** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D. C. 20549**

 

**FORM 10-Q**

 

 

**QuarterlyReport Under Section 13 or 15(d)**

**of theSecurities Exchange Act of 1934**

 
| **x****          ****For  the Quarterly Period Ended September 30, 2007**                                                |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                       |
| **OR**                                                                                                                                                                     |
|                                                                                                                                                                       |
| **o****           ****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 0-22081**

----

 

 

 

**EPIQ SYSTEMS, INC.**

(Exact name of registrantas specified in its charter)

 

 

| **Missouri**                                                    | ** ** | **48-1056429**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (IRS Employer  Identification Number) |

 

**501 Kansas Avenue, Kansas City,Kansas 66105-1300**

(Address of principalexecutive office)

 

**913-621-9500**

(Registrant’s telephonenumber)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes x No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.

| Large Accelerated Filer o |   | Accelerated Filer x |   | Non-Accelerated Filer o |
|---------------------------|--------|---------------------|--------|-------------------------|

 

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

Yes o  Nox

 

The number of shares outstanding of registrant’s common stock atOctober 17, 2007:

 

| **Class**                     | ** ** | **Outstanding** |
|-------------------------------|------------|-----------------|
| Common Stock, $.01 par  value |       | 30,221,222      |

 

 

----

 

**EPIQSYSTEMS, INC.**

**FORM 10-Q**

**QUARTERENDED SEPTEMBER 30, 2007**

 

 

**CONTENTS**

 
|                               |                                                                                        | **Page** |
|------------------------------------|---------------------------------------------------------------------------------------------|----------|
|                               |                                                                                        |     |
| **PART I - FINANCIAL INFORMATION** |                                                                                        |
|                               |                                                                                        |     |
| Item  1.                           | Condensed  Consolidated Financial Statements                                                |     |
|                               |                                                                                        |     |
|                               | Condensed  Consolidated Statements of Income —                                         |     |
|                               | Three  and nine months ended September 30, 2007 and 2006 (Unaudited)                        | 1        |
|                               |                                                                                        |     |
|                               | Condensed  Consolidated Balance Sheets —                                               |     |
|                               | September  30, 2007 and December 31, 2006 (Unaudited)                                       | 2        |
|                               |                                                                                        |     |
|                               | Condensed  Consolidated Statement of Changes in Stockholders’ Equity —            |     |
|                               | Nine  months ended September 30, 2007 (Unaudited)                                           | 3        |
|                               |                                                                                        |     |
|                               | Condensed  Consolidated Statements of Cash Flows —                                     |     |
|                               | Nine  months ended September 30, 2007 and 2006 (Unaudited)                                  | 4        |
|                               |                                                                                        |     |
|                               | Notes to  Condensed Consolidated Financial Statements (Unaudited)                           | 5        |
|                               |                                                                                        |     |
| Item 2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 21       |
|                               |                                                                                        |     |
| Item 3.                            | Quantitative  and Qualitative Disclosures about Market Risk                                 | 32       |
|                               |                                                                                        |     |
| Item 4.                            | Controls and  Procedures                                                                    | 32       |
|                               |                                                                                        |     |
| **PART II - OTHER  INFORMATION**   |                                                                                        |
|                               |                                                                                        |     |
| Item  1A.                          | Risk  Factors                                                                               | 33       |
|                               |                                                                                        |     |
| Item  6.                           | Exhibits                                                                                    | 33       |
|                               |                                                                                        |     |
| Signatures                         |                                                                                        | 34       |
|                                    |                                                                                             |          |  |

 

----

 

**PART I -FINANCIAL INFORMATION**

 

**ITEM 1. Condensed Consolidated Financial Statements.**

 

##### **EPIQ SYSTEMS, INC.**

##### **CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

**(InThousands, Except Share and Per Share Data)**

**(Unaudited)**

** **
| ** **                                                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2007**                                   | ** ** | **2006**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **REVENUE:**                                                                                                      | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Case management  services                                                                                         |       | $                                          | 26,536     |                                      | $          | 16,980 |   | $ | 71,069 |   | $ | 54,064 |   |
| Case management  bundled products and services                                                                    |       | 6,728                                      |       | 12,818                                    |       | 20,139 |   | 80,511 |   |
| Document  management services                                                                                     |       | 5,921                                      |       | 4,591                                     |       | 21,242 |   | 26,495 |   |
| Operating  revenue before reimbursed direct costs                                                                 |       | 39,185                                     |       | 34,389                                    |       | 112,450 |   | 161,070 |   |
| Operating  revenue from reimbursed direct costs                                                                   |       | 5,662                                      |       | 4,643                                     |       | 17,730 |   | 16,676 |   |
| Total Revenue                                                                                                     |       | 44,847                                     |       | 39,032                                    |       | 130,180 |   | 177,746 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **OPERATING  EXPENSES:**                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Direct costs of  services (exclusive of depreciation and amortization shown separately below)                     |       | 9,355                                      |       | 8,299                                     |       | 30,101 |   | 33,427 |   |
| Direct cost of bundled products and services (exclusive of depreciation  and amortization shown separately below) |       | 998                                        |       | 961                                       |       | 2,782 |   | 2,976 |   |
| Reimbursed  direct costs                                                                                          |       | 5,593                                      |       | 4,685                                     |       | 17,625 |   | 16,852 |   |
| General and  administrative                                                                                       |       | 16,208                                     |       | 12,411                                    |       | 44,383 |   | 36,469 |   |
| Depreciation and  software and leasehold amortization                                                             |       | 3,272                                      |       | 2,633                                     |       | 9,071 |   | 7,424 |   |
| Amortization of  identifiable intangible assets                                                                   |       | 2,352                                      |       | 3,027                                     |       | 7,228 |   | 8,672 |   |
| Other operating  expenses                                                                                         |       | 565                                        |       | —                                    |       | 565 |   | 250 |   |
| Total Operating  Expenses                                                                                         |       | 38,343                                     |       | 32,016                                    |       | 111,755 |   | 106,070 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **INCOME  FROM OPERATIONS**                                                                                       |       | 6,504                                      |       | 7,016                                     |       | 18,425 |   | 71,676 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **INTEREST  EXPENSE (INCOME):**                                                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Interest income                                                                                                   |       | (10                                        | )          | (23                                       | )          | (42 | ) | (111 | ) |
| Interest expense                                                                                                  |       | 2,168                                      |       | 2,523                                     |       | 10,615 |   | 9,215 |   |
| Net Interest  Expense                                                                                             |       | 2,158                                      |       | 2,500                                     |       | 10,573 |   | 9,104 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **INCOME  BEFORE INCOME TAXES**                                                                                   |       | 4,346                                      |       | 4,516                                     |       | 7,852 |   | 62,572 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **PROVISION  FOR INCOME TAXES**                                                                                   |       | 1,922                                      |       | 1,835                                     |       | 3,485 |   | 25,348 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **NET  INCOME**                                                                                                   |       | $                                          | 2,424      |                                      | $          | 2,681 |   | $ | 4,367 |   | $ | 37,224 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **NET  INCOME PER SHARE INFORMATION:**                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                                             |       | $                                          | .08        |                                      | $          | .09 |   | $ | .15 |   | $ | 1.28 |   |
| Diluted                                                                                                           |       | $                                          | .07        |                                      | $          | .09 |   | $ | .14 |   | $ | 1.10 |   |
|                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| **WEIGHTED  AVERAGE COMMON SHARES OUTSTANDING:**                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                                             |       | 30,185                                     |       | 29,162                                    |       | 29,770 |   | 29,057 |   |
| Diluted                                                                                                           |       | 36,704                                     |       | 34,366                                    |       | 31,803 |   | 34,597 |   |

** **

**See accompanyingnotes to condensed consolidated financial statements.**

 

 

1

----

 

**EPIQ SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(In Thousands, Except Share Data)**

**(Unaudited)**

 
| ** **                                                                                                                                                                               | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                               | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                               | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| **CURRENT ASSETS:**                                                                                                                                                                      | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Cash and cash equivalents                                                                                                                                                                |       | $                           | 2,854      |                       | $          | 5,274 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $1,349 and $1,684,  respectively                                                                                     |       | 36,219                      |       | 33,066                     |       |
| Prepaid expenses                                                                                                                                                                         |       | 2,878                       |       | 2,537                      |       |
| Income taxes refundable                                                                                                                                                                  |       | 160                         |       | 332                        |       |
| Deferred income taxes                                                                                                                                                                    |       | 655                         |       | 1,313                      |       |
| Other current assets                                                                                                                                                                     |       | 1,609                       |       | 740                        |       |
| Total Current Assets                                                                                                                                                                     |       | 44,375                      |       | 43,262                     |       |
|                                                                                                                                                                                     |       |                        |       |                       |       |
| **LONG-TERM ASSETS:**                                                                                                                                                                    | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Property, equipment and leasehold improvements, net                                                                                                                                      |       | 32,147                      |       | 23,153                     |       |
| Software development costs, net                                                                                                                                                          |       | 9,766                       |       | 9,611                      |       |
| Goodwill                                                                                                                                                                                 |       | 260,933                     |       | 260,609                    |       |
| Identifiable  intangible assets, net of accumulated amortization of $30,946 and $25,387,  respectively                                                                                   |       | 36,612                      |       | 43,840                     |       |
| Other                                                                                                                                                                                    |       | 918                         |       | 1,745                      |       |
| Total Long-term Assets                                                                                                                                                                   |       | 340,376                     |       | 338,958                    |       |
| **Total Assets**                                                                                                                                                                         |       | $                           | 384,751    |                       | $          | 382,220 |   |
|                                                                                                                                                                                     |       |                        |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                           | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| **CURRENT LIABILITIES:**                                                                                                                                                                 | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Accounts payable                                                                                                                                                                         |       | $                           | 6,819      |                       | $          | 7,930 |   |
| Customer deposits                                                                                                                                                                        |       | 1,577                       |       | 1,978                      |       |
| Accrued compensation                                                                                                                                                                     |       | 6,510                       |       | 3,514                      |       |
| Other accrued expenses                                                                                                                                                                   |       | 3,268                       |       | 4,143                      |       |
| Deferred revenue                                                                                                                                                                         |       | 493                         |       | 1,073                      |       |
| Current maturities of long-term obligations                                                                                                                                              |       | 3,774                       |       | 70,488                     |       |
| Total Current Liabilities                                                                                                                                                                |       | 22,441                      |       | 89,126                     |       |
|                                                                                                                                                                                     |       |                        |       |                       |       |
| **LONG-TERM LIABILITIES:**                                                                                                                                                               | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Long-term obligations (excluding current maturities)                                                                                                                                     |       | 135,710                     |       | 83,873                     |       |
| Deferred income taxes                                                                                                                                                                    |       | 19,860                      |       | 23,307                     |       |
| Other long-term liabilities                                                                                                                                                              |       | 8,800                       |       | 1,735                      |       |
| Total Long-term Liabilities                                                                                                                                                              |       | 164,370                     |       | 108,915                    |       |
|                                                                                                                                                                                     |       |                        |       |                       |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                                        | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| ** **                                                                                                                                                                               | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                           | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Common stock -  $0.01 par value; 50,000,000 shares authorized; issued and outstanding  —30,212,071 and 29,218,259 shares at September 30, 2007 and December 31,  2006, respectively |       | 302                         |       | 292                        |       |
| Additional paid-in capital                                                                                                                                                               |       | 148,802                     |       | 136,947                    |       |
| Accumulated other comprehensive income                                                                                                                                                   |       | 57                          |       | 18                         |       |
| Retained earnings                                                                                                                                                                        |       | 48,779                      |       | 46,922                     |       |
| Total Stockholders’ Equity                                                                                                                                                          |       | 197,940                     |       | 184,179                    |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                      |       | $                           | 384,751    |                       | $          | 382,220 |   |

** **

**See accompanying notes to condensed consolidated financialstatements.**

** **

 

2

----

 

**EPIQ SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTOF CHANGES IN STOCKHOLDERS’ EQUITY**

**(In Thousands)**

**(Unaudited)**

 
| ** **                                                                                     | ** ** | **Nine Months Ended September 30,  2007** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
|                                                                                           |       |                                      |       |
| COMMON SHARES (50,000 authorized):                                                             |       |                                      |       |
| Shares, beginning of year                                                                      |       | 29,218                                    |       |
| Shares issued upon exercise of options                                                         |       | 994                                       |       |
|                                                                                           |       |                                      |       |
| Shares, end of period                                                                          |       | 30,212                                    |       |
|                                                                                           |       |                                      |       |
| COMMON STOCK — PAR VALUE $0.01 PER SHARE:                                                 |       |                                      |       |
| Balance, beginning of year                                                                     |       | $                                         | 292        |   |
| Proceeds from exercise of options                                                              |       | 10                                        |       |
|                                                                                           |       |                                      |       |
| Balance, end of period                                                                         |       | 302                                       |       |
|                                                                                           |       |                                      |       |
| ADDITIONAL PAID-IN CAPITAL:                                                                    |       |                                      |       |
| Balance, beginning of year                                                                     |       | 136,947                                   |       |
| Proceeds from exercise of options                                                              |       | 8,722                                     |       |
| Share-based income tax benefit                                                                 |       | 1,324                                     |       |
| Share-based compensation expense                                                               |       | 1,809                                     |       |
|                                                                                           |       |                                      |       |
| Balance, end of period                                                                         |       | 148,802                                   |       |
|                                                                                           |       |                                      |       |
| ACCUMULATED OTHER COMPREHENSIVE INCOME:                                                        |       |                                      |       |
| Balance, beginning of year                                                                     |       | 18                                        |       |
| Foreign currency translation adjustment                                                        |       | 39                                        |       |
|                                                                                           |       |                                      |       |
| Balance, end of period                                                                         |       | 57                                        |       |
|                                                                                           |       |                                      |       |
| RETAINED EARNINGS:                                                                             |       |                                      |       |
| Balance, beginning of year                                                                     |       | 46,922                                    |       |
| Cumulative effect of adoption of FIN 48,*Accounting for**Uncertainty in Income Taxes* (note 4) |       | (2,510                                    | )          |
| Net income                                                                                     |       | 4,367                                     |       |
|                                                                                           |       |                                      |       |
| Balance, end of period                                                                         |       | 48,779                                    |       |
|                                                                                           |       |                                      |       |
|                                                                                           |       |                                      |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                                |       | $                                         | 197,940    |   |

 

**See accompanying notes to condensed consolidated financialstatements.**

 

3

----

 

**EPIQSYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(InThousands)**

**(Unaudited)**

 
| ** **                                                                              | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                              | ** ** | **2007**                                 | ** ** | **2006** | ** ** |
| ** **                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                              | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net income                                                                              |       | $                                        | 4,367      |   | $ | 37,224 |   |
| Adjustments to  reconcile net income to net cash from operating activities:             |       |                                     |       |   |   |
| Share-based  compensation expense                                                       |       | 1,809                                    |       | 1,671 |   |
| (Benefit)  expense for deferred income taxes                                            |       | (1,778                                   | )          | 22,761 |   |
| Depreciation and  software and leasehold amortization                                   |       | 9,071                                    |       | 7,424 |   |
| Change in  valuation of embedded option and convertible debt                            |       | 2,190                                    |       | (277 | ) |
| Amortization of  identifiable intangible assets                                         |       | 7,228                                    |       | 8,672 |   |
| Other                                                                                   |       | 1,376                                    |       | 515 |   |
| Changes in  operating assets and liabilities, net of effects from business acquisition: |       |                                     |       |   |   |
| Trade accounts  receivable                                                              |       | (2,818                                   | )          | 2,632 |   |
| Prepaid expenses  and other assets                                                      |       | (1,815                                   | )          | 28 |   |
| Accounts payable  and other liabilities                                                 |       | 1,004                                    |       | (1,878 | ) |
| Deferred revenue                                                                        |       | (580                                     | )          | (59,398 | ) |
| Excess tax  benefit related to share-based compensation                                 |       | (594                                     | )          | (154 | ) |
| Income taxes                                                                            |       | 3,976                                    |       | 4,355 |   |
| Net cash  provided by operating activities                                              |       | 23,436                                   |       | 23,575 |   |
|                                                                                    |       |                                     |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                              | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Purchase of  property, equipment, and leasehold improvements                            |       | (12,160                                  | )          | (5,182 | ) |
| Software  development costs                                                             |       | (3,467                                   | )          | (3,275 | ) |
| Cash paid for  acquisition of business                                                  |       | —                                   |       | (3,586 | ) |
| Other                                                                                   |       | 279                                      |       | (45 | ) |
| Net cash used in  investing activities                                                  |       | (15,348                                  | )          | (12,088 | ) |
|                                                                                    |       |                                     |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                              | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Proceeds from  long-term debt borrowings                                                |       | 39,000                                   |       | 3,000 |   |
| Principal  payments under long-term debt obligations                                    |       | (58,834                                  | )          | (26,643 | ) |
| Excess tax  benefit related to share-based compensation                                 |       | 594                                      |       | 154 |   |
| Proceeds from  exercise of share options                                                |       | 8,732                                    |       | 2,602 |   |
| Other                                                                                   |       | —                                   |       | (137 | ) |
| Net cash used in  financing activities                                                  |       | (10,508                                  | )          | (21,024 | ) |
|                                                                                    |       |                                     |       |   |   |
| **NET  DECREASE IN CASH AND CASH EQUIVALENTS**                                          |       | (2,420                                   | )          | (9,537 | ) |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                     |       | 5,274                                    |       | 13,563 |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                           |       | $                                        | 2,854      |   | $ | 4,026 |   |

 

**Seeaccompanying notes to condensed consolidated financial statements.**

 

4

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**EPIQSYSTEMS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

 

**NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

***Principlesof Consolidation***

 

The condensedconsolidated financial statements include the accounts of Epiq Systems, Inc. (“Epiq”)and its wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated inconsolidation.

 

***Natureof Operations***

 

We are a provider of integrated technology solutions for the legalprofession.  Our solutions streamline theadministration of bankruptcy, litigation, financial transactions and regulatorycompliance matters.  We offer innovativetechnology solutions for electronic discovery, document review, legalnotification, claims administration and controlled disbursement of funds.  Our clients include law firms, corporatelegal departments, bankruptcy trustees and other professional advisors whorequire innovative technology, responsive service and deep subject-matterexpertise.

 

***CommonStock Split***

 

On May 17, 2007,the board of directors approved a 3 for 2 stock split, effected in the form ofa 50% stock dividend, payable June 7, 2007 to holders of record as of May 24,2007.  All per share and sharesoutstanding data in the condensed consolidated financial statements and theaccompanying notes have been revised to reflect the stock split.

 

***Comprehensive Income***

 

Statement of Financial Accounting Standards No. 130, *Reporting Comprehensive Income*, establishes requirements forreporting and displaying comprehensive income and its components.  Our accumulated other comprehensive income isincluded as a separate component of stockholders’ equity on our condensedconsolidated balance sheets.  Othercomprehensive income is not considered material to the results of operations.

 

***Incometaxes***

 

Effective January1, 2007, we adopted Financial Accounting Standard Board (FASB) InterpretationNo. 48 (FIN 48), *Accounting for Uncertainty in Income Taxes —*an interpretation of FASB Statement No. 109, *Accountingfor Income Taxes*.  FIN 48prescribes a comprehensive model for how companies should recognize, measure,present, and disclose in their financial statements uncertain tax positionstaken or expected to be taken on a tax return. Under FIN 48, tax positions are initially recognized in the financialstatements when it is more likely than not the position will be sustained uponexamination by the tax authorities.  Suchtax positions are initially and subsequently measured as the largest amount oftax benefit that is greater than 50% likely of being realized upon ultimatesettlement with the tax authority assuming full knowledge of the position andall relevant facts.  Application of FIN48 requires numerous estimates based on available information.  We consider many factors when evaluating andestimating our tax positions and tax benefits, which may require periodicadjustments and which may not accurately anticipate actual outcomes.  The cumulative effect of applying the provisionsof FIN 48 was reported as an adjustment to the opening balance of retainedearnings as of January 1, 2007.  Thecumulative effect adjustment does not include items that would not berecognized in earnings, such as the effect on tax positions related to businesscombinations.  For additional informationrelated to our adoption of FIN 48, see note 4 of the condensed consolidatedfinancial statements.

 

***Revenue Recognition. ***

 

We provide twoclasses of products and services — case management products and services anddocument management services.  Casemanagement solutions provide clients with integrated technology-based productsand services for the automation of various administrative tasks.  Document management solutions includeproprietary technology and production services to ensure timely, accurate andcomplete execution of the many documents associated with multifaceted legalcases.

 

5

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Significant sources of revenue include:

 

•                  Fees contingent upon the month-to-month delivery ofcase management services defined by client contracts, such as claimsprocessing, claims reconciliation, professional services, call center support,and conversion of data into an organized, searchable electronic database. Theamount we earn varies based primarily on the size and complexity of theengagement;

 

•                  Hosting fees based on the amount of data stored;

 

•                  Deposit-based fees from financial institutions, primarily based on apercentage of total liquidated assets placed on deposit at that financialinstitution by our bankruptcy trustee clients, to whom we provide, at nocharge, software licenses, limited hardware and hardware maintenance, andpostcontract customer support (PCS) services;

 

•                  Legal noticing services, including media campaign and advertisingmanagement in which we coordinate notification through various media outlets,such as print, radio and television, to potential parties of interest for aparticular client engagement; and

 

•                  Reimbursement for costs incurred, primarily related to postage onmailing services.

 

*Software Arrangements*

 

For our primarybankruptcy trustee arrangements, we provide our trustee clients with a softwarelicense, hardware lease, hardware maintenance, and PCS services, all at nocharge to the trustee.  The trusteesplace their liquidated estate deposits with a financial institution with whichwe have an arrangement.  The financialinstitution pays us a monthly fee contingent on the dollar level of averagemonthly deposits placed by the trustees with that financial institution.

 

For thesearrangements with financial institutions, we earn contingent monthly fees fromthe financial institution related to the software license, hardware lease,hardware maintenance, and PCS services. We account for the software license and PCS service elements inaccordance with Statement of Position 97-2, *Software RevenueRecognition* (SOP 97-2).  Sincewe have not established vendor specific objective evidence (VSOE) of the fairvalue of the software license, we do not recognize any revenue on delivery ofthe software.  The software element isdeferred and included with the remaining undelivered element, which is PCSservices.  This revenue, when recognized,is included on our condensed consolidated statements of income as a componentof case management bundled products and services revenue.  Revenue related to PCS services is entirelycontingent on the placement of liquidated estate deposits by the trustee withthe financial institution.  Accordingly,we recognize this contingent usage based revenue consistent with the guidanceprovided by the American Institute of Certified Public Accountants’ TechnicalPractice Aid (TPA) 5100.76, *Fair Value inMultiple-Element Arrangements That Include Contingent Usage-Based Fees andSoftware Revenue Recognition* as the fee becomes fixed ordeterminable at the time actual usage occurs and collectibility isprobable.  This occurs monthly as aresult of the computation, billing and collection of monthly deposit feescontractually agreed to.  At that time,we have also satisfied the other revenue recognition criteria contained in SOP97-2 as we have persuasive evidence that an arrangement exists, services havebeen rendered, the price is fixed and determinable, and collectibility isreasonably assured.

 

We also provide our trustees with certain hardware, such as desktopcomputers, monitors, and printers, and hardware maintenance.  We retain ownership of all hardware providedand, based on guidance provided in EITF 01-8, *DeterminingWhether an Arrangement Contains a Lease*, we account for thishardware as a lease.  As the hardwaremaintenance arrangement is an executory contract similar to an operating lease,we use guidance related to contingent rentals in operating lease arrangementsfor hardware maintenance as well as for the hardware lease.  Since all of the payments under ourarrangements are contingent upon the level of trustee deposits and the deliveryof upgrades and other services and there remain important uncertaintiesregarding the amount of unreimbursable costs yet to be incurred by us, weaccount for the hardware lease as an operating lease in accordance with SFAS13, *Accounting for Leases*.  Therefore, all lease payments were accountedfor as contingent rentals under EITF Issue No. 98-9, *Accounting for Contingent Rent* and Staff Accounting BulletinTopic 13, *Revenue Recognition*(SAB Topic 13), which requires that we recognize rental income when the changesin the factor on which the contingent lease payment is based actuallyoccur.  This occurs at the end of eachperiod as our target is achieved when deposits are held at the depositoryfinancial institution as, at that time, evidence of an arrangement exists,delivery has occurred, the amount has become fixed and determinable, andcollection is reasonably assured.  Thisrevenue, 

 

6

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which is less than ten percent of our total revenue, is included in ourcondensed consolidated statements of income as a component of “Case managementservices” revenue.

 

Prior to October 1, 2006, we had anarrangement with our primary depository financial institution under which we delivered two specifiedupgrades annually with the last specified upgrade in the second quarter of2006.  This arrangement includedspecific pricing for each software upgrade and certain projects in addition tothe contingent deposit-based pricing related to the software license, hardware,hardware maintenance, and PCS to each trustee client.  Therefore,the software upgrades and projects are part of a bundled arrangement.  Each software upgrade is considered aseparate and discrete product and, as we do not sell each software upgrade on astandalone basis, we were unable to establish VSOE of the fair value of thesoftware upgrades.  As a result, thelicensed software, software upgrade, projects and PCS were a combined unit ofaccounting.  Revenue for this combinedunit of accounting, when recognized, was included as a component of casemanagement bundled products and services revenue.  Since we did not have VSOE of the fairvalue of each separate upgrade, we deferred recognition of substantially allrevenue from the October 1, 2003 inception of this arrangement until delivery,in the second quarter of 2006, of the final upgrade.  The ongoing costs related to this arrangement wererecognized as expense when incurred.  Payments received in advance of satisfactionof the related revenue recognition criteria were recognized as deferred revenueuntil all revenue recognition criteria had been satisfied.  On delivery of the finalupgrade during the second quarter of 2006, the only remaining undeliveredelement was PCS services.  In accordancewith SOP 97-2, on delivery of the final software upgrade, we recognized revenuepreviously deferred on a proportionate basis over the three year term of thecontract.  As the contract commencedOctober 1, 2003 and terminated September 30, 2006, we recognized approximately$60.1 million of net deferred revenue during the second quarter of 2006 and werecognized approximately $6.0 million of deferred revenue related to thisarrangement during the third quarter of 2006.

 

*Other Arrangements*

 

Services related to electronic discovery andsettlements and claims are billed based on volume and are evaluated pursuant toEmerging Issues Task Force (EITF) 00-21, *RevenueArrangements with Multiple Deliverables*.  For these contractual arrangements, we haveidentified the following deliverable services:

 

•                  Electronic Discovery

•               Data processing

•               Hosting

•                  Settlements and Claims

•               Consulting

•               Claims administration

•               Printing and mailing

•               Document management

•               Notice campaigns

•               Call center support

•               Web site design/hosting

 

Based on our evaluation of each element, wehave determined that each element delivered has standalone value to ourcustomers because we or other vendors sell such services separately from anyother services/deliverables.  We havealso obtained objective and reliable evidence of the fair value of each elementbased either on the price we charge when we sell an element on a standalonebasis or based on third-party evidence of fair value of such services.  Lastly, our arrangements do not includegeneral rights of return.  Accordingly,each of the service elements in our multiple element case and documentmanagement arrangements qualifies as a separate unit of accounting under EITF00-21.  We allocate revenue to thevarious units of accounting in our arrangements based on the fair value of eachunit of accounting, which is generally consistent with the stated prices in ourarrangements. As we have evidence of an arrangement, revenue for each separateunit of accounting is recognized each period in accordance with SAB Topic13.  As the services are rendered, ourfee becomes fixed and determinable, and collectibility is reasonablyassured.  Payments received in advance ofsatisfaction of the related revenue recognition criteria are recognized as acustomer deposit until all revenue recognition criteria have been satisfied.

 

*Reimbursements*

 

We have revenue related to the reimbursementof certain costs, primarily postage. Consistent with guidance provided by EITF No. 01-14, *Income Statement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred*, 

 

7

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reimbursed postage and other reimbursabledirect costs are recorded gross in the condensed consolidated statements ofincome as “Operating  revenue fromreimbursed direct costs” and as “Reimbursed direct costs”.

 

***Recent Accounting Pronouncements***

 

In February 2007, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards No. 159, *The FairValue Option for Financial Assets and Financial Liabilities — Including anamendment of FASB Statement No. 115** *(SFAS 159).  SFAS 159 permits the measurement of specifiedfinancial instruments and warranty and insurance contracts at fair value on acontract-by-contract basis, with changes in fair value recognized in earningseach reporting period.  SFAS 159 iseffective for fiscal years beginning after November 15, 2007.  We do not anticipate that adoption of thisstatement will have a material impact on our consolidated financial statements.

 

In September 2006, the FASB issued Statement of Financial AccountingStandards No. 157, *Fair Value Measurements*,(SFAS 157).  SFAS 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.  SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 andinterim periods within those fiscal years. Management is still evaluating the impact, if any, that the adoption ofSFAS 157 will have on our consolidated financial statements.

 

In June 2007, the EITF issued Issue No. 06-11, *Accountingfor Income Tax Benefits of Dividends on Share based Payment Awards*(EITF 06-11).  EITF 06-11 providesinterpretive guidance on the recognition of income tax benefits received ondividends paid to nonvested equity share awards.  EITF 06-11 is effective for fiscal yearsbeginning after December 15, 2007.  We donot anticipate that adoption of EITF 06-11 will have a material impact on ourconsolidated financial statements.

 

**NOTE 2:  INTERIM FINANCIAL STATEMENTS**

 

The accompanying condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (GAAP) and with the rules and regulations forreporting on Form 10-Q for interim financial statements.  Accordingly, they do not include certaininformation and disclosures required for comprehensive annual financialstatements.  The interim financialstatements have not been audited.  Thefinancial statements should be read in conjunction with our audited financialstatements and accompanying notes, which are included in our Form 10-K, asupdated and superseded by information contained in our Form 8-K filed on August7, 2007, for the year ended December 31, 2006.

 

In the opinion of our management, the accompanying condensedconsolidated financial statements reflect all adjustments necessary (consistingsolely of normal recurring adjustments) to present fairly our financialposition as of September 30, 2007, the changes in stockholders’ equity for thenine month period ended September 30, 2007, the results of operations for thethree and nine month periods ended September 30, 2007 and 2006, and cash flowsfor the nine month periods ended September 30, 2007 and 2006.

 

The results of operations for the three and nine month periods endedSeptember 30, 2007 are not necessarily indicative of the results to be expectedfor the entire year.

#### ** **

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#### **NOTE 3:   GOODWILL AND INTANGIBLE ASSETS**

 

Amortizing identifiableintangible assets as of September 30, 2007 and December 31, 2006 consisted ofthe following (in thousands):

 
| ** **              | ** ** | **September 30, 2007** | ** ** | **December 31, 2006**   | ** ** |
|-------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **              | ** ** | **Gross Carrying Amount**   | ** ** | **Accumulated Amortization** | ** ** | **Gross Carrying Amount** | ** ** | **Accumulated Amortization** | ** ** |
| Customer  contracts     |       | $                           | 39,287     |                         | $          | 16,656 |   | $ | 39,287 |   | $ | 12,779 |   |
| Trade names             |       | 745                         |       | 734                          |       | 2,414 |   | 2,301 |   |
| Non-compete  agreements |       | 27,526                      |       | 13,556                       |       | 27,526 |   | 10,307 |   |
|                    |       | $                           | 67,558     |                         | $          | 30,946 |   | $ | 69,227 |   | $ | 25,387 |   |

 

 

Aggregate amortizationexpense related to identifiable intangible assets was $2.4 million and $3.0million for the three month periods ended September 30, 2007 and 2006,respectively and was $7.2 million and $8.7 million for the nine month periodsended September 30, 2007 and 2006, respectively.  Amortization expense related to identifiableintangible assets for 2007 and the following five years is estimated as follows(in thousands):

 

| **Year Ending   December 31,** | ** ** | **Estimated  Amortization  Expense** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|
| 2007                           |       | $                                    | 9,531      |   |
| 2008                           |       | 8,361                                |       |
| 2009                           |       | 6,829                                |       |
| 2010                           |       | 6,439                                |       |
| 2011                           |       | 4,706                                |       |
| 2012                           |       | 4,535                                |       |
|                           |       | $                                    | 40,401     |   |

 

 

As of September 30, 2007 andDecember 31, 2006, goodwill had a carrying value of $260.9 million and $260.6million, respectively.  The $0.3 millionincrease in goodwill results from an adjustment of the acquisition date taxbasis pursuant to FIN 48, partly offset by a subsequent reversal of theacquisition date tax basis adjustment as certain federal and state tax returnswere closed under the statute of limitation and by a purchase price adjustmentrelated to the receipt of cash on final settlement of an escrowed amountrelated to our acquisition of our electronic discovery business.  Goodwill by segment is disclosed in note 8 ofthe condensed consolidated financial statements.

### ** **

9

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### **NOTE 4:  INCOME TAXES**

 

In June 2006, the FASB issued FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes —*aninterpretation of FASB Statement No. 109, *Accounting for IncomeTaxes*(FIN 48)*.*  FIN 48 clarifies the accounting for uncertaintyin income taxes in an enterprise’s financial statements in accordance with SFASNo. 109, *Accounting for Income Taxes*.  This interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  FIN 48 also provides guidance onderecognition of tax benefits, classification on the balance sheet, interestand penalties, accounting in interim periods, disclosures, and transition.

 

We adopted FIN 48 effective January 1, 2007.  As a result of the adoption, we recognizedadditional tax related liabilities of approximately $3.4 million consisting ofa $2.5 million reduction to retained earnings and a $0.9 million increase togoodwill related to prior acquisitions. In addition, we reclassified approximately $1.3 million of income taxliabilities from a current liability classification to a non-current liabilityclassification as payment of the liability is not anticipated within one yearof the balance sheet date. We also recorded approximately $1.2 million ofdeferred tax assets related to the tax benefits associated with interestexpense and federal benefits associated with state tax expenses. As of January1, 2007, the gross amount of unrecognized tax benefits, including penalty andinterest was approximately $5.9 million. If recognized, approximately $3.7 million would affect our effective taxrate.  As of September 30, 2007, thegross amount of unrecognized tax benefits, including penalty and interest, wasapproximately $6.6 million.  Ifrecognized, approximately $4.7 million would affect our effective tax rate.

 

We file income tax returns in the U.S. federal jurisdiction, the UnitedKingdom, Australia and various state jurisdictions.  We have also made an evaluation of thepotential impact of assessments by state jurisdictions in which we have notfiled tax returns. During the nine months ended September 30, 2007, theInternal Revenue Service initiated an examination of our 2004 federal incometax return and the State of New York initiated an examination of our 2003 —2005 New York state income tax returns. It is possible that the examination phase of these audits will concludein 2007 and it is reasonably possible that a change in the unrecognized taxbenefits may occur within the next twelve months; however, we were not able toreasonably estimate the amount that would be recognized during this period..

 

As of the January 1, 2007 adoption date of FIN 48, the 2003 — 2006federal tax returns were open.  Inaddition, 2002 — 2006 state and foreign tax returns were open to audit underthe statute of limitations.  As ofJanuary 1, 2007, it was reasonably possible that approximately $0.6 million ofnet unrecognized tax benefits would be recognized in the following twelvemonths due to the closing of 2002 and 2003 years for federal and statejurisdictions, of which $0.2 million would affect our effective tax rate and$0.4 million would decrease goodwill.

 

During the three months ended September 30, 2007, certain prior year federal and state taxjurisdiction returns were closed due to the lapse in the statute oflimitations.  As a result, during boththe three and nine months ended September 30, 2007, we recognized $0.4 millionof net unrecognized tax benefits, of which $0.3 million decreased goodwill and$0.1 million reduced tax expense.  Our2004 — 2006 federal tax returns and certain 2003 — 2006 state tax returnsremain open under the relevant statute of limitations.

 

As permitted by FIN 48, we have classified interest and penalties as acomponent of income tax expense. Estimated interest and penalties classified as a component of income taxexpense for the three and nine months ended September 30, 2007 wasapproximately $0.1 million and $0.3 million, respectively.  Accrued interest and penalties were $1.3million and $1.1 million as of September 30, 2007 and January 1, 2007,respectively.

 

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#### **NOTE 5:  INDEBTEDNESS**

 

The following is asummary of indebtedness outstanding (in thousands):

 

| ** **                                                           | ** ** | ** **             | ** ** | ** **            | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                                           | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Senior revolving  loan                                               |       | $                      | 77,028     |                  | $          | 78,028 |   |
| Senior term loan                                                     |       | —                 |       | 15,000                |       |
| Contingent  convertible subordinated debt, including embedded option |       | 54,360                 |       | 52,170                |       |
| Capital leases                                                       |       | 1,803                  |       | 179                   |       |
| Deferred  acquisition price                                          |       | 6,293                  |       | 8,984                 |       |
| Total  indebtedness                                                  |       | $                      | 139,484    |                  | $          | 154,361 |   |

 

***Credit Facilities***

 

As of December 31, 2006, we had a creditfacility, with KeyBank National Association as administrative agent, thatconsisted of a $15.0million senior term loan and a $100.0 million senior revolving loan.  During April 2007, we paid in full andterminated the senior term loan.  Thesenior revolving loan matures in November 2008. During the term of the credit facility, we have the right, subject tocompliance with our covenants, to increase the senior revolving loan to $175.0million.

 

The credit facility is secured by liens on our real property and asignificant portion of our personal property. Interest on the credit facility is generally based on a spread, which asof September 30, 2007 was 300 basis points, over the LIBOR rate.  As of September 30, 2007, the averageinterest rate charged on outstanding borrowings under the credit facility wasapproximately 8.5% per annum.

 

Our credit facility contains financial covenants related to earningsbefore interest, provision for income taxes, depreciation, amortization andother adjustments as defined in the agreements (EBITDA) and total debt.  In addition, our credit facility alsocontains financial covenants related to senior debt, fixed charges, and workingcapital.  As of September 30, 2007, wewere in compliance with all financial covenants.

 

***Contingent Convertible Subordinated Notes***

 

During June 2004, we issued $50.0 million of contingent convertiblesubordinated notes with a fixed 4% per annum interest rate and an originalmaturity of June 15, 2007.  The holdersof the convertible subordinated notes had the right to extend the maturity dateby up to three years.  During April 2007,the holders exercised this right and the convertible subordinated notesmaturity date was extended to June 15, 2010. If we change our capital structure (for example, through a stockdividend or stock split) while the notes are outstanding, the conversion pricewill be adjusted on a consistent basis and, accordingly, the number of sharesof common stock we would issue on conversion would be adjusted.  During May 2007, we declared a 3 for 2 stocksplit, effected as a stock dividend, payable June 7, 2007, and we adjusted theconversion ratio to reflect this change in our capital structure.  As such, the notes are now convertible into4.3 million shares of our common stock at a price of approximately $11.67 pershare.  We have the right to require thatthe holders of the convertible subordinated notes convert to equity if ourshare price exceeds $23.33 on a weighted average basis for 20 consecutivetrading days.

 

Under SFAS No. 133, *Accounting for DerivativeInstruments and Hedging Activities*, the right to extend the maturityof the convertible subordinated notes was accounted for as an embedded optionsubject to bifurcation.  The embeddedoption was initially valued at $1.2 million and the subordinated convertiblenote balance was reduced by the same amount. The subordinated convertible note was accreted approximately $0.1million each quarter such that the subordinated convertible note balance,exclusive of the embedded option value, totaled $50.0 million as of the June15, 2007 original maturity date.  On ouraccompanying condensed consolidated statements of income, this accretion is acomponent of interest expense.  Theembedded option was revalued at each period end based on the probabilityweighted discounted cash flows related to the additional 4% interest ratepayments resulting from the three year extension of the contingent convertiblesubordinated notes maturity.  DuringApril 2007, the holders of the convertible subordinated notes exercised thisright to extend and we performed a final valuation to estimate the fair valueof the embedded option as of the approximate date of the extension.  The estimated fair value of the embeddedoption at this date, included as a component of the subordinated convertiblenote, was 

 

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approximately $4.8 million.  The$4.8 million estimated fair value of the embedded option is amortized as acredit to interest expense over the period to the extended maturity, which isJune 15, 2010.  If any convertible debtis converted into shares of our common stock prior to June 15, 2010, theunamortized embedded option value related to those shares will be recognized asa gain in the period the conversion occurs. The above changes related to the carrying value of the contingentconvertible subordinated note, the estimated fair value of the embedded option,and the amortization of the fair value of the embedded option do not affect ourcash flow.

 

***Deferred Acquisition Price***

 

We have made acquisitions for which a portionof the purchase price was deferred. These deferred payments, which are either non-interest bearing or have abelow market interest rate, have been discounted at imputed interest ratesranging from 3% to 8%.  As of September30, 2007 and December 31, 2006, the discounted value of the remaining notepayments was approximately $6.3 million and $9.0 million, respectively, ofwhich approximately $3.0 million and $3.3 million, respectively, was classifiedas a current liability in the condensed consolidated balance sheets as ofSeptember 30, 2007 and December 31, 2006, respectively.

 

***Scheduled Principal Payments***

 

Our long-term obligations, including creditfacility debt, convertible debt (including embedded option), deferredacquisition costs, and capitalized leases, mature as follows for eachtwelve-month period ending September 30 (in thousands):

 

|   |   |   |    |
|--------|--------|--------|---------|
| 2008   |   | $      | 3,774   |   |
| 2009   |   | 79,344 |    |
| 2010   |   | 55,824 |    |
| 2011   |   | 532    |    |
| 2012   |   | 10     |    |
| Total  |   | $      | 139,484 |   |

 

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**NOTE 6:  SHARE-BASED COMPENSATION**

 

During June 2004,our 2004 Equity Incentive Plan was approved by our shareholders and replacedour 1995 Stock Option Plan, as amended (the “1995 Plan”).  During June 2006, an amendment to the 2004Equity Incentive Plan was approved by our shareholders.  The 2004 Equity Incentive Plan, as amended,(the “2004 Plan”) limits the combined grant of options to acquire shares ofcommon stock, stock appreciation rights, and restricted stock under the 2004Plan to 7,500,000 shares.  Any grantunder the 2004 Plan that expires or terminates unexercised, becomesunexercisable or is forfeited will be available for future grants unless, inthe case of options granted, related stock appreciation rights are exercised.  At September 30, 2007, there wereapproximately 2,689,000 shares of common stock available for futureequity-related grants under the 2004 Plan. Although various forms of equity instruments may be issued, to date wehave issued only incentive share options and nonqualified share options underthis Plan.  These share options, whichhave a contractual term of 10 years, are issued with an exercise price equal tothe grant date closing market price of our common stock.  The vesting periods range from immediate to 5years.  Share options which vest over 5years generally vest either 20% per year on the first five anniversaries of thegrant date or 25% per year on the second through fifth anniversaries of thegrant date.  Shares vesting over a shorterperiod will generally vest 100% as of the designated vesting date.  We issue new shares to satisfy share optionexercises.  We do not anticipate that wewill repurchase shares on the open market during the next year for the purposeof satisfying share option exercises.

 

Following is information related to exercisable share options and shareoptions expected to vest as of September 30, 2007 (shares and aggregateintrinsic value in thousands):

 

 

| ** **                           | ** ** | **Shares** | ** ** | **Weighted Average Exercise Price** | ** ** | **Weighted Average Remaining Contractual Term** | ** ** | **Aggregate Intrinsic  Value** | ** ** |
|--------------------------------------|------------|------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|--------------------------------|------------|
|                                 |       |       |       |                                |       |                                            |       |                           |       |
| Options  exercisable                 |       | 4,879      |       | $                                   | 9.40       |                                            | 6.35       |                           | $          | 45,960 |   |
| Options vested  and expected to vest |       | 6,860      |       | $                                   | 10.31      |                                            | 6.96       |                           | $          | 58,372 |   |
|                                 |       |       |       |                                |       |                                            |       |                           |       |

 

The aggregate intrinsic value was calculated using the differencebetween the September 30, 2007 market price and the grant price for only thoseawards that have a grant price that is less than the September 30, 2007 marketprice.

 

The weighted average grant-date fair value of options granted duringthe three months ended September 30, 2007 and 2006 were $6.64 and $3.68,respectively.  The total intrinsic valueof options exercised during the three months ended September 30, 2007 and 2006were $0.7 million and $0.2 million, respectively.  During the three months ended September 30, 2007and 2006, we received cash for payment of the grant price of exercised optionsof approximately $0.5 million and $1.0 million, respectively, and we anticipatewe will realize a tax benefit related to these exercised options ofapproximately $0.3 million and less than $0.1 million, respectively.

 

During the three months ended September 30, 2007 and 2006, werecognized share-based compensation expense, which is a non-cash charge, ofapproximately $0.8 million and $0.6 million, respectively, of which $0.2 millionand $0.2 million, respectively, is included under the caption “Direct costs ofservices” and $0.6 million and $0.4 million, respectively, is included underthe caption “General and administrative” on the accompanying condensedconsolidated statements of income. During the three months ended September 30, 2007 and 2006, we recognizeda net tax benefit of approximately $0.3 million and $0.2 million, respectively,related to aggregate share-based compensation expense recognized during thesame period.

 

The weighted average grant-date fair value of options granted duringthe nine months ended September 30, 2007 and 2006 were $5.35 and $4.94,respectively.  The total intrinsic valueof options exercised during the nine months ended September 30, 2007 and 2006were $6.2 million and $1.5 million, respectively.  During the nine months ended September 30,2007 and 2006, we received cash for payment of the grant price of exercisedoptions of approximately $8.7 million and $2.6 million, respectively, and weanticipate we will realize a tax benefit related to these exercised options ofapproximately $1.6 million and $0.5 million, respectively.  The cash received for payment of the grantprice is included as a component of cash flow from 

 

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financing activities.  The taxbenefit related to the option exercise price in excess of the option fair valueat grant date is separately disclosed as a component of cash flow fromfinancing activities on the consolidated statement of cash flows; the remainderof the tax benefit is included as a component of cash flow from operatingactivities.

 

During the ninemonths ended September 30, 2007 and 2006, we recognized share-basedcompensation expense, which is a non-cash charge, of approximately $1.8 millionand $1.7 million, respectively, of which $0.6 million and $0.4 million,respectively, is included under the caption “Direct costs of services” and $1.2million and $1.3 million, respectively, is included under the caption “Generaland administrative” on the accompanying condensed consolidated statements ofincome.  During the nine months endedSeptember 30, 2007 and 2006, we recognized a net tax benefit of approximately$0.6 million and $0.6 million, respectively, related to aggregate share-basedcompensation expense recognized during the same period.  As of September 30, 2007, there was $9.1million of total unrecognized compensation cost related to nonvestedshare-based compensation arrangements, which will be recognized over aweighted-average period of 3.5 years.

 

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** **

**NOTE 7:                NETINCOME PER SHARE**

 

Basic net income per share is computed by dividing net income availableto common shareholders by the weighted average number of common sharesoutstanding for the period. Diluted net income per share is computed bydividing net income available to common shareholders, increased by the amountof interest expense, net of tax, related to outstanding convertible debt, bythe weighted average number of outstanding common shares and incremental sharesthat may be issued in future periods related to outstanding share options andconvertible debt, if dilutive. When calculating incremental shares related tooutstanding share options, we apply the treasury stock method. The treasurystock method assumes that proceeds, consisting of the amount the employee mustpay on exercise, compensation cost attributed to future services and not yetrecognized, and excess tax benefits that would be credited to additionalpaid-in capital on exercise of the share options, are used to repurchaseoutstanding shares at the average market price for the period. The treasurystock method is applied only to share grants for which the effect is dilutive.

 

The computations of basicand diluted net income per share are as follows (in thousands, except per sharedata):

 
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2007**                             | ** ** | **2006** | ** ** |
| ** **                      | ** ** | **Net Income**                       | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per  Share  Amount** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per Share  Amount** | ** ** |
| Basic net income  per share     |       | $                                    | 2,424      |   | 30,185 |   | $ | .08 |   | $ | 2,681 |   | 29,162 |   | $ | .09 |   |
|                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Effect of  dilutive securities: |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Share options                   |       |                                 |       | 2,233 |   |   |   |   |   | 918 |   |   |   |
| Convertible debt                |       | 305                                  |       | 4,286 |   |   |   | 305 |   | 4,286 |   |   |   |
|                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Diluted net  income per share   |       | $                                    | 2,729      |   | 36,704 |   | $ | .07 |   | $ | 2,986 |   | 34,366 |   | $ | .09 |   |
|                                 |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

#### **For the three month periods endedSeptember 30, 2007 and 2006, weighted-average outstanding share optionstotaling approximately 0.6 million and 4.2 million shares of common stock,respectively, were antidilutive and therefore not included in the computationof diluted earnings per share.**

 
| ** **                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|-------------------------------------|------------|
| ** **                      | ** ** | **2007**                            | ** ** | **2006** | ** ** |
| ** **                      | ** ** | **Net Income**                      | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per  Share  Amount** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per Share  Amount** | ** ** |
| Basic net income  per share     |       | $                                   | 4,367      |   | 29,770 |   | $ | .15 |   | $ | 37,224 |   | 29,057 |   | $ | 1.28 |   |
|                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Effect of  dilutive securities: |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Share options                   |       |                                |       | 2,033 |   |   |   |   |   | 1,254 |   |   |   |
| Convertible debt                |       | —                              |       | — |   |   |   | 904 |   | 4,286 |   |   |   |
|                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Diluted net  income per share   |       | $                                   | 4,367      |   | 31,803 |   | $ | .14 |   | $ | 38,128 |   | 34,597 |   | $ | 1.10 |   |

 

#### **For the nine month periods endedSeptember 30, 2007 and 2006, weighted-average outstanding share optionstotaling approximately 1.3 million and 2.5 million shares of common stock wereantidilutive and, therefore, not included in the computation of dilutedearnings per share. For the nine months ended September 30, 2007, we did notassume conversion of the contingent convertible subordinated convertible notesas the effect would have been antidilutive.**

 

15

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**NOTE 8:                SEGMENT REPORTING**

 

In the first quarter of 2007, we revised the structure of our operatingsegments and changed the nature of the financial information provided to ourchief operating decision makers. Additionally, certain of the internal segmentfinancial reporting information used to measure and evaluate the performance ofour operating segments, such as allocation of certain shared costs, have beenrevised for consistency with the underlying reorganized segment structure. Thesegment measure of profit for the three and nine months ended September 30,2007 has been recast in accordance with our new structure, including thechanges in certain internal financial reporting information. We have threeoperating segments: (i) electronic discovery, (ii) bankruptcy trustee, and(iii) settlements and claims. Our electronic discovery business providestechnology solutions to corporations and the litigation departments of lawfirms. Produced documents are made available primarily through a hostedenvironment, and our DocuMatrixTM software allows for efficient plaintiff anddefendant counsel review and data requests. Our bankruptcy trustee segment provides solutions that address the needs ofChapter 7 and Chapter 13 trustees to process large bankruptcy caseloads and tomake required distributions to creditors accurately and efficiently. Oursettlements and claims segment administers complex legal proceedings whichinvolve notification of a class of actual or potential claimants or creditorsand the administration of funds related to settlement with the class ofclaimants or creditors.

 

Each segment’s performance is assessed based on earnings beforeinterest, taxes, depreciation and amortization, other operating expenses, andshare-based compensation expense. In management’s evaluation of performance,certain administrative costs, such as compensation and related costs forcorporate staff and executive management, are not allocated by segment and,accordingly, the operating segment results do not include such unallocatedcosts. Assets reported within a segment are those assets that can be identifiedto a segment and primarily consist of trade receivables, property, equipmentand leasehold improvements, software, identifiable intangible assets andgoodwill. Cash, tax-related assets, and certain prepaids and other assets arenot allocated to our segments. We identify long-lived assets such as property,equipment and leasehold improvements, software, and identifiable intangibleassets by operating segment, however, we do not allocate the relateddepreciation and amortization to the segment as management evaluates segmentperformance exclusive of these non-cash expenses.

 

16

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Following is a summary of segment information (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended September 30, 2007** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic Discovery**                  | ** ** | **Bankruptcy Trustee** | ** ** | **Settlements and Claims** | ** ** | **Total** | ** ** |
| Revenue:                                          |       |                                      |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                         | 13,003     |   | $ | 8,417 |   | $ | 17,765 |   | $ | 39,185 |   |
| Operating  revenue from reimbursed direct costs   |       | 24                                        |       | 148 |   | 5,490 |   | 5,662 |   |
| Total revenue                                     |       | 13,027                                    |       | 8,565 |   | 23,255 |   | 44,847 |   |
|                                              |       |                                      |       |   |   |   |   |   |
| Direct costs, general  and administrative costs   |       | 6,916                                     |       | 3,080 |   | 16,147 |   | 26,143 |   |
| Segment  performance measure                      |       | $                                         | 6,111      |   | $ | 5,485 |   | $ | 7,108 |   | $ | 18,704 |   |

 

 
| ** **                                        | ** ** | **Three Months Ended September 30, 2006** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic Discovery**                  | ** ** | **Bankruptcy Trustee** | ** ** | **Settlements and Claims** | ** ** | **Total** | ** ** |
| Revenue:                                          |       |                                      |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                         | 7,354      |   | $ | 14,369 |   | $ | 12,666 |   | $ | 34,389 |   |
| Operating  revenue from reimbursed direct costs   |       | 58                                        |       | 122 |   | 4,463 |   | 4,643 |   |
| Total revenue                                     |       | 7,412                                     |       | 14,491 |   | 17,129 |   | 39,032 |   |
|                                              |       |                                      |       |   |   |   |   |   |
| Direct costs,  general and administrative costs   |       | 4,148                                     |       | 2,852 |   | 14,549 |   | 21,549 |   |
| Segment  performance measure                      |       | $                                         | 3,264      |   | $ | 11,639 |   | $ | 2,580 |   | $ | 17,483 |   |

 

Following is a reconciliation of our segment performance measure toincome before income taxes (in thousands):

 
| ** **                                            | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2007**                             | ** ** | **2006** | ** ** |
| Segment  performance measure                          |       | $                                    | 18,704     |   | $ | 17,483 |   |
| Corporate and  unallocated expenses                   |       | (5,216                               | )          | (4,228 | ) |
| Share-based  compensation expense                     |       | (795                                 | )          | (579 | ) |
| Depreciation and  software and leasehold amortization |       | (3,272                               | )          | (2,633 | ) |
| Amortization of  intangible assets                    |       | (2,352                               | )          | (3,027 | ) |
| Other operating  expense                              |       | (565                                 | )          | — |   |
| Interest  expense, net                                |       | (2,158                               | )          | (2,500 | ) |
| Income before  income taxes                           |       | $                                    | 4,346      |   | $ | 4,516 |   |

 

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| ** **                                        | ** ** | **Nine Months Ended September 30, 2007** | ** ** |
|---------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic Discovery**                 | ** ** | **Bankruptcy Trustee** | ** ** | **Settlements and Claims** | ** ** | **Total** | ** ** |
| Revenue:                                          |       |                                     |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                        | 35,339     |   | $ | 25,012 |   | $ | 52,099 |   | $ | 112,450 |   |
| Operating  revenue from reimbursed direct costs   |       | 49                                       |       | 363 |   | 17,318 |   | 17,730 |   |
| Total revenue                                     |       | 35,388                                   |       | 25,375 |   | 69,417 |   | 130,180 |   |
|                                              |       |                                     |       |   |   |   |   |   |   |
| Direct costs,  general and administrative costs   |       | 17,612                                   |       | 8,362 |   | 52,292 |   | 78,266 |   |
| Segment  performance measure                      |       | $                                        | 17,776     |   | $ | 17,013 |   | $ | 17,125 |   | $ | 51,914 |   |
|                                                   |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 
| ** **                                        | ** ** | **Nine Months Ended September 30, 2006** | ** ** |
|---------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic Discovery**                 | ** ** | **Bankruptcy Trustee** | ** ** | **Settlements and Claims** | ** ** | **Total** | ** ** |
| Revenue:                                          |       |                                     |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                        | 23,046     |   | $ | 85,459 |   | $ | 52,565 |   | $ | 161,070 |   |
| Operating  revenue from reimbursed direct costs   |       | 106                                      |       | 331 |   | 16,239 |   | 16,676 |   |
| Total revenue                                     |       | 23,152                                   |       | 85,790 |   | 68,804 |   | 177,746 |   |
|                                              |       |                                     |       |   |   |   |   |   |   |
| Direct costs,  general and administrative costs   |       | 11,882                                   |       | 8,657 |   | 55,913 |   | 76,452 |   |
| Segment  performance measure                      |       | $                                        | 11,270     |   | $ | 77,133 |   | $ | 12,891 |   | $ | 101,294 |   |
|                                                   |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

Following is a reconciliation of our segment performance measure toincome before income taxes (in thousands):

 
| ** **                                            | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                            | ** ** | **2007**                            | ** ** | **2006** | ** ** |
| Segment performance  measure                          |       | $                                   | 51,914     |   | $ | 101,294 |   |
| Corporate and  unallocated expenses                   |       | (14,816                             | )          | (11,601 | ) |
| Share-based  compensation expense                     |       | (1,809                              | )          | (1,671 | ) |
| Depreciation and  software and leasehold amortization |       | (9,071                              | )          | (7,424 | ) |
| Amortization of  intangible assets                    |       | (7,228                              | )          | (8,672 | ) |
| Other operating  expense                              |       | (565                                | )          | (250 | ) |
| Interest  expense, net                                |       | (10,573                             | )          | (9,104 | ) |
| Income before  income taxes                           |       | $                                   | 7,852      |   | $ | 62,572 |   |
|                                                       |            |                                     |            |  |  |  |  |  |

 

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Following are totalassets by segment (in thousands):

 
| ** **                 | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------|------------|-------------------------|------------|------------------------|------------|
| **Assets**                 | ** ** | ** **              | ** ** | ** **             | ** ** |
| Electronic  Discovery      |       | $                       | 133,229    |                   | $          | 125,515 |   |
| Bankruptcy  Trustee        |       | 85,601                  |       | 85,646                 |       |
| Settlements and  Claims    |       | 149,587                 |       | 150,343                |       |
| Corporate and  unallocated |       | 16,334                  |       | 20,716                 |       |
| Total consolidated  assets |       | $                       | 384,751    |                   | $          | 382,220 |   |

 

Following is goodwill bysegment (in thousands):

 
| ** **              | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-------------------------|------------|------------------------|------------|-----------------------|------------|
| **Goodwill**            | ** ** | ** **             | ** ** | ** **            | ** ** |
| Electronic  Discovery   |       | $                      | 76,082     |                  | $          | 76,369 |   |
| Bankruptcy  Trustee     |       | 75,205                 |       | 74,937                |       |
| Settlements and  Claims |       | 109,646                |       | 109,303               |       |
| Total goodwill          |       | $                      | 260,933    |                  | $          | 260,609 |   |

 

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**NOTE 9:                DERIVATIVES**

 

As discussed under Risk Factors in our Annual Report on Form 10-K, someof our bankruptcy trustee revenue is subject to variability based onfluctuations in short-term interest rates. In order to limit our economicexposure to market fluctuations in interest rates, we purchased one-month LIBORbased interest rate floor options with a total notional amount of $800 millionand initial contractual maturity of three years. We are exposed to credit riskwith the counterparty, which is a major financial institution with aninvestment grade credit rating, to this derivative transaction. Thecounterparty is obligated to make payments to us only if the interest ratefloor options are in-the-money. As of September 30, 2007, none of the interestrate floor options were in-the-money. We account for this transaction pursuantto the guidance contained in Statement of Financial Accounting Standards No.133, *Accounting for Derivative Instruments and HedgingActivities*, as amended and interpreted (SFAS 133). SFAS 133 requiresthat all derivative instruments be recorded on the balance sheet at fair value.As the interest rate floor options have not been designated as an accountinghedge, changes in the fair value of the derivatives are recorded each period incurrent earnings. At inception, the aggregate fair value of the interest ratefloor options was approximately $1.6 million. The estimated fair value of theinterest rate floor options as of September 30, 2007 was approximately $1.0million. On our accompanying condensed consolidated balance sheets, the fairvalue of the interest rate floor options has been included as a component ofother current assets. For the three months ended September 30, 2007, the $0.6million decrease in the estimated fair value of the interest rate floor optionshas been included as a component of other operating expenses on ouraccompanying condensed consolidated statements of income.

 

**NOTE 10:              SUPPLEMENTALCASH FLOW INFORMATION**

 

Supplemental cash flowinformation is as follows (in thousands):

 
| ** **                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                            | ** ** | **2006** | ** ** |
| Cash paid  (received) for:                                                   |       |                                |       |   |   |
| Interest                                                                     |       | $                                   | 7,937      |   | $ | 7,730 |   |
| Income taxes  paid (refunded), net                                           |       | 1,253                               |       | (1,758 | ) |
| Non-cash  investing and financing transactions:                              |       |                                |       |   |   |
| Capitalized  lease obligations incurred                                      |       | 2,566                               |       | — |   |
| Property,  equipment, and leasehold improvements accrued in accounts payable |       | 768                                 |       | 429 |   |
| Obligation  incurred in purchase transactions                                |       | —                              |       | 10,173 |   |
|                                                                              |            |                                     |            |  |  |  |  |  |

 

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

 

This discussion and analysis should be read in conjunction with thecondensed consolidated financial statements and the accompanying notes to thecondensed consolidated financial statements included in this Form 10-Q.

 

### **Overview**

 

We are a provider of integrated technology solutions for the legalprofession.  Our solutions streamline theadministration of bankruptcy, litigation, financial transactions and regulatorycompliance matters.  We offer innovativetechnology solutions for electronic discovery, document review, legalnotification, claims administration and controlled disbursement of funds.  Our clients include law firms, corporatelegal departments, bankruptcy trustees and other professional advisors whorequire innovative technology, responsive service and deep subject-matterexpertise.

 

We have acquired a number of businesses during the past severalyears.  In January 2003, we acquired BSI(now Epiq Bankruptcy Solutions), which expanded our offerings to include claimsadministration solutions for the Chapter 11 corporate restructuringmarket.  In January 2004, we acquiredPoorman-Douglas (now Epiq Class Action & Claims Solutions), which expandedour administrative offerings in support of the class action and mass tortmarket.  In October 2005, we acquiredHilsoft Notifications, which enhanced our expert legal notification servicesrelated to class action, mass tort and bankruptcy noticing.  In November 2005, we acquired nMatrix (nowEpiq eDiscovery Solutions) to expand our offerings to include electronicdiscovery.

 

We have three operatingsegments: electronic discovery, bankruptcy trustees, and settlements andclaims.

 

***ElectronicDiscovery Segment***

 

Our electronic discoverybusiness provides processing and search and review capabilities to corporationsand the litigation departments of law firms. Our eDataMatrixTM software analyzes, filters, deduplicates and producesdocuments for review.  Produced documentsare made available primarily through a hosted environment, and our DocuMatrixTMsoftware allows for efficient plaintiff and defendant counsel review and datarequests.

 

Ourcustomers are typically large corporations that use our products and servicescooperatively with their legal counsel to manage the electronic discovery processfor complex litigation matters.

 

Thesubstantial increase of electronic documents by businesses has changed thedynamics of how attorneys support discovery in complex litigation matters.  According to the 2007 Socha-GelbmannElectronic Discovery Survey, the 2006 domestic commercial electronic discoveryrevenues were estimated at $2.0 billion, an approximate 51% increase from2005.  According to this same source, themarket is expected to continue to grow at a substantial rate from 2007 to 2009,with expected increases of approximately 23% to 33% each year.  Due to the complexity of cases, theincreasing volume of data that are maintained electronically, and theincreasing volume of documents that are produced in all types of litigation,law firms are increasingly reliant on electronic evidence management systems toorganize and manage the electronic discovery process.

 

Significantsources of revenue include:

 

•                  Fees related to the conversion of data into an organized, searchableelectronic database. The amount we earn varies primarily on the size (number ofdocuments) and complexity of the engagement; and

 

•                  Hosting fees based on the amount of data stored.

 

***Bankruptcy Trustee Segment***

 

Ourbankruptcy trustee business addresses the needs of Chapter 7 and Chapter 13bankruptcy trustees.

 

•                  Chapter 7 is a liquidation bankruptcy forindividuals or businesses that, as measured by the number of new cases filed infiscal 2006, accounted for approximately 75% of all bankruptcy filings.  In a Chapter 7 case, the debtor’s assets areliquidated and the resulting cash proceeds are used by the Chapter 7 bankruptcytrustee to pay creditors.  Chapter 7cases typically last several years.

 

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•                  Chapter 13 is a reorganization model of bankruptcyfor individuals that, as measured by the number of new cases filed in fiscal2006, accounted for approximately 24% of all bankruptcy filings.  In a Chapter 13 case, debtors make periodiccash payments into a reorganization plan and a Chapter 13 bankruptcy trusteeuses these cash payments to make monthly distributions to creditors.  Chapter 13 cases typically last between threeand five years.

 

Ourend-user customers are professional bankruptcy trustees.  The Executive Officefor United States Trustees, a division of the U.S. Department of Justice,appoints all bankruptcy trustees.  AUnited States Trustee is appointed in most federal court districts andgenerally has responsibility for overseeing the integrity of the bankruptcy system.  The bankruptcy trustee’s primaryresponsibilities include liquidating the debtor’s assets or collecting fundsfrom the debtor, distributing the collected funds to creditors pursuant to theorders of the bankruptcy court, and preparing regular status reports for theExecutive Office for United States Trustees and for the bankruptcy court.  Trustees manage an entire caseload ofbankruptcy cases simultaneously.

 

The primarysources of revenue are deposit-based fees, earned primarily as a percentage ofChapter 7 total liquidated assets placed on deposit with a designated financialinstitution by our trustee clients to whom we provide, at no charge, softwarelicenses, limited hardware and hardware maintenance, and postcontract customersupport (PCS) services, and fees earned based on the number of cases managed bya Chapter 13 bankruptcy trustee.  Thefees we earn based on total liquidated assets placed on deposit by our trusteeclients may vary based on fluctuations in short-term interest rates.

 

***Settlements and Claims Segment***

 

Oursettlements and claims segment supports the administration of complex legalproceedings that involve notification of a class of claimants or creditors andthe administration of funds related to settlement with the class of claimantsor creditors for Chapter 11 bankruptcies and class action and mass tortlawsuits.

 

Chapter 11 is a reorganization model of bankruptcy for corporationsthat, as measured by the number of new cases filed in fiscal 2006, accountedfor approximately 1% of all bankruptcy filings. Chapter 11 generally allows a company, often referred to as thedebtor-in-possession, to continue operating under a plan of reorganization torestructure its business and to modify payment terms of both secured andunsecured obligations.  Chapter 11 casesmay last several years.

 

Classaction and mass tort refer to litigation in which class representatives bring alawsuit against a defendant company or other persons on behalf of a large groupof similarly affected persons (the class). Mass tort refers to class action cases that are particularly large orprominent.  The class action and masstort marketplace is significant, with estimated annual tort claim costs ofapproximately $260 billion in 2005, according to a study issued in 2006 byTowers Perrin.  Administrative costs,which include costs, other than defense costs, incurred by either the insurancecompany or self-insured entity in the administration of claims, compriseapproximately 20% of this total.  Keyparticipants in this marketplace include law firms that specialize inrepresenting class action and mass tort plaintiffs and other law firms thatspecialize in representing defendants. Class action and mass tort litigation is often complex and the cases,including administration of any settlement, may last several years.

 

Our customers are companies that administer the settlement or resolutionof class action cases and debtor corporations that have filed a plan ofreorganization.  We sell our servicesdirectly to those customers; however, our relationships with other interestedparties, including legal counsel, often provide access to these customers.

 

Significantsources of revenue include:

 

•                  Fees contingent upon the month-to-month delivery of case managementservices such as claims processing, claims reconciliation, professionalservices, call center support, and controlled disbursements.  The amount we earn varies primarily on thesize and complexity of the engagement;

 

•                  Legal noticing services, including media campaign and advertisingmanagement, in which we coordinate notification either directly or throughvarious media outlets, such as print, radio and television, to potentialparties of interest for a particular client engagement; and

 

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•                Reimbursement for costs incurredrelated to postage on mailing services.

 

**Critical Accounting Policies**

 

In our Annual Report on Form 10-K for the year ended December 31, 2006,as updated and superseded by information contained in our Form 8-K filed onAugust 7, 2007, we disclose accounting policies, referred to as criticalaccounting policies, that require management to use significant judgment orthat require significant estimates. Management regularly reviews the selection and application of ourcritical accounting policies.  Managementdetermined that the application of FASB Interpretation No. 48 (FIN 48), *Accounting for Uncertainty in Income Taxes —*aninterpretation of FASB Statement No. 109, *Accounting for IncomeTaxes,*adopted effective January 1, 2007, requires significantmanagement judgment and the use of significant estimates.  Management also determined that, with thepurchase of interest rate floor options during the third quarter of 2007, thatthe application of Statement of Financial Accounting Standards No. 133, *Accounting for Derivative Instruments and Hedging Activities*,as amended and interpreted (SFAS 133), requires significant management judgmentand the use of significant estimates. Therefore, in addition to the critical accounting policies contained inour Annual Report on Form 10-K for the year ended December 31, 2006, as updatedand superseded by information contained in our form 8-K filed on August 7, 2007for the year ended December 31, 2006, we have added income taxes and derivativefinancial instruments as critical accounting policies.

 

***Incometaxes***

 

FIN 48 prescribes acomprehensive model for how companies should recognize, measure, present, anddisclose in their financial statements uncertain tax positions taken orexpected to be taken on a tax return. Under FIN 48, tax positions are initially recognized in the financialstatements when it is more likely than not the position will be sustained uponexamination by the tax authorities.  Suchtax positions are initially and subsequently measured as the largest amount oftax benefit that is greater than 50% likely of being realized upon ultimatesettlement with the tax authority assuming full knowledge of the position andall relevant facts.  Application of FIN48 requires numerous estimates based on available information.  We consider many factors when evaluating andestimating our tax positions and tax benefits, which may require periodicadjustments and which may not accurately anticipate actual outcomes.  Changes in these factors may have a materialimpact, either positive or negative, on our effective tax rate.  As a result, the application of FIN 48 may,in the future, have a material affect on income tax expense recorded within ourcondensed consolidated statements of income and also may have a material affecton our current tax payable or refundable, our long-term tax payable, and bothcurrent and long-term deferred income tax line items within our condensedconsolidated balance sheets.  Foradditional information regarding the effect of adoption of FIN 48, see note 4of the condensed consolidated financial statements.

 

***Derivative financial instruments***

 

SFAS 133 establishes accounting andreporting standards for derivative instruments. For a derivative instrument not designated as an accounting hedge, thegain or loss is recognized in earnings in the period of change.  During the quarter ended September 30, 2007,we purchased interest rate floor options with a notional value of $800 million,and these instruments were not designated as accounting hedges.  The interest rate floor options werepurchased in negotiated transactions.  Asa result, we cannot determine the fair value of the interest rate floor optionsbased on quoted prices in active markets for identical assets.  Instead, as of each period end we estimatethe fair value of the interest rate floor options based on quoted prices forsimilar assets in active markets and based on inputs other than quoted prices,primarily interest rates and yield curves, which are observable.  Changes in these estimates, included as acomponent of other operating expenses on our condensed consolidated statementsof income, may have a material impact on our net income.

 

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**Results of Operations for the ThreeMonths Ended September 30, 2007 Compared with the Three Months Ended September30, 2006**

 

### **Consolidated Results**

 

### ***Revenue***

 

Total revenue of $44.8 million for the three months ended September 30,2007 increased approximately $5.8 million, or 15%, compared to $39.0 million ofrevenue for the same period in the prior year. A significant part of our total revenue consists of reimbursement fordirect costs we incur, such as postage related to document managementservices.  We reflect the operatingrevenue from these reimbursed direct costs as a separate line item on ouraccompanying condensed consolidated statements of income.  Although operating revenue from reimburseddirect costs may fluctuate significantly from quarter to quarter, thesefluctuations have a minimal effect on our income from operations as we realizelittle or no margin from this revenue. Operating revenue exclusive of operating revenue from reimbursed directcosts, which we refer to as operating revenue before reimbursed direct costs,increased approximately $4.8 million, or 14%, to $39.2 million for the threemonths ended September 30, 2007 compared to $34.4 million for the same periodin the prior year.  The increase primarilyrelates to an approximate $5.6 million increase in electronic discoveryoperating revenue before reimbursed direct costs combined with an approximate$5.1 million increase in settlements and claims revenue before reimburseddirect costs, partly offset by a $6.0 million decrease in bankruptcy trusteeoperating revenue before reimbursed direct costs.  As more fully explained under the caption “SignificantAccounting Policies, Revenue Recognition” in note 1 to the condensedconsolidated financial statements, the decrease in bankruptcy trustee operatingrevenue before reimbursed direct costs is primarily the result of therecognition, during the three months ended September 30, 2006, of approximately$6.0 million of previously deferred revenue following delivery of the finalspecified software upgrade pursuant to a specific arrangement which terminatedSeptember 30, 2006.  Changes by segmentare discussed below.

 

### ***OperatingExpenses***

 

Direct costs of services, exclusive of depreciation and amortization,increased by approximately $1.1 million, or 13%, to approximately $9.4 millionfor the three months ended September 30, 2007 compared with $8.3 million duringthe same period in the prior year.  Thisincrease primarily results from $0.4 million of expense incurred related todata center relocation and reconfiguration, a $0.3 million increase in softwaremaintenance expense, and a $0.1 million increase in compensation and benefitsexpense.  Changes by segment arediscussed below.

 

Direct cost of bundled products and services, exclusive of depreciationand amortization, was approximately $1.0 million for both the three monthsended September 30, 2007 and 2006. Changes by segment are discussed below.

 

Reimbursed direct costs increased by approximately $0.9 million to $5.6million for the three months ended September 30, 2007 compared with $4.7million during the same period in the prior year.  This increase corresponds to the increase inoperating revenue from reimbursed direct costs. Changes by segment are discussed below.

 

General and administrative costs increased approximately $3.8 million,or 31%, to $16.2 million for the three months ended September 30, 2007 comparedwith $12.4 million for the same period in the prior year.  The increase is primarily due to a $3.3million increase in compensation and benefits expense primarily resulting fromexpanded staffing and increased incentive compensation and benefits combinedwith a $0.2 million increase in outside professional fees.  Changes by segment are discussed below.

 

Depreciation and software and leasehold amortization costs increasedapproximately 24% to $3.3 million for the three months ended September 30, 2007compared with $2.6 million for the same period in the prior year primarily as aresult of increased software amortization and hardware depreciation related toour electronic discovery segment.

 

Amortization of identifiable intangible assets, compared with the sameperiod in the prior year, decreased by approximately 22% to $2.4 million forthe three months ended September 30, 2007 compared with $3.0 million for thesame period in the prior year, primarily as a result of certain customercontracts and trade names that became fully amortized.

 

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Other operating expenses, which include the mark-to-market adjustmentfor purchased interest rate floor options and acquisition related expenses,totaled $0.6 million for the three months ended September 30, 2007.  A portion of our bankruptcy trustee pricingis tied to interest rates, and a decrease in interest rate may result in adecrease in bankruptcy trustee revenue. To mitigate this exposure, during the third quarter of 2007, wepurchased LIBOR based interest rate floors with strike prices ranging from1.75% to 2.75% and a notional value of $800 million.  These instruments were not designated asaccounting hedges.  At the end of eachperiod, we estimate the fair value of these instruments and the change inmarket value is recognized as a component of other operating expenses.  The adjustment as of September 30, 2007resulted in the recognition of $0.6 million of expense.  We did not incur any acquisition relatedexpenses during the three months ended September 30, 2007 or 2006.

 

***Interest Expense***

 

We recognized interest expense of $2.2 million for the three monthsended September 30, 2007 compared with $2.5 million for the same period in theprior year.  The decrease in our interestexpense is primarily the result of a decrease in average outstanding creditfacility borrowings partially offset by an increase in our average creditfacility borrowing rate.

 

***Income Taxes***

 

During the three months ended September 30, 2007, our tax expense as apercent of pre-tax income was 44.2%.  Ourestimated annual effective tax rate of 43.4% was increased due to tax expenserelated to a discrete adjustment to record interest on uncertain tax positions,partly offset by a discrete adjustment to record tax benefits associated withrecognizing uncertain tax benefits related to the expiration of the statute oflimitations in various jurisdictions. During the three months ended September 30, 2006, the effective tax rateto record the tax expense related to our net income was 40.6 %.  The prior year effective tax rate was lowerthan in the current year as the effect of nondeductible items on the effectivetax rate was mitigated by the higher level of pre-tax income.  Our tax rate is higher than the statutoryfederal rate of 35% primarily due to state taxes.  We have significant operations located in NewYork City that are subject to state and local tax rates that are higher thanthe tax rates assessed by other jurisdictions where we operate.

 

***NetIncome***

 

Our net income wasapproximately $2.4 million for the three months ended September 30, 2007compared with net income of approximately $2.7 million for the same period inthe prior year. This decrease of $0.3 million is primarily the result of  the recognition during the three months endedSeptember 30, 2006 of $6.0 million of previously deferred revenue, a $3.8million increase in general and administrative expenses, primarily related toincreases in compensation and benefits, a $1.1 million increase in direct costof services, primarily related to the combination of data center relocation andreconfiguration expenses and an increase in software maintenance expense, and a$0.6 million mark-to-market adjustment of our purchased interest rate floors,partly offset by an approximate $5.6 million increase in electronic discoveryoperating revenue before reimbursed direct costs combined with an approximate$5.1 million increase in settlements and claims revenue before reimburseddirect costs.

 

**Electronic Discovery Segment**

 

Electronic discovery operating revenue before reimbursed direct costsincreased approximately $5.6 million, or 77%, to $13.0 million for the threemonths ended September 30, 2007 compared to $7.4 million for the same period inthe prior year.  This increase isprimarily attributable to additional projects from existing clients as well asan expansion of our client base.  Hostingservices, which is generally a recurring revenue stream, accounted forapproximately $2.1 million of this increase while processing services, whichare generally project oriented, accounted for approximately $3.3 million ofthis increase.

 

Electronic discovery direct and administrative expenses increasedapproximately $2.8 million, or 67%, to $6.9 million for the three months endedSeptember 30, 2007 compared to $4.1 million for the same period in the prioryear.  This increase is primarily aresult of a $1.8 million increase in compensation and benefits expenseresulting from expanded staffing and increased commission and incentivecompensation linked to improved operating performance, $0.4 million of expensesrelated to data center relocation and reconfiguration, and a $0.3 millionincrease in software maintenance expense.

 

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**Bankruptcy TrusteeSegment**

 

Bankruptcy trustee operating revenue before reimbursed direct costsdecreased $6.0 million to $8.4 million for the three months ended September 30,2007 compared to $14.4 million for the same period in the prior year.  As more fully explained under the caption “SignificantAccounting Policies, Revenue Recognition” in note 1 to the condensedconsolidated financial statements, the higher level of revenue for the threemonths ended September 30, 2006 is primarily the result of our revenuerecognition related to a specific arrangement with our primary depositoryfinancial institution.  During the secondquarter of 2006, we delivered the final software upgrade specified under thearrangement.  As the only remainingundelivered element was PCS services, in accordance with SOP 97-2 we recognizedover the remaining term of the arrangement a pro-rated portion of previouslydeferred revenue.  The pro-rated portionof previously deferred revenue recognized during the three months endedSeptember 30, 2006 was $6.0 million. Effective October 1, 2006, we entered into a new arrangement with thisdepository financial institution; this new arrangement does not includeprovisions related to software upgrades. Accordingly, we now recognize revenue based on a contingent usage basedrevenue model and, during the three months ended September 30, 2007, we did notdefer any bankruptcy trustee revenue or recognize any previously deferredbankruptcy trustee revenue.

 

Bankruptcy trustee direct and administrative expenses increasedapproximately $0.2 million, or 8%, to $3.1 million for the three months endedSeptember 30, 2007 compared with approximately $2.9 million in the same periodin the prior year.  This increase isprimarily attributable to a $0.1 million increase in compensation and benefitsexpense.

 

**Settlements and ClaimsSegment**

 

Settlements and claims operating revenue before reimbursed direct costsincreased $5.1 million, or approximately 40%, to $17.8 million for the threemonths ended September 30, 2007 compared to $12.7 million for the same periodin the prior year.  This increase is primarilythe result of a $3.8 million increase in case management revenue, primarilyrelated to transaction processing revenue, combined with a $1.2 millionincrease in legal notification revenue. The increase in case management revenue is primarily the result ofservices required for a large case.  Theincrease in legal notification revenue is primarily attributable to thenoticing requirements.  Legalnotification revenue tends to be variable as an individual noticing campaignmay have a short duration and generate significant revenue during that time.

 

Settlements and claims direct and administrative expenses, includingreimbursed direct costs, increased $1.6 million, or approximately 11%, to $16.1million for the three months ended September 30, 2007 compared to $14.5 millionfor the same period in the prior year. This increase is primarily the result of a $0.9 million increase inreimbursed direct costs combined with a $0.4 million increase in compensationand benefits expense.

 

**Results of Operations for the NineMonths Ended September 30, 2007 Compared with the Nine Months Ended September30, 2006**

 

### **Consolidated Results**

 

### ***Revenue***

 

Total revenue decreased approximately 27% to $130.2 million for thenine months ended September 30, 2007 compared to $177.7 million of revenue forthe same period in the prior year.  Asignificant part of our total revenue consists of reimbursement for directcosts we incur, such as postage related to document management services.  We reflect the operating revenue from thesereimbursed direct costs as a separate line item on our accompanying condensedconsolidated statements of income. Although reimbursed operating revenue may fluctuate significantly fromquarter to quarter, these fluctuations have a minimal effect on our operatingincome as we realize little or no margin from this revenue.  Operating revenue exclusive of operatingrevenue from reimbursed direct costs, which we refer to as operating revenuebefore reimbursed direct costs, decreased approximately $48.6 million, or 30%,to $112.5 million for the nine months ended September 30, 2007 compared to$161.1 million for the same period in the prior year.  As more fully explained under the caption “SignificantAccounting Policies, Revenue Recognition” in note 1 to the condensedconsolidated financial statements, the decrease primarily relates to the $60.4million decrease in bankruptcy trustee operating revenue before reimburseddirect costs, primarily the result of the recognition of approximately $59.7million of previously deferred revenue during the nine months ended September30, 2006, related to a specific arrangement, partly offset by a $12.3 millionincrease in electronic discovery operating revenue before reimbursed directcosts.  Changes by segment are discussedbelow.

 

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### ***OperatingExpenses***

 

Direct costs of services, exclusive of depreciation and amortization,decreased by approximately $3.3 million, or 10%, to $30.1 million for the ninemonths ended September 30, 2007 compared with $33.4 million during the sameperiod in the prior year, primarily as a result of a $4.9 million decrease inlegal notification expense partly offset by a $0.9 million increase incompensation and benefits expense and a $0.6 million increase related to datacenter relocation and reconfiguration expenses. Changes by segment are discussed below.

 

Direct cost of bundled products and services, exclusive of depreciationand amortization, decreased by approximately $0.2 million to approximately $2.8million for the nine months ended September 30, 2007 compared with $3.0 millionfor the same period in the prior year as a result of a decrease in compensationand benefits expense.  Changes by segmentare discussed below.

 

Reimbursed direct costs totaled $17.6 million for the nine months endedSeptember 30, 2007 compared with $16.9 million during the same period in theprior year.  This increase corresponds tothe increase in operating revenue from reimbursed direct costs.  Changes by segment are discussed below.

 

General and administrative costs increased approximately $7.9 million,or 22%, to $44.4 million for the nine months ended September 30, 2007 comparedwith $36.5 million for the same period in the prior year.  The increase is primarily due to a $7.0million increase in compensation and benefits expense primarily resulting fromexpanded staffing and increased incentive compensation combined with anincrease in rent expense of $0.7 million. Changes by segment are discussedbelow.

 

Depreciation and software and leasehold amortization costs increasedapproximately 22%, to $9.1 million for the nine months ended September 30, 2007compared with $7.4 million for the same period in the prior year primarily as aresult of increased software amortization expense and increased hardwaredepreciation related to electronic discovery capital expenditures.

 

Amortization of identifiable intangible assets decreased byapproximately 17% to $7.2 million for the nine months ended September 30, 2007compared with $8.7 million for the same period in the prior year, primarily asa result of certain customer contracts and trade names that became fullyamortized.

 

Other operating expenses, which include the mark-to-market adjustmentfor purchased interest rate floor options and acquisition related expenses,totaled $0.6 million for the nine months ended September 30, 2007.  A portion of our bankruptcy trustee pricingis tied to interest rates, and a decrease in interest rate may result in adecrease in bankruptcy trustee revenue. To mitigate this exposure, during the third quarter of 2007, wepurchased LIBOR based interest rate floors with strike prices ranging from1.75% to 2.75% and a notional value of $800 million.  These instruments were not designated asaccounting hedges.  At the end of eachperiod, we estimate the fair value of these instruments and the change inmarket value is recognized as a component of other operating expenses.  The adjustment as of September 30, 2007resulted in the recognition of $0.6 million of expense.  We did not incur any acquisition relatedexpenses during the nine months ended September 30, 2007 compared with $0.3million of acquisition related expenses incurred during the nine months endedSeptember 30, 2006.

 

***Interest Expense***

 

We recognized interest expense of $10.6 million for the nine monthsended September 30, 2007 compared with $9.2 million for the same period in theprior year.  This increase is primarilyrelated to a $2.5 million increase in the estimated fair value of ourcontingent convertible subordinated note holders’ option to extend the maturityof the contingent convertible subordinated notes from June 15, 2007 to June 15,2010, partly offset by a $1.0 million decrease in interest expense related toour credit facility.  During April 2007,the holders of the contingent convertible subordinated notes exercised theirright to extend the maturity of the convertible notes.  As a result, we will continue to payinterest, at a rate of 4% per annum, during the extension period on anyconvertible notes that remain outstanding (the holders of the convertible notesmay chose at any time to convert some or all of the notes into our commonshares — see note 5 of the notes to the condensed consolidated financialstatements for additional information regarding this conversion right).  We estimated the fair value of the optionimmediately prior to the note holders’ vote to extend and recorded a finaladjustment to the fair value of the option to extend the subordinatedconvertible notes’ maturity.  This finaladjustment was recorded as a charge to interest expense.  We are currently amortizing the exercise datefair value of the option as a reduction to interest expense over the term ofthe extension.  During the nine 

 

27

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months ended September 30, 2007, we recognized approximately $2.7million of adjustments to the fair value of option to extend the maturity termas a charge to interest expense, partly offset by a reduction to interestexpense of $0.5 million related to the amortization of the fair value of theoption to extend the maturity term subsequent to the extension date.  The $1.0 million decrease in interest expenserelated to our credit facility is primarily the result of a decrease in averageoutstanding borrowings partially offset by an increase in our average borrowingrate.

 

***Income Taxes***

 

During the nine months ended September 30, 2007, our tax expense as apercent of pre-tax income was 44.4%.  Ourestimated annual effective tax rate of 43.4% was increased due to tax expenserelated to a discrete adjustment to record interest on uncertain tax positions,partly offset by discrete adjustments to record tax benefits associated withrecognizing uncertain tax benefits related to the expiration of the statute oflimitations in various jurisdictions and to record tax benefits associated withthe exercise of certain incentive stock options.  During the nine months ended September 30,2006, the effective tax rate to record the tax expense related to our netincome was 40.5%.  The prior yeareffective tax rate was lower than in the current year as the effect ofnondeductible items on the effective tax rate was mitigated by the higher levelof pre-tax income.  Our tax rate ishigher than the statutory federal rate of 35% primarily due to statetaxes.  We have significant operationslocated in New York City that are subject to state and local tax rates that arehigher than the tax rates assessed by other jurisdictions where we operate.

 

***Net Income***

 

Our net income was approximately $4.4 million for the nine months endedSeptember 30, 2007 compared with net income of approximately $37.2 million forthe same period in the prior year.  Thisdecrease is primarily the result of a $48.6 million decrease in operatingrevenue before reimbursed direct costs combined with a $7.9 million increase ingeneral and administrative expenses, partly offset by a $21.9 million decreasein income tax expense.  The decrease inoperating revenue is primarily attributable to the recognition during the ninemonths ended September 30, 2006 of $59.7 million of deferred revenue that wasdeferred as of December 31, 2005, partly offset by an approximate $12.3 millionincrease in electronic discovery operating revenue before reimbursed directcosts.  The increase in general andadministrative expenses was primarily related to increases in compensation andbenefits and lease expense.  The decreasein income tax expense is primarily attributable to the recognition during thenine months ended September 30, 2006 of deferred tax expense related to therecognition of deferred revenue.

 

**ElectronicDiscovery Segment**

 

Electronic discoveryoperating revenue before reimbursed direct costs increased $12.3 million, orapproximately 53%, to $35.3 million for the nine months ended September 30,2007 compared to $23.0 million for the same period in the prior year.  This increase is primarily attributable toadditional projects from existing clients as well as an expansion of our clientbase.  Hosting services, which isgenerally a recurring revenue stream, accounted for approximately $6.6 millionof this increase while processing services, which are generally projectoriented, accounted for approximately $5.5 million of this increase.

 

Electronic discovery direct and administrative expenses increased $5.7million, or approximately 48%, to $17.6 million for the nine months endedSeptember 30, 2007 compared with $11.9 million for the same period in the prioryear. This increase is primarily a result of a $4.3 million increase incompensation and benefits expense resulting from expanded staffing andincreased commission and incentive compensation, $0.6 million of expensesrelated to data center moves, a $0.3 million increase in software maintenanceexpense, and a $0.3 million increase in rent expense.

 

**BankruptcyTrustee Segment**

 

Bankruptcy trusteeoperating revenue before reimbursed direct costs decreased approximately $60.5million to $25.0 million for the nine months ended September 30, 2007 comparedto $85.5 million for the same period in the prior year.  As more fully explained under the caption “SignificantAccounting Policies, Revenue Recognition” in note 1 to the condensedconsolidated financial statements, this decrease is primarily the result of ourrevenue recognition related to a specific arrangement in 2006 with our primarydepository financial institution.  Duringthe second quarter of 2006, we delivered the final software upgrade specifiedunder this arrangement.  As the onlyremaining undelivered element was PCS services and as the contract terminatedSeptember 30, 2006, in accordance with SOP 97-2 we recognized all previouslydeferred revenue during the second and third quarters of 2006.  During the nine months ended September 30,2006, we recognized $59.7 million of revenue that had been 

 

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deferred as of December31, 2005.  Effective October 1, 2006, weentered into a new arrangement with this depository financial institution; thisnew arrangement does not include provisions related to software upgrades.  Accordingly, we now recognize this revenuebased on a contingent usage based revenue model and, during the nine monthsended September 30, 2007, we did not defer any bankruptcy trustee revenue or recognizeany previously deferred bankruptcy trustee revenue.

 

Bankruptcy trustee direct and administrative expenses decreasedapproximately $0.3 million, or approximately 3%, to approximately $8.4 millionfor the nine months ended September 30, 2007 compared with approximately $8.7million in the same period in the prior year primarily as the result of a $0.2million decrease in information access expense.

 

**Settlementsand Claims Segment**

 

Settlements and claimsoperating revenue before reimbursed direct costs decreased $0.5 million, orapproximately 1%, to $52.1 million for the nine months ended September 30, 2007compared to $52.6 million for the same period in the prior year.  This decrease is primarily the result of anapproximate $5.3 million decrease in document management revenue, offset by a$4.8 million increase in case management revenue.  The decrease in document management revenueis primarily attributable to a decline in legal notification revenue.  Legal notification revenue tends to bevariable as an individual noticing campaign may have a short duration andgenerate significant revenue during that time. During the nine months ended September 30, 2007, we had fewer largelegal noticing projects than during the same period in the prior year.  The increase in case management revenue is primarilythe result of increased requirements and size of cases compared to the sameperiod in the prior year.

 

Settlements and claims direct and administrative expenses, includingreimbursed direct costs, decreased approximately $3.6 million, or 6% to $52.3million for the nine months ended September 30, 2007 compared to $55.9 millionfor the same period in the prior year. This decrease is primarily the result of a $4.9 million decrease in thecost of legal noticing, which is related to the decrease in legal notificationrevenue, partly offset by a $0.8 million increase in reimbursed direct costsand a $0.4 million increase in compensation and benefits.

 

**Liquidity and Capital Resources**

 

***Operating Activities***

 

During the nine months ended September 30, 2007, ouroperating activities provided net cash of approximately $23.4 million.  The primary sources of cash from operatingactivities was net income of $4.4 million, adjusted for non-cash charges andcredits, primarily depreciation and amortization, of $19.8 million and changesin operating assets and liabilities that decreased our operating cash flow by$0.8 million, primarily as a result of an increase in income taxes, largelyoffset by a decrease related to trade accounts receivable.  The effect of income taxes will fluctuatefrom period to period depending on the accrual related to the current taxexpense and the timing of estimated tax payments made or refunds received.  Trade accounts receivable will fluctuate fromperiod to period depending on the timing of sales and collections.

 

***Investing Activities***

 

During the nine months ended September 30, 2007, we used cash ofapproximately $12.2 million for purchases of property and equipment, primarilycomputer hardware and purchased software licenses for our electronic discoveryoperating segment and purchased computer hardware for our bankruptcy trusteeoperating segment.  Enhancements to ourexisting software and development of new software is essential to our continuedgrowth and, during the nine months ended September 30, 2007, we used cash ofapproximately $3.5 million to fund internal costs related to development ofsoftware for which technological feasibility has been established.  We anticipate that cash generated fromoperations will be adequate to fund our anticipated property, equipment andsoftware spending for the foreseeable future.

 

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***FinancingActivities***

 

During the nine monthsended September 30, 2007, we used available cash to reduce our total creditfacility borrowings by $16.0 million and to pay approximately $3.5 millionrelated to our capitalized leases and deferred acquisition debt.  This financing use of cash was partly offsetby $8.7 million of net proceeds from stock issued in connection with theexercise of employee share options. During the nine months ended September 30, 2007, we recognizedapproximately $0.6 of excess tax benefit related to the exercise of share-basedcompensation as a financing cash flow.

 

As of September 30, 2007, our indebtedness consisted of $54.4 millionfrom the contingent convertible subordinated notes (including the fair value ofthe embedded option), $77.0 million under our senior revolving loan, andapproximately $8.1 million of obligations related to capitalized leases anddeferred acquisition debt.

 

As of September 30, 2007, significant covenants, all as defined withinour credit facility agreement, include a leverage ratio not to exceed 3.25 to1.00, a senior leverage ratio not to exceed 2.25 to 1.00, a fixed chargecoverage ratio of not less than 1.25 to 1.00, and a current ratio of not lessthan 1.50 to 1.00.  As of September 30,2007, we were in compliance with all financial covenants.

 

We believe that the funds generated from operations plus amountsavailable under our credit facility’s senior revolving loan will be sufficientfor the foreseeable future to finance currently anticipated working capitalrequirements, software expenditures, property and equipment expenditures,interest payments due on our outstanding borrowings, and payments forcontractual obligations.  We have norequired principal reductions on our senior revolving loan until it matures inNovember 2008.

 

We may pursueacquisitions in the future.  If theacquisition price exceeds our then available cash and unused borrowingcapacity, we may decide to issue equity, restructure our credit facility,partly finance the acquisition with a note payable, or some combination of thepreceding.  Covenants contained in ourcredit facility may limit our ability to consummate an acquisition.  Pursuant to the terms of our credit facility,we generally cannot incur indebtedness outside the credit facility, with theexceptions of capital leases with an aggregate principal limit of $5.0 millionand subordinated debt with an aggregate principal limit of $100.0 million.  Furthermore, for any acquisition we must beable to demonstrate that, on a pro forma basis, we would be in compliance withour covenants during the four quarters prior to the acquisition and we mustobtain bank permission for any acquisition for which cash consideration exceeds$65.0 million or total consideration exceeds $125.0 million.

 

**Contractual Obligations**

 

The following table sets forth a summary of our contractual obligationsand commitments for each twelve month period ending September 30 (inthousands):

 
| ** **                               | ** ** | ** **                 | ** ** | ** **              | ** ** | ** **            | ** ** | ** **            | ** ** | ** **               | ** ** |
|------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------------------|------------|-----------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **Payments Due By Period** | ** ** |
| **Contractual  Obligations (1)**         | ** ** | **Total**                  | ** ** | **Less  than   1 Year** | ** ** | **1 — 3  Years** | ** ** | **3 — 5  Years** | ** ** | **More  Than   5 Years** | ** ** |
|                                     |       |                       |       |                    |       |                  |       |                  |       |                     |       |
| Long-term debt  and future accretion (2) |       | $                          | 133,621    |                    | $          | 3,093                 |       | $                     | 130,028    |                     | $          | 500 |   | $ | — |   |
| Interest  payments (3)                   |       | 6,822                      |       | 2,428                   |       | 4,267                 |       | 102                   |       | 25                       |       |
| Employment agreements  (4)               |       | 5,759                      |       | 2,534                   |       | 2,865                 |       | 360                   |       | —                   |       |
| Capital lease  obligations               |       | 1,803                      |       | 797                     |       | 929                   |       | 77                    |       | —                   |       |
| Operating leases                         |       | 38,380                     |       | 5,256                   |       | 10,671                |       | 9,905                 |       | 12,548                   |       |
| Total                                    |       | $                          | 186,385    |                    | $          | 14,108                |       | $                     | 148,760    |                     | $          | 10,944 |   | $ | 12,573 |   |

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(1)         Approximately $6.6 million of unrecognized taxbenefits are not included in this contractual obligations table due to theuncertainty related to the timing of any payments.

 

(2)         A portion of the purchase price of certainacquisitions were in the form of notes on which the interest rate was below ourincremental borrowing rate, and which were discounted using our estimatedincremental borrowing rate.  Thediscounts 

 

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are accreted overthe life of the note and each period’s accretion is added to the principal ofthe respective note.  The amount in theabove contractual obligations table includes both the notes’ principal, asreflected on our September 30, 2007 condensed consolidated balance sheet, andall future accretion.  If certainfinancial objectives are satisfied, we will make additional payments over thenext four years related to our acquisition of Hilsoft and Epiq PreferenceSolutions.  Such payments, if any, arenot included in the above contractual obligation table.  Convertible debt is included at the statedvalue of the principal redemption and excludes adjustments related to theembedded option, which will not be paid in cash.  Any conversion to our common stock of part orall of the convertible debt will reduce our cash obligation related to theconvertible debt.

 

(3)       Represents payments on fixed interest debt and assumesall subordinate convertible debt is held to the extended maturity date.  Interest related to the variable interestrevolving debt has been excluded due to uncertainties related to the amount ofsuch payments.

 

(4)       In conjunction with acquisitions, we have entered intoemployment arrangements with certain key employees of the acquired companies.

 

**RecentAccounting Pronouncements**

 

In February 2007, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards No. 159, *The FairValue Option for Financial Assets and Financial Liabilities — Including anamendment of FASB Statement No. 115** *(SFAS 159).  SFAS 159 permits the measurement of specifiedfinancial instruments and warranty and insurance contracts at fair value on acontract-by-contract basis, with changes in fair value recognized in earningseach reporting period.  SFAS 159 iseffective for fiscal years beginning after November 15, 2007.  We do not anticipate that adoption of thisstatement will have a material impact on our consolidated financial statements.

 

In September 2006, the FASB issued Statement of Financial AccountingStandards No. 157, *Fair Value Measurements*,(SFAS 157).  SFAS 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.  SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 andinterim periods within those fiscal years. Management is still evaluating the impact, if any, that the adoption ofSFAS 157 will have on our consolidated financial statements.

 

In June 2007, the EITF issued Issue No. 06-11, *Accountingfor Income Tax Benefits of Dividends on Share based Payment Awards*(EITF 06-11).  EITF 06-11 providesinterpretive guidance on the recognition of income tax benefits received ondividends paid to nonvested equity share awards.  EITF 06-11 is effective for fiscal yearsbeginning after December 15, 2007.  We donot anticipate that adoption of EITF 06-11 will have a material impact on ourconsolidated financial statements.

 

**Forward-LookingStatements**

 

In this report, in otherfilings with the SEC and in press releases and other public statements by ourofficers throughout the year, Epiq Systems, Inc. makes or will make statementsthat plan for or anticipate the future. These forward-looking statements include statements about our futurebusiness plans and strategies, and other statements that are not historical innature.  These forward-looking statementsare based on our current expectations.  Inthis Quarterly Report on Form 10-Q, we make statements that plan for or anticipatethe future.  Many of these statements arefound in the “Management’s Discussion and Analysis of Financial Condition andResults of Operations” section of this report.

 

Forward-looking statements may be identified by words or phrases suchas “believe,” “expect,” “anticipate,” “should,” “planned,” “may,” “estimated,” “goal,”“objective” and “potential.”  Section 27Aof the Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended, provide a “safe harbor” for forward-lookingstatements.  Because forward-lookingstatements involve future risks and uncertainties, listed below are a varietyof factors that could cause actual results and experience to differ materiallyfrom the anticipated results or other expectations expressed in ourforward-looking statements.  Thesefactors include (1) any material changes in our total number of clientengagements and the volume associated with each engagement, (2) any materialchanges in our client’s deposit portfolio or the services required or selectedby our clients in engagements, (3) material changes in the number of bankruptcyfilings, class action filings or mass tort actions each year, (4) risksassociated with handling of confidential data and compliance with informationprivacy laws, (5) changes in pricing structures and arrangements, (6) risksassociated with the integration of acquisitions into our existing businessoperations, (7) risks associated with our indebtedness, (8) risks associatedwith the application of complex 

 

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accounting rules to unique transactions, including the risk that goodfaith application of those rules and audits of those results may be laterreversed by new interpretations of those rules or new views regarding theapplication of those rules, and (9) other risks detailed from time to time inour SEC filings, including our annual report on Form 10-K.  In addition, there may be other factors notincluded in our SEC filings that may cause actual results to differ materiallyfrom any forward-looking statements. We undertake no obligations to update anyforward-looking statements contained herein to reflect future events ordevelopments.

 

**ITEM 3.          Quantitative and QualitativeDisclosures About Market Risk.**

 

Market risk refers to the risk that a changein the level of one or more market prices, interest rates, indices,volatilities, correlations or other market factors, such as liquidity, willresult in losses for a certain financial instrument or group of financialinstruments.  Except for interest ratefloor options purchased during 2007, our exposure to market risk has notchanged significantly since December 31, 2006.

 

During the third quarter of 2007, wepurchased three year interest rate floor options, referenced to one-month LIBORand with various strike prices, with a notional value of $800 million.  If the one-month LIBOR increased by 100 basispoints, we estimate the effect would be to decrease income before taxes byapproximately $0.6 million and that there would be no effect on our cashflow.  If the one-month LIBOR decreasedby 100 basis points, we estimate the effect would be to increase income beforetaxes by approximately $1.8 million and that there would be no effect on ourcash flow.

 

**ITEM 4.          Controls and Procedures.**

 

***Disclosure Controls and Procedures***

 

An evaluation was carried out by the EpiqSystems, Inc.’s (the Company’s) Chief Executive Officer (CEO) and ChiefFinancial Officer (CFO) of the effectiveness of the design and operations ofthe Company’s disclosure controls and procedures as defined in Exchange ActRule 13a-15(e).  Based on thisevaluation, our management, including the CEO and CFO, concluded that ourdisclosure controls and procedures are effective.  Disclosure controls and procedures aredesigned to ensure that information required to be disclosed by the Company inits periodic filings with the SEC is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by the Company in the reports that it files or submitsto the SEC is accumulated and communicated to Company’s management, includingits principal executive and principal financial officers, or persons performingsimilar functions, as appropriate to allow timely decisions regarding requireddisclosure.

 

***Changes in Internal Control OverFinancial Reporting***

 

There have been no changes in our internalcontrols over financial reporting during the quarter ended September 30, 2007,that have materially affected, or are reasonably likely to materially affect,our internal controls over financial reporting.

 

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**PART II -OTHER INFORMATION**

 

**ITEM 1A**.       **Risk Factors. **

 

There have been nomaterial changes in our Risk Factors from those disclosed in our 2006 AnnualReport on Form 10-K as updated and superseded by information contained in ourForm 8-K filed on August 7, 2007.

 

**ITEM 6**.          **Exhibits.**

 
| 31.1   |   | Certifications of Chief  Executive Officer of the Company under Rule 13a-14(a), as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                   |
| 31.2   |   | Certifications of Chief  Financial Officer of the Company under Rule 13a-14(a), as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                   |
| 32.1   |   | Certifications of CEO  and CFO pursuant to 18 U.S.C. Section 1350.                                                                                     |
|   |   |                                                                                                                                                   |

 

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##### **SIGNATURES**

 

 

                Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas caused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| ** ** | ** **       | ** ** | **Epiq Systems, Inc**.                            | ** ** |
|------------|------------------|------------|---------------------------------------------------|------------|
|       |             |       |                                              |       |
| Date:      | October 26, 2007 |       | /s/ Tom W. Olofson                                |       |
|       |             |       | Tom W. Olofson                                    |       |
|       |             |       | Chairman of the Board                             |       |
|       |             |       | Chief Executive Officer                           |       |
|       |             |       | Director                                          |       |
|       |             |       | (Principal Executive Officer)                     |       |
|       |             |       |                                              |       |
| Date:      | October 26, 2007 |       | /s/ Elizabeth M. Braham                           |       |
|       |             |       | Elizabeth M. Braham                               |       |
|       |             |       | Executive Vice President, Chief Financial Officer |
|       |             |       | (Principal Financial Officer)                     |       |
|       |             |       |                                              |       |
| Date:      | October 26, 2007 |       | /s/ Douglas W. Fleming                            |       |
|       |             |       | Douglas W. Fleming                                |       |
|       |             |       | Director of Finance                               |       |
|       |             |       | (Principal Accounting Officer)                    |       |
|       |             |       |                                              |       |

 

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