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

**Washington, D.C. 20549**

** **

**FORM 10-QSB**

** **
| **(Mark One)**                                     |                                                                                          |
|----------------------------------------------------|-----------------------------------------------------------------------------------------------|
| **x**                                              | **QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF  THE SECURITIES EXCHANGE ACT OF 1934**        |
| ** **                                         | ** **                                                                                    |
| **For the  quarterly period ended: June 30, 2006** |
| ** **                                         |
| **OR**                                             |
| ** **                                         |
| o                                                  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(D) OF THE SECURITIES EXCHANGE ACT OF 1934** |

** **

**For the transition periodfrom                            to                            **

** **

**Commission File Number000-50758**

** **

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**VISTULA COMMUNICATIONS SERVICES, INC.**

(Exact name of small business issuer as specified inits charter)

 

| **Delaware**                     |   | **20-0734966**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (IRS Employer        |
| incorporation or  organization)  |   | Identification  No.) |

 

**Suite 801, 405 Park Avenue**

**New York, New York 10022**

(Address of principal executive offices and zip code)

 

**(212) 317-8900**

(Issuer’s telephone number)

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during the past12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.           Yes  x          No o

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

As of August 4, 2006, there were 64,464,898 shares ofcommon stock, $0.001 par value, of the registrant issued and outstanding.

Transitional SmallBusiness Disclosure Format (*Check one*):         Yes o       No x

 

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**VISTULA COMMUNICATIONS SERVICES, INC.**

**FORM 10-QSB**

**FOR THE THREE MONTHS ENDED JUNE 30,2006**

Facing Page

Table of Contents
| PART I.    |   | FINANCIAL  INFORMATION(*): |   |                                                                                                                   |
|------------|--------|----------------------------|--------|------------------------------------------------------------------------------------------------------------------------|
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item 1.                    |   | Financial Statements                                                                                                   |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   |                       |   | Consolidated  Balance Sheets as of June 30, 2006 (unaudited) and December 31, 2005                                     |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   |                       |   | Consolidated  Statements of Operations for the Three and Six Months ended June 30, 2006 and  June 30, 2005 (unaudited) |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   |                       |   | Consolidated  Statements of Stockholders’ Equity (Deficit) for the Six Months ended June  30, 2006 (unaudited)    |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   |                       |   | Consolidated  Statements of Cash Flows for the Six Months ended June 30, 2006 and June 30,  2005 (unaudited)           |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   |                       |   | Notes to Unaudited Consolidated Financial Statements                                                                   |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item 2.                    |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item 3.                    |   | Controls and  Procedures                                                                                               |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
| PART II.   |   | OTHER INFORMATION          |   |                                                                                                                   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item  1.                   |   | Legal Proceedings                                                                                                      |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item 2.                    |   | Unregistered  Sales of Equity Securities                                                                               |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item 3.                    |   | Defaults Upon  Senior Securities                                                                                       |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item 4.                    |   | Submission of  Matters to a Vote of Security Holders                                                                   |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item 5.                    |   | Other  Information                                                                                                     |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
|       |   | Item  6.                   |   | Exhibits                                                                                                               |   |   |
|       |   |                       |   |                                                                                                                   |   |   |
| SIGNATURES |   |                       |
|            |        |                            |        |                                                                                                                        |  |  |  |

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(*)            Allof the financial statements contained in this Quarterly Report are unauditedwith the exception of the financial information at December 31, 2005, which hasbeen derived from our audited financial statements at that date and should beread in conjunction therewith. Our audited financial statements as of December31, 2005 and for the year then ended, and the notes thereto, can be found inour Annual Report on Form 10-KSB (File No. 000-50758), which was filed with theSecurities and Exchange Commission on March 31, 2006.

 

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**PART I. FINANCIALINFORMATION**

**Item 1. FinancialStatements.**

***VISTULA COMMUNICATIONS SERVICES, INC.***

Consolidated BalanceSheets as of June 30, 2006 andDecember 31, 2005
| ** **                                                                                                                                                                       | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(unaudited)**         | ** ** | **(audited)**               | ** ** |
| **ASSETS**                                                                                                                                                                       | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                  |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                        |       | $                       | 2,468,229  |                        | $          | 553,127 |   |
| Accounts receivable                                                                                                                                                              |       | 101,923                 |       | 130,748                     |       |
| Prepaid expenses and other current assets                                                                                                                                        |       | 379,670                 |       | 1,045,795                   |       |
| Total current assets                                                                                                                                                             |       | 2,949,822               |       | 1,729,670                   |       |
|                                                                                                                                                                             |       |                    |       |                        |       |
| Property and  equipment, net                                                                                                                                                     |       | 2,203,703               |       | 2,362,373                   |       |
| Deferred  financing costs                                                                                                                                                        |       | 472,109                 |       | 613,742                     |       |
| Intangible  assets                                                                                                                                                               |       | 26,279,189              |       | —                      |       |
| Other assets                                                                                                                                                                     |       | 29,290                  |       | 57,272                      |       |
| Total Assets                                                                                                                                                                     |       | $                       | 31,934,113 |                        | $          | 4,763,057 |   |
|                                                                                                                                                                             |       |                    |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY (DEFICIT)**                                                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                             |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                 |       | $                       | 718,832    |                        | $          | 398,841 |   |
| Accrued expenses                                                                                                                                                                 |       | 563,169                 |       | 628,154                     |       |
| Accrued acquisition liability                                                                                                                                                    |       | 4,796,024               |       | —                      |       |
| Convertible promissory note to related party                                                                                                                                     |       | 175,000                 |       | 175,000                     |       |
| Notes payable                                                                                                                                                                    |       | —                  |       | 870,000                     |       |
| Total current liabilities                                                                                                                                                        |       | 6,253,025               |       | 2,071,995                   |       |
| Convertible  debentures                                                                                                                                                          |       | 5,609,363               |       | 5,424,902                   |       |
| Total liabilities                                                                                                                                                                |       | 11,862,388              |       | 7,496,897                   |       |
|                                                                                                                                                                             |       |                    |       |                        |       |
| Stockholders’ equity  (deficit):                                                                                                                                            |       |                    |       |                        |       |
| Preferred stock, $0.001 par value, 10,000,000 shares  authorized; no shares issued and outstanding                                                                               |       | —                  |       | —                      |       |
| Common stock, $0.001 par value, 100,000,000 shares  authorized, 60,533,731 and 31,914,898 shares issued and outstanding as of  June 30, 2006 and December 31, 2005, respectively |       | 60,533                  |       | 31,914                      |       |
| Additional paid-in capital                                                                                                                                                       |       | 44,429,317              |       | 13,975,077                  |       |
| Deferred compensation                                                                                                                                                            |       | —                  |       | (13,422                     | )          |
| Accumulated deficit                                                                                                                                                              |       | (24,275,170             | )          | (16,576,999                 | )          |
| Cumulative translation adjustment                                                                                                                                                |       | (142,955                | )          | (150,410                    | )          |
| Total stockholders’ equity (deficit)                                                                                                                                        |       | 20,071,725              |       | (2,733,840                  | )          |
| Total  Liabilities and Stockholders’ Equity (Deficit)                                                                                                                       |       | $                       | 31,934,113 |                        | $          | 4,763,057 |   |

 

See accompanying notes to unaudited consolidatedfinancial statements.

3

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***VISTULA COMMUNICATIONS SERVICES, INC***

Consolidated Statementsof Operations for theThree and Six Months ended June 30, 2006 and 2005
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(unaudited)**                                 | ** ** | **(unaudited)**                               | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
| Net revenues                                           |       | $                                               | 237,919    |                                          | $          | 230,130 |   | $ | 557,338 |   | $ | 352,327 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Cost of revenues                                       |       | 324,091                                         |       | 211,511                                       |       | 675,604 |   | 399,780 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Gross margin (loss)                                    |       | (86,172                                         | )          | 18,619                                        |       | (118,266 | ) | (47,453 | ) |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Selling, general  and administrative expenses          |       | 3,125,449                                       |       | 1,829,600                                     |       | 6,966,029 |   | 3,012,704 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Loss from operations                                   |       | (3,211,621                                      | )          | (1,810,981                                    | )          | (7,084,295 | ) | (3,060,157 | ) |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Interest  expense, net                                 |       | (298,773                                        | )          | (380,822                                      | )          | (613,876 | ) | (542,565 | ) |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Net loss                                               |       | $                                               | (3,510,394 | )                                             | $          | (2,191,803 | ) | $ | (7,698,171 | ) | $ | (3,602,722 | ) |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Weighted-average  basic and diluted shares outstanding |       | 43,985,250                                      |       | 25,179,406                                    |       | 38,691,981 |   | 24,887,003 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Basic and diluted net  loss per common share           |       | $                                               | (0.08      | )                                             | $          | (0.09 | ) | $ | (0.20 | ) | $ | (0.14 | ) |

 

See accompanying notes to unaudited consolidatedfinancial statements.

4

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***VISTULA COMMUNICATIONS SERVICES, INC.***

Consolidated Statements of Stockholders’ Equity(Deficit) for theSix Months ended June 30, 2006(unaudited)
| ** **                                                               | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **       | ** ** | ** **      | ** ** | ** **     | ** ** | **Total**              | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|------------------|------------|-----------------|------------|----------------|------------|------------------------|------------|------------|------------|
| ** **                                                               | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **       | ** ** | ** **      | ** ** | **Cumulative** | ** ** | **Stockholders’** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Deferred**   | ** ** | **Accumulated**  | ** ** | **Translation** | ** ** | **Equity**     | ** ** | **Comprehensive**      | ** ** |
| ** **                                                               | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Deficit**     | ** ** | **Adjustment** | ** ** | **(Deficit)**          | ** ** | **Loss**   | ** ** |
| Balance, December 31, 2005                                               |       | 31,914,898            |       | $           | 31,914     |           | $          | 13,975,077       |       | $               | (13,422    | )              | $          | (16,576,999            | )          | $          | (150,410   | ) | $ | (2,733,840 | ) |   |   |
| Application of deferred compensation against  additional paid-in capital |       |                  |       |        |       | (13,422        | )          | 13,422           |       |            |       |           |       | —                 |       |       |       |
| Issuance of common stock                                                 |       | 27,868,833            |       | 27,869      |       | 29,375,272     |       |             |       |            |       |           |       | 29,403,141             |       |       |       |
| Exercise of stock options                                                |       | 750,000               |       | 750         |       | 74,250         |       |             |       |            |       |           |       | 75,000                 |       |       |       |
| Issuance of stock options                                                |       |                  |       |        |       | 375,350        |       |             |       |            |       |           |       | 375,350                |       |       |       |
| Issuance of warrants pursuant to consulting agreement                    |       |                  |       |        |       | 231,945        |       |             |       |            |       |           |       | 231,945                |       |       |       |
| Issuance of warrants pursuant to revolving credit  facility              |       |                  |       |        |       | 410,845        |       |             |       |            |       |           |       | 410,845                |       |       |       |
| Net loss                                                                 |       |                  |       |        |       |           |       |             |       | (7,698,171      | )          |           |       | (7,698,171             | )          | $          | (7,698,171 | ) |
| Change in cumulative translation adjustment                              |       |                  |       |        |       |           |       |             |       |            |       | 7,455          |       | 7,455                  |       | 7,455      |       |
| Balance, June 30,  2006                                                  |       | 60,533,731            |       | $           | 60,533     |           | $          | 44,429,317       |       | $               | —     |           | $          | (24,275,170            | )          | $          | (142,955   | ) | $ | 20,071,725 |   | $ | (7,690,716 | ) |
|                                                                          |            |                       |            |             |            |                |            |                  |            |                 |            |                |            |                        |            |            |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to unaudited consolidatedfinancial statements.

5

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***VISTULACOMMUNICATIONS SERVICES, INC***

**Consolidated Statements of Cash Flows for theSix Months ended June 30, 2006 and 2005**
| ** **                                                                                                | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                                                                                | ** ** | **(unaudited)**                                   | ** ** | **(unaudited)** | ** ** |
| Cash flows from  operating activities:                                                                    |       |                                              |       |   |   |
| Net loss                                                                                                  |       | $                                                 | (7,698,171 | ) | $ | (3,602,722 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:                              |       |                                              |       |   |   |
| Depreciation                                                                                              |       | 260,509                                           |       | 27,970 |   |
| Non-cash expense  pursuant to financial advisory agreements                                               |       | 1,875,000                                         |       | — |   |
| Non-cash  compensation expense                                                                            |       | 375,350                                           |       | 397,000 |   |
| Non-cash  interest expense                                                                                |       | 326,094                                           |       | 320,012 |   |
| Issuance of  warrant pursuant to consulting agreement                                                     |       | 231,945                                           |       | 29,913 |   |
| Issuance of  warrant pursuant to revolving credit facility                                                |       | 410,845                                           |       | — |   |
| Changes in  assets and liabilities:                                                                       |       |                                              |       |   |   |
| (Increase) decrease  in:                                                                                  |       |                                              |       |   |   |
| Accounts  receivable                                                                                      |       | 28,825                                            |       | (26,644 | ) |
| Prepaid expenses  and other current assets                                                                |       | 294,918                                           |       | (600,790 | ) |
| Increase  (decrease) in:                                                                                  |       |                                              |       |   |   |
| Accounts payable                                                                                          |       | 319,991                                           |       | (167,182 | ) |
| Accrued expenses                                                                                          |       | (64,985                                           | )          | (736,935 | ) |
| Net cash used in  operating activities                                                                    |       | (3,639,679                                        | )          | (4,359,378 | ) |
|                                                                                                      |       |                                              |       |   |   |
| Cash flows from  investing activities:                                                                    |       |                                              |       |   |   |
| Purchases of  property and equipment                                                                      |       | (72,265                                           | )          | (339,765 | ) |
| Purchase of  software and intellectual property                                                           |       | (8,800,000                                        | )          | — |   |
| Net cash used in  investing activities                                                                    |       | (8,872,265                                        | )          | (339,765 | ) |
|                                                                                                      |       |                                              |       |   |   |
| Cash flows from  financing activities:                                                                    |       |                                              |       |   |   |
| Net proceeds  from issuance of common stock                                                               |       | 15,244,165                                        |       | — |   |
| Proceeds from  bridge revolving credit agreement                                                          |       | 1,250,000                                         |       | — |   |
| Proceeds from  exercise of stock options                                                                  |       | 75,000                                            |       | — |   |
| Proceeds from  issuance of convertible debentures and warrants, net of deferred financing  costs          |       | —                                            |       | 7,452,874 |   |
| Payment on  bridge revolving credit agreement                                                             |       | (1,250,000                                        | )          | — |   |
| Payment on notes  payable                                                                                 |       | (870,000                                          | )          | — |   |
| Payments on due  to stockholder                                                                           |       | —                                            |       | (801,630 | ) |
| Payment of  capital lease obligation                                                                      |       | —                                            |       | (500,000 | ) |
| Net cash  provided by financing activities                                                                |       | 14,449,165                                        |       | 6,151,244 |   |
|                                                                                                      |       |                                              |       |   |   |
| Effect of exchange  rates on cash                                                                         |       | (22,119                                           | )          | (12,420 | ) |
|                                                                                                      |       |                                              |       |   |   |
| Net increase in cash  and cash equivalents                                                                |       | 1,915,102                                         |       | 1,439,681 |   |
| Cash and cash  equivalents, beginning of period                                                           |       | 553,127                                           |       | 3,221 |   |
|                                                                                                      |       |                                              |       |   |   |
| Cash and cash  equivalents, end of period                                                                 |       | $                                                 | 2,468,229  |   | $ | 1,442,902 |   |
|                                                                                                      |       |                                              |       |   |   |
| **Supplemental disclosure of cash  flow information:**                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Cash paid for  interest                                                                                   |       | $                                                 | 319,427    |   | $ | 251,418 |   |
|                                                                                                      |       |                                              |       |   |   |
| Cash paid for  taxes                                                                                      |       | $                                                 | —     |   | $ | — |   |
|                                                                                                      |       |                                              |       |   |   |
| **Supplemental disclosure of  non-cash financing activities:**                                            | ** ** | ** **                                        | ** ** | ** ** | ** ** |
|                                                                                                      |       |                                              |       |   |   |
| Issuance of  common stock pursuant to financial advisory agreement                                        |       | $                                                 | 1,875,000  |   | $ | — |   |
|                                                                                                      |       |                                              |       |   |   |
| Issuance of  common stock warrant pursuant to consulting agreement                                        |       | $                                                 | 231,945    |   | $ | — |   |
|                                                                                                      |       |                                              |       |   |   |
| Issuance of  common stock warrant pursuant to revolving credit facility                                   |       | $                                                 | 410,845    |   | $ | — |   |
|                                                                                                      |       |                                              |       |   |   |
| Issuance of  common stock pursuant to purchase of software and intellectual property                      |       | $                                                 | 12,283,976 |   | $ | — |   |
|                                                                                                      |       |                                              |       |   |   |
| Reclass of  prepaid royalties to purchase of intangible asset                                             |       | $                                                 | 399,189    |   | $ | — |   |
|                                                                                                      |       |                                              |       |   |   |
| Company expenses  paid directly by and returned directly to stockholder                                   |       | $                                                 | 75,000     |   | $ | — |   |
|                                                                                                      |       |                                              |       |   |   |
| Issuance of  common stock pursuant to capital lease obligation                                            |       | $                                                 | —     |   | $ | 324,874 |   |
|                                                                                                      |       |                                              |       |   |   |
| Issuance of note  payable pursuant to capital lease obligation                                            |       | $                                                 | —     |   | $ | 970,000 |   |
|                                                                                                      |       |                                              |       |   |   |
| Issuance of  common stock warrants in connection with convertible debenture financing                     |       | $                                                 | —     |   | $ | 184,844 |   |
|                                                                                                      |       |                                              |       |   |   |
| Reduction in fixed  assets and related indebtedness pursuant to modification of asset purchase  agreement |       | $                                                 | —     |   | $ | 200,000 |   |

 

See accompanying notes to unaudited consolidatedfinancial statements.

6

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**VISTULA COMMUNICATIONS SERVICES, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2006**

**(1)   Basis of Presentation**

The accompanying unaudited consolidated financialstatements of Vistula Communications Services, Inc. (“Vistula” or the “Company”)have been prepared in accordance with accounting principles generally acceptedin the United States (GAAP) for interim financial information and with theinstructions to Form 10-QSB and Item 310 of Regulation S-B. Accordingly, theydo not include all of the information and footnotes required by GAAP forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for the fairpresentation of the results for the interim periods have been included. Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying notes. Interim results are not necessarilyindicative of results to be expected for the entire fiscal year ending December31, 2006. These unaudited financial statements should be read in conjunctionwith the Company’s audited annual financial statements for the fiscal yearended December 31, 2005 and the footnotes thereto. Those audited financialstatements are included in the Company’s Annual Report on Form 10-KSB, whichwas filed with the Securities and Exchange Commission (SEC) on March 31, 2006.

The Company uses the United States dollar as itsreporting currency. The British pound is the functional currency of itswholly-owned subsidiary, Vistula Limited. The South African rand is thefunctional currency of its 60% owned subsidiary, Vistula CommunicationsServices SA (Pty) Ltd. Assets and liabilities of the Company’s internationaloperations are translated into U.S. dollars at exchange rates that are ineffect on the balance sheet date and equity accounts are translated athistorical exchange rates. Income and expense items are translated at averageexchange rates which are in effect during the period. Translation adjustmentsare accumulated in other comprehensive loss as a separate component ofstockholders’ deficit in the consolidated balance sheet. Transaction gains(losses) were immaterial for the three- and six-month periods ended June 30,2006 and June 30, 2005.

In the event that the Company is not successful inimplementing its business plan, or does not raise third-party capital, theCompany will have to curtail certain expenditures, seek additional financingfrom one of its principal stockholders, or both in order to sustain operations.One of the Company’s principal stockholders has historically provided workingcapital advances and has caused a lender to issue letters of credit in favor ofcertain vendors and personally guaranteed advances drawn under a revolvingcredit agreement entered in March 2006. While the stockholder is not obligatedto provide these working capital advances to the Company, or to providepersonal guarantees with respect to credit facilities of the Company, or tocause a lender to issue standby letters of credit in favor of its vendors, theCompany expects that the stockholder will continue to provide funds foroperations in 2006, as and if needed, until such time that the Company’soperations are self-sustaining or the Company raises additional externalcapital, as the case may be. As described in Note 9, in March 2006 and April2006 the Company received a total of $1.25 million in net proceeds under arevolving credit agreement. As described in Note 15, in May 2006 the Companyreceived net proceeds of approximately $15.2 million from the sale of units,each unit consisting of one share of common stock and eight-tenths of onewarrant to acquire one share of common stock.

The consolidated financial statements shown for theperiod ended June 30, 2006 have been prepared on a going concern basis whichcontemplates the realization of assets and the satisfaction of liabilities inthe normal course of business. As shown in the accompanying consolidatedfinancial statements, the Company incurred a net loss of $7,698,171 for thesix-month period ended June 30, 2006 and had an accumulated deficit of$24,275,170 at June 30, 2006. Further, the Company had cash of $2,468,229 and aworking capital deficit at June 30, 2006 of $3,303,203. These factors amongothers may indicate that the Company will be unable to continue as a goingconcern.

7

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The consolidated financial statements do not includeany adjustments relating to the recoverability of assets and satisfaction ofliabilities that might be necessary should the Company be unable to continue asa going concern. The Company has engaged financial advisors to assist in theraising of additional debt or equity capital. The Company’s continuation as agoing concern is dependent upon its ability to generate sufficient cash flow tomeet its obligations on a timely basis, to comply with the terms of itsfinancing arrangements, to obtain additional financing as may be required, andultimately to attain profitability.

Certain amounts from the three- and six-month periodended June 30, 2005 have been reclassified to conform with the currentpresentation.

**(2)   Stock-Based Compensation**

Effective January 1, 2006, the Company adopted thefair value recognition provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123(R),*Share-BasedPayment* (“SFAS 123R”), using the modified-prospective-transition method.Under this transition method, compensation cost recognized for the first sixmonths of 2006 includes: (a) compensation cost for all stock-based paymentsgranted, but not yet vested as of January 1, 2006, based on the grant-date fairvalue estimated in accordance with the original provisions of SFAS No. 123, *Accounting for Stock Based Compensation*,and (b) compensation cost for all stock-based payments granted subsequent toJanuary 1, 2006, based on the grant-date fair value estimated in accordance withthe provisions of SFAS 123R. Results for prior periods have not been restated.For stock options granted to non-employees, the Company recognizes compensationexpense in accordance with the requirements of Emerging Issues Task Force (“EITF”)No. 96-18, *Accounting for Equity InstrumentsThat Are Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods or Services*. EITF 96-18 requires that companiesrecognize compensation expense based on the estimated fair value of optionsgranted to non-employees over their vesting period, which is generally theperiod during which services are rendered by such non-employees. The fair valueof unvested non-employee stock awards is re-measured at each reporting period.

Prior to January 1, 2006, consistent with theprovisions of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB25”), the Company recorded deferred compensation in the stockholders’ deficitsection of the consolidated balance sheet when stock options were granted at anexercise price that was less than the fair value of the underlying common stockat the date of grant. These amounts were recognized as stock-based compensationexpense over the vesting period. Effective January 1, 2006, as provided in SFAS123R, the Company has reversed the unamortized deferred compensation for theunvested portions of stock option grants awarded prior to the effective date ofSFAS 123R, applying the balance to additional paid-in capital.

*Stock Incentive Plan.  *In February 2004, theboard of directors adopted the 2004 Stock Incentive Plan (the “Plan”). The Planinitially covered 6,000,000 shares of the Company’s common stock issuable uponexercise of incentive stock options and non-statutory stock options and in connectionwith grants of restricted stock. The Plan was amended by the Board on June 3,2005 to, among other things, increase the number of shares available foroptions or restricted stock grants from 6,000,000 to 8,000,000. Theshareholders of the Company approved the amendment to the Plan on July 14,2005. On December 23, 2005, the board of directors approved an increase, from8,000,000 to 15,000,000, in the number of shares of common stock authorizedunder the Plan, on April 11 and 12, 2006 the board of directors approved anadditional increase, from 15,000,000 to 18,000,000, and on June 21, 2006 theboard of directors approved an additional increase, from 18,000,000 to20,000,000, in the number of shares of common stock authorized under the Plan.The shareholders of the Company ratified these amendments to the Plan on July17, 2006.

The Board has the authority to select the employees,officers, directors, consultants and advisors to whom options are granted anddetermine the terms of each option, including (i) the number of shares ofcommon stock subject to the option, (ii) when the option becomes exercisable,(iii) the option exercise price, which must be at least 100% (110% in the caseof incentive stock options granted to a stockholder owning in excess of 10% ofthe Company’s common stock) of the fair market value of the common stock as ofthe date of grant and (iv) the duration of the option, which may be up to 10years or, in the case of 

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incentivestock options issued to a stockholder owning in excess of 10% of the Company’scommon stock, five years.

As a result of the January 1, 2006 adoption of SFAS123R and stock compensation expense related to options granted tonon-employees, the Company recognized $292,584, and $375,350 in stock-basedcompensation expense for the three- and six-month periods ended June 30, 2006,respectively.

The following tableillustrates the effect on net loss and net loss per share had the Companyapplied the fair value recognition provisions of SFAS 123R in the first two quartersof 2005. For purposes of this pro-forma disclosure, the value of the options isestimated using the Black-Scholes option-pricing model and amortized to expenseover the options’ vesting periods. 

|                                                                              | ** ** | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net loss as  reported                                                        |       | $                                                     | (2,191,803 | )                                                   | $          | (3,602,722 | ) |
| Add: Stock  compensation expense included in net loss                        |       | 198,500                                               |       | 397,000                                             |       |
| Deduct: Stock  compensation expense determined under fair value based method |       | (241,458                                              | )          | (482,916                                            | )          |
| Pro-forma net  loss                                                          |       | $                                                     | (2,234,761 | )                                                   | $          | (3,688,638 | ) |
|                                                                         |       |                                                  |       |                                                |       |
| Basic and  diluted net loss per common share:                                |       |                                                  |       |                                                |       |
| As reported                                                                  |       | $                                                     | (.09       | )                                                   | $          | (0.14 | ) |
| Pro-forma                                                                    |       | $                                                     | (.09       | )                                                   | $          | (0.15 | ) |

 

The fair value of each stock award is estimated on thegrant date using the Black-Scholes option-pricing model based on theassumptions noted in the following table:

|                          | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Volatility               |       | 80                                            | %          | 80 | % |
| Risk-free  interest rate |       | 4.45 - 4.86                                   | %          | 3.55 | % |
| Expected life  (years)   |       | 5                                             |       | 5 |   |
| Dividend                 |       | None                                          |       | None |   |

 

Volatility is determined based on the Company’sestimate of fluctuation in its common stock price and its review of comparablepublic company data due to the limited amount of time that the Company’s commonstock has been publicly traded. The expected life of stock options granted isbased on the Company’s estimate of when options will be exercised in the futureas there have been limited stock option exercises to date. The expected life isgenerally applied to one group as a whole as the Company does not expectsubstantially different exercise or post-vesting termination behavior amongstits employee population. The risk-free interest rate is based on the U.S.Treasury yield curve in effect at the time of grant commensurate with theexpected life assumption.

The Company is using the straight-line attributionmethod to recognize stock-based compensation expense. The amount of stock-basedcompensation recognized during a period is based on the value of the portion ofthe awards that are ultimately expected to vest. SFAS 123R requires forfeituresto be estimated at the time of grant and revised, if necessary, in subsequentperiods if actual forfeitures differ from those estimates. The term “forfeitures”is distinct from “cancellations” or “expirations” and represents only theunvested portion of the surrendered option. The Company has applied an annualforfeiture rate of 0% to all unvested options as of June 30, 2006 as theCompany believes that forfeitures to date are not representative of likelyfuture forfeitures. This analysis will be re-evaluated quarterly and theforfeiture rate will be 

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adjustedas necessary. Ultimately, the actual expense recognized over the vesting periodwill be for only those shares that vest.

Using the Black-Scholes option-pricing model, theweighted average grant-date fair value of options granted during the six monthsended June 30, 2006 was $0.79. There were no options granted during the sixmonths ended June 30, 2005.

A summary of stock option activity as of June 30,2006, and changes during the six-month period then ended, is presented below:
| ** **                                           | ** ** | **Options  Outstanding** | ** ** | **Weighted-  average  Exercise Price** | ** ** | **Weighted-average  Remaining  Contracted Term in  Years** | ** ** | **Aggregate  Intrinsic  Value (1)** | ** ** |
|------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------------------------|------------|
|                                                 |       |                     |       |                                        |       |                                                                 |       |                                     |       |
| Outstanding at  December 31, 2005                    |       | 5,153,000                |       | $                                           | 0.31       |                                                                 |       |                                     |       |   |
| Granted                                              |       | 3,552,000                |       | $                                           | 1.20       |                                                                 |       |                                     |       |   |
| Cancelled                                            |       | (2,200,000               | )          | $                                           | 0.10       |                                                                 |       |                                     |       |   |
| Exercised                                            |       | (750,000                 | )          | $                                           | 0.10       |                                                                 |       |                                     |       |   |
| Outstanding at  June 30, 2006                        |       | 5,755,000                |       | $                                           | 0.96       |                                                                 | 9.5        |                                     | $          | 1,213,700 |   |
| Exercisable at  $0.05 at June 30, 2006               |       | 15,000                   |       | $                                           | 0.05       |                                                                 | 2.8        |                                     | $          | 15,750 |   |
| Exercisable at  $0.45 at June 30, 2006               |       | 1,760,000                |       | $                                           | 0.45       |                                                                 | 9.0        |                                     | $          | 1,144,000 |   |
| Exercisable at  $1.18 at June 30, 2006               |       | 50,000                   |       | $                                           | 1.18       |                                                                 | 9.8        |                                     | $          | — |   |
| Exercisable at $1.30 to  $1.42 at June 30, 2006 |       | 325,000                  |       | $                                           | 1.32       |                                                                 | 9.5        |                                     | $          | — |   |

----

(1)             Theaggregate intrinsic value in this table was calculated based on the positivedifference between the closing market price of the Company’s common stock atthe end of the respective period and the exercise price of the underlyingoptions.

During the six months ended June 30, 2006, the totalintrinsic value of options exercised (i.e., the difference between the marketprice at exercise and the price paid by the employee to exercise the options)was $937,500 and the total amount of cash received from exercise of theseoptions was $75,000. The total grant-date fair value of stock options thatvested during the three and six months ended June 30, 2006 was $39,500 and$87,000, respectively.

As of June 30, 2006, there was approximately$2,598,000 of total unrecognized compensation cost related to unvestedshare-based awards. This cost is expected to be recognized over a weightedaverage period of 3.0 years. The Company expects 3,605,000 shares subject tounvested options to vest in the future.

In April 2006 and December 2005, the Board ofDirectors granted stock options which have not been included in the abovecalculations because they were contingent upon the approval by the Company’sstockholders of an increase in the number of shares available for option orrestricted stock grants under the Company’s 2004 Stock Incentive Plan to atleast 18,000,000 shares.  On July 17,2006, the stockholders ratified an increase in the number of shares availableunder the Plan to 20,000,000.  Thesestock option grants are described further below.

On April 12, 2006, the Company granted stock optionsto purchase 1,270,000 shares of common stock to certain consultants, employees,and directors.  All of the options havean exercise price of $1.25 per share and an expiration date of April 12, 2016.The options were granted as compensation for consulting, employment or directorservices, as applicable. The options became vested as to 25% of the 

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totalnumber of option shares upon shareholder ratification of the increase in thenumber of shares authorized under the Company’s 2004 Stock Incentive Plan to atleast 18,000,000 shares, which occurred on July 17, 2006. Thereafter, theoptions will become vested as to an additional 6.25% of the total number of optionshares in quarterly installments beginning on September 30, 2006.

On April 11, 2006, the Company granted stock optionsto J. Keith Markley to purchase 3,052,000 shares of common stock.  Mr. Markley was also granted on that day anoption to purchase 948,000 shares of common stock contingent upon the approvalby the Company’s stockholders of an increase in the number of shares availablefor options on restricted stock grants to at least 16,000,000 shares.  As per the amendment to Mr. Markley’semployment described in Note 7, a portion of his option to purchase948,000 shares of common stock which entitled him to purchase 500,000 shareshas been cancelled.  The remaining448,000 shares subject to such option have an exercise price of $1.18 per shareand an expiration date of April 11, 2016. Each option vests with respect to one-sixth of the total number ofshares subject to the option six months after the date of grant. Each optioncontinues to vest with respect to an additional one thirty-sixth of the totalnumber of shares subject to the option on a monthly basis thereafter untilfully vested. The options will accelerate in full upon a change of control ofthe Company or a termination without cause (as defined in the employment agreement).

On December 23, 2005, the Company granted stockoptions to purchase 6,350,000 shares of common stock to certain consultants,employees, and directors. All of the stock options have an exercise price of$1.50 per share and an expiration date of December 23, 2015.  The stock options were granted ascompensation for consulting, employment or director services, asapplicable.  The options became vested asto 25% of the total number of option shares upon stockholder ratification ofthe increase in the number of shares authorized under the Company’s 2004 StockIncentive Plan to at least 15,000,000, which occurred on July 17, 2006.Thereafter, the options will become vested as to an additional 6.25% of thetotal number of option shares in quarterly installments beginning on September30, 2006.

The stock option grants on April 11 and 12, 2006, andDecember 23, 2005, subject to stockholder ratification of an amendment toincrease the number of shares issuable under the Plan, had an aggregatefair-value on the date granted by the board of directors of $8,051,252,calculated using the Black-Scholes option-pricing model.

**(3)   Income Taxes**

The Company accounts for income taxes in accordancewith SFAS No. 109, *Accounting for IncomeTaxes*(“SFAS 109”). Under SFAS 109, deferred tax assets orliabilities are computed based on the difference between the financialstatement and income tax basis of assets and liabilities, and net operatingloss carryforwards, using the enacted tax rates. Deferred income tax expense orbenefit is based on changes in the asset or liability from period to period.The Company did not record a provision for federal, state or foreign incometaxes for the six-month periods ended June 30, 2006 and 2005 because theCompany has experienced losses since inception. The Company has not recorded abenefit for deferred tax assets as their realizability is uncertain.

**(4)   Balance Sheet Detail**

Prepaidexpenses and other current assets at June 30, 2006 and December 31, 2005consisted of the following:

|                                   | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                              |       |                    |       |                        |       |
| Insurance                         |       | $                       | 106,392    |                        | $          | 44,610 |   |
| Rent                              |       | 79,042                  |       | 62,736                      |       |
| Value added tax                   |       | 70,572                  |       | 77,043                      |       |
| Non-trade  receivables            |       | 65,210                  |       | 164,472                     |       |
| Prepaid call  termination charges |       | 44,496                  |       | 44,446                      |       |
| Professional  fees                |       | —                  |       | 121,694                     |       |
| Maintenance  agreement            |       | —                  |       | 40,370                      |       |
| Software                          |       | —                  |       | 77,436                      |       |
| Prepaid  royalties                |       | —                  |       | 399,899                     |       |
| Other                             |       | 13,958                  |       | 13,089                      |       |
|                              |       | $                       | 379,670    |                        | $          | 1,045,795 |   |

 

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Other assets consisted of the following at June 30,2006 and December 31, 2005:

|                           | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                      |       |                    |       |                        |       |
| Call termination  charges |       | $                       | 22,318     |                        | $          | 21,145 |   |
| Legal deposit             |       | 4,792                   |       | 4,540                       |       |
| Rent                      |       | —                  |       | 29,522                      |       |
| Other                     |       | 2,180                   |       | 2,065                       |       |
|                      |       | $                       | 29,290     |                        | $          | 57,272 |   |

 

Accruedexpenses at June 30, 2006 and December 31, 2005 consisted of the following:

|                              | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                         |       |                    |       |                        |       |
| Professional  fees           |       | $                       | 266,777    |                        | $          | 313,897 |   |
| Payroll and  payroll-related |       | 156,319                 |       | 141,983                     |       |
| Travel                       |       | 50,171                  |       | 33,415                      |       |
| Termination  costs           |       | 36,951                  |       | 60,924                      |       |
| Interest                     |       | 23,818                  |       | 17,693                      |       |
| Repairs and  maintenance     |       | 15,047                  |       | —                      |       |
| Printing                     |       | 5,000                   |       | 14,655                      |       |
| Rent                         |       | —                  |       | 8,514                       |       |
| Directors’ fees         |       | —                  |       | 20,200                      |       |
| Other                        |       | 9,086                   |       | 16,873                      |       |
|                         |       | $                       | 563,169    |                        | $          | 628,154 |   |

 

**(5)   Comprehensive Loss**

For the three- and six-month periods ended June 30,2006 and 2005, the components of other comprehensive loss consisted of theCompany’s net loss and foreign currency translation adjustments. Comprehensiveloss was $3,511,724 and $2,225,807 for the three months ended June 30, 2006 and2005, respectively. Comprehensive loss was $7,690,716 and $3,624,104 for thesix months ended June 30, 2006 and 2005, respectively.

**(6)    Net Loss Per Share**

Basic net loss per share is computed by dividing netloss for the period by the weighted average number of common shares outstandingduring the period. Diluted net loss per share is computed by dividing net lossby the weighted average number of common shares outstanding during the periodplus the dilutive effect of potential common stock equivalents thenoutstanding. As there was a net loss for the three-and six-month periods endedJune 30, 2006, 5,755,000 outstanding stock options (excluding 6,350,000 optionsgranted on December 23, 2005, 948,000 options granted on April 11, 2006, laterreduced to 448,000 (see Note 7), and 1,270,000 granted on April 12, 2006, allpending shareholder ratification of an 

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amendmentto the 2004 Stock Incentive Plan, which was approved on July 17, 2006),24,778,725 outstanding warrants, and 8,399,999 common shares obtainable uponexercise of the conversion feature of the convertible debentures were excludedfrom the calculation of diluted earnings per share because they wereanti-dilutive. As there was a net loss for the three- and six-month periodsending June 30, 2005, 3,025,000 outstanding stock options, 9,302,500outstanding warrants, and 11,200,000 common shares obtainable upon exercise ofthe conversion feature of the convertible debentures were excluded from thecalculation of diluted earnings per share because they were anti-dilutive.

**(7)   Employment Agreements**

On April 11, 2006, the Company entered into anemployment agreement with J. Keith Markley relating to Mr. Markley’s employmentas its chief executive officer. On August 1, 2006, the Company entered into anamendment of the employment agreement in connection with a reorganization ofthe Company’s management positions.   Theamendment provides, among other things, that Mr. Markley resigns as the Company’schief executive officer and agrees to serve as the president of Vistula USA,Inc., a wholly-owned US subsidiary of the Company. Under the amended employmentagreement, the Company will pay Mr. Markley an annual base salary of $290,000and provide him with customary employment-related benefits.

The amendment also provides that, in addition to theexisting severance benefits already contained in his employment agreement, inthe event he voluntarily terminates his employment prior to a change of control(as defined in the amendment) or in the event that the Company elects toterminate his employment as a result of his repeated failure to comply withreasonable directions and instructions of the Company’s chief executive officeror board of directors in connection with the performance of his duties andresponsibilities under his employment agreement prior to a change of control,the Company will be required to make severance payments to him equivalent tothe base salary he would have received had his employment continued and tocontinue to provide medical benefits, in each case for a period of twelvemonths following termination of his employment. In the event the Companyterminates Mr. Markley’s employment without cause, the Company will be requiredto make severance payments equivalent to the base salary he would have receivedhad his employment continued and to continue to provide medical benefits, ineach case for a period of twelve months following the termination if hisemployment is terminated in his first year of employment and in each case for aperiod of eighteen months if his employment is terminated at any time after hisfirst year of employment.

The original employment agreement provided for thegrant to Mr. Markley of two non-qualified stock options to purchase shares ofcommon stock, one exercisable for 3,052,000 shares and the other exercisablefor 948,000 shares, with the latter option grant subject to the ratification bystockholders at the next annual meeting of an increase in the number of sharesavailable under the Amended and Restated 2004 Stock Incentive Plan to at least16,000,000 shares, which ratification occurred on July 17, 2006. The Company’scompensation committee approved these grants on April 11, 2006, and fixed theexercise price per share at $1.18, representing the fair market value of theCompany’s common stock on the date of grant based on the previous day’s closingprice.  In the amendment, Mr. Markleyalso agreed to waive his rights to exercise that portion of his outstandingoption to purchase 948,000 shares of common stock granted to him on April 11,2006 which entitles him to purchase 500,000 shares of common stock. Mr. Markleywill retain the right to purchase up to 448,000 shares of common stock underthat option. In the amendment, Mr. Markley also agreed to waive any claims hemight have against the Company in connection with his change in position withthe Company.

Each option vests with respect to one-sixth of thetotal number of shares subject to the option six months after the date of grant(April 11, 2006). Each option continues to vest with respect to an additionalone thirty-sixth of the total number of shares subject to the option on amonthly basis thereafter until fully vested. The options will accelerate infull upon a change of control of the Company or a termination without cause (asdefined in the employment agreement).

Mr. Markley has agreed not to engage, during hisemployment and for a period equal to the longer of (a) one year followingthe termination of his employment or (b) the period for which he isentitled to severance payments following the termination of his employment, inany activities competitive with the Company in the United States or any foreignterritory where the Company or any of its subsidiaries are conducting business.Mr. Markley also agreed, during that period, not to solicit any of the Company’semployees or the employees of 

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itssubsidiaries to leave the Company or to solicit any of the Company’s clients toterminate or curtail their business relationships with the Company.

On January 5,2006, the Company entered into an employment agreement with Ian Cope relatingto Mr. Cope’s employment as its chief operations officer. Under theemployment agreement, the Company will pay Mr. Cope an annual base salaryof $140,000 and provide him with certain employment-related benefits. Inaddition, the employment agreement provides that the Company will grantMr. Cope an incentive stock option to purchase 250,000 shares of theCompany’s common stock with an exercise price equal to $1.42 per share; 50,000of those shares subject to the option vested immediately and the remaining200,000 shares subject to the option will vest in four equal annualinstallments of 50,000 shares beginning on January 5, 2007. The option issubject to the terms and conditions of the Company’s Amended and Restated 2004Stock Incentive Plan. The employment agreement also provides that ifMr. Cope is terminated without cause, the Company will pay him his basesalary for three months.

OnFebruary 28, 2006, the Company finalized an agreement with Mark Scullyresolving matters relating to his cessation of employment as president andchief executive officer of Vistula USA, one of the Company’s wholly-ownedsubsidiaries, on November 2, 2005. In connection with a mutual release ofclaims, the Company paid Mr. Scully $50,000 in severance and issued to him750,000 shares of common stock in respect of the exercise of an outstandingoption issued under the Company’s Amended and Restated 2004 Stock IncentivePlan.

**(8)   Related Party Transactions**

On March 10, 2006, on behalf of the Company, theCompany’s Chairman, Rupert Galliers-Pratt (the “Chairman”), advanced $75,000directly to an escrow agent, allowing the Company to fulfill a contractualcommitment in the normal course of business. The deposit was returned to theChairman in full on March 27, 2006.

**(9)   Commitments and Contingencies**

Since its inception, the Company has sustained itsoperations through funding provided by the Company’s  Chairman, as well as contributed services bythe Chairman and other stockholders, and debt and equity financings. The Chairmanhas made various advances to the Company from a credit facility established inthe name of the Chairman, as well as other of the Chairman’s personal assets.The Company may obtain future advances from the Chairman from both the creditfacility and the Chairman’s other personal assets in order to meet certainworking capital needs. The Chairman may also cause the lender under the creditfacility to issue standby letters of credit in favor of one or more of theCompany’s vendors to secure the Company’s obligations to such vendor orvendors. While the Chairman is not obligated to provide these advances to theCompany or to cause the lender to issue standby letters of credit in favor ofthe Company’s vendors, the Company expects the Chairman to continue providingfunds for operations in 2006 as and if needed, until such time that the Companyraises additional external capital. In the absence of external capital, theCompany will continue to be dependent on the Chairman to fund existingoperations and provide growth capital. Although the Company raised asubstantial amount of capital from third parties during the six months endedJune 30, 2006 (see Note 15), there can be no assurances that the Company cancontinue to raise such capital on acceptable terms, if at all.

On January 27, 2006, the Company entered into aFinancial Advisory Agreement (the “Agreement”) with Indigo Ventures LLC (“Indigo”)in which the Company agreed to appoint Indigo as its financial advisor toadvise, consult with, and assist the Company in various matters which mayinclude:

·                  areview of the Company’s business, operations and financial condition, includingadvising the Company on capitalization structures;

·                  advicerelating to general capital-raising matters;

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·                  recommendationsrelating to specific business operations, transactions and joint ventures;

·                  adviceregarding future financings involving the Company or any of the Company’saffiliates’ debt or equity securities; and

·                  assistancein connection with the due diligence review of any significant acquisitiontransactions proposed by the Company during the term of the agreement.

In consideration for these services, the Companyagreed to pay Indigo a cash fee of $20,000 per month in arrears, increasing to$30,000 per month beginning in the first month following the consummation of asignificant debt or equity financing from which the Company obtains grossproceeds of at least $5 million. Following the May 2006 financing described inNote 15, the monthly cash fee payable to Indigo increased to $30,000.  Also, the Company issued to Indigo 1,500,000restricted shares of common stock, which shares vested on May 22, 2006 upon theclosing of the financing described in Note 15. The shares the Company issued to Indigo are restricted shares and maynot be sold, assigned or transferred by Indigo for a one (1) year periodbeginning on January 27, 2006 and ending on January 27, 2007. If the Companyterminates the Agreement as a result of a material breach of this Agreement byIndigo, the Company will have the right and option to repurchase fifty percent(50%) of all of the then unvested shares at a purchase price of $0.001 pershare.

On March 30, 2006 the Company entered into a revolvingcredit agreement with Indigo Investments I LLC that provides for up to$5,000,000 in advances to be available to the Company. Upon the closing of thiscredit facility, $1,000,000 was advanced to the Company and an additional$250,000 was advanced under the credit agreement in April 2006. Additionaladvances under the credit facility are dependent upon the Company’s accountsreceivable balances and adherence to certain covenants as described in thecredit agreement. Outstanding principal under this credit facility bearsinterest at a rate of 1.5% per month, increasing to 2.5% per month in the eventof a default by the Company under the credit agreement. In addition, theCompany is required to pay the lender a 2.25% commitment fee on the totalamount of the credit facility and issue the lender a five-year warrant topurchase up to 500,000 shares of common stock at an exercise price of $1.50 pershare. The exercise price of the warrant is subject to adjustment in certaincircumstances.

All outstanding principal and interest on the creditfacility plus the commitment fee became due and payable on May 22, 2006, whichwas the earlier of (i) September 30, 2006, or (ii) the closing of the sale of aminimum of $6,000,000 of the Company’s equity securities. As the financingclosed prior to September 30, 2006, the Company also paid the lender an earlyrepayment fee equal to 2.25% of the total amount of the credit facility. Therights of the lender under the credit facility are junior to those of theoutstanding convertible debentures. Advances drawn under this agreement wereguaranteed by the Company’s Chairman.

A portion of the cash received due to the sale ofunits consisting of common stock and warrants described in Note 15, was used onMay 24, 2006, to pay down the credit facility in its entirety including allinterest accrued, commitment fees, and early repayment fees. Also, the sale ofunits consisting of common stock and warrants described in Note 15, resulted inan anti-dilution adjustment to the exercise price of the outstanding warrantsdescribed above. Such adjustment reduced the exercise price of such warrantsfrom $1.50 to $1.34 per share of common stock and increased the number ofexercisable shares related to such warrants from 500,000 to 559,701.

**(10)         Indemnification**

As permitted under Delaware law, the Company hasagreements with its directors whereby it indemnifies them for certain events oroccurrences while they are, or were serving, at the Company’s request as adirector (or in any other capacity). The term of the indemnification period isthe director’s lifetime. The maximum potential amount of future payments theCompany could be required to make under 

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theseindemnification agreements is unlimited; however, the Company has a directorand officer insurance policy pursuant to which the Company may recover all or aportion of amounts it pays to directors under their indemnification agreements.As a result of its insurance policy coverage, the Company believes theestimated fair value of these indemnification agreements is minimal.

The Company enters into standard indemnificationagreements in the ordinary course of its business. Pursuant to theseagreements, the Company indemnifies, holds harmless, and agrees to reimbursethe indemnified party for losses suffered or incurred by the indemnified party,generally distributors, agents, or customers, in connection with any patent,copyright, trademark, trade secret or other intellectual property infringementclaim by any third party with respect to the Company’s products. The term ofthese indemnification agreements is generally perpetual. The maximum potentialamount of future payments the Company could be required to make under theseindemnification agreements is often capped at a dollar figure. In addition, theCompany has agreed to indemnify the investors in the private placementfinancings described in Note 12 and 15 against certain losses arising under theSecurities Act for misleading statements or omissions by the Company containedin a registration statement or prospectus relating to securities being sold bysuch investors. The Company has never incurred costs to defend lawsuits orsettle claims related to these indemnification agreements. As a result, theCompany believes the estimated fair value of these agreements is minimal.

**(11)         ConvertiblePromissory Note to Related Party**

On July 2, 2004, the Company entered into a notesubscription agreement with the J. Rothschild Assurance Self Invested PersonalPension Plan No. 2, the sole beneficiary of which is the Company’s Chairman,Rupert Galliers-Pratt. The note subscription agreement was amended and restatedon August 11, 2004. Under the amended and restated note subscription agreement,the Company issued and sold to Mr. Galliers-Pratt’s pension plan convertiblepromissory notes in the principal amounts of $125,000 and $50,000 on July 12,2004 and on August 11, 2004, respectively. Both convertible promissory noteshave a one year term, accrue interest at the rate of 7% per annum and areconvertible into shares of the Company’s common stock at the price of $1.50 pershare. On August 11, 2005, the pension plan confirmed its earlier agreement toextend the maturity date of both promissory notes until December 31, 2005. OnDecember 15, 2005, the pension plan confirmed its earlier agreement to extend thematurity date of both promissory notes until June 30, 2006.  On June 30, 2006, the pension plan confirmedits earlier agreement to extend the maturity date of both promissory notesuntil December 31, 2006.

**(12)         ConvertibleDebentures and Warrant Financing**

On February 18, 2005 and March 4, 2005, the Companyissued and sold convertible debentures and warrants to certain sophisticatedinstitutional and individual investors pursuant to a securities purchaseagreement between the Company and the investors. In the two closings of theprivate placement under the securities purchase agreement, the Company soldconvertible debentures in the aggregate principal amount of $8,400,000,convertible into common stock of the Company at $0.75 per share, and warrantsto purchase an aggregate of 8,400,000 shares of common stock, at an exerciseprice of $1.00 per share. These warrants expire five years after the issuedate.

The debentures accrue interest daily at a rate of 8%per annum, which interest is payable quarterly on each March 31, June 30,September 30 and December 31 following the issue date. The final interestpayment is due on the date of maturity of the debentures, the third anniversaryof the issue date. In addition, on any date on which all or a portion of the principalof a debenture is converted, all unpaid interest having accrued on suchprincipal at the time of such conversion will become immediately payable. TheCompany is not permitted to prepay any portion of the principal amount of anyof the debentures without the prior consent of the holder thereof.

The debentures are convertible at the option of theholders into shares of common stock at any time at an initial conversion priceof $0.75 per share. Except in the case of certain designated issuances, in theevent the Company issues shares of common stock or common stock equivalents(i.e., securities convertible into, or exercisable or exchangeable for, sharesof common stock) at a price per share (or in the

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case ofcommon stock equivalents, a conversion, exercise or exchange price per share)below the then applicable conversion price of the debentures, the conversionprice of the debentures will be reduced to that lower price per share.Issuances that will not result in adjustment to the conversion price includeissuances to employees, consultants, directors or officers pursuant to a stockor option plan adopted by the Company’s board of directors, securities issuedupon conversion of other securities outstanding prior to the date of issuanceof the warrants, warrants issued in connection with obtaining bank financing,common stock issued in connection with the settlement of claims, and securitiesissued in connection with acquisitions, joint ventures or other strategictransactions.

The Company has agreed to certain restrictions underthe terms of the debentures, including a prohibition on the payment of cashdividends to stockholders while any of the debentures are outstanding. Upon theoccurrence of an event of default under the debentures, an amount equal to (i)130% of the then outstanding principal amount, plus any accrued and unpaidinterest thereon, or (ii) the product of the then outstanding principal amount,plus any accrued and unpaid interest thereon, times the ratio obtained bydividing the conversion price of the debentures and the market price of theCompany’s common stock, whichever is greater, will, at the holder’s option,become immediately due and payable in cash along with any other amounts, costs,expenses or liquidated damages then due in respect of such debentures. Theratio referred to in clause (ii) is to be calculated based on the conversionprice in effect on the date of such default or the date the accelerated amountis paid in full (whichever is less), and the market price of the Company’scommon stock on the date of such default or the date the accelerated amount ispaid in full (whichever is greater, such market price to be determined inaccordance with the terms of the debenture). Upon an event of a default, theinterest rate on the debentures will also be increased to 18% per annum.

Events of default under the debentures include failureto pay any amounts under the debentures when due, a material default under theCompany’s other agreements with the investors or default in the Company’sobligations under mortgage, credit facility or similar agreements, a materialinaccuracy in the representations and warranties made to the investors inconnection with the convertible debenture and warrant financing, and theinitiation of voluntary or involuntary bankruptcy proceedings against theCompany.

Of the $8,400,000 aggregate principal amount ofconvertible debentures sold, through June 30, 2006, $2,100,000 in outstandingprincipal has been converted into 2,799,993 shares of common stock, reducingthe amount of interest required to be paid in future periods, with $6,300,000in principal remaining outstanding at June 30, 2006.  In the Company’s consolidated balance sheetat June 30, 2006, the remaining principal of $6,300,000 has been reduced by unamortizeddebt discount of $690,637.

The common stock purchase warrants issued to theinvestors are exercisable at an initial exercise price of $1.00. The warrantshave an expiration date of five years after the date of issuance. They containa cashless exercise provision whereby the holder may pay the exercise price byhaving the Company withhold upon exercise shares having a fair market valueequal to the applicable aggregate exercise price if after the first anniversaryof the date of issuance of the warrant there is no effective registrationstatement registering, or no current prospectus available for, the resale ofthe shares issuable upon the exercise of the warrants. In the event thisprovision is used with respect to an exercise, the Company would receive noproceeds from the sale of its common stock in connection with suchexercise.  The warrants were initiallyexercisable for an aggregate 8,400,000 shares of common stock. As of June 30,2006, the Company had issued 3,190,499 shares upon exercise of warrants, all inconnection with the warrant exercise agreements described below.

The exercise price is subject to adjustment in theevent of certain issuances of new securities. Specifically, except in the caseof certain designated issuances, if the Company issues shares of common stockor common stock equivalents (i.e., securities convertible into, or exercisableor exchangeable for, shares of the Company’s common stock) at a price per share(or in the case of common stock equivalents, a conversion, exercise or exchangeprice per share) below the then applicable exercise price of the warrants, theexercise price of the warrants will be reduced to that lower price per share.In the event of such an adjustment, the number of shares for which the warrantsare exercisable will be increased such that the aggregate exercise price of thewarrants after the adjustment will equal the aggregate exercise price

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immediatelyprior to the adjustment. Issuances that will not result in adjustment to theexercise price include issuances to employees, consultants, directors orofficers pursuant to a stock or option plan adopted by the Company’s board ofdirectors, securities issued upon conversion of other securities outstandingprior to the date of issuance of the warrants, warrants issued in connectionwith obtaining bank financing, common stock issued in connection with thesettlement of claims, and securities issued in connection with acquisitions,joint ventures or other strategic transactions.

In connection with the two closings of the privateplacement, the Company paid placement fees in the aggregate amount of $802,500to the placement agent. At the second closing, the Company also issued to theplacement agent a warrant to purchase up to 802,500 shares of common stock atan initial exercise price of $1.00 per share. The warrant, which expires onMarch 4, 2010, is on substantially the same terms as the warrants issued to theinvestors in the private placement.

The Company registered for resale under the SecuritiesAct of 1933, as amended (the “Securities Act”), the shares underlying thedebentures and warrants pursuant to a registration statement on Form SB-2, asamended (File No. 333-123815). The registration statement was declaredeffective on May 3, 2005.

*Warrant Exercise Agreements. *In October 2005, theCompany entered into several warrant exercise agreements with holders ofwarrants issued in the private placement that closed in the first quarter of2005. Pursuant to these agreements, the Company issued to these holders newcommon stock purchase warrants exercisable for a number of shares equal to thenumber of shares they purchased upon exercise of the warrants issued to them inthe private placement. These new warrants have an exercise price of $1.50 pershare. The Company received aggregate proceeds of $3,190,499 in connection withthe exercise of the prior warrants, and issued new warrants, which expire fiveyears after the issue date, to purchase an aggregate of 3,190,499 shares ofcommon stock (plus an additional warrant, which expires five years after theissue date, to purchase 159,525 shares of common stock to a placement agent whoassisted with the transaction). The shares of common stock underlying thesewarrants have been registered for resale with the Securities and ExchangeCommission pursuant to a registration statement on Form SB-2 (File No.333-130808). This registration statement was declared effective on January 31,2006.

**(13)         Distributionand Marketing Agreement**

On August 11, 2004, the Company entered into adistribution and marketing agreement with NetYantra Inc. (“NetYantra US”)  and NetYantra India Pvt. Ltd. (“NetYantraIndia”, with NetYantra US and NetYantra India being hereinafter referred tocollectively as “NetYantra”) pursuant to which NetYantra granted to the Companythe exclusive worldwide rights (other than in India where NetYantra isheadquartered and subject to certain existing distribution agreements) tomarket and distribute the V-CubeTM IP-PBX software platform developed byNetYantra to Tier 1 carriers, telecommunications equipment manufacturers,internet service providers, large corporations, SMEs and other businessentities and individual retail customers. Under this agreement, the Companypaid NetYantra $400,000 and was required to pay NetYantra fifty percent ofcertain net revenues that the Company derived from the distribution of theV-CubeTM platform.

In addition, the agreement stated that in the eventthat the Company’s common stock was quoted or traded on a stock market on orbefore the first anniversary of the agreement, the Company would issue toNetYantra shares of the Company’s common stock having a market value of$1,000,000 based on the opening price of the Company’s common stock on thefirst day of trading (or, at the Company’s option, pay to NetYantra a cashpayment of $1,000,000 instead of issuing such shares). On July 21, 2005, publictrading in the Company’s common stock began jointly on the OTC Bulletin Boardand the Pink Sheets Electronic Quotation Service under the trading symbol “VSTL.”  The opening sale was at a price of $2.00 pershare. The Company issued 500,000 shares of its common stock to NetYantra incompliance with the agreement.

On May 1, 2006, the Company executed and delivered anAsset Purchase Agreement with NetYantra relating to the V-CubeTM IP-PBX softwareplatform. See Note 14. The distribution and marketing agreement was terminatedupon closing of the acquisition of the V-CubeTM platform and associatedintellectual property under the Asset Purchase Agreement on June 7, 2006.

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**(14)         Purchase ofSoftware and Intellectual Property**

Effective April 28, 2006, Vistula executed anddelivered an Asset Purchase Agreement (the “Purchase Agreement”) withNetYantra. Under the terms of the Purchase Agreement, Vistula agreed topurchase NetYantra’s V-Cube IP-PBX platform software and associatedintellectual property that the Company was licensed to market and distributepursuant to the distribution and marketing agreement described in Note 13above. The purchase price for the software and associated intellectual propertywas $8.8 million in cash, 14 million shares of Vistula’s common stock (the “ShareConsideration”) and the outstanding prepaid amount ($399,189) for royalties dueon future net revenues that was paid under the terms of the distribution and marketingagreement described in Note 13 above. Completion of the acquisition was subjectto Vistula obtaining sufficient financing to pay the cash portion of thepurchase price, the negotiation of ancillary agreements between the parties(including a services agreement under which NetYantra will provide support anddevelopment services with respect to the acquired software and a registrationrights agreement under which Vistula will grant NetYantra US certain rights torequire registration of the shares received as part of the purchase price forresale under the Securities Act), and completion, to Vistula’s satisfaction, ofa due diligence review in connection with the acquisition and customary closingconditions.

On May 11, 2006, the Company and NetYantra enteredinto an amendment (“Amendment No. 1”) to the Purchase Agreement. The effect ofAmendment No. 1 was to allow the Company to issue, at the closing, such portionof the Share Consideration as may be validly delivered by it and to defer theissuance of the remaining portion of the Share Consideration until a date on orbefore the fifth business day immediately following the date on which theCompany amended its certificate of incorporation to increase the shares ofcommon stock authorized thereunder; provided, however that such amendment wouldoccur not later than August 31, 2006.

On June 7, 2006 the Company and NetYantra entered intoa second amendment to the Purchase Agreement (“Amendment No. 2”). The effect ofAmendment No. 2 was to add several new sections to the Purchase Agreementrequiring the Company and NetYantra to use commercially reasonable efforts tonegotiate and execute within sixty (60) days following the closing of the assetpurchase transaction a license and revenue agreement, a services agreement andan executive employment agreement. Further, Amendment No. 2 also provides thatduring the term of the services agreement and for 12 months thereafter neitherthe Company nor NetYantra will solicit for hire, directly or indirectly, anemployee, subcontractor or consultant of the other party, without that otherparty’s written consent. Finally, Amendment No. 2 contains a provision thatrequires NetYantra to take all necessary steps to terminate certain designatedagreements between NetYantra and third parties. On August 3, 2006, the Company and NetYantra agreed to a 30 dayextension to negotiate and execute a license and revenue agreement, a servicesagreement, and an executive employment agreement.

On June 7, 2006, in connection with the PurchaseAgreement, as amended, the Company entered into a Registration Rights Agreementwith NetYantra US (the “Registration Rights Agreement”) which providesNetYantra US with certain registration rights with respect to the shares beingissued to NetYantra US pursuant to the Purchase Agreement (“RegistrableSecurities”). Under the terms of the Registration Rights Agreement, if at anytime after the earlier of (i) the second anniversary of the date of thatagreement or (ii) the date on which a persons or persons acting in concert whoare not shareholders of the Company as at the date of that agreement acquire ina transaction or series of related transactions an aggregate of at least thirtypercent (30%) of the then outstanding shares of common stock of the Company,the Company receives a request from NetYantra US that it requests aregistration with respect to the Registrable Securities then outstanding, thenthe Company shall as soon as practicable, and in any event within forty-five(45) days after the date such request is given by NetYantra US, file aregistration statement under the Securities Act, covering all RegistrableSecurities then outstanding. NetYantra US also has the right to request thatthe Registrable Securities be registered if the Company proposes to registerany of its stock or

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othersecurities under the Securities Act in connection with the public offering ofsuch securities solely for cash.

On June 7, 2006, Vistula completed the acquisition ofcertain assets of NetYantra for an aggregate purchase price of $8.8 million incash and the Share Consideration. In accordance with the terms of the PurchaseAgreement, as amended, 10,068,833 shares of the Share Consideration were issuedto NetYantra US at the closing, and recorded at the day’s closing stock priceof $1.22 per share.  The remaining sharesto be issued (3,931,167) were accrued for at June 30, 2006 at $1.22 per share($4,796,024).  The remaining shares comprisingthe Share Consideration were issued as of July 19, 2006, following the approvedincrease in the Company’s authorized common stock by its stockholders at theannual meeting held on July 17, 2006. The source of the cash portion of thepurchase price was funds the Company had received in a common stock and warrantfinancing that closed on May 22, 2006 (see Note 15).

The Company recorded the acquisition of the V-CubeTMIP-PBX platform software and associated intellectual property as an asset inJune 2006 at a total of $26,279,189 ($8.8 million in cash, 14 million shares at$1.22 per share, and the outstanding prepaid royalty amount of $399,189).  The Company has determined that the assetwill be amortized over a five year estimated useful life beginning on July 1,2006, which coincides with the first V-CubeTM product launch by one of theCompany’s customers.  On July 19, 2006,the remaining Share Consideration of 3,931,167 shares was issued to NetYantra US.

**(15)         Stock andWarrant Purchase Agreement**

On May 22, 2006, the Company entered into a stock andwarrant purchase agreement with 23 accredited investors whereby the Companysold 16,300,000 units consisting of one share of common stock and eight-tenthsof one warrant to acquire one share of common stock. The effective purchaseprice of the units was $1.00 per unit. In exchange for the units sold, theCompany received gross cash proceeds of $16,300,000. The Company issuedwarrants for 13,040,000 common stock shares. The warrants are exercisable until May 22, 2011 at an exercise price of$1.00 per share.

CRT Capital Group LLC (“CRT”) acted as the placementagent in connection with the offering. The aggregate commissions payable to CRTin connection with the private placement were approximately $978,000. Inaddition, the Company issued warrants to the placement agent to purchase1,467,000 shares of common stock similar to those sold to the investors.

The Company realized net proceeds from the sale ofunits, after deducting placement agent fees and expenses, of approximately$15.2 million. The Company used a portion of these proceeds to purchase thesoftware and intellectual property rights of NetYantra’s V-CubeTM IP-PBXplatform as described in Note 14 ($8.8 million); pay the outstanding principal,interest and fees related to the revolving credit agreement with IndigoInvestments I LLC described in Note 9 ($1.5 million); and pay the outstandingprincipal and interest related to a promissory note for equipment ($0.8million).

The Company agreed to register the resale of theshares of common stock sold in the offering and issuable upon exercise of thewarrants. The Company was required to file the registration statement with theSecurities and Exchange Commission (“SEC”) within forty-five (45) days of theclosing and use its best efforts to cause the registration statement to bedeclared effective under the Securities Act no later than the earlier of (i)ninety (90) days (or in the case of a full review one hundred and twenty (120)days) after the closing date and (ii) the sixth (6th) business day followingthe date on which the Company is notified by the SEC that the registrationstatement will not be reviewed or is no longer subject to further review andcomments. The Company is required to use its best efforts to keep theregistration statement continuously effective under the Securities Act untilthe earlier of the date when all the registrable securities covered by theregistration statement have been sold or are freely saleable and the secondanniversary of the closing. In the event that the registration statement is nottimely filed or declared effective when due, or after effectiveness ceases toremain effective, the Company is obligated to make cash payments in the natureof liquidated damages up to a limit of 10% of the purchase price of theunits.  A registration statement wasfiled on June 30, 2006 and became effective on July 14, 2006.

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**(16)         SubsequentEvents**

On July 17, 2006, the stockholders of the Companyapproved an amendment to the Company’s Certificate of Incorporation to increaseto 200,000,000 the number of shares of common stock, par value $.001, theCompany is authorized to issue (the “Amendment”). The Amendment becameeffective on July 18, 2006 upon the filing of the Amendment with the DelawareSecretary of State’s office.

On July 17, 2006, the stockholders of the Company ratifiedan amendment to the Company’s 2004 Stock Incentive Plan to increase the numberof shares available for issuance thereunder to 20,000,000 shares.  Upon approval of the amendment to the Plan,the Board-approved options granted on December 23, 2005 (6,350,000), April 11,2006 (448,000) and April 12, 2006 (1,270,000), became issued and outstandingfor financial reporting purposes.  SeeNote 2.

On July 19, 2006, following the approved increase inthe Company’s authorized common stock by its stockholders at the annual meetingheld on July 17, 2006, the Company issued the remaining 3,931,161 shares toNetYantra US in accordance with the Purchase Agreement, as amended.

Effective August 1, 2006, the Company reorganized themanagement structure of Vistula and its wholly-owned subsidiaries, Vistula Limitedand Vistula USA, Inc. As part of the reorganization, Rupert Galliers-Pratt willretain his position as Chairman and President of Vistula CommunicationsServices, Inc. and will also now serve as its Chief Executive Officer. AdamBishop will continue to serve as Chief Executive Officer of Vistula Limited,Vistula’s UK-based subsidiary and has resigned as President of Vistula USA,Inc., Vistula’s US operating company. Keith Markley has assumed the position ofPresident of Vistula USA, Inc., and has resigned as Chief Executive Officer ofVistula. Mr. Markley will continue to serve on the Board of Directors ofVistula.  Jared Taylor has been appointedthe Company’s Chief Financial Officer.

Effective August 1, 2006, Mr. Rupert-Galliers-Pratthas been appointed by the Company’s board of directors as chief executiveofficer to replace Mr. Markley, effective upon Mr. Markley’s resignation fromthat position. Mr. Galliers-Pratt has served as chairman of the Company’s boardof directors since its inception. He served as the Company’s president andchief executive officer from the Company’s inception until September 1, 2004and resumed service in those capacities on February 8, 2005 until April 11,2006 when he resigned as chief executive officer upon the appointment of Mr.Markley to that position. He also serves as chairman of the board of directorsof the Company’s wholly-owned subsidiaries, Vistula Limited, Vistula USA, Inc.and Cardlink Services Limited.

On August 1, 2006, the Company entered into anamendment of the employment agreement with Keith Markley, the Company’s formerchief executive officer, in connection with the reorganization of the Company’smanagement positions described above. The amendment provided, among other things, that Mr. Markley resign asthe Company’s chief executive officer and that he agree to serve as thepresident of Vistula USA, Inc., the Company’s wholly-owned US subsidiary. Theamendment also amended Mr. Markley’s employment agreement to provide that, inaddition to the existing severance benefits already contained in his employmentagreement, in the event he voluntarily terminates his employment prior to achange of control (as defined in the amendment) or in the event that theCompany elects to terminate his employment as a result of his repeated failureto comply with reasonable directions and instructions of the Company’s chiefexecutive officer or the Company’s board of directors in connection with theperformance of his duties and responsibilities under his employment agreementprior to a change of control, the Company will be required to make severancepayments to him equivalent to the base salary he would have received had hisemployment continued and to continue to provide medical benefits, in each casefor a period of twelve months following termination of his employment.

In the amendment, Mr. Markley also agreed to waive hisrights to exercise that portion of his outstanding option to purchase 948,000shares of the Company’s common stock granted to him on April 11, 2006 whichentitles him to purchase 500,000 shares of the Company’s common stock. He willretain the right to purchase up to 448,000 shares of the Company’s common stockunder that option. In the

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amendment,Mr. Markley also agrees to waive any claims he might have against the Companyin connection with his change in position with the Company.

Effective August 1, 2006, Jared Taylor has beenappointed as the Company’s Chief Financial Officer, Treasurer and Secretaryfollowing the resignation of George Vaughn of Vaughn & Associates, P.C.,who was serving in these capacities under a consulting agreement between theCompany and Vaughn & Associates, P.C. Mr. Taylor was promoted from hisprior position of Manager of Accounting and Administration, a position he heldsince he joined the Company in July 2005. In connection with Mr. Taylor’spromotion to the role of chief financial officer, the Company has agreed to payMr. Taylor an annual base salary of $125,000 and to grant him an incentivestock option to purchase up to 200,000 shares of the Company’s commonstock.  The option has an exercise priceof $0.65 per share, representing the fair market value of the Company’s commonstock on the date of grant (July 28, 2006). The option vests in four equalannual installments of 50,000 shares commencing on the first anniversary dateof the date of option grant and thereafter on each subsequent anniversary ofthe date of option grant until fully vested. The option shall become fullyvested upon a change of control (as defined in his option agreement).

**Item 2.****                          Management’s Discussion andAnalysis of Financial Condition and Results of Operations.**

**Introduction**

The following information should be read inconjunction with the financial statements and notes thereto in Part I, Item 1of this Quarterly Report and with Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contained in our Annual Report onForm 10-KSB for the year ended December 31, 2005 (File No. 000-50758).

**Cautionary Statements**

We do not provide forecasts of our future financialperformance. However, from time to time, information provided by us orstatements made by our employees may contain “forward-looking” information thatinvolves risks and uncertainties. In particular, statements contained in thisQuarterly Report that are not historical facts constitute forward-lookingstatements and are made under the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. Forward-looking statements involvesubstantial risks and uncertainties. You can identify these statements byforward-looking words such as “may”, “will”, “expect”, “anticipate”, “believe”,“estimate”, “continue”, and similar words. You should read forward-lookingstatements carefully because they: (1) discuss our future expectations; (2)contain projections of our future operating results or financial condition; or(3) state other “forward-looking” information. Various factors described below,as well as any other instances of cautionary language in this Quarterly Report,refer to or provide examples of risks, uncertainties and events that may causeour actual results to be materially different than the expectations describedin our forward-looking statements. You should be aware that the occurrence ofany of the events or factors described below and elsewhere in this QuarterlyReport could materially and adversely affect our business. All forward-lookingstatements included in this Quarterly Report are based on information availableto us on the date hereof, and we assume no obligation to update any suchforward-looking statements.

Each forward-looking statement should be read inconjunction with the financial statements and notes thereto in Part I, Item 1of this Quarterly Report, this section, and Management’s Discussion andAnalysis of Financial Condition and Results of Operations contained in ourAnnual Report on Form 10-KSB for the year ended December 31, 2005 (FileNo.000-50758), including but not limited to the section therein entitled “FactorsAffecting Future Performance.”

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In addition to the risks and uncertainties facedgenerally by participants in the telecommunication industry, we face thefollowing risks and uncertainties:

·                                          Wehave a limited operating history; therefore, we may not be able to accuratelyforecast future results and operating losses in future periods could be greaterthan expected.

·                                          Ifwe do not obtain a substantial amount of additional financing, we may have tocurtail or suspend operations.

·                                          Wemay continue to lose money on our operations.

·                                          Ifwe fail to establish the Vistula and Cardlink brands or to attract repeatcustomers, we may not be able to increase our revenues sufficiently to fund ouroperations.

·                                          Wehave only limited revenue of which a significant portion is derived from alimited number of contracts and customers. If we are unable to replacecontracts upon completion and maintain customer relationships, we could have asignificant decrease in our revenues that would negatively impact our results.

·                                          Wemay experience significant fluctuations in our results as a result ofuncertainties relating to our ability to generate additional revenues, manageour expenditures and other factors, certain of which are outside of ourcontrol.

·                                          Ourcontracts typically contain provisions giving customers the ability toterminate their contracts under various circumstances and we may not be able toreplace the revenues from such contracts that may have an adverse effect on ourrevenues and operating results.

·                                          Wemay not be able to promptly reduce expenses in response to any decrease in ourrevenues, which would result in lower net margins.

·                                          Ifwe are unable to collect receivables from development stage customers and othertelecommunications companies, our operating results may be materially harmed.

·                                          Theextent of our dependence on international operations may give rise to increasedmanagement challenges and could harm our results of operations.

·                                          Providingservices outside the United States carries the additional risk of currencyfluctuations and foreign exchange controls imposed by certain countries sincemany of our non-U.S. projects are undertaken in local currency.

·                                          Ourinability to anticipate or adapt to changes in technology may harm ourcompetitive position, reputation and opportunities for revenue growth.

·                                          Wemay not be able to hire or retain a sufficient number of qualified engineersand other employees to meet our customers’ needs or maintain the quality of ourservices.

·                                          Futureacquisitions of new companies or technologies may result in disruption to ourbusiness and expose us to risks associated with acquisitions.

·                                          Theconsolidation of telecommunication service providers could adversely impact ourbusiness.

·                                          Governmentregulations may adversely affect our business.

·                                          Ifwe fail to retain our key personnel and attract and retain additional qualifiedpersonnel, we might not be able to meet our customers’ needs.

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·                                          Themanagement of our finances and the quality and timeliness of our financialreporting may be adversely affected if we are unable to increase the size andcapabilities of our internal administrative and finance function as ourbusiness grows.

·                                          Wewill not be successful if we do not grow our customer base beyond our initialcustomers.

·                                          Ifwe do not respond rapidly to technological changes or to changes in industrystandards, our products and services could become obsolete.

·                                          Wewill not retain customers or attract new customers if we do not anticipate andmeet specific customer requirements and if our products and services do notadequately interoperate with our customers’ existing networks.

·                                          Ifwe fail to compete successfully, our ability to increase our revenues orachieve profitability will be impaired.

·                                          Ourbusiness is exposed to the general conditions of the telecommunications market.

·                                          Themarkets for wholesale voice services (particularly VoIP services) and pre-payproducts are new and evolving and, if these markets do not develop as expected,then it could have a material adverse effect on our business.

·                                          Intellectualproperty infringement claims against us or any of our subsidiaries, evenwithout merit, could require us to enter into costly licenses or deprive us ofthe technology we need.

·                                          Failureto protect our intellectual property rights could have a material adverseeffect on our business.

·                                          Ifour products contain defects, then our sales are likely to suffer, and we maybe exposed to legal claims.

·                                          Wemay be subject to litigation.

Because of the foregoing and other factors, we mayexperience material fluctuations in our future operating results on a quarterlyor annual basis which could materially adversely affect our business, financialcondition and operating results.

**Overview**

Vistula Communications Services, Inc. (“VCS”, the “Company”or “we”) currently has three wholly-owned subsidiaries: Vistula Limited (“Vistula”),Vistula USA, Inc. (“Vistula USA”) and Cardlink Services Limited (“Cardlink”),and has one subsidiary that is 60% owned, Vistula Communications Services SA(Pty) Ltd. (“Vistula SA”). Through Vistula and Vistula USA, we currentlyprovide wholesale value-added telecommunications services (including direct andpartner voice routing services) to Tier 1 and Tier 2 telecommunication carriersand transit operators. In the first quarter of 2005, through Vistula, VistulaUSA, and Vistula SA we began to market our V-CubeTM Voice over InternetProtocol, or “VoIP,” IP-PBX software platform to telecommunications carriers,Internet service providers, or “ISPs,” large corporations and small and mediumenterprises, or “SMEs,” throughout the world.

Through our Cardlink subsidiary we plan to market anddistribute electronic top-up software, which enables prepayment for servicesprovided by mobile telephone operators, and associated services to Tier 1 andTier 2 telecommunications carriers and transit network operators throughout theworld. Cardlink 

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hasdeveloped a software product suite that enables mobile operators toelectronically process prepayments from “pay-as-you-go” mobile phone customers.

***Vistula, Vistula USA, and Vistula SA***

Vistula, Vistula USA, and Vistula SA are aggregatorsof wholesale telecommunications services to Tier 1 and Tier 2telecommunications carriers and transit network operators. Vistula, VistulaUSA, and Vistula SA are collectively referred to as the “Vistula Companies.”The Vistula Companies have switching facilities in London and Los Angeles andinterconnect agreements with suppliers and customers in these locations. Webelieve that the Vistula Companies are well positioned to take advantage of thedisruption and uncertainty in the telecommunications sector over the past fewyears. We believe the opportunity for well-managed and well-financed wholesalecarriers is significant.

The Vistula Companies began to actively market ourV-CubeTM IP-PBX platform to carriers, transit network operators, largecorporations, and SMEs in the first quarter of 2005. We expect this multiplefeature VoIP platform, which will enable customers to convert their existingPBX phone systems to provide VoIP capability without the need for significantinvestment in new hardware, will provide the Vistula Companies with a highlycompetitive VoIP solution.

On April 1, 2005, we entered into a distribution andmarketing agreement with Telstra Europe Limited, a U.K.-basedtelecommunications carrier. Under this agreement, we license Telstra Europe toprovide hosted IP-PBX services to its customers using the hosted V-CubeTM IP-PBXplatform. The agreement grants Telstra Europe an exclusive license to providethe hosted solution to its customers in the United Kingdom and Ireland for aperiod of five years. The monthly license fee payable by Telstra Europe to usis based on the number of individual users at the various Telstra Europecustomers who are using the VoIP services provided by Telstra Europe throughuse of the V-CubeTM platform. We anticipate leveraging the marketing advantagesand customer relationships of Telstra Europe to provide us with regular monthlyrevenue. On July 3, 2006, Telstra Europe launched IP-PBX services to itscustomers using the hosted V-CubeTM IP-PBX platform.

Cardlink was first acquired by Rupert Galliers-Prattand certain members of his family in April 2003. VCS acquired Cardlink throughthe share exchange completed in March 2004. Cardlink will offer an electronictop-up, or “ETU”, software product suite which will enable mobile operators toelectronically process prepayments from “pay-as-you-go” customers. Cardlink’sproducts will allow these customers to “electronically top-up” their accountswith the mobile operator. We believe that the market for these prepaymentservices is expanding both in the developed and in the underdeveloped regionsin the world and we believe that Cardlink’s ETU product will be of value as newmobile operators throughout the world seek to adopt this technology.

We believe that the potential for providing ETUservices in markets where the adoption and use of mobile telephony is growingrapidly will create opportunities and long-term growth potential for Cardlink.We intend that Cardlink will typically receive a percentage of the total mobilerevenues transacted through the Cardlink system. As a result, Cardlink will bea beneficiary of any increase in mobile telephony revenues without anyinvestment of capital in building infrastructure. We currently expect to usethird parties to provide necessary software updates, maintenance and supportfor these activities.

**Recent Developments**

On May 22, 2006, we completed a private placement ofunits with 23 accredited investors whereby we sold 16,300,000 units consistingof one share of common stock and eight-tenths of one warrant to acquire oneshare of common stock.  The effectivepurchase price of the units was $1.00 per unit. In an exchange for the units sold, we received gross proceeds of$16,300,000.  The warrants areexercisable until May 22, 2011 at an exercise price of $1.00 per share.  See Note 15.

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On June 7, 2006, we purchased NetYantra’s VoIP IP-PBXplatform software and associated intellectual property. We previouslydistributed this software as the V-CubeTM VoIP IP-PBX platform offering under adistribution and marketing agreement with NetYantra. The V-CubeTM VoIP IP-PBXplatform enables telecom carriers and internet service providers to offer abroad range of IP telephony services from simple IP telephone calls to videoconferencing to their customers.

The purchase price for the software and associatedintellectual property was $8.8 million in cash, 14 million shares of our commonstock and $399,189 in prepaid royalties. See Note 14.

Following ratification of an amendment to the Company’sCertificate of Incorporation to increase to 200,000,000 the number of shares ofcommon stock, par value $.001, the Company is authorized to issue, and an amendmentto the Company’s 2004 Stock Incentive Plan to increase the number of sharesavailable for issuance thereunder to 20,000,000 shares, the Board-approvedoptions granted on December 23, 2005 (6,350,000), April 11, 2006 (448,000) andApril 12, 2006 (1,270,000), became issued and outstanding for financialreporting purposes. On July 19, 2006, following the approved increase in theCompany’s authorized common stock, the Company issued the remaining 3,931,161shares to NetYantra US in accordance with the Purchase Agreement, as amended. 

Effective August 1, 2006, the Company reorganized themanagement structure of Vistula and its wholly-owned subsidiaries, Vistula Limitedand Vistula USA, Inc. As part of the reorganization, Rupert Galliers-Pratt willretain his position as Chairman and President of Vistula CommunicationsServices, Inc. and will also now serve as its Chief Executive Officer. AdamBishop will continue to serve as Chief Executive Officer of Vistula Limited,Vistula’s UK-based subsidiary and has resigned as President of Vistula USA,Inc., Vistula’s US operating company. Keith Markley has assumed the position ofPresident of Vistula USA, Inc., and has resigned as Chief Executive Officer ofVistula. Mr. Markley will continue to serve on the Board of Directors ofVistula.  Jared Taylor has been appointedthe Company’s Chief Financial Officer. See Note 16.

**Critical Accounting Policies**

Our consolidated financial statements are prepared inaccordance with accounting principles generally accepted in the United States.These accounting principles require us to make certain estimates, judgments andassumptions. We believe that the estimates, judgments and assumptions uponwhich we rely are reasonable based upon information available to us at the timethat these estimates, judgments and assumptions are made. These estimates,judgments and assumptions can affect the reported amounts of assets andliabilities as of the date of the financial statements, as well as the reportedamounts of revenues and expenses during the periods presented. Those estimatesand judgments are based on management’s historical experience, the terms ofexisting agreements, our observance of trends in the industry, information thatwe obtain from our customers and outside sources, and on various otherassumptions that management believes to be reasonable and appropriate under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. To the extent there are material differences between theseestimates, judgments or assumptions and actual results, our financialstatements will be affected.

We believe that the following accounting policiesreflect our more significant judgments and estimates used in the preparation ofour financial statements.

*Revenue Recognition*.   Our revenue is derived primarily from feescharged to terminate voice services over our network. We recognize suchrevenue, net of reserves, when persuasive evidence of a sales arrangementexists, delivery has occurred or services have been rendered, the sales priceis fixed and determinable and collectibility is reasonably assured. We reservefor potential billing disputes at the time revenue is recognized or the disputeis known. Such disputes can result from disagreements with customers regardingthe duration, destination or rates charged for each call. These revenueallowances are based on estimates derived from factors that include, but arenot limited to, historical results, analysis of credits issued, currenteconomic trends and changes in demand. Amounts billed in advance of the servicemonth are recorded as deferred revenue and recognized as revenue as theunderlying services are rendered.

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Reciprocal compensation is the amount paid by onecarrier to complete particular calls on another local exchange carrier’snetwork. Reciprocal compensation paid to and received from other carriers isbased on contractual fixed rate per minute charges. We apply the receipt ofreciprocal compensation against the cost of reciprocal compensation and reflectthe net amount as either revenue (receipts greater than costs) or expense(costs greater than receipts) at each settlement date.

We have entered into transactions such as buying,selling, swapping or exchanging capacity to complete and complement ournetwork. In general, these transactions represent the exchange of productiveassets not held for sale in the ordinary course of business and, as such, donot result in the culmination of the earnings process. Accordingly, we do notrecognize any revenue for these types of transactions. We account for theexchange of a non-monetary asset based on the recorded amount of thenon-monetary asset relinquished with no gain or loss recognized in accordancewith Accounting Principles Board (APB) Opinion No. 29, *Accounting for Non-Monetary Transactions*.

*Stock-Based Compensation*.Commencing on January 1, 2006 we began applying the provisions of Statement ofFinancial Accounting Standards (SFAS) No. 123R, *Share Based Payment*, or SFAS 123R, in accounting forstock-based compensation. SFAS 123R requires measurement of the cost ofemployee services received in exchange for an award of equity instruments basedon the grant-date fair value of the award. That cost is recognized over theperiod during which an employee is required to provide service in exchange forthe award (usually the vesting period). Prior to January 1, 2006, we followedAccounting Principles Board (APB), Opinion No. 25, *Accounting for Stock Issued to Employees*, or APB 25, andrelated interpretations, in accounting for our stock-based compensation plans,rather than the alternative fair-value method provided for under SFAS No. 123, *Accounting for Stock-Based Compensation*,or SFAS 123. In the notes to our financial statements, we provide pro-formadisclosures in accordance with SFAS 123. We account for transactions in whichservices are received from non-employees in exchange for equity instrumentsbased on the fair value of such services received or of the equity instrumentsissued, whichever is more reliably measured, in accordance with SFAS 123 andthe Emerging Issues Task Force (EITF) Issue 96-18, *Accounting for Equity Instruments That Are Issued to Other thanEmployees for Acquiring, or in Conjunction with Selling, Goods or Services*,or EITF 96-18.

Accounting for equity instruments granted or sold byus under APB 25, SFAS 123, SFAS 123R and EITF 96-18 requires fair-valueestimates of the equity instrument granted or sold. If our estimates of thefair value of these equity instruments are too high or too low, our expensesmay be over- or understated. For equity instruments granted or sold in exchangefor the receipt of goods or services, we estimate the fair value of the equityinstruments based upon consideration of factors that we deem to be relevant atthat time. Because shares of our common stock were not publicly traded prior toJuly 21, 2005, market factors historically considered in valuing stock andstock option grants included comparative values of public companies discountedfor the risk and limited liquidity provided for in the shares we are issuing;prior valuations of stock grants and the effect of events that occurred betweenthe time of such grants; economic trends; and the comparative rights andpreferences of the security being granted compared to the rights andpreferences of our other outstanding equity.

Prior to July 21, 2005, the fair value of our commonstock was determined by our board of directors contemporaneously with thegrant. In the absence of a public trading market for our common stock, ourboard of directors considered numerous objective and subjective factors indetermining the fair value of our common stock. At the time of option grants andother stock issuances, our board of directors considered the status of privateand public financial markets; valuations of comparable private and publiccompanies; the likelihood of achieving a liquidity event such as an initialpublic offering; our existing financial resources; our anticipated continuingoperating losses and increased spending levels required to meet our businessplan; dilution to common stockholders from anticipated future financings; and ageneral assessment of future business risks.

**Results of Operations**

Net revenues for the three-month period ended June 30,2006 were $237,919 which represents an increase of $7,789 (3.4%) over the$230,130 in net revenues for the three-month period ended June 30,

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2005.Net revenues for the six-month period ended June 30, 2006 were $557,338 whichrepresents an increase of $205,011 (58.2%) over the $352,327 in net revenuesfor the six-month period ended June 30, 2005. These increases are primarilyattributable to an increase in wholesale revenues from UK customers.

Cost of revenues for the three-month period ended June30, 2006 were $324,091, an increase of 53.2% over the $211,511 in thethree-month period ended June 30, 2005. Cost of revenues for the six-monthperiod ended June 30, 2006 were $675,604, an increase of 69.0% over the$399,780 in the six-month period ended June 30, 2005. The increase for thethree-month period ended June 30, 2006 is primarily due to the increased costof our co-location facilities in both the United States and the United Kingdom.  The increase for the six-month period endedJune 30, 2006 is primarily due to an increase in wholesale revenues and cost ofco-location facilities in both the United States and the United Kingdom.  Both increases for the three- and six-monthperiods ended June 30, 2006 over the respective periods in 2005 are net ofengineering costs classified as costs of revenue. For the three-month periodended June 30, 2006 engineering costs classified as costs of revenue of $42,606decreased 63.1% as compared to the same period in fiscal 2005, and engineeringcosts classified as costs of revenue for the six-month period ended June 30,2006 of $85,807 decreased 53.1% compared to the same period in fiscal2005.  Both three and six month decreasesin engineering costs are due to reductions in personnel costs.

Selling, general and administrative costs for thethree-month period ended June 30, 2006 were $3,125,449, an increase of 70.8%over the $1,829,600 for the three-month period ended June 30, 2005. Selling,general and administrative costs for the six-month period ended June 30, 2006were $6,966,029, an increase of 131.2% over the $3,012,704 for the six-monthperiod ended June 30, 2005. During the three-month period ended June 30, 2006,we incurred non-cash expenses of $231,945 as a result of the issuance of awarrant to a financial advisory firm as compensation for its services to us,and $410,845 as a result of the issuance of a warrant to the lender as partialcompensation for the revolving credit facility described in Note 9, which wasfully repaid during the three-month period ended June 30, 2006. In addition, weincurred increases in expenses for the three-month period ended June 30, 2006associated with our periodic public company filing requirements including professionaland consulting fees, public and investor relations fees, public companyrecordkeeping costs, and insurance. We also incurred increases in operationalexpenses due to the growing needs of the business, including compensation ofadditional employees and consultants, marketing and engineering activitiesrelated to our VoIP product offering, increased rental costs for ourfacilities, and fees for the establishment of a revolving credit facility, netof a decrease in travel and entertainment expenses.

During the six-month period ended June 30, 2006, weincurred non-cash expenses of $1,875,000 as a result of the issuance of commonstock to a financial advisory firm as partial compensation for its services tous, $231,945 as a result of the issuance of a warrant to a financial advisoryfirm as partial compensation for its services to us, and $410,845 as a resultof the issuance of a warrant to the lender as partial compensation for therevolving credit facility described in Note 9, which was fully repaid duringthe six-month period ended June 30, 2006. In addition, we incurred increases inexpenses for the six-month period ended June 30, 2006 associated with ourperiodic public company filing requirements including professional andconsulting fees, public and investor relations fees, public companyrecordkeeping costs, insurance, and printing. We also incurred increases inoperational expenses due to the growing needs of the business includingcompensation of additional employees and consultants, expenses relating tomaintenance and support agreements of purchased telecommunications equipment,marketing and engineering activities related to our VoIP product offering,increased rental costs for our facilities, and fees for the establishment of acredit facility, net of a decrease in travel and entertainment expenses.

Interest expense, net for the three-month period endedJune 30, 2006 of $298,773 decreased 21.5% compared to $380,822 for thethree-month period ended June 30, 2005. Interest expense, net for the six-monthperiod ended June 30, 2006 of $613,876 increased 13.1% over the $542,565 forthe six-month period ended June 30, 2005. During the three-month period ended June 30, 2006 interest expense, netdecreased over the respective period in fiscal 2005 primarily due to a lowerlevel of debt as the result of $2.1 million of convertible debentures beingconverted in late 2005, net of an increase in interest earned on cash balancesfrom the revolving credit facility described in Note 9 and from proceeds obtainedfrom the stock and warrant purchase agreement described in Note 15.  During the six-month period ended June 30,

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2006the increase in interest expense, net is attributable to interest expense onthe revolving credit facility described in Note 9, together with increasedconvertible debenture interest due to the debentures being outstanding for theentire six-month period ended June 30, 2006.

The non-cash expense for employee compensation forstock options for the three-month periods ended June 30, 2006 and June 30, 2005was $270,068 and $198,500, respectively. The non-cash expense for employee compensation for stock options for thesix-month periods ended June 30, 2006 and June 30, 2005 was $330,171 and$397,000, respectively.  The non-cashexpense for non-employee compensation for stock options for the three-monthperiods ended June 30, 2006 and June 30, 2005 was $22,516 and $0,respectively.  The non-cash expense fornon-employee compensation for stock options for the six-month periods endedJune 30, 2006 and June 30, 2005 was $45,179 and $0, respectively.

For the three-month period ended June 30, 2006, weincurred a net loss of $3,510,394 or $0.08 net loss per common share, basic anddiluted.  For the six-month period endedJune 30, 2006, we incurred a net loss of $7,698,171 or $0.20 net loss percommon share, basic and diluted.

**Liquidity And Capital Resources**

As of June 30, 2006, we had cash and cash equivalentsof approximately $2,468,000 and a working capital deficit of approximately$3,303,000. This represents an increase in cash and cash equivalents ofapproximately $1,915,000 from December 31, 2005 and an increase in the workingcapital deficit of approximately $2,961,000 from that at December 31, 2005.Since our inception through June 30, 2006, we have generated losses ofapproximately $24,275,000. Accounts receivable were approximately $102,000 atJune 30, 2006, a decrease of approximately $29,000 from December 31, 2005.Accounts payable and accrued liabilities at June 30, 2006 increased approximately$5,051,000 from December 31, 2005, of which approximately $4,796,000 has beenaccrued for the outstanding payment due in common stock to NetYantra for thesoftware and intellectual property acquisition described in Note 14.

We have made cash expenditures for capital equipmentfrom our inception until June 30, 2006 of approximately $11,210,000, inconnection with the purchase of telecommunications equipment necessary to beginour business.

On May 22, 2006, we entered into a stock and warrantpurchase agreement with 23 accredited investors whereby we sold 16,300,000units. Each unit consists of one share of our common stock and eight-tenths ofone warrant to acquire one share of common stock and was sold at a purchaseprice of $1.00 per unit. In exchange for the units sold, we received gross cashproceeds of $16,300,000. The warrants are exercisable until May 2011 at anexercise price of $1.00 per share.

CRT Capital Group LLC (“CRT”) acted as the placementagent in connection with the offering. The aggregate commissions payable to CRTin connection with the private placement were approximately $978,000. Inaddition, we issued warrants to the placement agent to purchase 1,467,000shares of common stock similar to those sold to the investors.

We realized net proceeds from the sale of units, afterdeducting placement agent fees and expenses, of approximately $15.2 million. Weused a portion of these proceeds to purchase the software and intellectualproperty rights of NetYantra’s V-Cube IP-PBX platform as described below ($8.8million); paid the outstanding principal, interest and fees related to therevolving credit agreement with Indigo Investments I LLC described in Note 9($1.5 million); and paid the outstanding principal and interest related to a promissorynote for equipment ($0.8 million).  Wewill need to obtain additional financing in order to sustain our operations.

On May 1, 2006, we executed and delivered an Asset PurchaseAgreement with NetYantra relating to the V-CubeTM IP-PBX software platform. OnJune 7, 2006, we completed the acquisition of software and intellectualproperty for $8.8 million in cash and 10,068,833 shares of common stock, withthe remaining 3,931,167 shares of common stock being issued on July 19, 2006,as permitted by the second amendment to the purchase agreement.  The terms of this agreement are described inNote 14.

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As of June 30, 2006, we have $6,300,000 of 8%convertible debentures outstanding, out of the original $8,400,000 principalamount issued in March 2005. For financial reporting purposes, the remainingprincipal of $6,300,000 has been reduced by unamortized debt discount ofapproximately $700,000. The debentures accrue interest daily at a rate of 8%per annum, which interest is payable quarterly on each March 31, June 30,September 30 and December 31 following the issue date. The final interestpayment is due on the date of maturity of the debentures, the third anniversaryof the issue date. In addition, on any date on which all or a portion of theprincipal of a debenture is converted, all unpaid interest having accrued onsuch principal at the time of such conversion will become immediately payable.We are not permitted to prepay any portion of the principal amount of any ofthe debentures without the prior consent of the holder thereof.

The debentures are convertible at the option of theholders into shares of our common stock at any time at an initial conversionprice of $0.75 per share. Except in the case of certain designated issuances,in the event we issue shares of common stock or common stock equivalents (i.e.,securities convertible into, or exercisable or exchangeable for, shares of ourcommon stock) at a price per share (or in the case of common stock equivalents,a conversion, exercise or exchange price per share) below the then applicableconversion price of the debentures, the conversion price of the debentures willbe reduced to that lower price per share. Issuances that will not result inadjustment to the conversion price include issuances to employees, consultants,directors or officers pursuant to a stock or option plan adopted by our boardof directors, securities issued upon conversion of other securities outstandingprior to the date of issuance of the warrants, warrants issued in connectionwith obtaining bank financing, common stock issued in connection with thesettlement of claims, and securities issued in connection with acquisitions,joint ventures or other strategic transactions.

We have agreed to certain restrictions under the termsof the debentures, including a prohibition on the payment of cash dividends toour stockholders while any of the debentures are outstanding. Upon theoccurrence of an event of default under the debentures, an amount equal to (i)130% of the then outstanding principal amount, plus any accrued and unpaidinterest thereon, or (ii) the product of the then outstanding principal amount,plus any accrued and unpaid interest thereon, times the ratio obtained bydividing the conversion price of the debentures and the market price of ourcommon stock, whichever is greater, will, at the holder’s option, becomeimmediately due and payable in cash along with any other amounts, costs,expenses or liquidated damages then due in respect of such debentures. Theratio referred to in clause (ii) is to be calculated based on the conversionprice in effect on the date of such default or the date the accelerated amountis paid in full (whichever is less), and the market price of our common stockon the date of such default or the date the accelerated amount is paid in full(whichever is greater, such market price to be determined in accordance withthe terms of the debenture). Upon an event of a default, the interest rate onthe debentures will also be increased to 18% per annum.

Events of default under the debentures include failureto pay any amounts under the debentures when due, a material default under ourother agreements with the investors or default in our obligations undermortgage, credit facility or similar agreements, a material inaccuracy in therepresentations and warranties we made to the investors in connection with theconvertible debenture and warrant financing, and the initiation of voluntary orinvoluntary bankruptcy proceedings against us.

Through June 30, 2006, $2,100,000 in outstandingprincipal amount of convertible debentures has been converted into 2,799,993shares of common stock, reducing the amount of interest required to be paid infuture periods.

The common stock purchase warrants issued to theinvestors are exercisable at an initial exercise price of $1.00. The warrantshave an expiration date of five years after the date of issuance. They containa cashless exercise provision whereby the holder may pay the exercise price byhaving us withhold upon exercise shares having a fair market value equal to theapplicable aggregate exercise price if after the first anniversary of the dateof issuance of the warrant there is no effective registration statementregistering, or no current prospectus available for, the resale of the sharesissuable upon the exercise of the warrants. In 

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theevent this provision is used with respect to an exercise, we would receive noproceeds from the sale of our common stock in connection with such exercise.The warrants were initially exercisable for an aggregate 8,400,000 shares ofour common stock. As of June 30, 2006, we had issued 3,190,499 shares uponexercise of warrants, all in connection with the warrant exercise agreementsdescribed below. The exercise price is subject to adjustment in the event ofcertain issuances of new securities. Specifically, except in the case ofcertain designated issuances, if we issue shares of common stock or common stockequivalents (i.e., securities convertible into, or exercisable or exchangeablefor, shares of our common stock) at a price per share (or in the case of commonstock equivalents, a conversion, exercise or exchange price per share) belowthe then applicable exercise price of the warrants, the exercise price of thewarrants will be reduced to that lower price per share. In the event of such anadjustment, the number of shares for which the warrants are exercisable will beincreased such that the aggregate exercise price of the warrants after theadjustment will equal the aggregate exercise price immediately prior to theadjustment. Issuances that will not result in adjustment to the exercise priceinclude issuances to employees, consultants, directors or officers pursuant toa stock or option plan adopted by our board of directors, securities issuedupon conversion of other securities outstanding prior to the date of issuanceof the warrants, warrants issued in connection with obtaining bank financing, commonstock issued in connection with the settlement of claims, and securities issuedin connection with acquisitions, joint ventures or other strategictransactions.

We also issued to the placement agent a warrant topurchase up to 802,500 shares of our common stock at an initial exercise priceof $1.00 per share. The warrant, which expires on March 4, 2010, is onsubstantially the same terms as the warrants issued to the investors in theprivate placement.

We have registered for resale under the Securities Actthe shares underlying the debentures and warrants pursuant to a registrationstatement on Form SB-2, as amended, (File No. 333-123815). The registrationstatement was declared effective on May 3, 2005.

In October 2005, we entered into several Warrant ExerciseAgreements with holders of warrants issued in the private placement that closedin the first quarter of 2005. Pursuant to these agreements, we issued to theseholders new common stock purchase warrants exercisable for a number of sharesequal to the number of shares they purchased upon exercise of the warrantsissued to them in the private placement. These new warrants have an exerciseprice of $1.50 per share. We received aggregate proceeds of $3,190,499 inconnection with the exercise of the prior warrants, and issued new warrants,which expire five years after the issue date, to purchase an aggregate of3,190,499 shares of our common stock (plus an additional warrant, which expiresfive years after the issue date, to purchase 159,525 shares of common stock toa placement agent who assisted with the transaction). The shares of commonstock underlying these warrants have been registered for resale with theSecurities and Exchange Commission pursuant to a registration statement on FormSB-2 (File No. 333-130808). This registration statement was declared effectiveon January 31, 2006.

We expect that we will need to raise additional debtor equity financing to pay the required interest and principal payments underthe convertible debentures issued in our private placement.

On May 23, 2006, we paid the remaining principalamount ($770,000) and any unpaid interest originally payable pursuant to apromissory note for an aggregate principal amount of $1,170,000 issued in March2005 in connection with our purchase of certain telecommunications equipment(including two Sonus Networks switches) from MRS.

We do not believe that our available cash and cashequivalents, including the cash proceeds from the recently completed privateplacement described above, will be sufficient to meet our working capitalrequirements, including the funding of operating losses, and capitalexpenditure requirements for our next fiscal year. Previously, our primarysources of capital have been the revenues generated from interconnectagreements with our customers, debt and equity financings, and advances made byone of our principal stockholders from a credit facility established in thename of the stockholder and other of the stockholder’s personal assets.

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In the event that we do not succeed in implementingour business plan, and do not otherwise raise additional third-party capital,we will have to curtail certain expenditures, seek additional financing fromour principal stockholder, or both in order to sustain operations. As notedabove, the principal stockholder has historically provided working capitaladvances. While the stockholder is not obligated to provide these workingcapital advances to us, we expect the stockholder to continue providing funds foroperations as and if needed, until such time that our operations areself-sustaining or we raise additional external capital, as the case may be.

Our plans for growth and expansion will require theneed for additional capital in the future. As a result, we may have to relyupon the issuance of additional debt or equity securities in order to continueto grow our business as well as to fund the negative cash flow we haveexperienced to date, and may experience in the future, as a result of theseactivities. If additional funds are raised through the issuance of equitysecurities, our existing stockholders may experience significant dilution. Inthe absence of achieving profitable operations in future periods, obtainingadditional capital through asset sales, securing a revolving credit facility,debt or equity offerings, or a combination of the foregoing, we may encounterliquidity difficulties. No assurance can be given that we will be able to raiseadditional capital when needed, or at all, or that such capital, if available,will be on acceptable terms.

To date, inflation has not had a material impact onour financial results. There can be no assurance, however, that inflation willnot adversely affect our financial results in the future.

**Other Arrangements and Obligations**

On December 13, 2005, we entered into a Consultant,Representative and Professional Services Agreement with QuestTelecommunications, Inc. (“Quest”). Under this agreement, we have appointedQuest as an independent advisor and our exclusive representative in thegeographic areas of Vietnam, Cambodia, Malaysia and Turkey (and any other areasto which we and Quest agree in writing). Within these geographic areas, Questwill (i) assist in structuring and establishing business relationships, includingintroducing us and the V-CubeTM IP-PBX software platform to potential partners,distributors, licensees and/or purchasers, and (ii) provide project managementservices relating to business operations, including developing revenue targets,establishing technical support capability, facilitating technical supportdelivery, and monitoring license fee reconciliation. Quest will also act as ouragent for the V-CubeTM to consumers from, but residing outside, the geographicarea covered by this agreement (except for consumers residing in territoriesfor which we or any of our affiliates have granted or hereafter grant exclusivedistribution or agency rights).

Under this agreement, we paid Quest $50,000 inconsideration for Quest’s assistance relating to the execution by us and SaigonPost and Telecommunications Services Corporation (“SPT”) of a memorandum ofunderstanding and pilot license agreement with respect to the V-CubeTM. Thememorandum of understanding, which we entered into on September 20, 2005,contemplates that, following legal and technical evaluation of the V-CubeTMplatform by SPT, SPT and the Company will negotiate and enter into an agreementwith respect to the deployment and commercialization of the V-CubeTM platform inVietnam. The pilot license agreement, which we entered into on October 15,2005, permitted SPT to use the V-CubeTM platform for evaluation and testingpurposes on a royalty-free basis from November 15, 2005 through February 15,2006.

We entered into a distribution and marketing agreementwith SPT with respect to the V-CubeTM on July 3, 2006.  Upon signing this agreement, we are obligatedto issue to Quest 300,000 shares of our common stock and to pay to Quest$150,000 in cash, plus a continuing commission of thirty percent of the licensefees we receive from SPT in connection with the licensing and distribution ofthe V-CubeTM in the above-mentioned geographic areas (net of sales, use andvalue added taxes, if any, payable by us in connection with such license fees).

OnJanuary 27, 2006, we entered into a Financial Advisory Agreement (the “Agreement”)with Indigo Ventures LLC (“Indigo”) in which we agreed to appoint Indigo as ourfinancial advisor to advise, consult with, and assist us in various matterswhich may include:

·                  a review of ourbusiness, operations and financial condition, including advising us on capitalizationstructures;

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·                  advicerelating to general capital raising matters;

·                  recommendationsrelating to specific business operations, transactions and joint ventures;

·                  adviceregarding future financings involving our or any of our affiliates’ debt or equitysecurities; and

·                  assistancein connection with the due diligence review of any significant acquisitiontransactions proposed by us during the term of the agreement.

In consideration for these services, we have agreed topay Indigo a cash fee of $20,000 per month in arrears, increasing to $30,000per month beginning in the first month following the consummation by us of asignificant debt or equity financing from which we obtain gross proceeds of atleast $5 million. Following the May 2006 financing described in Note 15, themonthly cash fee payable to Indigo increased to $30,000.  Also, we issued to Indigo 1,500,000restricted shares of our common stock, which shares vested on May 22, 2006 uponthe closing of the financing described in Note 15. The shares we issued toIndigo are restricted shares and may not be sold, assigned or transferred byIndigo for a one (1) year period beginning on January 27, 2006 and ending onJanuary 27, 2007. If we terminate the Agreement as a result of a materialbreach of this Agreement by Indigo, we will have the right and option torepurchase fifty percent (50%) of all of the then unvested shares at a purchaseprice of $0.001 per share.

*Guaranty of Vistula Limited.  *One of our subsidiaries,Vistula, had agreed to unconditionally guarantee the obligations of one of ourprincipal stockholders under a $3,000,000 credit facility established in thename of the stockholder. This guarantee was released by the financialinstitution on March 27, 2006.

**Item 3. **** Controlsand Procedures.**

Evaluationof Disclosure Controls and Procedures

Based on Company management’s evaluation (with theparticipation of the Company’s principal executive officer and principalfinancial officer), as of the end of the period covered by this report, theCompany’s principal executive officer and principal financial officer haveconcluded that the Company’s disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, asamended, (the “Exchange Act”)) are effective to ensure that informationrequired to be disclosed by the Company in reports that it files or submitsunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission rules andforms.

It should be noted that any system of controls,however well designed and operated, can provide only reasonable, and notabsolute, assurance that the objectives of the system are met. In addition, thedesign of any control system is based in part upon certain assumptions aboutthe likelihood of future events. Because of these and other inherentlimitations of control systems, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.

Changesin Internal Control over Financial Reporting

The Company’s management, in connection with itsevaluation of internal controls (with the participation of the Company’sprincipal executive officer and principal financial officer), did not identifyany change in internal control over the financial reporting process thatoccurred during the Company’s second fiscal quarter of 2006 that would havematerially affected, or would have been reasonably likely to materially affect,the Company’s internal control over financial reporting.

 

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**PART II. OTHERINFORMATION**

**Item 1:  Legal Proceedings**

None.

**Item 2.  Unregistered Sales of Equity Securities**

None.

**Item 3.  Defaults Upon Senior Securities**

None.

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

None.

**Item 5.  Other Information**

** **None.

**Item 6. Exhibits**

**     (a) Exhibits.**
|             | ** ** | ** **                                                                                                                                                                   | ** ** | ** **                          | ** ** | ** **                              | ** ** |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------------|------------|
| **Exhibit** | ** ** | ** **                                                                                                                                                                   | ** ** | **Filed with  this Form** | ** ** | **Incorporated by Reference** | ** ** |
| **Number**  | ** ** | **Exhibit Description**                                                                                                                                                 | ** ** | **10-QSB**                          | ** ** | **Form**                                | ** ** | **Filing Date** | ** ** | **Exhibit No.** | ** ** |
| 2.1         |       | Asset Purchase Agreement  by and among Vistula Communications Services, Inc., NetYantra, Inc. and  NetYantra India Private Limited dated as of April 28, 2006                |       |                                |       | Form 8-K                                |       | May 2, 2006 |   | 2.1 |   |
| 2.2         |       | Amendment No. 1 to the  Asset Purchase Agreement by and among Vistula Communications Services, Inc.,  NetYantra, Inc. and NetYantra India Private Limited dated May 11, 2006 |       |                                |       | Form 8-K                                |       | June 13, 2006 |   | 2.1 |   |
| 2.3         |       | Amendment No. 2 to the  Asset Purchase Agreement by and among Vistula Communications Services, Inc.,  NetYantra, Inc. and NetYantra India Private Limited dated June 7, 2006 |       |                                |       | Form 8-K                                |       | June 13, 2006 |   | 2.2 |   |
| 2.4         |       | Registration Rights  Agreement by and between Vistula Communications Services, Inc. and NetYantra,  Inc. dated  June 7, 2006                                                 |       |                                |       | Form 8-K                                |       | June 13, 2006 |   | 2.3 |   |
| 3.1         |       | Certificate of  Incorporation filed with the Delaware Secretary of State on September 22,  2003                                                                              |       |                                |       | Form 10-SB                              |       | May 12, 2004 |   | 3.1 |   |
| 3.2         |       | Certificate of  Amendment of Certificate of Incorporation filed with the Delaware Secretary  of State on January 23, 2004                                                    |       |                                |       | Form 10-SB                              |       | May 12, 2004 |   | 3.2 |   |

 

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| 3.3  |   | Certificate of  Amendment of Certificate of Incorporation filed with the Delaware Secretary  of State on March 4, 2004                                                                                                                                 |   |   |   | Form 10-SB |   | May 12, 2004   |   | 3.3    |   |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|------------|--------|----------------|--------|--------|--------|
| 3.4  |   | Certificate of  Amendment of Certificate of Incorporation filed with the Delaware Secretary  of State on July 18, 2006                                                                                                                                 |   |   |   | Form 8-K   |   | July 20, 2006  |   | 3.1    |   |
| 10.1 |   | Employment  Agreement with John Keith Markley dated  April 11, 2006                                                                                                                                                                                    |   |   |   | Form 8-K   |   | April 14, 2006 |   | 10.1   |   |
| 10.2 |   | Stock and  Warrant Purchase Agreement by and among Vistula Communications Services, Inc.  and the Investors named therein dated May 19, 2006                                                                                                           |   |   |   | Form 8-K   |   | May 22, 2006   |   | 99.2   |   |
| 10.3 |   | Registration  Rights Agreement by and among Vistula Communications Services, Inc. and the  Holders named therein dated May 22, 2006                                                                                                                    |   |   |   | Form 8-K   |   | May 22, 2006   |   | 99.3   |   |
| 10.4 |   | Form of Investor  Common Stock Purchase Warrant                                                                                                                                                                                                        |   |   |   | Form 8-K   |   | May 22, 2006   |   | 99.4   |   |
| 10.5 |   | Form of  Placement Agent Common Stock Purchase Warrant                                                                                                                                                                                                 |   |   |   | Form 8-K   |   | May 22, 2006   |   | 99.5   |   |
| 10.6 |   | Placement Agency  Agreement with CRT Capital Group LLC dated May 19, 2006                                                                                                                                                                              |   |   |   | Form 8-K   |   | May 22, 2006   |   | 99.6   |   |
| 31.1 |   | Certification by Rupert  Galliers-Pratt pursuant to Rule 13a-14(a) and 15d-14(a), as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, relating to  Vistula Communications Services, Inc.                        |   | X      |   |       |   |           |   |   |   |
| 31.2 |   | Certification by Jared  P. Taylor pursuant to Rule 13a-14(a) and 15d-14(a), as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, relating to  Vistula Communications Services, Inc.                              |   | X      |   |       |   |           |   |   |   |
| 32.1 |   | Certification by Rupert  Galliers-Pratt pursuant to Section 1350, Chapter 63 of Title 18, United  States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002, relating to Vistula Communications Services, Inc. |   | X      |   |       |   |           |   |   |   |
| 32.2 |   | Certification by Jared  P. Taylor pursuant to Section 1350, Chapter 63 of Title 18, United  States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002, relating to Vistula Communications Services, Inc.       |   | X      |   |       |   |           |   |   |   |

 

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**SIGNATURES**

In accordance with the requirements of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                       | Vistula Communications Services, Inc. |
|-----------------------|---------------------------------------|
|                  |                                  |   |
| Date: August 14, 2006 | By:                                   | /s/ Rupert Galliers-Pratt |
|                  |                                  | Rupert Galliers-Pratt |
|                  |                                  | Chief Executive Officer |

 

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