stockholders would be diluted, and the new
investors may demand rights, preferences or privileges senior to those of existing holders of our common stock. Additional debt incurred by us would be senior to equity with respect to the ability of the debt holders to make claims on our assets. In
addition, the terms of any debt issued could impose restrictions on our operations. If adequate funds are not available to satisfy either short- or long-term capital requirements, we may be required to curtail our operations significantly or to seek
funds through arrangements with strategic partners or other parties that may require us to relinquish material rights to certain of our products, technologies or potential markets, or we may be forced to seek protection under bankruptcy laws.

We are dependent on contract manufacturers to produce our printed circuit assemblies and rely on sole and limited source suppliers which could
adversely affect our operations.

The Companys NIC and NAA products are currently produced in Clearwater, Florida. The Company subcontracts the
manufacture of computer systems boards, plastic molds and metal chassis and certain subassemblies and components for the NIC and NAA products. The Company performs final assembly and programs the products with our software. The Company implements
strict quality control procedures throughout each stage of the manufacturing process and tests the boards and subassemblies at various stages in the process, including final test and qualification of the product. Effective as of January 31,
2005, we entered into a letter agreement with MC Test Service, Inc. of Melbourne, Florida, to provide our subcontract manufacturing services. In the future, any failure to maintain our agreements with MC Test Service or enter into a substitute
manufacturing agreement in a timely fashion could interrupt our operations and adversely impact our ability to manufacture our products, book sales and fulfill customer orders.

The Companys OWM and OTS products are currently produced at both Noah Industries, Inc., an outsourced pilot production facility in Melbourne, Florida and in Billerica, Massachusetts, a company owned facility.
The Company subcontracts the manufacture of computer systems boards, plastic molds and metal chassis and certain subassemblies and components for the OTS and OWM products. The Company performs final assembly and programs the products with our
software.

We currently utilize several key components in the manufacture of our products from sole-source or limited-source suppliers. Certain laser and
laser amplifier components, power supplies, touch-screen sensors, single-board computers and SONET overhead terminators used in our NIC and the NAA products are sourced from a single or a limited number of suppliers. We purchase a filter, a
controller board and an interface board from a single or limited number of suppliers for the NAA product. Certain oscillators, power supplies, single board computers, and other optical components are key components in the manufacture of our OTS
products and are sourced from a single or limited number of supplies. We use detectors, switches and an imbedded operating system as key components in the manufacture of our OWM products that are sourced from a single or limited number of suppliers.
We are currently attempting to qualify certain additional suppliers for certain of the sole-sourced components. The loss of a supplier for any of these key components could seriously disrupt our operations.

We forecast product sales on a quarterly basis and order materials and components based on these forecasts. Lead times for materials and components that we order vary
significantly and depend on factors such as the specific supplier, purchase terms and demand for a component at a given time. There may be excess or inadequate inventory of certain materials and components if actual orders vary significantly from
forecasts.

In the past, there have been industry-wide shortages in some of the optical components used in our products. If such shortages occur



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again, suppliers may be forced to allocate available quantities among their customers and we may not be able to obtain components and material in a timely
manner, if at all. These shortages could lead to delays in shipping our products to our customers, which could significantly harm our business. Additionally, if prices of these components increase significantly, our margins on our products will
decrease.

Our largest stockholder has substantial influence over us and could dilute the interests of our other stockholders as a result of his
interests as our largest stockholder and principal creditor.

As of March 20, 2006, Dr. Bryan J. Zwan, our chairman of the board,
beneficially owned 13,420,008 shares of our common stock, which represented approximately 38.1% of our outstanding common stock as of that date. Of those shares, 920,000 shares, or approximately 2.6% of our outstanding common stock as of that date,
were subject to forward sales agreements. In addition, all or any portion of the Secured Convertible Promissory Note held by Optel, an entity controlled by Dr. Zwan, is convertible into our common stock at the option of Optel at any time. The
conversion price of the Secured Convertible Promissory Note is based upon the volume-weighted average trading price of our common stock during the five-day period preceding the date of any conversion (the Applicable Conversion Price). As
of March 20, 2006, the aggregate outstanding principal and accrued interest under the Secured Convertible Promissory Note was approximately $32.2 million and the Applicable Conversion Price was approximately $0.43 per share. Accordingly, on
March 20, 2006, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 74,776,660 shares of our common stock. If Optel had fully converted the Secured Convertible Promissory Note into shares of common stock
on March 20, 2006, Dr. Zwan would have been the beneficial owner of 88,196,669 shares of common stock as of such date, which would have represented approximately 80.2% of our outstanding common stock after giving effect to the conversion.
Any such conversion of the Secured Convertible Promissory Note would substantially dilute the interests of existing stockholders of the Company. In addition, as the beneficial holder of a majority of the common stock of the Company, Dr. Zwan
would have substantial control over matters to be determined by the stockholders of the Company, which control may be exercised in a manner adverse to the interests of other stockholders of the Company.

In addition, as of March 20, 2006, we owed Optel Capital, LLC, approximately $48.8 million plus accrued interest, which debt is secured by a first priority security
interest in substantially all of our assets, and Optel has entered into various other commercial and financial arrangements with us, our creditors and our vendors. Approximately $46.8 million of the amount we owe Optel is currently payable upon
demand and approximately $2.0 million will become payable upon demand by March 31, 2006 (See We need to raise additional capital under the caption entitled Risk Factors). Should Optel demand payment upon the Short-Term Notes,
the Company would not have the resources to satisfy its obligations to Optel, and Optel may seek legal remedies, including filing a petition for involuntary bankruptcy, or we may elect to seek relief by filing a voluntary bankruptcy petition.

We experience fluctuations in our operating results.

Our quarterly operating results have fluctuated in the past and future quarterly operating results are likely to vary significantly due to a variety of factors which are outside our control. Factors that could affect our quarterly operating
results include the following:



| |  |  | fluctuations in capital expenditures and the uneven buying patterns by customers within the telecommunications industry;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | pricing changes by our competitors;
| | - |  | -----------------------------------



| |  |  | the limited number of our major customers;
| | - |  | ------------------------------------------



| |  |  | the product mix, volume, timing and number of orders received from our customers;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | the long sales cycle for obtaining new orders;
| | - |  | ----------------------------------------------



| |  |  | the timing of introduction and market acceptance of new products;
| | - |  | -----------------------------------------------------------------



| |  |  | our success in developing, introducing and shipping product enhancements and new products;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | our ability to enter into long-term agreements or blanket purchase orders with customers;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | our ability to obtain sufficient supplies of sole or limited source components for our products;
| | - |  | ------------------------------------------------------------------------------------------------



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| |  |  | our ability to attain and maintain production volumes and quality levels for our current and future products;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | changes in costs of materials, labor and overhead; and
| | - |  | ------------------------------------------------------



| |  |  | the financial condition of our customers.
| | - |  | -----------------------------------------

Our operating results for any
particular quarter may not be indicative of future operating results, in part because our sales often reflect orders shipped in the same quarter in which they are received, which makes our sales vulnerable to short-term fluctuations. These factors
have historically been and are expected to continue to be difficult to forecast. Any unfavorable changes in these or other factors could have a material adverse effect on our business, financial condition and results of operations.

Our net sales and operating results generally depend on the volume and timing of the orders we receive from customers and our ability to fulfill the orders received.
Orders may be cancelled, modified or rescheduled after receipt. Most of our operating expenses are relatively fixed and cannot be reduced in response to decreases in net sales. The timing of orders and any subsequent cancellation, modification or
rescheduling of orders have affected and will continue to affect our results of operations from quarter to quarter. The deferral of any large order from one quarter to another could have a material adverse effect on our business, financial condition
and results of operations. We must obtain orders during each quarter for shipment in that quarter to achieve our net sales and profit objectives. There can be no assurance regarding the amount or timing of purchases by any customer in any future
period, and business fluctuations affecting our customers have affected and will continue to affect our business.

The initiatives we have undertaken to
reduce costs may have long-term adverse effects on our business.

Since 2001, we have undertaken a number of initiatives to reduce costs. These measures
have included significant reductions in workforce, temporary executive salary reductions, and the outsourcing of manufacturing and production for our NIC and NAA product lines.

There are several risks inherent in our efforts to transition to a reduced cost structure, including, but not limited to, the risk that we will not be able to sustain our cost structure at a level necessary to restore
profitability, resulting in the need for further restructuring initiatives that would entail additional charges and the risk that our ability to effectively develop and market products and remain competitive in the industries in which we compete
will be impaired. Our cost-cutting measures could have long-term effects on our business by reducing our pool of technical talent, decreasing or slowing improvements in our products, making it more difficult for us to respond to customers, limiting
our ability to increase production quickly if the demand for our products increases, limiting our ability to maintain and update information systems and limiting our ability to hire and retain key personnel. These circumstances could have a material
adverse effect on our business, financial condition and results of operations.

Changes in United States and worldwide economies and fluctuations in
capital expenditures within the telecommunications industry could adversely affect us.

Our products are mainly purchased and used by telecommunications
customers. Our sales are affected by the following marketplace conditions:



| |  |  | fluctuations in the economic conditions in the United States and global markets that could result in decreased capital expenditures by telecommunication equipment manufacturers and
equipment rental and leasing companies;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | bankruptcies and decreased capital expenditures that could result in the telecommunications sector in the United States and global markets by competitive local exchange carriers,
Internet service providers and enterprise network operator segments; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in the implementation of bandwidth expansion strategies by the incumbent local exchange carriers.
| | - |  | ---------------------------------------------------------------------------------------------------------

These marketplace conditions may contribute to quarterly or annual fluctuations in our operating results and could have a material adverse effect on our business,
financial condition and results of operations. In addition, the threat of terrorism and war may cause further disruptions to the economy, create further uncertainties and have a material adverse effect on our business, operating results, and
financial condition.



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Economic, political and other risks associated with international sales and operations could adversely affect our
results of operations.

Because we sell our products worldwide, our business is subject to risks associated with doing business internationally. For the
fiscal year December 31, 2005, net sales from international customers represented approximately 36% of our total net sales for that period. We anticipate that net sales from international customers will continue to represent a significant
portion of our total net sales. In addition, many of our new distributors, service and sales personnel are increasingly located outside the U.S. Accordingly, our future results could be harmed by a variety of factors, including:



| |  |  | changes in foreign currency exchange rates;
| | - |  | -------------------------------------------



| |  |  | changes in a specific countrys or regions political, economic or other conditions;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | stability and performance of new distributors, exposure to collection of receivables, sales returns and allowances;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | trade protection measures and import or export licensing requirements;
| | - |  | ----------------------------------------------------------------------



| |  |  | negative consequences from changes in tax laws; and
| | - |  | ---------------------------------------------------



| |  |  | difficulty in staffing and managing widespread operations.
| | - |  | ----------------------------------------------------------

We may not
be able to achieve sustained operating profitability.

We shipped our first product, the NIC, in February 1996, and we have shipped in excess of 5,800
units. However, we have experienced limited product shipments with respect to our NAA, OTS, and OWM products. In addition, we have incurred substantial costs, including costs to:



| |  |  | develop and enhance our technology and products;
| | - |  | ------------------------------------------------



| |  |  | develop our engineering, production and quality assurance operations;
| | - |  | ---------------------------------------------------------------------



| |  |  | recruit and train sales, marketing and customer service groups;
| | - |  | ---------------------------------------------------------------



| |  |  | build administrative and operational support organizations; and
| | - |  | ---------------------------------------------------------------



| |  |  | establish international sales channels and strengthen existing domestic sales channels.
| | - |  | ---------------------------------------------------------------------------------------

Our net losses totaled approximately $21.1 million and $12.9 million for the years ended December 31, 2005 and December 31, 2004, respectively. We anticipate that our operating losses will continue in fiscal
year 2006 as we create and introduce new products and technologies and develop additional distribution channels. We expect that any related increases in net sales will lag behind these cost increases for the foreseeable future. If we cannot fund
expected losses until we achieve operating profitability or positive cash flow from operations, we may not be able to meet our cash and working capital requirements, which would have a material adverse effect on our business, financial condition and
results of operations.

Future changes in financial accounting standards or taxation rules may adversely affect our reported results of operations.

A change in accounting standards or a change in existing taxation rules can have a significant effect on our reported results of operations. New
accounting pronouncements and taxation rules and varying interpretations of accounting pronouncements have occurred and may occur in the future. These new accounting pronouncements and taxation rules may adversely affect our reported financial
results or the way we conduct our business.

For example, under the newly issued SFAS No. 123R, we will be required to account for equity issued under
our stock plans as a compensation expense, and our net income and net income per share will be significantly reduced. Currently, we record compensation expense only in connection with option grants that have an exercise price below the trading price
of the stock. For option grants that have an exercise price less than the fair market value for the options (which reflect expected future increases in the stock price), we calculate compensation expense and disclose their impact on net income
(loss) and net income (loss) per share, as well as the impact of all stock-based compensation expense in a footnote to the consolidated financial statements. SFAS No. 123R requires that we adopt



15



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##### Table of Contents

the new accounting provisions beginning in our first quarter of 2006, and will require us to expense share-based payment awards, including shares issued
under employee stock purchase plans, stock options, restricted stock and stock appreciation rights, as compensation cost.

Compliance with the
Sarbanes-Oxley Act will cause us to incur additional expenses.

We will continue to make a significant investment to comply with the requirements of the
Sarbanes-Oxley Act, and specifically Section 404 as required by the appropriate regulatory authority for the fiscal year ended December 31, 2006. The allocation of financial and human resources sufficient to ensure the completion of proper
documentation, testing, disclosure and remediation efforts will negatively impact our operating results.

We may engage in acquisitions, mergers,
strategic alliances, joint ventures and divestitures that could result in financial results that are different than expected.

In the normal course of
business, we engage in discussions with third parties relating to possible acquisitions, mergers, strategic alliances, joint ventures and divestitures. As part of our business strategy, we completed two asset acquisitions during 2002. Acquisition
transactions are accompanied by a number of risks, including:



| |  |  | use of significant amounts of cash;
| | - |  | -----------------------------------



| |  |  | potentially dilutive issuances of equity securities on potentially unfavorable terms;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | incurrence of debt on potentially unfavorable terms as well as amortization expenses related to certain intangible assets; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | the possibility that we may pay too much cash or issue too much of our stock as consideration for an acquisition relative to the economic benefits that we ultimately derive from
such acquisition.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The process of integrating any acquisition may create unforeseen operating difficulties and expenditures including the
following:



| |  |  | diversion of management time during the period of negotiation through closing and further diversion of such time after closing from focus on operating the businesses to issues of
integration and future products;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | decline in employee morale and retention issues resulting from changes in compensation, reporting relationships, future prospects or the direction of the business;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the need to integrate each companys accounting, management information, human resource and other administrative systems to permit effective management, and the lack of control
if such integration is delayed or not implemented;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the need to implement controls, procedures and policies appropriate for a larger public company at companies that prior to acquisition had been smaller, private companies;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the need to incorporate acquired technology, content or rights into our products and unanticipated expenses related to such integration; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the need to successfully develop an acquired in-process technology to achieve the value currently capitalized as intangible assets.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------

From time to time, we may engage in discussions with candidates regarding the potential acquisition of our product lines, technologies and businesses. If such
divestiture were to occur, there can be no assurance that our business, operating results and financial condition will not be materially and adversely affected. A successful divestiture depends on various factors, including our ability to:



| |  |  | effectively transfer liabilities, contracts, facilities and employees to the purchaser;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | identify and separate the intellectual property to be divested from the intellectual property that we retain; and
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | reduce fixed costs previously associated with the divested assets or business.
| | - |  | ------------------------------------------------------------------------------



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##### Table of Contents

In addition, if customers of the divested business do not receive the same level of service from the new owners, this may
adversely affect our other businesses to the extent that these customers also purchase other Digital Lightwave products. All of these efforts require varying levels of management resources, which may divert attention from other business operations.
Further, if market conditions or other factors lead us to change our strategic direction, we may not realize the expected value from such transactions. If we do not realize the expected benefits or synergies of such transactions, our consolidated
financial position, results of operations, cash flows and stock price could be negatively affected.

We are dependent on key personnel and our ability
to recruit and retain such personnel may affect our business.

Our success depends to a significant degree upon the continued contributions of key
management and other personnel, some of whom could be difficult to replace. We do not currently maintain key man life insurance covering our officers. Our success will depend on the performance of our officers, our ability to retain and motivate our
officers, our ability to integrate new officers into our operations and the ability of all personnel to work together effectively as a team. We have had significant turnover of our executive officers in the past and could continue to have problems
retaining and recruiting executive officers in the future. Our failure to retain and recruit officers and other key personnel could have a material adverse effect on our business, financial condition and results of operations.

We are dependent on a limited number of products and are uncertain of the market for our current products and planned new products.

The majority of our sales are from our initial product, the NIC, and we expect that sales of NIC will continue to account for a substantial portion of our sales for the
foreseeable future. During 1998, we started shipping a commercial version of our NAA based on the same core technology as the NIC. We cannot predict the future level of acceptance by our customers of the NAA product, and we may not be able to
generate significant net sales from this product. We are uncertain about the size and scope of the market for our current and future products, including the product lines we have acquired. Our future performance will depend on increased sales of the
NIC, market acceptance of the NAA, our ability to successfully transition the OWM and OTS products obtained in 2002, and the successful development, introduction and market acceptance of other new and enhanced products.

Market acceptance of our products and our credibility with our customers might be diminished if we are delayed in introducing or producing new products or fail to detect
software or hardware errors in new products (which frequently occur when new products are first introduced). Any delay in introducing or producing new products or failure to detect software or hardware errors in new products could have a material
adverse effect on our business, financial condition and results of operations.

Our industry is subject to rapid technological change.

To remain competitive, we must respond to the rapid technological change in our industry by developing, manufacturing and selling new products and technology and
improving our existing products and technology. The market in which we compete is characterized by the following:



| |  |  | rapid technological change;
| | - |  | ---------------------------



| |  |  | changes in customer requirements and preferences;
| | - |  | -------------------------------------------------



| |  |  | frequent new product introductions; and
| | - |  | ---------------------------------------



| |  |  | the emergence of new industry standards and practices.
| | - |  | ------------------------------------------------------

These factors
could cause our sales to decrease or render our current products obsolete. Our success will depend upon our ability to:



| |  |  | create improvements on and enhancements to our existing products;
| | - |  | -----------------------------------------------------------------



| |  |  | develop, manufacture and sell new products to address the increasingly sophisticated and varied needs of our current and prospective customers;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| |  |  | increase market acceptance of our products.
| | - |  | -------------------------------------------



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The failure to meet these objectives or to adapt to changing market conditions or customer requirements could have a
material adverse effect on our business, financial condition and results of operations.

Our products serve an industry that is extremely competitive,
and such competition may negatively affect our business.

The market for our products is intensely competitive and is subject to rapid technological
change, frequent product introductions with improved performance, competitive pricing and shifting industry standards. We believe that the principal factors on which we compete include the following:



| |  |  | product performance;
| | - |  | --------------------



| |  |  | product quality;
| | - |  | ----------------



| |  |  | product reliability;
| | - |  | --------------------



| |  |  | value;
| | - |  | ------



| |  |  | customer service and support; and
| | - |  | ---------------------------------



| |  |  | length of operating history, industry experience and name recognition.
| | - |  | ----------------------------------------------------------------------

Many of our competitors and certain prospective competitors have significantly longer operating histories, larger installed bases, greater name recognition and significantly greater technical, financial, manufacturing and marketing
resources. In addition, a number of these competitors have long-established relationships with our customers and potential customers. We expect that competition will increase in the future and that new competitors will enter the market for most, if
not all, of the products we currently do and will offer. Increased competition could reduce our profit margins and cause us to lose, or prevent us from gaining, market share. Any of these events could have a material adverse effect on our business,
financial condition and results of operations.

We are dependent on a limited number of major customers and a decrease in orders from any major customer
could decrease our net sales.

For the year ended December 31, 2005, three customers combined to account for approximately 32% of net sales. For
the year ended December 31, 2004, one customer accounted for approximately 21% of net sales. For the year ended December 31, 2003, two customers combined to account for approximately 27% of net sales. No other customer accounted for sales
of 10% or more during those years.

Our success is dependent upon our ability to broaden our customer base to increase the level of sales. None of our
customers has a written agreement with us that obligates them to purchase additional products from us. If one or more of our major customers decide not to purchase additional products or cancels orders previously placed, our net sales could decrease
which could have a material adverse effect on our business, financial condition and results of operations.

We are dependent on our products continuing
to meet changing regulatory and industry standards.

Our products must meet industry standards and regulations that are evolving as new technologies are
deployed. In the United States, our products must comply with various regulations promulgated by the Federal Communications Commission and Underwriters Laboratories, as well as industry standards established by the American Standards Institute and
other organizations. Internationally, our products must comply with standards established by the European Union and communication authorities in other countries as well as with recommendations of the Consultative Committee on International Telegraph
and Telephony. Some of our planned products may be required to be certified by Telcordia in order to be commercially viable. The failure of our products to comply, or delays in compliance, with the various existing and evolving regulations could
prevent us from selling our products in certain markets which could have a material adverse effect on our business, financial condition and results of operations.



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##### Table of Contents

We are dependent on proprietary technology.

Our success and our ability to compete depend upon our proprietary technology that is protected through a combination of patent, copyright, trade secret and trademark law. As of March 20, 2006, we had six issued
patents relating to the NIC and NAA technology and two issued patents relating to the Dense Wavelength Division Multiplexing technology in the United States. Currently, we have 14 patents pending relating to our technology. We cannot assure you that
the patents for which we have applied or intend to apply will be issued or that the steps that we take to protect our technology will be adequate to prevent misappropriation. Our competitors may independently develop technologies that are
substantially equivalent or superior to our technology. Our business strategy includes a plan to continue the increase in net sales in international markets, and the laws of some foreign countries may not protect our proprietary rights to the same
extent as do the laws of the United States.

To further protect our proprietary information, we generally enter into non-disclosure agreements and
proprietary information and invention assignment agreements with our employees and suppliers and limit access to, and distribution of, our proprietary information. It may be possible for third parties to copy or otherwise obtain and use our
technology without authorization despite these precautions.

We may either license our proprietary rights to third parties or license certain technologies
from third parties for use in our products. The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. We believe that our technology does not
infringe on the proprietary rights of others, and we have not received any notice of claimed infringements. However, third parties may assert infringement claims against us in the future that may or may not be successful. We could incur substantial
costs regardless of the merits of the claims if we must defend ourselves or our customers against such claims. Parties making such claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our
products and could obtain an award of substantial damages. We may be required to obtain one or more licenses from third parties, including our customers, in the event of a successful claim of infringement against us. Any such claim could have a
material adverse effect on our business, financial condition and results of operations.

Conversely, we may be required to spend significant resources to
monitor and police our intellectual property rights. We may not be able to detect infringement and our competitive position may be harmed before such detection takes place. In addition, competitors may design around our technology or develop
competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, which could make it easier for competitors to capture market share. Furthermore, some intellectual property rights are licensed to
other companies, allowing them to compete with us using that intellectual property.

The market price of our common stock may be volatile.

The market price of our common stock has been and is likely in the future to be highly volatile. Our common stock price may fluctuate significantly in
response to factors such as:



| |  |  | quarterly variations in operating results;
| | - |  | ------------------------------------------



| |  |  | announcements of technological innovations;
| | - |  | -------------------------------------------



| |  |  | new product introductions by us or our competitors;
| | - |  | ---------------------------------------------------



| |  |  | competitive activities;
| | - |  | -----------------------



| |  |  | changes in earnings estimates by analysts or our failure to meet such earnings estimates;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | significant issuances of warrants to purchase common stock;
| | - |  | -----------------------------------------------------------



| |  |  | significant outstanding debt becoming convertible;
| | - |  | --------------------------------------------------



| |  |  | announcements by us regarding significant acquisitions, strategic relationships or capital expenditure commitments;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | additions or departures of key personnel;
| | - |  | -----------------------------------------



| |  |  | issuances of convertible or equity securities for general or merger and acquisition purposes;
| | - |  | ---------------------------------------------------------------------------------------------



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##### Table of Contents

| |  |  | issuances of debt or convertible debt for general or merger and acquisition purposes;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | changes in federal, state or foreign regulations affecting the telecommunications industry;
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | general market and economic conditions; and
| | - |  | -------------------------------------------



| |  |  | developments relating to future significant litigation.
| | - |  | -------------------------------------------------------

The stocks of
technology companies have experienced extreme price and volume fluctuations. These fluctuations often have been unrelated or disproportionate to the operating performance of these companies. These broad market and industry factors listed above may
have a material adverse effect on the market price of our common stock, regardless of our actual operating performance, and fluctuations in the market price of our common stock could have a material adverse effect on our business, financial
condition and results of operations.

The sale or issuance of a significant number of shares of our stock could depress the price of our stock.

Sales or issuances of a large number of shares of our common stock in the public market or the perception that sales may occur could cause the market
price of our common stock to decline. As of March 20, 2006, 35,207,075 shares of our common stock were outstanding. Of these shares, 23,697,599 are eligible for sale in the public market without restriction, including 5,000,000 shares held by
an entity controlled by Dr. Zwan, our largest stockholder, that are registered for resale. In addition, entities controlled by Dr. Zwan hold an additional 8,420,008 shares of outstanding common stock, including 920,000 shares that are subject
to forward sales agreements. As an affiliate of the Company (as defined under Rule 144 of the Securities Act of 1933, as amended), Dr. Zwan may only sell shares of common stock in the public market in compliance with the volume
limitations of Rule 144 or pursuant to an effective registration statement.

We have agreed to register the shares of our common stock issuable upon
conversion of the Secured Convertible Promissory Note held by Optel. The conversion price of the Secured Convertible Promissory Note is based upon the volume-weighted average trading price of our common stock during the five-day period preceding the
date of any conversion. The registration of our common stock issuable upon conversion of Secured Convertible Promissory Note could depress the price of our stock, the conversion by Optel of such note would substantially dilute the ownership of
existing stockholders, and the resale of such shares could further depress the price of our stock.

We are exposed to various risks related to legal
proceedings or claims.

We have been, and in the future may be, involved in legal proceedings or claims regarding employment law issues, contractual
claims, securities laws violations and other matters. We are currently not involved in any legal proceedings or claims. Any future legal proceedings and claims, whether with or without merit, could be time-consuming and expensive to prosecute or
defend and could divert managements attention and resources. There can be no assurance regarding the outcome of legal proceedings. We may incur significant litigation expenses associated with legal proceedings and claims, which could have a
material adverse effect on our business, financial condition and results of operations.

Our common stock is classified as a penny stock
under SEC rules, which may make it more difficult for our stockholders to resell our common stock.

Our common stock trades on the OTC Bulletin Board.
As a result, the holders of our common stock may find it more difficult to obtain accurate quotations concerning the market value of the stock. Stockholders also may experience greater difficulties in attempting to sell the stock than if it was
listed on a national securities exchange or quoted on the Nasdaq National Market or the Nasdaq SmallCap Market. Because our common stock is not traded on a stock exchange or on Nasdaq, and the market price of the common stock is less than $5.00 per
share, the common stock is classified as a penny stock. Rule 15g-9 of the Securities Exchange Act of 1934 as amended, imposes additional sales practice requirements on broker-dealers that recommend the purchase or sale of penny stocks to
persons other than those who qualify as an established customer or an accredited investor. These include the requirement that a broker-dealer must make a determination that investments in penny stocks are suitable for the
customer and must make special disclosures to the customer concerning the risks of penny stocks. Application of the penny stock rules to our common stock could adversely affect the market liquidity of the shares, which in turn may affect the ability
of holders of our common stock to resell the stock.



20



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##### Table of Contents

Item 1B.Unresolved Staff Comments

Not applicable.

Item 2.Properties

Our corporate headquarters and production and shipping facilities are located at
15550 Lightwave Drive, Clearwater, Florida. We currently lease the building space from Lightwave Drive LLC. The lease expires in November 2008 and may be extended by the company for up to two five-year periods.

We also maintain an engineering and assembly and repair facility located at 101 Billerica Avenue, Building 4, Billerica, Massachusetts. We sublease the facility from
Agilent Technologies, Inc. The sublease was renewed during fiscal year 2004, and expires May 31, 2006. We are currently in the process of renegotiating the lease.

We believe these facilities are adequate and suitable for our present and foreseeable business requirements.

Item 3.Legal Proceedings

The Company from time to time may be involved in various lawsuits and actions by
third parties arising in the ordinary course of business. The Company is not aware of any pending litigation, claims or assessments that would have a material adverse effect on the Companys business, financial condition and results of
operations.

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

During the fourth quarter of 2005, no
matters were submitted to a vote of stockholders through the solicitation of proxies or otherwise.



21



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##### Table of Contents

PART II

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

The Companys shares of Common Stock have traded on the OTCBB under the symbol DIGL since June 8, 2005. Prior to that, the Companys shares were traded on the Nasdaq SmallCap Market under
the same symbol since September 23, 2004 and prior to that on the Nasdaq National Market, also under the same symbol since February 7, 1997. The following table sets for the high and low prices of our Common Stock as reported by the Nasdaq
National Market, the Nasdaq SmallCap Market and OTCBB, as applicable, during the periods indicated for fiscal years ending December 31, 2005 and 2004.



|            |  |              |      |     |   |     
|----------- |  | ------------ | ---- | --- | - | ----
|            |  | Common Stock
|            |  | High         |      | Low
|2004        |  |              |      |     |   |     
|1st Quarter |  | $            | 3.43 |     | $ | 0.85
|2nd Quarter |  | $            | 2.99 |     | $ | 0.73
|3rd Quarter |  | $            | 1.64 |     | $ | 1.05
|4th Quarter |  | $            | 1.65 |     | $ | 0.93
|            |  |             
|2005        |  |              |      |     |   |     
|1st Quarter |  | $            | 1.34 |     | $ | 0.75
|2nd Quarter |  | $            | 0.95 |     | $ | 0.25
|3rd Quarter |  | $            | 0.31 |     | $ | 0.21
|4th Quarter |  | $            | 0.40 |     | $ | 0.12

On March 20, 2006, the last-sale price of the Companys Common Stock was $0.45 per share. As of
March 20, 2006, there were 649 holders of record of the Companys Common Stock.

Dividend Policy

The Company has not paid any dividends since its inception and does not contemplate payment of dividends in the foreseeable future. We anticipate that any earnings in the
near future will be retained for the development and expansion of its business.

Recent Sales of Unregistered Securities

During the fiscal years ended December 31, 2005 and 2004, there were no sales of unregistered securities, except for those disclosed in a previously filed Quarterly
Report on Form 10-Q or Current Report on Form 8-K.



22



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##### Table of Contents

Item 6.Selected Financial Data

SELECTED FINANCIAL DATA

(In thousands, except share and per share data)

The
following selected financial data are derived from the Consolidated Financial Statements of the Company. The selected financial data should be read in conjunction with Item 7, Managements Discussion and Analysis of Financial
Condition and Results of Operations, and the Consolidated Financial Statements of the Company and Notes thereto.



|                                                                 |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|---------------------------------------------------------------- |  | -------------------------------- | ---------- | --- | ---- | - | ---------- | ---- |  | - | ---------- | ---- |  | ---- | ---------- | ---- |  | - | ---------- | ---
|                                                                 |  | For the Years Ended December 31, |           
|                                                                 |  | 2005                             |            |     | 2004 |   |            | 2003 |  |   | 2002       |      |  | 2001 |           
|Consolidated Statement of Operations:                            |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Net sales                                                        |  | $                                | 12,882     |     |      | $ | 13,739     |      |  | $ | 7,514      |      |  | $    | 17,823     |      |  | $ | 82,780     |    
|Gross profit (loss) (8)                                          |  |                                  | 1,872      |     |      |   | 1,097      | (1)  |  |   | (9,450     | )(2) |  |      | (8,957     | )(2) |  |   | 51,170     |    
|Operating expenses:                                              |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Engineering and development (8)                                  |  |                                  | 7,752      |     |      |   | 5,133      |      |  |   | 5,535      |      |  |      | 14,798     |      |  |   | 14,985     |    
|Sales and marketing (8)                                          |  |                                  | 5,774      |     |      |   | 6,113      |      |  |   | 8,033      |      |  |      | 12,756     |      |  |   | 22,261     |    
|General and administrative                                       |  |                                  | 3,461      |     |      |   | 3,932      |      |  |   | 7,527      |      |  |      | 7,904      |      |  |   | 8,063      |    
|Restructuring charge                                             |  |                                  |           |     |      |   | 40         | (3)  |  |   | 744        | (3)  |  |      | 1,646      | (3)  |  |   | 500        | (3)
|Litigation settlements and charges                               |  |                                  |           |     |      |   |           |      |  |   |           |      |  |      | 1,512      | (4)  |  |   | 4,100      | (5)
|Impairment of long-lived assets                                  |  |                                  | 3,369      | (6) |      |   | 322        | (6)  |  |   | 3,302      | (6)  |  |      | 15,945     | (6)  |  |   |           |    
|                                                                 |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Total operating expenses                                         |  |                                  | 20,356     |     |      |   | 15,540     |      |  |   | 25,141     |      |  |      | 54,561     |      |  |   | 49,909     |    
|                                                                 |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Income (loss) from operations                                    |  |                                  | (18,484    | )   |      |   | (14,443    | )    |  |   | (34,591    | )    |  |      | (63,518    | )    |  |   | 1,261      |    
|Other income (loss)                                              |  |                                  | (2,609     | )   |      |   | 1,565      |      |  |   | 2,175      |      |  |      | (22        | )    |  |   | 1,545      |    
|                                                                 |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Net income (loss)                                                |  | $                                | (21,093    | )   |      | $ | (12,878    | )    |  | $ | (32,416    | )    |  | $    | (63,540    | )    |  | $ | 2,806      |    
|                                                                 |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Basic and diluted net income (loss) per share (7)                |  | $                                | (0.60      | )   |      | $ | (0.39      | )    |  | $ | (1.03      | )    |  | $    | (2.03      | )    |  | $ | 0.09       |    
|                                                                 |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Weighted average common and common equivalent shares outstanding |  |                                  | 35,094,986 |     |      |   | 33,065,582 |      |  |   | 31,489,642 |      |  |      | 31,361,412 |      |  |   | 30,927,386 |    
|                                                                 |  |                                  |            |     |     
|Consolidated Balance Sheet Data:                                 |  |                                  |            |     |      |   |            |      |  |   |            |      |  |      |            |      |  |   |            |    
|Cash and cash equivalents                                        |  | $                                | 499        |     |      | $ | 809        |      |  | $ | 312        |      |  | $    | 612        |      |  | $ | 51,044     |    
|Working capital (deficit)                                        |  | $                                | (48,789    | )   |      | $ | (31,920    | )    |  | $ | (25,930    | )    |  | $    | (2,018     | )    |  | $ | 64,755     |    
|Total assets                                                     |  | $                                | 8,314      |     |      | $ | 12,554     |      |  | $ | 17,924     |      |  | $    | 42,398     |      |  | $ | 86,262     |    
|Total long-term liabilities                                      |  | $                                | 438        |     |      | $ | 265        |      |  | $ | 517        |      |  | $    | 783        |      |  | $ | 809        |    
|Stockholders equity (deficit)                                   |  | $                                | (49,190    | )   |      | $ | (29,146    | )    |  | $ | (21,140    | )    |  | $    | 10,764     |      |  | $ | 74,066     |    

---

|(1) | Includes the benefit of $800,000 resulting from settlement with Jabil Circuit, Inc., offset by a $617,000 inventory adjustment and a charge of $1.3 million for excess and obsolete
inventory for the year ending December 31, 2004.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes a charge of $4.0 million for the year ended December 31, 2003, and $12.7 million for the year ended December 31, 2002, for obsolete inventory as described in Note
3 of the Consolidated Financial Statements  Inventory. Additionally, for the year ended December 31, 2003, includes a charge of approximately $4.0 million for inventory claims for inventory held at Jabil as discussed in Note
16 of the Consolidated Financial Statements  Legal Proceedings.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Includes restructuring expense of $40,000, $700,000, $1.6 million and $500,000 for fiscal years ending December 31, 2004, 2003, 2002 and 2001, respectively for charges as
described under Managements Discussion and Analysis of Financial Condition and Results of Operations  Overview and Note 15 of the Consolidated Financial Statements  Restructuring
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Includes a charge of $1.5 million made in connection with the Seth Joseph arbitration as described in Note 16 of the Consolidated Financial Statements  Legal
Proceedings.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|(5) | Includes a charge of $4.1 million made in connection with the Seth Joseph arbitration as described in Form 10-K for the fiscal year ended December 31, 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Includes an impairment charge for long-lived assets of $3.4 million, $322,000, $3.3 million and $15.9 million, for the years ended December 31, 2005, December 31,
2004, December 31, 2003, and December 31, 2002, respectively. The impairments are a result of the carrying value of property and equipment and other long-lived assets being in excess of the estimated fair value of such assets as
described in Note 1 of the Consolidated Financial Statements  Summary of Significant Accounting Policies.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Incremental shares for common stock equivalents are not included in the loss per share calculations due to the antidilutive effect.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(8) | Amounts reflect the reclassification of certain costs from engineering and development and sales and marketing expense, for production and customer service department costs, to cost
of goods sold.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations

This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future
events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict, potential or continue, the negative of terms like
these or other comparable terminology. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not
historical are forward-looking statements. These statements are only predictions. These statements involve known and unknown risks and uncertainties and other factors that may cause actual events or results to differ materially from the results and
outcomes discussed in the forward-looking statements. All forward-looking statements included in this document are based on information available to us on the date of filing, and we assume no obligation to update any such forward-looking statements,
except as required by law. In evaluating these statements, you should specifically consider various factors, including the risks outlined under the caption Risk Factors set forth in Item 1A and those contained from time to time in
our other filings with the SEC. We caution you that our business and financial performance are subject to substantial risks and uncertainties. The following discussion should be read in conjunction with the Consolidated Financial Statements and
related Notes thereto that appear elsewhere in this Report.

Executive Summary

The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the twelve months ended December 31, 2005, and continuing into the first three months of 2006,
the Company has addressed this shortfall by obtaining financing from Optel Capital, LLC (Optel), an entity controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan.
As of December 31, 2005, the Company had a secured convertible note and various secured promissory notes in the aggregate amount of approximately $46.8 million plus accrued interest in the amount of approximately $5.9 million that became due
and payable on or before December 31, 2005 and which are now payable on demand to Optel at any time. If the Company is not able to obtain additional financing, it expects that it will not have sufficient cash to fund its working capital and
capital expenditure requirements for the near term and will not have the resources required for the payment of its current liabilities when they become due. The Companys ability to meet cash requirements and maintain sufficient liquidity over
the next 12 months is dependent on the Companys ability to obtain additional financing from funding sources which may include, but may not be limited to, Optel. Optel currently is and continues to be the principal source of financing for the
Company. The Company has not identified any funding source other than Optel that would be prepared to provide current or future financing to the Company.

The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it achieves profitability that the profitability will be sustainable or that it will continue as a going concern. As a
result, our independent certified public accountants have included an explanatory paragraph for a going concern in their report for the year ended December 31, 2005.

Overview

Digital Lightwave, Inc. provides the global fiber-optic communications industry with products and
technology used to develop, install, maintain, monitor and manage fiber optic-based networks. Telecommunications service providers, owners of private networks (utilities, government and large enterprises) and equipment manufacturers deploy the
Companys products to provide quality assurance and ensure optimum performance of advanced optical communications networks and network equipment. The Companys products are sold worldwide to leading and emerging telecommunications service
providers, telecommunications equipment manufacturers, equipment leasing companies and international distributors.



24



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The Companys net sales are generated from sales of its products less an estimate for customer returns. We expect
that the average selling price of our products will fluctuate based on a variety of factors, including market demand, product configuration, potential volume discounts to customers, the timing of new product introductions and enhancements and the
introduction of competitive products. Because the cost of goods sold tends to remain relatively stable for any given product, fluctuations in the average selling price may have a material adverse effect on our business, financial condition and
results of operations.

Sales of our products have tended to be concentrated with a few major customers and we expect sales will continue to be
concentrated with a few major customers in the future. For the year ended December 31, 2005, three customers combined to account for approximately 32% of net sales. For the year ended December 31, 2004, one customer accounted for
approximately 21% of net sales. For the year ended December 31, 2003, two customers combined to account for approximately 27% of net sales. No other customer accounted for sales of 10% or more during those years.

The Company recognizes revenue from the sale of products when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed and
determinable and collection of the resulting receivable is reasonably assured. When selling through a distributor to an end-user customer, we either obtain an end-user purchase order documenting the order placed with the distributor or proof of
delivery to the end-user as evidence that a sales arrangement exists. No revenue is recognized on products shipped on a trial basis. We believe that our accrued warranty reserve is sufficient to meet our responsibilities for potential future
warranty work on products sold.

The Company has not entered into long-term agreements or blanket purchase orders for the sale of our products and,
accordingly, does not carry substantial backlog from quarter-to-quarter. Our sales during a particular quarter are highly dependent upon orders placed by customers during that period. Consequently, sales may fluctuate significantly from
quarter-to-quarter and year-to-year reflecting the timing and amount of our customers ordering trends. Because most of our operating expenses are relatively fixed and cannot be easily reduced in response to decreased revenues, quarterly fluctuations
in sales may have a significant effect on net income.

To maintain our market share, we are focused on maintaining technological leadership with our
product lines and expanding our sales network to identify emerging opportunities and improve our account presence. During fiscal years 2004 and 2005, we expanded our international presence through the use of local distributors in Europe, Asia and
the Middle East, while maintaining strong relationships with important domestic customers. Technologically, we continue to develop new applications for our installed product base to be realized with the use of new modular add-ons and enhancements to
meet the growing needs of global high-speed data service requirements. During fiscal years 2004 and 2005, we broadened our product offering and capabilities with the following important new products and enhancements:

Fiscal Year 2004



| |  |  | Serial Analyzer Interface Module functionality added to NIC.
| | - |  | ------------------------------------------------------------

Allows for the testing of legacy connectivity via serial interfaces. Government entities and others who use lower speed, legacy network connection interfaces are outfitted with an all-in-one solution for
modern high-speed testing, through the NIC advanced feature offerings as well as lower-speed testing needs.



| |  |  | Introduction of the NIC EP.
| | - |  | ---------------------------

A new form factor
offering of the NIC, allowing for a cost-effective, rack-mounted option whereby the NIC features are embedded at key points throughout the network. Customers may monitor one or more NIC EPs from a centralized location such as a network operations
center.



| |  |  | Next Generation (NextGen) Virtual Concatenation (VCAT) and Link Capacity Adjustment Scheme (LCAS) in the NIC.
| | - |  | -------------------------------------------------------------------------------------------------------------

With the addition of NextGen technologies in the NIC, customers are enabled to make use of developments in SONET and SDH network technologies thereby
allowing them to maximize efficiency of their data transport.



| |  |  | Introduction of 155 MHz-2.5 GHz Jitter/Wander to NIC, allows for Jitter and Wander testing of SDH and SONET networks at 155 MHz, 622 MHz and 2.5 GHz. Includes automatic
compliance testing to the ITU standards.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Fiscal Year 2005



| |  |  | Introduction of 2.6 GHz OTN Jitter/Wander to NIC, allows for Jitter and Wander testing of 2.6 GHz OTN Jitter/Wander networks.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| |  |  | High Density Ethernet added to the NIC,the high density Ethernet circuit pack supports 8 electrical 10/100/1000 Mbps ports and 4 optical 1-Gbps Ethernet ports
simultaneously. The optical ports are user accessible SFP modules.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 10 Gbps Ethernet added to the NIC,the 10 Gbps Ethernet circuit pack supports both LAN and WAN interfaces and works simultaneously with the High Density Ethernet card. The
optical port is a user accessible XFP module.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | System Controller II Upgrade added to the NIC,the system controller II enhances processing power, drive space, supports enhanced BITS/SETS Jitter/Wander features and reduces
boot time.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Mini Operational Support System (MOSS) added to support NIC and SpanView product families,the MOSS software system provides a user friendly interface that monitors all NIC
and SpanView products in a customer network. The MOSS consolidates all the elements in the network in a single view, collects performance data and provides an SQL interface for integration into other companies Operational Support System (OSS).
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We believe that these new products and product enhancements, strategic partnerships, and third-party distribution agreements will further
complement our product portfolio and enable us to offer a broader range of products to our global customers.

Critical Accounting Estimates

We believe that estimating valuation allowances and accrued liabilities are critical in that they are important to the portrayal of our financial
condition and results of operations and they require difficult, subjective and complex judgments that are often the results of estimates that are inherently uncertain. Specifically, we believe the following estimates to be critical:



| |  |  | sales returns and other allowances;
| | - |  | -----------------------------------



| |  |  | reserve for uncollectible accounts;
| | - |  | -----------------------------------



| |  |  | reserve for excess and obsolete inventory;
| | - |  | ------------------------------------------



| |  |  | deferred tax valuation allowance;
| | - |  | ---------------------------------



| |  |  | impairment of long-lived assets;
| | - |  | --------------------------------



| |  |  | warranty reserve; and
| | - |  | ---------------------



| |  |  | pending litigation.
| | - |  | -------------------

We make significant judgments and estimates and
assumptions in connection with establishing these valuation allowances. If we made different judgments or used different estimates or assumptions for establishing such amounts, it is likely that the amount and timing of our revenue or operating
expenses for any period would be materially different.

We estimate the amount of potential future product returns related to current period product
revenue. We consider many factors when making our estimates, including analyzing historical returns, current economic trends, changes in customer demand and acceptance of our products to evaluate the adequacy of the sales returns and other
allowances. Our estimate for the provision for sales returns and other allowances as of December 31, 2005 was $285,000.

We also estimate the
collectibility of our accounts receivables. We consider many factors when making our estimates, including analyzing accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and
changes in our customer payment terms when evaluating the adequacy of the reserve for uncollectible accounts. Our accounts receivable balance as of December 31, 2005 was $2.7 million, net of our estimated reserve for uncollectible accounts of
$145,000.



26



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##### Table of Contents

We estimate the amount of excess and obsolete inventory. We consider many factors when making our estimates, including
analyzing current and expected sales trends, the amount of current parts on hand, the current market value of parts on hand and the viability and technical obsolescence of our products when evaluating the adequacy of the reserve for excess and
obsolete inventory. The assumptions made relative to expected sales trends are subjective in nature and have a material impact on the estimate of the reserve requirement. Should future sales trends, in total or by product line, fluctuate from that
used in our estimates, this reserve could be overstated or understated. Our inventory balance was $4.8 million as of December 31, 2005, net of our estimated reserve for excess and obsolete inventory of approximately $15.7 million.

We estimate the impairment of long-lived assets. We monitor events and changes in circumstances that indicate whether carrying amounts of long-lived assets may not be
recoverable. These events and circumstances include decrease in market price of a long-lived asset, change in the manner in which a long-lived asset is used, changes in legal factors and a current-period operating loss or cash flow loss combined
with a history of operating losses or cash flow losses or a forecast that demonstrates continuing losses associated with the use of long-lived assets. When such an event or changes in circumstance occur, we assess the recoverability of long-lived
assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. We recognize impairment when there is an excess of the assets carrying value over the fair value as estimated using a
discounted expected future cash flows model. In estimating undiscounted expected future cash flows, we must make judgments and estimates related to future sales and profitability. Should future sales trends or profitability be significantly less
than that forecasted, our impairment could be understated. We could be required to take an additional impairment charge in the future should our actual cash flows be less than forecasted. During the year ending December 31, 2005, a review of
the carrying value of our long-lived assets and the probability of recovering such value indicated that an additional $3.4 million impairment charge was required which represented an impairment of the Companys remaining long-lived assets.

We estimate the valuation allowance with respect to our deferred tax assets. Since we believe that it is more likely than not that future tax benefits
will not be realized as a result of current and future income, a full valuation allowance was estimated. In determining a full valuation allowance was necessary, we considered the Companys history of large operating losses and the uncertainty
as to whether we would be able to sustain long-term profitability.

We estimate the amount of our warranty reserve. We consider many factors when making
our estimate, including historical trends, the number of products under warranty, the costs of replacement parts and the expected reliability of our products. We believe that our accrued warranty reserve is sufficient to meet our responsibilities
for potential future warranty work on products sold. Our accrued warranty reserve as of December 31, 2005 was approximately $813,000.

We estimate the
amount of liability the Company may incur as a result of pending litigation. The Company is currently not involved in any legal proceedings or claims and, accordingly, has no accrued liability resulting from pending litigation as of
December 31, 2005. During 2005, we recorded a gain of approximately $1.5 million relating to settlements of certain disputes and litigation during the year. See Note 16 of the Consolidated Financial Statements - Legal Proceedings.

Results of Operations

The
following table sets forth certain financial data expressed as a percentage of net sales.



|                                  |  |                         |    |  |      |    |  |      |   
|--------------------------------- |  | ----------------------- | -- |  | ---- | -- |  | ---- | --
|                                  |  | Year Ended December 31, |   
|                                  |  | 2005                    |    |  | 2004 |    |  | 2003 |   
|Net sales                         |  | 100                     | %  |  | 100  | %  |  | 100  | % 
|Cost of goods sold (1)            |  | 85                      |    |  | 92   |    |  | 226  |   
|                                  |  |                         |    |  |      |    |  |      |   
|Gross profit (loss)               |  | 15                      |    |  | 8    |    |  | (126 | ) 
|                                  |  |                         |   
|Operating expenses:               |  |                         |    |  |      |    |  |      |   
|Engineering and development (1)   |  | 60                      |    |  | 38   |    |  | 73   |   
|Sales and marketing (1)           |  | 45                      |    |  | 44   |    |  | 107  |   
|General and administrative        |  | 27                      |    |  | 29   |    |  | 100  |   
|Restructuring charge              |  | -                       |    |  | -    |    |  | 10   |   
|Impairment of long-lived assets   |  | 26                      |    |  | 2    |    |  | 44   |   
|                                  |  |                         |    |  |      |    |  |      |   
|Total operating expenses          |  | 158                     |    |  | 113  |    |  | 334  |   
|                                  |  |                         |    |  |      |    |  |      |   
|Operating income (loss)           |  | (143                    | )  |  | (105 | )  |  | (460 | ) 
|Interest income                   |  | -                       |    |  | -    |    |  | 1    |   
|                                  |  |                         |   
|Interest expense                  |  | (32                     | )  |  | (18  | )  |  | (29  | ) 
|Other income (expense),net        |  | 11                      |    |  | 29   |    |  | 57   |   
|                                  |  |                         |    |  |      |    |  |      |   
|Income (loss) before income taxes |  | (164                    | )  |  | (94  | )  |  | (431 | ) 
|                                  |  |                         |    |  |      |    |  |      |   
|Net income (loss)                 |  | (164                    | )% |  | (94  | )% |  | (431 | )%
|                                  |  |                         |    |  |      |    |  |      |   

---

|- | Represents less than 1% of net sales.
|- | -------------------------------------

|(1) | During 2005, the Company changed its presentation of costs associated with the production and customer service departments from engineering and development and sales and marketing
to cost of goods sold. These costs totaled approximately $5.0 million, $5.1 million and $3.7 million for the years ended December 31, 2005, 2004 and 2003, respectively.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Year Ended December 31, 2005 Compared With Year Ended December 31, 2004

Net Sales

Net sales for the year ended December 31, 2005,
decreased by $857,000, or 6%, to $12.9 million from $13.7 million for the year ended December 31, 2004. Sales to existing customers for the year represented approximately 78% of sales, or $10.1 million as compared to approximately 89% of sales,
or $12.1 million for 2004. During 2005, the Company shipped 309 total NIC and NAA units as compared to 370 units for the year ended December 31, 2004.

International sales for the year ended December 31, 2005, as a percentage of net sales, increased from 27% to 36% of net sales. For the year ended December 31, 2005, international sales increased by $959,000 or 26%, to $4.7
million from $3.7 million over the prior year.

Cost of Goods Sold

Cost of goods sold for the year ended December 31, 2005 decreased by $1.6 million, or 13%, to $11.0 million as compared to $12.6 million for the year ended December 31, 2004. The decrease in cost of goods
sold was due to a reduction in charges related to excess and obsolete inventory and other inventory claims as well as lower product sales. During 2004, there was a charge of approximately $1.3 million to increase the excess and obsolete inventory
reserve. Cost of goods sold includes direct material costs and the costs of material purchased from third party manufacturers as well as labor and overhead for production and service.

Gross Profit

Gross profit for the year ended December 31, 2005, improved to $1.9 million from $1.1 million for
the year ended December 31, 2004. Gross profit for the year ended December 31, 2004, excluding the charges related to excess and obsolete inventory and the write-off of inventory claims for inventory held at Jabil Circuit, was $2.4
million. Gross margins for the years ended December 31, 2005 and 2004, excluding the charges related to excess and obsolete inventory, were approximately 15% and 17%, respectively. The decrease in gross margin year over year was attributable to
a decrease in the volume of sales spread over the fixed portion of the cost of goods sold.



28



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##### Table of Contents

Engineering and Development

Engineering and development expenses principally include salaries for engineering, development and certain operations personnel, depreciation of product development assets, outside consulting fees and other development expenses. Engineering
and development expenses for the year ended December 31, 2005, increased by $2.6 million to $7.8 million, or 60% of net sales, from $5.1 million, or 38% of net sales, for the year ended December 31, 2004. The increase in spending during
the year reflected additional investment in product development through the increase of engineering staff and planned controlled spending initiatives to further the development of technologies and corresponding new products.

Sales and Marketing

Sales and marketing expenses principally include
salaries for sales, marketing and certain operations personnel, commissions, travel, tradeshows, promotional materials, and depreciation associated primarily with demonstration and loaner units. Sales and marketing expenses for the year ended
December 31, 2005, decreased by $339,000 to $5.8 million, or 45% of net sales, from $6.1 million, or 44% of net sales, for the year ended December 31, 2004. The decrease in expenses represents a reduction in depreciation due to fixed
assets being fully impaired (See Note 1 to the Consolidated Financial Statements - Summary of Significant Accounting Policies), partially offset by increases in lease of competitors units for demonstration at customer sites, consultant fees
for international and new product accounts and third party and/or distributor commissions.

General and Administrative

General and administrative expenses principally include salaries, professional fees, facility rentals, compensation and information systems related to general management
functions. General and administrative expenses for the year ended December 31, 2005, decreased by $471,000 to $3.5 million, or 27% of net sales, from $3.9 million, or 29% of net sales for the year ended December 31, 2004. The decrease
related to reductions in depreciation reflecting full impairment of the remaining long-lived assets carrying value, reductions in the various tax expense accounts reflecting adjustments of estimated remaining liabilities, less consultant fees
and contract services as well as reductions in the board of directors fees as negotiated. These were partially offset by $445,000 of severance and debt forgiveness costs relating to the resignation of the Companys former Chief Executive
Officer, James R. Green during the fiscal year ended December 31, 2005.

Impairment of Property and Equipment

For the year ended December 31, 2005, the Companys analysis, calculated in accordance with the guidelines set forth in SFAS 144, indicated future cash flows
from the Companys operations were insufficient to cover the carrying value of the Companys long-lived assets. Therefore, the Company calculated an impairment using the probability-weighted approach with an average life of five years, and
risk-free rate of interest of 3%. As a result during the fiscal year ended December 31, 2005, the Company recorded a total non-cash impairment charge for the remaining balance of its long-lived assets, which included $3.2 million and $200,000
on its property and equipment and other assets, respectively. During 2004, the Company recorded asset impairment charges of $322,000 related to certain of its long-lived assets (See Note 1 to the Consolidated Financial Statements  Summary of
Significant Accounting Policies)

Other Income (Expense)

Other expense for the year ended December 31, 2005, decreased by $4.2 million to $2.6 million of other expense from $1.6 million of other income in the year ended December 31, 2004. The decrease represents a reduction of other
income resulting from settlement of debt and payables to approximately $1.5 million in 2005 compared to $4.0 million in 2004, as well as the increase in interest expense of approximately $1.6 million associated with the increase in notes payable.

Net Income (loss)

Net loss for the year ended
December 31, 2005, was $21.1 million, or $0.60 per diluted share, an increase of approximately $8.2 million, from a net loss of $12.9 million, or $0.39 per diluted share, for the year ended December 31, 2004, for the reasons discussed
above.



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##### Table of Contents

Year Ended December 31, 2004 Compared With Year Ended December 31, 2003

Net Sales

Net sales for the year ended December 31, 2004,
increased by $6.2 million, or 83%, to $13.7 million from $7.5 million for the year ended December 31, 2003. Sales to existing customers for the year represented 89% of sales, or $12.1 million as compared to 80% of sales, or $6.0 million for
2003. During 2004, the Company shipped 370 total NIC and NAA units compared with 168 units for the year ended December 31, 2003. The telecommunications industry, our customer base, experienced a recognizable turnaround in fiscal year 2004
following a dramatic downturn during 2002 and 2003, brought on by a significant decrease in network build-outs and capital spending by the telecommunications carriers and equipment manufacturers.

International sales for the year ended December 31, 2004, as a percentage of net sales, increased from 25% to 27% of total sales. For the year ended
December 31, 2004, international sales increased by $1.8 million, or 48%, to $3.7 million from $1.9 million over the prior year.

Cost of Goods
Sold

Cost of goods sold for the year ended December 31, 2004, decreased by $4.3 million, or 26%, to $12.6 million as compared to $17.0 million for
the year ended December 31, 2003. The decrease in cost of goods sold was impacted by an increase in the volume of units sold offset by a reduction in charges related to excess and obsolete inventory. During 2004, there was a charge of
approximately $1.3 million to increase the excess and obsolete inventory reserve compared to $4.0 million in such charges during 2003 and $4.0 million write-off of inventory claims held at Jabil Circuit, Inc in 2003. Cost of goods sold consists of
direct material costs and the costs of material purchased from third party manufacturers as well as labor and overhead for production and service.

Gross Profit

Gross profit for the year ended December 31, 2004, improved to $1.1 million from a gross loss of $9.5 million for the
year ended December 31, 2003. Gross profit for the year ended December 31, 2004, excluding the charges related to excess and obsolete inventory was $2.4 million compared to a gross loss of $1.5 million for the year ended December 31,
2003 excluding the charges related to excess and obsolete inventory and the write-off of inventory claims for inventory held at Jabil. Gross margin for the year ended December 31, 2004, excluding the charges related to excess and obsolete
inventory, was approximately 17% compared to a gross margin loss of 19%, for the year ended December 2003, excluding the charges related to excess and obsolete inventory and the write-off of inventory claims for inventory held at Jabil. The increase
in gross margin year over year is attributed to a favorable shift in product mix offset in part by the decrease in the average selling price of the NIC product line.

Engineering and Development

Engineering and development expenses principally include salaries for engineering,
development and certain operations personnel, depreciation of product development assets, outside consulting fees and other development expenses. Engineering and development expenses for the year ended December 31, 2004, decreased by $402,000
to $5.1 million or 38% of net sales, from $5.5 million, or 73% of net sales for the year ended December 31, 2003. The decrease in the expense related to reductions in force implemented in 2003 partially offset by increase in new product
development efforts as well as a reduction in depreciation expenses resulting from the long-lived asset impairments taken in 2002 and 2003. (See Note 1 to the Consolidated Financial Statements  Summary of Significant Accounting Policies).

Sales and Marketing

Sales and marketing expenses
principally include salaries for sales, marketing and certain operations personnel, commissions, travel, tradeshows, promotional materials, and depreciation associated primarily with demonstration and loaner units. Sales and marketing expenses for
the year ended December 31, 2004 decreased by $1.9 million to $6.1 million, or 44% of net sales, from $8.0 million, or 107% of net sales for the year ended December 31, 2003. The decrease in the expense represented a decrease a reduction
in depreciation due to the return of capital leases to CIT Technologies Corporation (See Note 16 to the Consolidated Financial



30



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##### Table of Contents

Statements  Legal Proceedings), and a reduction in expenses related to international offices which were closed in 2003. These decreases were offset in
part by an increase in bad debt expense of approximately $98,000 during 2004 compared to a decrease of $444,000 in bad debt expense during 2003.

General and Administrative

General and administrative expenses principally include salaries, professional fees, facility rentals,
compensation and information systems related to general management functions. General and administrative expenses for the year ended December 31, 2004, decreased by $3.6 million, or 29% of net sales, from $7.5 million, or 100% of net sales, for
the year ended December 31, 2003. The decrease relates to workforce reductions implemented throughout 2003, as well as declines in directors and officers insurance premiums, legal fees and facility rentals.

Restructuring Charges

During fiscal years 2002 and 2003, the board
of directors approved a number of business restructuring and cost reductions initiatives in response to the downturn in the economy and specifically, the telecommunications industry. These initiatives included multiple reductions in the work force
and the closing of the Companys sales offices in Brazil, Singapore, India and Australia. The Company recorded restructuring charges of $700,000 in the fiscal year ending December 31, 2003. At December 31, 2004, all outstanding
liabilities relating to these restructuring efforts had been fully satisfied. (See Note 15 to the Consolidated Financial Statements  Restructuring)

Impairment of Property and Equipment

During 2004, the Company recorded asset impairment charges of $322,000 related to certain of its
long-lived assets compared to $3.3 million during the fiscal year 2003. The amount of the impairment was determined using estimates of future cash flows for the Company. (See Note 1 to the Consolidated Financial Statements  Summary of
Significant Accounting Policies)

Other Income (Expense)

Other income for the year ended December 31, 2004 decreased by $611,000 to $1.6 million from $2.2 million in the year ended December 31, 2003. The decrease represented a reduction of other income resulting from settlement of
payables of approximately $4.0 million in 2004 compared to $4.3 million in 2003, offset in part by increased interest expense of approximately $270,000 associated with the net increase in notes payable of approximately $15.9 million.

Net Income (loss)

Net loss for the year ended December 31, 2004
was $12.9 million, or $0.39 per diluted share, an improvement of $20.0 million, from a net loss of $32.4 million, or $1.03 per diluted share, for the year ended December 31, 2003 for the reasons discussed above.

Liquidity and Capital Resources

As of December 31, 2005, the
Companys unrestricted cash and cash equivalents were approximately $499,000, a decrease of $310,000 from December 31, 2004. As of December 31, 2005, the Companys working capital deficit was approximately $48.8 million as
compared to a working capital deficit of $31.9 million at December 31, 2004. During 2005, we incurred a net loss of $21.1 million and cash flows used by operations of $13.6 million. In 2004, we incurred a net loss of $12.9 million and cash
flows used by operations of $17.4 million. We had an accumulated deficit of $136.4 million at December 31, 2005.

Beginning in the third quarter of
2001 and continuing through December 31, 2005, the Company has incurred combined net losses of $149.4 million. The Company expects to continue to incur operating losses in fiscal year 2006. Management has taken actions to reduce operating
expenses and capital expenditures. These actions include restructuring operations to more closely align operating costs with revenues. As further discussed below, our ability to maintain sufficient liquidity in the future is dependent on us raising
additional capital, successfully negotiating extended payment terms with certain vendors and other creditors, maintaining tight controls over spending, successfully achieving our product release schedules and attaining our forecasted sales
objectives.



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##### Table of Contents

The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the
twelve months ended December 31, 2005, and continuing into the first three months of 2006, the Company has addressed this shortfall by obtaining financing from Optel Capital, LLC (Optel), an entity controlled by the Companys
largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan. The Company has used the financing provided by Optel to fund (i) the satisfaction of substantially all of its outstanding debt and liabilities owed
to creditors other than Optel, and (ii) the Companys short-term working capital needs.

As of March 20, 2006, the Company owed Optel
approximately $48.8 million in principal, plus accrued interest thereon, which debt is secured by a first priority security interest in substantially all of the Companys assets and such debt accrues interest at a rate of 10% per annum.
The maturity dates and corresponding payment schedules related to these obligations are as follows:



| |  |  | Secured Convertible Promissory Note. Pursuant to that certain secured convertible promissory note, dated as of September 16, 2004, the Company borrowed $27.0 million
from Optel on the following terms (the Secured Convertible Promissory Note):
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Accrued and unpaid interest as of September 16, 2004, plus interest that accrued on the $27.0 million outstanding principal that became due and payable on September 16,
2005, is now currently due and payable on demand at any time;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal is now currently due and payable on demand at any time.
| | - |  | ----------------------------------------------------------------------------------



| |  |  | Short-Term Notes. Pursuant to those several short-term secured promissory notes issued by the Company to Optel since September 30, 2004, the Company borrowed an
additional $21.8 million from Optel on the following terms (the Short-Term Notes):
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $19.8 million in principal plus accrued interest is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $2.0 million in principal plus accrued interest payable on demand at any time after March 31, 2006;
| | - |  | -----------------------------------------------------------------------------------------------------------------

On February 10, 2005, at a special meeting of the Companys stockholders, the conversion feature of the Secured Convertible Promissory Note was approved by the
Companys disinterested stockholders. Accordingly, all or any portion of such debt is convertible into our common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted average trading price of our
common stock during the five-day period preceding the date of any conversion. Further, the Company is required to file a registration statement covering the offer and sale by Optel of the shares of common stock issuable upon conversion and to keep
the registration statement effective until the date that is two years after the date that such registration statement is declared effective.

All of the
foregoing transactions with Optel were approved by the Companys board of directors, upon the recommendation of the special committee of the board. The special committee is composed solely of independent directors.

On March 11, 2005, the Company issued 981,258 shares of common stock to Optel in connection with Optels conversion of $1.0 million of the indebtedness
outstanding under the Secured Convertible Promissory Note. As of March 20, 2006, the aggregate outstanding principal and accrued interest under the Secured Convertible Promissory Note was approximately $32.2 million, and the applicable
conversion price was approximately $0.43 per share. Accordingly, on March 20, 2006, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of 74,776,660 shares of common stock. Further conversion by Optel of
all or any portion of the Secured Convertible Promissory Note could significantly dilute the ownership interests of the Companys other stockholders and give Optel and Dr. Zwan even greater control over the Company. If Optel converted all
of the indebtedness evidenced by the Secured Convertible Promissory Note, including principal and accrued interest, into shares of common stock on



32



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March 20, 2006, at an applicable conversion price of $0.43 per share, Optel and other entities controlled by the Companys largest stockholder and
current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately 80.2% of the then outstanding shares of common stock after giving effect to the conversion.

On March 15, 2005, Optel established an irrevocable letter of credit in the amount of $6.0 million on the Companys behalf and naming MC Test Service, Inc. as
beneficiary. MC Test Service, Inc. provides outsourced manufacturing services to us. With the letter of credit in place, MC Test Service, Inc. has extended to us regular payment terms to pay for purchased production material. On December 16,
2005, Optel renewed the letter of credit for the amount of $2.0 million and extended the expiration date to December 30, 2006.

The Company has
entered into discussions with Optel to restructure the Short-Term Notes and the Secured Convertible Promissory Note by extending the maturity date of such debt, to arrange for additional short-term working capital and to continue guarantees through
letters of credit to secure vendor obligations. If we do not reach an agreement to restructure the Short-Term Notes and the Secured Convertible Promissory Note, continue its guarantees through letters of credit and obtain additional financing from
Optel, we will be unable to meet our obligations to Optel and our other creditors, and in an attempt to collect payment, our creditors, including Optel, may seek legal remedies, including filing a petition for involuntary bankruptcy, or we may elect
to seek relief by filing a voluntary bankruptcy petition.

The Companys ability to meet cash requirements and maintain sufficient liquidity over the
next 12 months is dependent on its ability to obtain additional financing from funding sources which may include, but may not be limited to, Optel. As of December 31, 2005, the Company had certain Secured Convertible Promissory Note and
Short-Term Notes in the amount of approximately $46.8 million plus accrued interest in the amount of $5.9 million that became due and payable on or before December 31, 2005 and which are now payable on demand to Optel at any time. If the
Company is not able to obtain additional financing, it expects that it will not have sufficient cash to fund its working capital and capital expenditure requirements for the near term and will not have the resources required for the payment of its
current liabilities when they become due. Optel currently continues to be the principal source of financing for the Company. The Company has not identified any funding source other than Optel that would be prepared to provide current or future
financing to the Company.

The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it
achieves profitability that the profitability will be sustainable or that it will continue as a going concern. As a result, our independent certified public accountants have included an explanatory paragraph for a going concern in their report for
the year ended December 31, 2005.

Operating Activities

Net cash used in operating activities for the year ended December 31, 2005, was $13.6 million. This was primarily attributable to the net loss in 2005 of $21.1 million. The net loss from operations was favorably adjusted for a $3.4
million impairment charge, $374,000 forgiveness of a related party note receivable, $879,000 of depreciation and amortization; and offset by a $1.7 million gain on settlement of accounts payable and accrued litigation and a decrease in the provision
for excess and obsolete inventory of $539,000. The increase in accounts payable and accrued expenses totaled approximately $5.1 million resulted primarily from accrued but unpaid interest expenses of $2.9 million; from unpaid trade accounts payable
of $1.6 million; and from the conversion of debt to stock of $1.0 million, which was applied first to accrued interest. Usage of on-hand inventory and increase in prepaid expenses and other assets provided operating cash of $276,000 and $326,000,
respectively. Accounts receivable used operating cash of approximately $603,000 on net sales of approximately $12.9 million, as new customer billings outpaced cash collections.

Net cash used in operating activities for the year ended December 31, 2004, was $17.4 million. This reflects a net loss in 2004 of $12.9 million, coupled with decreases in accrued litigation charges of $5.8
million, settlements of accounts payable and accrued litigation of $4.4 million, increases in accounts receivable of $963,000 and increases in prepaid expenses and other assets of $364,000. These were partially offset by a $2.6 million decrease in
net inventories, a $1.5 million increase in accounts payable and accrued expenses as well as $2.1 million of non-cash expenses including, but not limited to depreciation and amortization of $2.3 million and an impairment charge for long-lived assets
of $322,000.

Net cash used in operating activities for the year ended December 31, 2003, was $16.4 million. This was primarily the result of a net
loss of $32.4 million on revenues of $7.5 million. After adjusting the net loss for 2003 by $10.8 million for non-cash items that impacted the Consolidated Statement of Operations, including but not limited to depreciation, amortization, allowance
for bad debts,



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##### Table of Contents

impairment of long-lived assets, restructuring charges, the result was a negative impact to cash of $21.6 million. During 2003, we paid approximately $3.4
million in expenses and settlements associated with the Seth Joseph matter. (See Note 16 to the Consolidated Financial Statements  Legal Proceedings) Accounts receivable and inventory both contributed cash to operations. Accounts receivable
decreased $3.4 million as a result primarily of collections exceeding billings. In fulfilling customer orders, we were able to reduce inventory by approximately $2.1 million, thereby reducing our cash requirements. Additionally, our increase of $3.8
million in accounts payable and accrued liabilities provided a positive flow of cash to the Company.

Investing Activities

Net cash used in investing activities was approximately $262,000 for the year ended December 31, 2005. This was primarily the result of the purchase of property and
equipment to further the development of technologies and corresponding new products.

Net cash provided from investing activities was approximately $1.9
million for the year ended December 31, 2004. This was generated by the release of restricted cash of approximately $2.0 million, partially offset by $133,000 of purchases of property and equipment.

Net cash provided from investing activities totaled $2.4 million for the year ended December 31, 2003. This was attributable to the repayment of a note receivable
of approximately $800,000, the $388,000 reduction in our restricted cash requirements, and the sale and maturity of unrestricted shortterm investments totaling $1.5 million. This provision of cash was offset in part by the purchase of fixed
assets totaling approximately $313,000.

Financing Activities

Net cash provided by financing activities for the year ended December 31, 2005 of $13.5 million was principally a result of $15.4 million additional financing provided by Optel, LLC and Optel Capital, LLC (see Note 12 to the
Consolidated Financial Statements  Related Party Transactions) offset by payments of $1.9 million made on notes payable to Jabil in conjunction with scheduled payments as well as the Settlement Agreement (See Note 3 to the Consolidated
Financial Statements  Inventories). The proceeds provided by Optels financing were used to fund the operating losses.

Net cash provided by
financing activities for the year ended December 31, 2004, was approximately $16.1 million. This was primarily attributable to $17.8 million in financing provided by Optel, LLC and Optel Capital, LLC. (See Note 12 to the Consolidated Financial
Statements  Related Party Transactions) Financing proceeds were used to fund operating losses, settlement payments and payments made on notes to Jabil Circuit, Inc. of $1.8 million. (See Note 9 to the Consolidated Financial Statements 
Notes Payable, Line of Credit and Letter of Credit)

Net cash provided by financing activities for the year ended December 31, 2003, was $13.6 million
and resulted primarily from $14.6 million in financing provided by Optel, LLC and Optel Capital, LLC. The proceeds provided by this financing were used to fund operating losses and to fund settlement payments with various creditors and vendors. (See
Note 12 to the Consolidated Financial Statements  Related Party Transactions)

Revolving Credit Facility

In April 2002, the Company entered into a Revolving Credit and Security Agreement (the Agreement) with Wachovia Bank (the Bank). The Agreement
expired on April 15, 2005. The terms of the Agreement provided the Company with a $27.5 million line of credit at LIBOR plus 0.7% collateralized by the Companys cash and cash equivalents and short-term investments. The advance rate varied
between 80% and 95% and was dependent upon the composition and maturity of the available collateral. An availability fee of 0.10% per annum was payable quarterly based on the Average Available Principal Balance (as defined in the Agreement) for
such three months. The Agreement had an initial term of three years. The Agreement could have been terminated by the Company at any time upon at least fifteen days prior written notice to the Bank, and the Bank had the right to terminate the
Agreement at any time, without notice upon or after the occurrence of an event of default.

At December 31, 2003, there were approximately $1.4
million of letters of credit outstanding, collateralized by approximately $1.4 million of the Companys cash and cash equivalents which were classified as restricted at December 31, 2003. The letters of credit expired in December 2004 and
were not renewed.



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##### Table of Contents

Legal Proceedings

As
of the date of this report, the Company is not aware of any pending litigation, claims or assessments that would have a material adverse effect on the Companys business, financial condition and results of operations. (See Note 16 to the
Consolidated Financial Statements - Legal Proceedings)

New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (the FASB) issued Statement on Financial Accounting Standard (SFAS) No. 123 (Revised 2004) Share-Based Payment
(SFAS No. 123R). SFAS No. 123R addresses all forms of share-based payment (SBP) awards, including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights.
SFAS No. 123R will require the Company to expense SBP awards with compensation cost for SBP transactions measured at fair value. The FASB originally stated a preference for a lattice model because it believed that a lattice model more fully
captures the unique characteristics of employee stock options in the estimate of fair value, as compared to the Black-Scholes model which the Company currently uses for its footnote disclosure. The FASB decided to remove its explicit preference for
a lattice model and not require a single valuation methodology. SFAS No. 123R requires the Company to adopt the new accounting provisions either prospectively or retrospectively beginning in the first quarter of 2006. The Company has determined
that it will adopt SFAS No. 123R prospectively but has not determined the impact of applying SFAS No. 123R to its financial statements.

In
November 2004, the FASB issued SFAS 151, Inventory Costs, an amendment of ARB No. 43, which is effective for inventory costs incurred by the Company beginning fiscal year 2006. The amendments made by SFAS 151 will improve financial reporting by
clarifying those abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on
the normal capacity of the production facilities. The Company does not believe that the adoption of SFAS 151 will have a significant effect on its financial statements.

Off-Balance Sheet Arrangements

During the fiscal year ended December 31, 2005, the Company did not engage in
any off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K by the Commission under the Securities Exchange Act of 1934, as amended.

Other Material Commitments

The Companys contractual cash obligations as of December 31, 2005 are summarized (in thousands) in
the table below.



|                                   |  |       |        |          |   |            |  |            |       |           |   |   |  |   |  
|---------------------------------- |  | ----- | ------ | -------- | - | ---------- |  | ---------- | ----- | --------- | - | - |  | - | -
|Contractual Cash Obligations       |  | Total |        | < 1 year |   | 1 - 3years |  | 3 - 5years |       | > 5 years
|Notes Payable - Related Party (1)  |  | $     | 46,830 |          | $ | 46,830     |  | $          |      |           | $ |  |  | $ | 
|Operating leases                   |  |       | 5,463  |          |   | 1,868      |  |            | 3,595 |           |   |  |  |   | 
|Non-cancelable purchase orders (2) |  |       | 2,596  |          |   | 2,596      |  |            |      |           |   |  |  |   | 
|Notes Payable - Other (1)          |  |       | 55     |          |   | 55         |  |            |      |           |   |  |  |   | 
|                                   |  |       |        |          |   |            |  |            |       |           |   |   |  |   |  
|Total contractual cash obligations |  | $     | 54,944 |          | $ | 51,349     |  | $          | 3,595 |           | $ |  |  | $ | 
|                                   |  |       |        |          |   |            |  |            |       |           |   |   |  |   |  

---

|(1) | Notes payable obligations are presented exclusive of accrued interest. (See Note 9 to the Consolidated Financial Statements - Notes Payable, Line of Credit and Letter of Credit)
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Reflects non-cancelable inventory purchase orders.
|--- | --------------------------------------------------

Trends and
Uncertainties

During 2005, the telecommunications industry experienced a modest recovery, aided by the broader improvement in the global economy. This
recovery follows a period from 2001 to 2003 where the economy in general and the telecommunications industry specifically experienced a significant downturn. While there can be no assurance of the continuation of the current positive trends in the
economy and in the telecom industry, we see the recovery in the telecommunications sector and fiber optic test equipment market continuing in the near term.



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Item 7A.Quantitative and Qualitative Disclosures about Market Risk

We are not exposed to
material fluctuations in currency exchange rates because the majority of our sales and expenses are denominated in U.S. dollars. Our cash balances are invested in short-term, interest-bearing money market accounts. We believe that the impact of a
10% increase or decline in interest rates would not be material to our investment income.

Item 8.Consolidated Financial Statements and Supplementary Data

The financial statements required by this Item are submitted at the end of this Annual Report on Form 10-K.

Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosures

None.

Item 9A.Controls and Procedures

Our principal executive officer and principal financial
officer evaluated the effectiveness of our disclosure controls and procedures pursuant to the Securities Exchange Act of 1934, as amended (the Exchange Act), as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of
December 31, 2005. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of December 31, 2005, our disclosure controls and procedures are not effective pursuant to the requirements of
the Sarbanes-Oxley Act of 2002 to ensure that (1) information to be disclosed in reports we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specifies by the rules and forms promulgated under
the Exchange Act and (2) information required to be disclosed in reports filed under the Exchange Act is accumulated and communicated to the principal executive officer and principal financial officer as appropriate to allow timely decisions
regarding required disclosure. There were no changes in the Companys internal control over financial reporting that occurred during the Companys last fiscal quarter that have materially affected or are reasonably likely to materially
affect, the Companys internal control over financial reporting. In conjunction with our procedures to implement the documentation and internal control requirements of the Sarbanes-Oxley Act of 2002 for companies of our size, we will initiate
corrective actions necessary to address internal control deficiencies, and thereafter we will continue to evaluate the effectiveness of our disclosure controls and internal controls and procedures on an ongoing basis, taking corrective action as
appropriate.

Item 9B.Other Information

None.



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##### Table of Contents

PART III

Certain information required by Part III is omitted from this report in that the registrant intends to file a
definitive proxy statement pursuant to Regulation 14A (the Proxy Statement) not later than 120 days after the end of the fiscal year covered by this Report, and certain information included therein is incorporated herein by reference.

Item 10.Directors and Executive Officers of the Registrant

The information required by this
Item will be set forth in the Proxy Statement, which information is hereby incorporated herein by reference.

Compliance with Section 16(a) of the
Exchange Act

Section 16(a) under the Securities Exchange Act of 1934, as amended, requires the Companys officers and directors, and persons
who own more than ten percent (10%) of a registered class of the Companys equity securities, to file reports of ownership and changes in ownership with the SEC. Officers, directors and greater than ten percent (10%) stockholders are
required by regulations of the SEC to furnish the Company with copies of all Section 16(a) forms that they file. To the Companys knowledge, based solely on review of the copies of such reports furnished to the Company and written
representations that no other reports were required, the Companys officers, directors and greater than ten percent (10%) stockholders complied with all applicable Section 16(a) filing requirements for the fiscal year ended
December 31, 2005, with the exception of a Form 4 filing for Mr. Hussey was not filed to report stock option grants during the year. On March 24, 2006, Form 4 was filed for Mr. Hussey to report stock option grants during 2005.

Policies on Business Conduct and Ethics

The Company
has adopted a code of business conduct and ethics that is applicable to all of its directors, offices and employees (the Code of Ethics). A copy of the Code of Ethics is available upon request, free of charge, by contacting the Company
at (727) 442-6677.

Item 11.Executive Compensation

The information required by this Item will be set forth in the
Proxy Statement, which information is hereby incorporated herein by reference.

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

The information required by this Item will be set forth in the Proxy Statement, which information is hereby incorporated herein by reference.

Item 13.Certain Relationships and Related Transactions

The information required by this Item will
be set forth in the Proxy Statement, which information is hereby incorporated herein by reference.

Item 14.Principal Accountant Fees and Services

The information required by this Item will be set
forth in the Proxy Statement, which information is hereby incorporated herein by reference.



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PART IV

Item 15.Exhibits and Financial Statement Schedules

(a) The following documents
are filed as a part of this report:



| | 1. | Financial Statements. See the Consolidated Financial Statements included with this report, the index to which is set forth on page F-1.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------



| | 2. | Financial Statement Schedules. See the last page of the Consolidated Financial Statements.
| | -- | ------------------------------------------------------------------------------------------



| | 3. | Exhibits. The following sets forth a list of the exhibits required by Item 601 of Regulation S-K and Item 15(b) of this form:
| | -- | -----------------------------------------------------------------------------------------------------------------------------



|            |  |       |  |   |  |                                                                                                                                                                 
|----------- |  | ----- |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Ref.  |  |   |  | Description                                                                                                                                                     
|3.1         |  | (1)   |  | - |  | Certificate of Incorporation of the Company.                                                                                                                    
|            |  |       | 
|3.2         |  | (4)   |  | - |  | Amendment to Certificate of Incorporation of the Company dated June 21, 2002.                                                                                   
|            |  |       | 
|3.3         |  | (4)   |  | - |  | Amended and Restated By-laws of the Company dated June 21,2002.                                                                                                 
|            |  |       | 
|3.4         |  | (19)  |  | - |  | Certificate of Amendment to the Amended and Restated Certificate of Incorporation.                                                                              
|            |  |       | 
|4.1         |  | (1)   |  | - |  | Specimen Certificate for the Common Stock.                                                                                                                      
|            |  |       | 
|10.1        |  | (1)*  |  | - |  | Form of Indemnification Agreement between the Company and officers and directors of the Company.                                                                
|            |  |       | 
|10.2        |  | (1)   |  | - |  | Digital Lightwave, Inc. 1996 Stock Option Plan.                                                                                                                 
|            |  |       | 
|10.3        |  | (2)   |  | - |  | L.P. Lease Agreement, dated January 9, 1998, between the Company and Orix Hogan-Burt Pinellas Venture.                                                          
|            |  |       | 
|10.4        |  | (2)   |  | - |  | First Lease Amendment, dated February 18, 1998, between the Company and Orix Hogan-Burt Pinellas Venture.                                                       
|            |  |       | 
|10.5        |  | (3)   |  | - |  | Manufacturing contract agreement between the Company and Jabil Circuit Inc. dated December 30, 2001.                                                            
|            |  |       | 
|10.6        |  | (4)   |  | - |  | Revolving Credit and Security Agreement between the Company and Wachovia Bank.                                                                                  
|            |  |       | 
|10.7        |  | (4)   |  | - |  | Form of Revolving Credit Note issued to Wachovia Bank.                                                                                                          
|            |  |       | 
|10.8        |  | (6)   |  | - |  | Compromise and Settlement Agreement, dated June 13, 2003, between the Company and Fidelity and Deposit Company, also known as Zurich American Insurance Company.
|            |  |       | 
|10.9        |  | (5)*  |  | - |  | Amendment to 1997 Employee Stock Purchase Plan.                                                                                                                 
|            |  |       | 
|10.10       |  | (7)   |  | - |  | Settlement and Release Modification Agreement, dated July 22, 2003, between the Company and Lightwave Drive, LLC.                                               
|            |  |       | 
|10.11       |  | (8)   |  | - |  | Settlement agreement between the Company and Tektronix, Inc. dated December 30, 2003.                                                                           
|            |  |       | 
|10.12       |  | (8)   |  | - |  | Settlement agreement between the Company and Micron Optics, Inc. dated December 9, 2003.                                                                        
|            |  |       | 
|10.13       |  | (8)   |  | - |  | Settlement agreement between the Company and Arrow Electronics, Inc. dated January 24,2004.                                                                     
|            |  |       | 
|10.14       |  | (9)   |  | - |  | Settlement Agreement dated May 11, 2004, between Jabil Circuit, Inc. and Digital Lightwave, Inc.                                                                
|            |  |       | 
|10.15       |  | (9)   |  | - |  | Promissory Note in the principal amount of $3,011,404, dated effective as of May 11, 2004, executed by Digital Lightwave, Inc. in favor of Jabil Circuit, Inc.  
|            |  |       | 
|10.16       |  | (9)   |  | - |  | Promissory Note in the principal amount of $2,227,500, dated effective as of May 11, 2004, executed by Digital Lightwave, Inc. in favor of Jabil Circuit, Inc.  
|            |  |       | 
|10.17       |  | (10)* |  | - |  | Settlement Agreement between George J. Matz and Digital Lightwave, Inc dated as of April 30, 2004.                                                              
|            |  |       | 
|10.18       |  | (10)* |  | - |  | Settlement Agreement between Glenn Dunlap and Digital Lightwave, Inc dated as of May 6, 2004.                                                                   
|            |  |       | 
|10.19       |  | (11)  |  | - |  | Settlement and Renewal Agreement dated May 26, 2004 between Plaut Sigma Solutions, Inc. and Digital Lightwave, Inc. and Optel Capital, LLC.                     
|            |  |       | 
|10.20       |  | (12)  |  | - |  | Mediation Settlement Agreement dated June 8, 2004 between CIT Technologies Corporation and Digital Lightwave, Inc.                                              
|            |  |       | 
|10.21       |  | (13)  |  | - |  | Loan and Restructuring Agreement between Digital Lightwave, Inc. and Optel Capital, LLC dated as of September 16, 2004.                                         



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|      |  |       |  |   |  |                                                                                                                                             
|----- |  | ----- |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------
|10.22 |  | (13)  |  | - |  | Twenty Second Amended and Restated Security Agreement between Digital Lightwave, Inc. and Optel Capital, LLC dated as of September 16, 2004.
|      |  |       | 
|10.23 |  | (13)  |  | - |  | Secured Convertible Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on September 16, 2004.                          
|      |  |       | 
|10.24 |  | (13)  |  | - |  | Registration Rights Agreement between Digital Lightwave, Inc. and Optel Capital, LLC dated as of September 16, 2004.                        
|      |  |       | 
|10.25 |  | (14)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on January 28, 2005.                                        
|      |  |       | 
|10.26 |  | (15)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on February 11, 2005.                                       
|      |  |       | 
|10.27 |  | (16)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on February 25, 2005.                                       
|      |  |       | 
|10.28 |  | (17)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 11, 2005.                                          
|      |  |       | 
|10.29 |  | (18)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 23, 2005.                                          
|      |  |       | 
|10.30 |  | (19)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on April 14, 2005.                                          
|      |  |       | 
|10.31 |  | (20)* |  | - |  | Amended and Restated 2001 Stock Option Plan.                                                                                                
|      |  |       | 
|10.32 |  | (20)* |  | - |  | Severance Agreement between Digital Lightwave, Inc. and James R. Green dated February 15, 2005.                                             
|      |  |       | 
|10.33 |  | (21)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on April 28, 2005.                                          
|      |  |       | 
|10.34 |  | (22)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on May 12, 2005.                                            
|      |  |       | 
|10.35 |  | (23)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on May 26, 2005.                                            
|      |  |       | 
|10.36 |  | (24)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on June 15, 2005.                                           
|      |  |       | 
|10.37 |  | (25)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on June 29, 2005.                                           
|      |  |       | 
|10.38 |  | (26)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on July 14, 2005.                                           
|      |  |       | 
|10.39 |  | (27)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on August 12, 2005.                                         
|      |  |       | 
|10.40 |  | (28)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on August 31, 2005.                                         
|      |  |       | 
|10.41 |  | (29)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on September 14, 2005.                                      
|      |  |       | 
|10.42 |  | (30)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on September 29, 2005.                                      
|      |  |       | 
|10.43 |  | (31)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on November 21, 2005.                                       
|      |  |       | 
|10.44 |  | (32)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on December 8, 2005.                                        
|      |  |       | 
|10.45 |  | (32)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on December 12, 2005.                                       
|      |  |       | 
|10.46 |  | (33)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on December 23, 2005.                                       
|      |  |       | 
|10.47 |  | (34)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on January 20, 2006.                                        
|      |  |       | 
|10.48 |  | (34)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on January 23, 2006.                                        
|      |  |       | 
|10.49 |  | (35)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on February 2, 2006.                                        
|      |  |       | 
|10.50 |  | (36)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on February 13, 2006.                                       
|      |  |       | 
|10.51 |  | (37)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on February 15, 2006.                                       
|      |  |       | 
|10.51 |  | (38)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 1, 2006                                            
|      |  |       | 
|10.52 |  | (39)  |  | - |  | Secured Promissory Note issued by Digital Lightwave, Inc. to Optel Capital, LLC on March 14, 2006.                                          
|      |  |       | 
|23.1  |  | +     |  | - |  | Consent of Grant Thornton LLP.                                                                                                              
|      |  |       | 
|24.1  |  | +     |  | - |  | Power of Attorney (included as part of signature page)                                                                                      
|      |  |       | 
|31.1  |  | +     |  | - |  | Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                     
|      |  |       | 
|31.2  |  | +     |  | - |  | Certification of the Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                 



39



---

##### Table of Contents

|     |  |   |  |   |  |                                                                                                                                                           
|---- |  | - |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|32.1 |  | + |  | - |  | Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.    
|     |  |   | 
|32.2 |  | + |  | - |  | Certification by the Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

---

|* | Indicates management contract or compensatory plan or arrangement.
|- | ------------------------------------------------------------------

|+ | Filed with this report.
|- | -----------------------

|(1) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Registration Statement on Form S-1, File No. 333-09457, declared
effective by the Securities and Exchange Commission on February 5, 1997.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Annual Report on Form 10K for the fiscal year ended December 31,
2004 and originally filed in connection with the Registrants Annual Report on Form 10-K for the fiscal year ended December 31, 1997.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Annual Report on Form 10-K for the fiscal year ended December 31,
2001.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 10-Q for the quarter ended March 31, 2002.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to Appendix B to the registrants Proxy Statement file April 22, 2002 for the 2002 Annual Meeting of Stockholders held on May 20, 2002.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on June 27, 2003.
|--- | ----------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on August 8, 2003.
|--- | -----------------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 10-K on April 14, 2004.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on May 13, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 10-Q on May 17, 2004.
|---- | ----------------------------------------------------------------------------------------------------------------------------------

|(11) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on June 10, 2004.
|---- | ----------------------------------------------------------------------------------------------------------------------------------

|(12) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on June 14, 2004.
|---- | ----------------------------------------------------------------------------------------------------------------------------------

|(13) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on September 21, 2004.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------

|(14) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on February 3, 2005.
|---- | -------------------------------------------------------------------------------------------------------------------------------------

|(15) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on February 16, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------

|(16) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on March 3, 2005.
|---- | ----------------------------------------------------------------------------------------------------------------------------------

|(17) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on March 15, 2005.
|---- | -----------------------------------------------------------------------------------------------------------------------------------

|(18) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on March 25, 2005.
|---- | -----------------------------------------------------------------------------------------------------------------------------------

|(19) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on April 15, 2005.
|---- | -----------------------------------------------------------------------------------------------------------------------------------

|(20) | Incorporated by reference to Appendix A to the registrants Proxy Statement filed January 4, 2005, for a Special Meeting of Stockholders held on February 10, 2005.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(21) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on May 2, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------

|(22) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on May 18, 2005.
|---- | ---------------------------------------------------------------------------------------------------------------------------------

|(23) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on June 2, 2005.
|---- | ---------------------------------------------------------------------------------------------------------------------------------

|(24) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on June 20, 2005.
|---- | ----------------------------------------------------------------------------------------------------------------------------------



40



---

##### Table of Contents

|(25) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on June 29, 2005.
|---- | ----------------------------------------------------------------------------------------------------------------------------------

|(26) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on July 19, 2005.
|---- | ----------------------------------------------------------------------------------------------------------------------------------

|(27) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on August 18, 2005.
|---- | ------------------------------------------------------------------------------------------------------------------------------------

|(28) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on September 7, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------

|(29) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on September 20, 2005.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------

|(30) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on October 4, 2005.
|---- | ------------------------------------------------------------------------------------------------------------------------------------

|(31) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on November 25, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------

|(32) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on December 12, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------

|(33) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on December 23, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------

|(34) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on January 26, 2006.
|---- | -------------------------------------------------------------------------------------------------------------------------------------

|(35) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on February 7, 2006.
|---- | -------------------------------------------------------------------------------------------------------------------------------------

|(36) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on February 16, 2006.
|---- | --------------------------------------------------------------------------------------------------------------------------------------

|(37) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on February 21, 2006.
|---- | --------------------------------------------------------------------------------------------------------------------------------------

|(38) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on March 7, 2006.
|---- | ----------------------------------------------------------------------------------------------------------------------------------

|(39) | Incorporated by reference to the similarly described exhibits filed in connection with the Registrants Form 8-K on March 20, 2006.
|---- | -----------------------------------------------------------------------------------------------------------------------------------

(b) Exhibits. The exhibits listed in Item 15(a)(3) above are filed as part of, or incorporated by reference into, this report.

(c) Financial Statement Schedules. See Item 15(a)(2) above.



41



---

##### Table of Contents

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.



DIGITAL LIGHTWAVE, INC.By:

/s/ KENNETH T. MYERSKenneth T. MyersPresident and Chief Executive Officer


Date: March 30, 2006

We the undersigned directors and officers of the Registrant, hereby severally constitute Kenneth T. Myers our true lawful attorney with full power to him to sign for us, in our names, in the capacities indicated
below, any and all amendments to this Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.



|                                        |  |                                                                     |  |               
|--------------------------------------- |  | ------------------------------------------------------------------- |  | --------------
|NAME                                    |  | TITLE                                                               |  | DATE          
|                                        |  |                                                                    
|/s/ KENNETH T. MYERS Kenneth T. Myers   |  | President and Chief Executive Officer (Principal
Executive Officer) |  | March 30, 2006
|                                        |  |                                                                    
|/s/ KENNETH T. MYERS Kenneth T. Myers   |  | Interim Chief Accounting Officer (Principal Accounting
Officer)     |  | March 30, 2006
|                                        |  |                                                                    
|/s/ DR. BRYAN J. ZWAN Dr. Bryan J. Zwan |  | Chairman of the Board                                               |  | March 30, 2006
|                                        |  |                                                                    
|/s/ PETER H. COLLINS Peter H. Collins   |  | Director                                                            |  | March 30, 2006
|                                        |  |                                                                    
|/s/ GERALD A. FALLON Gerald A. Fallon   |  | Director                                                            |  | March 30, 2006
|                                        |  |                                                                    
|/s/ ROBERT F. HUSSEY Robert F. Hussey   |  | Director                                                            |  | March 30, 2006
|                                        |  |                                                                    
|/s/ ROBERT MOREYRA Robert Moreyra       |  | Director                                                            |  | March 30, 2006



42



---

##### Table of Contents

Index to Financial Statements



|                                                          |  |     
|--------------------------------------------------------- |  | ----
|                                                          |  | Page
|Financial Statements                                      |  |     
|                                                          | 
|Report of Independent Registered Public Accounting Firm   |  | F-2 
|                                                          | 
|Consolidated Balance Sheets                               |  | F-3 
|                                                          | 
|Consolidated Statements of Operations                     |  | F-4 
|                                                          | 
|Consolidated Statements of Stockholders Equity (Deficit) |  | F-5 
|                                                          | 
|Consolidated Statements of Cash Flows                     |  | F-6 
|                                                          | 
|Notes to Consolidated Financial Statements                |  | F-7 
|                                                          | 
|Financial Statement Schedule                              |  |     
|                                                          | 
|Schedule II  Valuation and qualifying accounts           |  | F-28



F-1



---

##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Digital Lightwave, Inc. and its subsidiaries

We have audited the
accompanying consolidated balance sheets of Digital Lightwave, Inc. (a Delaware corporation) and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders equity, and cash flows for
each of the three years in the period ended December 31, 2005. These consolidated financial statements are the responsibility of the Companys management. 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 of America).
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
Digital Lightwave, Inc. and subsidiaries as of December 31, 2005, and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with
accounting principles generally accepted in the United States of America.

As discussed in Note 1, the Company has restated costs of goods sold for 2004
and 2003 to include costs associated with the production and customer service departments that were previously included in operating expenses.

We have
also audited Schedule II of Digital Lightwave, Inc. and subsidiaries for each of the three years ended December 31, 2005. In our opinion, this schedule, when considered in relation to the basic financial statements taken as a whole, presents
fairly, in all material respects, the information set forth therein.

The accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in Note 1, the Company has incurred net losses of $12.9 million in 2004 and $21.1 million in 2005 and as of December 31, 2005, has a working capital deficit of $48.8 million and a
stockholders deficit of $49.2 million. These factors, among others, as discussed in Note 1 to the financial statements, raise substantial doubt about the Companys ability to continue as a going concern. Managements plans in regard
to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ GRANT THORNTON LLP

Tampa, Florida

March 24, 2006



F-2



---

##### Table of Contents

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)



|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                      |  | December 31,2005 |          |   | December 31,2004 |  
|ASSETS                                                                                                                                                |  |                  |          |   |                  |   |          |  
|Current assets:                                                                                                                                       |  |                  |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                             |  | $                | 499      |   |                  | $ | 809      |  
|Accounts receivable, less reserve for uncollectible accounts of $145 and $690 in 2005 and 2004, respectively                                          |  |                  | 2,672    |   |                  |   | 2,069    |  
|Notes receivable from related party                                                                                                                   |  |                  |         |   |                  |   | 366      |  
|Inventories, net                                                                                                                                      |  |                  | 4,765    |   |                  |   | 5,488    |  
|Prepaid expenses and other current assets                                                                                                             |  |                  | 341      |   |                  |   | 783      |  
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|Total current assets                                                                                                                                  |  |                  | 8,277    |   |                  |   | 9,515    |  
|Property and equipment, net                                                                                                                           |  |                  |         |   |                  |   | 2,690    |  
|Other assets, net                                                                                                                                     |  |                  | 37       |   |                  |   | 349      |  
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|Total assets                                                                                                                                          |  | $                | 8,314    |   |                  | $ | 12,554   |  
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)                                                                                                        |  |                  |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Accounts payable and accrued liabilities                                                                                                              |  | $                | 10,181   |   |                  | $ | 6,289    |  
|Notes payable to related party                                                                                                                        |  |                  | 46,830   |   |                  |   | 31,435   |  
|Notes payable                                                                                                                                         |  |                  | 55       |   |                  |   | 3,711    |  
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|Total current liabilities                                                                                                                             |  |                  | 57,066   |   |                  |   | 41,435   |  
|Other long-term liabilities                                                                                                                           |  |                  | 438      |   |                  |   | 265      |  
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|Total liabilities                                                                                                                                     |  |                  | 57,504   |   |                  |   | 41,700   |  
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|Stockholders equity (deficit):                                                                                                                       |  |                  |          |   |                  |   |          |  
|Preferred stock, $.0001 par value; authorized 20,000,000 shares; no shares issued or outstanding                                                      |  |                  |         |   |                  |   |         |  
|Common stock, $.0001 par value; authorized 300,000,000 shares; issued and outstanding 35,204,425 and 34,183,204 shares in 2005 and 2004,
respectively |  |                  | 3        |   |                  |   | 3        |  
|Additional paid-in capital                                                                                                                            |  |                  | 87,182   |   |                  |   | 86,133   |  
|Accumulated deficit                                                                                                                                   |  |                  | (136,375 | ) |                  |   | (115,282 | )
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|Total stockholders equity (deficit)                                                                                                                  |  |                  | (49,190  | ) |                  |   | (29,146  | )
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  
|Total liabilities and stockholders equity (deficit)                                                                                                  |  | $                | 8,314    |   |                  | $ | 12,554   |  
|                                                                                                                                                      |  |                  |          |   |                  |   |          |  

The accompanying notes are an integral part of these consolidated financial statements.



F-3



---

##### Table of Contents

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per-share data)



|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|---------------------------------------------------------------- |  | -------------------------------- | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                 |  | For the Years Ended December 31, |           
|                                                                 |  | 2005                             |            |   | 2004 |   |            | 2003 | 
|Net sales                                                        |  | $                                | 12,882     |   |      | $ | 13,739     |      |  | $ | 7,514      |  
|Cost of goods sold                                               |  |                                  | 11,010     |   |      |   | 12,642     |      |  |   | 16,964     |  
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Gross profit (loss)                                              |  |                                  | 1,872      |   |      |   | 1,097      |      |  |   | (9,450     | )
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Operating expenses:                                              |  |                                  |            |   |      |   |            |      |  |   |            |  
|Engineering and development                                      |  |                                  | 7,752      |   |      |   | 5,133      |      |  |   | 5,535      |  
|Sales and marketing                                              |  |                                  | 5,774      |   |      |   | 6,113      |      |  |   | 8,033      |  
|General and administrative                                       |  |                                  | 3,461      |   |      |   | 3,932      |      |  |   | 7,527      |  
|Restructuring charge                                             |  |                                  |           |   |      |   | 40         |      |  |   | 744        |  
|Impairment of long-lived assets                                  |  |                                  | 3,369      |   |      |   | 322        |      |  |   | 3,302      |  
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Total operating expenses                                         |  |                                  | 20,356     |   |      |   | 15,540     |      |  |   | 25,141     |  
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Operating loss                                                   |  |                                  | (18,484    | ) |      |   | (14,443    | )    |  |   | (34,591    | )
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Other income (expense):                                          |  |                                  |            |   |      |   |            |      |  |   |            |  
|Interest income                                                  |  |                                  | 4          |   |      |   | 46         |      |  |   | 71         |  
|Interest expense                                                 |  |                                  | (4,062     | ) |      |   | (2,433     | )    |  |   | (2,163     | )
|Other income                                                     |  |                                  | 1,449      |   |      |   | 3,952      |      |  |   | 4,267      |  
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Total other income (expense)                                     |  |                                  | (2,609     | ) |      |   | 1,565      |      |  |   | 2,175      |  
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Loss before income taxes                                         |  |                                  | (21,093    | ) |      |   | (12,878    | )    |  |   | (32,416    | )
|Provision for income taxes                                       |  |                                  |           |   |      |   |           |      |  |   |           |  
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Net loss                                                         |  | $                                | (21,093    | ) |      | $ | (12,878    | )    |  | $ | (32,416    | )
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Per share of common stock:                                       |  |                                  |            |   |      |   |            |      |  |   |            |  
|Basic and diluted net loss net loss per share                    |  | $                                | (0.60      | ) |      | $ | (0.39      | )    |  | $ | (1.03      | )
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  
|Weighted average common and common equivalent shares outstanding |  |                                  | 35,094,986 |   |      |   | 33,065,582 |      |  |   | 31,489,642 |  
|                                                                 |  |                                  |            |   |      |   |            |      |  |   |            |  

The accompanying notes are an integral part of these consolidated financial statements.



F-4



---

##### Table of Contents

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (Deficit)

For The Years Ended December 31, 2005, 2004, and 2003

(In thousands, except share data)



|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|---------------------------------------------------- | ------ | ------------ | ------ | ------------------------ | - | ------------------ | - | ------ | ------------------------------------------ | - | -------- | -------------------------- |  | - | ----- | - |  | - | ------- | - |  | - | ------- | -
|                                                     |        | Common Stock |        | AdditionalPaid-InCapital |   | AccumulatedDeficit |   |        | AccumulatedOtherComprehensiveIncome (Loss) |   |          | ComprehensiveIncome (Loss) |  |   | Total |  
|                                                     |        |              |        |                          |   |                   
|                                                     | Shares |              | Amount |                          |   |                    |   |       
|Balance December 31, 2002                            |        | 31,406,365   |        | $                        | 3 |                    | $ | 80,855 |                                            | $ | (69,988  | )                          |  | $ | (106  | ) |  | $ |        |   |  | $ | 10,764  |  
|Comprehensive loss:                                  |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Net loss                                             |        |             |        |                          |  |                    |   |       |                                            |   | (32,416  | )                          |  |   |      |   |  |   | (32,416 | ) |  |   | (32,416 | )
|Foreign currency translation                         |        |             |        |                          |  |                    |   |       |                                            |   |         |                            |  |   | 25    |   |  |   | 25      |   |  |   | 25      |  
|Net unrealized loss in available for sale securities |        |             |        |                          |  |                    |   |       |                                            |   |         |                            |  |   | 81    |   |  |   | 81      |   |  |   | 81      |  
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                   |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  | $ | (32,310 | ) |  |   |         |  
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Issuance of common stock                             |        | 185,525      |        |                          |  |                    |   | 205    |                                            |   |         |                            |  |   |      |   |  |   |         |   |  |   | 205     |  
|Issuance of stock options for services               |        |             |        |                          |  |                    |   | 201    |                                            |   |         |                            |  |   |      |   |  |   |         |   |  |   | 201     |  
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Balance December 31, 2003                            |        | 31,591,890   |        |                          | 3 |                    |   | 81,261 |                                            |   | (102,404 | )                          |  |   |      |   |  |   |         |   |  |   | (21,140 | )
|Comprehensive loss:                                  |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Net loss                                             |        |             |        |                          |  |                    |   |       |                                            |   | (12,878  | )                          |  |   |      |   |  |   | (12,878 | ) |  |   | (12,878 | )
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                   |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  | $ | (12,878 | ) |  |   |         |  
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Issuance of common stock                             |        | 2,591,314    |        |                          |  |                    |   | 4,799  |                                            |   |         |                            |  |   |      |   |  |   |         |   |  |   | 4 ,799  |  
|Issuance of stock options for services               |        |             |        |                          |  |                    |   | 73     |                                            |   |         |                            |  |   |      |   |  |   |         |   |  |   | 73      |  
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Balance December 31, 2004                            |        | 34,183,204   |        |                          | 3 |                    |   | 86,133 |                                            |   | (115,282 | )                          |  |   |      |   |  |   |         |   |  |   | (29,146 | )
|Comprehensive loss:                                  |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Net loss                                             |        |             |        |                          |  |                    |   |       |                                            |   | (21,093  | )                          |  |   |      |   |  |   | (21,093 | ) |  |   | (21,093 | )
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                   |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  | $ | (21,093 | ) |  |   |         |  
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Issuance of common stock                             |        | 1,021,221    |        |                          |  |                    |   | 1,026  |                                            |   |         |                            |  |   |      |   |  |   |         |   |  |   | 1,026   |  
|Issuance of stock options for services               |        |             |        |                          |  |                    |   | 23     |                                            |   |         |                            |  |   |      |   |  |   |         |   |  |   | 23      |  
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  
|Balance December 31, 2005                            |        | 35,204,425   |        | $                        | 3 |                    | $ | 87,182 |                                            | $ | (136,375 | )                          |  | $ |      |   |  |   |         |   |  | $ | (49,190 | )
|                                                     |        |              |        |                          |   |                    |   |        |                                            |   |          |                            |  |   |       |   |  |   |         |   |  |   |         |  

The accompanying notes are an integral part of these consolidated financial statements.



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|----------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                        |  | For the Years Ended December 31, |        
|                                                                        |  | 2005                             |         |   | 2004 |   |         | 2003 | 
|Cash flows from operating activities:                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net loss                                                                |  | $                                | (21,093 | ) |      | $ | (12,878 | )    |  | $ | (32,416 | )
|Adjustments to reconcile net loss to cash used in operating activities: |  |                                  |         |   |      |   |         |      |  |   |         |  
|Depreciation and amortization                                           |  |                                  | 879     |   |      |   | 2,277   |      |  |   | 3,642   |  
|Loss on disposal of property                                            |  |                                  | 2       |   |      |   | 159     |      |  |   | 217     |  
|Provision for uncollectible accounts                                    |  |                                  |        |   |      |   | 98      |      |  |   | (444    | )
|Provision for excess and obsolete inventory                             |  |                                  | (539    | ) |      |   | (160    | )    |  |   | 4,022   |  
|Write-off of inventory claims for inventory held at Jabil               |  |                                  |        |   |      |   |        |      |  |   | 3,968   |  
|Impairment of long-lived assets                                         |  |                                  | 3,369   |   |      |   | 322     |      |  |   | 3,302   |  
|Restructuring charge                                                    |  |                                  |        |   |      |   | 40      |      |  |   | 744     |  
|Note receivable forgiven                                                |  |                                  | 374     |   |      |   |        |      |  |   |        |  
|Settlement of accounts payable and accrued litigation                   |  |                                  | (1,666  | ) |      |   | (4,401  | )    |  |   | (4,849  | )
|Compensation expense for stock option grants                            |  |                                  | 23      |   |      |   | 73      |      |  |   | 201     |  
|Changes in operating assets and liabilities:                            |  |                                  |         |   |      |   |         |      |  |   |         |  
|(Increase) decrease in accounts receivable                              |  |                                  | (603    | ) |      |   | (963    | )    |  |   | 3,389   |  
|Decrease in inventories                                                 |  |                                  | 276     |   |      |   | 2,639   |      |  |   | 2,081   |  
|(Increase) decrease in prepaid expenses and other assets                |  |                                  | 326     |   |      |   | (364    | )    |  |   | (664    | )
|Increase in accounts payable and accrued expenses                       |  |                                  | 5,097   |   |      |   | 1,537   |      |  |   | 3,819   |  
|Decrease in accrued litigation charge                                   |  |                                  |        |   |      |   | (5,802  | )    |  |   | (3,379  | )
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash used in operating activities                                   |  |                                  | (13,555 | ) |      |   | (17,423 | )    |  |   | (16,367 | )
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash flows from investing activities:                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Proceeds from sale of short-term investments                            |  |                                  |        |   |      |   |        |      |  |   | 388     |  
|Proceeds from the maturity of short-term investments                    |  |                                  |        |   |      |   |        |      |  |   | 1,139   |  
|Decrease in restricted cash and cash equivalents                        |  |                                  |        |   |      |   | 1,993   |      |  |   | 412     |  
|Purchases of property and equipment                                     |  |                                  | (262    | ) |      |   | (133    | )    |  |   | (313    | )
|Repayment of notes receivable                                           |  |                                  |        |   |      |   |        |      |  |   | 800     |  
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) investing activities                     |  |                                  | (262    | ) |      |   | 1,860   |      |  |   | 2,426   |  
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash flows from financing activities:                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Proceeds from notes payable - related party                             |  |                                  | 15,395  |   |      |   | 17,800  |      |  |   | 14,597  |  
|Principal payments on notes payable - related party                     |  |                                  |        |   |      |   |        |      |  |   | (962    | )
|Principal payments on notes payable - other                             |  |                                  | (1,914  | ) |      |   | (1,840  | )    |  |   |        |  
|Proceeds from sale of common stock, net of expense                      |  |                                  | 26      |   |      |   | 100     |      |  |   | 205     |  
|Principal payments on capital lease obligations                         |  |                                  |        |   |      |   |        |      |  |   | (199    | )
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by financing activities                               |  |                                  | 13,507  |   |      |   | 16,060  |      |  |   | 13,641  |  
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net increase (decrease) in cash and cash equivalents                    |  |                                  | (310    | ) |      |   | 497     |      |  |   | (300    | )
|Cash and cash equivalents at beginning of period                        |  |                                  | 809     |   |      |   | 312     |      |  |   | 612     |  
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents at end of period                              |  | $                                | 499     |   |      | $ | 809     |      |  | $ | 312     |  
|                                                                        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Other supplemental disclosures:                                         |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash paid for interest                                                  |  | $                                |        |   |      | $ |        |      |  | $ | 100     |  
|Inventory used as demonstration units transferred to fixed assets       |  |                                  | 604     |   |      |   | 302     |      |  |   |        |  
|                                                                        |  |                                  |        
|Non-Cash Transactions:                                                  |  |                                  |         |   |      |   |         |      |  |   |         |  
|See Note 19 - Non-Cash Transactions                                     |  |                                  |         |   |      |   |         |      |  |   |         |  

The accompanying notes are an integral part of these consolidated financial statements.



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

General

Digital Lightwave, Inc. provides the global fiber-optic communications industry with products and technology used to develop, install, maintain,
monitor and manage fiber-optic communication networks. Telecommunications service providers, owners of private networks (utilities, government and large enterprises) and equipment manufacturers deploy the Companys products to provide quality
assurance and ensure optimum performance of advanced optical communications networks and network equipment. The Companys products are sold worldwide to telecommunications service providers, owners of private networks (utilities, government and
large enterprises), telecommunications equipment manufacturers, equipment leasing companies and international distributors. The Companys wholly-owned subsidiaries are Digital Lightwave (UK) Limited (DLL), Digital Lightwave Asia
Pacific Pty, Ltd. (DLAP), and Digital Lightwave Latino Americana Ltda. (DLLA). DLL, DLAP, and DLLA provided international sales support, but are currently inactive. All significant intercompany transactions and balances are
eliminated in consolidation.

Operational Matters

As
of December 31, 2005, the Companys unrestricted cash and cash equivalents and short-term investments were $499,000, a decrease of $310,000 from December 31, 2004. As of December 31, 2005, the Companys working capital
deficit was approximately $48.8 million as compared to a working capital deficit of $31.9 million at December 31, 2004. During 2005, the Company incurred a net loss of $21.1 million and cash flows used by operations were $13.6 million. In 2004,
the Company incurred a net loss of $12.9 million and cash flows used in operations were $17.4 million. The Company had an accumulated deficit of $136.4 million at December 31, 2005.

Beginning in the third quarter of 2001 and continuing through December 31, 2005, the Company experienced significant net losses. The Company expects to continue to incur operating losses in 2006. Management has
taken actions to reduce operating expenses and capital expenditures. These actions include restructuring operations to more closely align operating costs with revenues. As further discussed below, the Companys ability to meet cash and future
liquidity requirements is dependent on its ability to raise additional capital, successfully negotiate extended payment terms with certain creditors, attain our business objectives, maintain tight controls over spending and release new products and
product upgrades on a timely basis.

The Company continues to have insufficient short-term resources for the payment of its current liabilities. During the
twelve months ended December 31, 2005 and continuing into the first three months of 2006, the Company has addressed this shortfall by obtaining financing from Optel Capital, LLC (Optel), an entity controlled by the Companys
largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan. As of December 31, 2005, the Company had a Secured Convertible Promissory Note and various Short-Term Notes in the aggregate principal amount of
approximately $46.8 million plus accrued interest in the amount of approximately $5.9 million that became due and payable on or before December 31, 2005 and which are now payable on demand to Optel.

Optel currently is and continues to be the principal source of financing for the Company. The Company has not identified any funding source other than Optel that would
be prepared to provide current or future financing to the Company. The Company cannot assure that it will be able to obtain adequate financing, that it will achieve profitability or, if it achieves profitability that the profitability will be
sustainable or that it will continue as a going concern.

As of March 20, 2006, the Company owed Optel approximately $48.8 million in principal, plus
accrued interest thereon, which debt is secured by a first priority security interest in substantially all of our assets and such debt accrues interest at a rate of 10% per annum. The maturity dates and corresponding payment schedules related
to these obligations are as follows:



| |  |  | Secured Convertible Promissory Note. Pursuant to that certain secured convertible promissory note, dated as of September 16, 2004, the Company borrowed $27.0 million
from Optel on the following terms (the Secured Convertible Promissory Note):
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Accrued and unpaid interest as of September 16, 2004, plus interest that accrued on the $27.0 million outstanding principal that became due and payable on September 16,
2005, is now currently due and payable on demand at any time;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal is now currently due and payable on demand at any time.
| | - |  | ----------------------------------------------------------------------------------



| |  |  | Short-Term Notes. Pursuant to those several short-term secured promissory notes issued by the Company to Optel since September 30, 2004, the Company borrowed an
additional $21.8 million from Optel on the following terms (the Short-Term Notes):
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $19.8 million in principal plus accrued interest is now currently due and payable on demand at any time; and,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $2.0 million in principal plus accrued interest payable on demand at any time after March 31, 2006;
| | - |  | -----------------------------------------------------------------------------------------------------------------

On February 10, 2005, at a special meeting of the Companys stockholders, the conversion feature of the Secured Convertible Promissory Note was approved by our
disinterested stockholders. Accordingly, all or any portion of such debt is convertible into the Companys common stock at the option of Optel at any time. The conversion price is based upon the volume-weighted average trading price of our
common stock during the five-day period preceding the date of any conversion. Further, as part of the conversion features approved by the disinterested stockholders, the Company is required to file a registration statement covering the offer and
sale by Optel of the shares of common stock issuable upon conversion and to keep the registration statement effective until the date that is two years after the date that such registration statement is declared effective.

All of the foregoing transactions with Optel were approved by the Companys board of directors, upon the recommendation of the special committee of the board. The
special committee is composed solely of independent directors.

On March 11, 2005, the Company issued 981,258 shares of common stock to Optel in
connection with Optels conversion of $1.0 million of the indebtedness outstanding under the Secured Convertible Promissory Note. As of March 20, 2006, the aggregate outstanding principal and accrued interest under the Secured Convertible
Promissory Note was approximately $32.2 million, and the applicable conversion price was approximately $0.43 per share. Accordingly, on March 20, 2006, Optel had the right to convert the Secured Convertible Promissory Note into an aggregate of
74,776,660 shares of common stock. Further, conversion by Optel of all or any portion of the Secured Convertible Promissory Note could significantly dilute the ownership interests of the Companys other stockholders and give Optel and
Dr. Zwan even greater control over the Company. If Optel converted all of the indebtedness evidenced by the Secured Convertible Promissory Note, including principal and accrued interest, into shares of common stock on March 20, 2006, at an
applicable conversion price of $0.43 per share, Optel and other entities controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, would control, in the aggregate, approximately
80.2% of the then outstanding shares of common stock after giving effect to the conversion.

On March 15, 2005, Optel established an irrevocable
letter of credit in the amount of $6.0 million on the Companys behalf and naming MC Test Service, Inc. as beneficiary. MC Test Service, Inc. provides outsourced manufacturing services to us. With the letter of credit in place, MC Test Service,
Inc. has extended to us regular payment terms to pay for purchased production material. On December 16 2005, Optel renewed the letter of credit for the amount of $2.0 million and extended the expiration date to December 30, 2006.

The Company has entered into discussions with Optel to restructure the Short-Term Notes and the Secured Convertible Promissory Note by extending the
maturity date of such debt, to arrange for additional short-term working capital and to continue guarantees through letters of credit to secure vendor obligations. If the Company does not reach an agreement to restructure the Short-Term Notes and
the Secured Convertible Promissory Note, continue its guarantees through letters of credit and obtain additional financing from Optel, the Company will be unable to meet its obligations to Optel and its other creditors, and in an attempt to collect
payment, its creditors, including Optel, may seek legal remedies.



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Acquisition of Assets

On October 11, 2002, the Company acquired certain assets related to the Optical Network Management product line from LightChip, Inc., a privately-held company based in Salem, N.H., in exchange for $1.0 million in cash. The acquired
assets included inventory, patented technology and equipment. The acquired product line from LightChip was renamed to Optical Wavelength Manager (OWM).

On
November 5, 2002, the Company acquired certain assets of the Optical Test System (OTS) product line of Tektronix which included related inventory and equipment, and assumed certain liabilities associated with the OTS line, in exchange for $10
million in cash.

Cash Equivalents

The Company
considers all highly liquid investments with an initial maturity of three months or less to be cash equivalents.

Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market. The Company records a provision for excess and obsolete inventory when conditions warrant.

Property and Equipment

The Companys property
and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over estimated useful lives of 3 to 7 years or over the lesser of the term of the lease or
the estimated useful life of assets under capital lease or improvements made to lease property. Maintenance and repairs are expensed as incurred while renewals and improvements are capitalized. The accounts are relieved of the cost and the related
accumulated depreciation and amortization upon the sale or retirement of property and equipment and any resulting gain or loss is included in the results of operations.

Capitalized Software

The Company capitalizes certain internal and external costs incurred to acquire or create
internal use software in accordance with AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Capitalized software is included in property and equipment under computer
equipment and software and is amortized over its useful life when development is complete.

Intangible Assets

Included in other assets are certain intangible assets including trademarks, patents, and acquired intangible assets. Intangible assets are amortized over their estimated
useful lives ranging from 5 to 10 years. (See Note 6  Other Assets).

Impairment of Long-Lived Assets

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. During the first quarter of 2003, the Company performed an impairment analysis, calculated in accordance with the guidelines set forth in SFAS 144, which indicated future cash flows from the Companys OTS product line were
insufficient to cover the carrying value of the long-lived assets supporting the OTS product line. Therefore, the Company calculated an impairment using the probability-weighted approach with an average life of 5 years, and a risk-free rate of
interest of 4.5%. As a result, in the first quarter of 2003, the Company recorded a non-cash impairment charge of $3.3 million on its intangible assets and property and equipment. For the year ending December 31, 2004, the Company
recorded a non-cash impairment charge of $322,000 for the intangible assets supporting the OTS product line.

During the fiscal year ending
December 31, 2005, the Companys impairment analysis calculated in accordance with the guidelines set



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forth in SFAS 144, indicated future cash flows from the Companys operations were insufficient to cover the carrying value of the Companys
long-lived assets. Therefore, the Company calculated an impairment using the probability-weighted approach with an average life of five (5) years, and a risk-free rate of interest of 3%. As a result, during the fiscal year ended
December 31, 2005, the Company recorded a total non-cash impairment charge for the remaining balance of its long-lived assets which included $3.2 million and $200,000 related to its property and equipment and other assets, respectively.

Accrued Warranty

The Company provides the customer a
warranty with each product sold. The Companys policy for product warranties is to review the warranty reserve on a quarterly basis for specifically identified or new matters and review the reserve for estimated future costs associated with any
open warranty years. The reserve is an estimate based on historical trends, the number of products under warranty, the costs of replacement parts and the expected reliability of our products. A change in these factors could result in a change in the
reserve balance. Warranty costs are charged against the accrual when incurred.

The reconciliation of the warranty reserve
is as follows:



|                   |  |                                 |      |   |      |   |      |      |  |   |       |  
|------------------ |  | ------------------------------- | ---- | - | ---- | - | ---- | ---- |  | - | ----- | -
|                   |  | For the year endingDecember 31, |     
|                   |  | 2005                            |      |   | 2004 |   |      | 2003 | 
|                   |  | (In thousands)                  |     
|Beginning balance  |  | $                               | 546  |   |      | $ | 678  |      |  | $ | 1,192 |  
|Warranty provision |  |                                 | 840  |   |      |   | 491  |      |  |   | (198  | )
|Warranty costs     |  |                                 | (573 | ) |      |   | (623 | )    |  |   | (316  | )
|                   |  |                                 |      |   |      |   |      |      |  |   |       |  
|Ending balance     |  | $                               | 813  |   |      | $ | 546  |      |  | $ | 678   |  
|                   |  |                                 |      |   |      |   |      |      |  |   |       |  

Revenue Recognition

The Company derives its revenue from product sales. The Company recognizes revenue from the sale of products when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed and determinable and
collection of the resulting receivable is reasonably assured.

For all sales, the Company uses a binding purchase order as evidence that a sales
arrangement exists. Sales through international distributors are evidenced by a master agreement governing the relationship with the distributor. The Company either obtains an end-user purchase order documenting the order placed with the distributor
or proof of delivery to the end user as evidence that a sales arrangement exists. For demonstration units sold to distributors, the distributors binding purchase order is evidence of a sales arrangement.

For domestic sales, delivery generally occurs when product is delivered to a common carrier. Demonstration units sold to international distributors are considered
delivered when the units are delivered to a common carrier. An allowance is provided for sales returns based on historical experience.

For sales made
under an OEM arrangement, delivery generally occurs when the product is delivered to a common carrier. OEM sales are defined as sales of the Company products to a third party that will market the products under their brand.

For trade-in sales, including both Company and competitor products, that have a cash component of greater than 25% of the fair value of the sale, the Company recognizes
revenue based upon the fair value of what is sold or received, whichever is more readily determinable, if the Company has demonstrated the ability to sell its trade-in inventory for that particular product class. Otherwise, the Company accounts for
the trade-in sale as a non-monetary transaction and follows the guidance of Accounting Principles Board Opinion No. 29, Accounting for Non-monetary Transactions and related interpretations. Revenue and cost of sales are recorded
based upon the cash portion of the transaction. The remaining costs associated with the new units are assigned to the units received on trade. When the trade-in units are resold, revenue is recorded based upon the sales price and cost of goods sold
is charged with the value assigned to trade-in units from the original transaction. For the years ended December 31, 2005, 2004 and 2003, the Company recorded approximately $543,000, $1.1 million and $600,000 revenue from transactions that
included a trade-in component.



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##### Table of Contents

At the time of the transaction, the Company assesses whether the price associated with its revenue transactions is fixed
and determinable and whether or not collection is reasonably assured. The Company assesses whether the price is fixed and determinable based on the payment terms associated with the transaction. Standard payment terms for domestic customers are 30
days from the invoice date. Distributor contracts provide standard payment terms of 60 days from the invoice date. Generally, the Company does not offer extended payment terms.

The Company assesses collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. Collateral is not requested from customers. If it is
determined that collection of an account receivable is not reasonably assured at the time of the sale, revenue is recognized at the time collection becomes reasonably assured.

Most sales arrangements do not generally include acceptance clauses. However, if a sales arrangement includes an acceptance provision, acceptance occurs upon the earlier of receipt of a written customer acceptance or
expiration of the acceptance period.

Reserve For Uncollectible Accounts

The Company estimates the collectibility of its accounts receivable. The Company considers many factors when making its estimates, including analyzing accounts receivable and historical bad debts, customer
concentrations, customer credit-worthiness, current economic trends and changes in its customer payment terms when evaluating the adequacy of the reserve for uncollectible accounts. When a specific account is deemed uncollectible, the account is
written off against the reserve for uncollectible accounts. Significant activity within the reserve include net writeoffs of $545,000, $(61,000) and $1.4 million for the years ended December 31, 2005, 2004 and 2003.

Research and Development

Software and product development costs are
included in engineering and development and are expensed as incurred. Capitalization of certain software development costs occurs during the period following the time that technological feasibility is established until general release of the product
to customers. The capitalized cost is then amortized over the estimated product life. To date, the period between achieving technological feasibility and the general release to customers has been short and software development costs qualifying for
capitalization have been insignificant.

Income Taxes

The Company recognizes deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax liabilities and assets are
determined based on the difference between the consolidated financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The Company provides for a
valuation allowance for the deferred tax assets when it concludes that it is more likely than not that the deferred tax assets will not be realized.

Shipping and Handling Costs

Shipping and handling costs associated with inbound freight are included in cost of goods sold. Shipping and
handling costs associated with outbound freight are generally billed to the customer and are recorded as revenue.

Foreign Currency Translation

Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment are translated to U.S. dollars at exchange rates in effect
at the balance sheet date with the resulting translation adjustments directly recorded as a separate component of accumulated other comprehensive income (loss). Income and expense accounts are translated at average exchange rates during the year.

Computation of Net Income Per Share

Basic net income
per share is based on the weighted average number of common shares outstanding during the periods presented. For all the years presented, diluted loss per share does not include the effect of incremental shares from common stock equivalents using
the treasury stock method, as the inclusion of such equivalents would be anti-dilutive. The total incremental shares from common stock equivalents were 140,179,472, 802,008 and 31,488 for the twelve months ended December 31, 2005, 2004 and
2003, respectively. The total incremental shares from common stock equivalents for the twelve months ended December 31, 2005 included 223,481 from outstanding stock options and 139,955,991 shares that were issuable pursuant to the conversion
feature of the Secured Convertible Promissory Note held by Optel Capital, LLC. Total outstanding stock options of 7,005,785, 4,177,419, and 3,982,425 shares for the twelve months ended



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December 31, 2005, 2004 and 2003, respectively, were excluded from the computation, as the inclusion of such would be anti-dilutive. The table below
presents the basic weighted average common shares outstanding and the incremental number of shares arising from common stock equivalents under the treasury stock method:



|                                                |  |                                 |  |            |  |           
|----------------------------------------------- |  | ------------------------------- |  | ---------- |  | ----------
|                                                |  | For The Year Ended December 31,
|                                                |  | 2005                            |  | 2004       |  | 2003      
|Basic:                                          |  |                                 |  |            |  |           
|Weighted average common shares outstanding      |  | 35,094,986                      |  | 33,065,582 |  | 31,489,642
|                                                |  |                                 |  |            |  |           
|Total basic                                     |  | 35,094,986                      |  | 33,065,582 |  | 31,489,642
|Diluted:                                        |  |                                 |  |            |  |           
|Incremental shares for common stock equivalents |  |                                |  |           |  |          
|                                                |  |                                 |  |            |  |           
|Total dilutive                                  |  | 35,094,986                      |  | 33,065,582 |  | 31,489,642
|                                                |  |                                 |  |            |  |           

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable. As of December 31, 2005, and 2004,
substantially all of the Companys cash balances were deposited with high quality financial institutions. During the normal course of business, the Company extends credit to customers conducting business primarily in the telecommunications
industry both within the United States and internationally.

For the years ended December 31, 2005, 2004 and 2003, the Companys largest
customers accounted for approximately 32%, 21% and 27% of net sales, respectively. In fiscal year 2004, net sales concentration was with a single customer. In fiscal year 2003, net sales concentration was with two customers and in fiscal year 2005,
net sales concentration was with three customers.

The Company sells its products in both domestic and international markets. Domestic sales represented
approximately 64%, 73%, and 75% of annual net sales for the years ended December 31, 2005, 2004, and 2003, respectively. International sales represented approximately 36%, 27%, and 25% of annual net sales for the years ended December 31,
2005, 2004 and 2003, respectively.

Fair Value of Financial Instruments

The carrying value of certain financial instruments, including cash and cash equivalents, accounts receivable, notes receivable, accounts payable, accrued liabilities, and other long-term liabilities approximate fair
market value based on their short-term nature.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates for sales returns and other allowances, the reserve for uncollectible accounts, the reserve for excess and obsolete
inventory, the impairment of long-lived assets, the warranty accrual and the assessment of the probability of litigation are significant estimates to the Company. Actual results could differ from these estimates.

Stock Based Compensation

At December 31, 2005, the Company has
two stock-based employee compensation plans, which are described more fully in Note 13  Common Stock and Stock Options. The Company accounts for the plans under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations. For the years ended December 31, 2005, 2004 and 2003 approximately $23,000, $73,000 and $201,000 of stock-based employee compensation cost is reflected in operating
expenses, respectively. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation,
to stock-based employee compensation.



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|                                                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                                      |  | Year Ended December 31, |        
|                                                                                                                                      |  | 2005                    |         |   | 2004 |   |         | 2003 | 
|                                                                                                                                      |  | (in thousands)          |        
|Net loss, as reported                                                                                                                 |  | $                       | (21,093 | ) |      | $ | (12,878 | )    |  | $ | (32,416 | )
|Add: Stock-based compensation included in reported net loss, net of related tax effects                                               |  |                         | 23      |   |      |   | 73      |      |  |   | 201     |  
|Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                         | (2,973  | ) |      |   | (3,485  | )    |  |   | (3,912  | )
|                                                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  
|Pro forma net loss                                                                                                                    |  | $                       | (24,043 | ) |      | $ | (16,290 | )    |  | $ | (36,127 | )
|                                                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  
|Loss per share:                                                                                                                       |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic and diluted  as reported                                                                                                       |  | $                       | (0.60   | ) |      | $ | (0.39   | )    |  | $ | (1.03   | )
|                                                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic and diluted - pro forma                                                                                                         |  | $                       | (0.69   | ) |      | $ | (0.49   | )    |  | $ | (1.15   | )
|                                                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  

Segment Reporting

As of December 31, 2005, the Company was not organized by multiple operating segments for the purpose of making operating decisions or assessing performance. Accordingly, the Company operated in one operating segment.

New Accounting Pronouncements

In December 2004, the Financial
Accounting Standards Board (the FASB) issued Statement on Financial Accounting Standard (SFAS) No. 123 (Revised 2004) Share-Based Payment (No. 123R). SFAS No. 123R addresses all forms of
share-based payment (SBP) awards, including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. SFAS No. 123R will require the Company to expense SBP awards with
compensation cost for SBP transactions measured at fair value. The FASB originally stated a preference for a lattice model because it believed that a lattice model more fully captures the unique characteristics of employee stock options in the
estimate of fair value, as compared to the Black-Scholes model which the Company currently uses for its footnote disclosure. The FASB decided to remove its explicit preference for a lattice model and not require a single valuation methodology. SFAS
No. 123R requires the Company to adopt the new accounting provisions either prospectively or retrospectively beginning in the first quarter of 2006. The Company has determined that it will adopt SFAS No. 123R prospectively but has not
determined the impact of applying SFAS No. 123R to its financial statements.

In November 2004, the FASB issued SFAS 151, Inventory Costs, an
amendment of ARB No. 43, which is effective for inventory costs incurred by the Company beginning fiscal year 2006. The amendments made by SFAS 151 will improve financial reporting by clarifying that abnormal amounts of idle facility expense,
freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The Company
does not believe that the adoption of SFAS 151 will have a significant effect on its financial statements.

Restatement of Costs

During 2005, the Company changed its presentation of costs associated with the production and customer service departments from engineering and development and sales and
marketing to cost of goods sold. These costs totaled approximately $5.0 million, $5.1 million and $3.7 million for the years ended December 31, 2005, 2004 and 2003, respectively.

2. NOTES RECEIVABLE

Notes receivable at December 31, 2004, is comprised of a single note from a former officer
of the Company. The amount of the note was approximately $366,000. In February 2005, the note was forgiven and charged to general and administrative expenses in the statement of operations as described in Note 12  Related Party
Transactions and as a result there was no balance remaining as of December 31, 2005.



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3. INVENTORIES

Net inventories at December 31, 2005 and 2004 are summarized as follows:



|               |  |                |       |      |   |      
|-------------- |  | -------------- | ----- | ---- | - | -----
|               |  | 2005           |       | 2004
|               |  | (In thousands)
|Raw materials  |  | $              | 3,745 |      | $ | 3,036
|Finished goods |  |                | 1,020 |      |   | 2,452
|               |  |                |       |      |   |      
|               |  | $              | 4,765 |      | $ | 5,488
|               |  |                |       |      |   |      

In December 2001, the Company signed a manufacturing service agreement with Jabil Circuit, Inc.
(Jabil), a leading provider of technology manufacturing services with a customer base of industry-leading companies. Under the terms of the agreement, Jabil purchased the Companys existing inventory to fulfill orders until the
Companys inventory was depleted to safety stock levels. Under the terms of the agreement, Jabil had served as the Companys primary contract manufacturer for the Companys circuit board and product assembly and provided engineering
design services.

On February 27, 2003 Jabil terminated the manufacturing service agreement and on March 19, 2003 commenced an arbitration
proceeding seeking damages in excess of $6.8 million. (See Note 16  Legal Proceedings) On December 5, 2003, the Company entered into a manufacturing services letter agreement with Jabil specifying the terms under which Jabil would provide
the Company with certain manufacturing services. The manufacturing services letter agreement expired on December 30, 2003, and the term of such letter agreement was extended through December 31, 2004. Jabil continued to provide
manufacturing services to the Company while Jabil and we discussed the renewal of a manufacturing services agreement.

On August 31, 2005, the Company
and Jabil amicably ended their manufacturing service relationship and all monies and inventories were exchanged as described in Note 1  Operational Matters.

Effective as of January 31, 2005, the Company entered into an agreement with MC Test Service, Inc. (MC) to also provide outsourced manufacturing services. On March 15, 2005, Optel established an irrevocable letter of
credit (LC) in the amount of $6.0 million on behalf of the Company and naming MC as beneficiary. MC Test Service, Inc. provides outsourced manufacturing services to the Company. With the letter of credit in place, MC Test Service, Inc.
has extended regular payment terms to pay for purchased production material. On December 16 2005, Optel renewed the letter of credit for the amount of $2.0 million and extended the expiration date to December 30, 2006.

In 2004 the Company recorded a charge to increase the excess and obsolete inventory reserve by approximately $1.3 million compared to a $4.0 million charge in fiscal
year 2003. The total reserve balance for excess and obsolete inventory at December 31, 2005 and 2004 approximated $15.7 million and $16.2 million, respectively. When evaluating the adequacy of the reserve for excess and obsolete inventory the
Company analyzes current and expected sales trends, the amount of current parts on hand, the current market value of parts on hand and the viability and technical obsolescence of products. The Company believes the reserve for excess and obsolete
inventory as of December 31, 2005 and 2004, is adequate

As of December 31, 2005 and 2004 inventories included approximately $951,000, and $1.5
million of trade-in products, respectively. At December 31, 2005, the Company allocated approximately $921,000 of the total excess and obsolete inventory reserve to trade-in products, resulting in a net trade-in product inventory value of
approximately $30,000.

4. PREPAID EXPENSES AND OTHER CURRENT ASSETS

Prepaid expenses and other current assets at December 31, 2005 and 2004 are summarized as follows:



|                    |  |                |     |      |   |    
|------------------- |  | -------------- | --- | ---- | - | ---
|                    |  | 2005           |     | 2004
|                    |  | (In thousands)
|Deposits            |  | $              | 165 |      | $ | 386
|Prepaid maintenance |  |                | 56  |      |   | 192
|Prepaid insurance   |  |                | 54  |      |   | 76 
|Prepaid taxes       |  |                |    |      |   | 28 
|Interest receivable |  |                | 5   |      |   | 15 
|Prepaid other       |  |                | 61  |      |   | 86 
|                    |  |                |     |      |   |    
|                    |  | $              | 341 |      | $ | 783
|                    |  |                |     |      |   |    



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##### Table of Contents

The deposits represent funds placed with vendors to ensure the availability of future inventory purchases. Prepaid
expenses and other current assets represent various marketing and administration needs of the Company that require cash payments upfront.

5. PROPERTY
AND EQUIPMENT

Property and equipment at December 31, 2005 and 2004 are summarized as follows:



|                                                                        |  |                |         |   |      |   |         |  
|----------------------------------------------------------------------- |  | -------------- | ------- | - | ---- | - | ------- | -
|                                                                        |  | 2005           |         |   | 2004 |  
|                                                                        |  | (in thousands) |        
|Test equipment                                                          |  | $              | 8,246   |   |      | $ | 7,937   |  
|Demonstration and loaner units                                          |  |                | 5,242   |   |      |   | 5,127   |  
|Computer equipment and software                                         |  |                | 4,778   |   |      |   | 4,448   |  
|Office furniture, fixtures and equipment                                |  |                | 2,369   |   |      |   | 2,367   |  
|Leasehold improvements                                                  |  |                | 2,383   |   |      |   | 2,383   |  
|Tooling                                                                 |  |                | 1,028   |   |      |   | 1,028   |  
|Tradeshow fixtures and equipment                                        |  |                | 359     |   |      |   | 359     |  
|                                                                        |  |                |         |   |      |   |         |  
|                                                                        |  |                | 24,405  |   |      |   | 23,649  |  
|Less: accumulated depreciation and impairment of property and equipment |  |                | (24,405 | ) |      |   | (20,959 | )
|                                                                        |  |                |         |   |      |   |         |  
|                                                                        |  | $              |        |   |      | $ | 2,690   |  
|                                                                        |  |                |         |   |      |   |         |  

Depreciation and amortization expense was approximately $737,000, $1.9 million, and $3.2 million for the years
ended December 31, 2005, 2004 and 2003, respectively.

The Company recorded charges for the impairment of property and equipment of $3.4 million,
$322,000 and $3.3 million during 2005, 2004 and 2003, respectively. (See Note 1  Summary of Significant Accounting Policies)

6. OTHER ASSETS

Other assets at December 31, 2005 and 2004 are summarized as follows:



|                                                             |  |                |        |   |      |   |        |  
|------------------------------------------------------------ |  | -------------- | ------ | - | ---- | - | ------ | -
|                                                             |  | 2005           |        |   | 2004 |  
|                                                             |  | (In thousands) |       
|Acquired intangible assets                                   |  | $              | 2,411  |   |      | $ | 2,411  |  
|Trademarks                                                   |  |                | 75     |   |      |   | 75     |  
|Patents                                                      |  |                | 120    |   |      |   | 120    |  
|Deposits                                                     |  |                | 37     |   |      |   | 37     |  
|Accumulated amortization and impairment of intangible assets |  |                | (2,606 | ) |      |   | (2,294 | )
|                                                             |  |                |        |   |      |   |        |  
|                                                             |  | $              | 37     |   |      | $ | 349    |  
|                                                             |  |                |        |   |      |   |        |  

Amortization expense for the year ended December 31, 2005, 2004 and 2003 totaled approximately $142,000,
$345,000 and $395,000, respectively. The Company acquired certain intangible assets in connection with its purchase from Tektronix during 2002. The Company recorded charges for the impairment of the acquired intangible assets totaling $1.2 million
during 2003, $322,000 in 2004 and the remaining balance of $200,000 in 2005. (See Note 1  Summary of Significant Accounting Policies)



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7. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liabilities at December 31, 2005 and 2004 are summarized as follows:



|                                    |  |                |        |      |   |      
|----------------------------------- |  | -------------- | ------ | ---- | - | -----
|                                    |  | 2005           |        | 2004
|                                    |  | (in thousands)
|Accounts payable                    |  | $              | 2,344  |      | $ | 722  
|Interest payable                    |  |                | 5,936  |      |   | 3,012
|Current portion of accrued warranty |  |                | 441    |      |   | 373  
|Employee related accruals           |  |                | 385    |      |   | 478  
|Accrued returns and allowances      |  |                | 284    |      |   | 284  
|Sales tax accruals                  |  |                | 236    |      |   | 475  
|Accrued expenses and other          |  |                | 468    |      |   | 816  
|Deferred revenue                    |  |                | 37     |      |   | 59   
|Sales commissions                   |  |                | 50     |      |   | 70   
|                                    |  |                |        |      |   |      
|                                    |  | $              | 10,181 |      | $ | 6,289
|                                    |  |                |        |      |   |      

8. INCOME TAXES

For the years ending December 31, 2005, 2004 and 2003, the Company has not recorded federal or state income tax provisions on a current or deferred basis due to the operating losses experienced during those periods. The tax effected
amounts of temporary differences at December 31, 2005 and 2004 are summarized as follows:



|                                      |  |                |          |   |      |   |          |  
|------------------------------------- |  | -------------- | -------- | - | ---- | - | -------- | -
|                                      |  | 2005           |          |   | 2004 |  
|                                      |  | (in thousands) |         
|Current:                              |  |                |          |   |      |   |          |  
|Deferred tax assets:                  |  |                |          |   |      |   |          |  
|Accrued liabilities                   |  | $              | 2,887    |   |      | $ | 1,800    |  
|Other assets                          |  |                | 6,119    |   |      |   | 6,650    |  
|Valuation allowance                   |  |                | (9,006   | ) |      |   | (8,450   | )
|                                      |  |                |          |   |      |   |          |  
|Total current deferred tax assets     |  |                |         |   |      |   |         |  
|                                      |  |                |          |   |      |   |          |  
|Non-current:                          |  |                |          |   |      |   |          |  
|Deferred tax assets:                  |  |                |          |   |      |   |          |  
|Net operating loss carry forward      |  |                | 138,396  |   |      |   | 130,070  |  
|Fixed assets                          |  |                | 1,843    |   |      |   | 2,810    |  
|Research and experimentation credit   |  |                | 4,140    |   |      |   | 4,140    |  
|Valuation allowance                   |  |                | (144,379 | ) |      |   | (137,020 | )
|                                      |  |                |          |   |      |   |          |  
|Total non-current deferred tax assets |  | $              |         |   |      | $ |         |  
|                                      |  |                |          |   |      |   |          |  

A full valuation allowance has been recorded at December 31, 2005 and 2004 with respect to the deferred tax
assets since the Company believes that it is more likely than not that future tax benefits will not be realized as a result of current and future income. Factors considered in determining that a full valuation allowance was necessary include the
Companys history of large operating losses and uncertainty as to whether the Company would be able to sustain long-term profitability.

The Company
had a valuation allowance of approximately $153.4 million and $145.5 million as of December 31, 2005, and 2004, respectively. The increase in the valuation allowance represents the non-recognition of the current year net deferred tax asset
because of the uncertainty as to their future use or realization. As of December 31, 2005, the Company had net operating loss carry forwards of approximately $362 million for tax purposes. The Company has recorded taxable deductions for the
exercise of stock options and for certain securities litigation costs which benefit of approximately $90 million would have been allocated to additional paid-in capital. The tax benefit of this additional net operating loss has not been realized due
to the 100% valuation allowance against the deferred tax assets. This deduction will be reported directly as an increase in additional paid-in capital and will not be recorded in the Companys



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Consolidated Statement of Operations when the tax benefit is realized. Loss carry forwards will expire between the years 2007 and 2024.As of
December 31, 2005, the Company also had general business credit carry forwards of approximately $4.1 million that expire between the years 2008 and 2021.

Following is a reconciliation of the applicable federal income tax as computed at the federal statutory tax rate to the actual income taxes reflected in the consolidated statement of operations.



|                                              |  |                                 |        |   |      |   |        |      |  |   |         |  
|--------------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                              |  | For The Year Ended December 31, |       
|                                              |  | 2005                            |        |   | 2004 |   |        | 2003 | 
|                                              |  | ( in thousands)                 |       
|Tax provision at U.S. federal income tax rate |  | $                               | (7,171 | ) |      | $ | (4,379 | )    |  | $ | (11,000 | )
|State income tax provision net of federal     |  |                                 | (766   | ) |      |   | (469   | )    |  |   | (1,174  | )
|Other, net                                    |  |                                 | 22     |   |      |   | 28     |      |  |   | 21      |  
|Valuation allowance increase                  |  |                                 | 7,915  |   |      |   | 4,820  |      |  |   | 12,153  |  
|                                              |  |                                 |        |   |      |   |        |      |  |   |         |  
|Provision for income taxes                    |  | $                               |       |   |      | $ |       |      |  | $ |        |  
|                                              |  |                                 |        |   |      |   |        |      |  |   |         |  

For the years ended December 31, 2004 and 2003, the income tax benefit of $66,000 and $30,000, respectively,
would have been allocated to additional paid-in capital for the tax benefits associated with the exercise of non-qualified stock options. No such income tax benefit was generated during the fiscal year December 31, 2005 as there were no
non-qualified stock options exercised.

9. NOTES PAYABLE, LINE OF CREDIT AND LETTER OF CREDIT

During the past two years, the Company has funded operations and other working capital requirements with short-term notes payable financing. The two principal lenders are
Optel Capital, LLC, which is referred to as Optel, an entity controlled by the Companys largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, and Jabil Circuit, Inc., the principal manufacturing
service vendor. The following is a summary of these liabilities for the years ended December 31, 2005 and 2004.



|                    |  |                                 |        |      |   |       
|------------------- |  | ------------------------------- | ------ | ---- | - | ------
|                    |  | For The Year Ended December 31,
|                    |  | 2005                            |        | 2004
|                    |  | ( in thousands)                
|Optel               |  | $                               | 46,830 |      | $ | 31,435
|Jabil Circuit, Inc. |  |                                 |       |      |   | 3,634 
|Other               |  |                                 | 55     |      |   | 77    
|                    |  |                                 |        |      |   |       
|Notes Payable Total |  | $                               | 46,885 |      | $ | 35,146
|                    |  |                                 |        |      |   |       

Optel

From
February 2003 through September 17, 2004, the Company borrowed approximately $27.0 million from Optel and its affiliates. In September 2004, the Company restructured this debt and issued Optel a secured convertible promissory note having the
following terms:



| |  |  | Interest Rate of 10% per annum;
| | - |  | -------------------------------



| |  |  | Accrued and unpaid interest as of September 16, 2004, plus interest that accrued on the $27.0 million outstanding principal that became due and payable on September 16,
2005, is now currently due and payable on demand at any time;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest that accrues from September 17, 2005, to December 31, 2005, is now currently due and payable on demand at any time;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | $27.0 million of principal is now currently due and payable on demand at any time any time; and,
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | Secured by a first priority security interest in substantially all of the assets of the Company.
| | - |  | ------------------------------------------------------------------------------------------------

From September 30, 2004, through December 31, 2005, the Company borrowed approximately an additional $19.8 million from Optel pursuant to the Short-Term Notes. Since January 1, 2006, the Company
borrowed an additional $2.0 million from Optel pursuant to the Short Term Notes. The Short-Term Notes have the following terms:



| |  |  | Interest Rate of 10% per annum;
| | - |  | -------------------------------



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| |  |  | Approximately $19.8 million in principal plus accrued interest is now currently due and payable on demand at any time;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | Approximately $2.0 million plus accrued interest thereon is payable on demand at any time after March 31, 2006; and,
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | Secured by a first priority security interest in substantially all of the assets of the Company.
| | - |  | ------------------------------------------------------------------------------------------------

On December 31, 2005, Optel notified the Company that it was not demanding payment of the approximately $46.8 million plus accrued interest thereof of approximately $5.9 million that was then and is currently
payable upon demand by Optel, but that it reserved its right to do so in the future.

On February 10, 2005, at a special meeting of our stockholders,
the conversion feature of the Secured Convertible Promissory Note was approved by our stockholders. Accordingly, all or any portion of such debt is convertible into our common stock at the option of Optel at any time. The conversion price is based
upon the volume-weighted average trading price of our common stock during the five-day period preceding the date of any conversion. On March 11, 2005, the Company issued 981,258 shares of common stock to Optel in connection with Optels
conversion of $1.0 million of the indebtedness outstanding under the Secured Convertible Promissory Note. Further conversion by Optel of all or any portion of the Secured Convertible Promissory Note could significantly dilute the ownership interests
of our other stockholders, and give Optel and Dr. Zwan even greater control over the Company.

On December 2, 2004, Optel established an
irrevocable standby letter of credit in the amount of approximately $1.4 million on the Companys behalf and naming Lightwave Drive LLC, the Companys landlord, as beneficiary. The letter of credit expires December 6, 2006. The letter
of credit replaced a previous letter of credit in the same amount, previously issued by us which had expired. The expired letter of credit had been secured by a restricted cash deposit of $1.4 million. With the letter of credit issued by Optel, we
have been able to utilize the $1.4 million cash deposit for working capital purposes.

On March 15, 2005, Optel established an irrevocable letter of
credit in the amount of $6.0 million on our behalf and naming MC Test Service, Inc. as beneficiary. MC Test Service, Inc. provides outsourced manufacturing services to us. With the letter of credit in place, MC Test Service, Inc. has extended the
Companys regular payment terms to pay for purchased production material. On December 16, 2005, Optel renewed the letter of credit for the amount of $2.0 million and extended the expiration date to December 30, 2006.

Wachovia

In April 2002, the Company entered into a Revolving Credit
and Security Agreement (the Agreement) with Wachovia Bank (the Bank). The Agreement expired on April 15, 2005. The terms of the Agreement provided the Company with a $27.5 million line of credit at LIBOR plus 0.7%
collateralized by the Companys cash and cash equivalents and short-term investments. The advance rate varied between 80% and 95% and was dependent upon the composition and maturity of the available collateral. An availability fee of
0.10% per annum was payable quarterly based on the Average Available Principal Balance (as defined in the Agreement) for such three months. The Agreement had an initial term of three years. The Agreement could have been terminated by the
Company at any time upon at least fifteen days prior written notice to the Bank, and the Bank had the right to terminate the Agreement at any time, without notice upon or after the occurrence of an event of default. Additionally, there were
approximately $1.4 million of letters of credit outstanding, collateralized by approximately $1.4 million of the Companys cash and cash equivalents which were not renewed. The Company currently has no additional borrowing capacity under this
facility and accordingly has no outstanding balance as of December 31, 2005.

Jabil Circuit, Inc.

On May 21, 2003 (but effective as of May 1, 2003), the Company and Jabil entered into a forbearance agreement (the Jabil Forbearance Agreement)
relating to Jabils claims against the Company relating to the manufacturing services agreement. As part of the terms of the Jabil Forbearance Agreement, the Company delivered to Jabil two promissory notes; one in the original principal amount
of approximately $2.84 million (the First Note), and another in the original principal amount of approximately $2.74 million (the Second Note and, together with the First Note, the Notes). The Notes carried an
interest rate of 6% per annum and matured on October 1, 2004. The First Note required monthly payments to be made beginning September 1, 2003. The Second Note required a balloon payment of principal and accrued interest on
October 1, 2004.

On May 11, 2004, Jabil and the Company entered into a settlement agreement (the 2004 Settlement), which resolved
and settled certain and all previous disputes between Jabil and the Company. Pursuant to the Settlement Agreement, the Company executed promissory notes (the Jabil Notes) totaling approximately $5.2 million in favor of Jabil for unpaid
accounts, notes and certain inventory for which the Company had not paid. The Jabil Notes were scheduled to mature on December 31, 2005, and bore interest at a rate of 6% per annum. During 2004, the Company made scheduled principal
payments under the Jabil Notes, including the initial payments, of approximately $1.8 million.



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On August 23, 2004, Optel entered into a guarantee agreement with Jabil Circuit, Inc., or Jabil, pursuant to which
Optel guaranteed certain obligations of the Company owing to Jabil relating to purchase orders for production material issued by the Company to Jabil after June 30, 2004. Optels maximum obligation under the guarantee agreement is $1.88
million. Prior to the completion of the guarantee agreement, the Company was required to prepay Jabil for all orders of production material. With the guarantee agreement in place, the Company was able to pay for production material purchased from
Jabil upon receipt of that material.

On August 31, 2005, the Company and Jabil entered into a Settlement Agreement and Mutual Release (the
Settlement Agreement) and in view of the fact that the Companys current manufacturing needs have changed, Jabil and the Company have agreed to amicably settle all outstanding principal and interest financial obligations between
them relating to the 2004 Settlement. Under the terms of the Settlement Agreement, Jabil returned to the Company approximately $810,000 in parts inventory and work-in-progress materials that had been purchased by the Company and warehoused at Jabil
for Jabils use in the on-going manufacturing of the Companys finished goods. Additionally, the Company paid Jabil $1.9 million (the Settlement Payment) on August 31, 2005. The Company and Jabil exchanged mutual releases
subject to specified exclusions and the Company obtained the remaining parts inventory and work-in-progress materials in Jabils possession on September 9, 2005. The settlement resulted in a gain of approximately $1.5 million which is
included with other income in the statement of operations.

10. LEASES

The Company is obligated under various non-cancelable leases primarily for office space. Future minimum lease commitments under operating leases were as follows as of December 31, 2005:



|           |  |                            |      
|---------- |  | -------------------------- | -----
|           |  | Operating LeaseCommitments
|           |  | ( in thousands)           
|2006       |  | $                          | 1,868
|2007       |  |                            | 1,854
|2008       |  |                            | 1,741
|2009       |  |                            |     
|2010       |  |                            |     
|Thereafter |  |                            |     
|           |  |                            |      
|           |  | $                          | 5,463
|           |  |                            |      

Total rent expense was approximately $2.4 million, $2.0 million, and $2.5 million for the years ended
December 31, 2005, 2004 and 2003, respectively.

11. COMMITMENTS

At December 31, 2005, the Company had outstanding non-cancelable purchase order commitments to purchase certain inventory items totaling approximately $2.6 million. The majority of the quantities under order are
deliverable upon demand by the Company or within thirty (30) days upon written notice of either party.

The Company indemnifies its officers and
directors against costs and expenses related to shareholder and other claims which are not covered by the Companys directors and officers insurance policy. This indemnification is ongoing and does not include a limit on the minimum potential
future payments, nor are there any resource provisions or collateral that may offset the cost. As of December 31, 2005, the Company has not recorded a liability for any obligations arising as a result of these indemnifications.



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12. RELATED PARTY TRANSACTIONS

Note Receivable

On February 15, 2005, in conjunction with a severance agreement between the Company and James
R. Green, the Companys former Chief Executive Officer, the Company agreed to forgive the entire amount of a note receivable from Mr. Green of approximately $374,000, including approximately $7,700 of accrued interest. Further, the Company
agreed to release all collateral held as security against such note, including a second lien on Mr. Greens residence. The costs associated with the forgiveness of the note and the severance agreement were reported as general and
administrative expenses during the fiscal year ended December 31, 2005.

Options For Services

On January 23, 2003, Robert Hussey, a director of the Company, was appointed Strategic Restructuring Advisor, effective as of December 1, 2002. In connection
with such appointment, Mr. Hussey was granted options to purchase 100,000 shares of the Companys common stock, vesting quarterly over a three-year period, at an exercise price of $1.28 per share, which was the market price of the
Companys common stock on the date of the grant. In addition, Mr. Hussey received service fees of $182,500 for the period from December 2002 through December 31, 2003.

Advisory Services

In April 2003, prior to Robert Moreyras appointment to the Companys board of
directors, Atlantic American Capital Advisors, LLC (AACA), a company of which Mr. Moreyra is Senior Managing Director, received compensation from the Company in the amount of $12,500 for certain services performed for the Company in
connection with the Companys negotiations with its creditors. The Company has no ongoing arrangements with AACA and does not intend to make any further payments to AACA.

13. COMMON STOCK AND STOCK OPTIONS

Stock Option Plans

The Companys 1996 Stock Option Plan (the 1996 Option Plan) became effective on March 5, 1996. A reserve of 5,000,000 shares of the Companys
Common Stock was established for issuance under the 1996 Option Plan. The stockholders of the Company approved the 2001 Stock Option Plan (the 2001 Option Plan) at a special meeting held February 27, 2001. Under the 2001 Option
Plan, 3,000,000 shares, plus (i) the number of shares available for grant under the 1996 Option Plan and (ii) the number of shares subject to options outstanding under the 1996 Option Plan to the extent that such options expire or
terminate for any reason prior to exercise in full, were reserved for issuance (with the sum of (i) and (ii) not to exceed 2,735,872 shares). The 2001 Option Plan superseded the 1996 Option Plan with respect to future grants.

On May 20, 2002, the stockholders of the Company approved an amendment to the 2001 Option Plan, increasing the number of shares of Common Stock authorized for
issuance thereunder by an additional 3,000,000 shares.

On February 10, 2005, the stockholders of the Company approved an amendment to the 2001 Option
Plan, increasing the number of shares of Common Stock authorized for issuance thereunder by an additional 5,000,000 shares. The stockholders also approved amendments to the 2001 Option Plan to increase the aggregate number of shares that can be
granted to an individual in a single fiscal year by 500,000 to 750,000, and to modify the circumstances in which vesting of certain options granted under such plan may be accelerated.

Generally, options issued vest in one-third annual increments or quarterly over a three-year period, with the exception of certain option agreements that provide for various vesting schedules throughout the same
three-year vesting period or options allowing vesting acceleration based on certain performance milestones. Where performance milestones are not met, the options will generally vest ratably over a five-and-one-half-year period. Option agreements
generally expire six years from date of issue if not exercised. Unvested options are generally forfeited upon termination of employment with the Company. Generally, vested shares must be exercised within sixty days of termination or be forfeited.
Total shares exercisable were 4,294,447, 3,121,959 and 1,909,322 as of December 31, 2005, 2004, and 2003, respectively.



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Transactions related to the 2001 and 1996 Option Plans are summarized as follows:



|                        |  |            |   |  |                             |     
|----------------------- |  | ---------- | - |  | --------------------------- | ----
|                        |  | Shares     |   |  | WeightedAverageOption Price
|Outstanding at 1/1/03   |  | 7,807,853  |   |  | $                           | 8.32
|Granted                 |  | 410,385    |   |  | $                           | 1.83
|Exercised               |  | (109,881   | ) |  | $                           | 1.20
|Forfeited               |  | (4,125,872 | ) |  | $                           | 6.29
|                        |  |            |   |  |                             |     
|Outstanding at 12/31/03 |  | 3,982,485  |   |  | $                           | 9.30
|Granted                 |  | 4,891,000  |   |  | $                           | 1.87
|Exercised               |  | (64,982    | ) |  | $                           | 1.29
|Forfeited               |  | (1,153,983 | ) |  | $                           | 6.62
|                        |  |            |   |  |                             |     
|Outstanding at 12/31/04 |  | 7,654,520  |   |  | $                           | 5.04
|Granted                 |  | 1,167,500  |   |  | $                           | 0.64
|Exercised               |  |           |   |  | $                           |    
|Forfeited               |  | (1,816,235 | ) |  | $                           | 8.79
|                        |  |            |   |  |                             |     
|Outstanding at 12/31/05 |  | 7,005,785  |   |  | $                           | 3.40
|                        |  |            |   |  |                             |     

The following table summarizes information about stock options outstanding at
December 31, 2005:



|                        |  |                                     |  |                                         |  |                                         |        |                                     |           |                                         |   |       
|----------------------- |  | ----------------------------------- |  | --------------------------------------- |  | --------------------------------------- | ------ | ----------------------------------- | --------- | --------------------------------------- | - | ------
|Range of Exercise Price |  | NumberOutstandingAtDecember 31,2005 |  | OutstandingWeightedAverageRemainingLife |  | OutstandingWeightedAverageExercisePrice |        | NumberExercisableAtDecember 31,2005 |           | ExercisableWeightedAverageExercisePrice
|$ 0.2200 - $ 1.4200     |  | 3,798,935                           |  | 4.18                                    |  | $                                       | 1.057  |                                     | 2,211,460 |                                         | $ | 1.219 
|$ 1.5100 - $ 5.1000     |  | 2,844,000                           |  | 4.04                                    |  | $                                       | 2.224  |                                     | 1,768,137 |                                         | $ | 2.223 
|$ 9.2200 - $ 9.2200     |  | 2,400                               |  | 1.75                                    |  | $                                       | 9.220  |                                     | 2,400     |                                         | $ | 9.220 
|$ 15.6719 - $ 21.0625   |  | 110,000                             |  | 1.24                                    |  | $                                       | 20.082 |                                     | 75,000    |                                         | $ | 19.625
|$ 27.5000 - $ 27.7500   |  | 165,500                             |  | 1.16                                    |  | $                                       | 27.750 |                                     | 152,500   |                                         | $ | 27.750
|$ 47.2500 - $ 113.8125  |  | 84,950                              |  | 0.36                                    |  | $                                       | 78.072 |                                     | 84,950    |                                         | $ | 78.072
|                        |  |                                     |  |                                         |  |                                         |        |                                     |           |                                         |   |       
|                        |  | 7,005,785                           |  |                                         |  |                                         |        |                                     | 4,294,447 |                                         |   |       

The pro forma amounts presented in Note 1  Summary of Significant Accounting Policies, were
determined using the Black-Scholes valuation model with the following key assumptions: (i) a discount rate of 3.93%, 4.0% and 2.44%, for the years ending December 31, 2005, 2004 and 2003, respectively; (ii) a volatility factor based
upon averaging the week ending price for Digital Lightwave and comparable public companies for periods matching the terms of the options granted (269% for 2005 and 2004); (iii) an average expected option life of 4.00 years for all three years;
and (iv) no payment of dividends. The average fair market value per option granted in 2005 was $1.60.

Employee Stock Purchase Plan

The Companys 1997 Employee Stock Purchase Plan provides employees with the opportunity to purchase shares of the Companys Common Stock. An aggregate of
300,000 shares of the Companys Common Stock were reserved for issuance under the Plan. On May 20, 2002 the shareholders of the Company approved an amendment to the Employee Stock Purchase Plan that increased the number of shares of Common
Stock authorized for issuance there under by an additional 300,000 shares. At December 31, 2005 a total of 417,701 shares had been purchased by employees participating in the plan at a weighted-average price per share of $4.41.



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14. DEFINED CONTRIBUTION PLAN

The Company offers a defined contribution plan that qualifies under IRC section 401(k). All full-time employees are eligible to participate in the plan after three months of service with the Company. Employees may contribute up to 15% of
their salary to the plan, subject to certain Internal Revenue Service limitations. The Company matches the first 6% of such voluntary contributions at 50% of the amount contributed by the employee. The Company has not made unmatched contributions.
For the years ended December 31, 2005, 2004 and 2003, total company contributions to the plan were approximately $130,000, $96,000, and $127,000, respectively.

15. RESTRUCTURING

During fiscal years 2002 and 2003, the board of directors approved a number of business
restructuring and cost reductions activities in response to the downturn in the economy and specifically, the telecommunications industry. These activities included multiple reductions in the work force and the closing of the Companys sales
offices in Brazil, Singapore, India and Australia. The Company recorded net restructuring charges of $700,000 in the fiscal years ending December 31, 2003. At December 31, 2004, all outstanding liabilities relating to these restructuring
efforts have been fully satisfied.

Activity associated with the restructuring charges for the years ended
December 31, 2005, 2004 and 2003 were as follows:



|                  |  |                |        |   |                |   |      |               |  |       |   |  |   |        |  
|----------------- |  | -------------- | ------ | - | -------------- | - | ---- | ------------- |  | ----- | - |  | - | ------ | -
|                  |  | Severance      |        |   | Legaland Other |   |      | LeasePayments |  | Total |  
|                  |  | (in thousands) |       
|January 1, 2003   |  | $              | 342    |   |                | $ | 152  |               |  | $     |  |  | $ | 494    |  
|Additions         |  |                | 1,334  |   |                |   | 53   |               |  |       |  |  |   | 1,387  |  
|Payments          |  |                | (1,661 | ) |                |   | (200 | )             |  |       |  |  |   | (1,861 | )
|                  |  |                |        |   |                |   |      |               |  |       |   |  |   |        |  
|December 31, 2003 |  |                | 15     |   |                |   | 5    |               |  |       |  |  |   | 20     |  
|Additions         |  |                |       |   |                |   |     |               |  |       |  |  |   |       |  
|Payments          |  |                | (15    | ) |                |   | (5   | )             |  |       |  |  |   | (20    | )
|                  |  |                |        |   |                |   |      |               |  |       |   |  |   |        |  
|December 31, 2004 |  |                |       |   |                |   |     |               |  |       |  |  |   |       |  
|Additions         |  |                |       |   |                |   |     |               |  |       |  |  |   |       |  
|Payments          |  |                |       |   |                |   |     |               |  |       |  |  |   |       |  
|                  |  |                |        |   |                |   |      |               |  |       |   |  |   |        |  
|December 31, 2005 |  | $              |       |   |                | $ |     |               |  | $     |  |  | $ |       |  
|                  |  |                |        |   |                |   |      |               |  |       |   |  |   |        |  

16. LEGAL PROCEEDINGS

As of the date of this report, the Company is not aware of any pending litigation, claims or assessments that would have a material adverse effect on the Companys business, financial condition and results of operations. The following
is a summary of litigation, claims or assessments that were settled or otherwise resolved during the years ending December 31, 2003, 2004 and 2005.

CIT Technologies Corporation

As described below, litigation between CIT Technologies Corporation
(CIT) and the Company has been dismissed.

On June 8, 2004, the Company entered into a settlement agreement (the Mediation
Settlement Agreement) with CIT, which resolved and settled certain disputes between the Company and CIT. Under the Mediation Settlement Agreement, and in full satisfaction of all claims by CIT against the Company, CIT received $5.2 million in
cash, 2,500,000 shares of common stock of the Company and certain equipment subject to the original lease agreements between the Company and CIT. Further, CIT dismissed the lawsuit it filed in April 2003.

In April 2003, CIT, which had been the Companys largest unsecured creditor, filed a compliant against the Company in the Circuit Court of the Sixth Judicial
Circuit for Pinellas County, Florida, in connection with the non-payment of monies due for equipment provided under various lease agreements between CIT and the Company. The Company returned to CIT approximately 80% of the units under lease. The
Mediation Settlement Agreement satisfied any requirement to return any other equipment to CIT.The complaint sought, among other things, damages in excess of $15.6 million as well as the return of all leased equipment.



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As a result of the Mediation Settlement Agreement, the Company realized a gain of $3.7 million from debt forgiveness.
This gain was contingent upon the timing of certain events that took place during the third quarter of 2004. Accordingly, at June 30, 2004, the Company reported in the balance sheet a deferred gain of $3.7 million. This gain was recognized as
other income in the quarter ended September 30, 2004. At December 31, 2003, the Companys financial statements reflected a liability of $13.6 million as an accrued litigation charge relating to this dispute.

Jabil Circuit, Inc.

As described
below, litigation between Jabil Circuit, Inc. (Jabil) and the Company has been dismissed.

On May 11, 2004, Jabil and the Company entered
into a settlement agreement (the 2004 Settlement), which resolved and settled certain and all previous disputes between Jabil and the Company. Pursuant to the Settlement Agreement, the Company executed promissory notes (the Jabil
Notes) totaling approximately $5.2 million in favor of Jabil for unpaid accounts, notes and certain inventory for which the Company had not paid. Further, the Company also placed additional purchase orders with Jabil approximating $1.1 million
and made cash payments to Jabil approximating $1.4 million in conjunction with new purchase orders and as initial payments under the Jabil Notes. Under the Settlement Agreement, the Company and Jabil agreed to dismiss the two lawsuits filed by Jabil
in 2003, and Jabil agreed to continue to provide manufacturing services to the Company through December 31, 2004.

On October 7, 2003, Jabil
filed two complaints in the Circuit Court of the Thirteenth Judicial Circuit for Hillsborough County, Florida, for certain unpaid accounts receivable and inventory for which the Company had not paid of approximately $5.6 million. Prior to filing the
complaints, in March 2003, Jabil commenced an arbitration proceeding against the Company and sought damages in excess of $6.8 million related to non-payment by the Company for amounts due under a manufacturing services agreement and costs
originating as a result of the termination of that agreement due to non-payment. On December 5, 2003, the Company entered into a manufacturing services letter agreement with Jabil for certain manufacturing services, at which time the Company
wrote off approximately $4.0 million in inventory claims for inventory held at Jabil.

On August 23, 2004, Optel entered into a guarantee agreement
with Jabil Circuit, Inc., or Jabil, pursuant to which Optel guaranteed certain obligations of the Company owing to Jabil relating to purchase orders for production material issued by the Company to Jabil after June 30, 2004. Optels
maximum obligation under the guarantee agreement was $1.88 million. Prior to the completion of the guarantee agreement, the Company was required to prepay Jabil for all orders of production material. With the guarantee agreement in place, the
Company was able to pay for production material purchased from Jabil upon receipt of that material.

On August 31, 2005, the Company and Jabil entered
into a Settlement Agreement and Mutual Release (the Settlement Agreement) relating to the 2004 Settlement. In connection with the Settlement Agreement, and in view of the fact that the Companys current manufacturing needs have
changed, Jabil and the Company have agreed to amicably settle all outstanding principal and interest financial obligations between them relating to the 2004 Settlement. Under the terms of the Settlement Agreement, Jabil returned to the Company
approximately $810,000 in parts inventory and work-in-progress materials that had been purchased by the Company and warehoused at Jabil for Jabils use in the on-going manufacturing of the Companys finished goods and the Company paid
Jabil $1.9 million (the Settlement Payment) on August 31, 2005. The Company and Jabil exchanged mutual releases subject to specified exclusions and the Company obtained the remaining parts inventory and work-in-progress materials in
Jabils possession on September 9, 2005.

Seth P. Joseph

As described below, the disputes between Seth P. Joseph, a former officer and director of the Company, and the Company have been resolved.

On November 23, 1999, Mr. Joseph commenced arbitration proceedings against the Company alleging breach of his employment agreement and stock option agreements, violation of the Florida Whistleblower statute,
and breach of an indemnification agreement and the Companys bylaws. The Company filed an answer denying Mr. Josephs allegations and alleged multiple affirmative defenses and counterclaims seeking repayment of loans of $113,000 plus
interest. The court subsequently dismissed without prejudice all of Mr. Josephs claims other than his claim under the Whistleblower Statute.

In
October 2001, following the conclusion of the arbitration hearing on Mr. Josephs Whistleblower claim, Mr. Joseph sought an



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award of $4.8 million plus attorneys fees, costs and interest thereon. In November 2001, the arbitrator issued an award to Mr. Joseph of $3.7
million, and in December 2001 issued a corrected award of $3.9 million, plus attorneys fees and costs. In July 2002, the arbitrator issued an award to Mr. Joseph of $750,000 for attorneys fees and costs plus interest.

In December 2001, the Company filed a petition to vacate or modify the arbitration award in the Circuit Court of the Sixth Judicial Circuit for Pinellas County, Florida.
Subsequently, Mr. Joseph filed a cross-motion to confirm the arbitration award. In March 2002, the Court denied the Companys petition to vacate the arbitration award, granted Mr. Josephs cross-motion to confirm the award, and
entered a judgment in favor of Mr. Joseph in the amount of $4.0 million including interest (the Final Judgment). The Company appealed the decision and judgment of the Circuit Court.

In April 4, 2002 the Company posted a civil supersedes bond in the amount of $4.8 million, issued by Fidelity and Deposit Company of Maryland, n/k/a Zurich American
Insurance Company (Fidelity), which represented the amount of the judgment plus two times the estimated interest, to secure a stay of enforcement of the Circuit Court judgment pending the Companys appeal. In January 2003, the
Company paid approximately $1.0 million into an escrow account for Mr. Josephs legal fees and interest on the balance recorded by the Company in 2002.

On April 23, 2003, the appellate court affirmed the decision and judgment of the Circuit Court, which was not appealed further by the Company. In May 2003, following the appellate courts decision, Mr. Joseph and the Company
agreed to the release of the $1.0 million escrowed funds, of which Mr. Joseph received $882,000 and the Company received the balance. Further, the Company was required to pay the amount of the Final Judgment on May 9, 2003. The Company was
unable to make this payment and, upon a motion for disbursement of bond proceeds, the Circuit Court ordered Fidelity to pay the Final Judgment, inclusive of prejudgment interest, totaling approximately $4.5 million, by June 16, 2003, plus
additional interest thereafter until paid. The Circuit Court also awarded Mr. Joseph appellate attorneys fees and costs in the amount of $65,415 (the Attorneys Fees and Costs Judgment).

On June 13, 2003, the Company and Fidelity entered into a Compromise and Settlement Agreement (the Fidelity Settlement Agreement). Under the terms of
the agreement, and pursuant to a payment schedule, the Company was required to pay Fidelity 60% of the amount paid by Fidelity under the Final Judgment and the Attorneys Fees and Costs Judgment by the end of fiscal year 2003. On June 18,
2003, Fidelity paid the Final Judgment plus interest in the amount of $4,484,414 and on July 15, 2003, Fidelity paid the Attorneys Fees and Cost Judgment in the amount of $65,415.

The Company paid Fidelity approximately $2.3 million pursuant to the Fidelity Settlement Agreement. The Company was unable to make the remaining payments under the terms
of the Fidelity Settlement Agreement and requested a further modification to the payment schedule. On February 20, 2004, Fidelity and the Company agreed upon final settlement arrangements whereby the Company made final cash payment of
approximately $230,000 in full settlement and satisfaction of all outstanding liabilities owed by the Company under the Fidelity Settlement Agreement. The settlement agreement also contained mutual releases.

At December 31, 2003, the Companys financial statements reflected a liability of approximately $230,000 as an accrued litigation charge. During 2003, the
Company recognized a gain on the decrease of approximately $2.0 million in the liability as a result of the Fidelity Settlement Agreement.

Other
Employee Matters

As described below, the disputes between certain former employees and the Company have been resolved.

During fiscal year 2004, the Company entered into settlement agreements with two former officers, George Matz and Dr. Glenn Dunlap. The settlements
related to outstanding obligations for previously negotiated severance agreements approximating $155,000 and $32,000 for Mr. Matz and Dr. Dunlap, respectively.

On April 30, 2004, Mr. Matz and the Company entered into a settlement agreement, pursuant to which the Company agreed to engage Mr. Matz as a consultant through March 31, 2006, for a consulting fee
of $50,000, of which $15,000 was paid on May 6, 2004. The remaining $35,000 in fees is to be paid monthly on a scheduled basis through March 2006. Further, the Company granted Mr. Matz options to purchase 60,000 shares of the
Companys common stock at an exercise price of $0.92 per share, which vest quarterly over three years. The Company also agreed to provide Mr. Matz medical insurance coverage through April 2006 at the Companys expense. The settlement
agreement also contained mutual releases.

On May 6, 2004, Dr. Dunlap and the Company entered into a settlement agreement whereby all claims and
liabilities and all previous agreements between Dr. Dunlap and the Company were settled for a lump sum payment of $25,000, which was paid upon execution



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of the settlement agreement. Pursuant to the settlement agreement, Dr. Dunlap retained the right to exercise an option to purchase 66,666 shares of the
Companys common stock at an exercise price of $1.42 per share, which expired on August 16, 2004. The settlement agreement also contained mutual releases.

Lightwave Drive, LLC

In July 2003, litigation between Lightwave Drive, LLC (Landlord) and the Company
relating to the lease between the Landlord and the Company for the Companys headquarters located at 15550 Lightwave Drive, Clearwater, Florida 33760 (the Leased Property) has been dismissed. The litigation was initiated by the
Landlord for unpaid rent and real estate taxes under the Lease.

As of the date of this report, the Company is current on all of its rental payment and
real estate tax obligations owed in connection with the Leased Property.

Other Legal Matters

During fiscal years 2003 and 2004, the Company was engaged in a number of other less significant legal actions and disputes, all of which have been resolved or dismissed.
These disputes were brought about as result of the significant economic downturn which occurred during that period and the corresponding decline in the Companys business and the constraints on the Companys working capital. The majority
of these disputes resulted from vendor actions over nonpayment by the Company for goods and services provided to the Company during that period. Payments during fiscal year 2004 in settlement of vendor disputes approximated $371,000 and $210,000 to
Arrow Electronics Inc. and Plaut Sigma Solutions, Inc., respectively. In fiscal year 2003, the Company paid settlements approximating $240,000 and $22,600 to Micron Optics, Inc. and Insight Electronics, LLC, respectively. In December 2003, the
Company agreed to release $1.0 million in previously escrowed funds to Tektronix, Inc. in connection with a certain Asset Purchase Agreement dated October 31, 2002, between the two companies. The Company also made a cash payment to Tektronix,
Inc. in 2004 in the amount of $100,000 as part of their mutually agreed to settlement.

Other

The Company from time to time may be involved in various other lawsuits and actions by third parties arising in the ordinary course of business. The Company is not aware
of any additional pending litigation, claims or assessments that could have a material adverse effect on the Companys business, financial condition and results of operations.

17. QUARTERLY OPERATING RESULTS (UNAUDITED)

The following table presents unaudited quarterly operating results for
each of the last eight quarters. This information has been prepared by the Company on a basis consistent with the Companys consolidated financial statements and includes all adjustments, consisting only of normal recurring accruals in
accordance with generally accepted accounting principles. Such quarterly results are not necessarily indicative of future operating results.



|                                                                                   |  |                                                 |            |   |               |   |            |                   |  |   |                  |   |  |   |            |  
|---------------------------------------------------------------------------------- |  | ----------------------------------------------- | ---------- | - | ------------- | - | ---------- | ----------------- |  | - | ---------------- | - |  | - | ---------- | -
|                                                                                   |  | Quarter Ended                                   |           
|                                                                                   |  | March 31,2005                                   |            |   | June 30, 2005 |   |            | September 30,2005 |  |   | December 31,2005 |  
|                                                                                   |  | (in thousands, except share and per-share data) |           
|Net sales                                                                          |  | $                                               | 2,865      |   |               | $ | 2,670      |                   |  | $ | 4,898            |   |  | $ | 2,449      |  
|Gross profit (loss) (1)                                                            |  |                                                 | (104       | ) |               |   | 343        |                   |  |   | 1,369            |   |  |   | 264        |  
|Operating loss                                                                     |  |                                                 | (5,577     | ) |               |   | (7,150     | )                 |  |   | (2,603           | ) |  |   | (3,154     | )
|Net loss                                                                           |  |                                                 | (6,423     | ) |               |   | (8,090     | )                 |  |   | (2,083           | ) |  |   | (4,497     | )
|                                                                                   |  |                                                 |            |  
|Basic and diluted loss per share (4)                                               |  | $                                               | (0.19      | ) |               | $ | (0.23      | )                 |  | $ | (0.06            | ) |  | $ | (0.13      | )
|                                                                                   |  |                                                 |            |  
|Weighted average shares outstanding and average shares and equivalents outstanding |  |                                                 | 34,419,148 |   |               |   | 35,179,118 |                   |  |   | 35,191,317       |   |  |   | 35,204,003 |  



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##### Table of Contents

|                                                                                   |  |                                                 |            |   |               |   |            |                   |  |   |                  |   |  |   |            |  
|---------------------------------------------------------------------------------- |  | ----------------------------------------------- | ---------- | - | ------------- | - | ---------- | ----------------- |  | - | ---------------- | - |  | - | ---------- | -
|                                                                                   |  | Quarter Ended                                   |           
|                                                                                   |  | March 31,2004                                   |            |   | June 30, 2004 |   |            | September 30,2004 |  |   | December 31,2004 |  
|                                                                                   |  | (in thousands, except share and per-share data) |           
|Net sales (2)                                                                      |  | $                                               | 4,392      |   |               | $ | 5,797      |                   |  | $ | 2,492            |   |  | $ | 1,058      |  
|Gross profit (loss) (1),(3)                                                        |  |                                                 | 1,138      |   |               |   | 1,968      |                   |  |   | 305              |   |  |   | (2,314     | )
|Operating loss                                                                     |  |                                                 | (2,087     | ) |               |   | (1,596     | )                 |  |   | (4,952           | ) |  |   | (5,808     | )
|Net loss                                                                           |  |                                                 | (2,466     | ) |               |   | (1,663     | )                 |  |   | (2,090           | ) |  |   | (6,659     | )
|                                                                                   |  |                                                 |            |  
|Basic and diluted loss per share (4)                                               |  | $                                               | (0.08      | ) |               | $ | (0.05      | )                 |  | $ | (0.06            | ) |  | $ | (0.19      | )
|                                                                                   |  |                                                 |            |  
|Weighted average shares outstanding and average shares and equivalents outstanding |  |                                                 | 31,609,216 |   |               |   | 32,278,334 |                   |  |   | 34,169,531       |   |  |   | 34,180,864 |  

---

|(1) | Amounts reflect the reclassification of certain costs from engineering and development and sales and marketing expenses to cost of goods sold.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------

|(2) | During the fourth quarter of the year ended December 31, 2004, the Company recorded a reduction in net sales resulting from product returns of approximately $2.0 million.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | During the fourth quarter of the year ended December 31, 2004, and 2003, the Company recorded charges of approximately $1.3 million and $4.0 million for excess and obsolete
inventory, respectively.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Earnings per share were calculated for each three-month periods on a stand-alone basis. Earnings per share for each of the quarters ended from March 31, 2004 through
December 31, 2005 do not include the impact of common stock equivalents as inclusion would be anti-dilutive.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The Companys sales
and operating results may fluctuate from quarter-to-quarter and from year-to-year due to the following factors: (i) the ability to obtain funding for working capital needs to allow the Company to procure inventory in sufficient supplies to meet
customer demand (ii) announced capital expenditure cutbacks by customers within the telecommunications industry, (iii) limited number of major customers, (iv) the product mix, volume, timing and number of orders received from
customers, (v) the long sales cycle for obtaining new orders, (vi) the timing of introduction and market acceptance of new products, (vii) success in developing, introducing and shipping product enhancements and new products,
(viii) pricing changes by our competitors, (ix) the ability to enter into long term agreements or blanket purchase orders with customers, (x) the ability to obtain sufficient supplies of sole or limited source components for products,
(xi) the ability to attain and maintain production volumes and quality levels for current and future products, and (xii) changes in costs of materials, labor and overhead. Any unfavorable changes in these or other factors could have a
material adverse effect on the Companys business, financial condition and results of operations. The Company does not anticipate that its backlog at the beginning of each quarter will be sufficient to achieve expected revenue for that quarter.
To achieve its revenue objectives, the Company expects that it will have to obtain orders during a quarter for shipment in that quarter.

18. SUBSEQUENT
EVENTS

Related Party Financing

As of
December 31, 2005, the outstanding balance owed to Optel Capital, LLC (Optel), an entity controlled by our largest stockholder and current chairman of the board of directors, Dr. Bryan J. Zwan, was approximately $46.8
million, exclusive of accrued interest of approximately $5.9 million. Since January 1, 2006, the Company borrowed an additional $2.0 million from Optel pursuant to the Short-Term Notes. (See Note 9 to the Consolidated Financial Statements
 Notes Payable, Line of Credit and Letter of Credit)



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##### Table of Contents

Restructuring

On
February 28, 2006, the Company instituted a reduction in force of 11 employees to more closely align its expenses and revenues.

19. NON-CASH
TRANSACTIONS

During the year ended December 31, 2005, Optel elected to convert a total of $1.0 million of the Secured Convertible Promissory Note
into 981,258 shares of common stock of the Company, reducing accrued interest payable by $1.0 million and increasing additional paid-in capital by the same amount. The number of shares issued increased common stock by $98.00.

In 2005, the Company forgave the notes receivable outstanding balance of $374,000 from Mr. James R. Green, the Companys former Chief Executive Officer,
as part of his severance arrangements (see Note 12  Related Party Transactions).

Also during the year ended December 31, 2005, pursuant to the
Settlement Agreement, the Company paid Jabil $1.9 million on the remaining notes which consisted of $3.1 million of principal and $300,000 of accrued interest. The Company realized a total non-cash gain of $1.7 million, which included a $1.5 million
of debt settlement gain on the current notes as well as $200,000 remaining deferred gain on settlement of the restructured Jabil Notes (see Note 16  Legal Proceedings).

During the year ended December 31, 2004, the Company completed litigation settlements representing $14.2 million of accrued litigation liabilities reported at December 31, 2003. In connection with the CIT
Technologies Corporation (CIT) settlement in fiscal year 2004, the Company paid $5.2 million in cash and recognized non-cash other income of $3.7 million and an increase of $4.7 million to additional paid-in capital related to the
issuance of 2,500,000 shares of common stock to CIT. The Company paid approximately $400,000 in cash related to certain other litigation settlements. During fiscal year 2003, as a result of the litigation with CIT, the Company returned leased
equipment with a net book value of approximately $735,000.

Further, the Jabil settlement, also completed during the year ended December 31, 2004,
resulted in a reduction of approximately $276,000 in accounts payable and accrued expenses and a net increase of approximately $69,000 to notes payable. During fiscal year 2004, the settlement completed with Jabil resulted in a $1.1 million increase
to prepaid assets for future inventory purchases, a reduction of $4.5 million in accounts payable, and a $5.6 million increase in notes payable. As a result of the Manufacturing Services Agreement entered into with Jabil on December 5, 2003,
approximately $4.0 million of prepaid assets were written off in the fourth quarter of 2003.

In 2003, accounts receivable totaling approximately $1.6
million were decreased with the return of approximately $900,000 of inventory with the remaining approximately $678,000 taken against the reserve for bad debts and the reserve for sales returns and allowances.



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##### Table of Contents

DIGITAL LIGHTWAVE, INC.

SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS

(Dollars in thousands)



|                                          |  |                             |  |                               |   |        |                            |  |            |      |  |                      
|----------------------------------------- |  | --------------------------- |  | ----------------------------- | - | ------ | -------------------------- |  | ---------- | ---- |  | ---------------------
|COL. A                                    |  | COL. B                      |  | COL. C                        |   | COL. D |                            |  | COL. E    
|                                          |  |                             |  | Additions                     |   |        |                            |  |           
|Description                               |  | BalanceatBeginningOf Period |  | (1)Chargedto CostsandExpenses |   |        | (2)Chargedto OtherAccounts |  | Deductions |      |  | Balanceat EndofPeriod
|Year 2005                                 |  |                             |  |                               |   |        |                            |  |            |      |  |                      
|Reserve for uncollectible accounts        |  | 690                         |  |                              |   |        |                           |  | 545        | (a)  |  | 145                  
|Reserve for excess and obsolete inventory |  | 16,249                      |  | (1                            | ) |        |                           |  | 537        | (b)  |  | 15,711               
|Year 2004                                 |  |                             |  |                               |   |        |                            |  |            |      |  |                      
|Reserve for uncollectible accounts        |  | 531                         |  | 98                            |   |        |                           |  | (61        | )(a) |  | 690                  
|Reserve for excess and obsolete inventory |  | 14,555                      |  | 1,315                         |   |        |                           |  | (379       | )(b) |  | 16,249               
|Year 2003                                 |  |                             |  |                               |   |        |                            |  |            |      |  |                      
|Reserve for uncollectible accounts        |  | 2,394                       |  | (444                          | ) |        |                           |  | 1,419      | (a)  |  | 531                  
|Reserve for excess and obsolete inventory |  | 10,938                      |  | 4,022                         |   |        |                           |  | 405        | (b)  |  | 14,555               

---

|(a) | Amounts written off as uncollectible, payments or recoveries.
|--- | -------------------------------------------------------------

|(b) | Amounts written off upon disposal or return of inventory.
|--- | ---------------------------------------------------------



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##### Table of Contents

Exhibit Index



|            |  |      |  |   |  |                                                                                                                                                           
|----------- |  | ---- |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Ref. |  |   |  | Description                                                                                                                                               
|23.1        |  | +    |  | - |  | Consent of Grant Thornton LLP.                                                                                                                            
|            |  |      | 
|24.1        |  | +    |  | - |  | Power of Attorney (included as part of signature page)                                                                                                    
|            |  |      | 
|31.1        |  | +    |  | - |  | Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                   
|            |  |      | 
|31.2        |  | +    |  | - |  | Certification of the Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                               
|            |  |      | 
|32.1        |  | +    |  | - |  | Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.    
|            |  |      | 
|32.2        |  | +    |  | - |  | Certification by the Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

---

|+ | Filed with this report.
|- | -----------------------