**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM10–K/A**

 

**Amendment No. 1**

 
| **ý****ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|-----------------------------------------------------------------------------------------------------------|
|                                                                                                      |
| **FOR THE FISCAL YEAR ENDED DECEMBER 31,  2004**                                                     |
| ** **                                                                                                |
| **OR**                                                                                                    |
| ** **                                                                                                |
| **o****TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|                                                                                                      |
| **COMMISSION FILE NUMBER: 000–27707**                                                                |
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| **AETHER  SYSTEMS, INC.**                                                                                 |
| (EXACT NAME OF REGISTRANT AS SPECIFIED IN  ITS CHARTER)                                                   |

 

| **DELAWARE**                                                                        | ** ** | **52-2186634**                        |
|-------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     |       | (IRS Employer  Identification Number) |
|                                                                                |       |                                  |
| **621 E. Pratt St., Suite 601, Baltimore, MD**                                      | ** ** | **21202**                             |
| (Address of principal executive offices)                                            |       | (Zip Code)                            |
|                                                                                |       |                                  |
| (Registrant’s telephone number, including  area code): **(443) 573–9400** |
|                                                                                |       |                                  |
| SECURITIES REGISTERED PURSUANT TO SECTION 12(b)  OF THE ACT:**NONE.**          |
|                                                                                |       |                                  |
| SECURITIES REGISTERED PURSUANT TO SECTION 12(g)  OF THE ACT:                   |
| **COMMON STOCK, PAR VALUE $.01**                                                    |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days. Yes ý No o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of regulation S–K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of the Form 10–K or any amendment of this Form 10–K. o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Act). Yes ý No o

 

The aggregate market valueof the voting stock held by nonaffiliates of the registrant was $134,092,738 ($3.44per share) as of June 30, 2004.

 

As of March 2, 2005, 44,000,921shares of the registrant’s common stock, $.01 par value per share, wereoutstanding.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Proxy Statement for the 2005Annual Meeting of the registrant, which will be filed with the Commissionwithin 120 days after the close of the fiscal year, is incorporated byreference into Part III.

 

**ExplanatoryNote**

 

The Company is filingthis Amendment No. 1 to its Annual Report on Form 10-K for the year ended December 31,2004, as filed with the Securities and Exchange Commission on March 16,2005.  This Amendment No. 1 restates theoriginal Form 10-K and includes the following changes resulting from theCompany’s and the Company’s independent registered public accounting firm’scompleted analysis of internal controls over financial reporting as required bysection 404 of the Sarbanes-Oxley Act of 2002, as permitted by theExemptive Order issued by the Securities and Exchange Commission on November 30,2004 (Release No. 50754) under section 36 of the Securities Exchange Actof 1934:

 

•                  additionto Item 8 of management’s report on internal controls over financial reportingand the report on internal controls over financial reporting from KPMG LLP, theCompany’s independent registered public accounting firm;

 

•                  replacementof Item 9A, Controls & Procedures;

 

•                  additionalconsent of KPMG LLP, independent registered public accounting firm (exhibit 23.1);and

 

•                  additionsto the section 302 certification letters from the Company’s chiefexecutive officer and chief financial officer to address internal control overfinancial reporting (exhibit 31.1 and 31.2, respectively).

 

The remainder of theinformation contained in the original Form 10-K filed on March 16, 2005has not been amended.

 

 

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**AETHER SYSTEMS, INC.**

**ANNUAL REPORT ON FORM 10-K/A**

**FOR THE YEAR ENDED DECEMBER 31, 2004**

 

**INDEX**

 
| PART I   |                                                                                        |
|----------|---------------------------------------------------------------------------------------------|
|     |                                                                                        |   |
| Item 1   | Business                                                                                    |   |
|     |                                                                                        |   |
| Item  2  | Properties                                                                                  |   |
|     |                                                                                        |   |
| Item 3   | Legal Proceedings                                                                           |   |
|     |                                                                                        |   |
| Item  4  | Submission  of Matters to a Vote of Security Holders                                        |   |
|     |                                                                                        |   |
| PART II  |                                                                                        |
|     |                                                                                        |   |
| Item  5  | Market  for the Company’s Common Equity and Related Stockholder Matters                |   |
|     |                                                                                        |   |
| Item 6   | Selected Financial Data                                                                     |   |
|     |                                                                                        |   |
| Item 7   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|     |                                                                                        |   |
| Item  7A | Quantitative  and Qualitative Disclosures About Market Risk                                 |   |
|     |                                                                                        |   |
| Item  8  | Financial  Statements and Supplementary Data                                                |   |
|     |                                                                                        |   |
| Item  9  | Change  In and Disagreements with Accountants on Accounting and Financial Disclosure        |   |
|     |                                                                                        |   |
| Item 9A  | Controls and  Procedures                                                                    |   |
|     |                                                                                        |   |
| PART III |                                                                                        |
|     |                                                                                        |   |
| Item 10  | Directors  and Executive Officers of the Registrant                                         |   |
|     |                                                                                        |   |
| Item 11  | Executive Compensation                                                                      |   |
|     |                                                                                        |   |
| Item 12  | Security  Ownership of Certain Beneficial Owners and Management                             |   |
|     |                                                                                        |   |
| Item  13 | Certain  Relationships and Related Transactions                                             |   |
|     |                                                                                        |   |
| Item  14 | Principal  Accounting Fees and Services                                                     |   |
|     |                                                                                        |   |
| PART IV  |                                                                                        |
|     |                                                                                        |   |
| Item  15 | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                            |   |

 

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**FORWARD-LOOKINGSTATEMENTS**

 

This Annual Report on Form10-K/A contains forward-looking statements that involve risks anduncertainties.  When used in this Report,the words “anticipate,” “believe,” “estimate,” “intend,” “may,” “will,” “expect”and similar expressions as they relate to our company or our management areintended to identify a statement as a “forward-looking statement.”  Our actual results, performance orachievements could differ materially from the results expressed in, or impliedby, these forward-looking statements. Factors that could cause or contribute to such differences include thosediscussed in Item 7 of this Report under the heading “Risk Factors.”Forward-looking statements reflect our reasonable beliefs and expectations asof the time we make them, and we have no obligation to update or revise anyforward-looking statements, whether as a result of new information, future eventsor otherwise.  In this Annual Report onForm 10-K/A, we refer to Aether Systems, Inc. as “Aether,” “the Company,” “we”or “us.” 

 

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**PART I**

 

**ITEM1.  BUSINESS**

 

INTRODUCTION

 

Ourbusiness objectives are to become profitable as quickly as possible and torealize value, in the form of tax savings, from our significant accumulated taxloss carryforwards.  In pursuit of theseobjectives during 2004, we accomplished the following:

 

•                  Wesold our mobile and wireless data businesses, which had continued to losemoney;

•                  Wefurther reduced our operating expenses;

•                  Wesimplified our balance sheet and repaid the balance of our 6% convertiblesubordinated notes; and 

•                  Weimplemented a strategy of building and managing a leveraged portfolio ofresidential mortgage-backed securities.

 

Asa result of these activities, at the end of 2004 our business was focused oninvesting primarily in adjustable rate, residential mortgage-backed securitiesissued by the Federal Home Loan Mortgage Association (“FHLMC”), the FederalNational Mortgage Association (“FNMA”) and the Government National MortgageAssociation (“GNMA”).  

 

AtDecember 31, 2004, we had approximately $131.7 million of cash (includingrestricted cash) and cash equivalents, investments in mortgage-backedsecurities, and other investments available for sale.  At December 31, 2004, we ownedapproximately $62.2 million of mortgage-backed securities at fair value.  Our total assets were approximately $136.6million, and our total liabilities were approximately $6.0 million.  We had accumulated federal net operatinglosses of approximately $765.5 million that we can “carry forward” and use tooffset future taxable income until they expire between 2012 and 2024.  We also had accumulated federal capitallosses of approximately $245.3 million that we can “carry forward” and use tooffset future capital gains until they expire between 2006 and 2009.

 

Inthis Report, discussions of our Company’s operations will reflect our ongoingmortgage-backed securities business.  Ourhistorical financial results reflect the operations of our ongoing business as “continuingoperations.”  The financial results ofour mobile and wireless data businesses are reported as “discontinuedoperations.”

 

*Mortgage-Backed Securities Strategy*

 

Webegan to make investments in mortgage-backed securities (“MBS”) during thesecond quarter of 2004, and we have continued to implement our MBS businessstrategy gradually and conservatively. While we had more than half of our available cash invested inmortgage-backed securities as of December 31, 2004, we will need to expandour business to achieve our objectives. As we have previously reported, we expect that an important part of ourMBS strategy will be to leverage our invested cash by borrowing additionalfunds for investment.  We plan to do thisby entering into short-term repurchase agreements with financial institutionsthat have received the highest available long-term debt rating from anationally recognized rating agency. These borrowings will allow us to expand the size of our portfolio, aswell as to seek increased overall returns from our investments (both in amountand yield).  As discussed below in Item 7under the heading “Risk Factors – Borrowings may negatively affect the performanceof our portfolio of MBS,” the use of leverage involves substantial risks anduncertainties and could negatively affect the performance of the MBSportfolio.  In addition to leveraging theportfolio, we may, from time to time in the future, seek to sell additionalshares of our common stock to raise additional cash that would be available forinvestment.

 

Ourearnings from these activities will be the spread between the interest incomewe earn on the mortgage-backed securities we own, less the interest expense weincur to finance the purchase of such securities (to the extent we employleverage) and the other expenses of managing our business.  The expenses of managing our business includethe management fee and the incentive fee we have agreed to pay to our outside investmentmanager.

 

Toassist in the management of our MBS business, we have retained outsideprofessional financial and investment advisors with substantial experience inthe MBS market and in managing a leveraged portfolio of MBS investments.  In June 2004, we engaged FBR InvestmentManagement, Inc. (“FBR”) as our outside investment advisor to carry out theday-to-day management of the MBS portfolio, subject to oversight by ourmanagement and our Board of Directors and to investment policies adopted by ourBoard.  FBR currently manages amulti-billion dollar leveraged portfolio of mortgage-backed securities for oneof its affiliates.  In addition, we havecontracted with FinPro, Inc. (“FinPro”) to provide us with independentoversight of FBR and to assist us in developing, evaluating and managing ourMBS strategy.  FinPro is an investmentadvisory and management consulting firm that specializes in providing financialadvisory services to financial institutions. FinPro has substantial experience in the MBS market and related markets.

 

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*Development of MBS Strategy and Other Activities*

 

Thetiming and amount of MBS purchases that we make, the level of leverage that weemploy and the alternative investment strategies we explore depend upon marketconditions, which we continuously monitor, the advice and recommendations ofour outside professional investment and financial advisors, with whom weregularly confer and applicable regulatory requirements.  In light of market conditions that existed duringthe second half of 2004 and into the first quarter of 2005, we limited ourpurchases of MBS to $63.8 million in securities (including purchase premiums)acquired pursuant to forward purchase commitments entered into during the thirdquarter of 2004 (settled in September and October 2004) and did notemploy any leverage with respect to our MBS portfolio. Our position reflectedour relative views of the total return we could achieve on our investments inMBS and the borrowing costs associated with leveraging those investments.  In general, short-term borrowing rates wereincreasing more quickly than the yields earned by MBS during this period.  During February 2005, we began to seecertain favorable changes in market conditions and in late February andearly March 2005, we entered into forward purchase arrangementsrepresenting commitments to purchase MBS in March and April 2005 withan estimated aggregate face value of $375.0 million.  In order to settle these forward purchasecontracts and acquire the underlying MBS, we will be required to borrow funds,which we expect to do by entering into short-term repurchase arrangements, asdiscussed above and below under the heading “Mortgage-Backed Securities –Leverage and Borrowing Strategy.”  Whilewe expect to have sufficient funds to purchase the MBS securities from acombination of our available cash and funding from one or more of the financialinstitutions with which we have master repurchase agreements in place, thosemaster repurchase agreements are not funding commitments.  If we are unable to secure necessary fundsthrough repurchase agreements or otherwise, our financial condition and resultscould be adversely affected, as discussed below in Item 7 under the heading “RiskFactors – We will depend on borrowings to expand our MBS portfolio.  If we fail to obtain or to renew sufficientfunding on favorable terms or at all, we may incur losses.” 

 

Whilewe continue to focus on our MBS business, in an effort to achieve our overallbusiness objectives we are also evaluating other potential opportunities thatcould serve either to complement or diversify our MBS business.  We have been contacted by a number of thirdparties regarding a variety of real estate-related opportunities and areevaluating these opportunities as appropriate within the context of achievingour business objectives as well as ensuring that we remain exempt fromregistration as an investment company under the Investment Company Act of 1940,as amended (the “Investment Company Act”). We may in the future pursue one or more of these opportunities, if weconclude that they could enhance our ability to achieve our stated objectivesmore quickly or more reliably.  We havenot made any decisions to pursue any of these alternatives, and we expect tocontinue to focus our business activities on our mortgage-backed securitiesstrategy.  The mix of our assets and theamount of leverage we incur may change significantly over time and also mayvary in response to changing market conditions.

 

*Disposition of Wireless and Mobile Data Businesses*

 

In2004, we sold our mobile and wireless data businesses, which were organizedinto three operating segments.  In January 2004,we sold our Enterprise Mobility Solutions (“EMS”) segment for $18.0 million incash and a $1.0 million note (which was paid in full in August 2004).  In September 2004 we sold ourTransportation and Mobile Government segments for $25.0 million in cash and$10.0 million in cash, respectively.  Forinformation on these dispositions, see Note 15 of the notes to our consolidatedfinancial statements included in Item 8 of this Report.

 

*TaxAspects of Our Business Strategy*

 

Animportant aspect of our business strategy is to realize value, in the form oftax savings, from our accumulated tax loss carryforwards.  Under federal and state tax laws, we may usethese carryforwards to substantially reduce the income taxes we otherwise wouldhave to pay on future taxable income.  Asa result, we could have little or no income tax liability for a period oftime.  Our ability to realize value fromthese tax loss carryforwards is subject to various risks and uncertainties,including regulations that, under certain circumstances, may limit our abilityto use these carryforwards to reduce future taxes that we might otherwise owe.

 

TheInternal Revenue Code and applicable Internal Revenue Service (“IRS”)regulations, contain limitations on certain changes in ownership of our stockby certain stockholders (generally persons who hold, or who acquire, at least5% of our outstanding shares, calculated in accordance with IRS regulations)which, if exceeded, could reduce or eliminate our ability to use ouraccumulated tax loss carryforwards in the future (if those changes resulted ina “change of ownership” as that term is defined in Section 382 of theInternal Revenue Code and applicable IRS regulations).  These same tax rules and the need to avoid anownership change could also restrict the amount of additional shares we couldissue to raise new capital for investment in our business.

 

Inan effort to mitigate these risks, we are considering recommending to ourshareholders a reorganization that would create transfer restrictions on ourstock to reduce the risk that we would experience an ownership change under thetax laws which would limit our use of tax loss carryforwards or otherwiserestrict our ability to issue additional shares out of concern that suchissuance (combined with such transfers) would create an ownership change.  The imposition of these transfer restrictionswould require stockholder approval.

 

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Inan effort to seek to accelerate the realization of the value from our accumulatednet operating loss and capital loss carryforwards, we may seek additionalcapital, from time to time, through periodic offerings of shares of our stockas market conditions allow.  Suchadditional capital would then be used to expand our business in pursuit ofadditional taxable income.  In general,we would expect to seek to sell shares only when such sales would not bedilutive to the value of our outstanding shares at the time of any suchoffering.  This means we generally wouldnot expect to sell shares at any time when the offering price is below the pershare book value of our assets.  Becausewe cannot predict the future trading price of our stock, we cannot predict whenor whether we would be able to sell shares of stock to raise additional capitalunder the desired conditions.  Inaddition, as noted above, provisions of the Internal Revenue Code and certainapplicable IRS regulations will limit the number of additional shares of stockwe can sell from time to time without causing a limitation on our ability touse our accumulated tax loss carryforwards to reduce our future taxobligations.

 

Raisingadditional capital will allow us to expand our MBS portfolio (both by investingthat capital in MBS and borrowing additional amounts to leverage the newlyraised capital).  In addition, to theextent we pursue additional or other business strategies, we could useadditional capital to expand these strategies. If we are successful in implementing our MBS strategy, a largerportfolio should generate greater earnings, which would allow us to consume ourtax loss carryforwards more quickly, thereby accelerating our realization offuture tax savings.  As the size of ourMBS business grows over time, we may seek to add to our employee base so thatour staff will have additional industry-specific capabilities and expertise tohelp manage our portfolio.  In thisevent, we likely would reduce our reliance on outside professionals for suchadvice and assistance.  In addition, wemay expand our corporate staff over time to enhance other corporate functions,such as financial, legal and other administrative and compliance activities, tothe extent our business grows and makes such additions cost-effective.

 

Althoughwe may choose to pay dividends in the future, we do not currently anticipatepaying dividends to our stockholders in the near term as we seek to realizevalue from our loss carryforwards by increasing our earnings as quickly aspossible.  Instead, we expect tore-invest earnings in our business to promote its expansion.  We expect that our tax loss carryforwardswill allow us to reinvest earnings without reduction for income tax paymentsfor as long as those carryforwards remain available to us.

 

Ifwe were to pay dividends to stockholders from current earnings, these dividendswould, generally speaking, be eligible to be treated as “qualified dividends”for federal income tax purposes, currently taxed at a maximum federal rate of15%, assuming that the recipient stockholder meets the various requirementsunder the Internal Revenue Code for such treatment.  The maximum rate for qualified dividends iscurrently projected to increase to the maximum federal income tax rateapplicable to ordinary income (currently 35%) for tax years beginning after December 31,2008 in accordance with the Jobs and Growth Tax Relief Reconciliation Act of2003.

 

Fora discussion of tax risks and uncertainties applicable to our businessstrategy, see the discussion below in Item 7 under the heading “Risk Factors –Regulatory and tax risks of our MBS business.”

 

MORTGAGE-BACKEDSECURITIES 

 

*Investment Approach and Policies*

 

OurBoard of Directors has authorized the investment of up to $100 million of our available cash inour MBS business.  We also are permittedto leverage our invested cash between five and eight times.  Our Board may increase, decrease or waivethese limitations in the future, at its discretion.  If we were to invest $100 million of ouravailable cash and cash equivalents in our MBS business, and if we were to incurleverage of eight times our cash investment to purchase additional MBS, ourtotal MBS portfolio would have a value (at cost) of approximately $900 million.

 

OurBoard of Directors, after consultation with FBR, FinPro and other outsideadvisors, has adopted a set of investment guidelines and policies that governour MBS business.  These guidelines andpolicies remain subject to ongoing review and refinement as we develop our MBSbusiness, as well as amendment or waiver at the discretion of the Board.  Under the terms of our management agreementwith FBR, we must approve in advance any actions by FBR that are not within thescope of our guidelines and policies.  Asa matter of corporate policy, we will not approve any action that deviates fromour guidelines and policies unless such deviation has been reviewed with FinProand, with the advice of management and FinPro, approved by our Board of Directors.

 

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Ourcurrent MBS guidelines and policies include the following:

 

•                  FBRmust obtain our permission before purchasing MBS individually in an amountexceeding $50 million or purchasing hybrid adjustable rate MBS greater than 5years to reset, fixed-rate MBS, or MBS derivatives.

•                  FBRmust obtain our permission before taking any actions that would cause theportfolio’s asset-to-equity ratio to exceed 9:1.

•                  FBRmay not enter into repurchase agreements on our behalf with any counter-partyin an amount that would exceed 35% of the aggregate amount of our thenoutstanding repurchase agreements.

•                  FBRmay not enter into interest rate swap agreements or futures contracts withoutour prior approval.

•                  Riskmanagement systems will be used to actively monitor and manage our exposure tointerest and mortgage prepayment rates, the shape of the yield curve, creditrisk, risk of capital loss, the availability and cost of financing, andchanging yield spreads relating to MBS.

 

OurBoard of Directors has the power to modify or waive these policies andstrategies without the consent of the stockholders to the extent that the Boardof Directors determines that the modification or waiver is in the bestinterests of our stockholders.  Amongother factors, developments in the market that affect our policies andstrategies or that change our assessment of the market may cause our Board of Directorsto revise our policies and strategies.  

 

*Leverage and Borrowing Strategy*

 

Weexpect to use short-term repurchase agreements as our principal source offinancing in connection with leveraging our MBS portfolio.  Amounts due upon maturity of our repurchaseagreements will be funded primarily through rollover/reissuance of newrepurchase agreements along with principal and interest payments received fromMBS we own.  As of December 31, 2004,we had not entered into any repurchase agreements.  In the future, we anticipate that we willenter into repurchase agreements primarily with financial institutions thathave the highest rating from a nationally recognized rating agency.  We have established master repurchasearrangements with four financial institutions, in amounts that we believe arecurrently in excess of our anticipated needs. These master agreements do not constitute commitments by us or by thecounterparties.  We expect to enter intorepurchase transactions with one or more of these financial institutions toprovide us with most of the funding we will need to satisfy our commitments topurchase approximately $375.0 million of MBS under the forward purchasearrangements we entered into during February and March 2005. 

 

Arepurchase agreement, although structured as a sale and repurchase obligation,acts as a financing under which we effectively pledge our MBS as collateral tosecure a short-term loan.  (While the MBSis used as collateral, we continue to receive principal and interest paymentsin respect of the MBS.)  Generally, theother party to the agreement makes the loan in an amount equal to a percentageof the market value of the pledged collateral. At the maturity of the repurchase agreement, we are required to repaythe loan and correspondingly receive back our collateral.  These types of leveraging arrangements forMBS purchases typically permit more than 90% of the purchase price of theunderlying MBS to be financed through the repurchase agreement.

 

Repurchaseagreements may require us to pledge additional assets to the lender in theevent the estimated fair value of existing pledged collateral declines below aspecified percentage.  The pledgedcollateral may fluctuate in value during the life of the repurchase agreementdue to, among other things, principal repayments, market changes in interestrates and credit quality.  In such cases,a lender may require us to post additional collateral, or we may choose to sellthe pledged security and repay the “loan.” This type of activity is one of the risks of a leveraged strategydiscussed below in Item 7 under the heading “Risk Factors – Borrowings may adverselyaffect the performance of our portfolio of MBS.”  We expect to use repurchase agreements thatwill have original maturities ranging from 30 to 90 days.  In the event a lender under a repurchaseagreement decides not to renew a repurchase agreement at its maturity, we willbe required to use our own cash or obtain other financing to close out therepurchase agreement and pay off the loan. In addition, as discussed below in Item 7 under the heading “RiskFactors – Differences in timing of interest rate adjustments on our acquired securitiesand our borrowings may adversely affect our MBS strategy and the returns on theportion of our cash we invest in MBS,” because the interest rates paid by ourMBS investments typically will not adjust more than once per year, in anenvironment of increasing short-term interest rates, our borrowing costs mayincrease more quickly than the interest rates paid by our MBS portfolio.  This could have a significant negative effecton our financial performance and could materially reduce the yield we realizefrom our MBS portfolio.

 

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Inthe event of our insolvency or bankruptcy, certain repurchase agreements mayqualify for special treatment under the Bankruptcy Code, the effect of which,among other things, would be to allow the creditor under the agreement to avoidthe automatic stay provisions of the Bankruptcy Code and to foreclose on thecollateral agreement without delay.  Inthe event of the insolvency or bankruptcy of a lender during the term of arepurchase agreement, the lender may be permitted, under applicable insolvencylaws, to repudiate the contract, and our claim against the lender for damagesmay be treated simply as an unsecured claim. In addition, if the lender is a broker or dealer subject to theSecurities Investor Protection Act of 1970, or an insured depositoryinstitution subject to the Federal Deposit Insurance Act, our ability toexercise our rights to recover our securities under a repurchase agreement orto be compensated for any damages resulting from the lender’s insolvency may befurther limited by those statutes.  Theseclaims would be subject to significant delay and, if and when received, may besubstantially less than the damages we actually incur.

 

Weintend to enter into repurchase agreements only with financial institutionsthat have received the highest available long-term debt rating from anationally recognized rating agency.  Ifthis credit rating is not met, we will not enter into repurchase agreementswith that lender without the consent of our Board of Directors.  In the event one of our lenders isdowngraded, the approval of our Board of Directors will have to be obtainedbefore entering into additional repurchase agreements with that lender.  We seek to diversify our exposure by enteringinto repurchase agreements with numerous separate lenders so that no one lenderconstitutes more than 35% of all of our outstanding repurchase agreements.  If, during the term of a repurchase agreement,a lender were to file for bankruptcy, we might experience difficulty recoveringthe pledged security and might have only an unsecured claim against the lender’sassets for the difference between the amount we borrowed and the estimated fairvalue of the collateral we pledged to such lender (if any). 

 

Wemay also use derivative transactions and other hedging strategies, such asinterest rate swaps and caps, options to purchase swaps and caps, financialfutures contracts and options on futures, to help mitigate prepayment andinterest rate risks if we determine that the cost of these transactions isjustified by their potential benefit.  Wewould use hedging to mitigate declines in the market value of ourmortgage-backed securities during periods of increasing or decreasing interestrates or to limit or cap the interest rates on our borrowings.  We expect that the extent and type of ourhedging activity will vary based on the level and volatility of interest ratesand mortgage principal prepayments, the type of mortgage-backed securities weacquire and other changing market conditions. We will not enter into hedgingtransactions for speculative purposes. The use of hedging strategies involves risks, which are described below inItem 7 under the heading “Risk Factors – Borrowings may adversely affect the performanceof our portfolio of MBS.” 

 

*Aether’sMBS Investments*

 

The MBS that we acquire andtrade are agency mortgage-backed securities which, although not rated, carry animplied “AAA” rating.  Agencymortgage-backed securities are mortgage-backed securities where a governmentagency or federally chartered corporation, such as FHLMC, FNMA or GNMA,guarantees payments of principal or interest on the securities.  Agency mortgage-backed securities consist ofpass-through certificates issued or guaranteed by an agency. 

 

The MBS that we acquireprovide funds for mortgage loans made primarily to residential homeowners.  These securities generally representinterests in pools of mortgage loans made by savings and loan institutions,mortgage bankers, commercial banks and other mortgage lenders.  These pools of mortgage loans are assembledfor sale to investors (like us) by various government, government-related andprivate organizations.  MBS differ fromother forms of traditional debt securities, which normally provide for periodicpayments of interest in fixed amounts with principal payments at maturity or onspecified call dates.  Instead, MBSprovide for a monthly payment, which consists of both interest andprincipal.  In effect, these payments area “pass-through” of the monthly interest and principal payments made by theindividual borrower on the mortgage loans, net of any fees paid to the issueror guarantor of the securities. Additional payments result from prepayments of principal upon the sale,refinancing or foreclosure of the underlying residential property.  Some MBS, such as securities issued by GNMA,are described as “modified pass-through” securities.  These securities entitle the holder toreceive all interest and principal payments owed on the mortgage pool, net ofcertain fees, regardless of whether the mortgagors actually make mortgagepayments when due. 

 

The investmentcharacteristics of pass-through mortgage-backed securities differ from those oftraditional fixed-income securities. The major differences include the paymentof interest and principal on the MBS on a more frequent schedule, as describedabove, and the possibility that principal may be prepaid at any time due toprepayments on the underlying mortgage loans or other assets.  These differences can result in significantlygreater price and yield volatility than is the case with traditionalfixed-income securities. 

 

Various factors affect therate at which mortgage prepayments occur, including changes in interest rates,general economic conditions, the age of the mortgage loan, the location of theproperty and other social and demographic conditions.  Generally prepayments on MBS increase duringperiods of falling mortgage interest rates and decrease during periods ofrising mortgage interest rates.  We mayreinvest prepayments at a yield that is higher or lower than the yield on the initialunderlying MBS security purchased, thus affecting the weighted average yield ofour investments. 

 

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To the extent MBS arepurchased at a premium, faster than expected prepayments result in acceleratedamortization of the premium paid, which can have a negative effect on the yieldfrom our mortgage-backed securities portfolio. Conversely, if these securitieswere purchased at a discount, faster than expected prepayments accelerate ourrecognition of the discount and can have a positive effect on the yield fromour mortgage-backed securities portfolio. 

 

FHLMC Certificates

 

FHLMC is a privately-owned,government-sponsored enterprise created pursuant to an act of Congress on July 24,1970.  The principal activity of FHLMCcurrently consists of the purchase of mortgage loans or participation interestsin mortgage loans and the resale of the loans and participations in the form ofguaranteed MBS.  FHLMC guarantees to eachholder of FHLMC certificates the timely payment of interest at the applicablepass-through rate and ultimate collection of all principal on the holder’s prorata share of the unpaid principal balance of the related mortgage loans, butdoes not guarantee the timely payment of scheduled principal of the underlyingmortgage loans.  The obligations of FHLMCunder its guarantees are solely those of FHLMC and are not backed by the fullfaith and credit of the United States. If FHLMC were unable to satisfy these obligations, distributions toholders of FHLMC certificates would consist solely of payments and otherrecoveries on the underlying mortgage loans and, accordingly, defaults anddelinquencies on the underlying mortgage loans would adversely affect monthlydistributions to holders of FHLMC certificates. 

 

FHLMC certificates may bebacked by pools of single-family mortgage loans or multi-family mortgage loans.These underlying mortgage loans may have original terms to maturity of up to 40years.  FHLMC certificates may be issuedunder cash programs (composed of mortgage loans purchased from a number ofsellers) or guarantor programs (composed of mortgage loans acquired from oneseller in exchange for certificates representing interests in the mortgageloans purchased). 

 

FHLMC certificates may payinterest at a fixed rate or an adjustable rate. The interest rate paid on adjustable-rate FHLMC certificates (“FHLMCARMs”) adjusts periodically within 60 days prior to the month in which theinterest rates on the underlying mortgage loans adjust. The interest rates paidon certificates issued under FHLMC’s standard ARM programs adjust in relationto the Treasury index. Other specified indices used in FHLMC ARM programsinclude the 11th District Cost of Funds Index published by the Federal HomeLoan Bank of San Francisco, LIBOR and other indices.  Interest rates paid on fully-indexed FHLMC ARMcertificates equal the applicable index rate plus a specified number of basispoints.  The majority of series of FHLMCARM certificates issued to date have evidenced pools of mortgage loans withmonthly, semi-annual or annual interest adjustments.  Adjustments in the interest rates paid aregenerally limited to an annual increase or decrease of either 100 or 200 basispoints and to a lifetime cap of 500 or 600 basis points over the initialinterest rate.  Certain FHLMC programsinclude mortgage loans which allow the borrower to convert the adjustablemortgage interest rate to a fixed rate. Adjustable-rate mortgages which are converted into fixed-rate mortgageloans are repurchased by FHLMC or by the seller of the loan to FHLMC at theunpaid principal balance of the loan plus accrued interest to the due date ofthe last adjustable rate interest payment. 

 

FNMA Certificates

 

FNMA is a privately-owned,federally-chartered corporation organized and existing under the FederalNational Mortgage Association Charter Act.  FNMA provides funds to the mortgage marketprimarily by purchasing home mortgage loans from local lenders, therebyreplenishing their funds for additional lending.  FNMA guarantees to the registered holder of aFNMA certificate that it will distribute amounts representing scheduledprincipal and interest on the mortgage loans in the pool underlying the FNMAcertificate, whether or not received, and the full principal amount of any suchmortgage loan foreclosed or otherwise finally liquidated, whether or not theprincipal amount is actually received. The obligations of FNMA under its guarantees are solely those of FNMAand are not backed by the full faith and credit of the United States.  If FNMA were unable to satisfy itsobligations, distributions to holders of FNMA certificates would consist solelyof payments and other recoveries on the underlying mortgage loans and,accordingly, defaults and delinquencies on the underlying mortgage loans wouldadversely affect monthly distributions to holders of FNMA. 

 

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FNMA certificates may bebacked by pools of single-family or multi-family mortgage loans.  The original term to maturity of any suchmortgage loan generally does not exceed 40 years.  FNMA certificates may pay interest at a fixedrate or an adjustable rate.  Each seriesof FNMA ARM certificates bears an initial interest rate and margin tied to anindex based on all loans in the related pool, less a fixed percentagerepresenting servicing compensation and FNMA’s guarantee fee.  The specified index used in different serieshas included the Treasury Index, the 11th District Cost of Funds Indexpublished by the Federal Home Loan Bank of San Francisco, LIBOR and otherindices.  Interest rates paid onfully-indexed FNMA ARM certificates equal the applicable index rate plus aspecified number of basis points.  Themajority of series of FNMA ARM certificates issued to date have evidenced poolsof mortgage loans with monthly, semi-annual or annual interest rateadjustments.  Adjustments in the interestrates paid are generally limited to an annual increase or decrease of either100 or 200 basis points and to a lifetime cap of 500 or 600 basis points overthe initial interest rate. Certain FNMA programs include mortgage loans whichallow the borrower to convert the adjustable mortgage interest rate of theadjustable-rate mortgage to a fixed rate. Adjustable-rate mortgages which are converted into fixed-rate mortgageloans are repurchased by FNMA or by the seller of the loans to FNMA at theunpaid principal of the loan plus accrued interest to the due date of the lastadjustable rate interest payment. Adjustments to the interest rates on FNMA ARM certificates are typicallysubject to lifetime caps and periodic rate or payment caps.

 

All of the MBS we held as ofDecember 31, 2004 and all of the MBS covered by the forward purchasearrangements we entered into during February and March 2005 are FNMAcertificates. 

 

GNMA Certificates

 

GNMA is a wholly ownedcorporate instrumentality of the United States within the Department of Housingand Urban Development.  The NationalHousing Act of 1934 authorizes GNMA to guarantee the timely payment of theprincipal of and interest on certificates which represent an interest in a poolof mortgages insured by the Federal Housing Administration or partiallyguaranteed by the Department of Veterans Affairs and other loans eligible forinclusion in mortgage pools underlying GNMA certificates.   Section 306(g) of the Housing Actprovides that the full faith and credit of the United States is pledged to thepayment of all amounts which may be required to be paid under any guaranty byGNMA. 

 

At present, most GNMAcertificates are backed by single-family mortgage loans.  The interest rate paid on GNMA certificatesmay be a fixed rate or an adjustable rate. The interest rate on GNMA certificates issued under GNMA’s standard ARMprogram adjusts annually in relation to the Treasury index.  Adjustments in the interest rate aregenerally limited to an annual increase or decrease of 100 basis points and toa lifetime cap of 500 basis points over the initial coupon rate.

 

REGULATION

 

We intend to operate underan exception from the definition of an “investment company” set forth in Section 3(c)(5)of the Investment Company Act for companies that are primarily engaged in thebusiness of purchasing or otherwise acquiring mortgages and other liens on andinterests in real estate.  Absent such exceptionor another applicable exception, we would be required to register as aninvestment company under the Investment Company Act and would be required to complywith the various regulations adopted by the SEC for application to registeredinvestment companies.  The staff of theSEC has expressed the view that, in order to be considered to be “primarilyengaged” in the real estate business, a company must have at least 55% of itsassets in qualifying real estate interests, which the SEC staff has said,through “no-action” positions, include whole pool mortgage interests issued byFHLMC, FNMA or GNMA, and at least 25% of its assets in other real estaterelated assets.  This 25% minimum isreduced to the extent a company invests more than 55% of its assets inqualifying real estate interests. Neither the SEC nor its staff has defined the term “real estate relatedassets” for purposes of the 25% requirement set forth above.  The staff has indicated, however, that a loanwill qualify as a real estate related asset if at least 55% of the fair marketvalue of the loan is secured by real estate at the time the company acquires theloan.  The staff has also indicated thatagency partial pool certificates and certain interests in companies that investin mortgages or other interests in real estate are real estate relatedassets.  We intend to conduct ourbusiness in such a manner as to be excepted from the definition of aninvestment company under Section 3(c)(5) of the Investment CompanyAct.  The MBS investments we havepurchased qualify as qualifying real estate assets, based on the current viewsof the SEC Staff.  If we failed to remainexempt from the regulations applicable to “investment companies,” our businesscould be adversely affected, as discussed below under the heading “Risk Factors– Loss of Investment Company Act exemption would adversely affect us.”

 

To the extent we explorealternative or additional business strategies, we may be limited by the rulesand regulations of the Investment Company Act. We will not pursue any strategy which would interfere with our exemptionfrom registration under the Investment Company Act.

 

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COMPETITION

 

Our ability to generateincome from our MBS business depends, in large part, on our ability to acquireMBS in the marketplace in order to assemble a leveraged MBS portfolio and earnfavorable spreads over our cost of funds. In acquiring MBS, we compete with real estate investment trusts (REITs),financial institutions, such as banks, life insurance companies, savings andloan associations, and institutional investors, such as mutual funds andpension funds, other lenders and other entities that purchase MBS, many ofwhich have greater financial resources than we do.  The existence of these competitors, as wellas the possibility of additional competitors in the future, may increasecompetition for the acquisition of MBS resulting in higher prices and loweryields on our assets.  In addition, weand other companies that invest in MBS may look to sell such investments at themost favorable prices when market conditions dictate in order to reduce ourleverage or reduce the overall amount we have invested in MBS.  At such times, we likely will be competingwith other sellers to obtain the best available sale prices for our MBS.  Our outside investment advisor acquires andsells MBS for an $11 billion portfolio that it manages for an affiliate.  This may create a conflict of interest withits obligations to us, as discussed below under the heading “Risk Factors – Themanager of our MBS portfolio may have a potential conflict of interest.”

 

GENERAL CORPORATE MATTERS

 

Aetherwas originally formed as Aeros, L.L.C. in January 1996.  We changed our name to Aether TechnologiesInternational, L.L.C. in August 1996 and to Aether Systems L.L.C. in September 1999.  Immediately prior to completing our initialpublic offering of common stock on October 20, 1999, we converted from alimited liability company to a Delaware corporation and changed our name toAether Systems, Inc.  Our principalexecutive offices are located at 621 E. Pratt St., Suite 601, Baltimore, MD  21202. Our telephone number is (443) 573-9400 and our fax number is (443)573-0383.

 

OurInternet address is www.aethersystems.com. We make available free of charge, on or through our website, our annualreport on Form 10-K, quarterly reports on Form 10-Q, current reports on Form8-K, and amendments to those reports filed or furnished to the Securities andExchange Commission (the “SEC”) pursuant to Section 13(a) or Section 15(d)of the Securities Exchange Act of 1934 (the “Exchange Act”) as soon asreasonably practicable after we electronically file such material with, orfurnish it to, the SEC.  We are providingthe address of our internet website solely for the information ofinvestors.  We do not intend the internetaddress to be an active link, and the contents of the website are not a part ofthis Report.

 

We have adopted a generalcode of ethics for our business.  We havealso adopted a code of ethical conduct that applies solely to our principalexecutive officer, principal financial officer, principal accounting officer,controller and persons performing similar functions.  The Board of Directors is responsible forreviewing and authorizing any waivers from both the code of ethics and code ofethical conduct for senior financial officers and we will file any waiversfrom, or amendments to, these codes with the SEC.  Both the general code of ethics and the codeof ethical conduct for senior financial officers, as well as the charters forour audit committee, nominating and corporate governance committee andcompensation committee, are available on Aether’s website,www.aethersystems.com.  This informationis also available in print upon written request to our secretary at the addressset forth above.  

 

We have also adoptedprocedures for our stockholders to communicate with our Board ofDirectors.  Stockholders who wish tocontact the Board of Directors, or an individual director, should contact theBoard of Directors or individual director at investor_relations@aethersystems.comor in writing at 621 E. Pratt St., Suite 601, Baltimore, MD  21202. The Secretary will compile all communications and submit them to theBoard of Directors, or individual directors, on a periodic basis.

 

EMPLOYEES

 

As of December 31,2004, our continuing operations had a total of 12 employees.  None of our employees is covered by acollective bargaining agreement.  Webelieve that our relations with our employees are good.  As of January 31, 2005, we furtherreduced our staffing levels and had a total of eight employees. 

 

**ITEM2.  PROPERTIES**

 

Ourprincipal offices are located in Baltimore, Maryland.  In addition, we maintain a lease for space inMarlborough, Massachusetts that we used as the headquarters for our MobileGovernment business.  We have sublet thisoffice space to BIO-Key International, Inc., the company that purchased ourMobile Government business.  Our lease of24,418 square feet in Owings Mills, Maryland (11500 Cronridge Drive) expired onJanuary 31, 2005.  We also lease anaggregate of approximately 5,000 square feet in Larkspur, California (which isbeing sublet and will expire on March 31, 2005).  We believe that our retained facilities areadequate for the purposes for which they are presently used and thatreplacement facilities are available at comparable cost, should the need arise.

 

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**ITEM3.  LEGAL PROCEEDINGS**

 

Aetheris among the hundreds of defendants named in nine class action lawsuits seekingdamages on account of alleged violations of securities law.  The case is being heard in the United StatesDistrict Court for the Southern District of New York.  The court has consolidated the actions by allof the named defendants that actually issued the securities in question.  Now there are approximately 310 consolidatedcases before Judge Scheindlin, including the Aether Systems action, under thecaption In Re Initial Public Offerings Litigation, Master File 21 MC 92(SAS).

 

Theseactions were filed on behalf of persons and entities that acquired our commonstock after our initial public offering in October 20, 1999.  Among other things, the complaints claim thatprospectuses, dated October 20, 1999 and September 27, 2000 andissued by Aether in connection with the public offerings of common stock,allegedly contained untrue statements of material fact or omissions of materialfact in violation of securities laws because the prospectuses allegedly failedto disclose that the offerings’ underwriters had solicited and receivedadditional and excessive fees, commissions and benefits beyond those listed inthe arrangements with certain of their customers which were designed tomaintain, distort and/or inflate the market price of Aether’s common stock inthe aftermarket.  The actions seekunspecified monetary damages and rescission. Aether believes the claims are without merit and is vigorouslycontesting these actions.

 

Initialmotions to dismiss the case were filed and the court held oral argument on themotions to dismiss on November 1, 2002.  On February 19, 2003,the court issued an Opinion and Order on defendants’ motions to dismiss, whichgranted the motions in part and denied the motions in part.  As to AetherSystems, the motion to dismiss the claims against it was denied in itsentirety.  Discovery has now commenced.  The plaintiffs voluntarilydismissed without prejudice the officer and director defendants ofAether.  On June 26, 2003, the Plaintiff’s Executive Committee inthis case announced a proposed settlement with the issuers.  The proposedsettlement is a settlement among the plaintiffs, theissuer-defendants, including Aether, and the officer and director defendants ofthe issuers.  The plaintiffs will continue litigating their claims againstthe underwriter-defendants.  Under terms of the proposed settlement,Aether would not incur any material financial or other liability.  OnJune 14, 2004, the plaintiffs and issuer defendants presented the executedsettlement agreement to Judge Scheindlin during a court conference. Subsequently, plaintiffs and issuers made a motion for preliminary approvalof the settlement agreement.  On July 14, 2004, the underwriterdefendants filed a memorandum of law in opposition to plaintiffs’ motion forpreliminary approval of the settlement agreement.  Reply briefs in supportof the settlement were submitted to the court.  In December 2004, thecourt ordered additional briefing on the motion.  All of the additionalbriefs were submitted to the court.  On February 15, 2005,Judge Scheindlin issued an Opinion and Order granting preliminary approval tothe settlement agreement.  The court will schedule a fairness hearingon the proposed settlement and subsequently will decide whether togrant final approval to the settlement agreement.  Thesettlement agreement is subject to the approval of the District Court.  Therecan be no assurance such approval will be granted.

 

Aether is also a party to otherlegal proceedings in the normal course of business.  Based on evaluation of these matters anddiscussions with counsel, Aether believes that liabilities arising from thesematters will not have a material adverse effect on the consolidated results ofits operations or financial position.

 

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**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters were submitted to Aether’s stockholdersfor consideration during the fourth quarter of the fiscal year ended December 31,2004.

 

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**PART II**

 

**ITEM 5. MARKET FOR AETHER’S’S COMMON EQUITY AND RELATED STOCKHOLDERMATTERS**

 

PRICE RANGE OF COMMON STOCK

 

Our common stock has beenquoted on the Nasdaq National Market under the symbol AETH since our initialpublic offering on October 20, 1999. Prior to that time, there was no public market for our commonstock.  The following table sets forth,for the periods indicated, the high and low prices per share of the commonstock as reported on the Nasdaq National Market.

 
| ** **        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| **QUARTER ENDED** | ** ** | **HIGH** | ** ** | **LOW**  | ** ** | **HIGH** | ** ** | **LOW** | ** ** |
| March 31     |       | $        | 5.91       |     | $          | 3.92 |   | $ | 3.95 |   | $ | 2.96 |   |
| June 30      |       | $        | 4.93       |     | $          | 3.23 |   | $ | 5.37 |   | $ | 3.15 |   |
| September 30 |       | $        | 3.45       |     | $          | 2.72 |   | $ | 6.21 |   | $ | 4.57 |   |
| December 31  |       | $        | 4.00       |     | $          | 3.27 |   | $ | 5.26 |   | $ | 4.50 |   |

 

APPROXIMATE NUMBER OF EQUITYSECURITY HOLDERS

 

The number of holders ofrecord of Aether’s common stock as of December 31, 2004 was 553.

 

DIVIDENDS

 

We have never declared orpaid any cash dividends on our capital stock nor, when we were organized as alimited liability company, did we make any distributions to our members.  As discussed above in Item 1 under theheading “Introduction,” for the period that our accumulated tax losscarryforwards remain available for use, we expect to retain earnings, if any,to support the development of our business, rather than pay periodic cashdividends.  Our Board of Directors mayreconsider or change this policy in the future. Payment of future dividends, if any, will be at the discretion of ourBoard of Directors, after taking into account such factors as it considersrelevant, including our financial condition, the performance of our business,the perceived benefits to the Company and our stockholders of re-investingearnings, anticipated future cash needs of our business, the tax consequencesof retaining earnings and the tax consequences to the Company and itsstockholders of making dividend payments.

 

SECURITIES AUTHORIZED FORISSUANCE UNDER EQUITY COMPENSATION PLANS

 
| **Plan Category**                                           | ** ** | **Plan Name**               | ** ** | **Number of  securities  to  be issued upon  exercise  of outstanding  options,  warrants and  rights** | ** ** | **Weighted-average  exercise price of  outstanding  options,  warrants and  rights** | ** ** | **Number of  securities  remaining  available for  future  issuance under  equity  compensation  plans** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
|                                                        |       |                        |       |                                                                                                    |       |                                                                                 |       |                                                                                                     |       |
| Equity compensation plans approved by  security holders     |       | 1999 Equity  Incentive Plan |       | 2,063,836                                                                                               |       | $                                                                                    | 4.03       |                                                                                                     | 6,728,957  |   |
|                                                        |       |                        |       |                                                                                                    |       |                                                                                 |       |                                                                                                     |       |
| Equity compensation plans not approved by  security holders |       | Acquisition  Incentive Plan |       | 18,325                                                                                                  |       | 0.00                                                                                 | (1)        | 1,881,675                                                                                                |       |
|                                                        |       |                        |       |                                                                                                    |       |                                                                                 |       |                                                                                                     |       |
| Total                                                       |       |                        |       | 2,082,161                                                                                               |       | $                                                                                    | 4.03       |                                                                                                     | 8,610,632  |   |

 

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(1) All of the securitiesissued to date under this plan have been shares of restricted stock that vestover various periods.

 

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Acquisition Incentive Plan 

 

The Acquisition IncentivePlan was effective December 15, 2000. Grants under the plan may be made to all employees, consultants andcertain other service providers (other than directors and executive officers)of the Company.  Under the plan, Aether’sBoard of Directors has authorized the issuance of up to 1,900,000 shares ofAether common stock in connection with the grant of stock options or restrictedstock.  All options granted under theAcquisition Incentive Plan must be nonqualified stock options.  Any shares covered by an award that are usedto pay the exercise price or any required withholding tax will become availablefor re-issuance under the plan.  In theevent of a “change of control” as such term is defined in the plan, awards ofrestricted stock and stock options will become fully vested or exercisable, asapplicable, to the extent the award agreement granting such restricted stock oroptions provides for such acceleration.  (Individualsreceive an award agreement upon grant of an award under the plan.)  A participant will immediately forfeit anyand all unvested options and forfeit all unvested restricted stock at the timeof termination from Aether, unless the award agreement provides otherwise.  No participant may exercise vested optionsafter the 90th day from the date of termination from Aether, unlessthe award grant provides otherwise.  Noawards may be made pursuant to the Acquisition Incentive Plan after December 14,2010.  The plan is administered by Aether’sCompensation Committee.

 

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**ITEM 6.SELECTED FINANCIAL DATA**

 

The table that follows presentsportions of our consolidated financial statements and is not a completepresentation in accordance with accounting principles generally accepted in theUnited States.  You should read thefollowing selected consolidated financial data together with our consolidatedfinancial statements and related notes and with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included elsewherein this Report.  The historical resultspresented below are not necessarily indicative of the results to be expectedfor any future fiscal year.

 

The results of operationsin the following Selected Financial Data, as well as in our consolidatedfinancial statements, present the results of our EMS, Transportation and MobileGovernment segments, which we sold during 2004, as discontinuedoperations.  Loss from continuingoperations does not include any financial results of the EMS, Transportation orMobile Government segments.

 

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| ** **                                                                                                                                                                         | ** ** | **YEAR ENDED DECEMBER 31,**             | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                                                                         | ** ** | **2000**                                     | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                                         | ** ** | **(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)** | ** ** |
| CONSOLIDATED STATEMENT OF OPERATIONS DATA:                                                                                                                                         |       |                                         |       |   |   |   |   |   |   |   |   |
|                                                                                                                                                                               |       |                                         |       |   |   |   |   |   |   |   |   |
| Interest income from MBS portfolio                                                                                                                                                 |       | $                                            | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | 928 |   |
| Interest expense from MBS portfolio                                                                                                                                                |       | —                                       |       | — |   | — |   | — |   | — |   |
| Net interest income from MBS portfolio                                                                                                                                             |       | —                                       |       | — |   | — |   | — |   | 928 |   |
| Gain on sale of MBS                                                                                                                                                                |       | —                                       |       | — |   | — |   | — |   | 1,826 |   |
|                                                                                                                                                                               |       |                                         |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                                                                                                                                                |       |                                         |       |   |   |   |   |   |   |   |   |
| Selling, general and administrative (1)                                                                                                                                            |       | (21,163                                      | )          | (38,340 | ) | (22,862 | ) | (15,779 | ) | (12,150 | ) |
| Depreciation and amortization                                                                                                                                                      |       | (2,165                                       | )          | (7,802 | ) | (6,319 | ) | (2,672 | ) | (2,212 | ) |
| Option and warrant expense                                                                                                                                                         |       | (3,889                                       | )          | (1,990 | ) | (1,735 | ) | (928 | ) | (594 | ) |
| Impairment of other assets                                                                                                                                                         |       | —                                       |       | (2,807 | ) | (7,589 | ) | (1,367 | ) | — |   |
| Other expense                                                                                                                                                                      |       | —                                       |       | — |   | — |   | (744 | ) | (60 | ) |
| Restructuring charge                                                                                                                                                               |       | —                                       |       | (875 | ) | (558 | ) | (306 | ) | (1,054 | ) |
| Total operating expenses                                                                                                                                                           |       | (27,217                                      | )          | (51,814 | ) | (39,063 | ) | (21,796 | ) | (16,070 | ) |
| Operating loss                                                                                                                                                                     |       | (27,217                                      | )          | (51,814 | ) | (39,063 | ) | (21,796 | ) | (13,316 | ) |
| Interest income from money market accounts                                                                                                                                         |       | 55,997                                       |       | 27,556 |   | 9,921 |   | 6,037 |   | 3,508 |   |
| Interest expense from subordinated notes                                                                                                                                           |       | (15,981                                      | )          | (20,402 | ) | (15,827 | ) | (10,427 | ) | (7,917 | ) |
| Equity in losses of investments                                                                                                                                                    |       | (47,886                                      | )          | (57,523 | ) | (4,744 | ) | (97 | ) | — |   |
| Gain (loss) on early extinguishment of debt                                                                                                                                        |       | —                                       |       | 7,684 |   | 42,765 |   | — |   | (2,419 | ) |
| Investment gain (loss), including  impairments, net                                                                                                                                |       | —                                       |       | (143,384 | ) | (14,412 | ) | 587 |   | (3,559 | ) |
| Loss from continuing operations before  discontinued operations and cumulative effect of change in accounting  principle                                                           |       | (35,087                                      | )          | (237,883 | ) | (21,360 | ) | (25,696 | ) | (23,703 | ) |
| Loss from discontinued operations, net of  tax expense (benefit) of $(1.6 million), $(10.7 million), $(535,000), $75,000  and $0 for 2000, 2001, 2002, 2003 and 2004, respectively |       | (327,613                                     | )          | (1,422,776 | ) | (304,062 | ) | (23,756 | ) | (45,450 | ) |
| Gain on sale of discontinued operations                                                                                                                                            |       | —                                       |       | — |   | — |   | — |   | 20,825 |   |
| Cumulative effect of change in accounting  principle relating to adoption of SFAS No. 133 in 2001                                                                                  |       | —                                       |       | 6,564 |   | — |   | — |   | — |   |
| Net loss                                                                                                                                                                           |       | $                                            | (362,700   | ) | $ | (1,654,095 | ) | $ | (325,422 | ) | $ | (49,452 | ) | $ | (48,328 | ) |
| Net loss per share from continuing  operations before discontinued operations and cumulative effect of change in  accounting principle                                             |       | $                                            | (0.97      | ) | $ | (5.84 | ) | $ | (0.51 | ) | $ | (0.60 | ) | $ | (0.54 | ) |
| Net loss per share from discontinued  operations                                                                                                                                   |       | (9.02                                        | )          | (34.93 | ) | (7.22 | ) | (0.56 | ) | (1.04 | ) |
| Gain per share on sale of discontinued  operations                                                                                                                                 |       | —                                       |       | — |   | — |   | — |   | 0.47 |   |
| Cumulative effect of change in accounting  principle                                                                                                                               |       | —                                       |       | 0.16 |   | — |   | — |   | — |   |
| Net loss per share – basic and diluted                                                                                                                                        |       | $                                            | (9.99      | ) | $ | (40.61 | ) | $ | (7.73 | ) | $ | (1.16 | ) | $ | (1.11 | ) |
| Weighted average shares outstanding                                                                                                                                                |       | 36,310                                       |       | 40,732 |   | 42,117 |   | 42,616 |   | 43,713 |   |
|                                                                                                                                                                               |       |                                         |       |   |   |   |   |   |   |   |   |
| CONSOLIDATED BALANCE SHEET DATA:                                                                                                                                                   |       |                                         |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents (including restricted  cash)                                                                                                                             |       | $                                            | 872,747    |   | $ | 527,430 |   | $ | 68,593 |   | $ | 39,682 |   | $ | 69,555 |   |
| Investments available for sale                                                                                                                                                     |       | 2,648                                        |       | 2,490 |   | 255,825 |   | 220,849 |   | — |   |
| MBS                                                                                                                                                                                |       | —                                       |       | — |   | — |   | — |   | 62,184 |   |
| Total assets                                                                                                                                                                       |       | 2,677,375                                    |       | 951,419 |   | 475,407 |   | 398,105 |   | 136,586 |   |
| Total debt                                                                                                                                                                         |       | 334,941                                      |       | 306,138 |   | 154,945 |   | 154,942 |   | — |   |
| Stockholders’ equity                                                                                                                                                          |       | $                                            | 2,167,699  |   | $ | 544,526 |   | $ | 229,398 |   | $ | 179,301 |   | $ | 130,590 |   |

 

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(1)          Exclusive of option and warrant expense - seeconsolidated financial statements.

 

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**ITEM7. ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussion andanalysis should be read in conjunction with our consolidated financialstatements and the related notes, which appear in Item 8 of this Report.

 

In this discussion andanalysis, we explain our financial condition and results of operations.  We have organized our discussion and analysisas follows:

 

•                  First, we briefly summarize the impact of thesales of our mobile and wireless data businesses on our operating results andour financial condition.

•                  We then discuss a number of aspects of ourfinancial results that make it difficult to compare results from one year tothe next.

•                  We then discuss our critical accountingpolicies.

•                  We then discuss the results of our continuingoperations for the year ended December 31, 2004, compared with results for2003 and 2002.

•                  Next, we review our financial conditionaddressing our sources and uses of cash, liquidity and capital resources andcontractual obligations. 

•                  We conclude with a description of risksassociated with our business.

 

INTRODUCTION AND OVERVIEW

 

*Sales ofMobile and Wireless Data Businesses*

 

We own and manage aportfolio of mortgage-backed securities and other short-term government agencyinvestments.  These investments and ourstrategy for managing this business are discussed in detail above in Item 1under the heading “Introduction.”

 

In2004, we sold our mobile and wireless data businesses, which had not beenprofitable historically, and we substantially reduced our operating losses andoverall cash consumption.  During thefourth quarter of 2004, we substantially completed our obligations undercertain transition services agreements with the purchasers of ourTransportation and Mobile Government businesses and began to focus primarily onour mortgage-backed securities business. We also further reduced staffing levels and reduced ongoing operatingexpenses.  Because of certain costsrelated to the sales of our Transportation and Mobile Government businesses andthe implementation of our new business strategy, however, overall fourthquarter operating expenses in 2004 were higher than we expect them to be infuture quarters.

 

Inconnection with our business transition, during the fourth quarter we reducedthe size of our corporate staff significantly and currently have a staff ofeight employees.  In addition, we haverelocated our corporate offices to a smaller leased facility in Baltimore, Maryland.  This new location will become our soleoperating location.  All other existingleases (except for the lease in Massachusetts that we have sublet to the buyerof our Mobile Government business) expire during the first quarter of 2005.  Going forward, we expect our general andadministrative expenses to be significantly lower, although we will still incurcosts associated with being a public company, including insurance, audit andother outside professional services, compliance and various regulatoryfees.  We also will continue to incur feesfor our outside investment and financial advisors.  

 

As a result of the sales ofour three mobile and wireless data business segments, we have presented theresults of the EMS, Transportation and Mobile Government segments as“discontinued operations.”  These threeoperating segments accounted for all of the operating revenue and a significantportion of the operating expenses that we have previously reported.  Consequently, when the results of thesesegments are presented as “discontinued operations,” the operating revenues andexpenses of our continuing operations are significantly lower than they havebeen in the past.  As required bygenerally accepted accounting principles, we have restated prior periods to reflectthe presentation of the Transportation and Mobile Government segments as“discontinued operations,” so that period-to-period results are comparable.

 

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We may be subject tocontinuing liabilities as a result of our sales of our operating business.  Under the definitive purchase agreements, wehave agreed to indemnify the buyers of these businesses for certain breaches ofrepresentations and warranties and other covenants that we provided to them withrespect to the sales of the businesses. In addition, we remain fully liable for the operation of each of thebusiness segments prior to the dispositions. We also have retained liability for certain continuing obligationsassociated with the Mobile Government segment, as described in Note 15 of thenotes to our consolidated financial statements included in Item 8 of thisReport.  In addition, as discussed belowin Item 7 under the heading “Sales of Discontinued Operations” and in Note 15of the notes to our consolidated financial statements included in Item 8 ofthis Report, we are involved in a dispute with the buyer of our Transportationsegment about the amount of post-closing payments and purchase priceadjustments.  To the extent this disputeis not resolved in our favor, we may not receive certain additional paymentsthat we expect and we may be required to make a cash payment to the buyer.  In such event, we would record a chargeagainst earnings, further increasing the loss on the sale of the Transportationsegment.

 

With the transition from ourmobile and wireless data businesses to our MBS business, we will no longerreport revenue, cost of revenue or gross profit.  Instead, we expect that our income statementwill consist primarily of interest income and expense, realized and unrealizedgains on transactions and selling, general and administrative expenses.  Our balance sheet now includes (or as wedevelop our MBS business, is expected to include) primarily cash and cashequivalents, investments, repurchase agreements (to the extent we borrow fundsto leverage our MBS portfolio), interest receivable and payable and other lesssignificant assets and liabilities, including the fair value of derivativeinstruments.  To the extent that we enteradditional or different businesses in the future, the results of our operationsand the composition of our assets and liabilities could again changematerially.

 

*OtherFactors Affecting Comparability of Results of Operations*

 

Certain items included inour results of operations have varied significantly from one year to the next,making it difficult to compare our overall results from year to year.  These items are discussed below.  In general, as discussed below, we do not expectthese items to have a material impact on our results of operations in futureyears.

 

Impairment Charges

 

*SFAS No.121 Impairments*

 

Through December 31,2001, we recorded approximately $1.718 billion in goodwill and otherintangibles in discontinued operations related to acquisitions of mobile andwireless data businesses.  During 2001,we performed on-going analysis of the recoverability of our goodwill and otherintangibles and the value of our investments in accordance with SFAS No. 121,“Accounting for the Impairment of Long-Lived Assets and For Long-Lived Assetsto be Disposed Of.”  Based onquantitative and qualitative measures, we assessed the need to recordimpairment losses on long-lived assets used in operations when impairmentindicators were present.

 

Based on a variety ofindicators, we determined during 2001 that the goodwill and other intangiblesfrom our acquisitions may have become impaired. As a result of our review, we determined that the carrying value ofgoodwill and certain other assets related to our acquisitions were not fullyrecoverable.  Accordingly, during 2001,we recorded impairment charges in continuing operations of approximately $2.8million, which represented the difference between the carrying value and fairvalue of the assets.  Also during 2001,we recorded impairment charges in discontinued operations of approximately$1.118 billion, which represented the difference between the carrying value andfair value of the goodwill, intangible and other assets.  These amounts are included in the loss fromdiscontinued operations.

 

*Goodwill*

 

Weadopted the provisions of SFAS No. 142, “Goodwill and Other IntangibleAssets,” as of January 1, 2002. Goodwill and intangible assets acquired in a purchase businesscombination and determined to have an indefinite useful life are notamortized.  Instead, they are tested forimpairment at least annually in accordance with the provisions of SFASNo. 142.  SFAS No. 142also requires that intangible assets with estimable useful lives be amortizedover their respective estimated useful lives to their estimated residualvalues, and reviewed for impairment in accordance with SFAS No. 144,“Accounting for Impairment or Disposal of Long-Lived Assets.”

 

Asa result of the adoption of SFAS No. 142, we recorded an impairment charge of$129.3 million ($29.7 million to goodwill and $99.6 million to intangibleassets) related to discontinued operations. SFAS No. 142 also requires that we repeat the impairment analysis eachyear, beginning with a recurring annual measurement date chosen by us in2002.  We chose September 30, 2002 tobe 2002’s measurement date, and we continued to perform annual impairmentreviews as of September 30th each subsequent year.  The September 30, 2002 review resultedin an additional impairment charge to goodwill of $26.8 million.  All of these amounts are included in lossfrom discontinued operations.  Weperformed this analysis again in September 2003 and determined that therewas no further impairment of goodwill at that time.

 

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During the second quarter of2004, with the potential future sale of the Transportation and MobileGovernment segments, we reassessed the value of the Transportation and MobileGovernment goodwill and recorded impairment charges related to goodwill of$12.2 million and $8.9 million, respectively. After the sale of the EMS, Transportation and Mobile Governmentsegments, we no longer have any goodwill on our balance sheet.  Therefore, SFAS No. 142 and goodwillimpairment charges will not be relevant to future results.

 

See Notes 3 and 15 of thenotes to our consolidated financial statements included in Item 8 of thisReport for a more detailed discussion of these subjects.

 

*Intangibles and Other Long-Lived Assets.*

 

SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”provides a single accounting model for long-lived assets to be disposedof.  SFAS No. 144 also changes thecriteria for classifying an asset as held for sale; and broadens the scope ofbusinesses to be disposed of that qualify for reporting as discontinuedoperations and changes the timing of recognizing losses on suchoperations.  We adopted SFAS No. 144on January 1, 2002.

 

During2002, we recorded an impairment charge to intangibles and other long-livedassets of $42.8 million.  Of this charge,$7.6 million related to continuing operations and $30.0 million, $5.1 millionand $125,000 related to EMS, Transportation and Mobile Government,respectively, which are reported as discontinued operations.

 

During2003, we recorded impairment charges to intangibles and other long-lived assetsof $2.7 million.  Of this charge, $1.4million related to continuing operations and $629,000 and $677,000 related toEMS and Transportation, respectively, which are reported as discontinuedoperations.

 

Duringthe second quarter of 2004, with the potential future sale of theTransportation and Mobile Government segments, we reassessed the value of theTransportation and Mobile Government intangibles and other long-lived assetsand recorded non-cash impairment charges related to Transportation intangiblesand other assets of $3.1 million and $11.3 million, respectively.  After the sale of the EMS, Transportation andMobile Government segments, we no longer have any intangible assets on ourbalance sheet.  Therefore, intangibleasset impairment charges will not be relevant to future results.  We will continue to evaluate our otherlong-lived assets in accordance with SFAS No. 144.

 

SeeNotes 3 and 15 of the notes to our consolidated financial statements includedin Item 8 of this Report for a more detailed discussion of these subjects.

 

*Investments*

 

From 1999 through 2001, wemade approximately $196.8 million of investments in other businesses throughour Aether Capital L.L.C. subsidiary. During 2001, we recorded a net charge of $143.4 million, which included$136.7 million in impairment charges related to our investments.  The remainder of the net charge related tonet gains and losses from the sales of investments, and changes in the fairvalue of warrants.  

 

During 2002, we recorded anet charge of $14.4 million, which included $14.1 million in impairment chargesrelated to our investments.  Theremainder of the charge related to net gains and losses from the sales ofinvestments, and changes in the fair value of warrants.  

 

During 2003, we recorded anet gain of $587,000, which included impairment charges of $71,000 related toour investments.  The remainder of thenet gain resulted from sales of investments.

 

During 2004, we recorded anet loss of $3.6 million, which included a $5.4 million loss on the liquidationof our investments available for sale consisting of highly liquid U.S.Government Agency-sponsored securities. The loss was partially offset by a gain of $1.8 million relating to thesale of other investments.

 

As of December 31,2004, our investment balances were primarily related to MBS and cashequivalents.

 

SeeNote 5 of the notes to our consolidated financial statements included in Item 8of this Report for a more detailed discussion of these subjects.

 

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Restructuring Charges

 

During 2001 through 2004, weimplemented expense reduction plans as part of our integration strategy focusedon improving operational efficiencies and the implementation of other measuresin order to reduce planned expenses. These efforts have resulted in the consolidation of excess facilitiesand a significant reduction in our workforce. As of December 31, 2004, we had a total of 12 employees, and all ofthem were located at our principal office in Baltimore, Maryland.  Employee separation benefits under therestructuring plans include severance, medical, and other benefits.  Facility closure costs and other costsincluded expected losses on subleases, brokerage commissions, asset impairmentcharges, contract termination costs and other costs.

 
| **(Charge  in thousands)**        | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Continuing  Operations            |       |     |       |     |       |     |       |
| Charge                            |       | $        | 558        |     | $          | 306      |       | $ | 1,054 |   |
| Positions Eliminated              |       | 37       |       | 10       |       | 14       |       |
| Discontinued Operations           |       |     |       |     |       |     |       |
| Charge                            |       | $        | 37,186     |     | $          | 5,851    |       | $ | 84 |   |
| Positions Eliminated              |       | 287      |       | 102      |       | —   |       |
| Facilities Closed or Consolidated |       | 2        |       | —   |       | —   |       |

 

As of December 31,2004, the accrued liability related to all restructuring activities was$259,000, the majority of which related to lease obligations.  Restructuring charges in 2005 are notexpected to be material to our results or financial condition.

 

See Note 8 of the notes toour consolidated financial statements included in Item 8 of this Report for amore detailed discussion of these subjects.

 

CRITICALACCOUNTING POLICIES

 

Our critical accountingpolicies affect the amount of income and expense we record in each period aswell as the value of our assets and liabilities and our disclosures regardingcontingent assets and liabilities.  Inapplying these critical accounting policies, we must make estimates andassumptions to prepare our financial statements that, if made differently,could have a positive or negative effect on our financial results.  We believe that our estimates and assumptionsare both reasonable and appropriate, in light of applicable accountingrules.  However, estimates involve judgments with respect to numerous factors that aredifficult to predict and are beyond management’s control.  As a result, actual amounts could materiallydiffer from estimates.

 

Management believes that thefollowing accounting policies represent “critical accounting policies,” whichthe Securities and Exchange Commission defines as those that are most importantto the portrayal of a company’s financial condition and results of operationsand require management’s most difficult, subjective, or complex judgments,often because management must make estimates about uncertain and changingmatters.  We discuss these and othersignificant accounting policies related to our continuing operations in Note 2of the notes to our consolidated financial statements included in Item 8 ofthis Report.

 

***Mortgage-backed securities***

 

We invest primarily inagency pass-through certificates representing interests in or obligationsbacked by pools of mortgage loans.

 

Statement of FinancialAccounting Standards No. 115, *Accounting forCertain Investments in Debt and Equity Securities*, requires us toclassify our investments as trading investments, available-for-sale investmentsor held-to-maturity investments. Although we generally intend to hold most of our investments untilmaturity, we may, from time to time, sell any of our investments as part of ouroverall management of our statement of financial condition.  Accordingly, this flexibility requires us toclassify all of our mortgage-backed securities as available for sale.  All assets classified as available for saleare reported at fair value, based on market pricing estimates provided byindependent pricing services and dealers who make markets in these financialinstruments, with unrealized gains and losses excluded from earnings andreported as a separate component of stockholders’ equity.

 

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Unrealizedlosses on mortgage-backed securities that are considered other than temporary,as measured by the amount of decline in fair value attributable to factorsother than temporary, are recognized in income and the cost basis of thesecurities is adjusted.  As of December 31,2004, we had two MBS in an aggregate unrealized loss position of $210,000because changes in interest rates have reduced their market value.  The securities carry an implied AAA rating.  We do not consider these unrealized lossesother-than-temporary since we have the ability and the intent to hold theinvestments for a period of time sufficient to allow for a market pricerecovery.

 

Interest income is accruedbased on the outstanding principal amount of the securities and theircontractual terms.  Premiums anddiscounts associated with the purchase of the securities are amortized intointerest income over the lives of the securities using the interest method inaccordance with Financial Accounting Standard No. 91, *Accounting for Nonrefundable Fees and CostsAssociated with Originating or Acquiring Loans and Initial Direct Costs ofLeases. *Our policy for estimating prepayment speedsfor calculating the effective yield is to evaluate historical performance,street consensus prepayment speeds, and current market conditions.  In general, as prepayment speeds on our MBSincrease, related purchase premium amortization increases, thereby reducing ournet yield on MBS.  If we used differentprepayment estimates, the amounts we report for interest income could bematerially different.

 

MBS transactions arerecorded on the trade date.  Purchases ofnewly issued securities are recorded when all significant uncertaintiesregarding the characteristics of the securities are removed, generally shortlybefore settlement date.  Realized gainsand losses on such transactions are determined on the specific identificationbasis.                                                 

 

SeeNote 4 of the notes to our consolidated financial statements included in Item 8of this Report for a more detailed discussion of the MBS we held at December 31,2004.

 

***Valuation of deferred tax assets***

 

We have deferred tax assetsas a result of years of accumulated tax loss carryforwards.  Management believes we will achieveprofitable operations in future years that will enable us to recover thebenefit of our deferred tax assets. However, we presently do not have sufficient objective evidence tosupport management’s belief and, accordingly, we maintain a full valuationallowance for our net deferred tax assets as required by generally accepted accountingprinciples.  When we have sufficientobjective evidence, we will reduce our valuation allowance accordingly.  

 

SeeNote 10 of the notes to our consolidated financial statements included in Item8 of this Report for a more detailed discussion of these subjects.

 

***Guarantees***

 

We have certain guaranteesrelated to assigned leases.  We alsoagreed to maintain a letter of credit as collateral assurance of performancefor a significant customer contract that was assigned to the buyer of our MobileGovernment business in connection with the sale of that business.  These arrangements have been evaluated inaccordance with FASB Interpretation No. 45, “Guarantors Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others” (FIN 45), and we have recorded a total liability of$308,000 in respect to these arrangements. This liability is included in “Other long-term liabilities” on ourbalance sheet.  The liability wasrecorded based on various scenarios that could result in potential liabilitiesfrom the guarantee ranging from $0 to $6.9 million and the estimatedprobability of those scenarios based on discussions with personnel closelyinvolved with the project.  Had we useddifferent estimates, the liability that we recorded could have differedmaterially.

 

See Note 14 of the notes toour consolidated financial statements included in Item 8 of this Report for amore detailed discussion of these subjects.

 

***Recent Accounting Pronouncements***

 

InDecember 2004, the FASB issued a revision of Statement of FinancialAccounting Standards No. 123, titled “Share-Based Payments” (“Statement No.123R”). Statement No. 123R requires that share-based payments, such as grantsof stock options, restricted shares, and stock appreciation rights, be measuredat fair value and reported as expense in a company’s financial statements overthe requisite service period.

 

See Note 2 of the notes toour consolidated financial statements included in Item 8 of this Report for amore detailed discussion of this subject.

 

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RESULTSOF CONTINUING OPERATIONS

 

*Overview*

 

Because we beganimplementing our MBS strategy in 2004, and because we have only invested alimited amount of cash in MBS, in response to market conditions and the adviceof our outside financial and investment advisors, the results of our operationsin 2004 and prior years are not indicative of what we expect our results to bein the future.  Most significantly, ouroperating expenses (though they have declined significantly) are still higherthan they will be, and we have realized only limited interest income from ourMBS portfolio (reflecting limited MBS investment for only a portion of 2004 andour decision not to expand the portfolio in 2004 through the use of leverage).

 

The most notable trend inour operating results is the decline in both expenses and operating loss.  From 2002 to 2003, our business saw thebenefits of our organizational restructuring efforts, which significantlyreduced our operating expenses.  In 2002,we also repurchased a portion of our 6% convertible subordinated notes at adiscount.  This not only produced asignificant one-time gain (which reduced our 2002 loss from continuingoperations), but also substantially reduced our interest expense going forward.

 

From2003 to 2004, our business continued to benefit from our organizationalrestructuring activities.  Our operatingloss continued to decline as a result of the decline in our expenses.  In October 2004, we redeemed all of theremaining outstanding 6% convertible subordinated notes at a price of101.2% and realized a $2.4 million loss on the early extinguishment.  The loss, however, was offset by lowerinterest expense as a result of the redemption. If we had not redeemed these notes, we would have been required to pay$4.3 million of interest on the notes through their maturity in March 2005.

 

Interest Income from MBSPortfolio

 

Duringthe second quarter of 2004, we began implementing an MBS strategy and investeda portion of our cash resources into an MBS portfolio.  Initially, our Board of Directors authorizedthe use of up to $75 million for the MBS strategy.  This limit was later increased to $100million.  Initially, we entered intoforward purchase contracts representing commitments to make futurepurchases of mortgage-backed securities with an estimated face value of $264.5million.  As discussed below, we sold our position fora gain in the third quarter of 2004 (before purchasing the underlyingmortgage-backed securities).  We theninvested approximately $63.8 million in MBS in September and October of2004.  The remainder of our cashallocated to the MBS strategy was invested in short-term U.S. GovernmentAgency-sponsored cash equivalents with yields between 1.23% and 2.27%.  We consider interest earned on all of theseinvestments to be interest from our MBS portfolio.  During 2004, the interest earned on theportfolio was approximately $928,000, net of premium amortization and custodianfees.

 
| **(in thousands)**                                              | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|
| Interest earned on MBS                                          |       | $        | 505        |   |
| Less: MBS premium amortization                                  |       | (22      | )          |
| Interest earned on U.S. Government Agency-sponsored  securities |       | 447      |       |
| Less: Custodian fees                                            |       | (2       | )          |
| Interest income from MBS portfolio                              |       | $        | 928        |   |

 

Ourinterest income from MBS, which reflects the amortization of purchase premiums,varies primarily as a result of changes in interest rates and prepaymentspeeds.  Changes in both interest ratesand prepayment speeds are uncertain and represent principal risks of our MBSstrategy, as discussed below in Item 7 under the heading “Risk Factors –Differences in timing of interest rate adjustments on our acquired securitiesand on our borrowings may adversely affect our MBS strategy and the returns onthe portion of our cash we invest in MBS.” Prepayment speeds, as reflected bythe Constant Prepayment Rate (“CPR”), and interest rates vary according to thetype of investment, conditions in financial markets, competition and otherfactors, none of which can be predicted with any certainty.  In general, as prepayment speeds on our MBSincrease, related purchase premium amortization increases, thereby reducing thenet yield on MBS.

 

Thefollowing table presents key metrics of our MBS, for the quarterly periodspresented:

 
| **Quarter Ended**       | ** ** | **Weighted  Average Coupon** | ** ** | **Weighted  Average CPR** | ** ** | **Weighted  Average  Yield** | ** ** |
|-------------------------|------------|------------------------------|------------|---------------------------|------------|------------------------------|------------|
| September 30, 2004 |       | 3.93                         | %          | —                    | %          | 3.88                         | %          |
| December 31, 2004  |       | 3.92                         | %          | 7.3                       | %          | 3.76                         | %          |

 

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Webelieve that the CPR in future periods will depend, in part, on changes in andthe level of market interest rates across the yield curve, with higher CPRsexpected during periods of declining interest rates and lower CPRs expectedduring periods of rising interest rates. 

 

Gain on Sale of MBS

 

In late June 2004,we purchased forward option contracts representing commitments to make futurepurchases of mortgage-backed securities with an estimated face value of $264.5million.  The purchase commitmentsappreciated in value during the third quarter of 2004 and we sold our position,realizing a cash gain of approximately $1.8 million.

 

Operating Expenses

 

Ouroperating expenses have declined significantly each year from 2002 to 2004,primarily due to the results of our restructuring efforts, in which westreamlined our organization and reduced our workforce.  In addition, we have not continued toexperience significant impairment charges on our long-lived assets, afterincurring significant impairment charges in 2002 and, to a lesser extent, 2003.

 

**Operating Expenses:**

 
| **(in thousands)**                            | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Selling, general and administrative  expenses |       | $        | (22,862    | )        | $          | (15,779  | )          | $ | (12,150 | ) |
| Depreciation                                  |       | (6,319   | )          | (2,672   | )          | (2,212   | )          |
| Option and warrant expense                    |       | (1,735   | )          | (928     | )          | (594     | )          |
| Impairment of other assets                    |       | (7,589   | )          | (1,367   | )          | —   |       |
| Other expense                                 |       | —   |       | (744     | )          | (60      | )          |
| Restructuring charge                          |       | (558     | )          | (306     | )          | (1,054   | )          |
|                                          |       |     |       |     |       |     |       |
| Total Operating Expenses                      |       | $        | (39,063    | )        | $          | (21,796  | )          | $ | (16,070 | ) |

 

We expect our 2005 operatingexpenses to be significantly lower than 2004. During the first quarter of 2005 we have substantially completedtransition activities that related to ongoing obligations to the buyers of ourTransportation and Mobile Government segments. We also have streamlined our corporate infrastructure to the levelrequired to support our ongoing business. However, we will continue to incur the costs of operating as a publiclytraded company, as discussed in more detail below in Item 7 under the heading“Risk Factors – Compliance with changing regulation of corporate governance andpublic disclosure may result in additional expenses.”

 

*Selling, General andAdministrative Expenses*

 

Selling, general andadministrative (SG&A) expenses consist primarily of cash compensation andrelated costs for general corporate personnel, along with rent and generalsupport costs.  These expenses alsoinclude the costs of outside professionals,****includinglegal counsel, accountants and investment bankers.

 

SG&A expenses decreased$7.1 million, or approximately 31% from 2002 to 2003.  Of the decrease, $2.1 million is primarilydue to reductions in personnel costs as a result of our reduction inworkforce.  Telecommunications costsdecreased $1.6 million.  Travel, taxesand facility expenses also decreased approximately $880,000, $709,000 and$686,000, respectively.

 

SG&A expenses decreased$3.6 million, or approximately 23%, from 2003 to 2004.  Of the decrease, $1.4 million is primarilydue to reductions in personnel costs as a result of our reduction in workforce.  Facility and travel costs decreasedapproximately $978,000 and $447,000, respectively.  Additional expense reductions were offsetsomewhat by a $1.0 million increase in investment banking fees paid in2004.  These investment banking feesincluded $900,000 related to the implementation of our MBS strategy, including$500,000 paid to our investment advisor (FBR Investment Management) forassisting with the development and launch of the MBS strategy, as well as$400,000 paid to a third-party investment expert to provide our management andour Board of Directors with an independent assessment of the MBS strategy.  Additionally, the investment banking feesincluded a $400,000 advisory fee related to an unconsummated deal to sell ourTransportation segment.

 

Our 2004 SG&A expensesinclude the fees we pay to our investment advisor relative to their advisoryservices for our MBS portfolio.  Thesefees include a quarterly management fee equal to 0.0375% of the aggregate costbasis of the portfolio and an incentive fee equal to 25% of the yield in excessof a certain yield threshold.  Themanagement fee will increase as the size of our MBS portfolio increases.  As of December 31, 2004, no incentivefee has been earned on the portfolio.

 

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We expect our 2005 SG&Aexpenses to be significantly lower than 2004 now that we have completed thesales of our operating segments and the transition of our business.  Over time, if we increase our MBS portfolioto a significant size, we may expand our corporate staff to add MBS investmentexpertise, which would allow us to reduce our reliance on, and the fees we arerequired to pay to our outside investment advisors.  We have not yet determined at what point, ifat all, we would consider it prudent and advisable to expand our corporatestaff to add this capability, but we plan to continuously evaluate thecost-effectiveness of additional personnel. 

 

*Depreciation*

* *

Depreciation expenses arisefrom property and equipment purchased for use in our operations.

 

Depreciation decreased $3.6million from 2002 to 2003.  The decreasewas primarily a result of the impairment charges recorded during 2002, whichsignificantly reduced the carrying value of our long-lived assets.

 

Depreciation decreasedapproximately $460,000 from 2003 to 2004. The decrease was primarily a result of the impairment charges recordedduring 2002 and 2003, which significantly reduced the carrying value of ourlong-lived assets, offset somewhat by accelerated depreciation on certainassets taken out of service during 2004. 

 

During 2004, we identifiedthat portion of our corporate assets that would cease to be used in our ongoingoperations after the streamlining of our corporate infrastructure and our moveto Baltimore.  At that point, we began acceleratingthe depreciation on those assets based on their shortened useful lives.  As a result, our fixed asset balances at December 31,2004 primarily include assets that will be used on an ongoing basis and thedepreciation on those assets in 2005 will be significantly lower than 2004depreciation.

 

See Note 6 of the notes toour consolidated financial statements included in Item 8 of this Report for amore detailed discussion of these subjects.

 

*Option and Warrant Expense*

* *

Option and warrant expensedecreased approximately $807,000 from 2002 to 2003 and approximately $334,000from 2003 to 2004.  The decreases in 2003and 2004 were primarily the result of the cancellation of options as we reducedour work force.

 

See Note 12 of the notes toour consolidated financial statements included in Item 8 of this Report for amore detailed discussion of these subjects. 

 

*Impairment of Other Assets and Restructuring Charges*

* *

Wehave discussed our impairment of other assets and restructuring charges abovein the introduction to this Item 7, under the headings “Impairment Charges –Intangibles and Other Long-Lived Assets” and “Restructuring,” respectively.

 

*OtherExpense*

 

Other expense wasapproximately $744,000 for 2003 and was primarily due to the loss on disposal ofour corporate jet, offset somewhat by gains on the disposal of other assets wesold.

 

Other expense for 2004 wasapproximately $60,000 and was primarily due to a litigation settlement.

 

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**Other Income (Expense):**

 
| **(in thousands)**                                  | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest income from money market accounts          |       | $        | 9,921      |     | $          | 6,037    |       | $ | 3,508 |   |
| Interest expense on subordinated notes  payable     |       | (15,827  | )          | (10,427  | )          | (7,917   | )          |
| Gain (loss) on early extinguishment of debt         |       | 42,765   |       | —   |       | (2,419   | )          |
| Equity in losses of investments                     |       | (4,744   | )          | (97      | )          | —   |       |
| Investment gain (loss), including  impairments, net |       | (14,412  | )          | 587      |       | (3,559   | )          |
| Total                                               |       | $        | 17,703     |     | $          | (3,900   | )          | $ | (10,387 | ) |
|                                                     |            |          |            |          |            |          |            |  |  |  |  |

 

Interest Income from MoneyMarket Accounts

 

Interest income from money market accounts consistsprimarily of interest from cash equivalents and investments with a maturity ofless than 12 months.  Interest incomefrom money market accounts decreased approximately $3.9 million from 2002 to2003 and approximately $2.5 million from 2003 to 2004 as the result of adecreasing cash and investment balance (as we continued to consume cash to fundour business and to repurchase (in 2002) and later redeem (in 2004) our 6%convertible subordinated notes), combined with decreased interest rates.  During 2004, we invested a substantialportion of our available cash in our MBS portfolio, and interest on suchamounts is reported as “Interest income from MBS portfolio,” as discussedabove.

 

Interest Expense onSubordinated Notes Payable

 

Interest expense onsubordinated notes payable consists primarily of debt service on ouroutstanding 6% convertible subordinated notes. Interest expense on subordinated notes payable decreased $5.4 millionfrom 2002 to 2003 and $2.5 million from 2003 to 2004, primarily due to adecrease in the outstanding principal amount of the notes as the result of therepurchase of debt in 2002 and the redemption of the remaining debt in2004.  As of October 4, 2004, all ofthe outstanding notes were redeemed and no further interest expense will beincurred.

 

Gain (Loss) on EarlyExtinguishment of Debt

 

During 2002, we realized again of $42.8 million, from repurchasing $135.6 million of our 6% convertiblesubordinated notes due March 22, 2005 at a discount to their face amount(including accrued interest).  During2004, we redeemed all of the remaining outstanding notes at a price of 101.2%and realized a $2.4 million loss, which consisted of the $1.9 million premiumon the repurchase and the recognition of approximately $560,000 in deferredfinancing costs.  The early retirement ofthe debt resulted in a savings of $4.3 million in interest expense on the notesthat we would have been required to pay through their maturity in March 2005.

 

Equity in Losses ofInvestments

 

Equity in losses ofinvestments consists of our proportionate share of the net losses in ourinvestments over which we exercised significant influence and as such accountedfor under the equity method of accounting. Equity in losses of investments decreased to approximately $97,000 for2003 from $4.7 million for 2002.  Thedecrease from 2002 to 2003 reflects a decrease in the number of equityinvestments in our portfolio in addition to decreased losses from thoseinvestments.  There were no equity lossesof investments during 2004 and we no longer have any investments accounted forunder the equity method.

 

Investment Gain (Loss),Including Impairments, Net

 

See the discussion under theheading “Impairment Charges - Investments,” above for a more detailed discussionof these subjects.

 

SALESOF DISCONTINUED OPERATIONS

 

***EMS Sale***

OnJanuary 13, 2004, we completed the sale of our EMS segment toTeleCommunication Systems, Inc. (“TCS”).  Pursuant to the purchase agreement, asamended, we received $19.0 million for the EMS segment, consisting of $18.0million in cash and a note in the principal amount of $1.0 million due in August 2004.  We also received 204,020 shares of TCS ClassA common stock valued as of closing at approximately $1.1 million.  In April 2004, we sold these securitiesand received approximately $1.4 million in cash.  In addition, the $1.0 million note from TCSwas repaid in full in August 2004.

 

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***Transportation Sale***

OnSeptember 17, 2004, we sold our Transportation segment to SlingshotAcquisition Corporation (“Slingshot”), which is an affiliate of Platinum EquityCapital Partners L.P., for $25.0 million in cash.  The purchase price is subject to apost-closing adjustment based on net working capital to the extent theTransportation segment’s adjusted net working capital at August 31, 2004was more than $28.2 million or less than $27.6 million.  In addition, the parties also agreed to netcash receipts and payments by (or for the account of) the Transportationsegment between September 1, 2004 and the closing date, with any positivenet cash balance being payable to Slingshot and any negative balance being duefrom Slingshot.  The transaction wasstructured as a sale of assets and assumption of certain liabilities.  The assets sold consisted of all of theassets used primarily in the Transportation segment.  Slingshot assumed responsibility forsubstantially all post-closing liabilities and certain historical liabilities,of the Transportation segment.  At theclosing of the purchase agreement, we entered into a transition servicesagreement with Slingshot to provide for the orderly transition of the businessto Slingshot, which is expected to be completed by early 2005. 

 

Inconnection with the sale of the Transportation segment, we recorded a $26.6million non-cash impairment charge in the second quarter of 2004. 

 

Duringthe fourth quarter of 2004, both parties advised each other of significantdisagreement over both the working capital adjustment and the cashtrue-up.  We advised Slingshot that basedon our calculation of net working capital, the purchase price should be reducedby approximately $67,000.  In addition,we advised Slingshot that pursuant to the cash true-up mechanism, Slingshotowed us approximately $923,000. Slingshot disputed our calculations and contended that its owncalculation of working capital supported a downward purchase price adjustmentof approximately $8.1 million and its view of the cash true-up arrangementsuggested that it should receive a payment from us of approximately$300,000.  We subsequently responded toSlingshot and rejected all of Slingshot’s calculations and arguments, exceptthat we agreed that the working capital calculation should result in anadditional downward price adjustment of approximately $40,000 and that amountsowed relative to the cash true-up mechanism should be reduced by approximately$79,000.

 

Wehave held discussions with Slingshot about the disputed amounts but have notreached agreement on any of them.  Whilewe strongly disagree with Slingshot’s positions on these matters, if thedisagreements cannot be resolved by agreement of the parties, they are requiredto be submitted (under the terms of the asset purchase agreement) to anindependent accounting firm for final resolution.  At this time, we cannot predict whether thedisagreements will be resolved consensually or what the results of any decisionby an independent accounting firm are likely to be.  As of December 31, 2004, we had $943,000in amounts due from Slingshot recorded on our balance sheet as **“**Prepaidexpenses and other assets.**”**  If we are not successful in collecting thisamount, we will have to write-off these assets with a future period charge toearnings.  In addition, if we do notprevail in our view of the appropriate working capital adjustment, we could berequired to make a cash payment to Slingshot in the amount of the workingcapital shortfall which would also result in a future period charge toearnings.

 

***Mobile Government Sale***

OnSeptember 30, 2004, we sold our Mobile Government segment to BIO-KeyInternational Inc. (“BIO-Key”) for $10.0 million in cash.  The purchase price is subject to apost-closing adjustment based upon net working capital.  The transaction was structured as a sale ofasset and assumption of certain liabilities. The assets sold consisted of all the assets used in the MobileGovernment segment.  BIO-Key assumedresponsibility for substantially all post-closing liabilities, and certainhistorical liabilities, of the Mobile Government segment.  We also entered into a transition servicesagreement with BIO-Key to provide for the orderly transition of the business toBIO-Key, which is expected to be completed by early 2005.

 

Inconnection with the sale of the Mobile Government segment, we recorded an $8.9million non-cash impairment charge in the second quarter of 2004. 

 

OnOctober 25, 2004, we informed BIO-Key that based on our calculation of networking capital, the purchase price should be increased by approximately$343,000.  During the fourth quarter of2004, BIO-Key paid us for the working capital adjustment and substantially allother amounts due related to the sale.

 

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FINANCIALCONDITION

 

*Introduction*

 

Inreviewing the discussion of our financial condition that follows, you shouldconsider the following:

 

•      Ourbusiness has never generated a profit. Consequently, we have required funding from sources other than ourbusiness operations to run our business. This funding has come principally from selling debt and equitysecurities.  We do not currently have abank line of credit or other bank borrowing facility, although we expect thatwe will be able to borrow money to expand our MBS portfolio through the use ofrepurchase agreements, as discussed above in Item 1 under the heading “Business– Introduction — Mortgage-Backed Securities Strategy.”

 

•                  AtDecember 31, 2004, we had cash balances and liquid investments (includingour investments in MBS and other U.S.-Government Agency sponsored securities)of approximately $122.9 million (excluding $8.8 million of restrictedcash).  This represents approximately 90%of the total assets on our balance sheet at December 31, 2004.  We have various obligations that we arerequired to pay over time under various contracts and agreements, as discussedin more detail below.  Our total balancesheet liabilities at December 31, 2004 were approximately $6 million.

 

•                  Sinceour inception in 1996, we have accumulated substantial net operating andcapital losses that we are allowed to carry forward for a period of time tooffset future taxable income.  These taxloss carryforwards would be a valuable asset if we become profitable in the futureand start to generate income that would otherwise be subject to incometax.  As discussed above in Item 1 underthe heading “Business – Introduction – Tax Aspects of Our Business Strategy,”subject to various regulatory limitations, under federal and state tax laws, weare permitted to use these losses to reduce the income taxes we otherwise wouldhave to pay on future income.  As aresult, we could have little or no income tax liability for a period of time ifwe are able to become profitable and generate taxable income.   See the discussion below under the heading“Risk Factors – We may not be able to realize value from our tax losscarryforwards” for more information on the risks associated with our ability touse these accumulated losses.

 

LIQUIDITYAND CAPITAL RESOURCES

 

Cash Flows

 

The following table reflects use of net cash foroperations, investing, and financing:

 
| ** **                                                        | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net cash used by operating activities from  continuing operations |       | $        | (17,763    | )        | $          | (53,279  | )          | $ | (18,557 | ) |
| Net cash used by discontinued operations                          |       | (90,136  | )          | (10,369  | )          | (6,031   | )          |
| Net cash used by operating activities                             |       | (107,899 | )          | (63,648  | )          | (24,588  | )          |
| Net cash provided by (used in) investing  activities              |       | (250,790 | )          | 37,102   |       | 209,243  |       |
| Net cash used in financing activities                             |       | (93,849  | )          | (3,459   | )          | (150,154 | )          |
| Net increase (decrease) in cash and cash  equivalents             |       | $        | (452,538   | )        | $          | (30,005  | )          | $ | 34,501 |   |
|                                                                   |            |          |            |          |            |          |            |  |  |  |  |

 

Net cash used inoperating activities was $24.6 million, $63.6 million and $107.9 million for2004, 2003 and 2002, respectively.  Whileour operating activities have not generated cash historically, we expect thatas we more fully implement our MBS business strategy, our continuing operationswill begin to generate cash during 2005, reflecting further reductions inoperating expenses, reduced restructuring payments, the completion oftransition service obligations associated with the sales of our mobile andwireless data businesses, and the elimination of interest payments related toour 6% subordinated notes. 

 

Netcash provided by investing activities was $209.2 million for 2004, consistingprimarily of $218.9 million from the liquidation of investments (primarilyUnited States Government Agency-sponsored securities) as discussed above underthe heading “Investment Gain (Loss), Including Impairments, Net.”  Additionally, we used $63.8 million topurchase mortgage backed securities and received $18.9 million, $23.0 million,and $8.8 million from the sale of our EMS, Transportation, and MobileGovernment segments, respectively, net of transaction expenses, and received$2.4 million from the sale of investments in Indivos Corporation and JuniperFinancial that we had made through Aether Capital L.L.C.  

 

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Net cash provided byinvesting activities was $37.1 million for 2003.  We received $33.2 million for the net sale ofshort-term and non-current investment instruments (primarily United StatesGovernment Agency-sponsored securities). Additionally, we used approximately$600,000 for the purchase of property and equipment (which was sold as part ofthe dispositions we completed in 2004) and received approximately $4.1 millionfrom sales of certain property and equipment.

 

Net cash used ininvesting activities was $250.8 million for 2002 and consisted primarily of the$248.7 million of purchases of short-term and non-current investmentinstruments, net of sales.  Additionally,approximately $2.2 million was used for the purchase of property and equipment.

 

Netcash used by financing activities was $150.2 million for 2004, consisting primarilyof $156.8 million used to redeem the remaining outstanding 6% convertiblesubordinated notes, as discussed above. Additionally, we received $4.6 million from the expiration of certainletters of credit in 2004.

 

Netcash used in financing activities was $3.5 million for 2003.  During 2003, financing activities includedthe investment of approximately $4.5 million of cash in certificates ofdeposit, which was used as collateral against certain letters of credit.

 

Netcash used in financing activities was $93.8 million for 2002, which primarilyconsisted of $92.3 million used for the repurchase of a portion of ouroutstanding 6% convertible subordinated notes due March 2005.

 

Asof December 31, 2003, we had investments available for sale totaling approximately$220.8 million that were classified as non-current assets since they all hadmaturities after December 31, 2004. During 2004, we liquated these investments and used the proceeds toredeem our remaining outstanding 6% subordinated notes and invest in MBS.  

 

As of December 31, 2004, our cash balances andliquid investments (including our investments in MBS and other U.S. Government Agency-sponsoredsecurities and excluding restricted cash) accounted for approximately $122.9million (90% of the total assets) on our balance sheet.  Our total liabilities as of the same datewere approximately $6.0 million.  The netimpact on our financial condition of our various strategic and operatingactivities during 2004 (as reflected by these cash flows) was to use a portionof our available cash to reduce our long-term liabilities, to convert variouscurrent and other assets that were used in our mobile and wireless databusinesses into cash, to eliminate various liabilities related to ourdiscontinued operations (through assignment of such liabilities to the buyersof those operations) and to begin to move a significant portion of ouravailable cash into our MBS business.

 

Capital Resources and Liquidity

 

We anticipate that our primary source of fundswith which to leverage our MBS portfolio will be repurchase agreements.  At December 31, 2004, we had masterrepurchase arrangements in place with four counterparties with no repurchaseagreements outstanding.  These masterrepurchase arrangements have no stated expiration but can be terminated at anytime at our option or at the option of the counterparty.  However, once a definitive repurchaseagreement under a master repurchase arrangement has been entered into, itgenerally may not be terminated by either party.  Increases in short-term interest rates couldnegatively impact the valuation of our mortgage related securities, which couldlimit our borrowing ability or cause our counterparties under our masterrepurchase arrangements to initiate margin calls.  This would increase our liquidity needs andcould reduce our ability to borrow.  Asdiscussed above in Item 1 under the heading “Business – Mortgage-BackedSecurities – Leverage and Borrowing Strategy,” we expect to enter intodefinitive repurchase arrangements to fund most of the amounts that will berequired to purchase MBS under the forward contract arrangements we enteredinto during February and March 2005.

 

For liquidity, we will also rely on cash flowfrom operations, primarily monthly principal and interest payments to bereceived on our MBS.  We believe thatcash flow from operations, and funding available through our master repurchasearrangements, will be sufficient to enable us to meet anticipated liquidityrequirements and plans to build our MBS portfolio.

 

Various changes in market conditions couldadversely affect our liquidity, including increases in interest rates andincreases in prepayment rates substantially above our expectations. If our cashresources are at any time insufficient to satisfy our liquidity requirements,we may be required to pledge additional assets to meet margin calls, liquidatemortgage related securities or sell debt or additional equity securities. Ifrequired, the sale of mortgage related securities at prices lower than thecarrying value of such assets would result in losses and reduced income.

 

We may in the future seekto increase our capital resources by making additional offerings of equity anddebt securities.  Additional equityofferings may be dilutive to stockholders’ equity or reduce the market price ofour common stock, or both.  We are unableto estimate the amount, timing or nature of any additional offerings as theywill depend upon market conditions and other factors, including limitationsunder applicable tax laws relating to our accumulated tax loss carryforwards,as discussed above under the heading “Risk Factors – We may not be able torealize value from our tax loss carryforwards.”

 

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Letters of Credit

 

As of December 31,2004, we have three letters of credit ($8.8 million) outstanding that expire atvarious times over the next four years. The largest of these serves as collateral assurance to secure theperformance of BIO-Key International, Inc., the buyer of the Mobile Governmentsegment, to Hamilton County, Ohio under a sales agreement that was assigned toBIO-Key as part of the sale of the Mobile Government business.  The remaining two letters of credit serve ascollateral to secure our performance on leased office space, including theMassachusetts office space used by the Mobile Government business, which wehave sublet to BIO-Key.  See thediscussion under the heading “Guarantees” below and in Note 14 of the notes toour consolidated financial statements included in Item 8 of this Report for amore detailed discussion of the Mobile Government letters of credit, includingarrangements that we have in place with BIO-Key to provide for repayment ifthese letters of credit are drawn.

 

Guarantees

 

As of December 31, 2004, we have made thefollowing guarantees:

 

•                  We haveguaranteed the payments on two leases that were assigned to the buyers of ourmobile and wireless data businesses. The maximum guarantee on these leases isapproximately $561,000.

•                  As of December 31,2004, we had $7.9 million of our certificates of deposit that were being heldon deposit to collateralize an irrevocable standby letter of credit put inplace when our Mobile Government segment entered into a sales agreement withHamilton County, Ohio to provide an automated field reporting solution and realtime wireless data infrastructure under a sales agreement.  The letter of credit provides collateralassurance of performance under the sales agreement.  The terms of the sales agreement and thestandby letter of credit state that Hamilton County can only draw on the letterof credit after (1) completing the internal dispute resolution process setforth in the sales agreement and (2) providing notice to Mobile Government ofits intent to declare a default under the sales agreement and proceed againstthe letter of credit.  A draw of thefunds under the letter of credit is subject to the limitations of liabilitycontained in the sales agreement.  Theletter of credit is required to remain in place through the earlier of the endof the warranty period or December 31, 2006.  The amount of the letter of credit can bereduced by 25% at the end of the third calendar month of the warranty period aslong as certain conditions are met. Although we sold the Mobile Government business to BIO-KeyInternational, Inc. on September 30, 2004, we agreed to maintain the $7.9million letter of credit in favor of Hamilton County.  In consideration of this arrangement, and toassure repayment to us of any amounts that Hamilton County collects by drawingon the letter of credit as a result of a default by BIO-Key, BIO-Key hasprovided us with a $1.0 million escrow and a $6.9 million subordinated securedpromissory note (the “BIO-Key Note”).  Weare entitled to retain the $1.0 million and to demand payment under the BIO-KeyNote if Hamilton County draws on the letter of credit.  The BIO-Key Note is secured by a second lienon substantially all of BIO-Key’s assets. The lien is subordinated to $5.0 million of senior secured debt held bycertain of BIO-Key’s lenders.  Asdiscussed above in Item 7, under the heading “Introduction and Overview,” wehave evaluated our potential exposure under this arrangement in accordance withFIN 45 and have recorded a liability of $308,000 on our balance sheet.  Additionally, we are maintaining the facilitylease for the Mobile Government headquarters in Massachusetts and sub-leasingit to BIO-Key.  As a condition toconsenting to the sublease, the landlord required us to maintain a $749,000letter of credit to the landlord securing performance under the lease.  BIO-Key has provided us with a $749,000deposit that would be available in the event of BIO-Key’s default on thesublease that results in a draw on our letter of credit.  The total remaining payments under both thelease and the sublease are approximately $4.5 million and the lease expires in August 2008.

 

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Contractual Obligations

 

The following table reflectsour contractual commitments, including our future minimum lease payments as of December 31,2004:

 
| ** **                                                                               | ** ** | **Payments due by period** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations (in thousands)**                                               | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More  than  5 years** | ** ** |
| ** **                                                                               | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long-term Debt Obligations                                                               |       | $                          | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Facility Leases                                                                          |       | 5,040                      |       | 1,393 |   | 3,647 |   | — |   | — |   |
| Less: Subleases                                                                          |       | (4,530                     | )          | (1,201 | ) | (3,329 | ) | — |   | — |   |
| Facility Leases, Net                                                                     |       | 510                        |       | 192 |   | 318 |   |   |   |   |   |
| Capital Lease Obligations                                                                |       | —                     |       | — |   | — |   | — |   | — |   |
| MBS Purchase Obligations *                                                               |       | —                     |       | — |   | — |   | — |   | — |   |
| Other Purchase Obligations                                                               |       | 471                        |       | 232 |   | 239 |   | — |   | — |   |
| Other Long-Term Liabilities Reflected on  the Registrant’s Balance Sheet under GAAP |       | —                     |       | — |   | — |   | — |   | — |   |
|                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |
| **Total**                                                                                |       | $                          | 981        |   | $ | 424 |   | $ | 557 |   | $ | — |   | $ | — |   |

 

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* During February and March 2005, we entered intoobligations under forward purchase arrangements with an estimated face value of$375.0 million.  These forward purchasearrangements come due at different times in March and April 2005, atwhich point, we expect to enter into repurchase transactions to provide us withmost of the funding we will need to satisfy these obligations.

 

In addition to the obligations above, we have guaranteed thelease payments for some assigned leases on properties related to discontinued operations.  We have also provided collateral assurance inthe form of a letter of credit in support of BIO-Key’s performance obligationsunder the Hamilton County, Ohio project. These obligations are discussed above under the heading “Guarantees” andin Note 14 of the notes to our consolidated financial statements included inItem 8 of this Report.

 

We have not includedcontracts for maintenance support on hardware or software that we own becausewe generally pay in advance for these services and have the option of choosingwhether or not to renew these services each year.  We have also not included in this tablepotential contingent liabilities that we may have to the buyers of our EMS,Transportation or Mobile Government segments, under the terms of the purchaseagreements with the buyers and we cannot readily estimate the potential amountof liabilities that might arise in the future, if any.  Potential liabilities to the buyers of our mobileand wireless data businesses are discussed below under the heading “RiskFactors – Risks associated with our mobile and wireless data businesses.”

 

Off Balance SheetArrangements

 

Except as discussed above,we have no other off-balance sheet arrangements.

 

RISKFACTORS 

 

Ourbusiness activities are subject to various important risks and uncertainties,including the following:

 

**Risks ofour Current Business Strategy**

 

***There is no assurance that we will be able to manage ourcurrent business strategy successfully or realize our objectives.***

 

Prior to entering the MBSbusiness, we explored several strategic options with the assistance of outsideadvisors.  There is no assurance that wewill be successful in managing a portfolio of MBS or that we will be able togenerate a profit and create value for our stockholders.  The Company has historically invested itsexcess cash in United States Government Agency-sponsored securities and doesnot have any past experience with investments in MBS.  Our current management team has limitedexperience in the MBS markets, in making investments in MBS, or in managing aleveraged investment portfolio.  We havenot developed an earnings history or experienced varying interest rateenvironments or market conditions.

 

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***We have not yet fully implemented our current businessstrategy of investing in MBS, and we may alter or diversify our focus, whichmay introduce new or additional risks.***

 

We are in the process ofimplementing our MBS investment strategy. As of March 9, 2005, we had invested approximately $62.8 million ofour available cash in MBS and had entered into forward purchase arrangementsrepresenting commitments to purchase MBS in March and April 2005 withan estimated face value of approximately $375.0 million.  We also have begun to evaluate otherpotential business opportunities that may complement our MBS business ordiversify our overall business strategy. There can be no assurance that we will be able to fully and successfullyimplement our current MBS strategy, whether as a result of market conditions orfor other business reasons, or that the strategy, if fully implemented, willproduce results consistent with our expectations.  In addition, if in the future we pursue otherbusiness strategies, they may have different business and market risks andconsiderations.  Accordingly, ourbusiness and our strategy, and the associated risks, may change significantlyover time.

 

***We will depend on borrowings to expand our MBSportfolio.  If we fail to obtain or torenew sufficient funding on favorable terms or at all, we may incur losses.***

 

We will depend onshort-term borrowings, primarily repurchase agreements, to fund purchases ofMBS and reach our desired amount of leverage. We will need to borrow funds to purchase the MBS underlying the forwardpurchase commitments that we entered into in February and March 2005,and we expect to receive such funding through the use of repurchaseagreements.  Accordingly, our ability tosatisfy commitments to purchase additional MBS and achieve our investment andleverage objectives depends on our ability to enter into repurchase agreementsin sufficient amounts and on favorable terms. In addition, because repurchase agreements are short-term arrangementsand MBS are long-term securities, we must be able to continually renew orreplace outstanding repurchase agreements as they mature.  We currently have repurchase arrangementswith four lenders to providefinancing for our purchases of MBS. These arrangements are not commitments to lend money to us.  If we are unable to obtain funds to satisfyour MBS purchase commitments, or if we are unable to renew or replace maturingborrowings on favorable terms or at all, our financial condition and resultscould be materially and adversely affected. We could be required to sell our MBS (or to sell forward purchasecommitments prior to their settlement, or sell the underlying MBS at the timeof settlement) under adverse market conditions, or for prices and on terms thatare less favorable than those we might otherwise be able to secure.  In such situations, we may be forced to sellinvestments at a loss.

 

***An increase in prepayment rates may adversely affect us.***

 

The MBS we plan toacquire are backed by pools of underlying mortgage loans.  We will receive payments, generally, from thepayments that will be made on these underlying mortgage loans.  When borrowers prepay their mortgage loans atrates that are faster than expected, the result is that our MBS are prepaidfaster than expected.  These acceleratedprepayments may adversely affect the performance of our business.

 

Prepayment ratesgenerally increase when interest rates fall and decrease when interest ratesrise, but changes in prepayment rates are difficult to predict.  Prepayment rates also may be affected by conditionsin the housing and financial markets, general economic conditions and therelative interest rates on fixed-rate and adjustable-rate mortgage loans.

 

We may purchase MBS thathave a higher interest rate than the market interest rate at the time. In exchangefor this higher interest rate, we would likely pay a premium over the marketvalue to acquire the security.  Inaccordance with accounting rules, we will amortize this premium ratably overthe term of the MBS.  If the MBS isprepaid in whole or in part prior to its maturity date, however, we will berequired to expense all (or a corresponding portion, in the case of a partialprepayment) of the remaining unamortized portion of the premium.  This accelerated expensing would negativelyimpact the yield from the MBS.

 

We may seek to reduce thepotential negative impact of increased prepayments by acquiring MBS at adiscount.  In accordance with generallyaccepted accounting principles, we will recognize this discount ratably over theterm of the MBS.  If a discountedsecurity is prepaid in whole or in part prior to its maturity date, we willrecognize income equal to the amount of the discount not previously recognized(or a portion of such remaining discount, in the case of a partial prepayment).  Consequently, the reported performance of ourbusiness would be enhanced if discounted securities are prepaid faster thanexpected.

 

While we will seek tominimize prepayment risk to the extent practical, in selecting investments wewill manage the prepayment risk against other risks and the potential returnsof each investment.  No strategy,however, can completely insulate us from prepayment risk.

 

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***An increase in interest rates might adversely affect the bookvalue of our MBS.***

 

Increases in the generallevel of interest rates can cause the fair market value of our assets todecline, particularly those mortgage-backed securities whose underlyingmortgages have fixed-rate components. Generally, hybrid adjustable-rate MBS (during the fixed-rate componentof the mortgages underlying such securities), which comprised 100% of our MBS,will be more negatively affected by such increases than adjustable-ratemortgage securities.  In accordance withGAAP, we will be required to reduce the carrying value of our mortgage-backedsecurities by the amount of any decrease in the fair value of ourmortgage-backed securities compared to their respective amortized costs.  If unrealized losses in fair value occur, wewill have to either reduce current earnings or reduce stockholders’ equitywithout immediately affecting current earnings, depending on how we classifysuch mortgage-backed securities under GAAP. In either case, our net book value will decrease to the extent of any realizedor unrealized losses in fair value.

 

***Our cash balances and cash flows may become limited relativeto our cash needs***.

 

We need cash to meet ourworking capital and other needs.  Cash isrequired to pay our operating expenses and fund our investments.  Cash flows from principal repayments could bereduced should prepayments slow or should credit quality trendsdeteriorate.  We intend to maintain whatwe believe are ample cash balances to meet our projected needs.  In the event, however, that our liquidityneeds exceed our access to liquidity, we may need to sell assets at aninopportune time, which could negatively impact our business.

 

***Limitations on our ability to raise additional capitalthrough sales of shares of our capital stock may restrict our ability toaddress liquidity needs through stock issuances and may limit our ability toexpand our MBS portfolio by raising additional capital through such stockofferings.***

 

Because of limitationsimposed by sections 382 and 383 of the Internal Revenue Code, which regulateour ability to use our accumulated net operating loss carryforwards and capitalloss carryforwards in the future (as discussed below), there are limits on thenumber of additional shares of stock we can sell to raise additional capital.  Accordingly, assuming market conditions wouldotherwise permit us to sell additional shares of our stock, this legal limitmay prevent us from raising as much additional capital through sales of ourstock as we might want or need at any particular time.  As a result, we may be unable to address aspecific liquidity need through a sale of our stock.  We also may not be able to increase the sizeof our MBS portfolio as much or as rapidly as we would otherwise like, becauseof limits on our ability to raise additional cash through stock offerings.

 

***We may change our investment policies and guidelines withoutstockholder approval***.

 

Our Board of Directorsand management determine all of our investment policies and guidelines.  Although there is currently no plan to amendor revise these policies, the Board of Directors and management may amend orrevise these investment policies and guidelines at any time without notice tostockholders.  Changes to the leverageratio, types of securities included in our portfolio and changes to our riskmanagement policies could adversely affect our financial condition, results ofoperations, or the market price of our common stock.

 

***Competition may increase and negatively impact our business***.

 

The success of ourbusiness depends, in large part, on our ability to acquire MBS at favorablespreads over borrowing costs, as well as our ability to sell MBS at favorableprices when necessary in response to changing market conditions.  In acquiring and selling MBS, we competeagainst REITs, financial institutions, such as banks, savings and loans, lifeinsurance companies and institutional investors such as mutual funds andpension funds.  Many of these entitieshave greater financial resources than us and as a result, we may not be able toacquire sufficient MBS at favorable spreads over our borrowing costs.  In addition, we may face competition for alimited number of buyers at a time when we are seeking to sell MBS, which couldresult in us receiving less favorable prices for MBS that we sell.  Existing competitors may grow, and newcompetition may enter the market over time, all of which can increasecompetition and may result in less favorable pricing and lower yields onassets.

 

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***Defaults on the mortgage loans underlying our MBS may reducethe value of our investment portfolio and may harm our results of operations***.

 

We bear the risk of anylosses resulting from any defaults on the mortgage loans underlying the MBS inour investment portfolio.  Themortgage-backed securities that we purchase will be subject to limitedguarantees of the payment of limited amounts of principal and interest onmortgage loans underlying such MBS, either by federal government agencies,including Ginnie Mae, by federally-chartered corporations, including Fannie Maeand Freddie Mac, or by other corporate guarantors.  While Ginnie Mae’s obligations are backed bythe full faith and credit of the United States, the obligations of Fannie Maeand Freddie Mac and other corporate guarantors are solely their own.  As a result, a substantial deterioration inthe financial strength of Fannie Mae, Freddie Mac or other corporate guarantorscould increase our exposure to future delinquencies, defaults or credit losseson our holdings of Fannie Mae or Freddie Mac-backed MBS or othercorporate-backed MBS, and could harm our results of operations.  In addition, while Freddie Mac guarantees theeventual payment of principal, it does not guarantee the timely paymentthereof, and our results of operations may be harmed if borrowers are late ordelinquent in their payments on mortgages underlying Freddie Mac-backedmortgage-backed securities.  Moreover,Fannie Mae, Freddie Mac, Ginnie Mae and other corporate guarantees relate onlyto payments of limited amounts of principal and interest on the mortgagesunderlying such agency-backed or corporate-backed securities, and do notguarantee the market value of such MBS or the yields on such MBS.  As a result, we remain subject to interestrate risks, prepayment risks, extension risks and other risks associated withour investment in such MBS and may experience losses in our investmentportfolio.

 

***A prolonged economic slow-down, a lengthy or severerecession or declining real estate values could harm our operations***.

 

The residential mortgagemarket has experienced considerable growth during the past ten years, withtotal outstanding U.S. mortgage debt growing from approximately $3.2 trillionat the end of 1993 to approximately $7.3trillion as of December 31, 2003, according to the Bond MarketAssociation and the Federal Reserve.  Ifthis growth cannot be sustained or we suffer an economic recession, the marketfor MBS may be adversely affected.

 

***We may exceed our target leverage ratios***.

 

We seek to maintain anasset-to-equity ratio between 4:1 and 9:1. However, we are not required to stay within this ratio if our Board of Directorsapproves a deviation from established investment guidelines.  We will incur leverage by borrowing against asubstantial portion of the market value of the MBS we acquire.  By incurring these borrowings we expect to beable to enhance our returns, but these borrowings, which are fundamental to ourstrategy, also create significant risks. Historically, we have managed a business with relatively modestborrowings, as compared to our available cash resources.  Accordingly, we do not have experiencemanaging a business within the constraints that can be imposed by the use ofleverage. In addition, if we exceed this ratio, the adverse impact on ourfinancial condition and results of operations from the types of risks describedabove would likely be more severe.

 

***Borrowings may negatively affect the performance of ourportfolio of MBS***.

 

Because ourmortgage-backed securities strategy will involve the use of leverage, ourreturns on invested capital and trading activities may be negatively affectedor our mortgage-backed securities portfolio may incur substantial losses if ourborrowing costs increase faster than the returns on our investments. We expectthat all of our borrowings will be collateralized borrowings in the form ofrepurchase agreements. If the interest rates on these repurchase agreementsincrease, this would adversely affect performance of our portfolio of mortgage-backedsecurities. Our borrowing costs under repurchase agreements will generallycorrespond to short-term interest rates such as LIBOR or a short-term Treasuryindex, plus or minus a margin. Our borrowing costs may increase for any of thefollowing reasons: 

 

•                  short-terminterest rates increase; 

•                  themarket value of our investment securities decreases; 

•                  interestrate volatility increases; or 

•                  theavailability of financing in the market decreases. 

 

If these costs increasefaster than the rates paid by the securities in which we invest, the financialresults of our new mortgage-backed securities strategy will be negativelyaffected.

 

While we may use hedgingstrategies to manage interest-rate sensitivity of our borrowings, suchstrategies may not be effective under certain conditions and may have anegative effect on the performance of our portfolio of mortgage-backedsecurities, as discussed below. 

 

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***Differences in timing of interest rate adjustments on ouracquired securities and on our borrowings may adversely affect our MBS strategyand the returns on the portion of our cash we invest in MBS.***

 

We will rely primarily onshort-term borrowings to acquire MBS with long-term maturities. Accordingly, ifshort-term interest rates increase, this may adversely affect our investmentstrategy and the returns on our capital. We expect all of the MBS we will acquire will be adjustable-ratesecurities.  This means that theirinterest rates may vary over time based upon changes in an objective index,such as:

 

•                  LIBOR:  The interest rate that banks in London offerfor deposits in London of U.S. dollars.

•                  Treasuryrate:  A monthly or weekly average yieldof benchmark U.S. Treasury securities, as published by the Federal ReserveBoard.

•                  CDrate:  The weekly average of secondarymarket interest rates on six-month negotiable certificates of deposit, aspublished by the Federal Reserve Board.

 

These indices generallyreflect short-term interest rates.  In aperiod of rising interest rates, we could experience a decrease in net incomeor a net loss from our MBS portfolio, because the interest rates on ourborrowings likely will adjust upward faster than the interest rates on ouradjustable-rate securities.

 

***Interest rate caps may reduce the returns from our business***.

 

Adjustable-rate andhybrid adjustable-rate MBS are typically subject to periodic and lifetimeinterest rate caps.  Periodic interestrate caps limit the amount an interest rate can increase during any givenperiod.  Lifetime interest rate capslimit the amount an interest rate can increase over the life of thesecurity.  Our borrowings will not besubject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, we wouldexperience a decrease in net income or experience a net loss from our MBSportfolio because increases in the interest rates on our borrowings will not belimited, while increases in the interest rates on our adjustable-ratesecurities would be capped.

 

***Hedging against interest rate exposure may adversely affectperformance of our portfolio of MBS***.

 

We may enter intoderivative transactions and other hedging strategies, such as interest rateswaps and caps, options to purchase swaps and caps, financial futures contractsand options on futures that are intended to hedge our exposure to rising rateson funds borrowed to finance our investment securities. Interest rate hedgingmay fail to reduce exposure to interest rate and prepayment risks discussed inthis “Risk Factors” section because, among other things:

•                  interestrate hedging can be expensive, particularly during periods of rising andvolatile interest rates, and the cost of implementing the hedge may offset itspotential benefit;

•                  availableinterest rate hedging may not correspond directly with the interest rate riskfor which protection is sought;

•                  theduration of the hedge may not match the duration of the related liability; and

•                  thecredit quality of the party owing money on the hedge may be downgraded to suchan extent that it impairs its ability to sell or assign its side of the hedgingtransaction.

 

***Our borrowings may result in margin calls and defaults andforce us to sell assets under adverse market conditions***.

 

Because we will purchaseMBS with borrowed funds, a decline in the value of our investment securities,caused by rising interest rates or prepayments, may result in our lendersinitiating margin calls.  A margin callmeans that the lender requires us to pledge additional collateral to re-establishthe ratio of the value of the collateral to the amount of the borrowing.  If we are unable to satisfy margin calls, ourlenders may foreclose on our collateral. This could force us to sell our MBS under adverse market conditionswhere the value of the collateral securing our borrowing is less than theamount owed to our lenders.  In thiscase, we would be responsible for any deficiency between the value of thecollateral and the amounts we borrowed. Additionally, repurchase agreements may qualify for special treatmentunder the Bankruptcy Code.  This specialtreatment would allow the lenders under these agreements to avoid the automaticstay provisions of the Bankruptcy Code and to liquidate the collateral underthese agreements without delay.

 

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***We are dependent on FBR to assist us in managing theportfolio of MBS***.

 

Because we do not haveexperience in managing a leveraged portfolio of MBS, we will be heavilydependent on the efforts and expertise of FBR. If we were to lose FBR’s services, our ability to fulfill our objectivesand carry out our MBS strategy could be adversely affected.  Although we have a one-year agreement withFBR to manage our portfolio of MBS, following the initial one-year term of the agreement,FBR could terminate the agreement with 90 days prior written notice and ceaseproviding services to us after an additional 90 days, if we request that FBRcontinue to manage our MBS portfolio during a transitional period.  During the term of the agreement,unanticipated changes in circumstances to us or FBR could result in FBR ceasingto provide services to us.  Accordingly,we cannot assure you that FBR will continue to work with us.  In addition, it may be difficult for us,within a reasonable period of time, to replace FBR with another firm havingcomparable expertise and offering comparable financial terms.

 

***The manager of our MBS portfolio, FBR, may have a potentialconflict of interest***.

 

FBR manages amulti-billion dollar portfolio of mortgage-backed securities for an affiliateusing a strategy very similar to the one we plan to implement.  FBR or one of its affiliates also may manageportfolios using strategies similar to this strategy for other asset managementclients.  These relationships createpotential conflicts of interest, including the allocation of opportunities toacquire or sell MBS at favorable prices. As noted above, our strategy depends in part upon our ability to acquiresuch securities at favorable spreads over our borrowing costs.  We also may seek to sell MBS in response tounfavorable market conditions at a time when many other MBS investors areseeking to sell.  FBR has no obligationto resolve in our favor conflicts of interest that may arise in connection withcompeting portfolios.  Employees of FBRwill only devote the time and attention to our new mortgage-backed securitiesstrategy that they deem necessary in their discretion, and there may beconflicts in allocating time, services and functions between our portfolio andother portfolios that FBR manages.  Thefailure of employees of FBR to devote adequate time and attention to our MBSstrategy could adversely affect the performance of our business.

 

***FBR’s past performance or the performance of other companiesthat invest in MBS may not be indicative of how our MBS portfolio will perform***.

 

The operations andresults of any business with which FBR or its related companies have been orare associated or of any other company that follows a strategy similar to theone we are implementing are not intended to be, and should not be consideredas, any indication of the likely future performance of our leveraged portfolioof MBS.  The performance of our MBSportfolio will be affected by changes in market conditions, prepayment rates,availability of financing and interest rates, which are outside of our controlor the control of FBR.  In addition,other companies employing a strategy similar to the one we are pursuing mayhave different investment policies or greater financial resources than we have.Therefore, the past performance of FBR or other companies that use a strategysimilar to ours is no guarantee, and may not be indicative, of the futureperformance of our portfolio of MBS.

 

**Regulatoryand Tax Risks of Our MBS Business**

 

***Loss of Investment Company Act exemption would adverselyaffect us***.

 

In managing a leveragedportfolio of MBS, we intend to rely on an exemption from the Investment CompanyAct for companies that are engaged primarily in the business of purchasing orotherwise acquiring mortgages and other liens on and interests in realestate.  Under the SEC staff’s currentinterpretation of that exemption, in order to meet the criteria for suchexemption, we will have to maintain at least 55% of our assets in qualifyingreal estate interests, such as whole pool mortgage interests issued by FHLMC,FNMA or GNMA, and at least 25% of our assets in other real estate relatedassets, such as non-whole pool mortgage-backed securities.  This 25% minimum is reduced to the extent weinvest more than 55% of our assets in qualifying real estate interests.  These requirements may limit our ability topurchase certain types of MBS that might otherwise be attractive, and theserestrictions could result in a lower level of income from our portfolio.

 

Changes in the InvestmentCompany Act or the rules thereunder, or in the SEC staff’s interpretation ofthe statute and rules, could force us to sell a substantial portion of ourportfolio under potentially adverse market conditions.  In addition, the use of leverage is afundamental part of our MBS strategy.  Inthe event we were required to register as an investment company under theInvestment Company Act, our ability to use leverage and the returns on ourequity capital would be substantially reduced, we would suffer additional regulatorycosts and expenses and we would not be able to pursue our MBS business asdescribed in this Annual Report.

 

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***We may not be able to realize value from our tax losscarryforwards***.

 

As of December 31,2004**,**we had federal and state netoperating loss carryforwards of approximately $765.5 million that expirebetween 2012 and 2024.  In addition, wehad capital loss carryforwards of approximately $245.3 million that expirebetween 2006 and 2009.  In the event weundergo a future ownership change as defined in section 382 of theInternal Revenue Code, our net operating loss carryforwards and capital losscarryforwards generated prior to the ownership change would be subject toannual limitation, which could reduce, eliminate, or defer the utilization ofthese losses.  Based upon a review ofpast changes in our ownership, as of December 31, 2004 we do not believethat we have experienced an ownership change (as defined under section 382)that would result in any limitation on our future ability to use these netoperating loss and capital loss carryforwards. However, we can not assure you that the IRS or some other taxingauthority may not disagree with our position and contend that we have alreadyexperienced such an ownership change, which would severely limit our ability touse our net operating loss carryforwards and capital loss carryforwards tooffset future taxable income.

 

Generally, an ownershipchange occurs if one or more stockholders, each of whom owns 5% or more invalue of a corporation’s stock, increase their aggregate percentage ownershipby more than 50% over the lowest percentage of stock owned by such stockholdersat any time during the preceding three-year period.  For example, if a single stockholder owning10% of our stock acquired an additional 50.1% of our stock in a three-yearperiod, a change of ownership would occur. Similarly, if ten persons, none of whom owned our stock, each acquiredslightly over 5% of our stock within a three-year period (so that such personsown, in the aggregate more than 50%) an ownership change would occur.  Ownership of stock here is determined bycertain constructive ownership rules which can attribute ownership of stockowned by entities (such as estates, trusts, corporations, and partnerships) tothe ultimate indirect owner.

 

For purposes of thisrule, all holders who each own less than 5% of a corporation’s stock aregenerally treated together as one (or, in certain cases, more than one) 5%stockholder.  Transactions in the publicmarkets among stockholders owning less than 5% of the equity securitiesgenerally are not included in the calculation. Special rules can result in the treatment of options (includingwarrants) or other similar interests as having been exercised if such treatmentwould result in an ownership change.

 

Due to the importance ofavoiding a future ownership change under the tax laws, we will be limited inour ability to issue additional stock in the future to provide capital for our business.  We would only be able to issue suchadditional stock in a manner that would not cause an ownership change, forpurposes of these rules, and thus, as discussed above, our ability to accessthe equity markets could be restricted, to some extent.

 

***We may not be able to use our tax loss carryforwards becausewe may not generate taxable income***.

 

The use of our netoperating loss carryforwards is subject to uncertainty because it is dependentupon the amount of taxable income we generate. Similarly, the extent of our actual use of our capital losscarryforwards is also subject to uncertainty because their use depends on theamount of capital gains we generate. There can be no assurance that we will have sufficient taxable income(or capital gains) in future years to use the net operating loss carryforwardsor capital loss carryfowards before they expire.  This is especially true for the capital losscarryfowards, because they expire over a shorter period of time than the netoperating loss carryforwards.

 

***The IRS could challenge the amount of our tax losscarryforwards***.

 

The amount of our netoperating loss carryforwards and capital loss carryforwards has not beenaudited or otherwise validated by the IRS. The IRS could challenge the amount of our net operating losscarryforwards and capital loss carryforwards, which could result in an increasein our liability for income taxes.  Inaddition, calculating whether an ownership change has occurred is subject touncertainty, both because of the complexity and ambiguity of section 382and because of limitations on a publicly traded company’s knowledge as to theownership of, and transactions in, its securities.  Therefore, we cannot assure you that thecalculation of the amount of our net loss carryforwards may not be changed as aresult of a challenge by a governmental authority or our learning of newinformation about the ownership of, and transactions in, our securities.

 

***We expect to be subject to the alternative minimum tax, andour net loss carryforwards would not offset that tax in its entirety***.

 

We do not plan to seek toqualify as a Real Estate Investment Trust under the Internal Revenue Code andwe will therefore continue to be subject to state and federal income tax.  However, as a result of our capital losscarryforwards and net operating loss carryforwards, we anticipate our federalincome tax liability for the current fiscal year as well as for several yearsinto the future to be substantially reduced. We do expect to be subject to the alternative minimum tax provisions ofthe Internal Revenue Code which limits the use of net operating losscarryforwards.  These provisions wouldresult, in effect, in 10% of our alternative minimum taxable income beingsubject to the 20% alternative minimum tax assessed on corporations.  This amounts to a 2% effective tax rate onour alternative minimum taxable income.

 

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***The IRS may seek to impose the accumulated earnings tax onsome or all of the taxable income we retain***.

 

As a component of our MBSinvestment strategy, we expect to retain all or a substantial portion of futureearnings over the next several years to finance the development and growth ofour business.  As a result, we may notdeclare or pay any significant dividends on shares of our common stock for anextended period.  If the IRS were tobelieve we were accumulating earnings beyond our reasonable business needs, theIRS could seek to impose an accumulated earnings tax, or AET, of 15% on ouraccumulated taxable income.  We do notbelieve that we will be subject to the AET due to various reasons, includingthe existence of our large deficit in accumulated earnings and profits.  However, the IRS may disagree with us on thispoint, and the IRS may attempt to impose the AET on all or a portion of ourtaxable income.  In such event, we wouldexpect to challenge any attempt by the IRS to impose the AET on our business,but the outcome of such a challenge is uncertain.

 

If we were to distributeour accumulated taxable income for each year to our stockholders as dividends,we would not be subject to the AET for the amounts so distributed, but wouldonly be subject to the AET for the amount of earnings retained.  If we were to pay dividends to stockholdersout of current earnings, these dividends would, generally speaking, be eligibleto be treated as “qualified dividends” for federal income tax purposes, taxedat the current maximum federal rate of 15%, assuming that the recipientstockholder meets the various requirements under the Internal Revenue Code forsuch treatment.  The maximum rate forqualified dividends is currently projected to increase to the maximum federalincome tax rate applicable to ordinary income (currently 35%) for tax yearsbeginning after December 31, 2008in accordance with the Jobs and Growth Tax Relief Reconciliation Act of 2003.

 

***Possible changes in legislation could negatively affect ourinvestments***.

 

Prospective investorsshould recognize that the present U.S. federal income tax treatment of aninvestment in our stock may be modified by legislative, judicial oradministrative action at any time, and that any such action may affectinvestments and commitments previously made. The rules dealing with U.S. federal income taxation are constantly underreview by persons involved in the legislative process and by the InternalRevenue Service and the U.S. Treasury Department, resulting in revisions ofregulations and revised interpretations of established concepts as well asstatutory changes.  Revisions in U.S.federal tax laws and interpretations thereof could adversely affect the taxconsequences of an investment in our stock and could impair our ability to usethe tax benefits associated with our net loss carryforwards. However, we arenot aware of any proposed changes in the tax laws or regulations that wouldmaterially impact our ability to use our net loss carryforwards.  

 

***Limits on ownership of our common stock could have anadverse consequence to you and could limit your opportunity to receive apremium on our stock***.

 

As noted above, it isimportant that we avoid an ownership change under section 382 of theInternal Revenue Code, in order to retain the ability to use our net operatingloss carryforwards and capital loss carryforwards to offset future income.  This means that a potential buyer of ourstock might be deterred from acquiring our common stock while we still havesignificant tax losses being carried forward, because such an acquisition mighttrigger an ownership change and severely impair our ability to use our taxlosses against future income.  Thus, thispotential tax situation could have the effect of delaying, deferring orpreventing a change in control and, therefore, could adversely affect ourshareholders’ ability to realize a premium over the then prevailing marketprice for our common stock in connection with a change in control.

 

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**RisksAssociated With Our Mobile and Wireless Data Businesses**

 

***We may be required to indemnify thepurchasers of our EMS, Transportation and Mobile Government segments.***

 

Wemay be required to indemnify TCS, Slingshot and/or BIO-key for certain breachesof representations and warranties and other covenants that we gave to TCS, Slingshotand BIO-key with respect to the sales of the EMS, Transportation and MobileGovernment segments, respectively.

 

Ourliability to Slingshot is limited to $10.0 million, other than in the case offraud and with respect to a small number of specific representations, such asthose relating to taxes owed for periods prior to the closing of the sale ofthe Transportation segment.  In addition,we remain fully liable for any claims that may arise relating to our operationof the Transportation business prior to the date on which Slingshot acquiredthat business from us.  The dispute weare having with Slingshot over post-closing adjustments is not subject to theterms of this indemnity and any payments we might be required to make would notbe subject to or count against the indemnity limits.

 

Ourliability to BIO-key is limited to $2.0 million, other than in the case offraud and with respect to a small number of specific representations, such asthose relating to taxes owed for periods prior to the closing of the sale of theMobile Government segment.  We alsoremain fully liable for any claims that may arise relating to our operation ofthe Mobile Government business prior to the date on which BIO-key acquired thatbusiness from us.  We have agreed tomaintain certain credit support and performance assurance arrangements onbehalf of BIO-key.  Under a salesagreement with Hamilton County, Ohio, our potential liability is secured by a$7.9 million letter of credit to assure performance under the terms of thatsales agreement.  We also have beenrequired to sublease (rather than assign) to BIO-key the Mobile Governmentleased facility in Marlborough, Massachusetts, and to keep in place a $749,000letter of credit in favor of the landlord under the lease.  For a discussion of these arrangements, see Note 14 of the notes to the consolidatedfinancial statements included in Item 8of this Report.

 

Wemay also be required to indemnify TCS for certain breaches of representationsand warranties and other covenants that we gave to TCS with respect to the saleof our EMS segment.  This liability islimited to $7.6 million, other than in the case of fraud and with respect to asmall number of specific representations, such as those relating to taxes owedfor periods prior to the closing of the sale of the EMS segment.  In addition, we remain fully liable for anyclaims that may arise relating to our operation of the EMS business prior tothe date on which TCS acquired that business from us, including any liabilityarising from our past sales of the blackberry devices manufactured by ResearchIn Motion (“RIM”).  Currently, RIM isengaged in legal proceedings with Inpro II to determine whether certain RIMproducts infringed on patents held by Inpro or NTP, Inc.  We have not been named in this suit, but maybe liable to Inpro or NTP, Inc. if it is established that RIM’s Blackberryactually infringes Inpro’s patents.  Amediation conference is scheduled for this matter in May 2005.

 

Otherthan our dispute with Slingshot over post-closing adjustments, which isdiscussed above under the heading “Sales of Discontinued Operations,” we arenot currently aware of any potential claims that we would expect to besignificant.  However, claims may arisein the future that could impose substantial liabilities on us.

 

**Other Risksof Our Business**

 

***Compliance with changing regulationof corporate governance and public disclosure may result in additional expenses***. 

 

Changing laws,regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations andNasdaq National Market rules, have required most public companies, includingour Company, to devote additional internal and external resources to variousgovernance and compliance matters.  Because we have a relatively small corporatestaff, we rely heavily on outside professional advisers to assist us with theseefforts.  As a result, we incurredadditional operating expenses in 2003 and 2004 and will incur further expensesin the future.  These costs have includedincreased accounting related fees associated with preparing the attestationreport on our internal controls over financial reporting as required under Section 404of the Sarbanes-Oxley Act of 2002.  Thesecosts have offset a portion of the savings we realized through our expensereduction program.  In addition, thesenew or changed laws, regulations and standards are subject to varyinginterpretations, as well as modifications by the government and Nasdaq.  The way in which they are applied andimplemented may change over time, which could result in even higher costs toaddress and implement revisions to compliance (including disclosure) andgovernance practices.

 

We are committed tomaintaining high standards of corporate governance and public disclosure. As aresult, we intend to invest resources to comply with evolving laws, regulationsand standards, and in addition to increased general and administrativeexpenses, this investment will require management to devote time and attentionthat will not be available for other matters. If our efforts to comply with new or changed laws, regulations andstandards differ from the activities intended by regulatory or governing bodiesdue to ambiguities related to practice, our reputation may be harmed and wecould be exposed to potential liability.

 

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**ITEM 7A.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

The following discussionabout our market risk disclosures involves forward-looking statements.  Actual results could differ materially fromthose projected in these forward-looking statements.

 

We seek to manage theinterest rate, market value, liquidity, and prepayment risks inherent in ourMBS investment strategy in a responsible manner designed to promote our growthand success while, at the same time, seeking to maximize stockholdervalue.  We are not planning to be adverseto risk, but are aiming to assume only those risks we believe we can manage andwhich we believe will produce a sufficient return to justify taking thoserisks.

 

***Interest Rate Risk***

 

We plan to invest primarilyin adjustable-rate MBS.  As we continueto build our portfolio of MBS, our debt obligations will generally beshort-term repurchase agreements that are periodically financed at currentmarket prices.

 

Adjustable-rate MBS aretypically subject to periodic and lifetime interest rate caps that limit theamount an adjustable-rate MBS’s interest rate can change during any givenperiod.  Also, adjustable-rate MBS may besubject to a maximum interest rate payable. Our borrowings are not subject to similar restrictions and therefore, ina period of rising interest rates, the interest rates on our borrowings couldincrease without limitation, while the interest rates on our MBS may notexperience corresponding increases.  Inaddition, certain MBS may be subject to periodic payment caps that result insome portion of the interest being deferred and added to the principal outstanding.  These factors could lower our net interestincome or cause a net loss during periods of rising interest rates, which wouldnegatively impact our liquidity and net income.

 

As we continue to implementour MBS investment strategy and use leverage for the acquisition of newsecurities, we will fund the purchase of a substantial portion of our portfoliowith borrowings that have interest rates based on indices and repricing termssimilar to, but generally with shorter maturities than, the interest rateindices and repricing terms of the MBS. Thus, we anticipate that in most cases the interest rate indices andrepricing terms of our mortgage assets and our funding sources will not beidentical, thereby creating an interest rate mismatch between assets andliabilities.  During periods of changinginterest rates, such interest rate mismatches could negatively impact our netincome and the market price of our common stock.

 

***Market Value Risk***

 

Although we intend to holdMBS investments that we make to their maturities, we may sell them at any timein response to market conditions.  As aresult, substantially all of our MBS investments will be classified asavailable-for-sale assets.  As such, theyare reflected at fair value (i.e. market value), with any adjustment betweencost and fair value being reflected as part of accumulated other comprehensiveincome that is included in the equity section of our balance sheet.  The market value of our assets can fluctuatedue to changes in interest rates and other factors including loss resultingfrom changes in interest rates, foreign currency exchange rates, commodityprices and equity prices.  Changes in thelevel of interest rates also can affect the value of our MBS and our ability torealize gains from the sale of these assets.

 

The chart below illustratesthe effect on portfolio value should interest rates rapidly increase ordecrease by 50 and 100 basis points (a rate shock).  We have estimated the impact, assuming theyield curves of the rate shocks will be parallel to each other and the currentyield curve.  Our portfolio of MBS as of December 31,2004 was valued at $62.2 million. Assumptions made in calculating the impact on our MBS portfolio valuefrom interest rate shocks include interest rates, prepayments and yield spreadof MBS relative to prevailing interest rates.

 
| **Change in Interest Rate** | ** ** | **Projected %  Change in  MBS Portfolio  Value** | ** ** |
|-----------------------------|------------|--------------------------------------------------|------------|
| - 100 basis  points         |       | 0.779                                            | %          |
| - 50 basis  points          |       | 0.456                                            | %          |
| Base  interest rate         |       | —                                           |       |
| + 50 basis  points          |       | (0.632                                           | )%         |
| +100 basis  points          |       | (1.413                                           | )%         |

 

The base interest ratescenario assumes interest rates at December 31, 2004.  Actual results could differ significantlyfrom those estimated in the table.

 

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***Liquidity Risk***

 

Our primary liquidity riskarises from financing long-maturity MBS with short-term borrowings.  The interest rates on our borrowingsgenerally adjust more frequently than the interest rates on our MBS.  Accordingly, in a period of rising interestrates, our borrowing costs will usually increase faster than our interestearnings from MBS.  As a result, we couldexperience a decrease in net income or an increase in net loss during theseperiods.  Assets that are pledged tosecure short-term borrowings will be high-quality, liquid assets.  As a result, we do not expect to have anyproblems rolling over our short-term debt as it matures.  However, there can be no assurance that wewill always be able to roll over our short-term debt.

 

***Prepayment Risk***

 

We are also subject toprepayment risk.  Prepayments are thefull or partial repayment of principal prior to the original term to maturityof a mortgage loan and typically occur due to refinancing of mortgageloans.  Prepayment rates on MBS vary fromtime to time and may cause changes in the amount of our net interest income.  Prepayments of adjustable-rate and hybrid MBSgenerally increase when mortgage interest rates fall and generally decreasewhen mortgage interest rates exceed the then-current interest rate on suchmortgages.  Prepayment experience alsomay be affected by the conditions in the housing and financial markets, generaleconomic conditions, seasonal changes and the relative interest rates onfixed-rate and adjustable-rate mortgage loans underlying MBS.  The price we pay for MBS is partiallydetermined by our expectations of the amounts and rates of prepayments.  If we expect few prepayments, we may pay apremium for the MBS we acquire.  If ourassumptions are wrong and the actual amount of prepayments is greater thanexpected, we could experience reduced earnings or losses.  In addition, if we were unable to acquire newMBS to replace the amounts received as prepayments, our financial condition,cash flows and results of operations could be adversely impacted.  For a more detailed discussion of the risk ofprepayments on our business, see the disclosure under the heading “Risk Factors– An increase in prepayment rates may adversely affect us.”

 

41

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**ITEM 8.  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

TABLE OF CONTENTS

 

Thefollowing financial statements required by this item are included in the Reportbeginning on page    .

 
| Report  of Management on Internal Control over Financial Reporting                                                        |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|
| Reports  of Independent Registered Public Accounting Firm                                                                 |   |
| Consolidated Balance Sheets  as of December 31, 2003 and 2004                                                        |   |
| Consolidated  Statements of Operations and Comprehensive Loss for the years ended December 31,  2002, 2003, and 2004 |   |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2002, 2003 and 2004          |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2002, 2003 and  2004                         |   |
| Notes to Consolidated  Financial Statements                                                                               |   |

 

42

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# **Report of Management on Internal Control overFinancial Reporting**

#  

TheBoard of Directors and Stockholders

AetherSystems, Inc.:

 

Weare responsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rules13a-15(f).  We conducted an evaluation ofthe effectiveness of our internal control over financial reporting based on theframework in *Internal Control-Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(the “COSO Framework”).  As noted in theCOSO Framework, an internal control system, no matter how well conceived andoperated, can provide only reasonable assurance to management and the board ofdirectors regarding achievement of an entity’s objectives.  Based on the evaluation under the COSOFramework, we concluded that our internal control over financial reporting waseffective as of December 31, 2004.

 

 
| /s/ David S. Oros                                   |   |
|-----------------------------------------------------|--------|
| *Chairman of the Board and Chief Executive Officer* |
|                                                |
|                                                |
| /s/ David C. Reymann                                |   |
| *Chief Financial Officer*                           |
|                                                |
|                                                |
| April 11, 2005                                 |
|                                                     |        |  |

 

43

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# **Report of Independent Registered Public Accounting Firm**

#  

TheBoard of Directors and Stockholders

AetherSystems, Inc.:

 

Wehave audited management’s assessment, included in the accompanying *Report of Management on Internal Control over Financial Reporting*,**that Aether Systems, Inc. andsubsidiaries (“Aether”) maintained effective internal control over financialreporting as of December 31, 2004, based on criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).**Aether’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of Aether’s internal control over financialreporting based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles.  A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairly reflectthe transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

Inour opinion, management’s assessment that Aether maintained effective internalcontrol over financial reporting as of December 31, 2004, is fairlystated, in all material respects, based on the criteria established in *Internal Control—Integrated Framework* issued by  COSO. Also, in our opinion, Aether maintained, in all material respects,effective internal control over financial reporting as of December 31,2004, based on criteria established in *InternalControl—Integrated Framework* issued by COSO.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofAether Systems, Inc. and subsidiaries as of December 31, 2004 and 2003,and the related consolidated statements of operations and comprehensive loss,stockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2004, and our report dated March 15, 2005expressed an unqualified opinion on those consolidated financial statements.

 

 
| /s/ KPMG LLP         |   |
|----------------------|--------|
|                 |
|                 |
| Baltimore, Maryland  |
| April 11,  2005 |

 

44

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**Report of Independent RegisteredPublic Accounting Firm**

 

TheBoard of Directors and Stockholders

AetherSystems, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Aether Systems,Inc. and subsidiaries, as of December 31, 2004 and 2003, and the relatedconsolidated statements of operations and comprehensive loss, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2004. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.  

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Aether Systems, Inc. and subsidiaries as of December 31, 2004and 2003, and the results of their operations and their cash flows for each ofthe years in the three-year period ended December 31, 2004, in conformitywith U.S. generally accepted accounting principles.

 

 
| /s/ KPMG LLP        |   |
|---------------------|--------|
|                |
|                |
| Baltimore, Maryland |
| March 15, 2005 |

 

45

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**AETHER SYSTEMS, INC.**

**CONSOLIDATED BALANCE SHEETS**

(IN THOUSANDS, EXCEPT SHARE DATA)

 
| ** **                                                                                                                                                                 | ** ** | **DECEMBER 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **2003**              | ** ** | **2004** | ** ** |
| ASSETS                                                                                                                                                                     |       |                  |       |   |   |
| Current assets (in 2003):                                                                                                                                                  |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                  |       | $                     | 26,222     |   | $ | 60,723 |   |
| Mortgage-backed securities, at fair value                                                                                                                                  |       | —                |       | 62,184 |   |
| Current assets from discontinued operations                                                                                                                                |       | 53,616                |       | — |   |
| Interest receivable                                                                                                                                                        |       | 1,567                 |       | 356 |   |
| Prepaid expenses and other assets                                                                                                                                          |       | 1,173                 |       | 4,124 |   |
| Total current assets                                                                                                                                                       |       | 82,578                |       |   |   |
|                                                                                                                                                                       |       |                  |       |   |   |
| Restricted cash                                                                                                                                                            |       | 13,460                |       | 8,832 |   |
| Investments available for sale                                                                                                                                             |       | 220,849               |       | — |   |
| Property and equipment, net                                                                                                                                                |       | 2,608                 |       | 367 |   |
| Non-current assets from discontinued operations                                                                                                                            |       | 74,017                |       | — |   |
| Other assets                                                                                                                                                               |       | 4,593                 |       | — |   |
|                                                                                                                                                                       |       | $                     | 398,105    |   | $ | 136,586 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                  |       |                  |       |   |   |
| Current liabilities (in 2003):                                                                                                                                             |       |                  |       |   |   |
| Accounts payable and accrued expenses                                                                                                                                      |       | $                     | 4,741      |   | $ | 3,494 |   |
| Current liabilities from discontinued operations                                                                                                                           |       | 35,168                |       | — |   |
| Accrued employee compensation and benefits                                                                                                                                 |       | 538                   |       | 186 |   |
| Restructuring accruals                                                                                                                                                     |       | 1,407                 |       | 259 |   |
| Accrued interest payable                                                                                                                                                   |       | 2,529                 |       | — |   |
| Total current liabilities                                                                                                                                                  |       | 44,383                |       |   |   |
|                                                                                                                                                                       |       |                  |       |   |   |
| Convertible subordinated notes payable                                                                                                                                     |       | 154,912               |       | — |   |
| Restructuring accruals                                                                                                                                                     |       | 70                    |       | — |   |
| Non-current liabilities from discontinued operations                                                                                                                       |       | 19,436                |       | — |   |
| Other long-term liabilities                                                                                                                                                |       | 3                     |       | 2,057 |   |
| Total liabilities                                                                                                                                                          |       | 218,804               |       | 5,996 |   |
|                                                                                                                                                                       |       |                  |       |   |   |
| Commitments and Contingencies                                                                                                                                              |       |                  |       |   |   |
|                                                                                                                                                                       |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                 |       |                  |       |   |   |
| Preferred stock, $0.01 par value; 1,000,000 shares authorized; 0  shares issued and outstanding at December 31, 2003 and 2004                                         |       | —                |       | — |   |
| Common stock, $0.01 par value; 1,000,000,000 shares authorized;  42,918,408 and 43,963,963 shares issued and outstanding at December 31,  2003 and 2004, respectively |       | 429                   |       | 440 |   |
| Additional paid-in capital                                                                                                                                                 |       | 2,589,608             |       | 2,592,977 |   |
| Accumulated deficit                                                                                                                                                        |       | (2,414,283            | )          | (2,462,611 | ) |
| Foreign currency translation adjustment                                                                                                                                    |       | 3,830                 |       | — |   |
| Unrealized loss on investments available for sale                                                                                                                          |       | (283                  | )          | (216 | ) |
| Total stockholders’ equity                                                                                                                                            |       | 179,301               |       | 130,590 |   |
| Total liabilities and stockholders’ equity                                                                                                                            |       | $                     | 398,105    |   | $ | 136,586 |   |

 

See accompanying notes toconsolidated financial statements.

 

46

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**AETHER SYSTEMS, INC.**

### CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE LOSS

(IN THOUSANDS, EXCEPT PER SHARE DATA)

 
| ** **                                                                                                                           | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2002**                         | ** ** | **2003** | ** ** | **2004** | ** ** |
| Interest income from MBS portfolio                                                                                                   |       | $                                | —     |   | $ | — |   | $ | 928 |   |
| Interest expense from MBS portfolio                                                                                                  |       | —                           |       | — |   | — |   |
| Net interest income from MBS portfolio                                                                                               |       | —                           |       | — |   | 928 |   |
| Gain on sale of MBS                                                                                                                  |       | —                           |       | — |   | 1,826 |   |
|                                                                                                                                 |       |                             |       |   |   |   |   |
| Operating expenses:                                                                                                                  |       |                             |       |   |   |   |   |
| Selling, general and administrative                                                                                                  |       | (22,862                          | )     | (15,779 | )  | (12,150 | ) |
| Depreciation                                                                                                                         |       | (6,319                           | )     | (2,672 | )  | (2,212 | ) |
| Option and warrant expense                                                                                                           |       | (1,735                           | )     | (928 | )  | (594 | ) |
| Impairment of other assets                                                                                                           |       | (7,589                           | )     | (1,367 | )  | — |   |
| Other expense                                                                                                                        |       | —                           |       | (744 | )  | (60 | ) |
| Restructuring charge                                                                                                                 |       | (558                             | )     | (306 | )  | (1,054 | ) |
| Total operating expenses                                                                                                             |       | (39,063                          | )          | (21,796 | ) | (16,070 | ) |
| Operating loss                                                                                                                       |       | (39,063                          | )     | (21,796 | )  | (13,316 | ) |
| Interest income from money market accounts                                                                                           |       | 9,921                            |       | 6,037 |   | 3,508 |   |
| Interest expense from subordinated notes                                                                                             |       | (15,827                          | )          | (10,427 | ) | (7,917 | ) |
| Equity in losses of investments                                                                                                      |       | (4,744                           | )     | (97 | )  | — |   |
| Gain (loss) on early extinguishment of debt                                                                                          |       | 42,765                           |       | — |   | (2,419 | ) |
| Investment gain (loss), including impairments, net                                                                                   |       | (14,412                          | )          | 587 |   | (3,559 | ) |
| Loss from continuing operations                                                                                                      |       | (21,360                          | )          | (25,696 | ) | (23,703 | ) |
| Loss from discontinued operations, net of tax expense (benefit) of ($535,000),  $75,000 and $0 for 2002, 2003 and 2004, respectively |       | (304,062                         | )          | (23,756 | ) | (45,450 | ) |
| Gain on sale of discontinued operations                                                                                              |       | —                           |       | — |   | 20,825 |   |
| Net loss                                                                                                                             |       |                             | (325,422   | ) |   | (49,452 | ) |   | (48,328 | ) |
| Other comprehensive loss:                                                                                                            |       |                             |       |   |   |   |   |
| Foreign currency translation adjustment                                                                                              |       | 3,235                            |       | 108 |   | (3,830 | ) |
| Unrealized holding gain (loss) on investments available for sale                                                                     |       | (111                             | )     | (1,757 | ) | 67 |   |
| Comprehensive loss                                                                                                                   |       | $                                | (322,298   | ) | $ | (51,101 | ) | $ | (52,091 | ) |
| Loss per share – basic and diluted from continuing operations before  discontinued operations                                   |       | $                                | (0.51      | ) | $ | (0.60 | ) | $ | (0.54 | ) |
| Loss per share – basic and  diluted from discontinued operations                                                                |       | (7.22                            | )          | (0.56 | ) | (1.04 | ) |
| Gain per share – basic and  diluted on sale of discontinued operations                                                          |       | —                           |       | — |   | 0.47 |   |
| Net loss per share – basic and diluted                                                                                          |       | $                                | (7.73      | ) | $ | (1.16 | ) | $ | (1.11 | ) |
| Weighted average shares outstanding-basic and diluted                                                                                |       | 42,117                           |       | 42,616 |   | 43,713 |   |

 

See accompanying notes toconsolidated financial statements.

 

47

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**AETHER SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

(DOLLARS IN THOUSANDS)

 
| ** **                                         | ** ** | **PREFERRED  STOCK** | ** ** | **COMMON  STOCK** | ** ** | **ADDITIONAL  PAID-IN  CAPITAL** | ** ** | **ACCUMULATED  DEFICIT** | ** ** | **FOREIGN  CURRENCY  TRANSLATION  ADJUSTMENT** | ** ** | **UNREALIZED  GAIN (LOSS)  ON  INVESTMENTS** | ** ** | **TOTAL** | ** ** |
|----------------------------------------------------|------------|----------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|-----------|------------|
| Balance at  December 31, 2001                 |       | $                    | —     |              | $          | 419                              |       | $                        | 2,579,445  |                                           | $          | (2,039,409                                   | )          | $         | 487        |   | $ | 1,585 |   | $ | 542,527 |   |
| Exercise of  options and warrants                  |       | —               |       | 3                 |       | 626                              |       | —                   |       | —                                         |       | —                                       |       | 629       |       |
| Option and  warrant expense                        |       | —               |       | —            |       | 6,542                            |       | —                   |       | —                                         |       | —                                       |       | 6,542     |       |
| Unrealized gain  on investments available for sale |       | —               |       | —            |       | —                           |       | —                   |       | —                                         |       | (111                                         | )          | (111      | )          |
| Foreign currency  translation                      |       | —               |       | —            |       | —                           |       | —                   |       | 3,235                                          |       | —                                       |       | 3,235     |       |
| Net loss                                           |       |                 |       | —            |       | —                           |       | (325,422                 | )          | —                                         |       |                                         |       | (325,422  | )          |
| Balance at  December 31, 2002                 |       | $                    | —     |              | $          | 422                              |       | $                        | 2,586,613  |                                           | $          | (2,364,831                                   | )          | $         | 3,722      |   | $ | 1,474 |   | $ | 227,400 |   |
| Exercise of  options and warrants                  |       | —               |       | 7                 |       | 1,071                            |       | —                   |       | —                                         |       | —                                       |       | 1,078     |       |
| Option and  warrant expense                        |       | —               |       | —            |       | 1,924                            |       | —                   |       | —                                         |       | —                                       |       | 1,924     |       |
| Unrealized gain  on investments available for sale |       | —               |       | —            |       | —                           |       | —                   |       | —                                         |       | (1,757                                       | )          | (1,757    | )          |
| Foreign currency  translation                      |       | —               |       | —            |       | —                           |       | —                   |       | 108                                            |       | —                                       |       | 108       |       |
| Net loss                                           |       | —               |       | —            |       | —                           |       | (49,452                  | )          | —                                         |       |                                         |       | (49,452   | )          |
| Balance at  December 31, 2003                 |       | $                    | —     |              | $          | 429                              |       | $                        | 2,589,608  |                                           | $          | (2,414,283                                   | )          | $         | 3,830      |   | $ | (283 | ) | $ | 179,301 |   |
| Exercise of  options and warrants                  |       | —               |       | 11                |       | 1,952                            |       | —                   |       | —                                         |       | —                                       |       | 1,963     |       |
| Option and  warrant expense                        |       | —               |       | —            |       | 1,417                            |       | —                   |       | —                                         |       | —                                       |       | 1,417     |       |
| Unrealized gain  on investments available for sale |       | —               |       | —            |       | —                           |       | —                   |       | —                                         |       | 67                                           |       | 67        |       |
| Foreign currency  translation                      |       | —               |       | —            |       | —                           |       | —                   |       | (3,830                                         | )     | —                                       |       | (3,830    | )          |
| Net loss                                           |       | —               |       | —            |       | —                           |       | (48,328                  | )          | —                                         |       | —                                       |       | (48,328   | )          |
| Balance at  December 31, 2004                 |       | $                    | —     |              | $          | 440                              |       | $                        | 2,592,977  |                                           | $          | (2,462,611                                   | )          | $         | —     |   | $ | (216 | ) | $ | 130,590 |   |

 

See accompanying notes toconsolidated financial statements.

 

48

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**AETHER SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(DOLLARS IN THOUSANDS)

 
| ** **                                                                                                       | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                       | ** ** | **2002**                         | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                                            |       |                             |       |   |   |   |   |
| Net loss from continuing operations                                                                              |       | $                                | (21,360    | ) | $ | (25,696 | ) | $ | (23,703 | ) |
| Adjustments to reconcile net loss from continuing operations to net  cash used by operating activities:          |       |                             |       |   |   |   |   |
| Depreciation and amortization                                                                                    |       | 6,319                            |       | 2,672 |   | 2,212 |   |
| Amortization of loan fees                                                                                        |       | 1,170                            |       | 1,119 |   | 840 |   |
| Amortization of mortgage premiums                                                                                |       | —                           |       | — |   | 22 |   |
| Equity in losses of investments                                                                                  |       | 4,744                            |       | 97 |   | — |   |
| Option and warrant expense                                                                                       |       | 1,735                            |       | 928 |   | 594 |   |
| (Gain) loss on disposal of assets                                                                                |       | —                           |       | 744 |   | (80 | ) |
| (Gain) loss on early extinguishment of debt                                                                      |       | (42,765                          | )          | — |   | 2,419 |   |
| Impairment of other assets                                                                                       |       | 7,589                            |       | 1,367 |   | — |   |
| Realized (gains) losses on long-term investments, including  impairments                                         |       | 14,412                           |       | (587 | ) | 3,559 |   |
| Realized gain on sale of MBS                                                                                     |       | —                           |       | — |   | (1,826 | ) |
| Changes in assets and liabilities, net of acquired assets and  liabilities:                                      |       |                             |       |   |   |   |   |
| Decrease (increase) in prepaid expenses and other assets                                                         |       | 8,326                            |       | (1,086 | ) | (513 | ) |
| Decrease (increase) in interest receivable                                                                       |       | (1,825                           | )     | 335 |   | 1,211 |   |
| Decrease in accounts payable, accrued expenses, accrued employee  compensation and benefits and interest payable |       | (557                             | )     | (2,167 | )  | (4,128 | ) |
| Increase (decrease) in restructuring reserve and other long term  liabilities                                    |       | 4,449                            |       | (31,005 | ) | 836 |   |
| Net cash used by operating activities from continuing operations                                                 |       | (17,763                          | )          | (53,279 | ) | (18,557 | ) |
| Net cash used by discontinued operations                                                                         |       | (90,136                          | )          | (10,369 | ) | (6,031 | ) |
| Net cash used by operating activities                                                                            |       | (107,899                         | )          | (63,648 | ) | (24,588 | ) |
|                                                                                                             |       |                             |       |   |   |   |   |
| Cash flows from investing activities:                                                                            |       |                             |       |   |   |   |   |
| Sales and maturities of investments available for sale                                                           |       | 352,675                          |       | 530,829 |   | 1,171,641 |   |
| Purchases of investments available for sale                                                                      |       | (605,367                         | )          | (497,630 | ) | (952,791 | ) |
| Proceeds from sale of EMS segment, net of transactions costs                                                     |       | —                           |       | — |   | 18,856 |   |
| Proceeds from sale of Transportation segment, net of transactions  costs                                         |       | —                           |       | — |   | 23,001 |   |
| Proceeds from sale of Mobile Government segment, net of transactions  costs                                      |       | —                           |       | — |   | 8,794 |   |
| Purchases of property and equipment                                                                              |       | (2,192                           | )          | (596 | ) | (331 | ) |
| Proceeds from the sale of property and equipment                                                                 |       | —                           |       | 4,056 |   | 93 |   |
| Funding of investment in joint venture                                                                           |       | (535                             | )          | — |   | — |   |
| Sale of long-term investments                                                                                    |       | 3,991                            |       | 443 |   | 2,396 |   |
| Increase in other intangible assets                                                                              |       | 638                              |       | — |   | — |   |
| Purchase of mortgage backed securities                                                                           |       | —                           |       | — |   | (63,839 | ) |
| Principal payments from mortgage-backed securities                                                               |       | —                           |       | — |   | 1,423 |   |
| Net cash provided by (used in) investing activities                                                              |       | (250,790                         | )          | 37,102 |   | 209,243 |   |
|                                                                                                             |       |                             |       |   |   |   |   |
| Cash flows from financing activities:                                                                            |       |                             |       |   |   |   |   |
| Repayment of notes payable including redemption of convertible debt                                              |       | (92,888                          | )          | — |   | (156,771 | ) |
| (Increase) decrease in restricted cash                                                                           |       | (1,590                           | )          | (4,537 | ) | 4,628 |   |
| Exercise of options and warrants                                                                                 |       | 629                              |       | 1,078 |   | 1,989 |   |
| Net cash used in financing activities                                                                            |       | (93,849                          | )          | (3,459 | ) | (150,154 | ) |
| Net increase (decrease) in cash and cash equivalents                                                             |       | (452,538                         | )          | (30,005 | ) | 34,501 |   |
| Cash and cash equivalents, at beginning of period                                                                |       | 508,765                          |       | 56,227 |   | 26,222 |   |
| Cash and cash equivalents, at end of period                                                                      |       | $                                | 56,227     |   | $ | 26,222 |   | $ | 60,723 |   |
| Supplemental disclosure of cash flow information:                                                                |       |                             |       |   |   |   |   |
| Cash paid during the year for interest                                                                           |       | $                                | 16,524     |   | $ | 9,295 |   | $ | 9,500 |   |

 

See accompanying notes toconsolidated financial statements.

 

49

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Supplemental disclosure ofnon-cash investing and financing activities:

 

In 2002, 2003, and 2004, theCompany incurred unrealized holding gains (losses) associated with itsinvestments available for sale totaling $(111,000), $(1.8 million), and $67,000,respectively.  These amounts have beenreported as increases (decreases) in stockholders’ equity.

 

See accompanying notes toconsolidated financial statements.

 

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**AETHER SYSTEMS, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**(1)ORGANIZATION, DESCRIPTION OF THE BUSINESS, AND BASIS OF PRESENTATION**

 

AetherSystems, Inc. (the “Company” or “Aether”) was originally formed in January 1996.  The Company’s principal business activity isthe investment in mortgage-backed securities (“MBS”) as discussed in Note 4 below.  As of December 31, 2004, we presentedour consolidated balance sheet in a non-classified manner.

 

EffectiveJanuary 2004, the Company sold the operations of its discontinuedEnterprise Mobility Solutions (“EMS”) segment. Effective September 17, 2004 and September 30, 2004 theCompany sold the operations of its discontinued Transportation and Mobile Governmentsegments, respectively.  The financialstatements for all periods presented have been restated to present the resultsof operations of the Company’s EMS, Transportation and Mobile Governmentsegments as discontinued operations, as discussed in Note 3 below.

 

Aether’scontinuing operations consist of a single business segment – the MBS business.

 

InDecember 2004, the Company relocated its headquarters from Owings Mills,MD to 621 E. Pratt Street, Suite 601, Baltimore, MD 21202.

 

**(2) SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES RELATED TO CONTINUING OPERATIONS**

 

The following accountingprinciples have been used by management in the preparation of the Company’sconsolidated financial statements:

 

(a) PRINCIPLES OFCONSOLIDATION

The consolidated financial statementsinclude the accounts of the Company and its majority-owned subsidiaries.  All significant intercompany transactions andbalances have been eliminated in consolidation.

 

(b) CASH AND CASHEQUIVALENTS

Cash equivalents include allhighly liquid investments purchased with original maturities of three months orless, with the exception of certificates of deposit which mature in less thanone year.  Cash and cash equivalentsconsisted of the following:

 
| **(in thousands)**                          | ** ** | **DECEMBER 31,  2003** | ** ** | **DECEMBER 31,  2004** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Cash                                        |       | $                           | 10,421     |                        | $          | 11,468 |   |
| Money market accounts                       |       | 11,097                      |       | 9,703                       |       |
| U.S. Government Agency-sponsored securities |       | —                      |       | 38,384                      |       |
| Certificates of deposit                     |       | 4,704                       |       | 1,168                       |       |
| Total                                       |       | $                           | 26,222     |                        | $          | 60,723 |   |

 

(c)INVESTMENTS AVAILABLE FOR SALE INCLUDING MORTGAGE-BACKED SECURITIES (“MBS”)

Investments available forsale consist of highly liquid investments in U.S. Government Agency-sponsoredsecurities with original maturities greater than one year.

 

The Company investsprimarily in MBS representing interests in or obligations backed by pools ofmortgage loans.  Acquisitions of existingMBS are recorded on the trade date. Purchases of newly issued MBS are recorded when all significantuncertainties regarding the characteristics of the securities are removed.  Realized gains and losses on suchtransactions are determined on the specific identification basis.

 

Statement of FinancialAccounting Standards (SFAS) No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*, requires theCompany to classify its investments as trading investments, available-for-saleinvestments or held-to-maturity investments. Currently, the Company classifies all of its MBS as available forsale.  All assets classified as availablefor sale are reported at fair value, based on market pricing estimates providedby independent pricing services and dealers who make markets in these financialinstruments, with unrealized gains and losses excluded from earnings andreported as a separate component of stockholders’ equity.  Unrealized losses on mortgage-backedsecurities that are considered other than temporary, as measured by the amountof decline in fair value attributable to factors other than temporary, arerecognized in income and the cost basis of the securities is adjusted.

 

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Interest income is accruedbased on the outstanding principal amount of the securities and theircontractual terms.  Premiums anddiscounts associated with the purchase of the securities are amortized intointerest income over the lives of the securities using the interest method inaccordance with Statement of Financial Accounting Standards No. 91, *Accounting for Nonrefundable Fees and CostsAssociated with Originating or Acquiring Loans and Initial Direct Costs ofLeases. *Our policy for estimating prepayment speedsfor calculating the effective yield is to evaluate historical performance,street consensus prepayment speeds, and current market conditions.

 

(d) OTHER INVESTMENTS

The Company accounts for thoseinvestments in which it exercises significant influence or has an ownershipinterest greater than twenty percent under the equity method.  For equity method investments, the Companyrecords its proportionate share of the investee’s net income or loss.Generally, the Company accounts for its investments in which the Company has anownership interest of less than twenty percent under the cost method for itsprivate investments. Investments in marketable equity securities, if notconsidered equity method investments, are considered available-for-salesecurities.

 

Investments carried at costor under the equity method are written down if circumstances indicate thecarrying amount of the investment may not be recoverable.  Investments in marketable equity securitiesare carried at fair value based on quoted market prices.  Net unrealized holding gains and losses areexcluded from income and are reported as a separate component of stockholders’equity unless a decline in market value is considered other than temporary.  Realized gains and losses are included inincome.

 

(e)PROPERTY AND EQUIPMENT

Property and equipment arestated at cost. Depreciation is calculated using the straight-line method overthe estimated useful lives of the assets, which range from three to sevenyears.  The costs of leaseholdimprovements are capitalized and amortized using the straight-line method overthe shorter of the lease term or the estimated useful life of the asset.

 

Inaccordance with SFAS No. 144 “Accounting for the Impairment or Disposal ofLong-Lived Assets,” long-lived assets, such as property, plant, and equipment arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable.  Recoverability of assets to be held and usedis measured by a comparison of the carrying amount of an asset to estimatedundiscounted future cash flows expected to be generated by the asset.  If the carrying amount of an asset exceedsits estimated future cash flows, an impairment charge is recognized by theamount by which the carrying amount of the asset exceeds the fair value of theasset.  Assets to be disposed of would beseparately presented in the balance sheet and reported at the lower of thecarrying amount or fair value less costs to sell, and are no longerdepreciated.  The assets and liabilitiesof a disposed group classified as held for sale would be presented separatelyin the appropriate asset and liability sections of the balance sheet.

 

(f) INCOME TAXES

The Company recognizesincome taxes using the asset and liability method, in accordance with SFAS No.109, *Accounting For Income Taxes*.  Under the asset and liability method,deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases.  Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled.  The effect of atax rate change on deferred tax assets and liabilities is recognized as incomein the period that includes the enactment date.

 

(g)FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying amounts of the Company’s financialinstruments, which include cash equivalents, investments available for sale,accounts receivable, restricted cash, accounts payable, accrued expenses andnotes payable (excluding the Company’s 6% convertible subordinated notes due2005) approximate their fair value due to the relatively short duration of theinstruments.

 

The fair value of theCompany’s 6% convertible subordinated notes due 2005 at December 31, 2003was $153.5 million, based on quoted market prices, as compared to the carryingvalue of the notes of $154.9 million at December 31, 2003.  The subordinated notes were redeemed during2004.

 

(h) CONCENTRATION OF CREDITRISK

Financial instruments, whichpotentially subject the Company to credit risk, consist primarily of cash, cashequivalents, and investments available for sale.

 

The Company invests cash notimmediately needed for operations in money market securities and high-gradeU.S. Government Agency-sponsored securities. The Company’s investments available for sale include commercial paperissued by financial institutions and other companies with high credit ratings,securities issued or sponsored by U.S. Government Agencies and money marketsecurities.  The amounts invested generallyexceed the F.D.I.C. limits.  Thesesecurities do not carry the full faith and credit of the U.S. Treasury.

 

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(i) DERIVATIVES

The Company recognizes all derivatives on the balancesheet at fair value. Derivatives that are not hedges are adjusted to fair valuethrough the statement of operations. If the derivative is a hedge, depending onthe nature of the hedge, changes in fair value of derivatives will either beoffset against the change in fair value of the hedged assets, liabilities orfirm commitments through earnings, or recognized in other comprehensive income(loss) until the hedged item is recognized in earnings.  The ineffective portion of a derivative’schange in fair value will be immediately recognized in earnings.  No derivative instruments were held at December 31,2003 and 2004.  

 

(j) STOCK OPTIONS ANDWARRANTS

The Company accounts forequity-based employee compensation arrangements in accordance with theprovisions of Accounting Principle Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations including FIN 44“Accounting for Certain Transactions Involving Stock Compensation.” Under APBNo. 25, compensation expense is based upon the difference, if any, on the dateof grant, between the fair value of the Company’s stock and the exercise price.All equity-based awards to non-employees are accounted for at their fair valuein accordance with SFAS No. 123, *Accounting for Stock BasedCompensation.*  SFAS No. 123established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans.  As allowed by SFAS No. 123, the Company haselected to continue to apply the intrinsic-value-based method of accountingdescribed above, and has adopted only the disclosure requirements of SFAS No.123.  The following table illustrates theeffect on net loss if the fair-value-based method had been applied to alloutstanding and unvested awards in each of the years ended December 31,2002, 2003 and 2004:

 
| **(in thousands)**                                                                                                | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net loss from continuing  operations, as reported                                                                 |       | $        | (21,360    | )        | $          | (25,696  | )          | $ | (23,703 | ) |
| Add stock-based employee  compensation expense included in reported net loss from continuing operations           |       | 1,735    |       | 928      |       | 594      |       |
| Deduct total stock-based  employee compensation expense determined under  fair-value-based method for all rewards |       | (2,651   | )          | (2,056   | )          | (1,568   | )          |
|                                                                                                              |       |     |       |     |       |     |       |
| Pro forma net loss from continuing operations                                                                     |       | $        | (22,276    | )        | $          | (26,824  | )          | $ | (24,677 | ) |
|                                                                                                              |       |     |       |     |       |     |       |
| Pro forma net loss per share from continuing operations                                                           |       | $        | (0.53      | )        | (0.63      | )        | (0.56      | ) |
|                                                                                                              |       |     |       |     |       |     |       |
| Weighted average shares outstanding                                                                               |       | 42,117   |       | 42,616   |       | 43,713   |       |

 

(k) EARNINGS PER SHARE

The Company computes netincome (loss) per share in accordance with SFAS No. 128, “Earnings Per Share.”  Under the provisions of SFAS No. 128, basicnet income (loss) per share is computed by dividing net income (loss) for theperiod by the weighted average number of common shares outstanding during theperiod.  Diluted net income (loss) pershare is computed by dividing the net income (loss) for the period by the weightedaverage number of common and dilutive common equivalent shares outstandingduring the period.  As the Company hashad a net loss in each of the periods presented, basic and diluted net loss pershare are the same.  Options and warrantsto purchase 7.1 million, 5.0 million and 2.1 million shares of the Company’scommon stock during 2002, 2003 and 2004, respectively, have been excluded fromthe calculation of diluted net loss per share because their inclusion would beanti-dilutive.

 

(l) OTHER COMPREHENSIVEINCOME (LOSS)

Comprehensive income, asdefined, includes changes in equity of a business during a period fromtransactions and other events and circumstances from non-owner sources.  Other comprehensive income refers to revenue,expenses, gains and losses that under generally accepted accounting principlesare included in comprehensive income, but excluded from net income.

 

For the years ended December 31,2002, 2003 and 2004, other comprehensive income (loss) consists of unrealizedgains (losses) on investments available for sale and MBS; and foreign currencytranslation adjustments.  For 2004, theCompany’s foreign currency translation loss was recognized through the sale ofthe foreign operations.

 

(m) USE OF ESTIMATES

The preparation ofconsolidated financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the dates of the consolidated financialstatements and the reported amounts of income and expenses during the reportingperiod.  Actual results could differ fromthose estimates.  Estimates are used inaccounting for, among other things, guarantees, recoverability of long-livedassets and investments, premium amortization, depreciation, employee benefits,restructuring accruals, taxes and contingencies.  Estimates and assumptions are reviewedperiodically and the effects of revisions are reflected in the consolidatedfinancial statements in the period they are determined to be necessary.

 

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(n) RECLASSIFICATIONS

Certain fiscal year 2002 and2003 amounts have been reclassified to conform to the current yearpresentation.  None of thesereclassifications had a material effect on the Company’s consolidated financialstatements.

 

(o) RECENT ACCOUNTINGPRONOUNCEMENTS

InDecember 2004, the FASB issued a revision of Statement of FinancialAccounting Standards No. 123, titled “Share-Based Payments” (“Statement No.123R”).  Statement No. 123R requires thatshare-based payments, such as grants of stock options, restricted shares, andstock appreciation rights, be measured at fair value and reported as expense ina company’s financial statements over the requisite service period.  The earlier guidance that Statement No. 123Rreplaced allowed companies the alternative of recognizing expense forshare-based payments in their financial statements or disclosing the pro formaeffect of those payments in the notes to the financial statements.  The Company periodically issues share-basedpayments to employees under its compensation programs and has elected to makepro forma disclosures under the current accounting guidance.  The Company is required to adopt StatementNo. 123R for the quarter ending September 30, 2005.  Beginning in that quarter, the Company willrecognize expense over the service period for the fair value of all grantsissued after June 30, 2005, as well as expense attributable to theremaining service period for all prior grants that have not fully vested bythat date.  At this time, the Companydoes not expect the effect of adopting Statement No. 123R to be significantlydifferent from the impact on net earnings reported in prior periods under thedisclosure provisions of the existing Statement No. 123.

 

**(3) SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES RELATED TO DISCONTINUED OPERATIONS**

 

The following accountingprinciples have been used by management in the preparation of the Company’sconsolidated financial statements and relate principally to the Company’sdiscontinued operations:

 

(a) GOODWILL AND OTHERLONG-LIVED ASSETS 

Goodwill represents the excess of costs over the fairvalue of assets of businesses acquired.  Identifiableintangible assets consisted of completed technology, trademarks, and acquiredsubscribers and were amortized on a straight-line basis over five to sevenyears.  Goodwill and intangible assetsacquired in a purchase business combination and determined to have anindefinite useful life are not amortized, but instead tested for impairment atleast annually in accordance with the provisions of SFAS No. 142, “Goodwilland Other Intangible Assets.”  SFAS No. 142also requires that intangible assets with estimable useful lives be amortizedover their respective estimated useful lives to their estimated residualvalues, and reviewed for impairment in accordance with SFAS No. 144.

 

(b) REVENUE RECOGNITION

***EMS***

The results of operations ofthe Company’s EMS segment have been classified as discontinued operations inthe accompanying consolidated financial statements.  The Company derived revenue in its EMSsegment from four primary sources. Subscriber revenue was generally recognized ratably over the term of thecustomer agreement, typically one year. Engineering services revenues on time and materials contracts wererecognized as the services were provided. Revenue on fixed-fee engineering services contracts was recognized onthe percentage-of-completion method based on costs incurred in relation tototal estimated costs.  Software andrelated services revenues were recognized in accordance with SOP 97-2.  The Company recognized software revenue whenthe license agreement was signed, the license fee was fixed and determinable,delivery of the software had occurred, and collectibility of the fees wasconsidered probable.  Device revenue wasgenerally recognized upon delivery.

 

***Transportation***

The results of operations ofthe Company’s Transportation segment have been classified as discontinuedoperations in the accompanying consolidated financial statements.  The Company derived revenue in itsTransportation segment from two primary sources.  Subscriber revenue was generally recognizedon a monthly basis as service was provided. Activation fees were deferred and recognized ratably over the expectedlife of the customer relationship. Device revenue was generally deferred and recognized over contract termsof three to five years.

 

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***Mobile Government***

The results of operations ofthe Company’s Mobile Government segment have been classified as discontinuedoperations in the accompanying consolidated financial statements.  Software revenue was generally recognizedwhen the license agreement was signed, the license fee was fixed anddeterminable, delivery of the software had occurred, and when it could beestimated that collectibility of the fees was probable.  At the time of the transaction, MobileGovernment assessed whether the fee associated with the revenue transactions wasfixed and determinable and whether or not collection was reasonablyassured.  If a significant portion of afee was due after the normal payment terms, Mobile Government accounted for thefee as not being fixed and determinable. In these cases, Mobile Government recognized revenue as the fees becamedue.  Mobile Government assessedcollection based on a number of factors, including past transaction historywith the customer and credit worthiness of the customer.  Mobile Government did not request collateralfrom customers.  If it was determinedthat collection of a fee was not reasonably assured, Mobile Government deferredthe fee and recognized the revenue at the time it became reasonably assured,which was generally upon receipt of cash. If collectibility was assessed differently, the timing and amount ofrevenue recognition may have differed materially from that reported.

 

Revenue from licensingsoftware that required significant customization and modification wasrecognized using the percentage of completion method, based on the hoursincurred in relation to the total estimated hours.  If Mobile Government made differentjudgements or utilized different estimates of the total amount of work expectedto be required to customize or modify the software, the timing of revenuerecognition, from period to period, and margins on the project in the reportingperiod, could have differed materially from amounts reported.  Anticipated contract losses were recognizedas soon as they became known and estimable. 

 

Revenues from maintenanceand technical support agreements, which provided for unspecified when-and-ifavailable product updates and customer telephone support services, wererecognized ratably over the term of the service period.  For arrangements with multiple elements,Mobile Government allocated revenue to each component of the arrangement usingthe residual value method.  This meansthat Mobile Government deferred revenue from the total fees associated with thearrangement equivalent to the fair value of the element(s) of the arrangementthat had not yet been delivered.  Thefair value of any undelivered elements was established by using historicalevidence specific to Mobile Government.

 

(c) USE OF ESTIMATES

The preparation of consolidatedfinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the dates of the consolidated financial statementsand the reported amounts of revenue and expenses during the reportingperiod.  Actual results could differ fromthose estimates.  Estimates are used inaccounting for, among other things, long-term contracts, allowances foruncollectible receivables, inventory obsolescence, recoverability of goodwill,long-lived assets and investments, depreciation and amortization, employeebenefits, restructuring accruals, taxes and contingencies.  Estimates and assumptions are reviewedperiodically and the effects of revisions are reflected in the consolidatedfinancial statements in the period they are determined to be necessary.

 

**(4) MORTGAGE-BACKED SECURITIES, AT FAIR VALUE**

 

Thefocus of the Company’s business strategy is the management of a leveragedportfolio of mortgage-backed securities (“MBS”).

 

Thetables below summarize the MBS portfolio as of December 31, 2004:

 
| **(in thousands)**     | ** ** | **FHLMC** | ** ** | **FNMA** | ** ** | **GNMA** | ** ** | **Total MBS** | ** ** |
|------------------------|------------|-----------|------------|----------|------------|----------|------------|---------------|------------|
| MBS, gross             |       | $         | —     |     | $          | 61,680   |       | $             | —     |   | $ | 61,680 |   |
| Unamortized  premium   |       | —    |       | 714      |       | —   |       | 714           |       |
| Amortized  cost        |       | —    |       | 62,394   |       | —   |       | 62,394        |       |
| Net  unrealized losses |       | —    |       | (210     | )          | —   |       | (210          | )          |
| Estimated  fair value  |       | $         | —     |     | $          | 62,184   |       | $             | —     |   | $ | 62,184 |   |

 

Thenet unrealized loss is included as a component of other comprehensive income instockholders’ equity.

 
| **(in thousands)** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  Loss** | ** ** | **Estimated  Fair Value** | ** ** |
|--------------------|------------|---------------------|------------|-----------------------------|------------|-----------------------------|------------|---------------------------|------------|
| Hybrid 3/1  ARMS   |       | $                   | 62,394     |                        | $          | —                      |       | $                         | (210       | ) | $ | 62,184 |   |
| Fixed Rate         |       | —              |       | —                      |       | —                      |       | —                    |       |
|               |       | $                   | 62,394     |                        | $          | —                      |       | $                         | (210       | ) | $ | 62,184 |   |

 

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Thehybrid adjustable rate MBS are limited by periodic caps (generally interestrate adjustments are limited to 2% every twelve months after the initial rateadjustment) and lifetime caps.  Theweighted average lifetime cap was 9.9% at December 31, 2004.

 

During2004, the Company realized $1.8 million in gains on sales of MBS.

 

As of December 31,2004, the Company owned two securitized pools of Federal National MortgageAssociation (FNMA) 3/1 hybrid adjustable-rate MBS.  The following table shows the fair value andgross unrealized losses of the Company’s MBS, aggregated by investment categoryand the length of time the individual securities have been in a continuousunrealized loss position as of December 31, 2004: 

 
| ** **                       | ** ** | **Less Than 12 Months** | ** ** | **12 Months or More**  | ** ** | **Total**       | ** ** |
|----------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------|------------|
| **(in thousands)**               | ** ** | **Fair  Value**         | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| FNMA  mortgage-backed securities |       | $                       | 62,184     |                   | $          | (210            | )          | $ | — |   | $ | — |   | $ | 62,184 |   | $ | (210 | ) |
|                                  |            |                         |            |                        |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thesesecurities are currently in an unrealized loss position because changes ininterest rates have reduced their market value. The securities carry an implied AAA rating.  The Company does not consider theseunrealized losses other-than-temporary since it has the ability and the intentto hold the investments for a period of time sufficient for a market pricerecovery to recover the losses.

 

Interestincome for 2004 is as follows:

 
| **(in thousands)**                                              | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|
| Interest  earned on MBS                                         |       | $        | 505        |   |
| Less: MBS premium  amortization                                 |       | (22      | )          |
| Interest  earned on U.S. Government Agency-sponsored securities |       | 447      |       |
| Less:  Custodian fees                                           |       | (2       | )          |
| Interest  income from MBS portfolio                             |       | $        | 928        |   |

 

During February and March 2005,the Company entered into forward purchase arrangements representing commitmentsto purchase MBS in March and April 2005 with an estimated aggregateface value of $375.0 million.  Atsettlement, the Company intends to enter into repurchase agreements to fund mostof these purchases.

 

**(5)INVESTMENTS AVAILABLE FOR SALE**

 

Asof December 31, 2003, investments available for sale totalingapproximately $220.8 million were classified as non-current assets since theyall had maturities after December 31, 2004.  The Company carries such investments at fairvalue.  Unrealized gains (losses) areexcluded from earnings (loss) and are reported as a separate component of othercomprehensive income (loss) until realized. Realized gains and losses from the sale of these investments aredetermined on a specific identification basis. 

 

As of December 31,2003, investments available for sale consisted of:

 
| **(in thousands)**                           | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Holding  Gains** | ** ** | **Gross  Unrealized  Holding  Losses** | ** ** | **Fair  Value** | ** ** |
|----------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|----------------------------------------|------------|-----------------|------------|
|                                         |       |                |       |                                  |       |                                   |       |            |       |
| U.S. Government  Agency-sponsored securities |       | $                   | 221,093    |                                  | $          | 347                                    |       | $               | (591       | )  | $ | 220,849 |   |
|                                              |            |                     |            |                                       |            |                                        |            |                 |            |  |  |  |  |

 

During 2002, the Companyrecorded a net charge of $14.4 million, which included $14.1 million inimpairment charges related to its investments. The remainder of the charge related to net gains (losses) from the salesof investments, and changes in the fair value of warrants.

 

During 2003, the Companyrecorded gains of $587,000, which primarily related to net gains on sales,offset somewhat by $71,000 in impairment charges related to its investments.

 

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During2004, the Company liquidated its investments available for sale to meetanticipated cash requirements, including the early redemption of the Company’s 6%convertible subordinated notes due March 2005. The Company recorded a netloss of $3.6 million which included a $5.4 million loss on the liquidation ofits investments available for sale, partially offset by a gain of $1.8 millionrelated to the sale of other investments.

 

**(6)PROPERTY AND EQUIPMENT**

 

Property and equipmentconsists of the following:

 
| **(in thousands)**                                     | ** ** | **ESTIMATED  USEFUL  LIVES** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|------------|------------|------------|------------|
| **DECEMBER 31,**                                  |
| **2003**                                               | ** ** | **2004**                     |
| Furniture and fixtures                                 |       | 7 Years                      |       | $          | 388        |       | $          | 3 |   |
| Computer and equipment                                 |       | 3 – 5 Years             |       | 750        |       | 29         |       |
| Software                                               |       | 3 Years                      |       | 3,676      |       | 59         |       |
| Leasehold improvements                                 |       | Term of Lease                |       | 1,176      |       | 1,630      |       |
| Total property and equipment                           |       |                         |       | $          | 5,990      |       | $          | 1,721 |   |
| Less accumulated depreciation                          |       |                         |       | (3,382     | )          | (1,354     | )          |
| Property and equipment net of accumulated depreciation |       |                         |       | $          | 2,608      |       | $          | 367 |   |

 

During 2003,the Company disposed of its corporate jet, which was classified as an assetheld for sale at December 31, 2002.  In connection with thisdisposal, the Company recorded a loss on disposal of assets of approximately $850,000.  This loss was partially offset by gains onthe disposal of other assets.

 

Inaddition, during 2003, the Company disposed of its Arizona NetworkOperations Center, which was recorded in discontinued operations.  As a result of this sale, the Companyreceived cash proceeds of $1.4 million.  A loss on disposal of theseassets of approximately $272,000 was recorded and is included in discontinuedoperations in the accompanying consolidated financial statements.

 

TheCompany assessed the fair value of certain of its long-lived assets, includingsoftware, computer equipment, other tangible assets and identifiable intangibleassets obtained in connection with acquisitions.  The Company, with the assistance of thirdparty appraisers, determined the fair value of these assets based on acombination of quoted market prices and a cost approach methodology.

 

During2002 and 2003, these assessments resulted in impairment charges to long-livedassets of $7.6 million and $1.4 million, respectively, related to continuingoperations.  The charges are included as “Impairmentof other assets” in the accompanying Consolidated Statements of Operations andComprehensive Loss.  There were noimpairment charges during 2004.

 

**(7) ACCOUNTS PAYABLE AND ACCRUED EXPENSES**

 

Accounts payable and accruedexpenses consist of the following:

 
| **(in thousands)**                    | **DECEMBER 31,** | ** ** |
|---------------------------------------|-----------------------|------------|
| **2003**                              | ** **            | **2004**   |
| Professional fees                     | $                     | 3,130      |   | $ | 1,110 |   |
| Taxes other than payroll and income   | 772                   |       | 1,781 |   |
| Other                                 | 839                   |       | 603 |   |
| Accounts payable and accrued expenses | $                     | 4,741      |   | $ | 3,494 |   |

 

**(8) RESTRUCTURING CHARGES**

 

During2002, the Company reduced expenses with a focus on improving operationalefficiencies and implementing other measures in order to reduce plannedexpenses.  These efforts resulted in theelimination of 37 positions.  As a resultof these actions, the Company recorded charges to earnings from continuingoperations during 2002 of approximately $558,000.

 

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OnJanuary 1, 2003, the Company adopted SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” which requires that a liabilityfor a cost associated with an exit or disposal activity be recognized whenincurred at fair value. The Company recorded charges to earnings fromcontinuing operations during 2003 of approximately $306,000.  The charges related mainly to workforcereductions of 10 positions. Employee separation benefits under therestructuring plan include severance, medical, and other benefits.  As of December 31, 2003, the accruedliability related to all restructuring activities was $1.5 million, themajority of which related to outstanding lease obligations.

 

TheCompany recorded charges to earnings from continuing operations during 2004 ofapproximately $1.1 million.  The chargesprimarily related to workforce reductions of 14 positions.  As of December 31, 2004, the accruedliability related to all restructuring activities was approximately $259,000,the majority of which related to outstanding lease obligations.

 

Calculationof the restructuring accrual related to expected losses on subleases requiresthe Company to make estimates concerning: (1) the expected length of time tosublease the facility; (2) the expected rental rates on subleases; and, (3)estimated brokerage expenses associated with executing the sublease.  The Company used the assistance of independentreal estate brokerage firms in developing these estimates and the Company’sestimates may be impacted by future economic trends.  The expected losses on subleases have notbeen discounted.  If the actual resultsdiffer from the Company’s estimates, or as management’s best estimates changefrom quarter to quarter, based on the latest information, the Company isrequired to adjust its restructuring accrual related to facilities, includingrecording additional losses.  Thesechanges in assumptions are reflected in the table below as adjustments.

 

Arollforward of the restructuring accrual is as follows:

 
| **(in thousands)**                                     | ** ** | **Employee  Separation  Benefits** | ** ** | **Facility  Closure  Costs and  Other** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------------|------------|-----------|------------|
| **2002  Restructuring:**                               |       |                               |       |                                    |       |      |       |
| Restructuring  liability as of December 31, 2001  |       | $                                  | 1,602      |                                    | $          | 26,215    |       | $ | 27,817 |   |
| Charges to  continuing operations                      |       | 558                                |       | —                                  |       | 558       |       |
| Net charge  and adjustments to discontinued operations |       | 5,044                              |       | 32,142                                  |       | 37,186    |       |
| Reclassification  from other accruals                  |       | —                             |       | 774                                     |       | 774       |       |
| Non-cash  charges                                      |       | —                             |       | (4,619                                  | )          | (4,619    | )          |
| Cash  payments                                         |       | (6,781                             | )          | (22,483                                 | )          | (29,264   | )          |
| Restructuring  liability as of December 31, 2002  |       | 423                                |       | 32,029                                  |       | 32,452    |       |
|                                                   |       |                               |       |                                    |       |      |       |
| **2003  Restructuring:**                               |       |                               |       |                                    |       |      |       |
| Charges to  continuing operations                      |       | 198                                |       | 108                                     |       | 306       |       |
| Net charge  and adjustments to discontinued operations |       | 1,237                              |       | 4,614                                   |       | 5,851     |       |
| Cash  payments                                         |       | (1,458                             | )          | (35,674                                 | )          | (37,132   | )          |
| Restructuring  liability as of December 31, 2003  |       | 400                                |       | 1,077                                   |       | 1,477     |       |
|                                                   |       |                               |       |                                    |       |      |       |
| **2004  Restructuring:**                               |       |                               |       |                                    |       |      |       |
| Charges to  continuing operations                      |       | 634                                |       | 606                                     |       | 1,240     |       |
| Adjustments                                            |       | —                             |       | (186                                    | )          | (186      | )          |
| Net charge  and adjustments to discontinued operations |       | 84                                 |       | —                                  |       | 84        |       |
| Cash  payments                                         |       | (1,050                             | )          | (1,306                                  | )          | (2,356    | )          |
| Restructuring  liability as of December 31, 2004  |       | $                                  | 68         |                                    | $          | 191       |       | $ | 259 |   |

 

**(9) DEBT**

 

On March 17, 2000, theCompany completed an offering for the sale of an aggregate $310.5 million of 6%convertible subordinated notes (“the Notes”) due in 2005.  The net proceeds after deduction ofunderwriting discounts and offering expenses were approximately $300.6million.  The underwriting discounts andexpenses of the Notes offering of $10.2 million were included in other assetsas deferred financing fees.  The Notes wereconvertible, at the option of the holder, at any time prior to maturity, intoshares of common stock of Aether at a conversion price of $243.95 per share,which is equal to a conversion rate of 4.0992 shares per $1,000 principalamount of Notes, subject to adjustment.

 

During 2001 and 2002, theCompany bought back $20.0 million and $135.6 million of outstanding Notes andrecognized gains of $7.7 million and $42.8 million, respectively on the earlyextinguishment of debt.  The Company didnot repurchase Notes in 2003.

 

58

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On October 4, 2004,the Company repurchased the remainder of its outstanding 6% subordinated notesdue March 2005 for a price of 101.2%. The total repurchase payment was $157.1 million, consisting of $154.9million in principal, a $1.9 million redemption premium and approximately$310,000 in accrued interest.  Inconnection with the repurchase, the Company recorded a $2.4 million chargewhich is presented in the Consolidated Statements of Operations andComprehensive Loss as “Loss on early extinguishment of debt.”  The charge consisted of the $1.9 millionredemption premium and a non-cash charge of approximately $560,000 related tothe recognition of unamortized deferred financing costs.

 

##### **(10)INCOME TAXES**

 

The Company has provided nocurrent income taxes due to the losses incurred in all periods.  The income tax benefit for 2002 primarilyrelates to refunds received from the carryback of federal net operating lossesto prior tax years.

 

A reconciliation of thestatutory Federal income tax rate and the effective income tax rate forcontinuing operations for the year ended December 31, 2002, 2003 and 2004follows:

 
| ** **                        | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory Federal income tax rate |       | (35.0    | )%         | (35.0    | )%         | (35.0    | )%         |
| Effect of:                        |       |     |       |     |       |     |       |
| Valuation allowance               |       | (8.3     | )     | 41.1     |       | 27.9     |       |
| Other                             |       | 43.3     |       | (6.1     | )          | 7.1      |       |
| Effective income tax rate         |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |

 

The tax effects of temporarydifferences that give rise to significant portions of the deferred tax assetsand liabilities at December 31, 2003 and 2004, are presented below:

 
| ** **                                  | ** ** | **DECEMBER 31,** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|
| **(in thousands)**                          | ** ** | **2003**              | ** ** | **2004** | ** ** |
| Deferred tax assets:                        |       |                  |       |   |   |
| Net operating loss carryforwards            |       | $                     | 303,181    |   | $ | 321,259 |   |
| Investments                                 |       | 35,713                |       | 21,783 |   |
| Capital loss carryforwards                  |       | 35,217                |       | 103,010 |   |
| Stock related compensation                  |       | 7,167                 |       | 6,349 |   |
| Allowance for doubtful accounts             |       | 8,544                 |       | — |   |
| Accrued compensation                        |       | 662                   |       | 28 |   |
| Reserves and other                          |       | 12,914                |       | 708 |   |
| Depreciation and amortization               |       | 5,213                 |       | 5,103 |   |
| Intangibles                                 |       | 22,896                |       | — |   |
| Tax credit carryforwards                    |       | 6,832                 |       | 6,372 |   |
| Gross deferred tax assets                   |       | $                     | 438,339    |   | $ | 464,612 |   |
| Valuation allowance for deferred tax assets |       | (438,339              | )          | (464,612 | ) |
| Net deferred tax assets                     |       | $                     | —     |   | $ | — |   |

 

The net change in thevaluation allowance for deferred tax assets was an increase of $27.8 million in2003 and $26.3 million in 2004.  Theincrease in 2003 and 2004 consists of an increase related to losses fromcontinuing and discontinued operations.

 

Approximately $372.0 millionof the valuation allowance for deferred tax assets as of December 31, 2004will be allocated to “Income Tax Benefit” in the consolidated statements ofoperations and comprehensive loss upon realization.  The remaining $92.6 million will be allocatedto “Additional Paid-In Capital.”

 

In addressing therealizability of deferred tax assets, management considers whether it is morelikely than not that some portion or all of the deferred tax assets will not berealized.  The Company has deferred taxassets principally as a result of accumulated net operating and capitallosses.  The Company will only be able torealize value from the accumulated net operating losses if it becomesprofitable and from the accumulated capital losses, only to the extent it cangenerate capital gains.  In addition, itsability to realize value from these accumulated losses is subject to variousrisks and uncertainties, including regulations that, under certaincircumstances, may limit the Company’s ability to use these net losses toreduce future taxes that it might otherwise owe.  Management believes that as a result of itschange in strategic direction, the Company will achieve profitable operationsin future years that will enable the Company to recover the benefit of all or aportion of its deferred tax assets.  However,the Company presently does not have sufficient objective evidence to supportmanagement’s belief and, accordingly, maintains a full valuation allowance forits net deferred tax assets as required by generally accepted accountingprinciples.

 

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Under federal and state taxlaws, the Company may use its accumulated losses to substantially reduce theincome taxes it otherwise would have to pay on future taxable income.  As a result, the Company could have little orno income tax liability for a period of time. As of December 31, 2004, the Company had accumulated federal netoperating losses totaling approximately $765.5 million that it can “carryforward” as potential tax deductions until they expire between 2012 and2024.  In addition, the Company hasaccumulated capital losses of approximately $245.3 million that it can “carryforward” as potential tax deductions (but only against net capital gains) untilthey expire between 2006 and 2009.  As aresult of changes in common stock ownership, the future realization of netoperating loss carryforwards, capital loss carryforwards and certain other taxcredits could become subject to regulatory limits.

 

**(11)PENSION PLANS**

 

The Company has two definedcontribution plans under Section 401(k) of the Internal Revenue Code thatprovide for voluntary employee contributions of 1 to 15 percent of compensationfor substantially all employees.  TheCompany contributed the following amounts to the plans for the years ended December 31,2002, 2003 and 2004, respectively:

 
| **(in thousands)**            | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Continuing  operations        |       | $        | 162        |     | $          | 105      |       | $ | 69 |   |
| Discontinued  operations      |       | 1,197    |       | 728      |       | 318      |       |
| Total  employer contributions |       | $        | 1,359      |     | $          | 833      |       | $ | 387 |   |

 

**(12) STOCKOPTIONS AND WARRANTS**

 

In 1996, the Company adopteda Unit Option Plan. In September 1999, the Company adopted the 1999 EquityIncentive Plan (the Plan) to replace the Unit Option Plan.  Under the Plan, the Company has the abilityto grant options to acquire up to 20% of the outstanding shares of common stockto its employees, directors, and service providers.  Options under the Plan generally expire afterten years and normally vest over a period of up to four years.  Options are generally granted at an exerciseprice equal to the fair value on the grant date. Effective December 15,2000, the Company adopted the Acquisition Incentive Plan (the 2000 Plan) toprovide options or direct grants to employees and other service providers ofthe Company and its related companies with respect to the Company’s commonstock.  The Company has the ability togrant options to acquire up to an additional 5% of the outstanding shares ofcommon stock under the 2000 Plan.  Allemployees (except directors and officers of the Company and any eligibleaffiliates) are eligible for the awards under the 2000 Plan, withoutshareholder approval.  Options aregenerally granted at an exercise price equal to the fair value of the commonstock on the grant date.

 

In January 2001, theCompany’s employees were offered the right to exchange existing options forshares of restricted stock.  In total,567 employees agreed to have their options canceled in exchange forapproximately 756,000 shares of restricted stock.

 

60

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The per share weighted-averagevalue of options granted by the Company during 2002, 2003 and 2004 was $2.22, $1.11and $2.53, respectively, on the date of grant using the Black-Scholesoption-pricing model.  The amounts foreach year were calculated based on an expected option life of five years andvolatility of 70 percent.  In addition,the calculations assumed a risk-free interest rate of 4.95 percent to 5.09percent in 2002, 2.46 percent to 3.25 percent in 2003 and 2.80 percent to 3.81percent in 2004.  A summary of the stockoption activity for the years ended December 31, 2002, 2003 and 2004 is asfollows:

 
| ** **                                     | ** ** | **2002**              | ** ** | **2003**                               | ** ** | **2004**              | ** ** |
|------------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|-----------------------|------------|
| **(In thousands, except  per share amounts)**  | ** ** | **NUMBER  OF SHARES** | ** ** | **WEIGHTED  AVERAGE  EXERCISE  PRICE** | ** ** | **NUMBER  OF SHARES** | ** ** | **WEIGHTED  AVERAGE  EXERCISE  PRICE** | ** ** | **NUMBER  OF SHARES** | ** ** | **WEIGHTED  AVERAGE  EXERCISE  PRICE** | ** ** |
|                                           |       |                  |       | **(PER  SHARE)**                       |       |                  |       | **(PER  SHARE)** |   |   |   | **(PER  SHARE)** |   |
| Stock options outstanding at beginning of year |       | 6,251                 |       | $                                      | 19.22      |                  | 7,079      |   | $ | 9.92 |   | 5,048 |   | $ | 8.33 |   |
|                                           |       |                  |       |                                   |       |                  |       |   |   |   |   |   |   |
| Granted                                        |       | 3,848                 |       | 3.01                                   |       | 203                   |       | 2.11 |   | 127 |   | 3.60 |   |
|                                           |       |                  |       |                                   |       |                  |       |   |   |   |   |   |   |
| Exercised                                      |       | (481                  | )          | 1.31                                   |       | (687                  | )          | 1.64 |   | (1,035 | ) | 4.66 |   |
|                                           |       |                  |       |                                   |       |                  |       |   |   |   |   |   |   |
| Canceled                                       |       | (2,539                | )          | 19.57                                  |       | (1,547                | )          | 17.82 |   | (2,058 | ) | 16.02 |   |
| Outstanding at end of year                     |       | 7,079                 |       | $                                      | 9.92       |                  | 5,048      |   | $ | 8.33 |   | 2,082 |   | $ | 4.03 |   |
|                                           |       |                  |       |                                   |       |                  |       |   |   |   |   |   |   |
| Stock options exercisable at year-end          |       | 2,282                 |       | $                                      | 11.44      |                  | 2,691      |   | $ | 9.78 |   | 1,625 |   | $ | 4.27 |   |

 

The following tablesummarizes information about stock options at December 31, 2004:

 
| ** **                     | ** ** | **OPTIONS  OUTSTANDING**               | ** ** | **OPTIONS  EXERCISABLE**                             | ** ** |
|--------------------------------|------------|----------------------------------------|------------|------------------------------------------------------|------------|
| **RANGE OF  EXERCISE  PRICES** | ** ** | **NUMBER  AT  DECEMBER 31, 2004** | ** ** | **WEIGHTED-  AVERAGE  REMAINING  CONTRACTUAL  LIFE** | ** ** | **WEIGHTED-  AVERAGE  EXERCISE  PRICE** | ** ** | **NUMBER  AT  DECEMBER 31,  2004** | ** ** | **WEIGHTED-  AVERAGE  EXERCISE  PRICE** | ** ** |
| ** **                     | ** ** | **(in  thousands)**                    | ** ** | **(in  years)**                                      | ** ** | **(PER  SHARE)** | ** ** | **(in  thousands)** | ** ** | **(PER  SHARE)** | ** ** |
| Restricted Stock               |       | 22                                     |       | 8.8                                                  |       | $ | — |   | — |   | $ | — |   |
| $  0.01—$1.00   |       | 7                                      |       | 0.1                                                  |       | 0.40 |   | 7 |   | 0.40 |   |
| $  1.01—$2.00   |       | 681                                    |       | 4.5                                                  |       | 1.60 |   | 681 |   | 1.60 |   |
| $  2.01—$3.00   |       | 707                                    |       | 7.5                                                  |       | 2.90 |   | 372 |   | 2.89 |   |
| $  3.01—$4.00   |       | 328                                    |       | 4.6                                                  |       | 3.82 |   | 277 |   | 3.89 |   |
| $  4.01—$5.00   |       | 24                                     |       | 7.7                                                  |       | 4.20 |   | 1 |   | 4.66 |   |
| $  5.01—$8.00   |       | 40                                     |       | 5.3                                                  |       | 7.64 |   | 36 |   | 7.84 |   |
| $  8.01—$10.00  |       | 200                                    |       | 5.0                                                  |       | 8.55 |   | 178 |   | 8.55 |   |
| $ 10.01—$127.75      |       | 73                                     |       | 3.5                                                  |       | 25.89 |   | 73 |   | 25.89 |   |
|                           |       | 2,082                                  |       | 5.6                                                  |       | $ | 4.03 |   | 1,625 |   | $ | 4.27 |   |

 

**(13) RELATED PARTY TRANSACTIONS**

 

The Company receives benefitcoordination services from Huber Oros, which is considered arelated party because an owner of Huber Oros is related to a member of theCompany’s senior management.  For the years ended December 31, 2002,2003 and 2004, expenses related to Huber Oros were approximately $169,000,$107,000 and $108,000, respectively.  Asof December 31, 2003 and 2004 there were no outstanding payables due toHuber Oros.

 

The Company receives legal servicesfrom Kirkland & Ellis LLP, which is considered a related partybecause a partner at that firm is a member of the Company’s Board ofDirectors.  For the years ended December 31, 2003 and2004, expenses related to Kirkland & Ellis LLP were approximately$1.4 and $2.1 million, respectively.  The Company did not receive legalservices from this firm prior to 2003. As of December 31, 2003 and 2004, the Company had outstandingpayables due to Kirkland & Ellis LLP of approximately $805,000 and $0,respectively.

 

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During 2004, the Company paid thelast $100,000 installment of a total $300,000 pledge to the University ofMaryland Foundation, which is a charitable organization affiliated with theUniversity of Maryland.  The Companycommitted to make this $300,000 contribution in 2001, and the first two$100,000 installments were paid in 2001 and 2002.  The Company’s chief executive officer iscurrently a member of the Foundation’s Board of Directors, which he joined in2002.

 

**(14)COMMITMENTS AND CONTINGENCIES**

 

(a) LEGAL PROCEEDINGS

 

Aetheris among the hundreds of defendants named in nine class action lawsuits seekingdamages on account of alleged violations of securities law.  The case isbeing heard in the United States District Court for the Southern District ofNew York.  The court has consolidated the actions by all of the nameddefendants that actually issued the securities in question.  Now there areapproximately 310 consolidated cases before Judge Scheindlin, including theAether Systems action, under the caption In Re Initial Public OfferingsLitigation, Master File 21 MC 92 (SAS).

 

Theseactions were filed on behalf of persons and entities that acquired theCompany’s stock after its initial public offering in October 20,1999.  Among other things, the complaints claim that prospectuses, dated October 20,1999 and September 27, 2000 and issued by Aether in connection with thepublic offerings of common stock, allegedly contained untrue statements ofmaterial fact or omissions of material fact in violation of securities lawsbecause the prospectuses allegedly failed to disclose that the offerings’underwriters had solicited and received additional and excessive fees,commissions and benefits beyond those listed in the arrangements with certainof their customers which were designed to maintain, distort and/or inflate themarket price of the Company’s common stock in the aftermarket.  Theactions seek unspecified monetary damages and rescission.  Aether believesthe claims are without merit and is vigorously contesting these actions.

 

Initialmotions to dismiss the case were filed and the court held oral argument on themotions to dismiss on November 1, 2002.  On February 19, 2003,the court issued an Opinion and Order on defendants’ motions to dismiss, whichgranted the motions in part and denied the motions in part.  As to AetherSystems, the motion to dismiss the claims against it was denied in itsentirety.  Discovery has now commenced.  The plaintiffsvoluntarily dismissed without prejudice the officer and director defendants ofAether.  On June 26, 2003, the Plaintiff’s Executive Committee inthis case announced a proposed settlement with the issuers.  The proposedsettlement is a settlement among the plaintiffs, theissuer-defendants, including Aether, and the officer and director defendants ofthe issuers.  The plaintiffs will continue litigating their claims againstthe underwriter-defendants.  Under terms of the proposed settlement,Aether would not incur any material financial or other liability.  OnJune 14, 2004, the plaintiffs and issuer defendants presented the executedsettlement agreement to Judge Scheindlin during a court conference. Subsequently, plaintiffs and issuers made a motion for preliminaryapproval of the settlement agreement.  On July 14, 2004, theunderwriter defendants filed a memorandum of law in opposition to plaintiffs’motion for preliminary approval of the settlement agreement.  Reply briefsin support of the settlement were submitted to the court.  In December 2004,the court ordered additional briefing on the motion.  All of theadditional briefs were submitted to the court.  On February 15,2005, Judge Scheindlin issued an Opinion and Order granting preliminaryapproval to the settlement agreement.  The court will schedule a fairnesshearing on the proposed settlement and subsequently will decide whether togrant final approval to the settlement agreement.  Thesettlement agreement is subject to the approval of the District Court. There can be no assurance such approval will be granted.

 

Aether is also a party to otherlegal proceedings in the normal course of business.  Based on evaluation of these matters anddiscussions with counsel, the Company believes that liabilities arising fromthese matters will not have a material adverse effect on the consolidatedresults of its operations or financial position.

 

(b) CONTRACTUAL COMMITMENTS 

 

In June 2004, theCompany contracted with FBR Investment Management Inc. (“FBR”) to obtaininvestment management services for its MBS portfolio for an initial term of oneyear.  The agreement will continue ineffect beyond its initial term until terminated by the Company or FBR.  The Company can terminate the agreement for atermination fee of $500,000 per calendar quarter through September 30, 2005sixty days after providing written notice of its intent to cancel.  Under the terms of the agreement, the Companyagreed to pay FBR a quarterly management fee equal to 0.0375% of the aggregatecost basis of the securities in the portfolio. In addition, if FBR’s management of the Company’s portfolio results in areturn in excess of 10% per annum, the Company would pay FBR an incentive fee equalto 25% of the return in excess of 10% per annum.

 

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(c) LEASES

 

The Company is obligatedunder noncancelable operating leases for office space that expire at variousdates through 2008.  Future minimum leasepayments under noncancelable operating leases and related sublease rentcommitments as of December 31, 2004 are as follows: (in thousands)

 
| **Years ending December 31:** | ** ** | **Gross  Commitments** | ** ** | **Subleased** | ** ** |
|------------------------------------|------------|------------------------|------------|---------------|------------|
| 2005                               |       | $                      | 1,394      |          | $          | 1,201 |   |
| 2006                               |       | 1,342                  |       | 1,218         |       |
| 2007                               |       | 1,384                  |       | 1,256         |       |
| 2008                               |       | 920                    |       | 855           |       |
| Total  minimum lease payments      |       | $                      | 5,040      |          | $          | 4,530 |   |

 

Rent expense from continuingoperations under operating leases was approximately $894,000, $653,000, and $454,000for the years ended December 31, 2002, 2003 and 2004, respectively.

 

The subleased payments shownabove are primarily related to the Mobile Government headquarters lease inMassachusetts, which the Company has subleased to the buyer of that business, BIO-KeyInternational, Inc.

 

(d) GUARANTEES

 

In November of 2002,the FASB issued FASB Interpretation No. 45, “Guarantors Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others.”  InterpretationNo. 45 discusses the necessary disclosures to be made by a guarantor in itsfinancial statements about its obligations under certain guarantees that it hasissued.  It also discusses that theguarantor must recognize a liability, at fair value, at the inception of theguarantee for the obligation incurred in issuing the guarantee.  The disclosure requirements are effective for2002.  The reporting requirements areeffective on a prospective basis for guarantees issued after December 31,2002.

 

The Company has guaranteed the payment of assignedleases on properties related to discontinued operations.  The maximum aggregate guarantee on theseproperties is approximately $561,000.

 

As of December 31, 2004, $7.9 million of theCompany’s certificates of deposit were held on deposit to collateralize anirrevocable standby letter of credit that was put in place when its MobileGovernment segment entered into a sales agreement with Hamilton County, Ohio toprovide an automated field reporting solution and real time wireless datainfrastructure under a sales agreement. The letter of credit provides collateral assurance of performance underthe sales agreement.  The terms of thesales agreement and the standby letter of credit state that Hamilton County canonly draw on the letter of credit after (1) completing the internal disputeresolution process set forth in the sales agreement and (2) providing notice toMobile Government of its intent to declare a default under the sales agreementand proceed against the letter of credit. A draw of the funds under the letter of credit is subject to thelimitations of liability contained in the sales agreement.  The letter of credit is required to remain inplace through the earlier of the end of the warranty period or December 31,2006.  The amount of the letter of creditcan be reduced by 25% at the end of the third calendar month of the warrantyperiod as long as certain conditions are met.

 

Although Mobile Government was sold to BIO-KeyInternational, Inc. on September 30, 2004, the Company agreed to maintainthe $7.9 million letter of credit.  Inconsideration of this arrangement, and to assure the Company’s reimbursement ofany amounts that Hamilton County collects by drawing on the letter of credit asa result of a default by the buyer, BIO-Key International, Inc., BIO-Key hasprovided the Company with a $1.0 million cash escrow and a $6.9 millionsubordinated secured promissory note (the “BIO-Key Note”).  The Company is entitled to retain the $1.0million and to demand payment under the BIO-Key Note if Hamilton County drawson the letter of credit.  The BIO-KeyNote is secured by a second lien on substantially all of BIO-Key’s assets.  The lien is subordinated to $5.0 million ofsenior secured debt held by certain of BIO-Key’s lenders.  The Company has evaluated our potentialexposure under this arrangement in accordance with FIN 45.

 

Additionally, the Company is maintaining the facilitylease for the Mobile Government headquarters in Massachusetts and sub-leasingit to BIO-Key.  As a condition toconsenting to the sublease, the landlord required the Company to maintain a$749,000 letter of credit to the landlord securing performance under the lease.  BIO-Key has provided the Company with a$749,000 cash deposit that would be available in the event of BIO-Key’s defaulton the sublease that results in a draw on the Company’s letter of credit.  The total remaining payments under both thelease and the sublease are approximately $4.5 million.  Both expire in August 2008.  

 

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The Mobile Government transactions discussed abovehave been included in the accompanying balance sheet as follows:

 
| **(in thousands)**                                         | ** ** | **Hamilton  County,  Ohio  Contract** | ** ** | **Massachusetts  Facility Lease** | ** ** | **Total** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| **Restricted  cash:**                                      |       |                                  |       |                              |       |      |       |
| Certificates  of deposit collateralizing letters of credit |       | $                                     | 7,885      |                              | $          | 749       |       | $ | 8,634 |   |
| **Other  long-term liabilities:**                          |       |                                  |       |                              |       |      |       |
| Deposits  from BIO-Key available in the event of default   |       | $                                     | 1,000      |                              | $          | 749       |       | $ | 1,749 |   |
| Other                                                      |       | 308                                   |       | —                            |       | 308       |       |
| Total                                                      |       | $                                     | 1,308      |                              | $          | 749       |       | $ | 2,057 |   |

 

(e)RESTRICTED CASH

 

Restrictedcash includes the portion of the Company’s certificates of deposit that aresecured by outstanding letters of credit and escrow accounts established tosecure certain of Mobile Government’s contracts and certain facilityleases.  At December 31, 2003, theCompany had $11.5 million of certificates of deposit, which were restricted byletters of credit.  In addition to theamounts above, $2.0 million was held in an escrow available to Lockheed Martinin the event of non-payment of liabilities for work performed by the MobileGovernment segment on a contract with the Pennsylvania State Police.  At December 31, 2004, the Company had$8.8 million of certificates of deposit, which collateralized the letters ofcredit.  The $2.0 million escrow wasreleased in connection with the sale of the Mobile Government segment.

 

**(15) SALES OF DISCONTINUED OPERATIONS**

 

During 2004, the Company discontinued and sold itsEnterprise Mobility Solutions (“EMS”), Transportation and Mobile Governmentsegments.  The following table providesthe detail of the gains (loss) recognized on the sales:

 
| **(in thousands)**                              | ** ** | **EMS** | ** ** | **Transportation** | ** ** | **Mobile  Government** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|---------|------------|--------------------|------------|------------------------|------------|-----------|------------|
| Proceeds                                        |       | $       | 20,143     |               | $          | 25,000                 |       | $         | 10,000     |   | $ | 55,143 |   |
| Estimated  working capital adjustment           |       | —  |       | (106               | )          | 343                    |       | 237       |       |
| Expenses                                        |       | (1,287  | )          | (1,999             | )          | (1,206                 | )          | (4,492    | )          |
| Net assets                                      |       | (750    | )          | (22,986            | )          | (6,019                 | )          | (29,755   | )          |
| Other                                           |       | —  |       | —             |       | (308                   | )          | (308      | )          |
| Gain (loss)  on sale of discontinued operations |       | $       | 18,106     |               | $          | (91                    | )          | $         | 2,810      |   | $ | 20,825 |   |

 

Thesummary of 2002 operating results from discontinued operations is as follows:

 
| **(in thousands)**                     | ** ** | **EMS** | ** ** | **Transportation** | ** ** | **Mobile  Government** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|---------|------------|--------------------|------------|------------------------|------------|-----------|------------|
| Net sales                              |       | $       | 57,212     |               | $          | 38,831                 |       | $         | 20,490     |   | $ | 116,533 |   |
| Net loss  from discontinued operations |       | $       | (225,853   | )                  | $          | (34,845                | )          | $         | (43,364    | ) | $ | (304,062 | ) |

 

Thesummary of 2003 operating results from discontinued operations is as follows:

 
| **(in thousands)**                              | ** ** | **EMS** | ** ** | **Transportation** | ** ** | **Mobile  Government** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|---------|------------|--------------------|------------|------------------------|------------|-----------|------------|
| Net sales                                       |       | $       | 53,403     |               | $          | 34,617                 |       | $         | 20,933     |   | $ | 108,953 |   |
| Net income  (loss) from discontinued operations |       | $       | (13,655    | )                  | $          | (10,634                | )          | $         | 533        |   | $ | (23,756 | ) |

 

64

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Thesummary of 2004 operating results from discontinued operations is as follows:

 
| **(in thousands)**                     | ** ** | **EMS** | ** ** | **Transportation** | ** ** | **Mobile  Government** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|---------|------------|--------------------|------------|------------------------|------------|-----------|------------|
| Net sales                              |       | $       | —     |               | $          | 21,858                 |       | $         | 13,776     |   | $ | 35,634 |   |
| Net loss  from discontinued operations |       | $       | (481       | )                  | $          | (33,556                | )          | $         | (11,413    | ) | $ | (45,450 | ) |

 

TheCompany does not allocate any interest income or expense to its discontinuedbusinesses.

 

During2002, 2003 and 2004, the Company performed the impairment analysis required bySFAS No. 142 and SFAS No. 144.  As aresult of these analyses, the Company recorded goodwill and asset impairmentcharges during the years ended December 31, 2002, 2003 and 2004, all ofwhich are recorded in discontinued operations in the Consolidated Statements ofOperations and Comprehensive Loss.  Thesummary of impairment charges is as follows:

 
| **(in thousands)**       | ** ** | **EMS** | ** ** | **Transportation** | ** ** | **Mobile  Government** | ** ** | **Total** | ** ** |
|--------------------------|------------|---------|------------|--------------------|------------|------------------------|------------|-----------|------------|
| 2002  impairment charges |       | $       | (131,308   | )                  | $          | (24,662                | )          | $         | (35,280    | ) | $ | (191,250 | ) |
| 2003  impairment charges |       | (629    | )          | (667               | )          | —                 |       | (1,296    | )          |
| 2004  impairment charges |       | —  |       | (26,622            | )          | (8,928                 | )          | (35,550   | )          |
|                          |            |         |            |                    |            |                        |            |           |            |  |  |  |  |

 

TheEMS segment generated $1.6 million and $800,000 of revenue from related partiesin 2002 and 2003, respectively.  Therelated parties consisted of companies in which Aether had made an equityinvestment.  The EMS segmentreceived data feeds from Reuters during 2002 and 2003. Reuters was considered a related party during 2002 because they were a partowner of EMS’s international operation.  During 2002, expenses related toReuters were approximately $587,000.  As of December 31, 2002 theCompany had outstanding payables due to Reuters of $1.2 million.

 

Assetsand liabilities of discontinued operations consisted of the following as of December 31,2003:

 
| **(in thousands)**                    | ** ** | **EMS** | ** ** | **Transportation** | ** ** | **Mobile  Government** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|---------|------------|--------------------|------------|------------------------|------------|-----------|------------|
| Cash and  cash equivalents            |       | $       | 1,882      |               | $          | —                 |       | $         | —     |   | $ | 1,882 |   |
| Accounts  receivable, net             |       | 7,947   |       | 5,703              |       | 9,311                  |       | 22,961    |       |
| Inventory,  net                       |       | 886     |       | 10,105             |       | 47                     |       | 11,038    |       |
| Net  investment in sales-type leases  |       | —  |       | 2,636              |       | —                 |       | 2,636     |       |
| Prepaid and  other assets             |       | 1,471   |       | 12,728             |       | 900                    |       | 15,099    |       |
| Current  assets                       |       | $       | 12,186     |               | $          | 31,172                 |       | $         | 10,258     |   | $ | 53,616 |   |
|                                  |       |    |       |               |       |                   |       |      |       |
| Property and  equipment, net          |       | $       | 1,652      |               | $          | 6,096                  |       | $         | 631        |   | $ | 8,379 |   |
| Goodwill                              |       | —  |       | 12,191             |       | 13,178                 |       | 25,369    |       |
| Intangible  assets, net               |       | —  |       | 8,915              |       | 3,256                  |       | 12,171    |       |
| Net investment  in sales-type leases  |       | —  |       | 8,765              |       | —                 |       | 8,765     |       |
| Other assets                          |       | 381     |       | 18,334             |       | 618                    |       | 19,333    |       |
| Non-current  assets                   |       | $       | 2,033      |               | $          | 54,301                 |       | $         | 17,683     |   | $ | 74,017 |   |
|                                  |       |    |       |               |       |                   |       |      |       |
| Accounts  payable and accrued expense |       | $       | 6,756      |               | $          | 5,950                  |       | $         | 4,175      |   | $ | 16,881 |   |
| Deferred  revenue                     |       | 2,914   |       | 7,717              |       | 7,656                  |       | 18,287    |       |
| Current  liabilities                  |       | $       | 9,670      |               | $          | 13,667                 |       | $         | 11,831     |   | $ | 35,168 |   |
|                                  |       |    |       |               |       |                   |       |      |       |
| Deferred  revenue                     |       | $       | 13         |               | $          | 18,799                 |       | $         | —     |   | $ | 18,812 |   |
| Other  liabilities                    |       | 4       |       | —             |       | 620                    |       | 624       |       |
| Non-current  liabilities              |       | $       | 17         |               | $          | 18,799                 |       | $         | 620        |   | $ | 19,436 |   |

 

65

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***EMS Sale***

OnJanuary 13, 2004, Aether completed the sale of its EMS segment toTeleCommunication Systems, Inc. (“TCS”). Pursuant to the purchase agreement, asamended, Aether received $19.0 million for the EMS segment, consisting of $18.0million in cash and a note in the principal amount of $1.0 million due in August 2004.  Aether also received 204,020 shares of TCSClass A common stock valued as of closing at approximately $1.1 million.  In April 2004, the Company sold thesesecurities and received approximately $1.4 million in cash.  In addition, the $1.0 million note from TCSwas repaid in full in August 2004.

 

***Transportation Sale***

OnSeptember 17, 2004, the Company sold its Transportation segment toSlingshot Acquisition Corporation (“Slingshot”), which is an affiliate ofPlatinum Equity Capital Partners L.P., for $25.0 million in cash.  The purchase price is subject to apost-closing adjustment based on net working capital to the extent theTransportation segment’s adjusted net working capital at August 31, 2004was more than $28.2 million or less than $27.6 million.  In addition, the parties also agreed to netcash receipts and payments by (or for the account of) the Transportationsegment between September 1, 2004 and the closing date, with any positivenet cash balance being payable to Slingshot and any negative balance being duefrom Slingshot.  The transaction wasstructured as a sale of assets and assumption of certain liabilities.  The assets sold consisted of all of theassets used primarily in the Transportation segment.  Slingshot assumed responsibility forsubstantially all post-closing liabilities and certain historical liabilities,of the Transportation segment.  At theclosing of the purchase agreement, Slingshot and the Company entered into atransition services agreement to provide for the orderly transition of thebusiness to Slingshot, which is expected to be completed by early 2005. 

 

Inconnection with the sale of the Transportation segment, the Company recorded a$26.6 million non-cash impairment charge in the second quarter of 2004. 

 

Duringthe fourth quarter of 2004, the Company and Slingshot advised each other ofsignificant disagreement over both the working capital adjustment and the cashtrue-up.  The Company advised Slingshotthat based on the Company’s calculation of net working capital, the purchaseprice should be reduced by approximately $67,000.  In addition, the Company advised Slingshotthat pursuant to the cash true-up mechanism, Slingshot owed the Companyapproximately $923,000.  Slingshotdisputed the Company’s calculations and contended that its own calculation ofworking capital supported a downward purchase price adjustment of approximately$8.1 million and its view of the cash true-up arrangement suggested that itshould receive a payment from the Company of approximately $300,000.  The Company subsequently responded toSlingshot and rejected all of Slingshot’s calculations and arguments, exceptthat it agreed that the working capital calculation should result in anadditional downward price adjustment of approximately $40,000 and that amountsowed relative to the cash true-up mechanism should be reduced by approximately$79,000.

 

TheCompany and Slingshot have held discussions about the disputed amounts but havenot reached agreement on any of them. While the Company strongly disagrees with Slingshot’s positions on thesematters, if the disagreements cannot be resolved by agreement of the parties,they are required to be submitted (under the terms of the asset purchaseagreement between the Company and Slingshot) to an independent accounting firmfor final resolution.  At this time, theCompany cannot predict whether the disagreements will be resolved consensuallyor what the results of any decision by an independent accounting firm arelikely to be.  As of December 31,2004, the Company had $943,000 in amounts due from Slingshot recorded on itsbalance sheet as **“**Prepaid expenses and other assets.**”** If the Company is not successful in collecting this amount, it will haveto write-off these assets with a future period charge to earnings.  In addition, if the Company does not prevailin its view of the appropriate working capital adjustment, it could be requiredto make a cash payment to Slingshot in the amount of the working capitalshortfall which would also include a future period charge to earnings.

 

***Mobile Government Sale***

OnSeptember 30, 2004, the Company sold its Mobile Government segment toBIO-Key International Inc. (“BIO-Key”) for $10.0 million in cash.  The purchase price is subject to apost-closing adjustment based upon net working capital.  The transaction was structured as a sale ofassets and assumption of certain liabilities. The assets sold consisted of all the assets used in the MobileGovernment segment.  BIO-Key assumedresponsibility for substantially all post-closing liabilities, and certainhistorical liabilities, of the Mobile Government segment.  BIO-Key and Aether also entered into atransition services agreement to provide for the orderly transition of thebusiness to BIO-Key, which is expected to be completed by early 2005.

 

Inconnection with the sale of the Mobile Government segment, the Company recordedan $8.9 million non-cash impairment charge in the second quarter of 2004. 

 

OnOctober 25, 2004, the Company informed BIO-Key that based on Aether’scalculation of net working capital, the purchase price should be increased byapproximately $343,000.  During thefourth quarter of 2004, BIO-Key paid the Company for the working capitaladjustment and substantially all other amounts due related to the sale.  

 

66

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**(16)QUARTERLY FINANCIAL INFORMATION (UNAUDITED)**

 
| **(in thousands, except per share amounts)**                                     | ** ** | **QUARTER  ENDED  MARCH 31,  2003** | ** ** | **QUARTER  ENDED  JUNE 30,  2003** | ** ** | **QUARTER  ENDED  SEPTEMBER  30,  2003** | ** ** | **QUARTER  ENDED  DECEMBER  31,  2003** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
|                                                                             |       |                                     |       |                                    |       |                                     |       |                                    |       |
| Net loss  from continuing operations                                             |       | $                                        | (7,309     | )                                       | $          | (8,482                                   | )          | $                                       | (4,358     | ) | $ | (5,547 | ) |
| Net loss  from discontinued operations                                           |       | (5,131                                   | )          | (6,236                                  | )          | (5,548                                   | )          | (6,841                                  | )          |
| Net loss                                                                         |       | $                                        | (12,440    | )                                       | $          | (14,718                                  | )          | $                                       | (9,906     | ) | $ | (12,388 | ) |
| Net loss  from continuing operations per common share — basic and diluted   |       | $                                        | (0.17      | )                                       | $          | (0.20                                    | )          | $                                       | (0.10      | ) | $ | (0.13 | ) |
| Net loss  from discontinued operations per common share — basic and diluted |       | (0.12                                    | )          | (0.15                                   | )          | (0.13                                    | )          | (0.16                                   | )          |
| Net loss per  common share – basic and diluted                              |       | $                                        | (0.29      | )                                       | $          | (0.35                                    | )          | $                                       | (0.23      | ) | $ | (0.29 | ) |
| Weighted  average shares outstanding – basic and diluted                    |       | 42,271                                   |       | 42,538                                  |       | 42,762                                   |       | 42,883                                  |       |

 
| **(in thousands, except per share amounts)**                                       | ** ** | **QUARTER  ENDED  MARCH  31,  2004** | ** ** | **QUARTER  ENDED  JUNE 30,  2004** | ** ** | **QUARTER  ENDED  SEPTEMBER  30,  2004** | ** ** | **QUARTER  ENDED  DECEMBER  31,  2004** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
|                                                                               |       |                                 |       |                                    |       |                                     |       |                                    |       |
| Net loss  from continuing operations                                               |       | $                                    | (5,410     | )                                       | $          | (10,563                                  | )          | $                                       | (4,040     | ) | $ | (3,690 | ) |
| Net loss  from discontinued operations                                             |       | (3,839                               | )          | (39,029                                 | )          | (2,582                                   | )          | —                                  |       |
| Gain on sale  of discontinued operations                                           |       | 18,396                               |       | (245                                    | )          | 2,876                                    |       | (202                                    | )          |
| Net income  (loss)                                                                 |       | $                                    | 9,147      |                                    | $          | (49,837                                  | )          | $                                       | (3,746     | ) | $ | (3,892 | ) |
| Net loss  from continuing operations per common share — basic and diluted     |       | $                                    | (0.13      | )                                       | $          | (0.24                                    | )          | $                                       | (0.09      | ) | $ | (0.08 | ) |
| Net loss  from discontinued operations per common share — basic and diluted   |       | (0.09                                | )          | (0.89                                   | )          | (0.06                                    | )          | —                                  |       |
| Gain on sale  of discontinued operations per common share — basic and diluted |       | 0.43                                 |       | (0.01                                   | )          | 0.06                                     |       | (0.01                                   | )          |
| Net income  (loss) per common share — basic and diluted                       |       | $                                    | 0.21       |                                    | $          | (1.14                                    | )          | $                                       | (0.09      | ) | $ | (0.09 | ) |
| Weighted  average shares outstanding - basic and diluted                           |       | 43,273                               |       | 43,802                                  |       | 43,840                                   |       | 43,904                                  |       |

 

67

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**ITEM 9.  CHANGE IN ANDDISAGREEMENTS WITH ACCOUNTANT****S ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM9A.  CONTROLS & PROCEDURES**

 

***Evaluation of Disclosure Controls and Procedures***

 

Wehave established disclosure controls and procedures to ensure that materialinformation relating to the Company, including its consolidated subsidiaries,is made known to the officers who certify the Company’s financial reports andto other members of senior management and the Board of Directors. 

 

Asrequired by Rule 13a-15(b) under the Securities and Exchange Act of 1934, asamended (the “Exchange Act”), management carried out an evaluation, with theparticipation of the Company’s chief financial officer and chief executiveofficer, of the effectiveness of the Company’s disclosure controls andprocedures, as of December 31, 2004. Based on their evaluation as of December 31, 2004, the chiefexecutive officer and chief financial officer of the Company have concludedthat the Company’s disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) areeffective to ensure that the information required to be disclosed by theCompany in the reports that it files or submits under the Securities ExchangeAct of 1934 is recorded, processed, summarized and reported within the timeperiods specified in SEC rules and forms. 

 

***Management’s Report on Internal Control Over FinancialReporting***

 

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rules13a-15(f).  Under the supervision andwith the participation of management, including our chief executive officer andchief financial officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting based on the framework in InternalControl Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the “COSO Framework”).  As noted in the COSO Framework, an internalcontrol system, no matter how well conceived and operated, can provide onlyreasonable assurance to management and the board of directors regardingachievement of an entity’s objectives. Based on the evaluation under the COSO Framework, our managementconcluded that our internal control over financial reporting was effective asof December 31, 2004. Our report is included in Item 8 of thisReport.  Our management’s assessment ofthe effectiveness of our internal control over financial reporting as of December 31,2004 has been audited by KPMG LLP, an independent registered public accountingfirm, as stated in their report which is included in Item 8 of this Report.

 

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***Changes in Internal Control Over FinancialReporting and Disclosure Controls and Procedures***

 

Following the sales of ourdiscontinued operations and in connection with the implementation of our MBSstrategy during 2004, we made certain changes and additions to our internalcontrol over financial reporting and our disclosure controls and proceduresthat we believed were necessary or appropriate to reflect the changes in ourbusiness.  Changes made prior to December 31,2004 were evaluated as part of our evaluations described above.  Because we employed only 12 persons as of December 31,2004, the flow of information inside our company is more streamlined than ithas been historically, and we have adjusted our disclosure controls andprocedures so that our CFO is personally contacted concerning all materialissues affecting the operations of the Company. We also altered the composition of our disclosure committee, which nowincludes our CFO, SVP of Finance, Director of Finance & Accounting and TaxDirector, to ensure that all relevant information is included in our publicreports and is promptly and accurately disclosed.  We did not make these changes because wethought our existing internal control over financial reporting or ourdisclosure controls and procedures were deficient.  Rather, we made these changes to reflect thesmaller size of our company, the changed nature of our business and to ensurethat management received timely information about the Company’s investment in MBSand the performance of the MBS portfolio. These changes have been discussed with our independent accountants andthe Audit Committee of our Board of Directors. Because of the significant changes in our business and our personnel, weplan to continue to monitor our internal control environment carefully toensure that the changes have been effective and to ensure that all necessarychanges have been made.

 

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**PART III**

 

**ITEM 10.  DIRECTORS ANDEXECUTIVE OFFICERS****OF THE REGISTRANT**

 

The information required bythis Item will be included in Aether’s Proxy Statement for the 2005 AnnualMeeting of Stockholders under the caption Directors and Executive Officerswhich will be filed with the Securities and Exchange Commission no later than 120days after the close of the fiscal year ended December 31, 2004, and isincorporated herein by reference.

 

**ITEM 11.  EXECUTIVECOMPENSATION**

 

The information required bythis Item will be included in Aether’s Proxy Statement for the 2005 AnnualMeeting of Stockholders under the caption Executive Compensation which will befiled with the SEC no later than 120 days after the close of the fiscal yearended December 31, 2004, and is incorporated herein by reference.

 

**ITEM 12.  SECURITYOWNERSHIP OF CERTAIN BENEFIC****IAL OWNERS AND MANAGEMENT**

 

The information required bythis Item will be included in Aether’s Proxy Statement for the 2005 AnnualMeeting of Stockholders under the caption Security Ownership of CertainBeneficial Owners and Management which will be filed with the SEC no later than120 days after the close of the fiscal year ended December 31, 2004, andis incorporated herein by reference.

 

**ITEM 13.  CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

The information required by thisItem will be included in Aether’s Proxy Statement for the 2005 Annual Meetingof Stockholders under the caption Certain Relationships and RelatedTransactions which will be filed with the SEC no later than 120 days after theclose of the fiscal year ended December 31, 2004, and is incorporatedherein by reference.

 

**ITEM 14.  PRINCIPALACCOUNTING FEES AND SERVICES**

 

The information required bythis Item will be included in Aether’s Proxy Statement for the 2005 AnnualMeeting of Stockholders under the caption Principal Accounting Fees andServices which will be filed with the SEC no later than 120 days after theclose of the fiscal year ended December 31, 2004, and is incorporatedherein by reference.

 

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**PART IV**

 

**ITEM 15.  EXHIBITS AND FINANCIALSTATEMENT SCHEDULES**

 

FINANCIAL STATEMENTS ANDSCHEDULES

 

The following financial statements required by thisitem are included in the Report beginning on page 42.

 
|   | Report  of Management on Internal Control over Financial Reporting                                                        |   |
|--------|---------------------------------------------------------------------------------------------------------------------------|--------|
|   | Reports  of Independent Registered Public Accounting Firm                                                                 |   |
|   | Consolidated Balance Sheets  as of December 31, 2003 and 2004                                                        |   |
|   | Consolidated  Statements of Operations and Comprehensive Loss for the years ended December 31,  2002, 2003, and 2004 |   |
|   | Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 2002,  2003 and 2004          |   |
|   | Consolidated  Statements of Cash Flows for the years ended December 31, 2002, 2003 and  2004                         |   |
|   | Notes to  Consolidated Financial Statements                                                                               |   |

 

All other schedules are omitted because they are notapplicable or the required information is shown in the Audited ConsolidatedFinancial Statements or the notes thereto.

 

EXHIBITS

 

The following exhibits are filed herewith or areincorporated by reference to exhibits previously filed with the SEC.

 

Exhibit Index

 

*2.1                          AssetPurchase Agreement dated December 18, 2003 by and among Aether Systems,Inc, TeleCommunication Systems, Inc., TSYS Acquisition Corp. and TCS Limited,as amended. (Designated as Exhibit 3.1 to the Form 8-K dated January 28,2004.)

 

*2.2                          AssetPurchase Agreement dated August 16, 2004 by and among Aether Systems Inc.,Sunpro Inc., Cerulean Technologies, Inc. and BIO-key International, Inc.  (Designated as Exhibit 2.1 to the Form 10-Qdated November 9, 2004.)

 

*2.3                          AssetPurchase Agreement dated July 20, 2004 by and among Aether Systems Inc.,Slingshot Acquisition Corporation and Platinum Equity Capital Partners,L.P.  (Designated as Exhibit 2.1 to theForm 10-Q dated August 9, 2004.)

 

*3.1                          Amendedand Restated Certificate of Incorporation of Aether Systems, Inc. (as amended). (Designated as Exhibit 3.3 to the FormS-1/A dated October 19, 1999.) 

 

*3.2                          Bylawsof Aether Systems, Inc. (Designated as Exhibit 3.2 to the Form S-1/A dated October 19,1999.) 

 

*4.1                          SpecimenCertificate for Aether Systems Common Stock. (Designated as Exhibit 4.1 to theForm S-1/A dated October 19, 1999.) 

 

*10.1                    EmploymentAgreement between Aether Technologies International, L.L.C. and David Orosdated July 7, 1999. (Designated as Exhibit 10.7 to the Form S-1/A dated September 10,1999.) 

 

*10.2                    EmploymentAgreement between Aether Systems, Inc. and David C. Reymann dated June 8,2001. (Designated as Exhibit 10.1 to the Form 10-Q dated August 14, 2001.)

 

*10.3                    AetherSystems, Inc. 1999 Equity Incentive Plan as amended June 22, 2001.(Designated as Exhibit 10.4 to the Form 10-K dated March 1, 2002.) 

 

*10.4                    AetherSystems, Inc. Senior Bonus Plan effective as of September 29, 1999.(Designated as Exhibit 10.20 to the Form S-1/A dated October 19, 1999.) 

 

*10.5                    AetherSystems, Inc. Acquisitions Incentive Plan effective as of December 15,2000. (Designated as Exhibit 4.1 to the Form S-8 dated December 20, 2000.)

 

*10.6                    InvestmentManagement Agreement, dated June 8, 2004 by and between Aether SystemsInc., and FBR Investment Management Inc. (Designated as Exhibit 10.1 to theForm 10-Q dated August 9, 2004.)

 

*10.7                    PrincipalStockholder Agreement dated July 20, 2004 by and among David S. Oros,NexGen Technologies, L.L.C. and Slingshot Acquisition Corporation. (Designatedas Exhibit 10.2 to the Form 10-Q dated August 9, 2004.)

 

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*10.8                    SecuredSubordinated Promissory Note in the principal amount of $6,884,588 dated September 30,2004 payable to Aether Systems, Inc by BIO-key International, Inc.  (Designated as Exhibit 10.2 to the Form 10-Qdated November 9, 2004.)

 

*10.9                    EmploymentMemorandum dated May 1, 2004 by and between Aether Systems, Inc. and FrankBriganti. (Designated as Exhibit 10.3 to the Form 10-Q dated August 9,2004.)

 

*10.10              Summary of agreementbetween Aether Systems, Inc. and Frank Briganti confirmed as of May 15, 2002.(Designated as Exhibit 10.13 to the Form 10-K dated March 15, 2004.)

 

*10.11              Summary of agreementbetween Aether Systems, Inc. and Michael Mancuso confirmed as of October 22,2002. (Designated as Exhibit 10.12 to the Form 10-K dated March 15, 2004.)

 

10.12                     MasterRepurchase Agreement between Aether Systems, Inc. (and FBR InvestmentManagement Inc. as Agent) and Daiwa Securities America, Inc.

 

10.13                     MasterRepurchase Agreement between Aether Systems, Inc. (and FBR InvestmentManagement Inc. as Agent) and UBS Financial Services, Inc.

 

10.14                     MasterRepurchase Agreement between Aether Systems, Inc. (and FBR InvestmentManagement Inc. as Agent) and Countrywide Securities Corporation.

 

10.15                     MasterRepurchase Agreement between Aether Systems, Inc. (and FBR InvestmentManagement Inc. as Agent) and Nomura Securities International, Inc.

 

*21.1                    Subsidiariesof Aether Systems. (Designated as Exhibit 21.1 to the Form 10-K dated March 15,2004.)

 

23.1                           Consentof KPMG LLP

 

31.1                           Certificationof Chief Executive Officer pursuant to Section 302 of the Sarbanes-OxleyAct of 2002 (“Sarbanes-Oxley”)

 

31.2                           Certificationof Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley

 

**32.1             Certificationspursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 ofthe Sarbanes– Oxley Act of 2002 for David S. Oros and David C. Reymann

 

----

*Incorporated byreference

 

** These certificationsare being furnished solely pursuant to Section 906 of the Sarbanes-OxleyAct of 2002 and are not being filed as part this Annual Report on Form 10-K/Aor as a separate disclosure document.

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedAmendment No. 1 to the report on Form 10-K to be signed on its behalf by theundersigned, thereunto duly authorized on April 11, 2005.

 
|   | **AETHER SYSTEMS, INC.** |
|--------|--------------------------|
|   |                     |
|   |                     |
|   | *By:*                    | /s/ David S. Oros |   |
|   |                     | *DAVID  S. OROS* |   |
|   |                     | *Chairman  and Chief Executive Officer* |   |

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed by the following persons inthe capacities and on the dates indicated.

 

 
| **SIGNATURE**             | ** ** | **TITLE**                                      | ** ** | **DATE**        | ** ** |
|---------------------------|------------|------------------------------------------------|------------|-----------------|------------|
|                      |       |                                           |       |            |       |
| /s/ David S. Oros         |       | Chairman and Chief                             |       | April 11, 2005. |       |
| DAVID S. OROS             |       | Executive Officer                              |       |            |       |
|                      |       |                                           |       |            |       |
| /s/ David C. Reymann      |       | Chief Financial Officer                        |       | April 11, 2005. |       |
| DAVID C. REYMANN          |       | (Principal Financial  and  Accounting Officer) |       |            |       |
|                      |       |                                           |       |            |       |
| /s/ J. Carter Beese,  Jr. |       | Director                                       |       | April 11, 2005. |       |
| J. CARTER BEESE, JR.      |       |                                           |       |            |       |
|                      |       |                                           |       |            |       |
| /s/ James T. Brady        |       | Director                                       |       | April 11, 2005. |       |
| JAMES T. BRADY            |       |                                           |       |            |       |
|                      |       |                                           |       |            |       |
| /s/ George P. Stamas      |       | Director                                       |       | April 11, 2005. |       |
| GEORGE P. STAMAS          |       |                                           |       |            |       |
|                      |       |                                           |       |            |       |
| /s/ Jack B. Dunn, IV      |       | Director                                       |       | April 11, 2005. |       |
| JACK B. DUNN, IV          |       |                                           |       |            |       |
|                      |       |                                           |       |            |       |
| /s/ Edward J. Mathias     |       | Director                                       |       | April 11, 2005. |       |
| EDWARD J. MATHIAS         |       |                                           |       |            |       |
|                      |       |                                           |       |            |       |
| /s/ Truman T. Semans      |       | Director                                       |       | April 11, 2005. |       |
| TRUMAN T. SEMANS          |       |                                           |       |            |       |

 

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