**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**




(Mark
      One)




x
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**For
                the quarterly period ended September 30, 2008oro
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**





For
      the
      transition period from ________ to ________




Commission
      file number: 000- 30152





**PAYMENT
      DATA SYSTEMS, INC.**


(Exact
      name of registrant as specified in its charter)





**Nevada**
            **98-0190072**(State
                or other jurisdiction of incorporation or organization)
            (I.R.S.
                Employer Identification No.)**12500
                San Pedro, Suite 120, San Antonio, Texas**
            **78216**(Address
                of principal executive offices)
            (Zip
                Code)





**(210)
      249-4100**


(Registrant’s
      telephone number, including area code)




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




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting company.
      See
      the definitions of "large accelerated filer," "accelerated filer," and "smaller
      reporting company" in Rule 12b-2 of the Exchange Act.




Large accelerated filer o
            Accelerated filer 
                oNon-accelerated filer(Do not check if a smaller reporting company) o
            Smaller
                reporting company  x




Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act).




Yes
o No
x




As
      of
      November 7, 2008, 100,943,478 shares of the issuer’s common stock, $0.001 par
      value, were outstanding.


1


**PAYMENT
      DATA SYSTEMS, INC.**





**INDEX**





PART
                I-FINANCIAL INFORMATION
            PageItem
                1.
            Financial
                Statements (Unaudited).Consolidated
                Balance Sheets as of September 30, 2008 and December 31,
                2007
            3Consolidated
                Statements of Operations for the three and nine months ended September
                30,
                2008 and 2007
            4Consolidated
                Statements of Cash Flows for the nine months ended September 30,
                2008 and
                2007
            5Notes
                to Interim Consolidated Financial Statements
            6Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations.
            10Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk.
            15Item
                4T.
            Controls
                and Procedures.
            15PART
                II-OTHER INFORMATIONItem
                1.
            Legal
                Proceedings.
            16Item
                1A.
            Risk
                Factors.
            17Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds.
            17Item
                3.
            Defaults
                Upon Senior Securities.
            17Item
                4.
            Submission
                of Matters to a Vote of Security Holders.
            17Item
                5.
            Other
                Information.
            17Item
                6.
            Exhibits.
            17




2


**PART
      I** - **FINANCIAL INFORMATION**





**Item
      1.** **FINANCIAL
      STATEMENTS.**





**PAYMENT
      DATA SYSTEMS, INC.**


**CONSOLIDATED
      BALANCE SHEETS**





September
                30, 2008
            
            December
                31, 2007(Unaudited)**Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            154,552
            
            $
            115,597Accounts
                receivable, net
            
            
            180,863
            
            
            85,677Prepaid
                expenses and other
            
            
            54,766
            
            
            30,895Total
                current assets
            
            
            390,181
            
            
            232,169Property
                and equipment, net
            
            
            73,081
            
            
            112,072Other
                assets
            
            
            16,693
            
            
            26,693Total
                assets
            
            $
            479,955
            
            $
            370,934**Liabilities
                and stockholders’ equity (deficit)**Current
                liabilities:Accounts
                payable
            
            $
            92,613
            
            $
            161,031Accrued
                expenses
            
            
            748,072
            
            
            553,901Deferred
                revenue
            
            
            137,055
            
            
            31,325Total
                current liabilities
            
            
            977,740
            
            
            746,257Stockholders’
                equity (deficit):Common
                stock, $0.001 par value, 200,000,000 shares authorized; 103,169,483
                and
                80,172,708 issued and 100,822,128 and 80,172,708
                outstanding
            
            
            103,170
            
            
            80,173Additional
                paid-in capital
            
            
            55,015,424
            
            
            53,758,696Treasury
                stock, at cost; 2,347,355 shares
            
            
            (176,052
            )
            
            (176,052
            )Deferred
                compensation
            
            
            (2,411,233
            )
            
            (1,558,804
            )Accumulated
                deficit
            
            
            (53,029,094
            )
            
            (52,479,336
            )Total
                stockholders’ equity (deficit)
            
            
            (497,785
            )
            
            (375,323
            )Total
                liabilities and stockholders’ equity (deficit)
            
            $
            479,955
            
            $
            370,934





*See
      notes to interim consolidated financial statements.*


3





**PAYMENT
      DATA SYSTEMS, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**(UNAUDITED)**





Three
                Months Ended September 30,
            
            Nine
                Months Ended September 30,2008
            
            2007
            
            2008
            
            2007Revenues
            
            $
            667,362
            
            $
            841,171
            
            $
            2,188,152
            
            $
            2,236,302Operating
                expenses:Cost
                of services
            
            
            537,204
            
            
            712,652
            
            
            1,790,578
            
            
            1,844,774Selling,
                general and administrative:Stock-based
                compensation
            
            
            145,439
            
            
            178,532
            
            
            505,346
            
            
            571,678Other
                expenses
            
            
            343,890
            
            
            320,213
            
            
            1,152,456
            
            
            943,203Depreciation
            
            
            11,166
            
            
            20,714
            
            
            47,249
            
            
            57,900Total
                operating expenses
            
            
            1,037,699
            
            
            1,232,111
            
            
            3,495,629
            
            
            3,417,555Operating
                loss
            
            
            (370,337
            )
            
            (390,940
            )
            
            (1,307,477
            )
            
            (1,181,253
            )Other
                income (expense):Interest
                income
            
            
            410
            
            
            55
            
            
            9,072
            
            
            623Interest
                expense
            
            
            -
            
            
            (6,319
            )
            
            (193
            )
            
            (76,242
            )Other
                income (expense)
            
            
            -
            
            
            -
            
            
            748,840
            
            
            (94,988
            )Total
                other income (expense), net
            
            
            410
            
            
            (6,264
            )
            
            757,719
            
            
            (170,607
            )Loss
                from operations before income taxes
            
            
            (369,927
            )
            
            (397,204
            )
            
            (549,758
            )
            
            (1,351,860
            )Income
                taxes
            
            
            -
            
            
            -
            
            
            -
            
            
            -Net
                loss
            
            $
            (369,927
            )
            $
            (397,204
            )
            $
            (549,758
            )
            $
            (1,351,860
            )Basic
                and diluted net loss per common share:
            
            $
            0.00
            
            $
            (0.01
            )
            $
            (0.01
            )
            $
            (0.02
            )Weighted
                average common sharesoutstanding
            
            
            100,822,128
            
            
            72,203,236
            
            
            93,077,167
            
            
            67,051,322





*See
      notes to interim consolidated financial statements.*





4


**PAYMENT
      DATA SYSTEMS, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(UNAUDITED)**




Nine
                Months Ended September 30,2008
            
            2007**Operating
                activities**Net
                loss
            
            $
            (549,758
            )
            $
            (1,351,860
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
            
            
            47,249
            
            
            57,900Non-cash
                issuance of common stock
            
            
            78,255
            
            
            136,626Deferred
                compensation
            
            
            319,071
            
            
            308,495Gain
                on sale of patents
            
            
            (750,000
            )
            
            -Loss
                on disposition of assets
            
            
            1,160
            
            
            -Amortization
                of debt discount
            
            
            -
            
            
            57,388Changes
                in current assets and current liabilities:Accounts
                receivable
            
            
            (95,186
            )
            
            5,201Prepaid
                expenses and other
            
            
            (3,871
            )
            
            71,051Accounts
                payable and accrued expenses
            
            
            154,086
            
            
            7,525Deferred
                revenue
            
            
            105,730
            
            
            (1,459
            )Net
                cash used in operating activities
            
            
            (693,264
            )
            
            (709,133
            )**Investing
                activities**Proceeds
                from sale of patents
            
            
            750,000
            
            
            -Purchases
                of property and equipment
            
            
            (19,418
            )
            
            (29,987
            )Net
                cash provided by (used in) investing activities
            
            
            730,582
            
            
            (29,987
            )**Financing
                activities**Principal
                payments for notes payable
            
            
            -
            
            
            (416,668
            )Issuance
                of common stock, net of issuance costs
            
            
            1,637
            
            
            1,128,132Net
                cash provided by financing activities
            
            
            1,637
            
            
            711,464Change
                in cash and cash equivalents
            
            
            38,955
            
            
            (27,656
            )Cash
                and cash equivalents, beginning of period
            
            
            115,597
            
            
            198,759Cash
                and cash equivalents, end of period
            
            $
            154,552
            
            $
            171,103





*See
      notes to interim consolidated financial statements.*


5


**PAYMENT
      DATA SYSTEMS, INC.**





**NOTES
      TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS**


**(UNAUDITED)**





**Note
      1. Basis of Presentation**





Payment
      Data Systems, Inc. and subsidiaries (the “Company”), has incurred substantial
      losses since inception, which has led to a deficit in working capital. The
      Company believes that its current available cash along with anticipated revenues
      may be insufficient to meet its anticipated cash needs for the foreseeable
      future. **Consequently,
      the Company’s ability to continue as a going concern is likely contingent on the
      Company receiving additional funds in the form of equity or debt financing.** The
      Company is currently aggressively pursuing strategic alternatives in addition
      to
      its equity line of credit (see Note 4). The sale of additional equity or
      convertible debt securities would result in additional dilution to the Company's
      stockholders, and debt financing, if available, may involve covenants which
      could restrict operations or finances. There can be no assurance that financing
      will be available in amounts or on terms acceptable to the Company, if at all.
      If the Company cannot raise funds on acceptable terms, or achieve positive
      cash
      flow, it may not be able to continue to exist, conduct operations, grow market
      share, take advantage of future opportunities or respond to competitive
      pressures or unanticipated requirements, any of which would negatively impact
      its business, operating results and financial condition. The accompanying
      unaudited consolidated financial statements of the Company do not include any
      adjustments to reflect the possible future effects on the recoverability and
      classification of assets or the amounts and classification of liabilities that
      may result from the outcome of this uncertainty.





The
      accompanying unaudited consolidated financial statements of the Company have
      been prepared without audit, pursuant to the rules and regulations of the
      Securities and Exchange Commission. Certain information and footnote disclosures
      normally included in financial statements prepared in accordance with United
      States generally accepted accounting principles have been condensed or omitted
      pursuant to such rules and regulations. In the opinion of management, the
      accompanying consolidated financial statements reflect all adjustments of a
      normal recurring nature considered necessary to present fairly the Company's financial position, results of operations and cash flows for such
      periods .
      The
      accompanying interim
      consolidated financial
      statements should be read in conjunction
      with the consolidated financial statements and the notes thereto included in
      the
      Company's Annual
      Report on Form 10-K for the year ended December 31, 2007. Results
      of operations for interim periods are not necessarily indicative of results
      that
      may be expected for any other interim periods or the full fiscal year.





Certain
      prior period amounts have been reclassified to conform to the current year
      presentation.





The
      preparation of financial statements in conformity with United States generally
      accepted accounting principles requires management to make estimates and
      assumptions that affect the reported amounts of assets and liabilities and
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting period. Actual results could differ from those estimates.





**Note
      2. Accrued Expenses**





Accrued
      expenses consist of the following:





September
                30, 2008
            
            December
                31, 2007Accrued
                salaries
            
            $
            371,510
            
            $
            174,945Reserve
                for merchant losses
            
            
            209,220
            
            
            209,220Customer
                deposits
            
            
            42,701
            
            
            80,499Accrued
                taxes
            
            
            23,912
            
            
            3,308Accrued
                professional fees
            
            
            5,500
            
            
            29,073Other
                accrued expenses
            
            
            95,229
            
            
            56,856Total
                accrued expenses
            
            $
            748,072
            
            $
            553,901




6


**Note
      3. Stock-Based Compensation**





On
      January 9, 2008, the Company granted a total of 21,300,000 shares of common
      stock to employees and its independent director as a long-term incentive valued
      at $1,171,500 on the date of grant. The common stock is restricted and vests
      on
      January 9, 2018. The Company also granted a total of 600,000 shares of common
      stock under the terms of the Company's Employee Comprehensive Stock Plan to
      certain employees and recorded $33,000 of compensation expense. The Company
      also
      granted a total of 400,000 shares of restricted common stock, which vests on
      January 9, 2009, valued at $22,000 to its advisory board members for
      providing consulting services to the Company.





During
      the nine months ended September 30, 2008, the Company granted a total of 256,775
      shares of common stock under the terms of its Employee Comprehensive Stock
      Plan
      to independent contractors providing consulting services to the Company and
      recorded $14,500 of related expense.





**Note
      4. Equity Line of Credit**





On
      June
      11, 2007, the Company entered into an agreement for an equity line of credit
      with Dutchess Private Equities Fund, LP (“Dutchess”). Under the terms of the
      agreement, the Company may elect to receive as much as $10 million from common
      stock purchases by Dutchess through August 23, 2012. During the nine months
      ended September 30, 2008, the Company sold 40,000 shares of its common stock
      pursuant to the equity line of credit and received proceeds, net of issuance
      costs, of $1,637.





**Note
      5. Income Taxes**





In
      July
      2006, the Financial Accounting Standards Board (“FASB”) issued FASB
      Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,
      an interpretation of FASB Statement No. 109.” FIN 48 prescribes a comprehensive
      model for how companies should recognize, measure, present and disclose in
      their
      financial statements uncertain tax positions taken or expected to be taken
      on a
      tax return. Under FIN 48, tax positions are recognized in the Company’s
      financial statements as the largest amount of tax benefit that has a greater
      than 50% likelihood of being realized upon ultimate settlement with tax
      authorities assuming full knowledge of the position and all relevant facts.
      These amounts are subsequently reevaluated and changes are recognized as
      adjustments to current period tax expense. FIN 48 also revised disclosure
      requirements to include an annual tabular roll forward of unrecognized tax
      benefits.





The
      Company adopted the provisions of FIN 48 on January 1, 2007. The adoption did
      not result in an adjustment to the Company’s tax liability for unrecognized
      income tax benefits. At the adoption date of January 1, 2007, the Company did
      not have any unrecognized income tax benefits. At September 30, 2008, the
      unrecognized tax benefit was unchanged from adoption. If applicable, the Company
      would recognize interest and penalties related to uncertain tax positions in
      interest expense. As of September 30, 2008, the Company had no accrued interest
      or penalties. The tax years ended December 31, 2002 through December 31, 2007
      remain subject to examination by tax authorities.





The
      Company has incurred net operating losses since its inception, resulting in
      a
      deferred tax asset of approximately $40.1 million. In assessing the reliability
      of deferred tax assets, management considers whether it is more likely than
      not
      that some portion or all of the deferred income tax assets will not be realized.
      The ultimate realization of deferred income tax assets is dependent upon the
      generation of future taxable income during the period in which those temporary
      differences become deductible. Management considers the scheduled reversal
      of
      deferred income tax liabilities, projected future taxable income, and tax
      planning strategies in making this assessment. Based on consideration of these
      items, management has determined that enough uncertainty exists relative to
      the
      realization of the deferred income tax asset balances to warrant the application
      of a full valuation allowance as of September 30, 2008 and December 31,
      2007.




7


**Note
      6. Sale of Patents**





On
      January 11, 2008, the Company signed an agreement to sell selected patents
      and
      patent applications to PCT Software Data, LLC, subject to customary closing
      conditions. On January 17, 2008, the Company completed the sale and received
      proceeds of $750,000. The patents and patent applications sold relate to bill
      payments made with debit and stored value cards. The Company retained a
      worldwide, non-exclusive license under the patents for use with all current
      and
      future customers.





**Note
      7. Net Income (Loss) Per Share**





Basic
      and
      diluted income (loss) per common share was calculated by dividing net income
      (loss) by the weighted average number of common shares outstanding during the
      period. Dilutive securities, which consist of stock options and warrants and
      convertible debt, were excluded from the computation of the weighted average
      number of common shares outstanding for purposes of calculating diluted income
      (loss) per common share because their effect was anti-dilutive.





**Note
      8. Related Party Transactions**





Beginning
      in December 2000, the Company pledged as loan guarantees certain funds held
      as
      money market funds and certificates of deposit to collateralize margin loans
      for
      the following executive officers of the Company: (1) Michael R. Long, then
      Chairman of the Board of Directors and Chief Executive Officer; (2) Louis A.
      Hoch, then President and Chief Operating Officer; (3) Marshall N. Millard,
      then
      Secretary, Senior Vice President, and General Counsel; and (4) David S. Jones,
      then Executive Vice President. Mr. Millard and Mr. Jones are no longer employees
      of the Company. The margin loans were obtained in March 1999 from institutional
      lenders and were secured by shares of the Company's common stock owned by these
      officers. The pledged funds were held in the Company’s name in accounts with the
      lenders that held the margin loans of the officers. The Company's purpose in
      collateralizing the margin loans was to prevent the sale of its common stock
      owned by these officers while it was pursuing efforts to raise additional
      capital through private equity placements. The sale of that common stock could
      have hindered the Company's ability to raise capital in such a manner and
      compromised its continuing efforts to secure additional financing. The highest
      total amount of funds pledged for the margin loans guaranteed by the Company
      was
      approximately $2.0 million. The total balance of the margin loans guaranteed
      by
      the Company was approximately $1.3 million at December 31, 2002. At the time
      the
      funds were pledged, the Company believed they would have access to them because
      (a) their stock price was substantial and the stock pledged by the officers,
      if
      liquidated, would produce funds in excess of the loans payable, and (b) with
      respect to one of the institutional lenders (who was also assisting the Company
      as a financial advisor at the time), even if the stock price fell, they had
      received assurances from that institutional lender that the pledged funds would
      be made available as needed. During the fourth quarter of 2002, the Company
      requested partial release of the funds for operating purposes, which request
      was
      denied by an institutional lender. At that time, their stock price had fallen
      as
      well, and it became clear that both institutional lenders would not release
      the
      pledged funds since
      the value of the stock pledged by the officers was less than the loans payable
      and the officers were unable to repay the loans .
      In
      light of these circumstances, the Company recognized a loss on the guarantees
      of
      $1,278,138 in the fourth quarter of 2002 and recorded a corresponding payable
      under related party guarantees on their balance sheet at December 31, 2002
      because it became probable at that point that they would be unable to recover
      their pledged funds. During the quarter ended March 31, 2003, the lenders
      applied the pledged funds to satisfy the outstanding balances of the loans.
      The
      total balance of the margin loans guaranteed by the Company was zero at
      September 30, 2008.





In
      February 2007, the Company signed employment agreements with Mr. Long and Mr.
      Hoch that require each to repay his respective obligation to the Company in
      four
      equal annual payments of cash or stock or any combination thereof. In
      December 2007, the Company accepted common stock and stock options valued
      at $133,826 and $112,343 from Mr. Long and Mr. Hoch, respectively, in
      satisfaction of their annual payments for 2007 as provided for under their
      employment agreements.





The
      Company may institute litigation or arbitration in collection of the outstanding
      repayment obligations of Mr. Millard and Mr. Jones, which currently total
      approximately $293,000. Presently, the Company has refrained from initiating
      action to recover funds from Mr. Millard because he may have an offsetting
      claim
      in excess of his repayment obligation by virtue of the deferred compensation
      clause in his employment agreement based on the Company’s preliminary analysis.
      The Company has not pursued the outstanding repayment obligation of Mr. Jones
      because the Company does not consider a recovery attempt to be cost beneficial.
      In order to attempt a recovery from Mr. Jones, the Company estimates that it
      would incur a minimum of $20,000 in estimated legal costs with no reasonable
      assurance of success in recovering his outstanding obligation of approximately
      $38,000. Because of the limited amount of the obligation, the Company also
      anticipates difficulty in retaining counsel on a contingency basis to pursue
      collection of this obligation. The ultimate outcome of this matter cannot
      presently be determined.




8





During
      the nine months ended September 30, 2008, the Company engaged Herb Authier
      to
      provide consulting services as an independent contractor related to network
      engineering and administration. The amount paid to Mr. Authier for such services
      consisted of $15,000 in cash and 206,775 shares of the Company’s common stock
      valued at $11,750. Mr. Authier is the father-in-law of Louis Hoch, the Company’s
      President and Chief Operating Officer. The terms of the agreement for the
      services performed by Mr. Authier were better than the Company could have
      received from an independent third party for such services.





**Note
      9. Fair Value Measurements**





In
      September 2006, the FASB issued SFAS 157, which defines fair value, establishes
      a framework for measuring fair value, and expands disclosures about fair value
      instruments. The provisions of SFAS 157 are effective January 1, 2008. The
      FASB
      has also issued Staff Position FAS 157-2 (FSP No. 157-2), which delays the
      effective date of SFAS 157 for nonfinancial assets and liabilities, except
      for
      items that are recognized or disclosed at fair value in the financial statements
      on a recurring basis (at least annually), until fiscal years beginning after
      November 15, 2008. Effective January 1, 2008, the Company adopted SFAS 157
      as
      discussed above and has elected to defer the application thereof to nonfinancial
      assets and liabilities in accordance with FSP No. 157-2.





As
      defined in SFAS 157, fair value is the price that would be received to sell
      an
      asset or paid to transfer a liability in an orderly transaction between market
      participants at the measurement date (exit price). The Company utilizes market
      data or assumptions that market participants would use in pricing the asset
      or
      liability, including assumptions about risk and the risks inherent in the inputs
      to the valuation technique. These inputs can be readily observable, market
      corroborated, or generally unobservable. The Company classifies fair value
      balances based on the observability of those inputs. SFAS 157 establishes a
      fair
      value hierarchy that prioritizes the inputs used to measure fair value. The
      hierarchy gives the highest priority to unadjusted quoted prices in active
      markets for identical assets or liabilities (level 1 measurements) and the
      lowest priority to unobservable inputs (level 3 measurements).





The
      three
      levels of the fair value hierarchy defined by SFAS 157 are as
      follows:




Level
                  1:
              Quoted
                  prices are available in active markets for identical assets or
                  liabilities;Level
                  2:
              Quoted
                  prices in active markets for similar assets and liabilities that
                  are
                  observable for the asset or liability; orLevel
                  3:
              Unobservable
                  pricing inputs that are generally less observable from objective
                  sources,
                  such as discounted cash flow models or
                  valuations.




The
      Company does not have any financial assets or liabilities subject to SFAS 157
      at
      September 30, 2008.





**Note
      10. Subsequent Events**





Subsequent
      to September 30, 2008 and through November 7, 2008, the Company sold 121,350
      shares of its common stock pursuant to the equity line of credit (see Note
      4)
      and received total proceeds, net of issuance costs, of $3,383.





On
      November 12, 2008, Michael Long, Chief Executive Officer and Chief Financial
      Officer, and Louis Hoch, President and Chief Operating Officer, were each
      granted 6,171,429 shares of restricted common stock by the Company as an annual
      bonus of $216,000 pursuant to the terms of their respective employment
      agreements. The number of shares granted to each officer was based on the
      closing price of the common stock on October 15, 2008, which was $0.035 per
      share.


9


**Item
                2.**
            **MANAGEMENT’S
                DISCUSSION AND ANALYSIS****OF FINANCIAL CONDITION AND RESULTS OF
                OPERATIONS.**





**FORWARD-LOOKING
      STATEMENTS DISCLAIMER**





This
      report on Form 10-Q contains forward-looking statements that involve risks
      and
      uncertainties. You should not place undue reliance on these forward-looking
      statements. Our actual results could differ materially from those anticipated
      in
      the forward-looking statements for many reasons, including the risks described
      in our annual report on Form 10-K and other reports we file with the Securities
      and Exchange Commission. Although we believe the expectations reflected in
      the
      forward-looking statements are reasonable, they relate only to events as of
      the
      date on which the statements are made. We do not intend to update any of the
      forward-looking statements after the date of this report to conform these
      statements to actual results or to changes in our expectations, except as
      required by law.





This
      discussion and analysis should be read in conjunction with the unaudited interim
      consolidated financial statements and the notes thereto included in this report,
      and our annual report on Form 10-K for the fiscal year ended December 31, 2007.





**Overview**





We
      provide integrated electronic payment processing services to merchants and
      businesses, including credit and debit card-based processing services and
      transaction processing via the Automated Clearinghouse Network. We also operate
      an online payment processing service for consumers under the domain name
      www.billx.com through which consumers can pay anyone. Since inception, we have
      incurred operating losses each quarter, and as of September 30, 2008, we
      have an accumulated deficit of approximately $53.0 million. Our prospects to
      continue as a going concern must be considered in light of the risks, expenses
      and difficulties frequently encountered by companies in their early stages
      of
      growth, particularly companies in rapidly evolving markets such as electronic
      commerce. To address these risks we must, among other things, grow our customer
      base, implement a successful marketing strategy, continue to maintain and
      upgrade our technology and transaction-processing systems, provide superior
      customer service, respond to competitive developments, attract, retain and
      motivate qualified personnel, and respond to unforeseen industry developments
      and other factors. We may not be successful in addressing such risks, and the
      failure to do so could have a material adverse effect on our business,
      prospects, financial condition and results of operations. We believe that our
      success will depend in large part on our ability to (a) manage our operating
      expenses, (b) add quality customers to our client base, (c) meet evolving
      customer requirements and (d) adapt to technological changes in an emerging
      market. Accordingly, we intend to focus on customer acquisition activities
      and
      outsource some of our processing services to third parties to allow us to
      maintain an efficient operating infrastructure and expand our operations without
      significantly increasing our fixed operating expenses.





**Critical
      Accounting Policies**





General





Management's
      Discussion and Analysis of Financial Condition and Results of Operations is
      based upon our consolidated financial statements, which have been prepared
      in
      accordance with United States generally accepted accounting principles. The
      preparation of these financial statements requires us to make estimates and
      judgments that affect the reported amounts of assets, liabilities, revenue
      and
      expenses, and related disclosure of contingent assets and liabilities. On an
      on-going basis, we evaluate our estimates, including those related to the
      reported amounts of revenues and expenses, bad debt, investments, intangible
      assets, income taxes, and contingencies and litigation. We base our estimates
      on
      historical experience and on various other assumptions that are believed to
      be
      reasonable under the circumstances, the results of which form the basis for
      making judgments about the carrying values of assets and liabilities that are
      not readily apparent from other sources. Actual results could differ from these
      estimates under different assumptions or conditions. We consider the following
      accounting policies to be critical because the nature of the estimates or
      assumptions is material due to the levels of subjectivity and judgment necessary
      to account for highly uncertain matters or the susceptibility of such matters
      to
      change or because the impact of the estimates and assumptions on financial
      condition or operating performance is material.




10





Revenue
      Recognition





Revenue
      consists primarily of fees generated through the electronic processing of
      payment transactions and related services, and are recognized as revenue in
      the
      period the transactions are processed or when the related services are
      performed. Merchants may be charged for these processing services at a bundled
      rate based on a percentage of the dollar amount of each transaction and, in
      some
      instances, additional fees are charged for each transaction. Certain merchant
      customers are charged a flat fee per transaction, while others may also be
      charged miscellaneous fees, including fees for chargebacks or returns, monthly
      minimums, and other miscellaneous services. Revenues derived from electronic
      processing of credit and debit card transactions that are authorized and
      captured through third-party networks are reported gross of amounts paid to
      sponsor banks as well as interchange and assessments paid to credit card
      associations (MasterCard and Visa). Revenue also includes any up-front fees
      for
      the work involved in implementing the basic functionality required to provide
      electronic payment processing services to a customer. Revenue from such
      implementation fees is recognized over the term of the related service contract.
      Sales taxes billed are reported directly as a liability to the taxing authority,
      and are not included in revenue.





Reserve
      for Losses on Card Processing





If,
      due
      to insolvency or bankruptcy of the merchant, or for another reason, we are
      not
      able to collect amounts from our card processing merchant customers that have
      been properly "charged back" by the cardholders, we must bear the credit risk
      for the full amount of the cardholder transaction. We may require cash deposits
      and other types of collateral from certain merchants to minimize any such risk.
      In addition, we utilize a number of systems and procedures to manage merchant
      risk. Card merchant processing loss reserves are primarily determined by
      performing a historical analysis of our chargeback loss experience and
      considering other factors that could affect that experience in the future,
      such
      as the types of card transactions processed and nature of the merchant
      relationship with their consumers. This reserve amount is subject to risk that
      actual losses may be greater than our estimates. At
      September 30, 2008, our card merchant processing loss reserve was
      $209,220. We have not incurred any chargeback losses to date. Our estimate
      for
      chargeback losses is likely to increase in the future if our volume of
      card-based transactions processed increases.





Bad
      Debts





We
      maintain an allowance for doubtful accounts for estimated losses resulting
      from
      the inability or failure of our customers to make required payments. We
      determine the allowance for doubtful accounts based on an account-by-account
      review, taking into consideration such factors as the age of the outstanding
      balance, historical pattern of collections and financial condition of the
      customer. Past losses incurred by us due to bad debts have been within our
      expectations. In 2007, we did not charge any bad debt expense and recorded
      bad
      debt write-offs of $5,675 against our allowance for doubtful accounts. At
      September 30, 2008, the balance of the allowance for doubtful accounts was
      approximately $31,000. If the financial condition of our customers were to
      deteriorate, resulting in an impairment of their ability to make contractual
      payments, additional allowances may be required. Our estimate for bad debt
      losses is likely to increase in the future as our volume of transactions
      processed increases.





Valuation
      of Long-Lived and Intangible Assets





We
      assess
      the impairment of long-lived and intangible assets at least annually, and
      whenever events or changes in circumstances indicate that the carrying value
      may
      not be recoverable. Factors considered important, which could trigger an
      impairment review, include the following: significant underperformance relative
      to historical or projected future cash flows; significant changes in the manner
      of use of the assets or the strategy of the overall business; and significant
      negative industry trends. When management determines that the carrying value
      of
      long-lived and intangible assets may not be recoverable, impairment is measured
      as the excess of the assets’ carrying value over the estimated fair value. No
      impairment losses were recorded in 2007 or during the nine months ended
      September 30, 2008.


11


Income
      Taxes





Deferred
      tax assets and liabilities are recorded based on the difference between the
      tax
      bases of assets and liabilities and their carrying amount for financial
      reporting purposes, as measured by the enacted tax rates and laws that will
      be
      in effect when the differences are expected to reverse. Deferred tax assets
      are
      computed with the presumption that they will be realizable in future periods
      when pre-taxable income is generated. Predicting the ability to realize these
      assets in future periods requires a great deal of judgment by management. It
      is
      our judgment that we cannot predict with reasonable certainty that the deferred
      tax assets as of September 30, 2008 will be realized in future periods.
      Accordingly, a valuation allowance has been provided to reduce the net deferred
      tax assets to $0. At December 31, 2007, we had available net operating
      loss carryforwards of approximately $40.1 million that expire beginning in
      the
      year 2020.





**Effect
      of New Accounting Pronouncements**





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” (“SFAS
      No. 157”). SFAS No. 157 defines fair value, establishes a framework for
      measuring fair value, and expands disclosures about fair value measurements.
      The
      standard applies whenever other standards require (or permit) assets or
      liabilities to be measured at fair value, but does not expand the use of fair
      value in any new circumstances. SFAS No. 157 is effective for financial
      statements issued for fiscal years beginning after November 15, 2007, and
      interim periods within those years. The adoption of SFAS No. 157 did not have
      a
      material impact on our consolidated financial statements.





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159
      allows entities the option to measure eligible financial instruments at fair
      value as of specified dates. Such election, which may be applied on an
      instrument by instrument basis, is typically irrevocable once elected. SFAS
      No. 159 is effective for fiscal years beginning after November 15, 2007. We
      did not elect the fair value option for any of our existing financial
      instruments other than those mandated by other FASB standards; accordingly,
      the
      impact of the adoption of SFAS No. 159 on our financial statements was
      immaterial.





In
      December 2007, the FASB issued SFAS No. 141(R), “Business
      Combinations” (“SFAS 141(R)”), which replaces SFAS 141.
      SFAS 141(R) establishes principles and requirements for how an acquirer
      recognizes and measures in its financial statements the identifiable assets
      acquired, the liabilities assumed, any non-controlling interest in the acquiree
      and the goodwill acquired. The Statement also establishes disclosure
      requirements that will enable users to evaluate the nature and financial effects
      of the business combination. SFAS 141(R) is effective for fiscal years
      beginning after December 15, 2008. The adoption of SFAS 141(R) will
      have an impact on accounting for business combinations once adopted, but the
      effect is dependent upon acquisitions at that time.





In
      December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests
      in Consolidated Financial Statements -- an amendment of Accounting Research
      Bulletin No. 51” (“SFAS 160”), which establishes accounting and
      reporting standards for ownership interests in subsidiaries held by parties
      other than the parent, the amount of consolidated net income attributable to
      the
      parent and to the non-controlling interest, changes in a parent's ownership
      interest and the valuation of retained non-controlling equity investments when
      a
      subsidiary is deconsolidated. The Statement also establishes reporting
      requirements that provide sufficient disclosures that clearly identify and
      distinguish between the interests of the parent and the interests of the
      non-controlling owners. SFAS 160 is effective for fiscal years beginning
      after December 15, 2008. We do not currently have any non-controlling
      interests in any of our subsidiaries.





In
      March
      2008, the FASB issued
      SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities -
      an amendment of FASB Statement
      No. 133” (“SFAS 161”). SFAS No. 133, “Accounting for Derivative Instruments and
      Hedging Activities,” currently establishes the disclosure requirements for
      derivative instruments and hedging activities. SFAS 161 amends and expands
      the
      disclosure requirements of SFAS No. 133 with enhanced quantitative, qualitative
      and credit risk disclosures. SFAS 161 requires quantitative disclosures in
      a
      tabular format about the fair values of derivative instruments, gains and losses
      on derivative instruments and information about where these items are reported
      in the financial statements. Also required in the tabular presentation is a
      separation of hedging and non-hedging activities. Qualitative disclosures
      include outlining objectives and strategies for using derivative instruments
      in
      terms of underlying risk exposures, use of derivatives for risk management
      and
      other purposes and accounting designation, and an understanding of the volume
      and purpose of derivative activity. Credit risk disclosures provide information
      about credit risk related contingent features included in derivative agreements.
      SFAS 161 also amends SFAS No. 107, “Disclosures about Fair Value of Financial
      Instruments,” to clarify that disclosures about concentrations of credit risk
      should include derivative adoption. SFAS 161 is effective for financial
      statements issued for fiscal years and interim periods beginning after
      November15, 2008. We do not expect the application of SFAS 161 on our
      disclosures to have a material impact on our financial statements.




12





**Results
      of Operations**





Our
      revenues are principally derived from providing integrated electronic payment
      services to merchants and businesses, including credit and debit card-based
      processing services and transaction processing via the Automated Clearinghouse
      Network. We also operate an online payment processing service for consumers
      under the domain name www.billx.com and sell this service as a private-label
      application to resellers. Revenues for the quarter ended September 30, 2008
      decreased 21% to $667,362 from $841,171 for the quarter ended September 30,
      2007. Revenues for the nine months ended September 30, 2008 decreased 2% to
      $2,188,152 from $2,236,302 for the nine months ended September 30, 2007. The
      decrease from the prior year periods was primarily attributable to the loss
      of
      our largest credit card processing merchant during the second quarter of 2008.
      Although this merchant had agreed to renew their processing agreement with
      us,
      our sponsoring bank did not approve the renewal so we were unable to continue
      processing for the merchant. The monthly average number of consumers using
      our
      billx.com online payment service decreased to 764 in the first nine months
      of
      2008 from 950 in the same period of 2007. We expect this trend to continue
      unless our current plan to introduce and establish enhanced value by offering
      a
      prepaid MasterCard in conjunction with our online payment service is successful
      in generating subscriber growth.





Cost
      of
      services includes the cost of personnel dedicated to the creation and
      maintenance of connections to third-party payment processors and fees paid
      to
      such third-party providers for electronic payment processing services. Through
      our contractual relationships with our payment processors, we are able to
      process Automated Clearinghouse and debit or credit card transactions on behalf
      of our customers and their consumers. We pay volume-based fees for debit and
      credit transactions initiated through these processors, and pay fees for other
      transactions such as returns, notices of change to bank accounts and file
      transmission. Cost of services was $537,204 and $712,652 for the quarters ended
      September 30, 2008 and 2007, respectively and $1,790,578 and $1,844,774 for
      the
      nine months ended September 30, 2008 and 2007, respectively. The decrease
      from the prior year periods was due primarily to the decrease in fees related
      to
      processing the decreased card-based transaction volume.





Stock-based
      compensation expenses decreased to $145,439 for the quarter ended September
      30,
      2008, from $178,532 for the third quarter of 2007. Stock-based compensation
      expenses decreased to $505,346 for the nine months ended September 30, 2008,
      from $571,678 for the same period of 2007. The decrease from the prior year
      quarter was principally due to the decrease in bonus expenses for annual bonuses
      payable to executives in 2008. The decrease from the prior year period was
      principally due to the absence of signing bonus expense in the first nine months
      of 2008, as we incurred $107,000 of such expense under executive employment
      agreements in the first quarter of 2007.





Other
      selling, general and administrative expenses increased to $343,890 for the
      quarter ended September 30, 2008, from $320,213 for the third quarter of 2007.
      Other selling, general and administrative expenses for the nine months ended
      September 30, 2008 increased to $1,152,456 from $943,203 for the nine
      months ended September 30, 2007. The increases from the prior year periods
      were
      principally due to annual salary increases for executives called for under
      their
      respective employment agreements.





Depreciation
      was $11,166 and $20,714 for the quarter ended September 30, 2008 and 2007,
      respectively. Depreciation for the nine months ended September 30, 2008
      decreased to $47,249 from $57,900 for the nine months ended September 30, 2007.
      The decreases from the prior periods were primarily due to lower depreciation
      expenses related to certain assets that became fully depreciated during 2007
      or
      2008. We capitalized $19,418 of computer hardware and software purchased during
      the nine months ended September 30, 2008.


13


Net
      other
      income was $410 for the third quarter of 2008 compared to net other expense
      of
      $6,264 for the quarter ended September 30, 2007. Net other income was $757,719
      for the first nine months of 2008 compared to net other expense of $170,607
      for
      the nine months ended September 30, 2007. The change from the prior year quarter
      was primarily due to the absence of interest expense from puts under our equity
      line of credit in the current quarter as we did not receive any funds from
      puts
      during the third quarter of 2008. The change from the prior year period was
      primarily attributable to a $750,000 gain on the sale of certain patents in
      January 2008.





Net
      loss
      decreased to $369,927 and $549,758 for the quarter and nine months ended
      September 30, 2008, respectively, from $397,204 and $1,351,860 for the quarter
      and nine months ended September 30, 2007, respectively, as a result of the
      items
      discussed above.




**Liquidity
      and Capital Resources**





At
      September 30, 2008, we had $154,552 of cash and cash equivalents, compared
      to
      $115,597 of cash and cash equivalents at December 31, 2007. We have incurred
      substantial losses since inception and have a deficit in net working capital.
      We
      believe that our current available cash and cash equivalents along with
      anticipated revenues may be insufficient to meet our anticipated cash needs
      for
      the foreseeable future. Consequently, our ability to continue as a going concern
      may be contingent on us receiving additional funds in the form of equity or
      debt
      financing. We are currently aggressively pursuing strategic financing
      alternatives.





On
      June
      11, 2007, we entered into an agreement for an equity line of credit with
      Dutchess Private Equities Fund, LP. Under the terms of the agreement, we may
      elect to receive as much as $10 million from common stock purchases by Dutchess
      through August 23, 2012. Through September 30, 2008, we have sold a total of
      1,373,913 shares of our common stock pursuant to the equity line of credit
      and
      received total proceeds, net of issuance costs, of $70,844.





The
      satisfactory completion of additional sales of common stock to private investors
      or under our equity line of credit, borrowing funds, or growth of cash flow
      from
      operations is essential to provide sufficient cash flows to meet our current
      operating requirements. The sale of additional equity or convertible debt
      securities would result in additional dilution to our stockholders, and debt
      financing, if available, may involve restrictive covenants which could restrict
      our operations or finances. Financing may not be available in amounts or on
      terms acceptable to us, if at all. If we cannot raise funds on acceptable terms
      or achieve positive cash flow, we may not be able to continue to exist, conduct
      operations, grow market share, take advantage of future opportunities or respond
      to competitive pressures or unanticipated requirements, any of which would
      negatively impact our business, operating results and financial
      condition.





Net
      cash
      used in operating activities was $693,264 and $709,133 for the nine months
      ended
      September 30, 2008 and 2007, respectively. Net cash used in operating activities
      was primarily attributable to operating losses generated by growth stage
      activities and overhead costs. We plan to focus on expending our resources
      prudently given our current state of liquidity.





Net
      cash
      provided by investing activities of $730,582 for the nine months ended September
      30, 2008 resulted from receiving $750,000 in proceeds from the sale of our
      patents and making capital expenditures for computer hardware and software
      of
      $19,418. Net cash used in investing activities of $29,987 for the nine months
      ended September 30, 2007 reflected capital expenditures for computer hardware
      and software.





Net
      cash
      provided by financing activities of $1,637 for the nine months ended September
      30, 2008 represented the net proceeds from the issuance of common stock under
      our equity line of credit. Net cash provided by financing activities of $711,464
      for the nine months ended September 30, 2007 resulted from receiving $1,128,132
      in net proceeds from the issuance of common stock, including $755,000 from
      private placements, and making payments of $416,668 under our note
      payable.


14


**Off-balance
      Sheet Arrangements**





We
      currently have no off-balance sheet arrangements that have or are reasonably
      likely to have a current or future material effect on our financial condition,
      changes in financial condition, revenues or expenses, results of operations,
      liquidity, capital expenditures or capital resources.




**Item
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK** **.**





Because
      we are a smaller reporting company, this Item is not applicable to
      us.





**Item
      4T. CONTROLS AND PROCEDURES** **.**





**Evaluation
      of Disclosure Controls and Procedures**





Our
      management evaluated, with the participation of our Chief Executive Officer
      /
      Chief Financial Officer, the effectiveness of our disclosure controls and
      procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
      Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the
      period covered by this quarterly report on Form 10-Q. Based on that
      evaluation, our Chief Executive Officer / Chief Financial Officer concluded
      that
      our disclosure controls and procedures as
      of
      September 30, 2008 are
      effective to ensure that information we are required to disclose in reports
      that
      we file or submit under the Exchange Act (i) is recorded, processed, summarized
      and reported within the time periods specified in SEC rules
      and
      forms, and (ii) is accumulated and communicated to our management, including
      our
      Chief Executive Officer / Chief Financial Officer, as appropriate, to allow
      timely decisions regarding required reasonable assurance that such information
      is accumulated and communicated to our management. Our disclosure controls
      and
      procedures are designed to provide reasonable assurance that such information
      is
      accumulated and communicated to our management. Our disclosure controls and
      procedures include components of our internal control over financial reporting.
      Management's assessment of the effectiveness of our internal control over
      financial reporting is expressed at the level of reasonable assurance that
      the
      control system, no matter how well designed and operated, can provide only
      reasonable, but not absolute, assurance that the control system's objectives
      will be met.





**Changes
      in Internal Control Over Financial Reporting**





There
      was
      no change in our internal control over financial reporting that occurred during the
      quarter ended September 30, 2008 that
      has
      materially affected, or is reasonably likely to materially affect, our internal
      control over financial reporting.




15


**PART
      II - OTHER INFORMATION**




**I** **tem
      1.** **LEGAL
      PROCEEDINGS.**





Beginning
      in December 2000, we pledged as loan guarantees certain funds held as money
      market funds and certificates of deposit to collateralize margin loans for
      the
      following executive officers: (1) Michael R. Long, then Chairman of the Board
      of
      Directors and Chief Executive Officer; (2) Louis A. Hoch, then President and
      Chief Operating Officer; (3) Marshall N. Millard, then Secretary, Senior Vice
      President, and General Counsel; and (4) David S. Jones, then Executive Vice
      President. Mr. Millard and Mr. Jones are no longer our employees. The margin
      loans were obtained in March 1999 from institutional lenders and were secured
      by
      shares of our common stock owned by these officers. The pledged funds were
      held
      in our name in accounts with the lenders that held the margin loans of the
      officers. Our purpose in collateralizing the margin loans was to prevent the
      sale of our common stock owned by these officers while we were pursuing efforts
      to raise additional capital through private equity placements. The sale of
      that
      common stock could have hindered our ability to raise capital in such a manner
      and compromised our continuing efforts to secure additional financing. The
      highest total amount of funds pledged for the margin loans guaranteed by us
      was
      approximately $2.0 million. The total balance of the margin loans guaranteed
      by
      us was approximately $1.3 million at December 31, 2002. At the time the funds
      were pledged, we believed we would have access to them because (a) our stock
      price was substantial and the stock pledged by the officers, if liquidated,
      would produce funds in excess of the loans payable, and (b) with respect to
      one
      of the institutional lenders (who was also assisting us as a financial advisor
      at the time), even if the stock price fell, we had received assurances from
      that
      institutional lender that the pledged funds would be made available as needed.
      During the fourth quarter of 2002, we requested partial release of the funds
      for
      operating purposes, which request was denied by an institutional lender. At
      that
      time, our stock price had fallen as well, and it became clear that both
      institutional lenders would not release the pledged funds. In light of these
      circumstances, we recognized a loss on the guarantees of $1,278,138 in the
      fourth quarter of 2002 and recorded a corresponding payable under related party
      guarantees on our balance sheet at December 31, 2002 because it became probable
      at that point that we would be unable to recover our pledged funds. During
      the
      quarter ended March 31, 2003, the lenders applied the pledged funds to satisfy
      the outstanding balances of the loans. The total balance of the margin loans
      guaranteed by us was zero at September 30, 2008. In February 2007, we signed
      employment agreements with Mr. Long and Mr. Hoch that require each to repay
      his
      respective obligation to us in four equal annual payments of cash or stock
      or
      any combination thereof. In December 2007, Mr. Long and Mr. Hoch each made
      the
      first annual payment to us pursuant to their respective employment agreements.
      We may institute litigation or arbitration in collection of the outstanding
      repayment obligations of Mr. Millard and Mr. Jones, which currently total
      approximately $293,000. Presently, we have refrained from initiating action
      to
      recover funds from Mr. Millard because he may have an offsetting claim in excess
      of his repayment obligation by virtue of the deferred compensation clause in
      his
      employment agreement based on our preliminary analysis. We have not pursued
      the
      outstanding repayment obligation of Mr. Jones because we do not consider a
      recovery attempt to be cost beneficial. In order to attempt a recovery from
      Mr.
      Jones, we estimate that we would incur a minimum of $20,000 in estimated legal
      costs with no reasonable assurance of success in recovering his outstanding
      obligation of approximately $38,000. Because of the limited amount of the
      obligation, we also anticipate difficulty in retaining counsel on a contingency
      basis to pursue collection of this obligation. The ultimate outcome of this
      matter cannot presently be determined.





On
      August
      29, 2008, Tara Patrick p/k/a Carmen Electra, commenced legal action against
      us
      in the Superior Court of the State of California for the County of Los Angeles.
      On October 7, 2008, we removed that case to the United States District Court
      for
      the Central District of California - Los Angeles Division. With respect to
      the
      suit, the plaintiff alleges that we violated her rights of publicity and
      breached the terms of our license agreement with her. The plaintiff alleges
      and
      seeks resulting economic, exemplary and punitive damages, interest, attorneys'
      fees and costs of court. We believe this suit is without merit and intend to
      vigorously defend ourselves. In addition, on November 14, 2008, we filed a
      counterclaim against Ms. Patrick in the United States District Court for the
      Central District of California - Los Angeles Division alleging that she breached
      the terms of our license agreement with her. We allege and seek to recover
      damages arising from Ms. Patrick’s breach of the agreement. As of the date of
      this report, there have been no material developments in the suit. The results
      of legal proceedings cannot be predicted with certainty. If we fail to prevail
      in this legal matter, our financial position, results of operations, and cash
      flows could be materially adversely affected.


16


**I** **tem
      1A.** **RISK
      FACTORS.**





*Current
      economic conditions could have a materially adverse affect on our
      business.*




Our
      operations and performance depend to some degree on economic conditions and
      their impact on levels of consumer spending, which have recently deteriorated
      significantly in many countries and regions, including the regions in which
      we
      operate, and may remain depressed for the foreseeable future. For example,
      some
      of the factors that could influence the levels of consumer spending include
      continuing increases in fuel and other energy costs, conditions in the
      residential real estate and mortgage markets, labor and healthcare costs, access
      to credit, consumer confidence and other macroeconomic factors affecting
      consumer spending behavior. These and other economic factors could have a
      material adverse effect on demand for our products and on our financial
      condition and operating results.





Other
      than the risk factor described above, there have been no other material changes
      from risk factors previously disclosed in our annual report on Form 10-K for
      the
      fiscal year ended December 31, 2007.





**Item
      2.** **UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**





During
      the quarter ended September 30, 2008, we did not sell any unregistered
      securities.





**Item
      3.** **DEFAULTS
      UPON SENIOR SECURITIES.**





During
      the quarter ended September 30, 2008, we did not default on any senior
      securities.





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





There
      were no matters submitted to a vote of our stockholders during the third quarter
      of fiscal year 2008.





**Item
      5.** **OTHER
      INFORMATION.**





Not
      applicable.





**Item
      6.** **EXHIBITS.**




Exhibit
              Number
            Description


3.1
            Amended
                and Restated Articles of Incorporation (included as exhibit 3.1 to
                the
                Form 10-KSB filed March 31, 2006, and incorporated herein by
                reference).





3.2
            Amended
                and Restated By-laws (included as exhibit 3.2 to the Form 10-KSB
                filed
                March 31, 2006, and incorporated herein by reference).





4.1
            Amended
                and Restated 1999 Employee Comprehensive Stock Plan (included as
                exhibit
                10.1 to the Form 8-K filed January 3, 2006, and incorporated herein
                by
                reference).





4.2
            Amended
                and Restated 1999 Non-Employee Director Plan (included as exhibit
                10.2 to
                the Form 8-K filed January 3, 2006, and incorporated herein by
                reference).





4.3
            Employee
                Stock Purchase Plan (included as exhibit 4.3 to the Form S-8 filed
                February 23, 2000, and incorporated herein by
                reference).





4.4
            Amended
                Registration Rights Agreement between the Company and Dutchess Private
                Equities Fund, Ltd., dated August 21, 2007 (included as exhibit 10.2
                to
                the Form 8-K filed August 23, 2007, and incorporated herein by
                reference).




17
 
 Exhibit
                  Number
                Description


4.5
            Rights
                Agreement between the Company and American Stock Transfer & Trust
                Company, dated February 28, 2007 (included as exhibit 4.1 to the
                Form 8-K
                filed March 5, 2007, and incorporated herein by
                reference).





10.1
            Lease
                Agreement between the Company and Frost National Bank, Trustee for
                a
                Designated Trust, dated August 2003 (included as exhibit 10.3 to
                the Form
                10-Q filed November 14, 2003, and incorporated herein by
                reference).





10.2
            Employment
                Agreement between the Company and Michael R. Long, dated February
                27, 2007
                (included as exhibit 10.1 to the Form 8-K filed March 2, 2007, and
                incorporated herein by reference).





10.3
            Employment
                Agreement between the Company and Louis A. Hoch, dated February 27,
                2007
                (included as exhibit 10.2 to the Form 8-K filed March 2, 2007, and
                incorporated herein by reference).





10.4
            Investment
                Agreement between the Company and Dutchess Private Equities Fund,
                LP,
                dated June 4, 2004 (included as exhibit 10.8 to the Form SB-2 filed
                June
                18, 2004, and incorporated herein by
                reference).





10.5
            Placement
                Agent Agreement between the Company, Charleston Capital Corporation,
                and
                Dutchess Private Equities Fund, LP, dated June 4, 2004 (included
                as
                exhibit 10.10 to the Form SB-2 filed June 18, 2004, and incorporated
                herein by reference).





10.6
            Affiliate
                Office Agreement between the Company and Network 1 Financial, Inc.
                (included as exhibit 10.11 to the Form SB-2 filed April 28, 2004,
                and
                incorporated herein by reference).





10.7
            Warrant
                Agreement between the Company and Kubra Data Transfer LTD, dated
                as of
                September 30, 2004 (included as exhibit 10.1 to the Form 8-K filed
                October
                6, 2004, and incorporated herein by
                reference).





10.8
            Promissory
                Note between the Company and Dutchess Private Equities Fund, II,
                LP, dated
                August 21, 2006 (included as exhibit 10.1 to the Form 8-K filed
                August 25, 2006, and incorporated herein by
                reference).





10.9
            Stock
                Purchase Agreement between the Company and Robert D. Evans, dated
                January 18, 2007 (included as exhibit 10.1 to the Form 8-K filed
                January 23, 2007, and incorporated herein by
                reference).





10.10
            Stock
                Purchase Agreement between the Company and Robert D. Evans, dated
                March
                1, 2007 (included as exhibit 10.1 to the Form 8-K filed March 5,
                2007, and incorporated herein by
                reference).





10.11
            Amended
                Investment Agreement between the Company and Dutchess Private Equities
                Fund, Ltd., dated August 21, 2007 (included as exhibit 10.16 to the
                Form
                8-K filed August 23, 2007, and incorporated herein by
                reference).





10.12
            Trademark
                and Domain Name Purchase Agreement between the Company and Alivio
                Holdings, LLC, dated November 14, 2005 (included as exhibit 10.1
                to the
                Form 8-K filed November 17, 2005, and incorporated herein by
                reference).





10.13
            Patent
                Purchase Agreement between the Company and PCT Software Data, LLC,
                dated
                January 11, 2008 (included as exhibit 10.14 to the Form 10-K filed
                March
                27, 2008, and incorporated herein by
                reference).





31.1
            Certificationof
                the Chief Executive Officer/Chief Financial Officerpursuant
                to Section 302 of the Sarbanes-Oxley Act of 2002(filed
                herewith).





32.1
            Certificationof
                the Chief Executive Officer/Chief Financial Officer pursuant to 18
                U.S.C.
                Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
                Act
                of2002(filed
                herewith).


18


**SIGNATURE**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned, thereunto
      duly authorized.


**PAYMENT
                DATA SYSTEMS, INC****.**Date:
                  November 14, 2008
              
              By:
              /s/
                  Michael R. LongMichael
                  R. LongChairman
                  of the Board,Chief
                  Executive Officer andChief
                  Financial Officer(principal
                  executive officer andprincipal
                  financial and accounting
                  officer)


19