**U. S. SECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

 

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**FORM 10-QSB**

 

**(MarkOne)**

 
| **ý** |   | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|--------|---------------------------------------------------------------------------------------------|

 

**Forthe quarterly period ended June 30, 2004**

 
| o |   | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF  THE EXCHANGE ACT** |
|---|--------|---------------------------------------------------------------------------|

 

**Forthe transition period from               to               **

 

**CommissionFile Number: 000-50638**

 

**GRAYMARK PRODUCTIONS, INC.**

(Name of smallbusiness issuer in its Charter)

 

| **OKLAHOMA**                                                     |                                                                                | **20-0180812**                      |
|------------------------------------------------------------------|-------------------------------------------------------------------------------------|-------------------------------------|
| (State or other jurisdiction of  incorporation or organization)  |                                                                                | (I.R.S. EmployerIdentification No.) |
|                                                             |                                                                                |                                |
| **101  N. Robinson, Suite 920****Oklahoma City, Oklahoma 73102** |
| (Address of principal executive offices)                         |
|                                                             |                                                                                |                                |
| **(405)  601-5300**                                              |
| (Issuer’s telephone number)                                 |
|                                                             |                                                                                |                                |
|                                                             |                                                                                |                                |
|                                                             | (Former name,  former address and former fiscal year, if changed since last report) |                                |
|                                                                  |                                                                                     |                                     |  |  |

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCYPROCEEDINGS DURING THE PRECEDING FIVE YEARS**

 

Check whether theregistrant filed all documents and reports required to be filed by Section 12,13 or 15(d) of the Exchange Act after the distribution of securities under aplan confirmed by a court.  Yes o No o

 

**APPLICABLEONLY TO CORPORATE ISSUERS**

 

State the number ofshares outstanding of each of issuer’s classes of common equity, as of thelatest practicable date:  As ofSeptember 30, 2004, 8,258,425 shares of the issuer’s common stock, $0.0001par value, were outstanding.

 

Transitional SmallBusiness Disclosure Format (Check One): Yes o No ý

 

 

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**GRAYMARKPRODUCTIONS, INC**.

FORM 10-QSB

For the QuarterEnded June 30, 2004

 

TABLE OF CONTENTS

 
| Part  I.   | Financial  Information                                          |   |
|------------|-----------------------------------------------------------------|--------|
| Item  1.   | Financial  Statements                                           |   |
| Item  2.   | Management’s  Discussion and Analysis or Plan of Operation |   |
| Item  3.   | Controls  and Procedures                                        |   |
|       |                                                            |   |
| Part II.   | Other  Information                                              |   |
| Item 1.    | Legal  Proceedings                                              |   |
| Item 2.    | Changes in  Securities and Use of Proceeds                      |   |
| Item 3.    | Defaults Upon Senior  Securities                                |   |
| Item  4.   | Submission  of Matters to a Vote of Security Holders            |   |
| Item 5.    | Other Information                                               |   |
| Item 6.    | Exhibits and Reports  on Form 8-K                               |   |
| SIGNATURES |                                                            |

 

Throughout this reportthe first personal plural pronoun in the nominative case form “we” and itsobjective case form “us”, its possessive and the intensive case forms “our” and“ourselves” and its reflexive form “ourselves” refer collectively to GrayMark Productions, Inc., its predecessor,GrayMark Productions, L.L.C., and its executive officers and directors.  The term “independent,” as used in thisreport, is used to distinguish us from the term “major studios” that isgenerally regarded in the entertainment industry to mean Universal Pictures,Warner Bros., Twentieth Century Fox, Sony Pictures Entertainment, ParamountPictures, The Walt Disney Company, Metro Goldwyn Mayer and their respectiveaffiliates.  The terms “low-budgetmotion pictures,” “low-budget films” or “low-budget movie” within this report,refer to motion pictures that have a production budget of $2 to $5 million.

 

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**PARTI. FINANCIAL INFORMATION**

 

**Item 1.****           Financial Statements**

 

Our financial statementswhich are prepared in accordance with Regulation S-B are set forth in thisreport beginning on page F-1.

 

**Item 2.****           Management’s Discussion and Analysis orPlan of Operation**

 

You should read thefollowing discussion in conjunction with our financial statements and notesthereto appearing elsewhere in this report.

 

**Overview**

 

**DevelopmentStage Company**

 

We are a developmentstage company.  We operated historicallyas a limited liability company, GrayMark Productions, L.L.C. that was formed inAugust 2001.   Since commencementof our operations in August 2001, we have not generated a material amountof revenue from operations.  EffectiveAugust 18, 2003, pursuant to an exchange agreement, the owners of themember interests in GrayMark Productions, L.L.C. exchanged their respectivemember interests in GrayMark Productions, L.L.C. for 4,870,000 shares of ourcommon stock.  As a result of thisexchange, GrayMark Productions, L.L.C. became a wholly-owned subsidiary of GrayMarkProductions, Inc. and the plan of operation of GrayMark Productions, L.L.C.became that of GrayMark Productions, Inc.

 

We have completedproduction of our first motion film project, *Cloud9*, and are in the process of marketing both the foreign and domesticrights to the film.  We have notgenerated any revenue to date from *Cloud 9*.

 

The following discussioncovers our plan of operations for the next 12 months.  As with any plan, there is no assurance that our operations asdescribed will go as planned or that we will be successful in achieving theanticipated results.

 

**MovieDevelopment and Production**

 

The movie industrygenerally consists of two principal activities, production anddistribution.  Production encompassesthe development, financing and creation of feature-length movies.  Distribution entails the promotion andmarketing of movies in the various media markets, including theatrical, homevideo and television presentation.

 

We anticipate primarilyproducing English language motion pictures intended primarily for domestictheatrical release and to a much lesser extent the ancillary market (home videoand television, including pay-per-view, cable, satellite and networkbroadcast), that have production budgets of $2 to $5 million (“low-budget motionpictures,” “low budget movies” or “low-budget films”).

 

The development andproduction costs of a low-budget film and each cost category varies frommovie-to-movie and this variation may be substantial.   Each movie is unique and the storyline, special effects,production locations, creative personnel involved, etc. affect the budgetamount of each cost category. Accordingly, we believe the cost categories are somewhat indeterminableuntil the particular movie is identified and developed.

 

Rather than retain andemploy personnel to develop screenplays and perform other movie developmentactivities, we typically acquire movies for production that are in thedevelopment phase, generally to the point that the initial screenplay has beenwritten, and that are low-budget films. In the pre-production and production phases of a motion picture, weintend to hire skilled creative and production personnel, includingcinematographers, editors, costume designers, set designers, sound and lightingtechnicians and actors on an as needed basis.

 

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We expect to enter intovarious production cost and revenue sharing arrangements, including jointventures, partnerships and limited liability companies, on a movie-by-moviebasis.  These sharing arrangements areintended to complement or expand our business to permit the production of agreater number of movies, while sharing the financial risks of the movie.  We may not realize the financial benefits weanticipated when we entered into these arrangements.  In addition, the negotiation of these arrangements, whethersuccessful or not, could require us to incur significant costs and causediversion of management’s time and resources. Accordingly, the costs of obtaining these sharing arrangements willincrease our invested cost in a movie without providing a correlating increasein the movies revenues; thus, adversely affecting the financial performance ofthe movie.

 

Following our productionof the movie, we intend to arrange for distribution through third-partiesprimarily into the domestic and international theatrical markets.  We do not have any plans to release ourmovies directly to the ancillary market (home video or pay and freetelevision).  However, we may distributeour movies into the ancillary markets if the opportunity were to develop.  Our primary distribution market will be thedomestic and international theatrical markets.

 

A substantial amount oftime may elapse between our expenditure of funds and the receipt of revenuefrom the motion picture.  Accordingly,we plan on producing one movie during 2004 and not undertake the production ofany additional movies unless we have sufficient funds with which to completeproduction.

 

Our produced movies willbe distributed domestically pursuant to licensing arrangements with unrelatedthird-parties that are independently engaged in the promotion and distributionof movies.  Any foreign distributionwill be pursuant to sale of the distribution rights to an unrelated third-partyinternational distributor for a single up-front payment.  As of the date of this report, we have notentered into any distribution arrangements.

 

We expect to distributeeach motion picture we produce outside North America by sale of the internationaldistribution rights to an international distributor for lump-sum single payment(in U.S. currency) without any retained participation in international sourcerevenues.  As a result, our ability tosell the international distribution rights will be subject to:

 

•                                          changesin local regulatory requirements, including restrictions on content,

 

•                                          changesin the laws and policies affecting trade, investment and taxes (including lawsand policies relating to the repatriation of funds and withholding taxes),

 

•                                          differingdegrees of protection for intellectual property,

 

•                                          instabilityof foreign economies and governments,

 

•                                          culturalbarriers,

 

•                                          warsand acts of terrorism, and

 

•                                          thespread of severe acute respiratory syndrome, or SARS.

 

Any of these factors couldhave a material adverse effect on our ability to sell the internationaldistribution rights of any motion picture.

 

The financial success ofeach motion picture we produce will depend principally on theatricalexhibition.  We do not expect to realizesignificant revenues from release and distribution of our produced movies intothe ancillary markets.  As reported bythe Motion Picture Association of America (MPAA), in 2002 the averagetheatrical costs of a MPAA company increased 14% that was attributable to theincrease in production costs, studio overhead and capitalized interest.  The increases in production costs, studiooverhead and capitalized interest were at a faster rate than theater admissions(an increase of 10.2%) and ticket prices (an increase of 2.7%) in 2002.  The production company

 

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receives a portion of thetheatrical admission revenues or box office receipts of a movie, generally 30%to 40%, after the distributor recovers its costs of distribution.  Consequently, as production costs increasebox office receipts must increase as much as three times the amount of increasein production costs to keep pace.  Theserising production costs without commensurate increases in movie admissions andadmission ticket prices adversely affect the financial performance of a movieand the ability to recover the invested costs in the movie as well as realizeany profit.  There is no assurance thatthis trend will reverse in the near term or continue for an extended period.

 

**ProductionBudget of Cloud 9**

 

In January 2004 wecommenced pre-production of the movie currently titled *Cloud 9*(formerly *Out of the Blue*).  The budgeted production and developmentcosts of this movie project are as follows:

 
|                                 |   | **$2,000,000  Budget** |      |
|--------------------------------------|--------|------------------------|-----------|
| Screenplay  rights                   |   | $                      | 40,970    |   |
| Producers  unit                      |   | 74,000                 |      |
| Direction                            |   | 87,100                 |      |
| Cast                                 |   | 379,695                |      |
| Travel  and living costs             |   | 825                    |      |
| Fringe  benefits and payroll taxes   |   | 43,275                 |      |
| Production  staff                    |   | 139,475                |      |
| Extra  talent                        |   | 47,750                 |      |
| Set  design                          |   | 27,325                 |      |
| Set  operations                      |   | 52,150                 |      |
| Set  dressing                        |   | 78,250                 |      |
| Property                             |   | 29,700                 |      |
| Wardrobe                             |   | 69,400                 |      |
| Makeup  and hair                     |   | 23,550                 |      |
| Lighting                             |   | 53,600                 |      |
| Camera                               |   | 115,650                |      |
| Production  sound                    |   | 27,750                 |      |
| Transportation                       |   | 116,170                |      |
| Location                             |   | 83,775                 |      |
| Tape  and transfers                  |   | 59,250                 |      |
| Production  period - fringe benefits |   | 84,705                 |      |
| Film  editing                        |   | 112,000                |      |
| Music                                |   | 40,000                 |      |
| Post-production  sound               |   | 35,000                 |      |
| Main  end and titles                 |   | 1,000                  |      |
| Publicity                            |   | 2,000                  |      |
| Post-production  - fringe benefits   |   | 5,560                  |      |
| Insurance                            |   | 20,000                 |      |
| General  expense                     |   | 10,000                 |      |
| Contingencies                        |   | 140,075                |      |
| Total  budget costs                  |   | $                      | 2,000,000 |   |

 

As of June 30, 2004,total production costs of *Cloud 9*were$2,212,128.  As of the filing of thisreport, we expect that total production costs of *Cloud 9*will be approximately $2,250,000.

 

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**ProductionAgreement**

 

Pursuant to the InvestorAgreement with A&A Productions, LLC and Frozen Televison, Inc., datedNovember 20, 2003, GrayMark Productions, Inc. shares the development andproduction costs and revenue of the picture known as *Cloud 9*(formerly *Out ofthe Blue*) (the “Picture”). The screenplay was developed and writtenby Brett Hudson, Burt Kearns and Albert S. Ruddy. The following is a summary ofthe material terms of the Investor Agreement:

 

***Exploitation Efforts.*** A&A Productions, LLC and FrozenTelevision, Inc. (the “Producer”) are to use their best efforts to arrange forthird parties to distribute and/or exploit the Picture on such commerciallyreasonable terms as the Producer might be able to obtain subject to the rightsof GrayMark Productions, Inc.

 

***Premium Recoupment and Profit Participation.*** For its financial contribution to the costsof making the Picture, GrayMark Productions, Inc. is entitled to receive thefollowing:

 

•                                          100%of revenue and proceeds received by Producer from the rights sales,distribution and/or any and all exploitation of the Picture until GrayMarkProductions, Inc. recovers its investment in the Picture (“PremiumRecoupment”), plus interest at the rate of Prime plus 2% per annum from thedate of the contribution until GrayMark Productions, Inc. is repaid the PremiumRecoupment in full, and

 

•                                          50%of “net profits” received by Producer from the rights sales, distributionand/or any and all exploitation of the Picture (“Profit Participation”). “Netprofits” is defined as the sum remaining after deduction of third-partydistribution fees and expenses; cash deferments (paid out on a equal prioritybasis with GrayMark Productions, Inc.) to cast, equipment suppliers, rightsholders or any other approved party.

 

In addition to the ProfitParticipation of GrayMark Productions, Inc., the Producer is permitted to grantsimilar net profit participations to third parties without obtaining theconsent of GrayMark Productions, Inc. However, the Producers are not permitted to grant participations thatmay in any way adversely affect or reduce the Premium Recoupment and ProfitParticipation of GrayMark Productions, Inc.

 

***Financial Contributions. ***Pursuant to amendment of the Investor Agreement(dated January 5, 2004), GrayMark Productions, Inc. agreed to makefinancial contributions to the production of the Picture of $2,000,000, all ofwhich has been made.  Because theproduction costs of the Picture exceed $2,000,000, Producer became obligated topay $25,000 of the production costs, and GrayMark Productions, Inc. isresponsible for the balance of the production costs of the Picture.

 

***Ownership and Decision Controls.*** Each of GrayMark Productions, Inc. and theProducer owns 50% of the copyright to the Picture and all underlying rights andmaterials.  Producer exercises creativecontrols, subject to the following approval rights (not to be unreasonablywithheld) of GrayMark Productions, Inc.:

 

•                                          anyproposed increase in the production budget;

 

•                                          anyre-allocation of budgetary line items in excess of $5,000;

 

•                                          allabove-the-line agreements (agreements with creative personnel, producer unit,story rights, etc.);

 

•                                          locationsof the production mutually with Producer;

 

•                                          shorteningof the Picture run-time to less than 85 minutes or lengthening of the Pictureto more than 100 minutes;

 

•                                          approveproduction legal counsel (Robert M. Angel, Esq. has been approved);

 

•                                          productionaccountant;

 

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•                                          alldistribution agreements;

 

•                                          unitproduction manager; and

 

•                                          ratingof the Picture (pre-approved that the Picture will be rated PG-13 or PG,subject to review by the MPAA).

 

Gray Frederickson is thedesignated representative of GrayMark Productions to exercise all approvalrights and to view daily photography, production notes, script changes, andotherwise review any other aspects of the production during principalphotography of the Picture.

 

**Credits.**  Subject to third-party distributor approval,credit presentation will be “A Ruddy Morgan Organization/Frozen FilmsProduction in Association with Graymark Productions” and the main titlesingle-card credits will be as follows:

 

•                                          “Producedby Gray Frederickson”

 

•                                          “Producedby Albert S. Ruddy and Andre Morgan”

 

•                                          “Producedby Brett Hudson and Burt Kearns”

 

•                                          “ExecutiveProducer John Simonelli”

 

•                                          “Writtenby Brett Hudson, Burt Kearns and Albert S. Ruddy”

 

***Sequel/Remake Options.*** In the event Producer proposes to produce aremake, sequel, prequel or television project based upon the Picture(“subsequent production”), GrayMark Productions, Inc. has the right (for a120-day period) to elect to provide financing for the subsequent product on thesame terms and conditions as the Picture. Initially failing timely to elect to provide this financing, prior toProducer’s acceptance of a third-party financing, GrayMark Productions willhave 10 days in which to match the material financial terms of any bona fidewritten third-party financing offer received by Producer.

 

***Security Interest.*** Producer granted GrayMark Productions, Inc. asecurity interest in the Picture to secure Producer’s obligations,representations, warranties and covenants under the Investor Agreement.  GrayMark Productions, Inc. has been appointedProducer’s attorney-in-fact to execute and deliver any required securitydocuments in the event Producer fails to do so if not executed and deliveredwithin 30 days following the request by GrayMark Productions, Inc.

 

***Indemnification.*** Each of GrayMark Productions, Inc. andProducer agreed to indemnify and hold harmless the other against claims,demands, causes of action, obligations, liability, loss, damage, cost andexpenses (including reasonable outside attorneys’ fees), incurred or sustained forany breach or alleged breach of the Investor Agreement.

 

***Accounting and Producer Reports***.  Producer agreed to maintain complete booksand records with respect to the distribution and exploitation of the Pictureand provide periodic accounting statements. Any accounting statement provided by Producer will be deemedconclusively true and correct and incontestable unless GrayMark Productions,Inc. delivers to Producer written objections within two years from the date theapplicable accounting statement was received from Producer.  GrayMark Productions, Inc. has the right toexamine the books and records of Producer (and make copies thereof) to theextent they pertain to the Picture. With respect to any accounting period forwhich an accounting statement has been rendered by Producer, this examinationshall be permitted only for a period of one year from the date the AccountingStatement was received by GrayMark Productions, Inc.

 

***Segregation of Funds.*** All funds received by Producer that arepayable to GrayMark Productions, Inc. are to be immediately deposited uponreceipt in a separate interest-bearing bank account naming GrayMarkProductions, Inc. as the beneficiary thereof.

 

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***No Agency Relationship.*** The relationship between GrayMarkProductions, Inc. and Producer is that of independent contractors and nopartnership, joint venture, agency or employment relationship is created by theInvestor Agreement.

 

***Assignment.*** The right or obligations under the Investor Agreement are notassignable without the prior written consent of the other party; however, aparty may assign its right to receive monies under the Investor Agreement.

 

 ***Arbitration.*** In the event a dispute arises under the Investor Agreement thatthe Producer and GrayMark Productions, Inc. are unable to resolve, the disputeis to be decided by arbitration pursuant to the regulations and procedures ofthe American Arbitration Association.

 

***Insurance.*** Producer is to obtain certificates of insurance, upon commencementof pre-production, naming GrayMark Productions, Inc. as an additional insured,indicating that all insurance normally obtained in connection with theproduction of a motion picture, including general liability and errors andomissions insurance, has been obtained with commercially reasonable liabilitylimits and deductibles, and that these policies cannot be cancelled or amendedwithout first giving 30 days’ prior written notice.

 

**A&AProductions, LLC**

 

A&A Productions, LLC(“A&A”) is a limited liability company owned by Albert S. Ruddy and AndréE. Morgan.  Mr. Ruddy is a writer andwith Burt Kearns developed and wrote the screenplay for *Cloud 9*. Each of Messrs. Ruddy and Morgan have produced feature length motionpictures and television programing, acted and worked on film crews.

 

Mr. Ruddy produced (andwrote the screenplay or script) *Flatland*(2002,television series), *Mean Machine*(2001,executive producer), Running Mates (2000, executive producer), Married to aStranger(1997, executive producer), *Heaven’sPrisoners*(1996), *The Scout*(1994),*Walker, Texas Ranger*, (1993,television series, produced and wrote the script), *The Godfather Trilogy: 1901-1980*(1992), *Miraclein the Wilderness*(1992, executive producer), *Ladybugs*(1992), *Impulse*(1990), *Speed Zone!*(1989, executive producer), *Cannonball Run II*(1984, produced andwrote the screenplay), *Lassiter*(1984),*Megaforce*(1982, produced andwrote the screenplay), *Death Hunt*(1981),*The Cannonball Run*(1981), *Matilda*(1978, produced and wrote thescreenplay), *The Macahans*(1976),*Coonskin*(1975), *The Longest Yard*(1974, produced and wrotethe screenplay), *The Godfather*(1972,won Academy Award for Best Picture-Production), *Making It*(1971), *LittleFauss and Big Halsy*(1970) and*Wild Seed*(1965).  He alsowrote *Bad Girls*(1994), *Revenue for a Rape*(1976, televisionproduction), and*Hogan’s Heroes*(1965,co-wrote one episode).

 

Mr. Morgan is theExecutive Producer of Golden Harvest Entertainment Co., Ltd., which is aChinese entertainment conglomerate engaged in a wide range of activities fromfilm production, stars management, film distribution, cinema exhibition andprint processing.  Golden HarvestEntertainment has produced more than 500 films, many of which have won awardsand critical acclaim at the world’s most prestigious international filmfestivals including Cannes, Berlin, Edinburgh, London, New York, Chicago, SanFrancisco and many others.  We do nothave any contractual arrangements with Golden Harvest Entertainment and do notanticipate developing any contractual arrangements.

 

Mr. Morgan has produced(and acted in) *Lei ting zhan jing*(2000),*Martial Law*(1998, televisionseries, executive producer), *Mr. Magoo*(1997, executive producer),  *Heaven’s Prisoners*(1996), *The Scout*(1994), *Bad Girls*(1994), *Miracle in the Wilderness*(1992), *Ladybugs*(1992), *Impulse*(1990), *Speed Zone!*(1989, executive producer), *Farewell to the King*(1989), *Cannonball Run II*(1984, executiveproducer), *Megaforce*(1982), *Death Hunt*(1981, unaccredited executiveproducer),  *The Cannonball Run*(1981, executive producer), *Si wang ta*(1981), *Night Games*(1980), *Game of Death*(1978, produced and actedin), *The Boys of Company C*(1978),*The Amsterdam Kill*(1977), *The Man from Hong Kong*(1975, produced andacted in ), *Himalayans*(1978), *Tie jin gang da po zi yang guan*(1974,unaccredited producer and acted in), *Enterthe Dragon*(1973, associate producer), *Meng long guojiang*(1972, associate producer) and *Jing wu men*(1972, unaccredited associateproducer).  Mr. Morgan also appeared in *Twisted*(1986), *Parting Glances*(1986), *Taiquan zhen jiu zhou*(1973) and *Menglong guojiang*(1972).

 

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***Frozen Television, Inc.***

 

Brett Hudson and BurtKearns control Frozen Television, Inc.  *Cloud 9*is the first feature length motionpicture produced by Messrs. Hudson and Kearns and Frozen Television, Inc.  Mr. Kearns has produced for television *My First Time*(2003, a series, executiveproducer), *Mark David Chapmen:  Death of a Beatle*(2001), *Hard Copy*(1989, a television series) and *A Current Affair*(1986, televisionseries).

 

Mr. Hudson has appearedin or on *Chantamania:  The Benzedrine Monks of Santo Damonica*(1994),*Hysterical*(1983), *Bonkers!*(1979, a hosted televisionseries), *The Millionaire*(1978), *Zero to Sixty*(1978) and *The Hudson Brothers Razzle Dazzle Show*(1974,a hosted television series).

 

**Formationof Production Company**

 

On December 22,2003, with A&A Productions, LLC and Frozen Television we formed Out of theBlue Productions, LLC, a California limited liability company (the “ProductionCompany”) and the entity under which Cloud 9 is being produced.  We are a 50% owner and each of A&AProductions, LLC and Frozen Television, Inc. is a 25% owner of the ProductionCompany (collectively the “members”).

 

***Summary of Operating Agreement***

 

 On April 23, 2004, the members amendedand restated the Operating Agreement of the Production Company, effectiveDecember 22, 2003. Under the terms of the Operating Agreement, as amendedand restated, to the extent that the Operating Agreement and the InvestorAgreement conflict or are inconsistent, the Operating Agreement is to control.

 

***Place of Business; Purpose. ***The initial address of the Production Company is9300 Wilshire Blvd., Ste 508, Beverly Hills, CA 90212, which may be changed bymajority vote of the members, from its business will be conducted or such otherplace or places as the members determine. The Production Company may engage inall business activities that are legal for a limited liability company toengage in under California law.

 

***Production Budget.*** The members have agreed to the productionbudget of *Cloud 9*attached to theInvestor Agreement and will also be the Production Company’s budget (the“Production Budget”),  unless the Membersmutually agree, in writing, to increase Production Budget.  Furthermore, there will not be any generaloverhead of A&A Productions, LLC or Frozen Television, Inc. included in theProduction Budget.

 

***Capital Contribution Obligations.*** Upon formation of the Production Company, wecontributed $50 and each of A&A Productions, LLC and Frozen Television,Inc. contributed $25.  Furthermore, wecontributed more than $2,200,000 to the Production Company to fund theproduction costs of *Cloud 9*.  The capital contributions under theOperating Agreement are the same as our cash flow funding obligations under theInvestor Agreement.  Any capitalcontributions we make to the Production Company are also deemed made under the InvestorAgreement.

 

***Banking.*** Funds and money received by the Production Company are to bedeposited in the bank account or accounts as the members determine. Checks,wire transfers or any other withdrawals from these bank accounts require oursignature and the signature of A&A Productions, LLC or Frozen Television,Inc.  No disbursements of these accountsof any nature are to be made without the signature of our representative, GrayFrederickson.

 

***Budget Overrun.*** The actual costs of producing *Cloud 9*(including script rightsacquisition, legal fees, setup of production offices, casting; locationscouting) exceed the $2,000,000 budget**(“BudgetOverrun”).  We anticipate that the totalBudget Overrun will be approximately $250,000. We will bear all of the Budget Overrun, other than $25,000 which will beborn by A&A Productions, LLC and Frozen Television, Inc. throughcontributions to the Production Company.

 

***Cash Distributions and Income and Loss Allocations.*** Distributions of the cash to the members willbe made quarterly or more frequently as determined by majority vote of themembers as follows:

 

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•                                          100%to us until we receive cumulative aggregate cash distributions of equal to ouraggregate capital contributions to the Production Company, plus interest on thecapital contributions at the rate of the prime rate plus 2% per annum from thedate of the capital contribution to the Production Company (“InvestmentRecoupment”); and thereafter,

 

•                                          50%to us and  25% to each of A&AProductions, LLC and Frozen Television, Inc.

 

However, a portion ofcash available for distribution may be retained by the Production Company uponmajority vote of the members to be used for the reasonable needs of theProduction Company.

 

All net income of theProduction Company will be allocated among the members in the same proportionthat distributions of cash available for distribution for the applicable fiscalyear were distributed or would have been distributed in the event nodistributions of cash available for distribution were made during theapplicable year.

 

All net loss will beallocated among the members in proportion to their respective capitalcontributions to the Production Company.

 

***Accounting Matters.*** The Production Company has elected to use theaccrual method of accounting. The accounting is to be maintained to disclosethe items (of income, gain, loss, deduction or credit) that the members arerequired to take into account separately for income tax purposes.  As to matters of accounting not provided forin the Operating Agreement, if any, generally accepted accounting principlesare to govern. The fiscal year of the Production Company ends onDecember 31 of each year. Each member is to be provided a report andstatement within two and one-half months after the end of each fiscal year.

 

***Management Decisions.*** Management decisions related to theProduction Company are to be made by the affirmative vote, or written consentby proxy or otherwise, of the members entitled to receive 51% or more ofdistributions of cash available for distribution prior to Investment Recoupmentat the applicable time of the decision. Accordingly, we have 100% voting control of the Production Company.  No member is obligated to devote full-timeto the business of the Production Company.

 

***Member Indemnification.*** The Production Company has agreed toindemnify the costs and expenses of any person who was or is a party or isthreatened to be made a party to any threatened, pending or completed action orsuit by reason that the person is or was a member of the Production Company, ifthe person acted in good faith and in a manner the person reasonably believedto be in or not opposed to the best interests of the Production Company.

 

***Transferability of Member Interest.*** A member is not permitted to sell itsinterest in the Production Company without the unanimous consent of themembers.  Each member has the firstright of refusal to purchase a selling member’s interest in the ProductionCompany within 30 days following receipt of notice of the proposed sale.

 

***Termination.*** The Production Company will terminate onDecember 31, 2025, unless sooner terminated by

 

•                                          agreementof all members, or

 

•                                          inaccordance with law (the laws of California, including the statutoryprovisions, all applicable provisions of the California Constitution, andreported judicial decisions interpreting those laws).

 

***Dissolution of a Member.*** In the event of dissolution of a member, theProduction Company has the right and option to purchase the dissolved member’sinterest in the Production Company within three months following thedissolution.  The purchase price for theinterest is the average of the value established by two independent appraisersand is payable over a 36-month period.

 

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**LiteraryPurchase Agreement**

 

As of December 22,2003, the Production Company entered into the Literary Purchase Agreement withBrett Hudson, Burt Kearns and Albert S. Ruddy. This agreement provides for the purchase by the Production Company ofthe motion picture, television, radio, stage, home video, sequel and remakerights, interactive/multimedia, publishing, novelization, music publishing,soundtrack album, internet, merchandising, and promotional and advertisingrights in the screenplay then titled *Out ofthe Blue*for $34,470.  Theserights did not include any written publishing rights including “books on tape,”but these rights include publishing rights limited to 10,000 words foradvertising and publicity of the movie. Messrs. Hudson, Kearns and Ruddy agreed to indemnify and hold harmlessthe Production Company for all claims sustained or incurred by the ProductionCompany based upon breach of any warranty, undertaking, representation oragreement by Messrs. Hudson, Kearns and Ruddy. The Production Company agreed to indemnify and hold harmless Messrs.Hudson, Kearns and Ruddy with respect to material added to the screenplay orresulting from the development, production, distribution, exhibition,broadcast, advertising, publicity, promotion or exploitation of the movie.

 

The Production Companyhas the right to assign its rights under the Literary Purchase Agreement to anyperson, but the assignment will not relieve the Production Company of itsobligations unless the assignee is a major studio, mini-major studio or networkor other financially responsible party that assumes the obligations of theProduction Company.

 

**Productionand Distribution of *Cloud 9***

 

The storyline of *Cloud 9*is about Billy, a down-and-outpromoter living in Malibu, California. A consummate hustler, Billy convinces a group of beautiful dancers fromthe local strip club to form a team to play beach volleyball.  The money starts pouring in as the girlsplay exhibition matches for the jeering crowds, but they become an embarrassmentto the professional beach volleyball association.  Although Billy is enjoying his new success, the girls convincehim that they can be a real team and play competitive beach volleyball.  Billy and the girls learn that winningrespect is more important than money. We expect to obtain a PG-13 rating of *Cloud9*.

 

The production phase of *Cloud 9*has been substantially completedand is currently in the post-production phase. We are editing the movie, and music and dialogue will be finalized and synchronizedwith the movie’s photography shortly. It is expected that this phase will be completed by the end ofOctober 2004.

 

We anticipate that *Cloud 9* will be theatrically releasedprior to end of 2004.  *Cloud 9* will be distributed domesticallypursuant to licensing arrangements with unrelated third-parties and any foreigndistribution will be pursuant to sale of the distribution rights to anunrelated third-party international distributor without retaining any right toreceive revenue from the international distribution of *Cloud 9*. We have not entered into any commitments or arrangements fordistribution, domestically or internationally. It is expected that as the production phase progresses, distributioncompanies will become more interested in obtaining distribution rights.

 

**Director’sLoanout Agreement**

 

Pursuant to our FreelanceDirector’s Loanout Contract – Theatrical Motion Picture Photoplay, dated as ofJanuary 19, 2004 (the “Loanout Agreement”), with Genco Olive Oil, Inc., weobtained the services of Harry Basil to direct *Cloud9*.  Under the LoanoutAgreement, Genco Olive Oil, Inc. provided the direction services of Mr. Basilon a non-union engagement basis, through completion of all services required bythe Production Company (completion of *Cloud9*) in compliance with instructions, directions, requests, rules andregulations made or issued by the Production Company.  The Production Company retained control of matters involvingartistic taste and judgment.  Withoutthe consent of the Production Company, Mr. Basil was not permitted to engagethe services or facilities of any third party in connection with the productionof *Cloud 9*or deviate or permitdeviation from the final screenplay or otherwise utilize any element notapproved by the Production Company.

 

For the directionservices, the Production Company paid Genco Olive Oil, Inc. $75,000.  In addition, Genco Olive Oil, Inc. will beentitled to receive 5% of the Production Company’s gross receipts fromexploitation of *Cloud 9*

 

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after the ProductionCompany has recouped its costs (including costs of production and distribution)in connection with *Cloud 9*.  Other than as described above, Genco OliveOil, Inc. is not entitled any additional compensation.

 

**Filmographyof Harry Basil.**  HarryBasil is a writer, actor, director and producer of feature length motionpictures.  He wrote or co-wrote *Back by Midnight*(2002), *The 4th Tenor*(2002), *My Five Wives*(2000) (also known as *Mes ciq chéris*(Canada: French title)), *Meet Wally Sparks*(1997), and *Guide to Golf Style and Etiquette*(1995).  As an actor, Mr. Basil had roles in *Meet Wally Sparks*(1997), *Ladybugs*(1992), *Martians Go Home*(1990), *The Seventh Sign*(1988) and *Peggy Sue Got Married*(1986).  Mr. Basil has previously directed threemovies, *Hairy Tale*(2004), *Back by Midnight*(2002) and *The 4th Tenor*(2002), and produced twomovies, *Meet Wally Sparks*(1997,co-producer) and *Ladybugs*(1992,associate producer).

 

**Castingand Actor Agreements**

 

**Pixie,Inc./Fenton-Cowitt Casting.** On January 20, 2004, Gray Frederickson on our behalf and MikeFenton as agent for Pixie, Inc., f/s/o Fention-Cowitt Casting entered into theFenton-Cowitt Casting Agreement for the providing of casting services for fourweeks .  For these services, we paidFenton-Cowitt Casting $31,600 and agreed to pay $3,000 per week if castingservices were to be required after March 5, 2004.  Furthermore, Fenton-Cowitt Casting isentitled to receive 1% of the net profits of *Cloud9*.

 

**BurtReynolds.**  OnFebruary 20, 2004, the Production Company entered into a letter agreementwith Clematis Productions, Inc. and a SAG Motion Picture Contract – WeeklyPerformer with Burt Reynolds for the providing of the employment of Mr.Reynolds to perform the role of Billy Cole in *Cloud9*.  For his services, we paidMr. Reynolds guaranteed compensation of $100,000 and agreed to pay $5,000 perday in the event his services are used in work days in excess of fourproduction weeks.  The $100,000guaranteed compensation is a recoupable, non-reimbursable advance against 10%of the Production Company’s gross receipts after the Production Company fullyrecoups all actual, direct, out-of-pocket “negative” costs of production of *Cloud 9*, plus interest of 2% in excess ofthe prime rate (limited to 5%) per annum. In addition, the Production Company provided one first class round tripairfare from Florida to Los Angeles, local transportation, a $2,000 weeklyexpense allowance, two hairpieces during the four-week production period,hairdresser and make-up person at $275 per 14-hour day.

 

**D.L.Hughley.**  As revisedon April 15, 2004, the Production Company entered into a letter agreementwith Five Timz Productions and a SAG Motion Picture Contract – Weekly Performerwith D.L. Hughley for the providing of the employment of Mr. Hughley to performthe role of Tenspot in *Cloud 9*.  For his services, we paid Mr. Hughleyguaranteed compensation of $100,000 and agreed to pay $5,000 per day in theevent his services are used in work days in excess of four productionweeks.  The Production Company alsoagreed to pay Mr. Hughley an amount equal to 2.5% of the net profits of *Cloud 9*.

 

**AngieEverhart.**  OnApril 16, 2004, the Production Company entered the SAG Motion PictureContract – Weekly Performer with Angie Everhart pursuant to which Ms. Everhartwas employed to perform the role of Julie in *Cloud9*.  For her services, we paidMs. Everhart $30,000.  The ProductionCompany also agreed to pay Ms. Everhart the following contingent amounts:

 

•                                          abonus of $25,000 when aggregate United States and Canada box office receipts asreported in *Daily Variety* are$10,000,000 or more;

 

•                                          abonus of $25,000 when aggregate United States and Canada box office receipts asreported in Daily Variety are $15,000,000 or more;

 

•                                          abonus of $25,000 when aggregate United States and Canada box office receipts asreported in Daily Variety are $20,000,000 or more; and

 

•                                          anamount equal to 2.5% of the net profits of *Cloud9*.

 

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**GabrielleReece.**  OnApril 14, 2004, the Production Company entered into the SAG Motion PictureContract – Weekly Performer with Gabrielle Reece pursuant to which Ms. Reecewas employed to perform the role of Christina in *Cloud 9*.  For herservices, we paid Ms. Reece $3,564 (110% of the applicable minimum low budgetscale for two non-consecutive work or production weeks pursuant to the 2001Screen Actors Guild Agreement), including the fee payable to her agent.  The Production Company also agreed to payMs. Reece the following contingent amounts:

 

•                                          abonus of $50,000 when aggregate United States and Canada box office receipts asreported in *Daily Variety* are$5,000,000 or more;

 

•                                          abonus of $75,000 when aggregate United States and Canada box office receipts asreported in Daily Variety are $7,500,000 or more;

 

•                                          abonus of $100,000 when aggregate United States and Canada box office receiptsas reported in Daily Variety are $10,000,000 or more; and

 

•                                          anamount equal to 2.5% of the net profits of *Cloud9*.

 

**Co-FinanceAgreements**

 

In May 2004, we enteredinto a Co-Finance Agreement with each of Roy T. Oliver, one of our majorshareholders, John Simonelli, our President and Chief Operating Officer, 36thStreet Properties LLC (of which Mark R. Kidd, our Chief Financial Officer is a 50% owner) and Larry E.Howell.  Pursuant to these Co-FinanceAgreements each of Messrs. Oliver, Simonelli, and Howell and 36th StreetProperties LLC made contributions to share in the production costs of *Cloud 9* of $250,000, $100,000, $50,000 and$100,000, respectively, for the aggregate sum of $500,000.  Their contributions to the production costsof *Cloud 9* are recoverable fromall proceeds we receive from the rights sales and distribution of *Cloud 9*, commencing from the first dollarwe receive until Messrs. Oliver, Simonelli and Howell and 36th StreetProperties LLC are repaid their respective contributions in full.  In addition, each of Messrs. Oliver,Simonelli and Howell and 36th Street Properties are entitled to receive in theaggregate 20% (10%, 4%,2% and 4%, respectively) of the “net profits” we receivefrom the rights sales and distribution of *Cloud9*.  “Net profits” is definedas the sum remaining of the proceeds from the rights sales and distribution of *Cloud 9*after deduction of third-partydistribution fees and expenses, our recoupment of all costs plus interest,production costs, distribution costs, cash deferments to cast, crew orproducers, equipment suppliers, rights holders or any other party.

 

**GrayMarkProductions’ Recovery of Production Costs and Participation in *Cloud 9* Net Profits**

 

As a result of theagreements with the director, casting company, actors and the Co-FinanceAgreements, our residual net profits interest in *Cloud 9* will be 30.6%. Messrs. Oliver, Simonelli and Howell and 36th Street Properties LLC areentitled to receive the first $500,000 of proceeds we receive from the rightssales and distribution of *Cloud 9*.After giving effect to the recovery of the $500,000 contributions to theproduction costs of *Cloud 9* underthe Co-Financing Agreements and then the recovery of our production costs andother invested costs and interest, our net profits interest in *Cloud 9* will be 30.6%.  The net profits interests of Genco OliveOil, Inc., Fenton-Cowitt Casting, D.L. Hughley, Angie Everhart, and GabrielleReece do not provide for an interest rate on the production and other costs of *Cloud 9*, while our entitlement todistributions from the Production Company and the net profits interest grantedto Bert Reynolds provide for interest at a rate of 2% above the prime rate(limited to 5%) for purposes of determining recovery of the production andother costs of *Cloud 9*.  The Co-Finance Agreements with Messrs.Oliver, Simonelli and Howell and 36th Street Properties LLC provide forinterest, but do not specify the applicable interest rate.

 

**AccountingMethods**

 

The application of thefollowing accounting policies, which are important in presenting our financialposition and results of operations, requires significant judgments andestimates on the part of management. For a summary of all of our accountingpolicies, including the accounting policies discussed below, see note 2 to theunaudited consolidated financial statements appearing elsewhere in this report.

 

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In June 2000, theAccounting Standards Executive Committee of the American Institute of CertifiedPublic Accountants issued Statement of Position 00-2, Accounting by Producersor Distributors of Films (“SoP 00-2”). SoP 00-2 establishes accounting standards for producers or distributorsof films, including changes in revenue recognition, capitalization andamortization of costs of acquiring films and television programs and accountingfor exploitation costs, including advertising and marketing expenses. Theseaccounting standards are as follows:

 

•                                          Advertisingand marketing costs are expensed the first time the advertising takes place.

 

•                                          Thecapitalization of production costs for episodic television series is limited torevenue that has been contracted for on an episode-by-episode basis until thetime that the criteria for recognizing secondary market revenues are met.

 

We capitalize the costsof production, including financing costs, to investment in motion pictures.  These costs will be amortized to directoperating expenses in accordance with SoP 00-2. These costs are stated at thelower of unamortized motion picture costs or fair value (net present value).  These costs for an individual motion picturewill be amortized in the proportion that current period actual revenues bear tomanagement’s estimates of the total revenue expected to be received from themotion picture over a period not to exceed 10 years from the date of delivery.  We will be required to regularly review andrevise when necessary the total revenue estimates of each motion pictureproduced.  As a result, if revenueestimates change with respect to a motion picture, it may be necessary to writedown all or a portion of the unamortized costs of the motion picture.  There is no assurance that revised revenueestimates will not occur that result in significant write-downs affecting ourresults of operations and financial condition.

 

Revenue from the sale orlicensing of motion pictures will be recognized upon meeting all recognitionrequirements of SoP 00-2.  Revenue fromthe theatrical release of motion pictures will be recognized at the time ofexhibition based on our participation in box office receipts.  If applicable, revenue from the sale of DVDsin the retail market, net of an allowance for estimated returns, will berecognized on the later of shipment to the customer or “street date” (when itis available for sale by the customer). Furthermore, if applicable, under revenue sharing arrangements, rentalrevenue would be recognized when we would become entitled to receipts.  For contracts that provide for rights toexploit a motion picture on multiple media (e.g. theatrical, video, television)with a fee for a single motion picture where the contract specifies thepermissible timing of release to various media, the fee will be allocated tothe various media based on an assessment of the relative fair value of therights to exploit each media and will be recognized as the movie is released toeach media.  For multiple-titlecontracts with a fee, the fee will be allocated on a title-by-title basis,based on an assessment of the relative fair value of each title.  If applicable, revenues from televisionlicensing are recognized when the motion picture becomes available to thelicensee for telecast.  Cash paymentsreceived are to be recorded as deferred revenue until all the conditions ofrevenue recognition have been met.  Ifapplicable, we will accrue for video returns and provide for allowances in thefinancial statements based on previous returns and our allowances history on atitle-by-title basis in each of the video businesses. In this case, there maybe differences between actual returns and allowances and our historicalexperience that we currently do not have.

 

We will depend on thedistributors of any motion picture we produce to account for and accuratelyreport our share of exhibition revenue. While we expect to have certain audit rights to verify exhibitionrevenues received by our North American distributors,

 

•                                          distributorsare often in a position to account for revenues in a manner that understates orfails accurately to account for revenues or

 

•                                          distributorsmay fail to maintain appropriate accounting records

 

making it difficult to determinea producer’s actual share of revenues upon audit.

 

Although we do not haveany experience related to auditing distributors’ revenue accounting, weanticipate that the costs associated with this type of audit may be substantialand may vary significantly from distributor-to-distributor and evenpicture-to-picture.  Therefore, there isno assurance that, in all cases, we will be able to obtain an accurate

 

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accounting of ourexhibition revenues or that audits will result in increases in the revenuesthat justify the associated audit costs.

 

**Resultsof Operations**

 

The following table setsforth selected results of our operations for the three months and six monthsperiods ended June 30, 2004 and 2003. The following information was derived and taken from our unauditedfinancial statements appearing elsewhere in this report.

 
|                                                               |   | **For the  Three Months Ended  June 30,** |    | **For the  Six Months Ended  June 30,** |   |
|--------------------------------------------------------------------|--------|------------------------------------------------|---------|----------------------------------------------|--------|
|                                                               |   | **2004**                                       |    | **2003**                                     |   | **2004** |   | **2003** |   |
| Revenue                                                            |   | $                                              | —  |                                         | $      | — |   | $ | — |   | $ | — |   |
| Operating expenses:                                                |   |                                           |    |                                         |   |   |   |   |   |
| Consulting  and management fees                                    |   | 5,000                                          |    | 39,499                                       |   | 10,000 |   | 83,698 |   |
| Salaries  and employee benefits                                    |   | 57,620                                         |    | —                                       |   | 117,990 |   | — |   |
| Legal  and professional fees                                       |   | 59,163                                         |    | 839                                          |   | 74,818 |   | 839 |   |
| Film  marketing                                                    |   | 4,200                                          |    | —                                       |   | 4,200 |   | — |   |
| Travel  and entertainment                                          |   | —                                         |    | 10,439                                       |   | 300 |   | 11,682 |   |
| Obligation  related to non-timely filing of registration statement |   | (44,325                                        | )       | —                                       |   | — |   | — |   |
| Other                                                              |   | 14,310                                         |    | 1,854                                        |   | 22,092 |   | 3,007 |   |
| Total  operating expenses                                          |   | 95,968                                         |    | 52,631                                       |   | 229,400 |   | 99,226 |   |
| Operating  income (loss)                                           |   | (95,968                                        | )       | (52,631                                      | )      | (229,400 | ) | (99,226 | ) |
| Other  income (expense):                                           |   |                                           |    |                                         |   |   |   |   |   |
| Interest  and other income                                         |   | 3,391                                          |    | 447                                          |   | 11,374 |   | 1,028 |   |
| Income  (loss) before income taxes                                 |   | (92,577                                        | )       | (52,184                                      | )      | (218,026 | ) | (98,198 | ) |
| Provision  for income taxes                                        |   | —                                         |    | —                                       |   | — |   | — |   |
|                                                               |   |                                           |    |                                         |   |   |   |   |   |
| Net  loss                                                          |   | $                                              | (92,577 | )                                            | $      | (52,184 | ) | $ | (218,026 | ) | $ | (98,198 | ) |

 

**Comparisonof the Three-Month Periods Ended June 30, 2004 and 2003**

 

During the three monthsended June 30, 2003, our operations involved the development a businessplan and a plan to raise capital for the production of low-budget motionpicture projects.  Expenditures duringthe three months ended June 30, 2003 included consulting and managementfees of $39,499 paid to two shareholders who were involved in the developmentof the business and capital plan. Travel and entertainment expenses of $10,439 were incurred during thethree months ended June 30, 2003 and were incurred in association with thedevelopment of our business and capital resources plan.

 

During the three monthsended June 30, 2004, our operations had advanced to the development andproduction of motion picture projects and were in the production phase on ourfirst motion picture project titled *Cloud 9*.  During the three months ended June 30,2004, we incurred salary and benefits expense of $57,620 for the management andadministrative team put in place during 2004. Legal and professional fees of $59,163 were incurred during the three monthsended June 30, 2004 and were attributable to the registration of theshares of common stock issued under the Company’s private placement.  We incurred film marketing costs of $4,200in conjunction with *Cloud 9*.  The Company agreed, at its expense, toregister under the Securities Act of 1933, as amended, the common stock sharesand redeemable warrants issued in our private placement offering and to obtaineffectiveness of the registration on or before July 14, 2004.  As of March 31, 2004, due to theuncertainty of when the Company’s registration would become effective theCompany accrued an obligation to security holders of $44,325.  On July 13, 2004, the Company’sregistration statement was granted effectiveness by the Securities and ExchangeCommission.  Because registrationeffectiveness was timely obtained, the obligation to security holders of$44,325 was reversed as of June 30, 2004. Consulting fees of $5,000 were

 

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paid during the threemonths ended June 30, 2004 to a writer for work on a script that may beused for a future film project.  Otherexpenses of $14,310 were incurred during the three months ended June 30,2004 and were primarily comprised of expenses associated with the day to day operationsof the Company’s corporate office.

 

**Comparisonof the Six-Month Periods Ended June 30, 2004 and 2003**

 

During the six monthsended June 30, 2003, our operations involved the development a businessplan and a plan to raise capital for the production of low-budget motionpicture projects.  During the six monthsended June 30, 2003 we paid consulting and management fees of $83,698 totwo shareholders who were involved in the development of our business andcapital resources plan.  We incurredtravel and entertainment expenses of $11,682 during the six months endedJune 30, 2003 in association with the development of our business andcapital resources plan.

 

During the six monthsended June 30, 2004, our operations had advanced to the development andproduction of motion picture projects and we were in the production phase onour first motion picture project titled *Cloud9*.  During the six monthsended June 30, 2004, we incurred salary and benefits expense totaling$117,990 for the management and administrative team we put in place during2004.  Legal and professional fees of$74,818 were incurred during the six months ended June 30, 2004 and wereattributable to the registration of the shares of common stock issued under ourprivate placement.  We incurred filmmarketing costs of $4,200 in conjunction with *Cloud9*.  Consulting fees of$10,000 were paid during the six months ended June 30, 2004 to a writerfor work on a script that may be used for a future film project.  Other expenses of $22,092 were incurredduring the six months ended June 30, 2004 that were primarily comprised ofexpenses associated with the day to day operations of our corporate office.

 

**Liquidityand Capital Resources**

 

In April 2004, wecompleted our private placement offering of our common stock shares andredeemable warrants in units of one common stock share and one redeemablewarrant. During 2003 and 2004, we received net proceeds of $2,535,224 from thisprivate placement offering.  Based uponour cash and cash equivalents at June 30, 2004 (that totaled $1,119,837)and the anticipated revenue from our motion picture project,*Cloud 9*, we anticipate that our cashrequirements will be met for at least the next 15 months.

 

At June 30, 2004, wehad working capital of $1,003,619. Operating activities for the six months ended June 30, 2004, usednet cash of $2,355,072.  We used cash asthe result of a net loss of $218,026, which was reduced by depreciation andamortization of $2,433 and an increase in accrued liabilities of $48,179 andincreased by the costs we incurred in the production of our first motionpicture project, *Cloud 9*,totaling $2,187,658.  During the firstsix months of 2003, our operating activities generated net cash of $843 as theresult of a net loss of $98,198 that was offset by an increase in accruedliabilities of $99,041.  During thefirst six months of 2004, (i) we sold 25,000 shares of our common stock in aprivate placement for gross proceeds of $25,000 (net proceeds of $21,750) and(ii) we received $500,000 in funding under a co-financing agreement associatedwith our motion picture project, *Cloud 9*.

 

***Financial Commitments***

 

***FilmCapital, Inc. Agreement.**** *InMarch 2002, Messrs. Frederickson and Stansberry, members of GrayMarkProductions, L.L.C., entered into an agreement to pay FilmCapital, Inc. $50,000for services performed.  This liabilityis only payable in the event GrayMark Productions, L.L.C. or its affiliatesobtain funding for film projects from outside investors.  Messrs. Frederickson and Stansberry haveeach represented that their intent was not to cause GrayMark Productions,L.L.C. to be liability for this obligation and each has agreed to indemnify usfor any liable that may arise out of this agreement.  In December 2003, we recorded a consulting expense andliability of $50,000 related to the agreement with FilmCapital.  At the time that we pay this recordedliability, Messrs. Frederickson and Stansberry will be required immediately toreimburse us for the payment.

 

***Registration Obligations.***** We agreed, at our expense, to register the common stock shares andredeemable warrants offered for sale pursuant to our private placement of2,995,000 common stock shares and redeemable warrants exercisable for thepurchase of 2,995,000 common stock shares under the 1933 Act and to maintaineffectiveness of the

 

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registration for aseven-year period ending on April 14, 2010.  Registration of the common stock shares and redeemable warrantsbecame effective July 13, 2004.

 

Furthermore, we alsosimilarly agreed to register (and maintain effective of the registration underthe 1933 Act for the seven-year period) the common stock shares underlying theplacement agent warrants sold to the underwriter of our private placementoffering, Viewtrade Financial, and 383,425 common stock shares issued pursuantto the one-year Financial Advisor Agreement to Viewtrade Financial.  In accordance with this obligation, weinitially included these common stock shares in the registration statement thatregistered the private placement common stock shares and redeemable warrants;however, on February 27, 2004, Viewtrade Financial, on its own behalf aswell as the other holders of the placement agent warrants and the recipientsand holders of the common stock shares assigned to affiliates of ViewtradeFinancial, elected to remove those shares from the registration statement.  These common stock shares are currentlysubject to a one-year agreement that does not permit sale or transfer exceptunder very limited circumstances.  Priorto expiration of this one-year period ending on April 14, 2005, we intendto file a registration statement in accordance with our registrationobligation.

 

***Office Space Arrangement*.** Our corporate headquarters and offices arelocated at 101 North Robinson, Suite 920, Oklahoma City, Oklahoma.  These office facilities consistapproximately of 1,500 square feet and are occupied under a 12-month unwrittenlease, requiring monthly rental payments of $500.  The costs of building-out and improving our offices was approximately$15,000 which we paid rather than Corporate Tower, LLC, our landlord.  These improvements included removal andconstruction of new walls, ceilings and doorways, and painting of the wallsthroughout and installation of carpeting in the offices and reception area andvinyl flooring in a utility room, and installation of computer cabling forcommunications, including internet access services and telephone services.  Roy T. Oliver, one of our greater than 5%shareholders and affiliates, controls Corporate Tower, LLC.  Mr. Oliver on behalf of Corporate Tower, LLChas orally indicated that there is no intent to terminate our occupancy of theoffice facilities following the end of the 12-month period and that the term ofthe lease will simply be on a month-to-month basis, requiring 30-day priorwritten notice of termination under Oklahoma law.  Upon termination of this occupancy arrangement, we believe thereis adequate office space and facilities available in the Oklahoma Cityarea.  In the event we are required tomove from our current office facilities, the terms of occupancy, including theincreased rental payments, will be substantially different than those underwhich our office space is currently occupied and the annual rental rate willprobably be from $8 to $12 per square foot ($12,000 to $18,000 per year basedupon 1,500 square feet of office facilities).

 

***12-Month Overhead Budget***

 

Our budgeted overheadexpenses for the next 12 months are as follows:

 
| **Expenditure**                    |   | **Monthly** |   | **12  Months** |   |
|------------------------------------|--------|-------------|--------|----------------|--------|
| Administrative  expenditures:      |   |        |   |           |   |
| Executive  officer compensation    |   | $           | 15,333 |           | $      | 184,000 |   |
| Administrative  salaries           |   | 1,517       |   | 18,200         |   |
| Payroll  taxes                     |   | 2,527       |   | 30,330         |   |
| Film  marketing                    |   | 2,000       |   | 24,000         |   |
| Telephone                          |   | 700         |   | 8,400          |   |
| Rent                               |   | 500         |   | 6,000          |   |
| Legal                              |   | 2,917       |   | 35,000         |   |
| Accounting                         |   | 2,917       |   | 35,000         |   |
| Public  relations                  |   | 417         |   | 5,000          |   |
| Travel                             |   | 4,167       |   | 50,000         |   |
| Health  insurance                  |   | 1,020       |   | 12,240         |   |
| Automobile                         |   | 500         |   | 6,000          |   |
| Miscellaneous                      |   | 485         |   | 5,820          |   |
| Total  Administrative Expenditures |   | $           | 35,000 |           | $      | 419,990 |   |

 

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***Additional Financial Commitments***

 

Other than ourcommitments discussed above, we do not have any capital commitments.  We neither have any plans nor anticipate theneed to raise additional funds during the next 12 months; however, we mayreceive additional funds from the exercise of outstanding warrants and stockoptions, the exercise of which is generally not within our control.

 

If our productionactivities are successful (of which there is no assurance) or movie productionbudgets increase, we may be required to increase overhead by hiring additionalemployees and increase our office facilities. We anticipate that during the next 12 months we will not be required toincrease our number of employees or increase our office facilities.

 

We believe that ouroperations as a result of our motion picture project, *Cloud 9*, will achieve profitability.  We provide no assurance that

 

•                                          we will be successful in implementing ourbusiness plan or

 

•                                          unanticipated expenses or problems ortechnical difficulties will not occur which would result in significant delays.

 

Any one of these willadversely affect our ability to become profitable or to maintain profitability.

 

**CautionaryStatement Relating to Forward Looking Information**

 

We have includedsome forward-looking statements in this section and other places in thisreport regarding our expectations. These forward-looking statements involve known and unknown risks,uncertainties and other factors which may cause our actual results, levels ofactivity, performance or achievements, or industry results, to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by these forward-looking statements.  Some of these forward-looking statements canbe identified by the use of forward-looking terminology including “believes,”“expects,” “may,” “will,” “should” or “anticipates” or the negative thereof orother variations thereon or comparable terminology, or by discussions of strategiesthat involve risks and uncertainties. You should read statements that contain these words carefully becausethey:

 

•                                          discuss our future expectations;

 

•                                          contain projections of our future operatingresults or of our future financial condition; or

 

•                                          state other “forward-looking” information.

 

We believe it isimportant to discuss our expectations; however, it must be recognized thatevents may occur in the future over which we have no control and which we arenot accurately able to predict.  Readersare cautioned to consider the specific business risk factors described in theprospectus that is a part of our Amendment No. 4 to Registration Statement onForm SB-2 filed with the United States Securities and Exchange Commission onJune 29, 2004, and not to place undue reliance on the forward-lookingstatements contained herein, which speak only as of the date hereof.  We undertake no obligation to publiclyrevise forward-looking statements to reflect events or circumstances that mayarise after the date of this report.

 

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**Item3.****           Controls and Procedures**

 

Our ChiefExecutive Officer and Chief Financial Officer are responsible primarily forestablishing and maintaining disclosure controls and procedures designed toensure that information required to be disclosed in our reports filed orsubmitted under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the U.S. Securities and ExchangeCommission.  These controls andprocedures are designed to ensure that information required to be disclosed inour reports filed or submitted under the Exchange Act is accumulated andcommunicated to our management, including our principal executive and principalfinancial officers, or persons performing similar functions, as appropriate toallow timely decisions regarding required disclosure.

 

Furthermore, ourChief Executive Officer and Chief Financial Officer are responsible for thedesign and supervision of our internal controls over financial reporting thatare then effected by and through our board of directors, management and otherpersonnel, to provide reasonable assurance regarding the reliability of ourfinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles.  These policies and procedures (i) pertain tothe maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of our assets; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that our receipts and expenditures are being madeonly in accordance with authorizations of our management and directors; and(iii) provide reasonable assurance regarding prevention or timely detection ofunauthorized acquisition, use or disposition of our assets that could have amaterial effect on our financial statements.

 

Our ExecutiveOfficer and Chief Financial Officer, based upon their evaluation of theeffectiveness of our disclosure controls and procedures and the internalcontrols over financial reporting as of the last day of the period covered bythis report, concluded that our disclosure controls and procedures and internalcontrols over financial reporting were fully effective as of the last day ofthe period covered by this report and reported to our auditors and board ofdirectors that no change occurred in our disclosure controls and procedures andinternal control over financial reporting occurred during the period covered bythis report that would materially affect or is reasonably likely to materiallyaffect our disclosure controls and procedures or internal control overfinancial reporting.  In conductingtheir evaluation of our disclosure controls and procedures and internalcontrols over financial reporting, these executive officers did not discoverany fraud that involved management or other employees who have a significantrole in our disclosure controls and procedures and internal controls overfinancial reporting.  Furthermore, therewere no significant changes in our disclosure controls and procedures, internalcontrols over financial reporting, or other factors that could significantlyaffect our disclosure controls and procedures or internal controls overfinancial reporting subsequent to the date of their evaluation.  Because no significant deficiencies ormaterial weaknesses were discovered, no corrective actions were necessary ortaken to correct significant deficiencies and material weaknesses in ourinternal controls and disclosure controls and procedures.

 

**PART II OTHERINFORMATION**

 

**Item 1.****           Legal Proceedings**

 

None

 

**Item2.****           Changes in Securities and Use ofProceeds**

 

(a)                                  None

 

(b)                                 None

 

(c)                                  OnApril 14, 2004, we accepted the subscription for the purchase of 25,000units, each consisting of one common stock share and one redeemable warrantexercisable for the purchase of one common stock share, that were offeredpursuant to our its private placement offering that commenced inSeptember 2003.  Pursuant to

 

17

----

 

this sale, we received$1.00 per unit for the aggregate sum of $25,000.  In connection with this sale, Viewtrade Financial served asplacement agent and received sales commissions of $2,500 (10%) and anon-accountable expense allowance of $750 (3%).  The estimated net proceeds from this sale are $21,750 andaggregate offering costs of $3,250 paid from proceeds.  The purchaser is an individual and nototherwise affiliated with us.

 

We relied on Rule506 of Regulation D, and Sections 4(2)and 4(6) of the Security Act of 1933, asamended.  The purchaser of the commonstock shares and redeemable warrants was furnished information concerning ouroperations and had the opportunity to verify the information supplied.  Additionally, we obtained a signedrepresentation from the purchaser in connection with the sale of the commonstock shares and redeemable warrants of his intent to acquire the securitiesfor the purpose of investment only, and not with a view toward the subsequentdistribution thereof, and the qualification of each as an “accredited investor”as defined in Rule 501 and Section 4(6) of the Act; each of thecertificates or other evidence representing the securities sold carries alegend restricting transfer of the securities represented thereby, and weissued stop transfer instructions to UMB Bank, N.A., the transfer and warrantagent and registrar of registrant’s common stock and redeemable warrants, withrespect to all certificates representing the common stock and redeemablewarrants acquired by the purchaser.

 

We complied withthe information requirements of Rule 506 and the other rules of RegulationD.  In connection with the offering andsale of the securities, we along with Viewtrade Financial (the placement agent)and Capital West Securities, Inc. and their affiliates involved in thedistribution of the securities offered and sold, complied with the limitationsof paragraph (c) of Rule 502 and no from of general solicitation or generaladvertising was utilized in the offer and sale of the subject securities asproscribed by the Rule.

 

(d)                                 OnJuly 13, 2004, our Registration Statement (No. 333-111819) becameeffective under the Securities Act of 1933 for the resale of 2,955,000 commonstock shares, 2,955,000 redeemable warrants and the 2,955,000 common stockshares for which the redeemable warrants are exercisable and 100,000 commonstock shares underlying a stock option granted to E. Peter Hoffman.  The 2,955,000 common stock shares and2,955,000 redeemable warrants were sold pursuant to our private placementoffering that commenced in September 2003.  These common stock shares and redeemable warrants were offered inunits consisting of one common stock share and one redeemable warrant for $1.00each, resulting in gross proceeds of $2,955,000.  The placement agent received a 10% commission and a 3%non-accountable expense allowance of the gross proceeds for an aggregate of$384,150.  Additional offering expenseswere $57,376 resulting in net proceeds of $2,513,474.  The following expenditures have been made from the net proceeds:

 

•                                          $1,722,128 ofthe costs of producing the motion picture *Cloud9*,

 

•                                          $185,890 forworking capital, and

 

•                                          thebalance has been invested in high grade, short-term interest bearinginvestments.

 

**Item 3.****           Defaults Upon Senior Securities**

 

None

 

**Item 4.****           Submission of Matters to a Vote ofSecurity Holders**

 

None

 

**Item 5.****           OtherInformation**

 

None

 

18

----

 

**Item6.****           Exhibits and Reports on Form 8-K**

 

**(a)Exhibits:**

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                                                                        |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |   | Registrant’s  Certificate of Incorporation, incorporated by reference to Registration  Statement on Form SB-2 (No. 333-111819) filed with the Commission on  January 9, 2004.                                                                                                                |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 3.2             |   | Registrant’s Bylaws,  incorporated by reference to Registration Statement on Form SB-2 (No.  333-111819) filed with the Commission on January 9, 2004.                                                                                                                                       |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.1            |   | Co-Finance Agreement,  dated May 7, 2004 between Registrant and John Simonelli.                                                                                                                                                                                                                        |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.2            |   | Co-Finance Agreement,  dated May 7, 2004 between Registrant and 36th Street Properties LLC.                                                                                                                                                                                                            |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.3            |   | Co-Finance Agreement,  dated May 7, 2004 between Registrant and Larry E. Howell.                                                                                                                                                                                                                       |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.4            |   | Co-Finance Agreement,  dated May 10, 2004 between Registrant and Roy T. Oliver.                                                                                                                                                                                                                        |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.5            |   | SAG Motion Picture  Contract – Weekly Performer between Angie Everhart and Out of the Blue  Productions, LLC, dated April 16, 2004.                                                                                                                                                          |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.6            |   | Letter agreement  between Five Timz Productions and Out of the Blue Productions, LLC dated  April 15, 2004 with the SAG Motion Picture Contract – Weekly Performer  between D.L. Hughley and Out of the Blue Productions, LLC dated  April 15, 2004 attached as Exhibit A.              |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.7            |   | SAG Motion Picture  Contract – Weekly Performer between Gabrielle Reece and Out of the Blue  Productions, LLC, dated April 14, 2004.                                                                                                                                                         |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.8            |   | Letter agreement  between Out of the Blue Productions, LLC and Clematis Productions, Inc.,  dated February 20, 2004 with the SAG Motion Picture Contract – Weekly  Performer between Burt Reynolds and Out of the Blue Productions, LLC attached  as Exhibit A dated February 20, 2004. |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 10.9            |   | Fenton-Cowitt Casting  Agreement between Gray Frederickson and Pixie, Inc., dated January 20,  2004.                                                                                                                                                                                              |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 31.1            |   | Certification of Harry  Gray Frederickson, Jr., Chief Executive Officer of Registrant.                                                                                                                                                                                                                 |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 31.2            |   | Certification of Mark  R. Kidd, Chief Financial Officer and Controller of Registrant.                                                                                                                                                                                                                  |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 32.1            |   | Certification Pursuant  to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of  Sarbanes-Oxley Act of 2002 of Harry Gray Frederickson, Jr., Chief Executive  Officer of Registrant.                                                                                                |
|            |   |                                                                                                                                                                                                                                                                                                   |
| 32.2            |   | Certification Pursuant  to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of  Sarbanes-Oxley Act of 2002 of Mark R. Kidd, Chief Financial Officer and  Controller of Registrant.                                                                                                 |

 

**(b)Reports on Form 8-K:** None

 

19

----

 

**SIGNATURES**

 

In accordance withSection 13 or 15(d) of the Exchange Act, the Registrant caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                         | GRAYMARK PRODUCTIONS,  INC. |
|------------------------------|-----------------------------|
|                         | (Registrant)                |
|                         |                        |
|                         | By:                         | /S/HARRY G. “GRAY”  FREDERICKSON, JR. |   |
|                         |                        |   | Harry G. “Gray”  Frederickson, Jr. |
|                         |                        |   | Chief Executive Officer |
| Date: October 11,  2004 |                        |
|                         |                        |
|                         | By:                         | /S/MARK R. KIDD |   |
|                         |                        |   | Mark R. Kidd |
|                         |                        |   | Chief Financial Officer  and Controller |
| Date: October 11,  2004 |                        |
|                              |                             |  |  |  |  |

 

20

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**INDEX TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 
| Condensed  Consolidated Balance Sheets as of June 30, 2004 and  December 31, 2003                                                                         |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                |   |
| Condensed  Consolidated Statements of Operations and Accumulated Deficit for the  Three Months Ended June 30, 2004 and 2003                                    |   |
|                                                                                                                                                                |   |
| Condensed  Consolidated Statements of Operations for the  Six Months Ended June 30, 2004 and 2003 and from  Inception (August 2001) to June 30, 2004 |   |
|                                                                                                                                                                |   |
| Condensed  Consolidated Statements of Shareholders’ Equity for the  Six Months Ended June 30, 2004                                                        |   |
|                                                                                                                                                                |   |
| Condensed  Consolidated Statements of Cash Flows for the  Six Months Ended June 30, 2004 and 2003 and from  Inception (August 2001) to June 30, 2004 |   |
|                                                                                                                                                                |   |
| Notes  to Condensed Consolidated Financial Statements                                                                                                               |   |

 

F-1

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Balance Sheets**

**(Unaudited)**

 
|                                                                                                                                                                                        |   | **June 30,  2004** |      | **December 31,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|-----------|-----------------------------|--------|
| ASSETS                                                                                                                                                                                      |   |                    |      |                        |   |
|                                                                                                                                                                                        |   |                    |      |                        |   |
| Cash  and cash equivalents                                                                                                                                                                  |   | $                       | 1,119,837 |                        | $      | 2,953,159 |   |
| Total  current assets                                                                                                                                                                       |   | 1,119,837               |      | 2,953,159                   |   |
| Fixed  assets, net                                                                                                                                                                          |   | 23,623                  |      | 26,056                      |   |
| Investment  in films                                                                                                                                                                        |   | 2,222,128               |      | 34,470                      |   |
| Total  assets                                                                                                                                                                               |   | $                       | 3,365,588 |                        | $      | 3,013,685 |   |
|                                                                                                                                                                                        |   |                    |      |                        |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                  |   |                    |      |                        |   |
| Liabilities:                                                                                                                                                                                |   |                    |      |                        |   |
| Accrued  liabilities                                                                                                                                                                        |   | $                       | 116,218   |                        | $      | 68,039 |   |
| Film  obligations                                                                                                                                                                           |   | 500,000                 |      | —                      |   |
| Total  liabilities                                                                                                                                                                          |   | 616,218                 |      | 68,039                      |   |
| Shareholders’  Equity:                                                                                                                                                                 |   |                    |      |                        |   |
| Preferred  stock $0.0001 par value, 10,000,000 authorized; no shares issued and  outstanding                                                                                                |   | —                  |      | —                      |   |
| Common  stock $0.0001 par value, 90,000,000 shares authorized; 8,233,425 issued and  outstanding at June 30, 2004 (8,208,425 shares issued and outstanding at  December 31, 2003) |   | 823                     |      | 821                         |   |
| Paid-in  capital                                                                                                                                                                            |   | 3,812,692               |      | 3,790,944                   |   |
| Deficit  accumulated during development stage                                                                                                                                               |   | (1,064,145              | )         | (846,119                    | )      |
| Total  shareholders’ equity                                                                                                                                                            |   | 2,749,370               |      | 2,945,646                   |   |
| Total  liabilities and shareholders’ equity                                                                                                                                            |   | $                       | 3,365,588 |                        | $      | 3,013,685 |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

 

F-2

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Statements ofOperations**

**(Unaudited)**

 
|                                                               |   | **Three  Months Ended  June 30,** |    |
|--------------------------------------------------------------------|--------|----------------------------------------|---------|
|                                                               |   | **2004**                               |    | **2003** |   |
|                                                               |   |                                   |    |   |   |
| Revenues                                                           |   | $                                      | —  |   | $ | — |   |
| Operating  expenses:                                               |   |                                   |    |   |   |
| Consulting  and management fees                                    |   | 5,000                                  |    | 39,499 |   |
| Salaries  and employee benefits                                    |   | 57,620                                 |    | — |   |
| Legal  and professional fees                                       |   | 59,163                                 |    | 839 |   |
| Film  marketing                                                    |   | 4,200                                  |    | — |   |
| Travel  and entertainment                                          |   | —                                 |    | 10,439 |   |
| Obligation  related to non-timely filing of registration statement |   | (44,325                                | )       | — |   |
| Other                                                              |   | 14,310                                 |    | 1,854 |   |
| Total  operating expenses                                          |   | 95,968                                 |    | 52,631 |   |
| Operating  loss                                                    |   | (95,968                                | )       | (52,631 | ) |
| Other  Income (Expense):                                           |   |                                   |    |   |   |
| Interest  and other income                                         |   | 3,391                                  |    | 447 |   |
| Net  loss                                                          |   | $                                      | (92,577 | ) | $ | (52,184 | ) |
| Net  loss per share of common stock, basic and diluted             |   | $                                      | (0.01   | ) | $ | (0.01 | ) |
| Weighted  average number of common shares outstanding              |   | 8,233,425                              |    | 4,870,000 |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

 

F-3

----

 
|                                                     |   | **Six Months****Ended  June 30,** |     | **Inception  (August 2001)  to  June 30,** |   |
|----------------------------------------------------------|--------|----------------------------------------|----------|------------------------------------------------------|--------|
|                                                     |   | **2004**                               |     | **2003**                                             |   | **2004** |   |
|                                                     |   |                                   |     |                                                 |   |   |   |
| Revenues                                                 |   | $                                      | —   |                                                 | $      | — |   | $ | 13,391 |   |
| Operating  expenses:                                     |   |                                   |     |                                                 |   |   |   |
| Consulting  and management fees                          |   | 10,000                                 |     | 83,698                                               |   | 794,274 |   |
| Salaries  and employee benefits                          |   | 117,990                                |     | —                                               |   | 117,990 |   |
| Legal  and professional fees                             |   | 74,818                                 |     | 839                                                  |   | 90,304 |   |
| Film  marketing                                          |   | 4,200                                  |     | —                                               |   | 4,200 |   |
| Travel  and entertainment                                |   | 300                                    |     | 11,682                                               |   | 40,045 |   |
| Other                                                    |   | 22,092                                 |     | 3,007                                                |   | 47,668 |   |
| Total  operating expenses                                |   | 229,400                                |     | 99,226                                               |   | 1,094,481 |   |
| Operating  loss                                          |   | (229,400                               | )        | (99,226                                              | )      | (1,081,090 | ) |
| Other  Income (Expense):                                 |   |                                   |     |                                                 |   |   |   |
| Interest  and other income                               |   | 11,374                                 |     | 1,028                                                |   | 16,945 |   |
| Net  loss - deficit accumulated during development stage |   | $                                      | (218,026 | )                                                    | $      | (98,198 | ) | $ | (1,064,145 | ) |
| Net  loss per share of common stock, basic and diluted   |   | $                                      | (0.03    | )                                                    | $      | (0.02 | ) | $ | (0.19 | ) |
| Weighted  average number of common shares outstanding    |   | 8,220,925                              |     | 4,870,000                                            |   | 5,539,828 |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

 

F-4

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Statements ofShareholders’ Equity**

**(Unaudited)**

 
|                                                  |   | **Common  Stock** |   | **Additional  Paid-in** |   | **Accumulated** |   |
|-------------------------------------------------------|--------|-------------------|--------|-------------------------|--------|-----------------|--------|
|                                                  |   | **Shares**        |   | **Amount**              |   | **Capital**     |   | **Deficit** |   |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Balance, Inception  (August 2001)                |   | —            |   | $                       | — |            | $      | — |   | $ | — |   |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Capital  contributions                                |   | —            |   | —                  |   | 21,263          |   | — |   |
| Net  loss                                             |   | —            |   | —                  |   | —          |   | (21,089 | ) |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Balance,  December 31, 2001                      |   | —            |   | —                  |   | 21,263          |   | (21,089 | ) |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Capital  contributions                                |   | —            |   | —                  |   | 222,991         |   | — |   |
| Net  loss                                             |   | —            |   | —                  |   | —          |   | (178,768 | ) |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Balance,  December 31, 2002                      |   | —            |   | —                  |   | 244,254         |   | (199,857 | ) |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Capital  contributions                                |   | —            |   | —                  |   | 610,412         |   | — |   |
| Issuance  of stock in incorporation-reorganization    |   | 4,870,000         |   | 487                     |   | (487            | )      | — |   |
| Sale  of stock                                        |   | 2,955,000         |   | 296                     |   | 2,513,178       |   | — |   |
| Issuance  of stock to investment banking firm         |   | 383,425           |   | 38                      |   | 383,387         |   | — |   |
| Issuance  of stock options to non-employee consultant |   | —            |   | —                  |   | 40,200          |   | — |   |
| Net  loss                                             |   | —            |   | —                  |   | —          |   | (646,262 | ) |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Balance,  December 31, 2003                      |   | 8,208,425         |   | 821                     |   | 3,790,944       |   | (846,119 | ) |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Sale  of stock                                        |   | 25,000            |   | 2                       |   | 21,748          |   | — |   |
| Net  loss                                             |   | —            |   | —                  |   | —          |   | (218,026 | ) |
|                                                  |   |              |   |                    |   |            |   |   |   |
| Balance, June 30,  2004                          |   | 8,233,425         |   | $                       | 823    |            | $      | 3,812,692 |   | $ | (1,064,145 | ) |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

 

F-5

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Statements ofCash Flows**

**(Unaudited)**

 
|                                                                         |   | **Six Months  Ended  June 30,** |      | **Inception  (August 2001)  to  June 30,** |   |
|------------------------------------------------------------------------------|--------|--------------------------------------|-----------|------------------------------------------------------|--------|
|                                                                         |   | **2004**                             |      | **2003**                                             |   | **2004** |   |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Operating  activities:                                                       |   |                                 |      |                                                 |   |   |   |
| Net  loss                                                                    |   | $                                    | (218,026  | )                                                    | $      | (98,198 | ) | $ | (1,064,145 | ) |
| Adjustments  to reconcile net loss to net cash used by operating activities: |   |                                 |      |                                                 |   |   |   |
| Depreciation                                                                 |   | 2,433                                |      | —                                               |   | 3,069 |   |
| Issuance  of common stock to investment banking firm                         |   | —                               |      | —                                               |   | 383,425 |   |
| Issuance  of stock options to non-employee consultant                        |   | —                               |      | —                                               |   | 40,200 |   |
| Changes  in assets and liabilities –                                    |   |                                 |      |                                                 |   |   |   |
| Accrued  liabilities                                                         |   | 48,179                               |      | 99,041                                               |   | 116,218 |   |
| Investment  in Films                                                         |   | (2,187,658                           | )         | —                                               |   | (2,222,128 | ) |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Net  cash used by operating activities                                       |   | (2,355,072                           | )         | 843                                                  |   | (2,743,361 | ) |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Investing  activities:                                                       |   |                                 |      |                                                 |   |   |   |
| Purchase  of fixed assets                                                    |   | —                               |      | —                                               |   | (26,692 | ) |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Net  cash used by investing activities                                       |   | —                               |      | —                                               |   | (26,692 | ) |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Financing  activities:                                                       |   |                                 |      |                                                 |   |   |   |
| Capital  contributions                                                       |   | —                               |      | 110,413                                              |   | 854,667 |   |
| Sale  of stock                                                               |   | 21,750                               |      | —                                               |   | 2,535,223 |   |
| Proceeds  from film co-financing agreement                                   |   | 500,000                              |      | —                                               |   | 500,000 |   |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Net  cash provided by financing activities                                   |   | 521,750                              |      | 110,413                                              |   | 3,889,890 |   |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Net  change in cash and cash equivalents                                     |   | (1,833,322                           | )         | 111,256                                              |   | 1,119,837 |   |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Cash  and cash equivalents at beginning of period                            |   | 2,953,159                            |      | 51,514                                               |   | — |   |
|                                                                         |   |                                 |      |                                                 |   |   |   |
| Cash  and cash equivalents at end of period                                  |   | $                                    | 1,119,837 |                                                 | $      | 162,770 |   | $ | 1,119,837 |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

 

F-6

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Notesto Condensed Consolidated Financial Statements**

**(Unaudited)**

 

Note 1 – Nature ofBusiness

 

GrayMark Productions,Inc. (the “Company”) is a development stage company organized in Oklahoma andan independent producer and distributor of film entertainment content.  The Company began operations in 2001 as GrayMarkProductions, L.L.C. (the “LLC”), all of the assets of which were recentlyacquired by the Company through our incorporation-reorganization, effectiveAugust 18, 2003.

 

The Company has notpreviously developed or produced any film entertainment content; however, theCompany has commenced production of its first motion picture project.  The Company intends to produce anddistribute films that are completed and marketed using smaller budgets thanthose of major studios.  Managementbelieves that producing and distributing low- or modest-budget, commerciallysuccessful films will afford us access to Hollywood talent and scripts andthird-party production packages for acquisition, without compromisingmanagement’s approach to managing financial risk.

 

Note 2 – Summary ofSignificant Accounting Policies

 

*Interim Financial Information*– The unaudited condensed consolidated financial statements have been preparedin accordance with generally accepted accounting principles for interimfinancial information, they do not include all of the information and footnotesrequired by generally accepted accounting principles for complete financialstatements.

 

The accompanyingfinancial statements are unaudited, but include all adjustments (consistingonly of normal recurring adjustments) which are, in the opinion of management,necessary for a fair presentation of the financial position at such dates andof the operations and cash flows for the periods then ended.  Operating results for the periods ended June 30,2004 and 2003 are not necessarily indicative of results that may be expectedfor the entire year.

 

*Development stage operations*– The accompanying financial statements have been prepared in conformity withgenerally accepted accounting principles, which contemplate continuation of theCompany as a going concern.  The Companyhas generated a limited amount of consulting revenues; however, the Company hasyet to generate any revenue from the sale and/or distribution of filmentertainment content and has no assurance of future revenues from such salesand/or distribution.  In addition, theCompany plans to spend significant amounts on the production and distributionof its film projects.

 

In view of the mattersdescribed in the preceding paragraph, the ability of the Company to establish asource of recurring revenue is dependent upon the Company’s ability to develop,produce and market film entertainment content. The accompanying consolidated financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or amounts and classifications of liabilities that might be necessaryshould the Company be unable to continue in existence.

 

*Use of estimates* –The preparation of financial statements in conformity with generally acceptedaccounting principles requires management of the Company to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes.  Actual resultscould differ from those estimates.

 

F-7

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Note 2 – Investment inFilms

 
|                        |   | **June 30,  2004** |      | **December 31,  2003** |   |
|-----------------------------|--------|-------------------------|-----------|-----------------------------|--------|
|                        |   |                    |      |                        |   |
| Completed  and not released |   | $                       | 2,212,128 |                        | $      | — |   |
| In  development             |   | 10,000                  |      | 34,470                      |   |
|                        |   |                    |      |                        |   |
| Total                       |   | $                       | 2,222,128 |                        | $      | 34,470 |   |

 

Note 3 – Film Obligations

 

During May 2004, theCompany obtained $500,000 of funding under co-finance agreements for its motionpicture project, *Cloud 9*.  The termsof the co-financing provide for the investors to recoup their contribution fromthe first proceeds of *Cloud 9*. After all *Cloud 9* costs are recouped by the Company, the investors areentitled to a profit participation in the Company’s profit from *Cloud 9*.  As a group, the investors are entitled to20% of the net profits paid to the Company, but the investors do not have anyownership rights in the film.  The$500,000 received under the co-financing agreements represents 22% of theanticipated total cost of *Cloud 9*. The funding under the co-financing agreements came from related partiesto the Company as described below:

 
| **Source of Funding**                                               |   | **Amount** |    |
|---------------------------------------------------------------------|--------|------------|---------|
|                                                                |   |       |    |
| Greater  than 5% shareholder                                        |   | $          | 250,000 |   |
| Company’s  president and chief operating officer               |   | 100,000    |    |
| A  company controlled by the Company’s chief financial officer |   | 100,000    |    |
| Company  shareholder                                                |   | 50,000     |    |
|                                                                |   |       |    |
| Total                                                               |   | $          | 500,000 |   |

 

Note 4 – Film ProfitParticipation and Contingent Compensation

 

Pursuant to an investoragreement between the Company and the developers of the screenplay for *Cloud 9*(the“Picture”), the Company shares the development and productions costs andrevenue of *Cloud9*.  For its financialcontribution to the costs of making *Cloud 9*, the Company is entitled toreceive the following:

 

•                                          100% of revenue and proceeds from the rights sales,distribution and/or any and all exploitation of *Cloud 9* until the Company recoversits investment in the Picture, plus interest at the rate of prime plus 2% perannum from the date of the contribution until the Company is repaid itsinvestment in the Picture.

 

•                                          50% of “net profits” received from the rights sales,distribution and/or any and all exploitation of the Picture.  “Net Profits” is defined as the sumremaining after deduction of third party distribution fees; cash deferments tocast, equipment suppliers, rights holders or any other approved party.

 

The Company’s subsidiary,Out of the Blue Productions, LLC (the “Production Company”), has entered intocontingent compensation agreements with the director and certain cast membersof *Cloud9* in the form of “net profit participations” that are customary inthe film industry.  These netparticipations are typically based on the net profit of a film after allproduction and distribution costs have been recouped.  A percentage of these “net profits”, as negotiated between theparticipants,  are paid out ascontingent compensation for creative participants in a motion picturefilm.  The net participations negotiatedby the Production Company for *Cloud 9* total 23.5% of which the Company’sinterest in *Cloud9* is burdened by one-half of these net profit participations.  The Company’s residual net profits interestin *Cloud9* is 30.6% after giving effect to the net profits participationsgiven pursuant to contingent compensation arrangements and the co-financeagreements (see Note 3 – Film Obligations).

 

F-8

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The Production Companyalso agreed to pay certain cast members, in the aggregate, the followingcontingent amounts:

 

•                                          a bonus of $50,000 when aggregate United States andCanada box office receipts as reported in *Daily Variety* are $5,000,000 or more;

•                                          a bonus of $75,000 when aggregate United States andCanada box office receipts as reported in *Daily Variety* are $7,500,000 or more;

•                                          a bonus of $125,000 when aggregate United States andCanada box office receipts as reported in *Daily Variety* are $10,000,000 or more;

•                                          a bonus of $25,000 when aggregate United States andCanada box office receipts as reported in *Daily Variety* are $15,000,000 or more;

•                                          a bonus of $25,000 when aggregate United States andCanada box office receipts as reported in *Daily Variety* are $20,000,000 or more.

 

Note 5 – CapitalStructure

 

In December 2003,the Company conducted a private placement of common stock and issued 2,955,000shares of common stock.  The netproceeds of the private placement offering were$2,513,474 ($0.85 per share)after deduction of $441,526 in offering costs. In April 2004, the Companyissued an additional 25,000 shares under the private placement.  The net proceeds of the April 2004 saleof stock was $21,750 ($0.87 per share) after deduction of $3,250 in offeringcosts.  The Company issued a total of2,980,000 shares under the private placement for net proceeds of $2,535,224($0.85 per share) after deduction of $444,776 in offering costs.

 

The Company agreed, atits expense, to register under the Securities Act of 1933 the common stockshares and redeemable warrants issued as a result of the private placementoffering and to obtain effectiveness of the registration on or beforeJuly 14, 2004.  As ofMarch 31, 2004, due to the uncertainty of when the Company’s registrationwould become effective the Company accrued an obligation to security holders of$44,325.  On July 13, 2004, theCompany’s registration statement was granted effectiveness by the Securitiesand Exchange Commission.  Since the effectivedate was within the time required by the private placement memorandum, theobligation to security holders of $44,325 was reversed as of June 30,2004.

 

Note 5 – Stock Optionsand Warrants

 

Information with respectto stock options and warrants outstanding follows:

 
|                              |   | **June 30,  2004** |   |
|-----------------------------------|--------|-------------------------|--------|
|                              |   | **Shares**              |   | **Average  Exercise  Price** |   |
|                              |   |                    |   |   |   |
| Outstanding  at beginning of year |   | 3,498,250               |   | $ | 1.86 |   |
| Granted  at market value          |   | 25,000                  |   | 2.00 |   |
| Exercised                         |   | —                  |   | — |   |
| Forfeited                         |   | —                  |   | — |   |
|                              |   |                    |   |   |   |
| Outstanding  at end of year       |   | 3,523,250               |   | $ | 1.87 |   |

 

F-9

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