**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**Form 10-KSB**

 

**(Mark One)**
| **ý**                                           | **ANNUAL  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**     |
|------------------------------------------------------|-----------------------------------------------------------------------------------------------|
| ** **                                           |
| **For the fiscal year ended December 31, 2005** |
| ** **                                           |
| **o**                                                | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**Forthe transition period from                    to                     **

 

**Commissionfile number     000-50712**

 

**ETS PAYPHONES, INC.**

(Name of small business issuerin its charter)

 

| **Delaware**                                                              | ** ** | **58-2131736**      |
|---------------------------------------------------------------------------|------------|---------------------|
| (State or other  jurisdiction of                                          |       | (I.R.S. Employer    |
| incorporation or  organization)                                           |       | Identification No.) |
|                                                                      |       |                |
| **1490  Westfork Drive, Suite G, Lithia Springs, Georgia** | ** ** | **30122**           |
| (Address of principal  executive offices)                                 |       | (Zip Code)          |

 

Issuer’s telephone number (**770) 819-1600**

 

Securities registered underSection 12(b) of the Exchange Act:

 

| **Title of each class** | ** ** | **Name on each exchange on which registered** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|
| None                                   |       | None                                                                        |

 

Securities registered underSection 12(g) of the Exchange Act:

 

**CommonStock, $.0001 par value**

(Title of class)

 

Checkwhether the issuer is not required to be file reports pursuant to Section 13 or15(d) of the Exchange Act  o

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý  No o

 

Check if there is nodisclosure of delinquent filers in response to Item 405 ofRegulation S-B contained in this form, and no disclosure will becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-KSB or any amendment to this Form 10-KSB. x

 

Indicateby check mark whether the registrant is a shell Company (as defined in Rule12b-2 of the Exchange Act : Yes o  No ý

 

State issuer’s revenues forits most recent fiscal year. $16,509,221

 

State the aggregate marketvalue of the voting and non-voting common equity held by non-affiliatescomputed by reference to the price at which the common equity was sold, or theaverage bid and asked price of such common equity, as of a specified datewithin the past 60 days. (See definition of affiliate in Rule 12b-2of the Exchange Act.) There is no trading market for the issuer’s commonequity. There is no market maker and no ascertainable sales within the last 60days. The issuer is not able to determine the aggregate market value of itscommon equity.

 

**(ISSUERS INVOLVED IN BANKRUPTCYPROCEEDINGS DURING THE PAST FIVE YEARS)**

** **

Check whether the issuer hasfiled all documents and reports required to be filed by Section 12, 13 or15(d) of the Exchange Act after the distribution of securities under a planconfirmed by a court. Yes ý No o

 

**(APPLICABLE ONLY TO CORPORATEREGISTRANTS)**

** **

State the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date. 4,987,624

 

**DOCUMENTS INCORPORATED BYREFERENCE**

** **

Report on Form 8-K, dated asof November 1, 2005, filed November 7, 2005 (File Number 000-50712)

Definitive Proxy Statement,filed January 4, 2006 (File Number 000-50712)

 

Transitional Small BusinessDisclosure Format (Check one): Yes ý  No o

 

 

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**PART 1**

 

**ALTERNATIVE 2**

 

**ALL STATEMENTS, OTHERTHAN STATEMENTS OF HISTORICAL FACT, INCLUDED IN THIS REPORT, INCLUDING, WITHOUTLIMITATION, THE STATEMENTS UNDER “DESCRIPTION OF BUSINESS” ARE, OR MAY BEDEEMED TO BE, FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 21EOF THE SECURITIES EXCHANGE ACT OF 1934. IMPORTANT FACTORS THAT COULD CAUSEACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE DISCUSSED IN SUCH FORWARD-LOOKINGSTATEMENTS (“CAUTIONARY STATEMENTS”) INCLUDE BUT ARE NOT LIMITED TO: THEUNCERTAINTY OF REGULATION, INCLUDING REGULATION RELATED TO DIAL-AROUNDCOMPENSATION, OUR DEPENDENCE ON THIRD PARTY SUPPLIERS, OUR FAILURE TO ATTRACTCUSTOMERS, COMPETITIVE LOCAL EXCHANGE CARRIERS’ ACCESS TO LOCAL EXCHANGECARRIERS’ NETWORKS, AND THE IMPACT OF TECHNOLOGICAL CHANGE ON THE PAYPHONEMARKETPLACE. ALL SUBSEQUENT WRITTEN AND ORAL FORWARD-LOOKING STATEMENTSATTRIBUTABLE TO THE COMPANY OR PERSONS ACTING ON BEHALF OF THE COMPANY AREEXPRESSLY QUALIFIED IN THEIR ENTIRETY BY SUCH CAUTIONARY STATEMENTS.**

 

**Item 1. Description of Business.**

 

**General**

 

ETS Payphones, Inc. (“we,” “us,” “our,”or the “Company”) is a Delaware corporation that operates, services, andmaintains a system of payphones. We are one of the largest independent payphoneoperators in the United States, and currently own and operate approximately13,000 payphones from four branch offices handling 32 states, concentratedprimarily in the Eastern and Southern United States, as well as the District ofColumbia and Puerto Rico. We are an independent owner of payphone equipmentplaced at locations with client site owners that include retail establishments,convenience stores, hotels, hospitals and other publicly and privately ownedbusinesses. These locations are owned or managed by over 4,000 clients thatinclude Fortune 100 companies as well as single store accounts andmunicipalities. We also provide other telecommunications products to certainclients.

 

We contract with site owners to placepayphones in their locations and once a contract is signed we install, maintain,manage and collect money from the payphones. Our revenue is generated fromcoins gathered from the payphones and from funds we receive from othercommunications service providers, who receive revenue from calls made at ourpayphones using phone cards, credit cards and other forms of non-coin payment.Substantially all of our payphones accept coins as well as other forms ofpayment. Our payphones generate coin revenues primarily from local calls.

 

We outsource our long-distance and operatorservice operations to a long-distance carrier and a limited number of operatorservice providers. When callers do not designate a long-distance company, weroute the calls to one with which we have a contract. We also receive revenuefrom calls made when the caller uses a “1-800” or other toll-free number toaccess a provider with which we have not contracted directly. This “dial-around”revenue is provided to us as a result of a Federal Communications Commission (“FCC”)order.

 

Our expenses consist primarily of sitecommissions, line service fees, payphone maintenance and equipment, and generallabor costs. In most instances the site contracts entitle the site owner to acommission for each payphone installed on their properties, typically inaccordance with a formula based primarily upon a percentage of the payphone’srevenue. We pay monthly line and/or usage charges to local exchange carriersand competitive local exchange carriers to provide service to our payphones.

 

We utilize “smart phone” technology. Themajority of our payphones are equipped with microprocessors that allow us tomonitor the payphones remotely by tracking the payphone’s call traffic,operational status, and coin box amount. In addition to allowing us to trackwhen a coin box needs collecting and when a payphone needs maintenance, thesmart phone technology also allows us to change rates for certain types ofcalls.

 

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As of December 31, 2005, we had approximately79 employees. Our principal executive office is located at 1490 WestforkDrive, Suite G, Lithia Springs, Georgia 30122 and our telephone number is(770) 819-1600.

 

**Saleof the Company; Winding Down of Operations**

 

As we reported in the Form 8-K filed November7, 2005 (the “November 7 Form 8-K”) and the Definitive Proxy Statement, filedon January 4, 2006 (the “Definitive Proxy Statement”), the Company entered intoan Asset Sale Agreement dated November 1, 2005 (the “Asset Sale Agreement”),and related agreements including a security agreement and a promissory note tosell substantially all of its operating assets to Empire Payphones, Inc. (“Empire”).In addition as reported on the November 7 Form 8-K and the Definitive ProxyStatement, the Company also entered into a Management Services Agreementeffective November 1, 2005 (“Management Services Agreement”), with Empire inwhich Empire will provide management services and fund the operational lossesof the Company pending consummation of the sale transaction. A summarydescription of the transactions is below. The description below is qualified inits entirety by the more detailed description in the November 7 Form 8-K andthe Definitive Proxy Statement and to the exhibits therein, which areincorporated herein by reference.

 

***Asset Sale Agreement***

 

Pursuant to the Asset Sale Agreement, theCompany has agreed to sell substantially all of its assets used in its payphonebusiness to Empire. Under the Asset Sale Agreement, the purchase priceaggregates $4.5 million and will be paid in installments, some prior to theconsummation of the transaction, as follows: (i) $250,000 in cash on November1, 2005, (ii) payment of certain commissions under assigned contracts not toexceed $2.4 million in the aggregate and (iii) $1.85 million in cash, payablein monthly installments of $132,143 commencing December 1, 2005, with anyremaining balance being paid at the closing of the transaction. At November 1,2005, the carrying value of our operating assets, consisting primarily of fixedassets and inventories, was approximately $3.5 million.

 

The closing of the Asset Sale Agreement issubject to a number of conditions, including approval by our stockholders ofthe Asset Sale Agreement, as well as compliance with regulatory requirements. TheAsset Sale Agreement also includes termination provisions that may require usto repay certain amounts paid by Empire under this agreement and the ManagementServices Agreement discussed below.

 

***Management Services Agreement***

 

In order to provide for the funding ofoperational losses of our payphone business pending consummation of the AssetSale Agreement, the Company and Empire entered into the Management ServicesAgreement. Under the Management Services Agreement, Empire will provide to theCompany management services and fund operational losses of our payphonebusiness, subject to the oversight of our Board of Directors. In considerationfor its management services and the use by us of Empire’s affiliates’resources, Empire shall be entitled to receive a management fee calculated atthe end of the initial term of the Management Services Agreement and at the endof any renewal term in the amount of the first $400,000 of excess revenue,after repayment of, among other amounts, all expenses of operation and anyadvances made by Empire to fund operational losses plus 50% of any excessrevenue above $400,000. We shall receive the remaining 50% of excess revenueabove $400,000. For use of Empire’s affiliates’ resources during the term ofthe Management Agreement, the affiliates shall receive a monthly resource feeof $92,000.

 

The Management Services Agreement has aninitial term of two years and will be automatically extended for successiveperiods of one year unless Empire provides notice prior to the end of any termthat the agreement will terminate at the end of such term. The ManagementServices Agreement is also subject to other termination provisions, whichincludes the consummation of the Asset Sale Agreement detailed above. If theManagement Services Agreement is terminated other than upon the consummation ofthe Asset Sale Agreement, we will be required to repay certain amounts paid byEmpire under the Management Services Agreement.

 

***Stockholder Approval;******Winding Down ofOperations***

 

As discussed in Item 4 of Part II below,pursuant to the Annual Meeting of Stockholders held February 15, 2006, thestockholders of the Company approved, among other things, the sale ofsubstantially all of our assets to Empire pursuant to the Asset Sale Agreementand the winding down of our operations following the sale of substantially allof our assets to 

 

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Empire. Following the consummation of theAsset Sale Agreement, it is the intention of the Board of Directors to dissolvethe Company in accordance with applicable laws and to distribute any proceedsremaining after such dissolution to its stockholders. Upon consummation of theAsset Sale Agreement, the Company intends to file a certificate of dissolutionwith the Secretary of State of Delaware and close the stock transfer books todiscontinue recording transfers of our common stock at the close of business onthe date we file the certificate of dissolution with the Delaware Secretary ofState (the “Final Record Date”).

 

After consummation of the Asset SaleAgreement our activities will be limited to collecting proceeds from assets notincluded in the sale, paying off creditors, performing requirements underapplicable law and distributing any remaining proceeds to stockholders. As aresult of contingent or unmature liabilities that may materialize or mature,dissolution and liquidation may not create value to our stockholders or resultin any remaining capital for distribution to our stockholders. In addition,claims, liabilities and expenses during the winding down of our company willcontinue to be incurred which will reduce the amount of assets available fordistribution. Any distributions made by us shall be made solely to thestockholders of record at the close of business on the Final Record Date,except as may be necessary to reflect subsequent transfers recorded on ourbooks as a result of assignments by will, intestate succession or operation oflaw.

 

**Previous Operations**

 

Ourpredecessor company, also called ETS Payphones, Inc. but incorporated inGeorgia (“Old ETS”), was owned and controlled by Charles E. Edwards. Old ETSbegan operations with approximately 75 payphones and initially grew throughobtaining new site contracts and installing payphones. Old ETS was startedduring a time in which there was a rapid expansion of payphone serviceproviders who were independent from the Regional Bell Operating Companies (“RBOCs”).Old ETS and related affiliates also owned and operated automated tellermachines (“ATMs”) and coin-operated air and vacuum machines.

 

In late 1997 Old ETS began to aggressivelypursue a business model pursuant to which they would “sell” payphones toindividual investors (“Payphone Investors”) at prices up to $7,000 per phone.As part of the sales contract Old ETS agreed to immediately lease the payphoneback from the Payphone Investor and manage the location, collection, andmaintenance of the payphones. Old ETS was obligated to find a location for thepayphone, negotiate a contract with the site owner, and install and service thepayphone. Old ETS also obtained the necessary licenses, ensured compliance withregulatory requirements and obtained line service, long-distance service, andoperator service for the payphones. Under these “sale-leaseback” transactionsOld ETS agreed to make monthly payments to the Payphone Investor, whichannually totaled about 14% of the payphone sale price, regardless of therevenue generated from the payphone. For example, Old ETS agreed to payapproximately $80 per month with respect to a phone it sold for $7,000. Theagreements with the Payphone Investors generally had five year terms andobligated Old ETS to buy the payphone back at the end of the term.

 

To promote sales under this sale-leasebackscheme, Old ETS engaged independent sales representatives on a commissionbasis. These sales representatives marketed the payphones through trade showsfor entrepreneurs, direct marketing promotions, and personal solicitations.

 

The sales effort brought in a tremendousnumber of Payphone Investors and most investors purchased several payphones.Old ETS was not able to negotiate site contracts and install payphones at therate at which they were entering into sale-leaseback transactions with PayphoneInvestors. Consequently, Old ETS began to acquire established payphone routesfrom competing payphone companies, and assign the acquired payphones toPayphone Investors. From 1997 through 2000 Old ETS entered into varioustransactions and asset purchase agreements to acquire in excess of 35,000payphones. The total number of phones actually acquired pursuant to these salescontracts was less than the contracted for phone count. By September 2000there were approximately 18,000 Payphone Investors and Old ETS had entered intosale-leaseback transactions involving in excess of 70,000 payphones. However,the records of Old ETS indicate that it was operating approximately 50,000payphones. At that time Old ETS was the second largest payphone operator in theUnited States (excluding the RBOCs), with payphones located in 39 states, theDistrict of Columbia, Puerto Rico and the U.S. Virgin Islands. Old ETS had 30offices and employed more than 450 people.

 

Old ETS made a substantial immediate cashprofit on each sale-leaseback of a payphone to a Payphone Investor. However, virtuallyevery sale-leaseback transaction was destined to lose money for Old ETS in thelong run, as the payphones failed to generate sufficient revenue to cover(i) the lease payments to the Payphone Investors, (ii) the costs OldETS was paying to obtain site contracts, and (iii) operating andmaintaining the payphones.

 

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In addition to problems with the financingstructure of Old ETS, the effects of general industry trends were substantiallyreducing the revenue for payphones during the relevant time period. Thewidespread use of cellular telephones and dial-around calls substantiallyreduced the call volume on payphones, negatively impacting the revenues of OldETS. In order to fund operations and to make the required lease payments to thePayphone Investors, Old ETS sold more payphones to new Payphone Investors.

 

As a private company that was owned andcontrolled by Mr. Edwards, Old ETS did not have audited financialstatements. Because of difficulties and complications with integrating therecords of the various payphone companies that were purchased by Old ETS, rapidturnover of the company’s financial officers, poor internal controls on revenueand expenditures, and the loss of records, it is not possible to know the exactfinancial status of Old ETS during the time period of the sale-leasebacktransactions. However, it is known that by September of 2000 Old ETS(a) had over $375,000,000 of debt obligations (including obligations tothe Payphone Investors), (b) had lease payment obligations to PayphoneInvestors on its payphones that were not supportable by revenue from thepayphones, and (c) was not able to pay its obligations as they came due.

 

In 2000, the United States Securities andExchange Commission (“SEC”) began to scrutinize Old ETS’ operations, allegingthat the sale-leaseback transactions constituted the sale of securities by OldETS. In addition, securities enforcement agencies from a number of statesinitiated proceedings against Old ETS and its affiliates to enjoin securitiesviolations. A number of class action lawsuits were brought against Old ETS andcertain of its then officers, alleging breach of contract, as well as variousfraud allegations.

 

In early September 2000, Old ETS and itsaffiliates filed voluntary petitions under chapter 11 of Title 11 ofthe United States Code (the “Bankruptcy Code”) with the United StatesBankruptcy Court for the District of Delaware, In Re: PSA, Inc., ETSPayphones, Inc., ETS Vending, Inc., et al., jointly administeredunder Case No. 00-3570. The bankruptcy filings did not interrupt thepayphone servicing operations, but in conjunction with the bankruptcy filingand settlement of an injunction sought by the SEC, Old ETS agreed to stopentering into new sale-leaseback payphone agreements. Mr. Edwards resignedand agreed not to be involved in the management and operations of Old ETS goingforward.

 

On September 29, 2000, the SEC filed alawsuit against Old ETS and Charles E. Edwards in the United States DistrictCourt for the Northern District of Georgia, alleging, among other things, that(i) the sale-leaseback transactions constituted an illegal sale ofsecurities, (ii) the overall funding of Old ETS, in which its short termrevenue from new sales was used to fund long-term sale-leaseback obligations,constituted a “Ponzi Scheme” that defrauded the Payphone Investors, and(iii) Mr. Edwards and Old ETS had violated the registrationrequirements and the anti-fraud provisions of the Securities Act of 1933 andthe Securities Exchange Act of 1934, including Rule 10b-5 thereunder. OldETS stopped entering into the sale-leaseback transactions and settled itsinvolvement in the litigation with the SEC by consenting to an injunctionagainst any further such transactions, without admitting or denying any of theSEC’s allegations. Mr. Edwards continued to defend the SEC’s allegation againsthim, individually. The litigation went on appeal to the United States SupremeCourt which in a unanimous decision found in favor of the SEC and against Mr.Edwards. In September of 2005, Mr. Edwards was found guilty of, among otherthings, wire fraud, money laundering and conspiracy to commit money laundering.Mr. Edwards was sentenced to 13 years in prison in February 2006.

 

In connection with the bankruptcy filings,the Company retained legal counsel and financial advisors to assist in theassessment and restructuring of the Company’s operations and bankruptcy case. Anew Chief Executive Officer, Guy A. Longobardo, was hired in February of 2001.The Company’s management and advisors sorted out the financial situation andprojections for the Company’s operations post-bankruptcy. Extensivenegotiations with the committee of creditors appointed in the bankruptcy casetook place over a number of months regarding the best alternatives forliquidating or reorganizing the Company. These discussions led to thedevelopment of a business plan that contemplated streamlined payphoneoperations concentrated primarily on the East and Gulf coasts.

 

The business plan called for the sale ofnumerous payphone routes, including those in the U.S. Virgin Islands,California, Wisconsin, Minnesota, and elsewhere.

 

Based upon the business plan, the Company andits affiliates proposed a plan for reorganization through the bankruptcy courton July 25, 2001. The plan called for:

 

•                  thesale of unprofitable or non-core payphones and routes;

 

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•                  thesale of all ATM’s and coin-operated air and vacuum machines;

 

•                  reductionin operating expenses and staff reductions; and

 

•                  themerger of Old ETS and its nine subsidiaries into a new, reorganized corporationincorporated in Delaware.

 

On June 19, 2001, the Company filed adeclaratory judgment action with the Payphone Investors as the class ofdefendants, to have the sale-leaseback agreements deemed to be investments andthe payphones deemed assets of the Company. The Company’s proposal forresolving the litigation with the Payphone Investors, as included in the planof reorganization filed in the bankruptcy case, was to issue stock in theCompany to the Payphone Investors in place of their sale-leaseback agreements.The plan of reorganization and settlement of the litigation receivedoverwhelming support from the Payphone Investors.

 

On November 14, 2001, the bankruptcycourt issued an order confirming the plan of reorganization. With confirmationof the plan, there was a resolution of the declaratory judgment action with thePayphone Investors. The re-characterization of the sale-leaseback transactionschanged approximately $375,000,000 of liabilities of the Company into assetsworth about $10,000,000.

 

Pursuant to the reorganization plan, theCompany began to auction off various assets, including the payphone routes inthe U.S. Virgin Islands, California, Florida, Wisconsin, and Minnesota. Inaddition, Old ETS was reincorporated on November 8, 2002, under the lawsof the State of Delaware and all of the operating subsidiaries were merged intothe new Delaware corporation. With the sale of the payphone routes and removalof unprofitable payphones, the Company reduced its phones in operation toapproximately 19,000 from the initial 50,000.

 

With its streamlined operations and the moneyraised from the sales of assets, the Company was able to exit thechapter 11 bankruptcy proceedings and fund current operations. The Companyexited from bankruptcy on December 5, 2002. Pursuant to the reorganizationplan, the Payphone Investors became entitled to receive new, post-bankruptcycommon stock in the reorganized Company.

 

**Litigation Trust**

 

As part of the bankruptcy proceedings a trustwas established to pursue certain claims and causes of action the Company hadagainst the former management, Charles Edwards, the independent sales agentswho may have violated securities or other laws in the solicitation of thesale-leaseback transactions, and claims for money that was wrongfullytransferred from Old ETS prior to the bankruptcy filing. The trust alsoincludes claims for the recovery of money that was paid by the Company withinthe ninety days prior to the bankruptcy filing. This “Litigation Trust” wasestablished for the benefit of the Payphone Investors and the other generalunsecured creditors of Old ETS. The Litigation Trust is administered by DarrylLaddin, Esq., of the law firm Arnall Golden Gregory LLP, a trusteeselected by the creditors’ committee in the bankruptcy case. The LitigationTrust’s assets do not include proceeds from potential claims the Company mayhave arising after September 11, 2000, or claims related to breaches ofcontract prior to such date, the Debtors’ interest in New York Local TelephoneCompany, claims arising from Old ETS’ investments in Mexico, or claims relatedto end user common line charges that may have been wrongfully assessed byvarious local exchange carriers, or similar litigation.

 

Funds in the Litigation Trust will not go tothe Company. Eighty-five percent of the proceeds of the Litigation Trust, afterexpenses, will go to the Payphone Investors. However, rights to receive paymentfrom the Litigation Trust are completely separate from the Common Stock thePayphone Investors receive. If a Payphone Investor sells the Common Stockreceived, the Payphone Investor will still be entitled to receive any proceeds attributableto them from the Litigation Trust. Purchasers of Common Stock will not receiveany rights to proceeds from the Litigation Trust with such Common Stock. Theremaining fifteen percent of the Litigation Trust proceeds will be distributedto the other general unsecured creditors of Old ETS.

 

The Litigation Trust obtained approximately$2,004,000 in late 2004 as a result of legal settlements with Charles Edwards,et al., working with the United States Attorney’s Office for the NorthernDistrict of Georgia. Payments to vendors and shareholders were made as ofDecember 31, 2004 in the amount of $1,612,216, with the remainder of thesettlement in the amount of $392,118 being paid out at the end of February,2005.

 

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**Common Stock Allocation**

 

The Company’s plan of reorganization, asconfirmed by the bankruptcy court, provided for 5,000,000 shares of CompanyCommon Stock to be distributed to the Payphone Investors. The number of sharesof Common Stock received by each Payphone Investor was dependent upon theamount of each Payphone Investor’s claim relative to the total amount of allallowed Payphone Investor claims. The claim associated with each sale-leasebackagreement was calculated by adding the amount of all monthly payments remainingto be paid under the agreement as of the filing of the bankruptcy case plus theamount of the initial investment. Adjustments to this formula for calculatingclaim amounts were made for the situations that deviated from the usualsale-leaseback transaction, such as when payphones and agreements were providedas a bonus or commission to certain sales agents.

 

As of December 31, 2005, the totalnumber of shares of our Common Stock outstanding, after giving effect todistributions to Payphone Investors and adjustments resulting fromreconciliation of allowed Payphone Investor Claims, was 4,987,624.Approximately 385,347 of these shares had restrictions limiting theirtransferability as a result of a settlement of litigation by the Companyagainst the holders of the shares. Pursuant to the settlement, theseshareowners, among other things, were restricted from selling more than 25% oftheir individual aggregate ownership during any fiscal quarter until the secondanniversary of the distribution of the stock (May 12, 2005) withoutproviding the Company notice and the right of first refusal to purchase any ofthe restricted shares that are proposed to be sold. The right of first refusaldoes not apply in certain circumstances, including in the event a market existsfor the shares and certain levels of trading activity are met. The Certificateof Incorporation, confirmed as part of the Plan of Reorganization, authorizesthe issuance of up to 6,000,000 shares of Common Stock, including those issuedto the Payphone Investors.

 

**Payphone Industry Development and CurrentRegulatory Environment**

 

The initial growth of Old ETS in the 1990scoincided with a period of rapid expansion of payphone providers who wereindependent from the RBOCs. Before the 1984 break-up of AT&T into theRBOCs, there was no obligation to provide line service to payphones. AT&Toperated essentially all the payphones, and had no incentive to providetelephone lines to competitors. AT&T paid relatively small commissions tosite owners for the right to place a payphone on their premises, which AT&Tpresented as more of a utility service to the business owner and theircustomers than as a profit source for the business.

 

In older payphone systems all of thetechnology required to provide coin service was located at AT&T’s localexchanges and was supplied to each payphone via a “coin line.” The developmentof microprocessor-based payphones allowed these functions to be performedwithin the telephone rather than at the exchanges. This technology provided thecapability for independent payphone providers to route calls and determine theproper rate charges. The new systems also included maintenance diagnostics,coin administration, credit card, and reporting features. Independent payphoneproviders could now route calls to alternate long-distance and operatorservices, and store and retrieve call data and billing information. Thetechnological improvements allowed the owner to share in the non-coinlong-distance revenues generated by the payphone, reduce the cost ofmaintenance and collection, and to monitor coin losses, among other things.

 

With the break-up of AT&T the RBOCs tookover the payphone businesses in their respective areas of the country. However,the court-ordered and regulatory efforts associated with the break-up ofAT&T included requirements to provide coin line service to independentpayphone operators at competitive rates. Following a series of FCC and stateregulatory rulings in the 1980s and 1990s, the independent payphone sectordeveloped as an alternative to the payphone service offered by the regionaltelephone companies. These independent operators found that they could make asubstantial profit even after paying the site owners higher commissions thantheir RBOC competition.

 

Prior to 1987, coin calls were the solesource of revenues for independent payphone operators because there was nomechanism for them to receive revenue from collect and dial-around calls. Formost long-distance calls placed on an independent payphone the caller wouldhave to insert a lot of coins or call collect. AT&T would collect and keepall the money for the call from the other party (except the change that thecaller put in the phone). Beginning in 1987, technological and regulatory developmentsallowed competitive long-distance services using calling cards and other codenumbers (offered by companies such as Sprint and MCI) to develop. Theseservices, which competed with AT&T’s long-distance and operator services,offered independent payphone operators commissions for directing operatorassisted or calling card calls to them. However, the payphone operators stilldid not receive any revenue from calls where the caller “dialed around” thedefault service or placed a collect call.

 

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In 1990, Congress responded to concerns aboutrates that some of these alternate long-distance providers charged forinterstate calls from payphones and other locations (such as hotels andhospitals) by adopting the Telephone Operator Consumer Services Improvement Act(“TOCSIA”). TOCSIA created new requirements for long-distance companies and thecall aggregators (including the payphone service providers) who utilized thelong-distance operator services. In addition, the act directed the FCC toconsider the need to compensate independent payphone operators for alldial-around calls. In May 1992, the FCC ruled that independent payphoneoperators were entitled to dial-around compensation. Because of the lack of a systemto track compensable calls, reimbursement was originally set at $6.00 perpayphone per month.

 

In 1996, Congress enacted theTelecommunications Act, eliminating long-standing legal barriers separatingregional telephone companies, long-distance carriers, and cable televisioncompanies. The Telecommunications Act also preempted numerous state laws andregulations, in an effort to foster greater competition in alltelecommunications market sectors. As a result, the Telecommunications Acthelped to accelerate the widespread deployment of independent payphones.Section 276 of the Telecommunications Act focused on several payphone-industryrelated issues:

 

•                  TheFCC was given the power to preempt certain state payphone regulationsinconsistent with the Telecommunications Act.

 

•                  Payphoneoperators would be compensated for dial-around calls. A series of FCC andfederal court actions from 1997 through 2004 established the payment amountsand mechanisms that governed this relationship between the carriers and thepayphone providers. These actions are described in more detail below.

 

•                  Ratesfor local coin calls would be deregulated by October 1997. Payphoneservice providers (“PSPs”) are not permitted to require that coins be depositedin order to use payphones for dial-around calls.

 

•                  RBOCpayphone operations would be removed from the regulated rate base. RBOCs werealso required to make their access lines equally available to the independent,or competitive local exchange carriers, as well as ensuring that the cost ofthese lines met the FCC new services test requirements.

 

•                  RBOCswere now allowed to select (with the site location owner) the interLATA carrierthey wished to use.

 

•                  PSPsnow had the right to choose local, intraLATA, and interLATA providers (again,with the site location owner’s involvement).

 

The dial-around call compensation issue hasdeveloped primary importance because of the potential revenue impact for thePSPs. Many years of FCC, court, carrier, and PSP actions have culminated in theFifth Order on Reconsideration and Order on Remand (the “Interim Order”),issued by the FCC on October 23, 2002. This order resolved the remainingissues surrounding the prior periods of compensation rates and the methodologyof payment. Specifically, there were four time periods involved: (1) the “Early”period from June 1992 through November 1996; (2) the “Interim”period from November 7, 1996 to October 6, 1997; (3) the “Intermediate”period from October 7, 1997 to April 20, 1999; and (4) the “Post-intermediate”period after April 20, 1999. The FCC mandated a true-up process toreconcile over-payment and under-payment situations created by years ofdifferent reimbursement structures that were now changed as a result of thisorder. The true-up process included a calculation for interest due from theinitial payment point to the reconciling payment, whether the carrier owed thePSP or vice versa.

 

The FCC decided that no compensation was duefrom the carriers to the PSPs for the Early period because of the lack oftracking and accounting systems to determine a fair payment scheme.

 

The rate for the Interim period was revisedto $35.224 per payphone per month ($0.238 multiplied by a 148 monthly callindustry average). The calculation had originally been 131 calls multiplied by$0.35, and had undergone several revisions from 1997 to the date of the InterimOrder. Revisions for cost methodology, allowance for flexible automatic numberidentification cost, and interest assessments due to the delayed nature ofcarrier payments (carrier call information is routed through several majorclearinghouses on a quarterly basis before payment reaches the PSPs) were allfactored into the payment rationale. The FCC directed each carrier with over$100 million in annual revenues to pay a proportionate amount of the$35.224, depending on their call volume share in the marketplace. The true-upprocess occurring in 2003 and ongoing currently has usually resulted in amountsowed by the carriers to PSPs, depending on their original payments to the PSPs.In a few instances, the PSPs owed payment to the carriers.

 

8

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The rate for the Intermediate period alsowent through several modifications over time. The FCC finally established$0.238 per call (or $35.224 per phone, if call tracking was not available) asthe payment for the period. This typically resulted in a net amount due thecarrier since those that had previously paid did so at rates as much as $0.284per call.

 

In the first quarter of 1999, the FCCreleased the Third Report and Order and Order on Reconsideration of the SecondReport and Order. This Order set the per-call compensation rate at $0.24. Thisrate had undergone some adjustments that were effective for the Intermediateperiod. For the Post-intermediate period, the FCC established a $35.52 defaultrate per phone per month ($0.24 multiplied by a 148 monthly call industryaverage); if no per-call compensation had been paid by the carrier. Again, thisrate varied by carrier, depending on their assessed share of the market.

 

On August 29, 2002 and September 4,2002 respectively, the American Public Communications Council (“APCC”) and theRBOCs filed petitions with the FCC to revisit and increase the dial-aroundcompensation rate level. Using the FCC’s existing formula and adjusted only toreflect current costs and call volumes, the APCC and RBOCs petitions supportedan approximate doubling of the then current $0.24 rate. In response to thepetitions, on September 30, 2002 the FCC placed the petitions out forcomment and reply comment by interested parties, seeking input on how the FCCshould proceed to address issues raised by the filings. On October 28,2003 the FCC adopted an Order and Notice of Proposed Rulemaking (the “October 2003Rulemaking”) to determine whether a change to the dial-around rate iswarranted, and if so, to determine the amount of the revised rate. In theOctober 2003 Rulemaking, the FCC tentatively concluded that themethodology adopted in the Third Report and Order is the appropriatemethodology to use in reevaluating the default dial-around compensation rateand requested comments on, among other things, the cost studies presented inthe petitions. In August 2004, the FCC issued an order revising the defaultcompensation rate to $0.494 per call. The rate became effective onSeptember 27, 2004.

 

Another critical industry issue involves theability of the competitive local exchange carriers to retain access tounbundled network elements (“UNE”) originally mandated by the FCC. This openaccess to the local exchange carriers network elements created a competitivepricing environment that benefited the PSPs. Network elements were defined as “afacility or equipment used in the provision of a telecommunications service” thatincludes “...features, functions, and capabilities that are provided by meansof such facility or equipment, including subscriber numbers, databases,signaling systems, and information sufficient for billing and collection orused in the transmission, routing, or other provisions of a telecommunicationsservice.”

 

In the 2003 Triennial Review Order, the FCCrevisited the UNE issue and determined that the local exchange carriers mustcontinue to allow competitive local exchange carriers to purchase thoseelements necessary to offer local service to PSPs as an alternative to thelocal exchange carriers’ local service. On March 2, 2004, the UnitedStates Court of Appeals overturned parts of the Triennial Review Order, amongthem, the unbundling rules that affect the PSPs’ access to local line service.

 

The FCC ultimately responded to the court’sdecision with a December 2004 order that became effective March 11,2005. The order significantly reduced the incumbent local exchange carrier’sobligation to make network elements available to other carriers and providerssuch that after a twelve month transition period, incumbent local exchangecarriers will have no obligation to provide competitive local exchange carrierswith unbundled access to mass market switching. The order provides forincreased pricing for such access during the transition period. While theeventual outcome is uncertain, the effect of the order may increase costs toPSPs.

 

Regulatory actions and market factors, oftenoutside the Company’s control, could significantly affect the Company’sdial-around compensation revenues and line access charges. These factorsinclude (i) the possibility of administrative proceedings or litigationseeking to modify the dial-around compensation rate, (ii) ongoingtechnical or other difficulties in the responsible carriers’ ability andwillingness to properly track or pay for dial-around calls actually deliveredto them, and (iii) the possibility of administrative proceedings orlitigation that may change UNE access by competitive local exchange carriersand therefore affect the cost of local line service to the PSPs.

 

As a result of the changes created by theTelecommunications Act, regulations adopted by the FCC to implement itsprovisions, and competition from cellular and other wireless forms ofcommunication, we believe that the public payphone industry continues toundergo fundamental changes. The rapid growth in wireless telephone usage hasresulted in declining payphone usage and revenues. The RBOCs, which control amajor share of the payphone market, are no longer permitted to subsidize theirpublic communications businesses with profits from their regulated businesses.While opportunities exist for 

 

9

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the PSP, competitive and regulatory pressurescontinue to create a challenging environment as the telecommunications businessevolves.

 

**Current Operations**

 

Our primary business is to install andoperate payphones pursuant to contracts with location owners. We install publicpayphones in properties owned or controlled by others where significant demandexists for public payphone services, such as shopping centers, conveniencestores, service stations, grocery stores, hotels, restaurants, airports, truckstops, and bus terminals. We service and maintain the payphones and collect therevenue generated.

 

*Site Contracts*

 

The term of a location agreement with a siteowner generally ranges from three to ten years and usually provides for anautomatic renewal of the term of the contract unless it is canceled by thelocation owner pursuant to the terms of the agreement. We can generallyterminate a location agreement on 30 days’ prior notice to the locationowner if the payphone does not generate sufficient total revenues for twoconsecutive months. The duration of the contract and the commission arrangementdepends on the location, number of payphones and revenue potential of theaccount. Depending upon the revenues generated by the payphones, we may pay thelocation owner a commission (typically in accordance with a formula based upona percentage of the payphone’s revenue), or we may receive a payment from thelocation owner for providing a payphone to the location.

 

As of December 31, 2005, we owned andoperated approximately 13,000 payphones.

 

*Coin Calls*

 

Our publicpayphones generate coin revenues primarily from local calls. Historically, themaximum rate that we could charge for local calls was set by state regulatoryauthorities at $0.25 in most cases. Since local payphone coin rates werederegulated in October 1997, we have charged $0.25 to $0.50, dependingupon the location, to place a local coin call from our payphones.

 

Long-distance coin calls are typicallycarried by a long-distance carrier that has contracted to provide transmissionservices to our payphones. The Company pays a charge to the long-distancecarrier each time the carrier transports a long-distance call for which wereceive coin revenue from an end user.

 

*Non-Coin Calls*

 

We alsoreceive revenues from non-coin calls made from our payphones. These non-coincalls include credit card, calling card, prepaid calling card, collect andthird-party billed calls where the caller dials “0” plus the number or simplydials “0” for an operator. Non-coin calls often require a number of services,including automated or live operators to answer the call, verifying billinginformation, validating calling cards and credit cards, routing andtransmitting the call to its destination, monitoring the call’s duration anddetermining the charge for the call, and billing and collecting the applicablecharge. We have contracted with a limited number of operator service providersto handle these calls and perform all associated functions, while paying us acommission on the revenues generated thereby.

 

In accordance with the TelecommunicationsAct, we also receive additional non-coin revenue from carriers for “dial-around”calls made from our payphones. A dial-around call is made by dialing an accesscode for the purpose of reaching a long-distance carrier other than the onedesignated by the payphone operator or using a traditional “toll free” number,generally by dialing a 1-800, 888, 877, 866, or 855 number, or a seven-digit “101XXXX”code.

 

*Payphone Base*

 

As ofDecember 31, 2005, the Company had approximately 13,000 payphones inoperation in 32 states, Puerto Rico, and the District of Columbia, comparedwith approximately 16,000 in operation as of December 31, 2004, 17,000 inoperation at December 31, 2003, and 19,000 in operation at December 31,2002. As of December 31, 2005, the states in which we have the greatestnumbers of telephones installed were Texas, North Carolina, and Georgia.

 

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We select locations for our payphones wherethere is typically high demand for payphone service, such as shopping centers,convenience stores, service stations, grocery stores, hotels, restaurants,airports, truck stops, and bus terminals. We rely on a site survey thatexamines factors including traffic patterns as well as any available historicalrevenue information in determining whether to install a payphone.

 

*Technology*

 

Our payphonesutilize technology that provides voice synthesized calling instructions, countscoins deposited during each call, informs the caller at certain intervals ofthe time remaining on each call, and identifies the amount of any additionaldeposit needed in order to continue the call. The payphones can be programmedfrom our central computer facilities to update rate information or to directdifferent types of calls to particular carriers. Our payphones can alsodistinguish coins by size and weight, report to its central host computer thetotal amount of coin in the coin box, perform self-diagnosis and automaticallyreport problems to a pre-programmed service number and immediately reportattempts at vandalism or theft. Many of our payphones operate on poweravailable from the telephone lines, thereby avoiding the need for and relianceupon an additional power source at the installation location.

 

We utilize proprietary and non-proprietarysoftware to continuously track coin and non-coin revenues from each payphone,as well as expenses relating to each payphone, including commissions payable tolocation owners. Technology utilized by the Company also allows us to:

 

•                  efficientlytrack and facilitate the activities of our field technicians;

 

•                  respondquickly to equipment malfunctions and to minimize “downtime” on our payphonesby identifying service problems as quickly as possible; and

 

•                  accuratelytrack call traffic and make more timely and accurate commission payments tolocation owners.

 

We provide all technical support required tooperate the payphones, such as computers and software and hardware specialists,from our headquarters near Atlanta, Georgia. Each of our local officesmaintains inventories, equipment, spare parts, and accessories for immediatedeployment in the field. The Company has not conducted any Company sponsored orcustomer sponsored research and development activities during the last twofiscal years.

 

*Telephone Equipment*

 

We assemble payphones from componentsmanufactured by outside suppliers. In addition, we rely on outside suppliersfor local line access, billing and collection services, long-distance, andoperator services. We believe that multiple suppliers are available to meet allof the Company’s product and service needs at competitive prices and rates, andexpect the availability of such products and services to continue in thefuture.

 

Our payphones comply with all materialregulatory requirements regarding the performance and quality of payphoneequipment and have all of the operating characteristics required by theapplicable regulatory authorities, including free access to local emergency (“911”)telephone numbers, dial-around access to all available carriers, and automaticcoin return capability for incomplete calls. As of December 31, 2005, weemployed approximately 47 field service technicians, who collect coin boxes andclean and maintain a route of payphones. The technicians also respond totrouble calls made by location owners, by users of payphones or by thetelephone itself as part of its internal diagnostic procedures. Sometechnicians are also responsible for the installation of new payphones. Due toour polling and electronic tracking and trouble reporting systems and theability of our field service technicians to perform on-site service andmaintenance functions, we are able to limit the frequency of trips to thepayphones as well as the number of employees needed to service the payphones.

 

We re-utilize parts from payphones removedfrom field service for repair and installation of payphones and when necessarypurchase new or refurbished equipment from various suppliers. We often assemble,refurbish, and replace payphones or component parts obtained from our inventoryor purchased from component manufacturers. These components generally include ametal case, an integrated circuit board incorporating a microprocessor, ahandset and cord, and a coin box and lock.

 

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*Local Lines*

 

We obtainlocal line access from a number of local exchange carriers and competitivelocal exchange carriers, including MetTel, ECI, BellSouth, Verizon, SBC Communications,AllTel, Sprint, and a number of other suppliers of local line access. We paymonthly line and/or usage charges to these local exchange carriers to provideservice to our payphones.

 

*Long-distance and Operator Services*

 

We outsourceour long-distance calls to a long-distance carrier and our operator serviceoperations to a limited number of operator service providers. The revenue wereceive from operator service providers is based on the volume of calls carriedand the amount of revenues generated by the calls. We also receive revenuesfrom long-distance carriers for calls made from our public payphones, includingdial-around calls when the caller dials a code to obtain access to an operatorservice provider or a long-distance company other than one designated by us.

 

We expect the basic availability of suchproducts and services to continue in the future; however, the continuingavailability of alternative sources cannot be assured. Although we are notaware of any current circumstances that would require us to seek alternativesuppliers for any material portion of the products or services used in theoperation of our business, transition from our existing suppliers, ifnecessary, could have a disruptive effect on our operations and could give riseto unforeseen delays and/or expenses.

 

*Customers, Sales, and Marketing*

 

We contractdirectly with businesses and also with intermediaries for location agreements.As of December 31, 2005, corporate payphone accounts of 100 or morepayphones represented approximately forty percent of our installed payphonebase. One customer accounted for more than fifteen percent of the Company’spayphone operations revenues in 2005.

 

*Employees*

 

As of December 31, 2005, the Company had79 full-time employees, none of whom are subject to a collective bargainingagreement. The Company believes that its relationship with its employees isgood.

 

*Environmental Compliance*

 

The Companyhas not experienced any and does not anticipate any material effects, duringthe current fiscal year, on the Company’s capital expenditures, earnings, andcompetitive position from compliance with Federal, State and local provisionswhich have been enacted or adopted regulating the discharge of materials intothe environment.

 

*Competition*

 

We compete with other telecommunicationproviders including providers of wireless services, other payphone providers,and long-distance carriers.

 

We compete with providers of wirelesscommunications services for both local and long-distance traffic. Certainproviders of wireless communication services have introduced rate plans thatare competitively priced which have negatively impacted the usage of payphonesthroughout the nation.

 

We believe that the competitive factors amongpayphone providers are:

 

•                  thecommission payments to a location owner;

 

•                  theability to serve accounts in various regions or states; and

 

•                  thequality of service and availability of specialized services provided to alocation owner and payphone user.

 

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We believe we are currently competitive ineach of these areas; however most local exchange carriers and some independentpayphone providers that we compete against may have substantially greaterfinancial, marketing, and other resources than we do.

 

We also compete with long-distance carriersthat provide dial-around services which can be accessed through our payphones.Certain national long-distance operator service providers and prepaid callingcard providers have implemented extensive advertising, promotions, anddistribution schemes which have increased dial-around activity on payphones,thereby reducing coin revenues and non-coin traffic to our primary providers ofoperator-assisted services.

 

In December 2003, BellSouth, whichoperated the largest payphone network in the nine state region comprising thesoutheastern United States (via its wholly-owned subsidiary BellSouth PublicCommunications, Inc.), exited the payphone business. While the Companybenefited from this development by obtaining contracts to replace over 2500BellSouth payphones, the BellSouth exit is an indication of the difficultiesfaced by payphone owners as a result of various competitive and regulatoryfactors impacting the payphone industry. It is estimated that the embedded baseof payphones in the United States has contracted from approximately2.4 million terminals in operation in 1998 to approximately1.2 million terminals today.

 

**Business Strategy**

 

As we reported in the November 7 Form 8-K andthe Definitive Proxy Statement, the Company and Empire entered into the AssetSale Agreement and related agreements including a security agreement and apromissory note pursuant to which we have agreed, subject to the conditions ofthe Asset Sale Agreement, to sell substantially all of our assets to Empire. Inaddition, as discussed in the November 7 Form 8-K and the Definitive ProxyStatement, in order to provide for the funding of operational losses of ourpayphone business pending consummation of the Asset Sale Agreement, we enteredinto the Management Services Agreement with Empire. The consummation of theAsset Sale Agreement is subject to a number of conditions including approval byour stockholders and/or such other approvals required by Delaware law, andobtaining certain regulatory approvals. At the Annual Meeting of Stockholdersheld February 15, 2006, the stockholders, among other things, approved theAsset Sale Agreement and subsequent dissolution of the Company uponconsummation of the Asset Sale Agreement. As discussed in the November 7 Form8-K and the Definitive Proxy Statement, following the consummation of thetransactions contemplated by the Asset Sale Agreement, it is the intention ofthe Board of Directors to dissolve the Company in accordance with applicablelaws and to distribute any proceeds remaining after such dissolution to thestockholders. Upon consummation of the Asset Sale Agreement, the Companyintends to file a certificate of dissolution with the Secretary of State ofDelaware and close the stock transfer books to discontinue recording transfersof our common stock at the close of business on the date we file thecertificate of dissolution with the Secretary of State of Delaware. Afterconsummation of the Asset Sale Agreement our activities will be limited tocollecting proceeds from assets not included in the sale, paying off creditors,performing requirements under applicable law and distributing any remainingproceeds to stockholders of record. Any distributions made by us shall be madesolely to the stockholders of record at the close of business on the FinalRecord Date, except as may be necessary to reflect subsequent transfersrecorded on our books as a result of assignments by will, intestate successionor operation of law.

 

The foregoing description is qualified in itsentirety by the description in the November 7 Form 8-K and the Definitive ProxyStatement and to the exhibits therein which are incorporated herein byreference.

 

Prior to entering into the Asset SaleAgreement and Management Services Agreement in November 2005, we continued ourefforts to rationalize our overall cost structure, increase route density,improve service quality, monitor and remove underperforming payphones, and addprofitable payphones to our base.

 

*Cost structure*

 

The Company continued the cost-reductionefforts made during the reorganization process. Components of these effortsincluded:

 

Line costreductions—The Company reduced its overall line cost by consolidating wherepossible its local line access providers, utilizing a limited number ofincumbent and competitive local exchange carriers.

 

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OverheadElimination—The Company reviewed its support structure in order to streamlinethe functions that are provided. This resulted in the elimination of jobfunctions in its corporate headquarters, as well as the elimination ofadministrative functions in branch offices. Additionally, the Company completedthe consolidation of its warehouse and repair operations which are now at itsheadquarters.

 

Monitoring andRemoval of Unprofitable Payphones—The Company monitored the profitability ofits payphones and payphone accounts. The Company removed payphones that did notmeet certain profitability thresholds.

 

*Service Quality*

 

CarrierConsolidation—In addition to the efforts with respect to local line accessdescribed above, the Company consolidated its other coin and non-coin serviceswith a limited number of carriers. This has enabled the Company to benefit fromthe volume of its call traffic and obtain favorable rates and service fromproviders.

 

Monitoring andManagement Information Systems—The Company utilizes proprietary andnon-proprietary systems to track coin and non-coin revenues from each payphone,as well as to track other statistical and financial data. The technology usedby the Company also allows us to efficiently track and facilitate theactivities of our field technicians, to respond quickly to equipmentmalfunctions, and to minimize downtime on our payphones by promptly identifyingservice problems.

 

*Route Density*

 

New PayphoneInstallations—The Company has sought to add profitable locations to itsinstalled payphone base. Among the factors it considered in deciding to placephones is whether the geographic location allows us to utilize our existingfield infrastructure. This permits the Company to have more efficient serviceand collection routes, increasing the number of payphones that can be servicedby a technician and permitting faster response time to service problems.

 

Outsourcing ofService and Collection—In certain areas where the Company does not havesufficient route density to permit the establishment of efficient service andcollection routes, the Company sought to reduce costs by outsourcing such servicesto other providers, either by paying for such services on a per phone basis orby entering into reciprocal arrangements with other providers. We have alsobeen able to reduce the reliance on independent contractors in areas where wehave added payphones to make the establishment of service and collection routesby our own employees more cost effective.

 

**Factors to Consider**

 

The following characteristics of ouroperations or industry may have a material impact upon our future financialperformance.

 

# ***1.***Dissolution; Winding Down andLiquidation.

 

Pursuant to the Annual Meeting ofStockholders held February 15, 2006, the stockholders of the Company approved,among other things, the sale of substantially all of our assets to Empirepursuant to the Asset Sale Agreement and the winding down of our operationsfollowing the sale of substantially all of our assets to Empire. Afterconsummation of the Asset Sale Agreement our activities will be limited tocollecting proceeds from assets not included in the sale, paying off creditors,performing requirements under applicable law and distributing any remainingproceeds to stockholders of record. As a result of contingent or unmatureliabilities that may materialize or mature, dissolution and liquidation may notcreate value to our stockholders or result in any remaining capital fordistribution to our stockholders. In addition, claims, liabilities and expensesduring the winding down of our company will continue to be incurred which willreduce the amount of assets available for distribution. We will close our stocktransfer books and discontinue recording transfers of our common stock at theclose of business on the date we file the certificate of dissolution with theDelaware Secretary of State which is anticipated to be filed promptly followingthe consummation of the Asset Sale Agreement. Any distributions made by usshall be made solely to the stockholders of record at the close of business onthe Final Record Date, except as may be necessary to reflect subsequent transfersrecorded on our books as a result of assignments by will, intestate successionor operation of law. We cannot assure the stockholders of the amount, if any,or timing of any distribution to our stockholders as a result of thedissolution.

 

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# ***2.***Possible discontinuance of operations

#  

If we are unable to consummate the saletransaction to Empire pursuant to the Asset Sale Agreement we may not be ableto remain a viable company and may have to discontinue operations. Our expenseshave historically exceeded our revenues and we have sustained losses since ourbankruptcy reorganization in December 2002. Based on continued erosion ofrevenue and despite management’s reduction of operating expenses, there issubstantial doubt about the Company’s ability to continue as a going concern.

 

# ***3.***Regulatory Issues

#  

The enactment of the Telecommunications Actsignificantly altered the regulatory landscape in which payphone companiesoperate. Although we believe that the Telecommunications Act, as implemented bythe FCC, addressed certain historical inequities in the payphone marketplace,uncertainties relating to the impact and timing of the implementation of thenew regulatory framework still exist. The uncertainty with the greatestpotential financial impact relates to revenue from access code calls andtoll-free dialed calls, also referred to as dial-around compensation.Dial-around compensation accounts for a material percentage of our revenues.Additionally, the March 2004 Court of Appeals decision to vacate the FCCUnbundled Network Element rules will have an unknown effect on local lineaccess pricing, but is expected to increase prices to payphone serviceproviders.

 

# ***4.***Limited Financial Resources

#  

Our future performance and liquidity willdepend on a number of factors, including industry performance, general businessand economic conditions, the absence of contingencies, and other matters, manyof which are beyond our control. We have limited financial resources, and itmay be the case that we will not have the funds to make capital improvementsarising in the ordinary course of business.

 

# ***5.***Dependence Upon Third-PartyProviders

#  

We assemble payphones from componentsprovided by outside suppliers. In addition, we rely on outside suppliers forlocal line access, billing and collection services, and long-distance andoperator services. We believe that multiple suppliers are available to meet allof our product and service needs at competitive prices and rates and expect theavailability of such products and services to continue in the future. However,we cannot assure the continuing availability of alternative sources.

 

# ***6.***Competition

#  

We compete with other telecommunicationsproviders, including providers of wireless services, other payphone providersand long-distance carriers. Many of these competitors have substantiallygreater financial, marketing, and other resources than the Company.

 

# ***7.***Technological Change and NewServices

#  

Continuous technological change, frequentservice and product innovations, and evolving industry standards characterizethe telecommunications industry. We believe that our future success will dependin part on our ability to anticipate technological changes and respond in atimely and effective manner to meet new industry standards. Any failure to keeppace with technological change (including the technical support componentrequired to operate payphones) and new customer service demands could have amaterial adverse effect on our business.

 

# ***8.***Impact of Seasonality

#  

Our revenue from payphone operations isaffected by seasonal variations. Because many of our payphones are locatedoutdoors, weather patterns have differing effects on our revenue depending onthe region of the country where the payphones are located and the enclosurehousing of the phone. For example, our payphones throughout the Midwestern andEastern United States produce their highest call volumes during the second andthird quarters, when the climate tends to be more favorable. Seasonalvariations in revenues could have a material adverse effect on our business.Changes in the geographic distribution of our payphones may in the futureresult in different seasonal variations in our results.

 

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# ***9.***No established market for theCommon Stock.

#  

Our Common Stock is not listed on any stockexchange. Our Common Stock was issued to approximately 12,500 individuals andentities that entered into agreements with Old ETS to purchase payphones.Ownership interests are tracked by the transfer agent, American Stock Transferand Trust Company (“AST&T”), and transfers of ownership may be documentedthrough AST&T. The Common Stock is not traded on any recognized stockexchange, stock market or bulletin board system and there are no market makersfor the Common Stock. There can be no assurance that an active or liquidtrading market for our shares of Common Stock will develop or be maintained.The number of shares of Common Stock distributed to each Payphone Investor wasdetermined by formula confirmed by the bankruptcy court and that formula maynot be indicative of the market price for the Common Stock followingregistration.

 

**Item 2. Description of Property.**

 

We lease space in the following locations:

 
| **LOCATION**                                                | ** ** | **GENERAL CHARACTERISTICS**                        |
|-------------------------------------------------------------|------------|---------------------------------------------------------|
| 1490 Westfork Drive, Suite G  Lithia Springs, GA 30122 |       | Corporate Office and Branch Office                      |
|                                                        |       |                                                    |
| 309 Technical Ct.  Garner NC 27529                          |       | Branch Office                                           |
|                                                        |       |                                                    |
| 715A S. Main Street  Dobson, NC 27017                       |       | Branch Office (vacated January 31,  2006)          |
|                                                        |       |                                                    |
| 927 Crosstimbers  Houston, TX 77022                         |       | Branch Office                                           |
|                                                        |       |                                                    |
| 1343 Columbia Drive, Suite 405  Richardson, TX 75081        |       | Branch Office (currently subleased to  another company) |
|                                                        |       |                                                    |
| 25 Simon Madera,  Parcelas Falu, San Juan, PR 00924         |       | Branch Office                                           |

 

We believe that suitable additional oralternative space will be available on commercially reasonable terms as needed,but that existing facilities will be sufficient for operational purposesthrough the end of the leases.

 

**Item 3. Directors and Executive Officersand Significant Employees.**

 

The following sets forth informationconcerning our executive management and directors, including each person’sname, age as of December 31, 2005, and principal occupation or employmentduring the past five years.

 
| **Name**              | ** ** | **Age** | ** ** | **Position**                                                               |
|-----------------------|------------|---------|------------|----------------------------------------------------------------------------|
| Guy A.  Longobardo    |       | 44      |       | President, Chief Executive Officer and  Chairman of the Board(1)(2)        |
| Michael H.  McClellan |       | 54      |       | Executive Vice President, Chief Financial  Officer and Treasurer(1)(2)     |
| David C.  Jones       |       | 62      |       | Vice President of Human Resources and  Investor Relations and Secretary(1) |
| Jeffrey E.  Fennell   |       | 43      |       | Senior Vice President and Chief Operating  Officer(1)                      |
| Michael H.  Buck      |       | 71      |       | Director(2)                                                                |
| S. Gregory  Hays      |       | 48      |       | Director(2)                                                                |
| Michael M.  Scott     |       | 68      |       | Director(2)                                                                |

 

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(1)           Executive Officer

 

(2)           Director

 

Mr. Longobardo has been the President,Chief Executive Officer and Chairman of the Board of Directors since he joinedthe Company in February 2001. Mr. Longobardo was re-elected as a Class IIIdirector to the Board for a term ending 

 

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on December 31, 2008, at the Annual Meetingof Stockholders held February 15, 2006. Prior to that time he served as GeneralCounsel, Vice President of Corporate Development and Corporate Secretary ofAMNEX, Inc. since March 1998 and assumed the duties of ChiefExecutive Officer of AMNEX, Inc. and its subsidiaries after AMNEX hadfiled for bankruptcy in May of 1997. From February 1995 until joiningAMNEX, Mr. Longobardo was employed by HSBC Securities, Inc., the U.S.securities subsidiary of HSBC Holdings plc, where he most recently served as aManaging Director and Head of Corporate Finance in its Investment BankingDivision. From 1985 through February 1994, he was an attorney in theCorporate Department of the law firm of Milbank, Tweed, Hadley &McCloy. Mr. Longobardo holds a BA degree in Economics from WilliamsCollege and a JD from Columbia University School of Law. Mr. Longobardoserves as a director on the board of the American Public CommunicationsCouncil.

 

Mr. McClellan is the Executive VicePresident, Chief Financial Officer and Treasurer of the Company. Mr. McClellanhas also served on our Board since July 2003. Mr. McClellan was re-elected aClass III director to the Board for a term ending on December 31, 2008 at theAnnual Meeting of Stockholders held February 15, 2006. Mr. McClellanearned his Bachelor of Science Degree from Stanford University in Palo Alto,California. He later earned his MBA degree in Finance and Accounting fromRollins College in Winter Park, Florida. Prior to joining us inDecember 2000, Mr. McClellan served as Vice President-Finance for UPSTruck Leasing. He joined UPS Truck Leasing in 1987 and held various positionsin the Finance Department. At UPS, Mr. McClellan was responsible for creatingthe financial modeling and forecasting, cost reduction requirements andprograms improving returns on invested capital. Mr. McClellan serves as analternate director on the board of the American Public Communications Council.

 

Mr. Jones is the Company’s VicePresident of Human Resources and Investor Relations. He also serves asCorporate Secretary. He joined the Company in September 1999. Mr. Jonesearned his Bachelor of Arts Degree in English from the University of Richmond,Richmond, Virginia. From 1997 to 1999, Mr. Jones was Vice President of HumanResources for One Source, a commercial cleaning and landscaping company withannual sales in excess of $826 million and 38,000 employees. Mr. Jones manageda staff of ten Human Resources professionals in developing policies andprocedures, overseeing safety performance, designing benefit programs, anddeveloping compensation structure. Mr. Jones previously held Senior HumanResources positions with Scientific Games, Inc. in Atlanta, Georgia, andAvondale Mills in Sylacauga, Alabama.

 

Mr. Fennell is the Company’s Senior VicePresident and Chief Operating Officer. Mr. Fennell joined the Company inApril 2003. Mr. Fennell earned a degree from the Community College ofthe Air Force, majoring in Electronics Engineering Technology. Effective as ofMarch 31, 2006, Mr. Fennell resigned as the Company’s Senior Vice President andChief Operating Officer. Prior to joining us, from 2000 to 2002,Mr. Fennell was Vice President of North American Operations at Vital NetworkServices, a provider of voice and data networks to corporations. At VitalNetwork Services, he managed over one hundred employees including AreaOperations Managers, Project Managers, and Telecommunication Technicians.

 

Mr. Michael H. Buck was appointed aBoard Member in November 2002 as a Class I Director. Mr. Buck wasre-elected as a Class I director to the Board for a term ending on December 31,2006, at the Annual Meeting of Stockholders held February 15, 2006. Mr. Buckwas President of Buckland Group Inc, a Sears Authorized Dealer fromNovember 2001 until December 2003. Mr. Buck was also owner ofCommunications Opportunities from 1998 until 2000. Mr. Buck also served asa member of the creditors committee during the Old ETS bankruptcy.Mr. Buck earned his BA Degree from Dartmouth College. Mr. Buck alsowas a Registered Representative for a New York Stock Exchange member firm from1968 until 1997. Mr. Buck acted as an agent selling payphone leases forOld ETS.

 

Mr. S. Gregory Hays was appointed a BoardMember in July 2003 as a Class II Director. Mr. Hays was re-electedas a Class II director to the Board for a term ending on December 31, 2007, atthe Annual Meeting of Stockholders held February 15, 2006. Mr. Hays resignedfrom the Board of Directors effective as of March 30, 2006. Mr. Hayshas been Managing Director of Hays Financial Consulting in Atlanta, Georgiasince July 1, 2001. Previously Mr. Hays was Executive Vice Presidentfor William G. Hays & Associates, Inc. from January 1,1990 until June 30, 2001. Mr. Hays earned his BBA degree from StetsonUniversity, and his Masters Degree in Finance from Georgia State University. In2003 Mr. Hays received his professional designation as a CertifiedInsolvency & Restructuring Advisor.

 

Mr. Michael M. Scott was appointed aBoard Member in November 2002 as a Class II Director. Mr. Scott wasre-elected as a Class II director to the Board for a term ending on December31, 2007, at the Annual Meeting of Stockholders held February 15, 2006. Mr.Scott resigned from the Board of Directors effective as of March 30, 2006. Mr. Scotthas been self-employed as the owner of Sentinel Investment and InsuranceServices since October 1, 1992, selling insurance, tax 

 

17

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services, and until December 2001,securities. Mr. Scott earned his B.S and Masters of Science degrees fromCambridge University in England. He also received his Chartered FinancialConsultancy designation from American College in Pennsylvania. Mr. Scottacted as an agent selling payphone leases for Old ETS.

 

**Item 4. Remuneration of Directors andOfficers.**

 

The following table sets forth the aggregateannual remuneration of each of the three highest paid persons who are officersor directors and the aggregate annual remuneration of the officers anddirectors as a group during the issuer’s last fiscal year.

 
| **Name of Individual or Identity of   Group** | ** ** | **Capacities in Which  Remuneration Was Received** | ** ** | **Aggregate  Remuneration** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------|------------|
| Guy A. Longobardo                                                           |       | President and Chief Executive Officer                                  |       | $                           | 271,061    |   |
| Michael H. McClellan                                                        |       | Executive Vice President and Chief  Financial Officer                  |       | $                           | 176,022    |   |
| Jeffrey E. Fennell                                                          |       | Senior Vice-President and Chief Operating  Officer                     |       | $                           | 143,451    |   |
| Officers and Directors as a Group(1)                                        |       |                                                                   |       | $                           | 846,684    |   |

 

----

(1)           The Officers andDirectors Group consists of 5 officers and 3 directors. One of the officers,Jim Liembach, resigned in August 2005.

 

**Directors Compensation**

 

Non-executive officer members of the Boardreceive $20,000 annually for service on the Board of Directors or any committeethereof. In addition, Directors may be reimbursed for certain expenses inconnection with attendance at Board and committee meetings.

 

**Employment Agreements**

 

The Company has entered into employmentagreements with Guy A. Longobardo, Michael H. McClellan and Jeffrey E. Fennell.The Employment Agreement of Mr. Longobardo (the “Longobardo EmploymentAgreement”) was amended on November 11, 2005 to extend its term to December 31,2006. The employment agreement of Mr. McClellan (as amended, the “McClellanEmployment Agreement”), pursuant to which he is paid a base salary of $165,000,expires on December 5, 2006. The employment agreement of Mr. Fennell(the “Fennell Employment Agreement”) expires on January 28, 2009 andprovides for a base salary of $134,500 per year. The Longobardo EmploymentAgreement, as amended, the McClellan Employment Agreement and the FennellEmployment Agreement provide for severance payments equal to six months basesalary, twelve months base salary and twelve months base salary, respectively,as well as the continuation of certain medical insurance benefits, if theemployment of the individual is terminated without cause or upon certain otherevents including changes in control (in each case as defined in the respectiveagreements).

 

As described below in “Part II, OtherInformation”, effective as of March 29, 2006, the employment agreements ofMessrs. Longobardo and McClellan were amended to, among other things, amend theannual base salary and change the severance payment provisions of theagreements to ensure that Messrs. Longobardo and McClellan continue to servethe Company in order to help effectuate the closing of the Asset Sale Agreementand the dissolution and winding down of the Company rather than leave immediatelyupon payment of the severance payments, that would have been paid to Messrs.Longobardo and McClellan pursuant to the terms of the employment agreementsprior to the amendments in connection with the sale transaction with Empire andthe dissolution of the Company.

 

In addition, as described below in “Part II,Other Information”, the Company and Jeffrey E. Fennell entered into anamendment to Mr. Fennell’s January 28, 2005 employment agreement, effective asof April 1,2006, pursuant to which Mr. Fennell will receive monthly payments of$1,560.73 (less applicable state and federal individual taxes as well as anytaxes required to be paid by the Company in respect of such payment) for aperiod of one year from the termination of Mr. Fennell’s employment instead ofcontinuing to receive health insurance coverage for himself and his dependentsfor a year following termination. In addition, Mr. Fennell agreed to waiveelection of continuation of coverage for Mr. Fennell and his dependents underCOBRA under the Company’s medical insurance plan following termination of hisemployment.

 

18

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**Item 5. Security Ownership of Managementand Certain Security Holders.**

 

The following table sets forth certaininformation with respect to the beneficial ownership of the Company’s CommonStock as of March 1, 2006 for (a) each of the three highest paid personswho are officers or directors, (b) all directors and current executiveofficers of the Company as a group. The Company does not have any ten percent(10%) shareholders. Except as otherwise noted, the Company believes that thepersons or entities in this table have sole voting and investing power withrespect to all the shares of Common Stock owned by them. Any information appearingbelow concerning persons other than officers and directors of the Company is tothe Company’s best knowledge based on information obtained from the Company’stransfer agent.

 
| **(1)**                      | ** ** | **(2)**                                                                             | ** ** | **(3)**               | ** ** | **(4)**                        |
|------------------------------|------------|-------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------------------|
| **Title of Class** | ** ** | **Name and Address of Owner**                                   | ** ** | **Amount owned** | ** ** | **Percent of Class** |
| Common                       |       | Guy A. Longobardo(1)  1490 Westfork Drive Suite G  Lithia Springs, GA 30122    |       | 0                     |       | *                              |
|                         |       |                                                                                |       |                  |       |                           |
| Common                       |       | Michael H. McClellan(1)  1490 Westfork Drive Suite G  Lithia Springs, GA 30122 |       | 0                     |       | *                              |
|                         |       |                                                                                |       |                  |       |                           |
| Common                       |       | Jeffrey E. Fennell(1)  1490 Westfork Drive Suite G  Lithia Springs, GA 30122   |       | 0                     |       | *                              |
|                         |       |                                                                                |       |                  |       |                           |
| Common                       |       | Officers and Directors as a Group(2)                       |       | 5760                  |       | *                              |

 

----

*              Less than 1%

(1)           Executive Officer

(2)           The Officers andDirectors Group consists of 5 officers and 3 directors. One of the officers, JimLiembach, resigned in August 2005.

 

**Item 6. Interest of Management inCertain Transactions.**

 

None.

 

19

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**PART II**

 

**Item 1. Market Price of and Dividends onthe Registrant’s Common Equity and Other Stockholder Matters.**

 

There is no public trading market for theCommon Stock of the Company. As of December 31, 2005, there wereapproximately 12,500 holders of record of our Common Stock.

 

To date, the Company has not paid anydividends on the Common Stock, and the Board of Directors of the Company doesnot currently intend to declare cash dividends on the Common Stock. Any futurecash dividends would depend on future earnings, capital requirements and theCompany’s financial condition, Delaware law and other factors deemed relevantby the Board of Directors.

 

**Item 2. Legal Proceedings.**

 

On September 11 and September 21,2000, Old ETS and certain of its affiliates filed for protection from creditorsunder chapter 11 of Title 11 of the U.S. Code. See “Part I.Item 1. Description of Business—Previous Operations.”

 

Pursuant to the bankruptcy court’s orderconfirming the plan of reorganization and other bankruptcy court orders, anyand all claims and causes of action against the Company arising prior to theeffective date of the plan of reorganization, December 5, 2002, weredischarged and forever barred from being asserted against the Company,regardless of whether a proof of claim therefore was filed. In accordance withsections 524 and 1141 of the Bankruptcy Code, the discharge provided forin the plan and confirmation order act as an injunction against thecommencement or continuation of any action to collect, offset or recover anyclaims discharged in the bankruptcy. While occasionally the Company receivesclaims or demands by creditors attempting to assert discharged claims, as aresult of the bankruptcy case and confirmation and other orders, the claims arebarred from being prosecuted against the Company. On March 29, 2006 a finaldecree was entered closing the bankruptcy cases.

 

**Item 3. Changes in and Disagreementswith Accountants.**

 

None.

 

**Item 4. Submission of Matters to a Voteof Security Holders**

 

The followingmatters were voted on at the Annual Meeting of Stockholders held on February15, 2006 (the “Annual Meeting”), each as described in more detail in theDefinitive Proxy Statement which is incorporated herein by reference:  (i) the sale of substantially all of our assets to Empire pursuant to theAsset Sale Agreement, (ii) the dissolution and the winding down of ouroperations following the sale of substantially all of our assets to Empire,(iii) amending our Certificate of Incorporation to change our corporate name to“Payphone Wind Down Corporation” effective upon the consummation of thetransactions contemplated by the Asset Sale Agreement because Empire ispurchasing the name “ETS Payphones” as a part of the transaction and (iv) toextend the term of office of Michael H. Buck as a Class I director until thedate of the annual meeting following December 31, 2006, to extend the term ofoffice of Michael M. Scott and S. Gregory Hays as Class II directors until thedate of the annual meeting following December 31, 2007 and to extend the termof office of Guy A. Longobardo and Michael H. McClellan as Class III directorsuntil the date of the annual meeting following December 31, 2008.

 

At the Annual Meeting, the holders of a totalof 3,701,114 shares of the Company’s Common Stock, representing 74.21% of thetotal shares issued and outstanding and entitled to vote, were present inperson or by proxy at the meeting, constituting a quorum.

 

The number of votes cast for, against,abstaining or withheld for each matter are set forth below.

 

20

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***Saleof Substantially all of our Assets to Empire***

 

At the Annual Meeting, the votes cast for andagainst and those abstaining from voting with respect to the proposal toapprove the sale of substantially all of the Company’s assets to Empire are asfollows:

 
| ** ** | **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|------------|-----------|------------|-------------|------------|-------------|------------|
|       |      |       |        |       |        |       |
|       | 3,391,810 |       | 245,545     |       | 63,759      |       |

 

***Dissolutionand Winding Down of the Company’s Operations***

 

At the Annual Meeting, the votes cast for andagainst, and those abstaining from voting with respect to the proposal toapprove the Company’s dissolution and winding down of its operations are asfollows:

 
| ** ** | **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|------------|-----------|------------|-------------|------------|-------------|------------|
|       |      |       |        |       |        |       |
|       | 3,370,888 |       | 259,339     |       | 70,887      |       |

 

***Amendmentto the Certificate of Incorporation***

 

At the Annual Meeting, the votes cast for andagainst, and those abstaining from voting with respect to the proposal to amendthe Company’s Certificate of Incorporation to change the Company’s corporatename to “Payphone Wind Down Corporation” are as follows:

 
| ** ** | **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|------------|-----------|------------|-------------|------------|-------------|------------|
|       |      |       |        |       |        |       |
|       | 3,297,459 |       | 289,413     |       | 114,242     |       |

 

***Electionof Directors***

 

At the Annual Meeting, the following personsreceived the votes cast for and withheld with respect to the Election ofDirectors:

 
| ** **           | ** ** | **FOR**   | ** ** | **WITHHELD** | ** ** | ** ** | ** ** |
|----------------------|------------|-----------|------------|--------------|------------|------------|------------|
|                 |       |      |       |         |       |       |       |
| Michael H. Buck      |       | 3,385,600 |       | 315,514      |       |       |       |
|                 |       |      |       |         |       |       |       |
| S. Gregory Hays      |       | 3,386,304 |       | 314,810      |       |       |       |
|                 |       |      |       |         |       |       |       |
| Michael M. Scott     |       | 3,371,264 |       | 329,850      |       |       |       |
|                 |       |      |       |         |       |       |       |
| Guy A. Longobardo    |       | 3,368,485 |       | 332,629      |       |       |       |
|                 |       |      |       |         |       |       |       |
| Michael H. McClellan |       | 3,379,832 |       | 321,282      |       |       |       |

 

**Item 5. Compliance withSection 16(a) of the Exchange Act**

 

Section 16 of the Securities ExchangeAct requires that officers and directors of the Company, as well as thosepersons who beneficially own more than 10% of the outstanding common stock ofthe Company, file reports of security ownership and changes in such ownershipon Forms 3, 4 and 5 (and amendments thereto) with the Securities andExchange Commission within specified time periods. Based solely on a review ofcopies of such reports furnished to the Company, the Company believes thatduring the year ended December 31, 2005, such filing requirements werecomplied with by its officers, directors and applicable shareholders.

 

21

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**Other Information**

 

***Amendments to Employment Agreements forMessrs. Longobardo and McClellan and Change of Control Agreement for Mr. Jones***

 

Effective as of March 29, 2006, the Companyentered into amendments to the employment agreements of Guy Alfred Longobardoand Michael H. McClellan and into an amendment to the change in controlagreement of David C. Jones, pursuant to which, among other things, the annualbase salary and the severance payments due upon the occurrence of a change ofcontrol in the Company contained in each of the agreements were amended toensure that Messrs. Longobardo, McClellan and Jones would continue to serve theCompany in order to help effectuate the closing of the Asset Sale Agreementand, to the extent necessary, the dissolution and winding down of the Company. Amongother things, the amendments changed the severance payments payable upon changeof control of the Company under the employment agreements and change of controlagreement, to incentive payments payable upon the earlier of May 16, 2006 or 60days following the closing of the Asset Sale Agreement. In addition, theamendments provide that the annual base salary for each of Messrs. Longobardo,McClellan and Jones will be reduced to one-half of the annual base salary ineffect immediately prior to the date of the payment of the incentive payments,effective upon the date of the payment of such incentive payments.

 

Pursuant to the amendment to Mr. Longobardo’semployment agreement, the severance payment previously due to Mr. Longobardounder his employment agreement was changed to an incentive payment of $180,000and, effective on the date of the payment of the incentive payment, his annualbase salary will be reduced from $240,000 to $120,000. Pursuant to theamendment to Mr. McClellan’s employment agreement, the severance paymentpreviously due to Mr. McClellan under his employment agreement was changed toan incentive payment of $165,000 and, effective on the date of the payment ofthe incentive payment, his annual base salary will be reduced from $165,000 to$82,500. Pursuant to the amendment to Mr. Jones’ change of control agreement,the severance payment previously due to Mr. Jones under his change of controlagreement was changed to an incentive payment of $60,000 and, effective on thedate of the payment of the incentive payment, his annual base salary will bereduced from $120,000 to $60,000.

 

This brief description of the amendments setforth above is not intended to be complete and is qualified in its entirety byreference to the full text of the amendments which are annexed hereto asExhibits 10.4.3, 10.5.2 and 10.7.1 and incorporated herein by reference.

 

***Amendmentto Employment Agreement for Mr. Fennell***

 

The Company and Jeffrey E. Fennell enteredinto an amendment to Mr. Fennell’s January 28, 2005 employment agreement,effective as of April 1,2006, pursuant to which Mr. Fennell will receivemonthly payments of $1,560.73 (less applicable state and federal individualtaxes as well as any taxes required to be paid by the Company in respect ofsuch payment) for a period of one year from the termination of Mr. Fennell’semployment instead of continuing to receive health insurance coverage forhimself and his dependents for a year following termination. In addition, Mr.Fennell agreed to waive election of continuation of coverage for Mr. Fennelland his dependents under COBRA under the Company’s medical insurance planfollowing termination of his employment.

 

This brief description of the amendment setforth above is not intended to be complete and is qualified in its entirety byreference to the full text of the amendment which is annexed hereto as Exhibit10.6.1 and incorporated herein by reference.

 

***Resignationsof Messrs. Scott, Hays and Fennell***

 

Effective as of March 30, 2006, each ofMichael M. Scott and S. Gregory Hays resigned as a member of the Board ofDirectors. Effective as of March 31, 2006, Jeffrey E. Fennell resigned as theCompany’s Senior Vice President and Chief Operating Officer.

 

***BankruptcyCase***

 

On March 29, 2006 a final decree was enteredclosing the bankruptcy cases.

 

22

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**PARTF/S**

**TABLE OF CONTENTS**

 
| ** **                                              | **Page(s)** |
|---------------------------------------------------------|-------------|
| Report of Independent Registered Public Accounting Firm | 24          |
| Balance  Sheet                                          | 25          |
| Statements  of Operations                               | 26          |
| Statements of Shareholders’ Equity                 | 27          |
| Statements  of Cash Flows                               | 28          |
| Notes to Financial Statements                           | 29 - 37     |

 

23

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**Report of Independent Registered PublicAccounting Firm**

 

**To the Board of Directors and Shareholders**

 

**ETS Payphones, Inc.**

 

We have audited the accompanying balancesheet of ETS Payphones, Inc. (the “Company”) as of December 31, 2005,and the related statements of operations, shareholders’ equity, and cash flowsfor the years ended December 31, 2005 and 2004. These financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform an audit of internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statementsreferred to above present fairly, in all material respects, the financialposition of ETS Payphones, Inc. as of December 31, 2005, and theresults of its operations and its cash flows for the years endedDecember 31, 2005 and 2004 in conformity with accounting principlesgenerally accepted in the United States of America.

 

The accompanying financial statements havebeen prepared assuming that the Company will continue as a going concern. Asdiscussed in Note A, on February 15, 2006, the Company’s shareholders approvedthe sale of substantially all of the assets of the Company and approved theliquidation and dissolution of the Company following the closing of the sale. Asa result, the Company has changed its basis of accounting to the liquidationbasis as of February 15, 2006 on a go forward basis.

 
| /s/ TAUBER & BALSER, P. C. |   |
|--------------------------------|--------|
| Atlanta, Georgia               |
| February 17, 2006         |

 

24

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**ETSPAYPHONES, INC.**

 

**BALANCE SHEET**

 

**DECEMBER 31,2005**

 
| **ASSETS**                                                                                                      |   |       |      |
|-----------------------------------------------------------------------------------------------------------------|--------|------------|-----------|
| CURRENT ASSETS                                                                                                  |   |       |      |
| Cash                                                                                                            |   | $          | 1,835,616 |   |
| Cash, restricted                                                                                                |   | 351,770    |      |
| Accounts receivable                                                                                             |   | 2,271,323  |      |
| Inventories                                                                                                     |   | 398,443    |      |
| Prepaid expenses                                                                                                |   | 50,131     |      |
| TOTAL CURRENT ASSETS                                                                                            |   | 4,907,283  |      |
| FIXED ASSETS                                                                                                    |   |       |      |
| Payphones                                                                                                       |   | 4,843,504  |      |
| Property and Equipment                                                                                          |   | 1,377,492  |      |
|                                                                                                            |   | 6,220,996  |      |
| Accumulated Depreciation                                                                                        |   | (3,149,173 | )         |
|                                                                                                            |   | 3,071,823  |      |
| OTHER ASSETS                                                                                                    |   |       |      |
| Deposits                                                                                                        |   | 175,743    |      |
|                                                                                                            |   | 175,743    |      |
| TOTAL ASSETS                                                                                                    |   | $          | 8,154,849 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                  |   |       |      |
| CURRENT LIABILITIES                                                                                             |   |       |      |
| Advance on sale of business                                                                                     |   | $          | 382,143   |   |
| Accounts payable                                                                                                |   | 1,014,732  |      |
| Accrued expenses                                                                                                |   | 3,886,024  |      |
| Accrued property, excise and sales taxes                                                                        |   | 142,637    |      |
| 401K payable                                                                                                    |   | 8,741      |      |
| TOTAL CURRENT LIABILITIES                                                                                       |   | 5,434,277  |      |
| NON-CURRENT LIABILITIES                                                                                         |   |       |      |
| Accrued property, excise and sales taxes                                                                        |   | 157,383    |      |
| SHAREHOLDERS’ EQUITY                                                                                       |   |       |      |
| Common Stock, par value $.0001 per share;  authorized 6,000,000 shares; 4,987,624 shares issued and outstanding |   | 499        |      |
| Additional paid in capital                                                                                      |   | 11,432,656 |      |
| Accumulated deficit                                                                                             |   | (8,869,966 | )         |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                 |   | 2,563,189  |      |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                 |   | $          | 8,154,849 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

25

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**ETSPAYPHONES, INC.**

 

**STATEMENTS OF OPERATIONS**

 

**FOR THE YEARS ENDEDDECEMBER 31, 2005 AND 2004**

 
| ** **                                                  | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------|------------|
| REVENUE                                                     |       |       |       |       |       |
| Coin Calls                                                  |       | $          | 10,749,793 |       | $          | 14,209,407 |   |
| Non-coin calls                                              |       | 4,990,470  |       | 5,165,194  |       |
| Other payphone revenue                                      |       | 768,958    |       | 768,318    |       |
| Total Revenue                                               |       | 16,509,221 |       | 20,142,919 |       |
| OPERATING EXPENSES                                          |       |       |       |       |       |
| Telephone charges                                           |       | 5,421,121  |       | 6,304,830  |       |
| Commissions                                                 |       | 4,463,135  |       | 5,677,718  |       |
| Service, maintenance and network Costs                      |       | 5,143,571  |       | 6,342,634  |       |
| Depreciation and amortization                          |       | 1,035,827  |       | 1,374,197  |       |
| Selling, general and administrative                         |       | 5,081,151  |       | 5,152,873  |       |
| Impairment of goodwill, intangible assets  and fixed assets |       | —     |       | 1,294,795  |       |
| Total operating expenses                                    |       | 21,144,805 |       | 26,147,047 |       |
| Loss from Operations                                        |       | (4,635,584 | )          | (6,004,128 | )          |
| OTHER INCOME (EXPENSE)                                      |       |       |       |       |       |
| Interest income (expense)                                   |       | 13,882     |       | (2,136     | )          |
| Reorganization income (expense)                             |       | 411,336    |       | (169,391   | )          |
| Other income                                                |       | 2,547,957  |       | 1,915,616  |       |
| Gain (loss) on asset sales                                  |       | 654,179    |       | (2,755     | )          |
| Total other income, net                                     |       | 3,627,354  |       | 1,741,334  |       |
| NET LOSS                                                    |       | $          | (1,008,230 | )          | $          | (4,262,794 | ) |
| Basic and diluted net loss per common share                 |       | $          | (0.20      | )          | $          | (0.85 | ) |
| Weighted average number of common shares  outstanding       |       | 4,987,624  |       | 4,986,533  |       |

 

The accompanying notes are anintegral part of these financial statements.

 

26

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**ETSPAYPHONES, INC.**

 

**STATEMENTS OF SHAREHOLDERS’ EQUITY**

 

**FOR THE YEARS ENDEDDECEMBER 31, 2005 AND 2004**

 
| ** **                            | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in-Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total**  | ** ** |
|---------------------------------------|------------|--------------------|------------|-------------------|------------|---------------------------------|------------|--------------------------|------------|------------|------------|
| **Balance at December 31, 2003** |       | 4,985,826          |       | $                 | 499        |                            | $          | 11,573,007               |       | $          | (3,598,942 | ) | $ | 7,974,564 |   |
| Net loss                              |       | —             |       | —            |       | —                          |       | (4,262,794               | )          | (4,262,794 | )          |
| Organizational costs                  |       | —             |       | —            |       | (140,351                        | )          | —                   |       | (140,351   | )          |
| Stock Issuance                        |       | 1,798              |       | —            |       | —                          |       | —                   |       | —     |       |
| **Balance at December 31, 2004** |       | 4,987,624          |       | 499               |       | 11,432,656                      |       | (7,861,736               | )          | 3,571,419  |       |
| Net loss                              |       | —             |       | —            |       | —                          |       | (1,008.230               | )          | (1,008.230 | )          |
| **Balance at December 31, 2005** |       | 4,987,624          |       | $                 | 499        |                            | $          | 11,432,656               |       | $          | (8,869,966 | ) | $ | 2,563,189 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

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**ETSPAYPHONES, INC.**

 

**STATEMENTS OF CASH FLOWS**

 

**FOR THE YEARS ENDEDDECEMBER 31, 2005 AND 2004**

 
| ** **                                                                   | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Operating Activities                                                         |       |      |       |      |       |
| Net loss                                                                     |       | $         | (1,008,230 | )         | $          | (4,262,794 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |      |       |      |       |
| Depreciation expense                                                         |       | 1,035,827 |       | 1,136,634 |       |
| Amortization expense                                                         |       | —    |       | 237,562   |       |
| (Gain) Loss on asset sales                                                   |       | (654,179  | )          | 2,755     |       |
| Impairment of goodwill, intangible assets  and fixed assets                  |       | —    |       | 1,294,796 |       |
| Decrease in restricted cash balance, net                                     |       | 479,629   |       | 503,794   |       |
| Decrease in accounts receivable                                              |       | 282,544   |       | 653,181   |       |
| Decrease in inventories                                                      |       | 77,842    |       | 51,611    |       |
| Decrease in prepaid expenses                                                 |       | 20,011    |       | 45,042    |       |
| Decrease in accounts payable                                                 |       | (181,653  | )          | (473,973  | )          |
| Decrease in tax liabilities                                                  |       | (818,151  | )          | (131,900  | )          |
| Increase in accrued expenses                                                 |       | 214,592   |       | 861,935   |       |
| (Increase) Decrease in deposits                                              |       | (19,666   | )          | 18,268    |       |
| Total Adjustments                                                            |       | 436,796   |       | 4,199,705 |       |
| Net cash (used) in operating activities                                      |       | (571,434  | )          | (63,089   | )          |
| Investing Activities                                                         |       |      |       |      |       |
| Purchase of fixed assets                                                     |       | (23,221   | )          | (63,621   | )          |
| Proceeds from sale of fixed assets                                           |       | 503,129   |       | 17,315    |       |
| Advance on sale of business                                                  |       | 382,143   |       | —    |       |
| Net cash (used by) provided by investing  activities                         |       | 862,051   |       | (46,306   | )          |
| Financing Activities                                                         |       |      |       |      |       |
| Organizational costs                                                         |       | —    |       | (140,351  | )          |
| Net increase (decrease) in cash                                              |       | 290,617   |       | (249,746  | )          |
| Cash—Beginning of Year                                                  |       | 1,544,999 |       | 1,794,745 |       |
| Cash—End of Year                                                        |       | $         | 1,835,616  |      | $          | 1,544,999 |   |
| Supplemental Disclosure of Cash Flow Information                             |       |      |       |      |       |
| Cash paid for interest                                                       |       | $         | 2,128      |      | $          | 2,473 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

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**ETSPAYPHONES, INC.**

 

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE A—NATURE OF BUSINESS AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

***Organization and Nature of Business***

 

ETS Payphones, Inc. (“ETS” or the “Company”)is a Delaware corporation that operates, services, and maintains a system ofpayphones. ETS is one of the largest independent payphone operators in theUnited States, currently managing approximately 13,000 payphones from fourbranch offices handling 32 states, Washington D.C., and Puerto Rico. ETSemployed 79 people at December 31, 2005.

 

On September 11, 2000, ETS filedvoluntary petitions for relief under Chapter 11 of the Bankruptcy Code. ETScontinued to operate as debtor-in-possession subject to the jurisdiction of theBankruptcy Court for the District of Delaware. On November 14, 2001, theJoint Reorganization Plan was approved by the Court. On December 5, 2002,the “Reorganization Date” or “Effective Date”, all conditions necessary for theapproval of the Joint Reorganization Plan had occurred and the Debtors and theCommittee of Unsecured Creditors declared the Joint Reorganization Planeffective.

 

The Company reflected the terms of the JointReorganization Plan in its 2002 financial statements by adopting the fresh-startaccounting provisions of SOP 90-7 (American Institute of Certified PublicAccountants Statement of Position 90-7, “Financial Reporting by Entitiesin Reorganization Under the Bankruptcy Code”).

 

***Sale of the Company; Winding Down ofOperations***

 

As we reported in the Form 8-K filed November7, 2005 (the “November 7 Form 8-K”) and the Definitive Proxy Statement filed onJanuary 4, 2006 (the “Definitive Proxy Statement”), the Company entered into anAsset Sale Agreement dated November 1, 2005 (the “Asset Sale Agreement”), andrelated agreements including a security agreement and a promissory note to sellsubstantially all of its operating assets to Empire Payphones, Inc. (“Empire”).In addition as reported on the November 7 Form 8-K and the Definitive ProxyStatement, the Company also entered into a Management Services Agreementeffective November 1, 2005 (“Management Services Agreement”), with Empire inwhich Empire will provide management services and fund the operational lossesof ETS pending consummation of the sale transaction. A summary description ofthe transactions is below. The description below is qualified in its entiretyby the more detailed description in the November 7 Form 8-K and the DefinitiveProxy Statement and to the exhibits therein, which are incorporated herein byreference.

 

***Asset Sale Agreement***

 

Pursuant to the Asset Sale Agreement, theCompany has agreed to sell substantially all of its assets used in its payphonebusiness to Empire. Under the Asset Sale Agreement, the purchase priceaggregates $4.5 million and will be paid in installments, some prior to theconsummation of the transaction, as follows: (i) $250,000 in cash on November1, 2005, (ii) payment of certain commissions under assigned contracts not toexceed $2.4 million in the aggregate and (iii) $1.85 million in cash, payablein monthly installments of $132,143 commencing December 1, 2005, with anyremaining balance being paid at the closing of the transaction. At November 1,2005, the carrying value of ETS’ operating assets, consisting primarily offixed assets and inventories, was approximately $3.5 million.

 

The closing of the Asset Sale Agreement issubject to a number of conditions, including approval by the stockholders ofETS of the Asset Sale Agreement, as well as compliance with regulatoryrequirements. The Asset Sale Agreement also includes termination provisionsthat may require ETS to repay certain amounts paid by Empire under thisagreement and the Management Services Agreement discussed below.

 

***Management Services Agreement***

 

In order to provide for the funding ofoperational losses of ETS’ payphone business pending consummation of the AssetSale Agreement, ETS and Empire entered into the Management Services Agreement. Underthe Management Services Agreement, Empire will provide to ETS managementservices and fund operational losses of the payphone business of ETS, subjectto the oversight of the Board of Directors of ETS. In consideration for itsmanagement services and the use by ETS of Empire’s affiliates’ resources,Empire shall be entitled to receive a management fee calculated at the end ofthe initial term of the Management Services Agreement and at the end of anyrenewal term in the amount of the first $400,000 of excess 

 

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revenue, after repayment of, among otheramounts, all expenses of operation and any advances made by Empire to fundoperational losses plus 50% of any excess revenue above $400,000. ETS shallreceive the remaining 50% of excess revenue above $400,000. For use of Empire’saffiliates’ resources during the term of the Management Agreement, theaffiliates shall receive a monthly resource fee of $92,000 ($184,000 in 2005).

 

The Management Services Agreement has aninitial term of two years and will be automatically extended for successiveperiods of one year unless Empire provides notice prior to the end of any termthat the agreement will terminate at the end of such term. The ManagementServices Agreement is also subject to other termination provisions, whichincludes the consummation of the Asset Sale Agreement detailed above. If theManagement Services Agreement is terminated other than upon the consummation ofthe Asset Sale Agreement, ETS will be required to repay certain amounts paid byEmpire under the Management Services Agreement.

 

***StockholderApproval***

 

At the Annual Meeting of Stockholders held onFebruary 15, 2006, the Company’s shareholders approved the sale ofsubstantially all of the assets of the Company and approved the liquidation anddissolution of the Company following the closing of the sale. As a result, theCompany has changed its basis of accounting to the liquidation basis as ofFebruary 15, 2006 on a go forward basis.

 

***Cash and Cash Concentration***

 

The cash balance of $1,835,616 is notrestricted and is available for normal Company operations.

 

The restricted cash balance of $351,770consists of funds restricted per the Joint Reorganization Plan for payment tocreditors. Payments to unsecured creditors were made during 2004 through 2006.The Company also acted as Disbursing Agent for the Litigation Trust, which madepayments to both unsecured creditors and ETS shareholders in 2004. TheLitigation Trust disbursement was still in process as of the end of 2004, andcontinued into early 2005. The establishment and activities of the LitigationTrust are more fully described in the Company’s 2003 Form 10-SB filing and2004 Form 10-KSB filing.

 

The Company maintains its cash balances inseveral financial institutions. These balances, at times, may exceed federallyinsured limits. At December 31, 2005, the Company exceeded the insuredFDIC limit by approximately $1,643,000 at one of these financial institutions.The Company believes no significant concentration of credit risk exists withrespect to these cash holdings.

 

***Accounts Receivable***

 

Accounts receivable are reported at the amountmanagement expects to collect on balances outstanding at year-end. The amountof the accounting loss that the Company is at risk for these unsecured accountsreceivable is limited to their carrying value, which was $2,271,323 atDecember 31, 2005. Uncollectible receivables are written off based on theCompany’s experience with collections. The Company no longer carries anallowance for doubtful accounts.

 

***Fair Value of Financial Instruments***

 

The carryingamount of the Company’s financial instruments included in assets andliabilities approximates fair value due to their short-term nature. The fairvalue of the Empire receivable (see Note B) is estimated by discountingexpected future cash flows using current interest rates at which similar loanswould be made to borrowers with similar credit ratings and remaining maturities.As of December 31, 2005, the fair value of the Empire receivable approximatedthe carrying value.

 

***Revenue Recognition***

 

The Company derives its revenues from twoprincipal sources: coin calls and non-coin calls. Coin calls represent callspaid for by callers with coins deposited into the payphone. Coin call revenuesare recorded in the amount of coins deposited in the payphones and in theperiod deposited. Revenue from non-coin calls, which includes dial-aroundcompensation, is discussed in Note B, as are other non-coin revenue items.

 

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***Inventories***

 

Inventories are valued at the lower of costor market, determined on a first-in, first-out basis. Inventories consist ofpayphones held for future installations and repair parts held to repair phoneson an as needed basis. Inventories are not held for resale purposes.Inventories consist of the following at December 31, 2005.

 
| Repair parts |   | $      | 325,987 |   |
|--------------|--------|--------|---------|--------|
| Payphones    |   | 72,456 |    |
|         |   | $      | 398,443 |   |

 

***Fixed Assets***

 

Payphones, property and equipment are carriedat cost, which at December 31, 2005 represents the fair value of theassets as determined by appraisal on the Reorganization Date, plus the cost ofsubsequent purchases, less an impairment adjustment in 2004. Depreciation iscomputed using the straight-line method over the estimated useful lives of theassets, generally three to twelve years. Expenditures for additions andimprovements are capitalized, while repairs and maintenance costs are expensedas incurred.

 

***Site Licenses***

 

Site licenses were recorded at the appraisedvalue as of the Effective Date. These assets were amortized on a straight-linebasis over their estimated useful lives of ten years. As of the Effective Datethere were approximately six years remaining on the lives of these sitelicenses. The remaining balance was impaired in 2004 and was written off.

 

***Impairment of Long-Lived Assets***

 

The Companyreviewed goodwill at least annually, and also reviewed goodwill, site licenses,and reviews fixed assets for possible impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable.

 

Goodwill represented the portion ofreorganization value of the Company at December 31, 2002, that could notbe attributable to specific tangible or identified intangible assets recordedin connection with fresh-start accounting. In accordance with Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets” (“SFAS 142”), goodwill was not amortized, but was reviewed forpossible impairment at least annually or more frequently upon the occurrence ofan event or when circumstances indicate that its carrying amount is greater thanits fair value. The goodwill balance was deemed to be impaired and written offin 2004.

 

The Company also reviews long-lived assetsfor possible impairment when events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable. In accordance withStatement of Financial Accounting Standards No. 144, “Accounting for theImpairment of Long-Lived Assets” (“SFAS 144”) the Company reviewed andtested fixed assets for possible impairment as of December 31, 2005 and2004. In accordance with the provisions of SFAS 142 and SFAS 144 itwas determined that goodwill, site licenses, and fixed assets were impaired asof December 31, 2004, based on impairment tests performed by the Company.See Notes C and D.

 

***Income Taxes***

 

The Company recognizes deferred tax assetsand liabilities for the expected future tax consequences of events that havebeen included in the financial statements or tax returns. Under this method,deferred tax assets resulting from net operating loss carryforwards arecalculated using enacted tax rates. Net deferred tax assets are reduced by avaluation allowance when appropriate. Deferred tax assets and liabilities areadjusted for the effects of changes in tax laws and rates on the date ofenactment.

 

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***Use of Estimates***

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe balance sheet and the reported revenues and expenses during the year.Accordingly, actual results could differ from those estimates.

 

Significant estimates are used in preparingthese financial statements. It is at least reasonably possible that thesesignificant estimates used will change within the next year.

 

***Net Loss Per Common Share***

 

Basic loss per share is computed based on netloss divided by the weighted average number of common shares outstanding duringthe year. There were no potential common share equivalents outstanding during2005 and 2004; therefore the diluted loss per common share is the same as thebasic loss per common share.

 

**NOTE B—ACCOUNTS RECEIVABLE AND DIAL-AROUNDCOMPENSATION**

 

Accountsreceivable are composed of four types: Dial-around compensation (“DAC”),Operator Service Provider (“OSP”), Semi-public (“Semi-pub”), and Empire. DAC ispayment from long distance carriers for calls made from ETS’ payphones.Dial-around services such as pre-paid calling cards, 1-800-Collect, and1-800-CALLATT, are more frequently used at payphones than in the past. Theproliferation in dial-around services is perhaps most plainly evidenced by thefact that entirely new “toll-free” prefixes were needed along with the 101XXXXaccess numbers that are used by the interexchange carriers (“IXCs”). DAC, whichtypically comprises about 20% of ETS’ revenue, is estimated based on historicalvalues. The majority of DAC payments are issued quarterly through several mainclearinghouses that specialize in processing DAC data.

 

OSP revenue is commission-based payment fromproviders of operator-assisted calls. These providers assume responsibility fortracking, rating, billing, and collecting the revenue related to these callsand remit a percentage of the gross proceeds to the Company in the form of acommission payment. OSP payments are typically made semi-monthly. Receivablesfor the current month are based on projected results after the first severalweeks’ actual information has been obtained.

 

Semi-pub revenue is obtained from customerswhose call volume would not support a normal ETS installation. The customer iswilling to pay a monthly fee to the Company for the convenience of having apayphone on their premises (accommodation of clientele, employees, etc.).

 

Empire receivable is the amount outstandingfor the June 30, 2005 sale of the Northeast business (New York, New Jersey,Massachusetts and Connecticut) to Empire Payphones, Inc. The balance atDecember 31, 2005 of $598,405 is scheduled to be paid in full by December 31,2006.

 

A detail of the accounts receivable balanceat December 31 is as follows:

 
| ** **        | ** ** | **2005** | ** ** |
|-------------------|------------|----------|------------|
| Dial around calls |       | $        | 1,574,706  |   |
| Empire            |       | 598,405  |       |
| OSP               |       | 42,782   |       |
| Other receivables |       | 55,430   |       |
| Total receivables |       | $        | 2,271,323  |   |

 

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**NOTE C—FIXED ASSETS**

 

Fixed assets are summarized as follows atDecember 31, 2005.

 
| ** **                        | ** ** | **Range of  useful lives** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|------------|------------|
| Payphones in service              |       | 6-10 years                      |       | $          | 4,843,504  |   |
| Furniture, fixtures and equipment |       | 5 years                         |       | 152,447    |       |
| Leasehold improvements            |       | 12 years                        |       | 540,000    |       |
| Computer equipment and software   |       | 3 years                         |       | 685,045    |       |
|                              |       |                                 |       | 6,220,996  |       |
| Less: Accumulated depreciation    |       |                                 |       | (3,149,173 | )          |
| Fixed assets, net                 |       |                                 |       | $          | 3,071,823  |   |

 

Depreciation expense for the years endedDecember 31, 2005 and 2004 was $1,035,827 and $1,136,635, respectively. Animpairment adjustment of $153,246 reduced payphones in service in 2004.

 

**NOTE D—GOODWILL AND SITE LICENSES**

 
| ** **    | ** ** | **December 31, 2004** | ** ** |
|---------------|------------|---------------------------------|------------|
| ** **    | ** ** | **Gross  value**                | ** ** | **Impairment  losses** | ** ** | **Accumulated  amortization** | ** ** | **Net  carrying  value** | ** ** |
| Goodwill      |       | $                               | 176,483    |   | $ | (176,483 | ) | $ | — |   | $ | — |   |
| Site Licenses |       | 1,516,453                       |       | (965,067 | ) | (551,386 | ) | — |   |
| Total         |       | $                               | 1,692,936  |   | $ | (1,141,550 | ) | $ | (551,386 | ) | $ | — |   |

 

During 2003, amounts estimated as prepetitionliabilities (accrued commissions) were reconciled and the over accruedliability of $339,768 was adjusted by reducing goodwill. As noted previously inNote A, the goodwill balance was written off in 2004 as a result of theCompany’s annual impairment testing as required by SFAS 142.

 

During 2004, phones were removed fromapproximately 2,100 licensed sites. The related carrying value of site licensesfor these phones was written off. Amortization expense associated with sitelicenses for the years ended December 31, 2004 and 2003 was $237,562 and$290,980, respectively. As a result of the impairment testing of fixed assetsas described in Note A, the site licenses were written off in 2004.

 

**NOTE E—FRESH-START ACCOUNTING ANDREORGANIZATION**

 

As previously discussed, the Company adoptedthe provisions of fresh-start accounting as of December 5, 2002. Inadopting fresh-start accounting, the Company engaged an independent financialvaluation analyst to assist in the determination of the reorganization value orfair value of the entity.

 

***Plan of Reorganization***

 

OnSeptember 11, 2000, ETS filed voluntary petitions for relief underChapter 11 of the Bankruptcy Code. ETS continued to operate asdebtor-in-possession subject to the jurisdiction of the U.S Bankruptcy Courtfor the District of Delaware. On November 14, 2001, the JointReorganization Plan was approved by the Court. On December 5, 2002, allconditions necessary for the approval of the Joint Reorganization Plan hadoccurred and the Debtors and the Committee of Unsecured Creditors declared theJoint Plan effective. The Joint Reorganization Plan represents a consensualarrangement between the Committee of Unsecured Creditors, Debtors and ETS.

 

Pursuant to the Joint Reorganization Plan,the various debtor corporations were merged into a single corporation, ETSPayphones, Inc., incorporated in Delaware on November 8, 2002. TheJoint Reorganization Plan provides that each holder of an allowed PayphoneInvestor Claim shall receive shares of common stock in the Company in fullsatisfaction, 

 

33

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settlement, release and discharge of and inexchange for such claim. The number of shares issued has been calculatedaccording to the Payphone Investor Claims Formula provided in the JointReorganization Plan.

 

In settlement of a Declaratory Judgmentaction brought by ETS, holders of payphone investor claims in the amount of$375,000,000 agreed to exchange their investment for equity as shareholders inthe Company. Equity was issued in the amount of 4,985,826 shares, based upon aformula approved by the Bankruptcy Court.

 

A Litigation Trust was created on theEffective Date for the benefit of General Unsecured Claims and PayphoneInvestor Claims. The Litigation Trust is administered by a trustee selected bythe Creditors’ Committee. The Litigation Trust will be funded with property andproceeds of all claims and causes of action of ETS or the Creditors’ Committeeexisting as of the Petition Date against Charles Edwards, the former CEO of theCompany, various insiders, and others as described more fully in the JointReorganization Plan. The trustee will make distributions as and when fundsbecome available and at the trustee’s sole discretion. In 2004 the firstdistribution to Trust beneficiaries was initiated.

 

Income and expenses resulting from thereorganization are reported separately as reorganization income (expenses) inthe Statement of Operations. For the years ended December 31, 2005 and 2004,income and (expenses) directly associated with the Chapter 11 bankruptcyproceedings were $411,336 and $(169,391), respectively. These reorganizationexpenses consisted mainly of professional fees for legal, advisory, andadministrative services; 2005 reflects a credit due to settlement of litigationwith Puerto Rico Telephone Company.

 

Payments of restricted cash made by theCompany resulting from the plan for the year-ended December 31, 2005 areas follows:

 
| Restricted Cash—December 31, 2004 |   | $       | 831,399 |   |
|---------------------------------------------|--------|---------|---------|--------|
| Interest earned                             |   | 2,726   |    |
| Total restricted cash                       |   | 834,125 |    |
|                                        |   |    |    |
| Cash Disbursements:                         |   |    |    |
| Pre-Petition taxes paid                     |   | 75,000  |    |
| Claims paid                                 |   | 11,557  |    |
| Litigation Trust distributions              |   | 395,798 |    |
| Total cash disbursements                    |   | 482,355 |    |
| Restricted Cash—December 31, 2005 |   | $       | 351,770 |   |

 

**NOTE F—RETIREMENT PLAN**

 

The Company had a 401k plan through December31, 2005, that covered all employees who had attained certain servicerequirements as specified in the plan. The total Company contribution to theplan for the years ended December 31, 2005 and 2004 was $96,158 and$89,507, respectively. In contemplation of the consummation of the Asset SaleAgreement between the Company and Empire Payphones, Inc., the 401k plan wasterminated effective as of December 31, 2005.

 

**NOTE G—INCOME TAXES**

 

The effective tax rate varies from themaximum federal statutory rate as a result of the following items for the yearsended December 31, 2005 and 2004:

 
| ** **                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|
| Tax benefit computed at the maximum federal  statutory rate |       | (34.0    | )%         | (34.0    | )%         |
| Decrease in tax benefit resulting from:                     |       |     |       |     |       |
| Depreciation                                                |       | 32.8     |       | 9.0      |       |
| Amortization                                                |       | —   |       | 1.2      |       |
| Intangible asset impairment                                 |       | —   |       | 10.3     |       |
| Non-deductible reorganization costs                         |       | 1.4      |       | 1.3      |       |
| Sale of payphone assets                                     |       | 14.7     |       | —   |       |
| Bankruptcy related settlements                              |       | (21.3    | )          | —   |       |
| Increase in valuation allowance                             |       | 6.4      |       | 12.2     |       |
| Effective income tax rate                                   |       | 0.0      | %          | 0.0      | %          |

 

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Net deferred taxes consist of the followingcomponents as of December 31, 2005:

 

Deferred Tax assets:

 
| Net operating loss carryforwards |   | $          | 1,210,639 |   |
|----------------------------------|--------|------------|-----------|--------|
| Less valuation allowance         |   | (1,210,639 | )         |
|                             |   | $          | —    |   |

 

A valuation allowance has been recognized tooffset the entire net deferred tax asset due to the uncertainty of realizingthe benefit of the net deferred tax asset. The Company has available netoperating loss carryforwards totaling approximately $3.56 million thatexpire in various periods through 2025.

 

The Company realized substantial cancellationof debt, or “COD,” income as a result of the implementation of the JointReorganization Plan. Because the Company was a debtor in a bankruptcy case atthe time it realized the COD income, it is not required to include such CODincome in its taxable income for federal income tax purposes. Instead, theCompany will be required to reduce certain of its tax attributes by the amountof COD income so excluded. All of the Company’s net operating losscarryforwards related to activities before it emerged from bankruptcy wereeliminated in 2003. Certain of its other tax attributes will be reduced oreliminated as a result of COD income being excluded pursuant to the JointReorganization Plan.

 

**NOTE H—COMMITMENTS AND CONTINGENCIES**

 

***Operating leases***

 

The Company has entered into variousoperating leases for its corporate headquarters and warehouses, expiring atvarious dates through August 2009. Rent expense for the years endedDecember 31, 2005 and 2004 was $321,654 and $435,129, respectively.

 

Minimum future lease payments for the yearsending December 31 are as follows:

 
| 2006   |   | $       | 310,138 |   |
|--------|--------|---------|---------|--------|
| 2007   |   | 268,744 |    |
| 2008   |   | 260,763 |    |
| 2009   |   | 138,822 |    |
|   |   | $       | 978,467 |   |

***Litigation***

 

From time to time, the Company is a party tolitigation arising in the normal course of its business operations. In theopinion of management, after consulting with legal counsel, it is notanticipated that the matters will have a material adverse impact on the Company’sfinancial condition, liquidity or results of operations.

 

**NOTE I—OTHER INCOME**

 

Other Income for the years endedDecember 31 is as follows:

 
| ** **                                      | ** ** | **2005**  | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|-----------|------------|----------|------------|
| Dial Around True-Up Settlements                 |       | $         | 554,889    |     | $          | 402,730 |   |
| Legal settlements                               |       | 1,531,440 |       | 583,999  |       |
| MCI/Worldcom bankruptcy dial around  settlement |       | 276,626   |       | 807,285  |       |
| Other Income, net                               |       | 185,002   |       | 121,602  |       |
| Total                                           |       | $         | 2,547,957  |     | $          | 1,915,616 |   |

 

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These Other Income items not explainedpreviously or otherwise self-explanatory are as follows:

 

*Dial Around True-Up Settlements*  Certain DAC true-up payments have beenreceived and recorded as Other Income in 2005 and 2004. These payments aregenerally not accrued for since the amounts and time of payment are usuallyunknown. These payments are the results of past activity on Company payphonesthat was not reimbursed within the normal payment processing time. Thesepayments usually cover a period of time over a year or more after the time theactual calls were made.

 

*Legal Settlements*  This relates to funds received in respect ofDAC for phones acquired prior to bankruptcy; funds received in respect of carrierover charges paid in prior years; discharge of liability with regard to a NewYork regulatory authority stipulation agreement; funds received in connectionwith employee related fraud recovery.

 

*MCI/Worldcom Bankruptcy Dial Around Settlement*  These are payments received for dial aroundrevenue paid as a result of the MCI bankruptcy settlement for years prior to2003. These payments are cents on the dollar payments on the total amountsearned during the time period prior to MCI filing bankruptcy.

 

**NOTE J—SALE OF PAYPHONE ASSETS**

 

On June 30, 2005 the Company sold to anindependent third party substantially all of its payphones located in thestates of New York, New Jersey, Massachusetts, and Connecticut. This sale wasmade to Empire Payphones, Inc. The sale terms were such that the Companyreceived $200,000 in cash upon contract signing by both parties and willreceive future payments of $750,000 in total. The gain from this sale iscalculated as follows:

 
| Total sale price, $200,000 cash; $750,000  receivable; $145,849 liabilities assumed |                                                           | $      | 1,095,849 |   |
|-------------------------------------------------------------------------------------|----------------------------------------------------------------|--------|-----------|--------|
| Less:                                                                               | Imputed interest on $750,000 receivable                        |   | (29,567   | )      |
|                                                                                | $783,252 book value less accumulated  depreciation of $351,681 |   | (431,571  | )      |
|                                                                                | Parts inventory transferred to buyer                           |   | (12,798   | )      |
|                                                                                | Coin in phones collections not paid to ETS                     |   | (4,184    | )      |
| Gain on Sale                                                                        |                                                           | $      | 617,729   |   |

 

**NOTE K – SUBSEQUENT EVENTS**

 

***Stockholder Approval; Winding Down ofOperations***

 

Pursuant to the Annual Meeting ofStockholders held February 15, 2006, the stockholders of the Company approved,among other things, the sale of substantially all of our assets to Empirepursuant to the Asset Sale Agreement and the winding down of our operationsfollowing the sale of substantially all of our assets to Empire. Following theconsummation of the Asset Sale Agreement, it is the intention of the Board ofDirectors to dissolve the Company in accordance with applicable laws and todistribute any proceeds remaining after such dissolution to its stockholders. Uponconsummation of the Asset 

 

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Sale Agreement, the Company intends to file acertificate of dissolution with the Secretary of State of Delaware and closethe stock transfer books to discontinue recording transfers of our common stockat the close of business on the date we file the certificate of dissolutionwith the Secretary of State of Delaware.

 

After consummation of the Asset SaleAgreement our activities will be limited to collecting proceeds from assets notincluded in the sale, paying off creditors, performing requirements underapplicable law and distributing any remaining proceeds to stockholders. As aresult of contingent or unmature liabilities that may materialize or mature,dissolution and liquidation may not create value to our stockholders or resultin any remaining capital for distribution to our stockholders. In addition,claims, liabilities and expenses during the winding down of our company willcontinue to be incurred which will reduce the amount of assets available fordistribution. Any distributions made by us shall be made solely to thestockholders of record at the close of business on the Final Record Date,except as may be necessary to reflect subsequent transfers recorded on ourbooks as a result of assignments by will, intestate succession or operation oflaw.

 

***Bankrutpcy Case***

 

On March29, 2006 a final decree was entered closing the bankruptcy cases.

 

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**PART III**

 

**Item 1. Index to Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                          |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
|   3.1     |       | Certificate of Incorporation of ETS  Payphones, Inc. dated November 8, 2002(1)                                                                 |
|   3.2     |       | Bylaws of ETS Payphones, Inc.(1)                                                                                                                    |
|   4.1     |       | Settlement Agreement For Third Omnibus  Claims Objection ETS Payphones, Inc. and UPO dated February 28,  2003(1)                               |
| 10.1                |       | Cocot Agreement dated September 4,  2002 between Metropolitan Telecommunications, d/b/a MetTel and ETS  Payphones, Inc(1)                      |
| 10.2                |       | Cocot Agreement dated August 16, 2002  between Metropolitan Telecommunications, d/b/a MetTel and ETS  Payphones, Inc.(1)                       |
| 10.3                |       | ETS Creditors’ Litigation Trust Agreement  dated December 4, 2002(1)                                                                           |
| 10.4                |       | Employment Agreement dated December 5,  2002 between ETS Payphones, Inc. and Guy A. Longobardo(1)                                         |
| 10.4.1              |       | Amendment, dated as of January 28,  2005, to Employment Agreement between ETS Payphones, Inc. and  Guy A. Longobardo(2)                   |
| 10.4.2              |       | Amendment, dated as of November 11, 2005,  to Employment Agreement between ETS Payphones, Inc. and Guy A. Longobardo(3)                                  |
| 10.4.3              |       | Amendment, dated as of March 29, 2006, to  Employment Agreement between ETS Payphones, Inc. and Guy A. Longobardo                                   |
| 10.5                |       | Employment Agreement, dated as of  January 28, 2005, dated December 5, 2002 between ETS  Payphones, Inc. and Michael H. McClellan(1) |
| 10.5.1              |       | Amendment, dated as of January 28,  2005, to Employment Agreement between ETS Payphones, Inc. and  Michael H. McClellan(2)                |
| 10.5.2              |       | Amendment, dated as of March 29, 2006, to  Employment Agreement between ETS Payphones, Inc. and Michael H. McClellan                                     |
| 10.6                |       | Employment Agreement, dated as of January  28, 2005 between ETS Payphones, Inc. and Jeffrey E. Fennell(2)                                      |
| 10.6.1              |       | Amendment, effective as of April 1, 2006,  to Employment Agreement between ETS Payphones, Inc. and Jeffrey E. Fennell                                    |
| 10.7                |       | Form Change in Control Agreement(2)                                                                                                                      |
| 10.7.1              |       | Amendment, dated as of March 29, 2006, to  the January 28, 2005 Change of Control Agreement between ETS Payphones,  Inc. and David C. Jones         |
| 10.8                |       | Asset Sale Agreement, dated as of  November 1, 2005, between ETS Payphones, Inc. and Empire Payphones,  Inc.(3)                                     |
| 10.9                |       | Management Services Agreement, dated as of  November 1, 2005, between ETS Payphones, Inc. and Empire Payphones,  Inc.(3)                            |
| 10.10               |       | Security Agreement, dated as of  November 1, 2005, between ETS Payphones, Inc. and Empire Payphones,  Inc.(3)                                       |
| 10.11               |       | Note, dated as of November 1, 2005,  between ETS Payphones, Inc.(3)                                                                                 |
| 31.1                |       | Certification of Chief Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act                                                         |
| 31.2                |       | Certification of Chief Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act                                                         |
| 32.1                |       | Certification of Chief Executive Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act                                                         |
| 32.2                |       | Certification of Chief Financial Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act                                                         |

 

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(1)           Incorporated byreference from the Company’s Registration Statement on Form 10-SB (FileNo. 000-50712)

(2)           Incorporated byreference from the Company’s Report on Form 8-K dated February 2,2005 (File No. 000-50712)

 

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(3)           Incorporatedby reference from the Company’s Report on Form 10-QSB for the quarterlyperiod ended September 30, 2005, filed on November 14, 2005 (FileNo. 000-50712)

 

**SIGNATURES**

 

In accordance with Section 12 of theSecurities Exchange Act of 1934, the registrant has duly caused thisregistration statement to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                                        | ETS PAYPHONES, INC. |
|---------------------------------------------|--------------------------|
|                                        |                     | (Registrant) |
|                                        |                     |   |
|                                        |                     |   |
| Date:   March 31, 2006       | By:                      | /s/ GUY A. LONGOBARDO |
|                                        |                     | Guy A. Longobardo, *Director, President and Chief* |
|                                        |                     | *Executive Officer* |
|                                        |                     |   |
|                                        |                     |   |
| Date:    March 31, 2006 | By:                      | /s/ MICHAEL H. MCCLELLAN |
|                                        |                     | Michael H. McClellan, *Director, Executive Vice* |
|                                        |                     | *President and Chief Financial Officer* |

 

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