**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20549**

**FORM10-Q/A**

**AmendmentNo. 1**

**(Mark One)**

| **x**      |   | **Quarterly Report Under Section 13 or 15(d) of  the Securities Exchange Act of 1934**        |
|------------|--------|-----------------------------------------------------------------------------------------------|
| ** ** |   | ** **                                                                                    |
| ** ** |   | **For the  Quarterly Period Ended March 31, 2006**                                            |
| ** ** |   | ** **                                                                                    |
| ** ** |   | **OR**                                                                                        |
| ** ** |   | ** **                                                                                    |
| **o**      |   | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |

 

**For thetransition period from                   to                     **

**CommissionFile Number 0-22081**

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**EPIQSYSTEMS, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

(Address ofprincipal executive office)

**913-621-9500**

(Registrant’stelephone number)

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  No  x

The number of sharesoutstanding of registrant’s common stock at May 4, 2006:
| Class                         | ** ** | **Outstanding** |
|-------------------------------|------------|-----------------|
| Common Stock,  $.01 par value |       | 19,385,717      |

 

 

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**EPIQ SYSTEMS, INC.**

**FORM 10-Q/A**

**QUARTERENDED MARCH 31, 2006**

**CONTENTS**
|                                     | ** **                                                                                                                | ** ** |
|-------------------------------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                          |                                                                                                                      |
| **PART I - FINANCIAL  INFORMATION** |                                                                                                                      |
| ** **                          |                                                                                                                      |
| Item 1.                             | Condensed Consolidated  Financial Statements                                                                              | 1          |
|                                |                                                                                                                      |       |
|                                | Condensed  Consolidated Statements of Operations (Restated)–Three months ended March 31,  2006 and 2005 (Unaudited)  | 1          |
|                                |                                                                                                                      |       |
|                                | Condensed  Consolidated Balance Sheets (Restated)– March 31, 2006 and December 31, 2005  (Unaudited)                 | 2          |
|                                |                                                                                                                      |       |
|                                | Condensed Consolidated  Statements of Cash Flows (Restated)– Three months ended March 31, 2006 and  2005 (Unaudited) | 3          |
|                                |                                                                                                                      |       |
|                                | Notes to  Condensed Consolidated Financial Statements (Unaudited)                                                         | 4          |
|                                |                                                                                                                      |       |
| Item 2.                             | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                               | 23         |
|                                |                                                                                                                      |       |
| Item 3.                             | Quantitative  and Qualitative Disclosures about Market Risk                                                               | 34         |
|                                |                                                                                                                      |       |
| Item 4.                             | Controls and  Procedures                                                                                                  | 34         |
|                                |                                                                                                                      |       |
| **PART II - OTHER  INFORMATION**    | 35                                                                                                                        |
| ** **                          |                                                                                                                      |
| Item  1A.                           | Risk  Factors                                                                                                             | 35         |
|                                |                                                                                                                      |       |
| Item  6.                            | Exhibits                                                                                                                  | 35         |
|                                |                                                                                                                      |       |
| Signatures                          | 36                                                                                                                        |
|                                     |                                                                                                                           |            |  |

 

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**Explanatory Note**

EpiqSystems, Inc. is filing this Amendment No. 1 to its Quarterly Report on Form10-Q for the three months ended March 31, 2006 (Form 10-Q/A) to restate ourpreviously issued financial statements initially filed with the Securities andExchange Commission (SEC) on May 9, 2006, as discussed in note 10 to thecondensed consolidated financial statements.

This Form 10-Q/A amends and restates Items 1, 2 and 4 of Part I of theoriginal filing to reflect the effects of this restatement.  The remaining Items contained in this Form10-Q/A consist of all other Items contained in the original Form 10-Q for thethree months ended March 31, 2006.  Theseremaining Items are not amended by this filing. Except for the foregoing amended information, this 10-Q/A continues todescribe conditions as of the date of the original filing, and we have notupdated the disclosures contained herein to reflect events that occurred at alater date.  In addition, pursuant to therules of the SEC, Exhibits 31.1, 31.2, 32.1, and 32.2 of the original filinghave been amended to contain currently dated certifications from our ChiefExecutive Officer and Chief Financial Officer. The updated certifications are attached to this Form 10-Q/A as Exhibits31.1, 31.2, 32.1, and 32.2.

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**PART I - FINANCIAL INFORMATION**

**ITEM 1.          Condensed Consolidated FinancialStatements.**

**EPIQ SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(In Thousands, Except Per ShareData)**

**(Unaudited)**
| ** **                                                                                                                                                                   | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                   | ** ** | **(As Restated,  see note 10)**       | ** ** | **(As Restated,  see note 10)** | ** ** |
| **REVENUE:**                                                                                                                                                                 |       |                                                 |       |   |   |
| Case management  services                                                                                                                                                    |       | $                                                    | 18,901     |   | $ | 12,807 |   |
| Case management  bundled software license, software upgrade and postcontract customer support  services                                                                      |       | 685                                                  |       | 261 |   |
| Document  management services                                                                                                                                                |       | 12,975                                               |       | 6,081 |   |
| Operating  revenue before reimbursed direct costs                                                                                                                            |       | 32,561                                               |       | 19,149 |   |
| Operating  revenue from reimbursed direct costs                                                                                                                              |       | 5,657                                                |       | 5,495 |   |
| Total Revenue                                                                                                                                                                |       | 38,218                                               |       | 24,644 |   |
|                                                                                                                                                                         |       |                                                 |       |   |   |
| **OPERATING EXPENSES:**                                                                                                                                                      |       |                                                 |       |   |   |
| Direct costs of  services (exclusive of depreciation and amortization shown separately below)                                                                                |       | 14,376                                               |       | 7,247 |   |
| Direct cost of bundled software license, software upgrade  and postcontract customer support services  (exclusive  of depreciation and  amortization shown separately below) |       | 1,035                                                |       | 937 |   |
| Reimbursed  direct costs                                                                                                                                                     |       | 5,720                                                |       | 5,552 |   |
| General and  administrative                                                                                                                                                  |       | 11,699                                               |       | 7,992 |   |
| Depreciation and  software and leasehold amortization                                                                                                                        |       | 2,297                                                |       | 1,774 |   |
| Amortization of  other intangibles                                                                                                                                           |       | 2,767                                                |       | 1,623 |   |
| Total Operating  Expenses                                                                                                                                                    |       | 37,894                                               |       | 25,125 |   |
|                                                                                                                                                                         |       |                                                 |       |   |   |
| **INCOME (LOSS) FROM OPERATIONS**                                                                                                                                            |       | 324                                                  |       | (481 | ) |
|                                                                                                                                                                         |       |                                                 |       |   |   |
| **EXPENSES (INCOME) RELATED TO  FINANCING:**                                                                                                                                 |       |                                                 |       |   |   |
| Interest income                                                                                                                                                              |       | (46                                                  | )          | (39 | ) |
| Interest expense                                                                                                                                                             |       | 3,310                                                |       | 801 |   |
| Net Expenses  Related To Financing                                                                                                                                           |       | 3,264                                                |       | 762 |   |
|                                                                                                                                                                         |       |                                                 |       |   |   |
| **LOSS BEFORE INCOME TAXES**                                                                                                                                                 |       | (2,940                                               | )          | (1,243 | ) |
|                                                                                                                                                                         |       |                                                 |       |   |   |
| **PROVISION (BENEFIT) FOR INCOME  TAXES**                                                                                                                                    |       | (1,191                                               | )          | 885 |   |
|                                                                                                                                                                         |       |                                                 |       |   |   |
| **NET LOSS**                                                                                                                                                                 |       | $                                                    | (1,749     | ) | $ | (2,128 | ) |
| ** **                                                                                                                                                                   |       |                                                 |       |   |   |
| **NET  LOSS PER SHARE INFORMATION:**                                                                                                                                         |       |                                                 |       |   |   |
| Basic                                                                                                                                                                        |       | $                                                    | (0.09      | ) | $ | (0.12 | ) |
| Diluted                                                                                                                                                                      |       | $                                                    | (0.09      | ) | $ | (0.12 | ) |
|                                                                                                                                                                         |       |                                                 |       |   |   |
| **WEIGHTED  AVERAGE COMMON SHARES OUTSTANDING:**                                                                                                                             |       |                                                 |       |   |   |
| Basic                                                                                                                                                                        |       | 19,284                                               |       | 17,887 |   |
| Diluted                                                                                                                                                                      |       | 19,284                                               |       | 17,887 |   |

 

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

1

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**EPIQ SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

**(Unaudited)**
| ** **                                                                                                                                                                             | ** ** | **March 31, 2006**                   | ** ** | **December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                             | ** ** | **(As Restated,  see note 10)** | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                             |       |                                           |       |                            |       |
| **CURRENT ASSETS:**                                                                                                                                                                    |       |                                           |       |                            |       |
| Cash and cash equivalents                                                                                                                                                              |       | $                                              | 6,827      |                            | $          | 13,563 |   |
| Trade accounts receivable,  less allowance for doubtful accounts  of $3,229 and $3,481, respectively                                                                                   |       | 35,765                                         |       | 33,504                          |       |
| Prepaid expenses                                                                                                                                                                       |       | 3,125                                          |       | 2,818                           |       |
| Income taxes refundable                                                                                                                                                                |       | 3,415                                          |       | 4,643                           |       |
| Deferred income taxes                                                                                                                                                                  |       | 27,853                                         |       | 25,579                          |       |
| Other current assets                                                                                                                                                                   |       | 516                                            |       | 85                              |       |
| Total Current Assets                                                                                                                                                                   |       | 77,501                                         |       | 80,192                          |       |
|                                                                                                                                                                                   |       |                                           |       |                            |       |
| **LONG-TERM ASSETS:**                                                                                                                                                                  |       |                                           |       |                            |       |
| Property, equipment and  leasehold improvements, net                                                                                                                                   |       | 24,295                                         |       | 23,751                          |       |
| Software development costs,  net                                                                                                                                                       |       | 8,913                                          |       | 8,848                           |       |
| Goodwill                                                                                                                                                                               |       | 249,729                                        |       | 249,427                         |       |
| Other intangibles, net of  accumulated amortization of $16,525 and  $13,758, respectively                                                                                              |       | 50,302                                         |       | 53,399                          |       |
| Other                                                                                                                                                                                  |       | 2,722                                          |       | 2,854                           |       |
| Total Long-term Assets, net                                                                                                                                                            |       | 335,961                                        |       | 338,279                         |       |
| **Total Assets**                                                                                                                                                                       |       | $                                              | 413,462    |                            | $          | 418,471 |   |
|                                                                                                                                                                                   |       |                                           |       |                            |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                         |       |                                           |       |                            |       |
| **CURRENT LIABILITIES:**                                                                                                                                                               |       |                                           |       |                            |       |
| Accounts payable                                                                                                                                                                       |       | $                                              | 7,684      |                            | $          | 7,954 |   |
| Customer deposits                                                                                                                                                                      |       | 2,359                                          |       | 2,196                           |       |
| Accrued compensation                                                                                                                                                                   |       | 1,151                                          |       | 3,944                           |       |
| Other accrued expenses                                                                                                                                                                 |       | 3,387                                          |       | 3,322                           |       |
| Deferred revenue                                                                                                                                                                       |       | 67,027                                         |       | 60,224                          |       |
| Current maturities of  long-term obligations                                                                                                                                           |       | 18,496                                         |       | 27,642                          |       |
| Total Current Liabilities                                                                                                                                                              |       | 100,104                                        |       | 105,282                         |       |
|                                                                                                                                                                                   |       |                                           |       |                            |       |
| **LONG-TERM LIABILITIES:**                                                                                                                                                             |       |                                           |       |                            |       |
| Long-term obligations  (excluding current maturities)                                                                                                                                  |       | 145,645                                        |       | 145,906                         |       |
| Deferred income taxes                                                                                                                                                                  |       | 26,351                                         |       | 26,815                          |       |
| Other long-term liabilities                                                                                                                                                            |       | 481                                            |       | —                          |       |
| Total Long-term Liabilities                                                                                                                                                            |       | 172,477                                        |       | 172,721                         |       |
|                                                                                                                                                                                   |       |                                           |       |                            |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                         |       |                                           |       |                            |       |
| Common stock - $0.01 par  value; 50,000,000 shares authorized;  issued and outstanding – 19,358,717 and 19,253,466  shares at March 31, 2006 and December 31, 2005,  respectively |       | 194                                            |       | 193                             |       |
| Additional paid-in capital                                                                                                                                                             |       | 130,661                                        |       | 128,484                         |       |
| Retained earnings                                                                                                                                                                      |       | 10,042                                         |       | 11,791                          |       |
| Accumulated other  comprehensive loss                                                                                                                                                  |       | (16                                            | )          | —                          |       |
| Total Stockholders’ Equity                                                                                                                                                        |       | 140,881                                        |       | 140,468                         |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                    |       | $                                              | 413,462    |                            | $          | 418,471 |   |

 

**See accompanying notes to condensed consolidatedfinancial statements.**

2

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**EPIQ SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In Thousands)**

**(Unaudited)**
| ** **                                                                                              | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                                                                                              | ** ** | **(As Restated,  see note 10)**       | ** ** | **(As Restated,  see note 10)** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                              |       |                                                 |       |   |   |
| Net loss                                                                                                |       | $                                                    | (1,749     | ) | $ | (2,128 | ) |
| Adjustments to reconcile net loss to net cash from  operating activities:                               |       |                                                 |       |   |   |
| Share-based compensation expense                                                                        |       | 530                                                  |       | — |   |
| Benefit for deferred income taxes                                                                       |       | (2,547                                               | )          | (2,453 | ) |
| Depreciation and software and leasehold amortization                                                    |       | 2,297                                                |       | 1,774 |   |
| Loan fee amortization                                                                                   |       | 337                                                  |       | 284 |   |
| Amortization of other intangibles                                                                       |       | 2,767                                                |       | 1,623 |   |
| Other                                                                                                   |       | 39                                                   |       | (57 | ) |
| Changes in operating assets and liabilities, net of  effects from business acquisition:                 |       |                                                 |       |   |   |
| Trade accounts receivable                                                                               |       | (1,986                                               | )          | (6,230 | ) |
| Prepaid expenses and other assets                                                                       |       | (943                                                 | )          | (757 | ) |
| Accounts payable and other liabilities                                                                  |       | (1,377                                               | )          | (459 | ) |
| Deferred revenue                                                                                        |       | 6,803                                                |       | 6,818 |   |
| Excess tax benefit related to share-based  compensation                                                 |       | (145                                                 | )          | — |   |
| Income taxes (including $402 and $18 of tax benefit  related to share-based compensation, respectively) |       | 1,630                                                |       | 3,292 |   |
| Net cash provided by operating activities                                                               |       | 5,656                                                |       | 1,707 |   |
|                                                                                                    |       |                                                 |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                              |       |                                                 |       |   |   |
| Purchase of property and equipment                                                                      |       | (2,990                                               | )          | (404 | ) |
| Software development costs                                                                              |       | (935                                                 | )          | (437 | ) |
| Cash paid for acquisition of business, net of cash  acquired                                            |       | (150                                                 | )          | — |   |
| Purchase of short-term investments                                                                      |       | —                                               |       | (4,000 | ) |
| Sale of short-term investments                                                                          |       | —                                               |       | 2,150 |   |
| Other                                                                                                   |       | 3                                                    |       | (1,767 | ) |
| Net cash used in investing activities                                                                   |       | (4,072                                               | )          | (4,458 | ) |
|                                                                                                    |       |                                                 |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                              |       |                                                 |       |   |   |
| Proceeds from long-term debt borrowings                                                                 |       | —                                               |       | 5,000 |   |
| Principal payments under long-term debt obligations                                                     |       | (9,712                                               | )          | (7,118 | ) |
| Excess tax benefit related to share-based  compensation                                                 |       | 145                                                  |       | — |   |
| Proceeds from exercise of stock options                                                                 |       | 1,247                                                |       | 46 |   |
| Net cash used in financing activities                                                                   |       | (8,320                                               | )          | (2,072 | ) |
|                                                                                                    |       |                                                 |       |   |   |
| **NET  DECREASE IN CASH AND CASH EQUIVALENTS**                                                          |       | (6,736                                               | )          | (4,823 | ) |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                     |       | 13,563                                               |       | 13,330 |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                                           |       | $                                                    | 6,827      |   | $ | 8,507 |   |
| ** **                                                                                              |       |                                                 |       |   |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:**                                                 |       |                                                 |       |   |   |
| Interest paid                                                                                           |       | $                                                    | 2,913      |   | $ | 834 |   |
| Income taxes  paid (received)                                                                           |       | $                                                    | (275       | ) | $ | 46 |   |

 

**See accompanying notes tocondensed consolidated financial statements.**

3

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**EPIQSYSTEMS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**NOTE1:   NATURE OF OPERATIONS AND SUMMARY OFRECENTLY ADOPTED ACCOUNTING POLICIES**

***Principlesof Consolidation***

The consolidatedfinancial statements include the accounts of Epiq Systems, Inc. (“Epiq”) andits wholly-owned subsidiaries.  Allsignificant intercompany transactions and balances have been eliminated inconsolidation.

***Natureof Operations***

Epiq is a nationalprovider of technology-based solutions for the legal and fiduciary servicesindustries. Our products and services assist clients with the administration ofcomplex legal proceedings, including electronic litigation discovery,bankruptcy administration and class action administration. Our clients includeleading law firms, corporate legal departments, bankruptcy trustees, and otherprofessional advisors who require sophisticated case administration anddocument management capabilities, extensive subject matter expertise and a highservice capacity. We provide clients with an integrated offering of bothproprietary technology and value-added services that comprehensively addresstheir extensive business requirements.

***ComprehensiveLoss***

Statement of Financial Accounting Standards No. 130, *Reporting Comprehensive Income*, establishes requirements forreporting and display of comprehensive income or loss and its components.  Our total comprehensive loss, which includesnet earnings and foreign currency translation adjustments, was as follows (inthousands):
|                                          | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
|                                     |       |                             |       |   |   |
| Net loss                                 |       | $                                | (1,749     | ) | $ | (2,128 | ) |
| Foreign currency  translation adjustment |       | (16                              | )          | — |   |
| Total comprehensive loss                 |       | $                                | (1,765     | ) | $ | (2,128 | ) |

 

***Share-basedCompensation***

During the quarter endedMarch 31, 2006, we adopted Statement of Financial Accounting Standards No. 123(revised 2004) (SFAS No. 123R), *Share-Based Payment*.  SFAS No. 123R establishes standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods and services or incurs liabilities in exchange for goods or servicesthat are based on the fair value of the entity’s equity instruments or that maybe settled by the issuance of those equity instruments.  SFAS No. 123R requires a public entity tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award and torecognize that cost over the period during which an employee is required toprovide service in exchange for the award.

We elected to adopt SFAS No. 123R using the modifiedversion of prospective application. Under the modified version of prospective application, we haverecognized compensation costs related to share-based compensation beginningwith the quarter ended March 31, 2006. We recognize this expense on a straight-line basis over the requisiteservice period of the last separately vesting portion of the award.  Prior to 2006, we accounted for stock-basedcompensation awards under the intrinsic method of Accounting Principles BoardOpinion No. 25, *Accounting for Stock Issued to Employees,*whichrequired compensation cost to be recognized based on the excess, if any,between the quoted market price at the date of grant and the amount an employeemust pay to acquire stock.  Compensationcosts related to share-based compensation for periods ended on or beforeDecember 31, 2005 are reflected on a pro forma basis in note 6 of these notesto condensed consolidated financial statements.

4

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***RevenueRrecognition.***

We have agreements with clients pursuant to which wedeliver various case management and document management services each month.

Significant sources of revenue include:

·                  Feescontingent upon the month-to-month delivery of case management services definedby client contracts, such as claims processing, claims reconciliation,professional services, call center support, and conversion of data into anorganized, searchable electronic database. The amount we earn varies basedprimarily on the size and complexity of the engagement;

·                  Hostingfees based on the amount of data stored;

·                  Deposit-basedfees from financial institutions, primarily based on a percentage of totalliquidated assets placed on deposit at that financial institution by ourbankruptcy trustee clients, to whom we provide, at no charge, softwarelicenses, limited hardware and hardware maintenance, and postcontract customersupport (PCS) services;

·                  Legalnoticing services to parties of interest in bankruptcy and class actionmatters, including media campaign and advertising management in which wecoordinate notification through various media outlets, such as print, radio andtelevision, to potential parties of interest for a particular clientengagement; and

·                  Reimbursementfor costs incurred, primarily related to postage on mailing services.

*Non-Software Arrangements*

Case and document management servicesrelated to electronic discovery, corporate restructuring, and class actionrevenue, which are billed based on volume, are evaluated pursuant to EmergingIssues Task Force (EITF) 00-21, *RevenueArrangements with Multiple Deliverables*.  For each of these contractual arrangements,we have identified the following deliverables and/or services:

·                  Electronic Discovery

·               Data processing

·               Hosting

·                  Corporate Restructuring

·               Consulting

·               Claims management

·               Printing and reproduction

·               Mailing and noticing

·               Document management

·                  Class Action

·               Consulting

·               Notice campaigns

·               Toll free customer support

·               Web site design/hosting

·               Claims administration

·               Distribution

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 include generalrights of return.  Accordingly, each ofthe service elements in our multiple element case and document managementarrangements qualifies as a separate unit of accounting under EITF 00-21.  We allocate revenue to the various units ofaccounting in our arrangements based on the fair value of each unit ofaccounting, 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 StaffAccounting Bulletin Topic 13, *RevenueRecognition* (SAB Topic 13). As the services are rendered, our fee becomes fixed and determinable,and collectibility is reasonably assured. Payments

5

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received in advance of satisfaction of therelated revenue recognition criteria are recognized as a customer deposit untilall revenue recognition criteria have been satisfied.

*Software Arrangements*

For our Chapter 7 bankruptcy trustee arrangements, weprovide our trustee clients with a software license, hardware lease, hardwaremaintenance, and PCS services, all at no charge to the trustee.  The trustees place their liquidated estatedeposits with a financial institution with which we have an arrangement.  The financial institution pays us a monthly feecontingent on the dollar level of average monthly deposits placed by thetrustees with that financial institution.

For Chapter 7 related arrangements with financialinstitutions, we earn contingent monthly fees from the financial institutionrelated to the software license, hardware lease, hardware maintenance, and PCSservices.  We account for the softwarelicense and PCS service elements in accordance with Statement of Position 97-2,*Software Revenue Recognition* (SOP97-2).  Since we have not establishedvendor specific objective evidence (VSOE) of the fair value of the softwarelicense, we do not recognize any revenue on delivery of the software.  The software element is deferred and includedwith the remaining undelivered element, which is PCS services.  This revenue, when recognized, is included onour condensed consolidated statements of operations as a component of “Casemanagement bundled software license, software upgrade and postcontract customersupport services” revenue.  Revenuerelated to PCS services is entirely contingent on the placement of liquidatedestate deposits by the trustee with the financial institution.  Accordingly, we recognize this contingentusage based revenue consistent with the guidance provided by the AmericanInstitute of Certified Public Accountants’ Technical Practice Aid (TPA)5100.76, *Fair Value in Multiple-Element Arrangements ThatInclude Contingent Usage-Based Fees and Software Revenue Recognition*as the fee becomes fixed or determinable at the time actual usage occurs andcollectibility is probable.  This occursmonthly as a result of the computation, billing and collection of monthlydeposit fees contractually agreed to.  Atthat time, we have also satisfied the other revenue recognition criteriacontained in SOP 97-2, since we have persuasive evidence that an arrangementexists, services have been rendered, the price is fixed and determinable, andcollectibility is reasonably assured.

We also provide ourtrustees with certain hardware, such as desktop computers, monitors, andprinters, and hardware maintenance.  Weretain ownership of all hardware provided and, based on guidance provided inEITF 01-8, *Determining Whether anArrangement Contains a Lease*, we account for this hardware as alease.  As the hardware maintenancearrangement is an executory contract similar to an operating lease, we useguidance related to contingent rentals in operating lease arrangements forhardware maintenance as well as for the hardware lease.  Since all of the payments under our arrangementsare contingent upon the level of trustee deposits and the delivery of upgradesand other services and there remain important uncertainties regarding theamount of unreimbursable costs yet to be incurred by us, we account for thehardware lease as an operating lease in accordance with SFAS 13, *Accounting for Leases*.  Therefore, all lease payments were accountedfor as contingent rentals under EITF Issue No. 98-9, *Accounting for Contingent Rent* and SAB Topic 13, whichrequires that we recognize rental income when the changes in the factor onwhich the contingent lease payment is based actually occur.  This occurred at the end of each period as weachieve our target when deposits are held at the depository financialinstitution as, at that time, evidence of an arrangement exists, delivery hasoccurred, the amount has become fixed and determinable, and collection isreasonably assured.  This revenue, whichis less than ten percent of our total revenue, is included in our condensedconsolidated statements of operations as a component of “Case managementservices” revenue.

Effective October 1, 2003, we entered into anarrangement with our primary depository financial institution underwhich we deliver two specified upgrades annually with the last specified upgradeto occur in the second quarter of 2006.  Thisarrangement included specific pricing for each software upgrade and certainspecial projects in addition to the contingent deposit-based pricing related tothe software license, hardware, hardware maintenance, and PCS to each trusteeclient.  Therefore, the software upgrades and special projects are part of abundled arrangement.  Each softwareupgrade is considered a separate and discrete product and, as we do not selleach software upgrade on a standalone basis, we were unable to establish VSOEof the fair value of the software upgrades. As a result, the licensed software, software upgrade, special projectsand PCS are a combined unit of accounting. Revenue for this combined unit of accounting, when recognized, isincluded as a component of case management services revenue.  Since we do not have VSOE of the fairvalue of each separate upgrade, we have deferred recognition of substantiallyall revenue under this arrangement until delivery of the final upgrade.  Theongoing costs related to this arrangement were recognized as expense whenincurred.  When the final upgrade is delivered and the only remaining undeliveredelement is PCS services, we will recognize revenue on a pro-rata basis over theterm of the agreement.  Payments receivedin advance of satisfaction of the related revenue recognition criteria arerecognized as deferred revenue until all revenue recognition criteria have beensatisfied.  As of March 31, 2006 and2005, we had recorded on our consolidated balance sheets $66.1 million and$42.0 million, respectively, of deferred revenue under the October 2003Arrangement.  Once the final upgrade isdelivered and the only remaining undelivered element is PCS, we will recognizeincome on a pro-rata basis over the term of the agreement.

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*Reimbursements*

Our case and document management businessesboth have revenue related to the reimbursement of certain costs, primarilypostage.  Consistent with guidanceprovided by EITF No. 01-14, *Income Statement Characterizationof Reimbursements Received for “Out-of-Pocket” Expenses Incurred*,reimbursed postage and other reimbursable direct costs are recorded gross asrevenue from reimbursed direct costs and as reimbursed direct costs.

***RecentAccounting Pronouncements***

In March 2006, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standard 156, *Accounting for Servicingof Financial Assets*(SFAS 156). SFAS 156 requires that an entity separately recognize a servicing assetor a servicing liability when it undertakes an obligation to service afinancial asset under a servicing contract in certain situations.  Such servicing assets or servicingliabilities are required to be initially measured at fair value, ifpracticable.  SFAS 156 allows an entityto choose whether to subsequently measure its servicing assets and servicingliabilities using the amortization method or the fair value measurementmethod.  SFAS 156 is effective for anentity’s first fiscal year that begins after September 15, 2006 and should beapplied prospectively to all transactions after adoption.  We do not anticipate that adoption of thisstatement will have a material impact on our consolidated financial statements.

In February 2006, theFASB issued Statement of Financial Accounting Standard 155, *Accounting for Certain Hybrid Financial Instruments—an amendment ofFASB Statements No. 133 and 140*. (SFAS 155).  SFAS 155 allows an entity to make anirrevocable election to measure a financial instrument with an embeddedderivative, referred to as a hybrid financial instrument, at fair value in itsentirety rather than bifurcating and separately valuing the embedded derivativeinstrument.  SFAS 155 is effective forall financial instruments acquired, issued, or subject to a remeasurement (newbasis) event occurring after the beginning of an entity’s first fiscal yearthat begins after September 15, 2006.  Wedo not anticipate that adoption of this statement will have a material impacton our consolidated financial statements.

**NOTE2:   INTERIM FINANCIAL STATEMENTS**

The accompanyingcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of America(GAAP) and with the rules and regulations for reporting on Form 10-Q forinterim financial statements. Accordingly, they do not include certain information and disclosuresrequired for comprehensive annual financial statements.  The interim financial statements have notbeen audited.  The financial statementsshould be read in conjunction with our audited financial statements andaccompanying notes, which are included in our Form 10-K/A for the year endedDecember 31, 2005.

In the opinion of ourmanagement, the accompanying condensed consolidated financial statementsreflect all adjustments necessary (consisting solely of normal recurringadjustments) to present fairly our financial position as of March 31, 2006 andthe results of operations and cash flows for the three months ended March 31, 2006and 2005.

The results of operationsfor the period ended March 31, 2006 are not necessarily indicative of theresults to be expected for the entire year.

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#### **NOTE3:   GOODWILL AND INTANGIBLE ASSETS**

Amortizing identifiableintangible assets at March 31, 2006 and December 31, 2005 consisted of thefollowing (in thousands):
|                         | ** ** | **March 31, 2006**    | ** ** | **December 31, 2005** | ** ** |
|-------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization**   | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Customer  contracts     |       | $                               | 36,887     |                            | $          | 7,623 |   | $ | 37,313 |   | $ | 6,170 |   |
| Trade names             |       | 2,414                           |       | 1,844                           |       | 2,319 |   | 1,578 |   |
| Non-compete  agreements |       | 27,526                          |       | 7,058                           |       | 27,525 |   | 6,010 |   |
|                    |       | $                               | 66,827     |                            | $          | 16,525 |   | $ | 67,157 |   | $ | 13,758 |   |

 

Aggregate amortizationexpense related to identifiable intangible assets was $2.8 million and $1.6million for the three-month periods ended March 31, 2006 and 2005,respectively.  Amortization expenserelated to identifiable intangible assets for 2006 and the following five yearsis estimated as follows (in thousands):

| Year Ending  December 31, | ** ** | **Estimated  Amortization  Expense** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|
| 2006                                |       | $                                    | 10,853     |   |
| 2007                                |       | 8,384                                |       |
| 2008                                |       | 7,964                                |       |
| 2009                                |       | 6,882                                |       |
| 2010                                |       | 6,492                                |       |
| 2011                                |       | 4,759                                |       |
|                                |       |                                 |       |
|                                |       | $                                    | 45,334     |   |

 

During the three monthsended March 31, 2006, we received additional information regarding ourpreliminary valuation of nMatrix net assets acquired in November 2005 (see note4 of these notes to condensed consolidated financial statements).  Based on this information, we adjusted boththe recorded value of net assets acquired and the carrying value of goodwill byapproximately $0.3 million.  At bothMarch 31, 2006 and December 31, 2005, intangible assets not subject toamortization, consisting solely of goodwill, had carrying values of $249.7 millionand $249.4 million, respectively.

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### **NOTE 4:  BUSINESS ACQUISITIONS**

***nMatrix***

On November 15, 2005,Epiq, acting through a wholly-owned subsidiary, acquired all the issued andoutstanding shares of capital stock of nMatrix, Inc., nMatrix Australia Pty.Ltd., and nMatrix Ltd. (collectively, “nMatrix”) for approximately $126.3million, including capitalized acquisition costs.  We believe this acquisition further expandsthe product and service offerings of our legal services business.  The purchase price consisted of cash of$100.0 million and approximately 1.2 million shares of our common stock.  The fair value of our common stock issued,calculated based upon the five-day average of the closing price of the commonstock two days before and two days after the acquisition was consummated, wasapproximately $24.2 million.  Inconjunction with the acquisition, we entered into an agreement with the sellingshareholder to register the shares of common stock issued as a part of theacquisition consideration.  Within thisagreement, we guaranteed the common stock price of $20.35 per share, valued asthe average closing price of our common stock for the 40 consecutive tradingdays ending on the date four trading days prior to the closing date.  This guarantee terminates as of the close ofbusiness on the date that is after any 15 trading days on which the sellingshareholder may lawfully sell shares under a registration statement and thelast sale price for our common stock has been equal to or greater than the$20.35.  Based on our March 31, 2006closing price of $19.00 per share, as of March 31, 2006 the guarantee amountwas approximately $1.7 million.  We willnot record a liability for this guarantee until the contingency is resolved.  If a payment is made under this guarantee, wewill reduce the equity proceeds recorded as a part of the acquisitiontransaction.  Based on our valuation, thepurchase price has been allocated as follows (in thousands):
| Accounts receivable     |   | $       | 11,844  |   |
|-------------------------|--------|---------|---------|--------|
| Other current  assets   |   | 2,926   |    |
| Property and  software  |   | 7,236   |    |
| Trade names             |   | 569     |    |
| Customer  relationships |   | 24,614  |    |
| Non-compete  agreements |   | 6,676   |    |
| Current  liabilities    |   | (6,395  | )       |
| Deferred tax  liability |   | (16,110 | )       |
| Goodwill                |   | 94,947  |    |
|                    |   |    |    |
| Total purchase price    |   | $       | 126,307 |   |

 

Trade names, customerrelationships, and the non-compete agreements are amortized using thestraight-line method over one year, eight years, and five years,respectively.  The excess purchase priceof $94.9 million was allocated to goodwill and is not amortized but will bereviewed for impairment annually and between annual reviews if events orchanges in circumstances indicate that the asset might be impaired.  The purchase price in excess of the tax basisof the assets, primarily allocated to identifiable intangible assets andgoodwill, is not expected to be deductible for tax purposes.  Of our common shares issued as consideration,approximately 246,000 are held in escrow. On submission of properly approved indemnification claims, the escrowtrustee will liquidate sufficient shares to pay the indemnification claim.  As of March 31, 2006, we have not submittedany claims related to this escrow.  Theescrow arrangement terminates May 14, 2007, at which time any of our commonshares that have not been liquidated to pay claims will be distributed to theseller.  Also, $4.0 million of the cashconsideration is held in escrow pending collection of certain pre-acquisitionreceivables.  Each month, a portion ofthe escrow is released to the seller based on the prior month’s collection ofthese pre-acquisition receivables.  As ofMarch 31, 2006, approximately $1.0 million remained in this escrowaccount.  This escrow arrangementterminates following the payment for collections made through September 2006 ofthese pre-acquisition receivables, at which time any amount that remains inescrow will be distributed to us.

The acquisition wasaccounted for using the purchase method of accounting with the operatingresults included in the accompanying condensed consolidated financialstatements from the date of acquisition. The operating results of nMatrix are included within our case managementsegment.

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***Hilsoft, Inc.***

On October 20, 2005, we acquired for cash all theissued and outstanding shares of capital stock of Hilsoft, Inc.  We believe this acquisition providescomplementary diversification to our existing class action business, as Hilsoftis a specialty provider of legalnotification services, primarily for class action engagements.  The total value of the transaction, includingcapitalized transaction costs, was $9.3 million.  If certain revenue objectives are satisfied,we will be required to make additional payments of up to $3.0 million to theformer owners of Hilsoft.

The acquisition wasaccounted for using the purchase method of accounting with the operatingresults included in the accompanying condensed consolidated financialstatements from the date of acquisition. The operating results of Hilsoft are included within our documentmanagement segment.

***ProForma Results***

Pro forma results ofoperations assuming the above acquisitions were made at the beginning of 2005are shown below (in thousands, except per share data):
|                      | ** ** | **Three Months Ended  March 31, 2005** | ** ** |
|----------------------|------------|------------------------------------------------------------|------------|
|                 |       |                                                       |       |
| Total revenues       |       | $                                                          | 31,470     |   |
|                 |       |                                                       |       |
| Net loss             |       | $                                                          | (2,513     | ) |
| Net loss per  share: |       |                                                       |       |
| Basic                |       | $                                                          | (0.14      | ) |
| Diluted              |       | $                                                          | (0.14      | ) |

 

Pro formaadjustments include estimated amortization expense, interest expense,management compensation and income taxes. The pro forma information is not necessarily indicative of what wouldhave occurred if the acquisitions had been completed on that date nor is itnecessarily indicative of future operating results.

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

The following is asummary of indebtedness outstanding (in thousands):
|                                                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                           | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Senior term loan                                                     |       | $                  | 17,000     |                  | $          | 25,000 |   |
| Senior revolving loan                                                |       | 93,028             |       | 93,028                |       |
| Contingent convertible  subordinated debt, including embedded option |       | 51,597             |       | 51,326                |       |
| Capital leases                                                       |       | 964                |       | 972                   |       |
| Deferred acquisition  price                                          |       | 1,552              |       | 3,222                 |       |
| Total indebtedness                                                   |       | $                  | 164,141    |                  | $          | 173,548 |   |

 

***CreditFacilities***

Wehave a credit facility with KeyBank National Association as administrativeagent.  At inception, this facilityconsisted of a $25.0 million senior term loan and a $100.0 millionsenior revolving loan.  The senior termloan matures in August 2006 and the senior revolving loan matures in November2008.  The senior term loan does not haveany required amortizing payments.  Duringthe term of the loan we have the right, subject to compliance with ourcovenants, to increase the senior revolving loan to $175.0 million.

The credit facility issecured by liens on our real property and a significant portion of our personalproperty.  As of March 31, 2006, ourborrowings under the credit facility totaled $110.0 million, consisting of$17.0 million under the senior term loan and $93.0 million under the seniorrevolving loan.  Interest on the creditfacility is generally based on a spread over the LIBOR rate.  Effective July 1, 2006, the calculation ofthe interest rate for the senior term loan will be adjusted to increase thespread over the LIBOR rate by 2%.  As ofMarch 31, 2006, the interest rate charged on outstanding borrowings ranged from7.6% to 7.8%.

***ContingentConvertible Subordinated Debt***

During June 2004, weissued $50.0 million of contingent convertible subordinated notes.  Net proceeds of $47.4 million were used torepay and terminate an outstanding subordinated term loan and to pay in fullour then outstanding revolving loan balance. The contingency has been satisfied and the notes may, at the option ofthe holders, be converted into shares of our common stock at any time. Theseconvertible subordinated notes:

·                  bear interest at a fixed rate of 4%per annum, payable quarterly;

·                  are convertible into shares of ourcommon stock at a price of $17.50 per share; and

·                  matureon June 15, 2007, subject to extension of maturity to June 15, 2010 at theoption of the note holders.

If all shares wereconverted, the notes would convert into approximately 2.9 million shares of ourcommon stock.  If we change our capitalstructure (for example, through a stock dividend or stock split) while thenotes are outstanding, the conversion price will be adjusted on a consistentbasis and, accordingly, the number of shares of common stock we would issue onconversion would be adjusted.

The holders of the noteshave the right to extend the maturity of the notes for a period not to exceedthree years.  Under SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*,the right to extend the maturity of the notes represents an embedded optionsubject to bifurcation.  The embeddedoption was initially valued at $1.2 million and the convertible debt balancewas reduced by the same amount.  Theconvertible debt is accreted approximately $0.1 million each quarter such that,at the end of three years, the convertible debt balance will total $50.0million.  On our accompanying condensedconsolidated statements of operations, this accretion is a component of interestexpense.  The embedded option must berevalued at each period end based on the probability weighted discounted cashflows related to the additional 4% interest rate payments that will be made ifthe convertible debt maturity is extended an additional three years.  Under this methodology, the embedded optionhas a current value of approximately $2.1 million.  On our accompanying condensed consolidatedbalance sheets, our obligation related to the embedded option has been includedas a component of the convertible note payable. For the three months ended March 31, 2006, the value of the embeddedoption increased by approximately $0.2 million and this increase is included asa component of interest expense on our accompanying condensed consolidated statementsof operations.  The changes in carryingvalue of the convertible debt and fair value of the embedded

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option do not affect ourcash flow and, if the embedded option is exercised, the value assigned to theembedded option will be amortized as a reduction to our 4% convertible debtinterest expense over the periods payments are made.  If the option is not exercised by some or allconvertible debt holders, any remaining related value assigned to the embeddedoption will be recognized as a gain during that period.

***CovenantCompliance***

Our credit facilitycontains financial covenants related to earnings before interest, provision forincome taxes, depreciation, amortization and other adjustments as defined inthe agreements (EBITDA) and total debt. In addition, our credit facility also contains financial covenantsrelated to senior debt, fixed charges, and working capital.  As a result of the restatement, whichresulted in the deferral of a substantial portion of revenue as described innote 10, we were not in compliance with these financial covenants as of March31, 2006.  As a result of the recognitionof the deferred revenue during the second and third quarters of 2006; we werein compliance with all financial covenants as of June 30 and September 30, 2006.  The deferral of revenue and subsequentrecognition of revenue was not anticipated by us or the banks at the time weestablished the current financial covenants in the credit facility.  On December 14, 2006, we obtained a waiverregarding this event of noncompliance from our credit facility syndicate.  Accordingly, we have classified this debt ascurrent or long-term based on the debt’s original scheduled maturity.

***CapitalLease***

AtMarch 31, 2006, our debt obligation related to capital leases, classified as acurrent liability, was approximately $1.0 million.

***Deferred Acquisition Price***

OnJanuary 31, 2003, we acquired 100% of the membership interests of BankruptcyServices, LLC (“BSI”), a provider of technology-based case management,consulting and administrative services for Chapter 11 restructurings, for apurchase price of $67.0 million.  Aportion of the purchase price, $4.0 million, was deferred.  This deferred payment, which is non-interestbearing and payable in five annual installments, was discounted using animputed interest rate of 5% per annum. At March 31, 2006, the discounted value of the remaining notepayments was approximately $1.1 million of which approximately $0.6 million wasclassified as a current liability.

OnOctober 20, 2005, we acquired 100% of the equity of Hilsoft, a specialtyprovider of legal notification services primarily for class actionengagements.  A portion of the purchaseprice, $0.5 million, was deferred.  Thisdeferred payment, which is non-interest bearing and is payable on October 20,2007, was discounted using an imputed interest rate of 8% per annum.  At March 31, 2006, the discounted value ofthis deferred payment was approximately $0.5 million and is classified entirelyas a noncurrent liability.

***Scheduled Principal Payments***

Ourlong-term obligations, including credit facility debt, convertible debt(including embedded option), deferred acquisition costs, and capitalizedleases, mature as follows for each twelve-month period ending March 31 (inthousands):

| 2007  |   | $      | 18,496  |   |
|-------|--------|--------|---------|--------|
| 2008  |   | 52,617 |    |
| 2009  |   | 93,028 |    |
| Total |   | $      | 164,141 |   |

 

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**NOTE6:   SHARE-BASED COMPENSATION**

During the quarter endedMarch 31, 2006, we adopted SFAS No. 123R, *Share-Based Payment*.  SFAS No. 123R establishes standards for the accountingfor transactions in which an entity exchanges its equity instruments for goodsand services or incurs liabilities in exchange for goods or services that arebased on the fair value of the entity’s equity instruments or that may besettled by the issuance of those equity instruments.  SFAS No. 123R requires a public entity tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award and torecognize that cost over the period during which an employee is required toprovide service in exchange for the award.

We elected to adopt SFASNo. 123R using the modified version of prospective application.  Under the modified version of prospectiveapplication, we have recognized compensation costs related to share-basedcompensation beginning with the quarter ended March 31, 2006.  Compensation costs related to share-basedcompensation for periods ended on or before December 31, 2005 are reflected ona pro forma basis in this note to our condensed consolidated financialstatements.

As disclosed in our February 18, 2005 filing on Form8-K, during February 2005 our compensation committee approved acceleration ofthe vesting of approximately 0.5 million unvested options, with a weighted-averageexercise price of $14.28 per share, for certain employees, including anexecutive officer and non-employee directors. Unvested options to purchase approximately 1.2 million shares, with aweighted-average exercise price of approximately $15.26 per share, were notaccelerated as the employees holding the unvested options did not meet thecriteria established by our compensation committee.  The decision to accelerate the vesting ofthese options and eliminate future compensation expense was based primarily ona review of our long-term incentive programs considering the effect on ourfinancial statements of the then pending change in accounting rules for stockoptions.  This action, which had animmaterial effect on our financial statements for the year ended December 31,2005, reduced the amount of expense we would have recognized on adoption ofSFAS 123R by approximately $2.2 million (approximately $0.2 million during thethree months ended March 31, 2006, and approximately $0.8 million, $0.7 million,$0.5 million and $0.2 million for the years ending December 31, 2006, 2007,2008, and 2009, respectively).

Our 2004 Equity Incentive Plan (the Plan), which isshareholder approved, permits us to grant up to 3 million equity basedinstruments.  Although various forms ofequity instruments may be issued, to date we have issued only incentive shareoptions and nonqualified share options under this Plan.  These share options, which have a contractualterm of 10 years, are issued with an exercise price equal to the grant dateclosing market price of our common stock. The vesting periods range from immediate to 5 years.  Share options which vest over 5 yearsgenerally vest either 20% per year on the first five anniversaries of the grantdate, or 25% per year on the second through fifth anniversaries of the grantdate.  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 2006 for the purpose ofsatisfying share option exercises.

As a result of ouradoption of SFAS No. 123R, during the quarter ended March 31, 2006, werecognized expense related to options issued prior to but unvested as ofJanuary 1, 2006 as well as expense related to options issued during thequarter.  For options issued prior to butunvested as of January 1, 2006, compensation expense was based on the fairvalue of those options as calculated using the Black-Scholes option valuationmodel at the date the options were issued. Key assumptions for theBlack-Scholes option valuation model include expected volatility, expected termof options granted, the expected risk-free interest rate, and the expecteddividend rate.  The assumptions used inthose fair value calculations have been disclosed in our Annual Reports on Form10-K previously filed with the SEC.  Foroptions issued during the quarter ended March 31, 2006, the options were alsovalued using the Black-Scholes option valuation models and with key assumptionsrelated to expected volatility, expected term of options granted, the expectedrisk-free interest rate, and the expected dividend rate.  We estimate our expected volatility based onimplied volatilities from traded options on our stock and on our stock’shistorical volatility.  We have estimatedthe expected term of our options based on the historical exercise pattern ofgroups of employees that have similar historical exercise behavior.  The expected risk-free interest rate is basedon the U.S. Treasury yield curve in effect at the time of the grant.  Historically, we have not paid dividends andwe do not anticipate paying dividends in the foreseeable future; accordingly, ourexpected dividend rate is zero.

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Following is a summary ofkey assumptions used to value options granted during the three months endedMarch 31, 2006.
| Expected term (years)        |   | 5.0           |   |
|------------------------------|--------|---------------|--------|
| Expected  volatility         |   | 34.5% - 40.7% |   |
| Weighted-average  volatility |   | 38.0%         |   |
| Risk-free interest  rate     |   | 4.3% - 4.8%   |   |
| Dividend yield               |   | 0%            |   |

 

Compensation expense for the quarter ended March 31,2006 was adjusted for options we estimate will be forfeited prior tovesting.  We use historical informationto estimate employee termination and the resulting option forfeiture rate.

A summary of optionactivity during the three months ended March 31, 2006 is presented below(shares and aggregate intrinsic value in thousands):
|                                    | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------|------------|------------|------------|-----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
|                               |       |       |       |                                    |       |                                                |       |                            |       |
| Outstanding, beginning  of period  |       | 4,769      |       | $                                       | 14.49      |                                                |       |                            |       |   |
| Granted                            |       | 155        |       | 19.05                                   |       |                                                |       |                            |       |
| Exercised                          |       | (129       | )          | 11.91                                   |       |                                                |       |                            |       |
| Forfeited                          |       | (12        | )          | 15.28                                   |       |                                                |       |                            |       |
| Outstanding, end of  period        |       | 4,783      |       | 14.70                                   |       | 7.75                                                |       | $                               | 20,977     |   |
|                               |       |       |       |                                    |       |                                                |       |                            |       |
| Options exercisable, end of period |       | 3,296      |       | 13.53                                   |       | 7.22                                                |       | $                               | 18,027     |   |
|                                    |            |            |            |                                         |            |                                                     |            |                                 |            |  |  |

 

The weighted averagegrant-date fair value of options granted during the three months ended March31, 2006 and 2005 were $7.69 and $5.17, respectively.  The total intrinsic value of optionsexercised during the three months ended March 31, 2006 was $1.1 million.  During the three months ended March 31, 2006,we received cash for payment of the grant price of exercised options ofapproximately $1.2 million and we anticipate we will realize a tax benefitrelated to these exercised options of approximately $0.4 million.  The cash received for payment of the grantprice is included as a component of cash flow from financing activities.  The tax benefit related to the optionexercise price in excess of the option fair value at grant date ($0.1 million)is also included as a component of cash flow from financing activities; theremainder of the tax benefit ($0.3 million) is included as a component of cashflow from operating activities.

During the three months ended March 31, 2006, werecognized share-based compensation expense, which is a non-cash charge, ofapproximately $0.5 million, of which $0.1 million is included under the caption“Direct costs” and $0.4 million is included under the caption “General andadministrative” on the accompanying condensed consolidated statements ofoperations.  During the three monthsended March 31, 2006, we recognized a net tax benefit of approximately $0.2million related to aggregate share-based compensation expense recognized duringthe same period.  As a result, our lossbefore income taxes increased by approximately $0.5 million, our net lossincreased by approximately $0.3 million, and both our basic and diluted net loss per share increased byapproximately $0.02 per share. As of March 31, 2006, there was $7.8 million oftotal unrecognized compensation cost related to nonvested share-basedcompensation arrangements, which will be recognized over a weighted-averageperiod of 2.5 years.

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Prior to adoption of SFAS 123R, we accounted forstock-based compensation awards under the intrinsic method of AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued to Employees,*which required compensation cost to berecognized based on the excess, if any, between the quoted market price at thedate of grant and the amount an employee must pay to acquire stock. Optionsawarded under our option plans are granted with an exercise price equal to thefair market value on the date of the grant. As a result, our condensed consolidated statements of operations doesnot include expense related to share-based compensation for the three monthsended March 31, 2005.  Had thecompensation cost been determined based on the fair value at the grant datesbased on the guidance provided by Statement of Financial Accounting Standard (“SFAS”)No. 123, *Accounting for Stock-Based Compensation,*our net loss and net loss per share for the three months ended March 31, 2005would have been adjusted to the following pro forma amounts (in thousands,except per share data):
|                                                                                                        | ** ** | ** **  | ** ** | **Three Months Ended  March 31, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------|------------|------------------------------------------------------------|------------|
|                                                                                                   |       |        |       |                                                       |       |
| Net loss, as  reported                                                                                 |       |        |       | $                                                          | (2,128     | ) |
| Add: stock-based  employee compensation included in reported net earnings, net of tax                  |       |        |       | —                                                     |       |
| Deduct:  stock-based employee compensation expense determined under the fair value  method, net of tax |       |        |       | (3,066                                                     | )          |
| Net loss, pro  forma                                                                                   |       |        |       | $                                                          | (5,194     | ) |
|                                                                                                   |       |        |       |                                                       |       |
| Net loss per  share – Basic                                                                       |       | As reported |       | $                                                          | (0.12      | ) |
|                                                                                                   |       | Pro forma   |       | $                                                          | (0.29      | ) |
|                                                                                                   |       |        |       |                                                       |       |
| Net loss per share  – Diluted                                                                     |       | As reported |       | $                                                          | (0.12      | ) |
|                                                                                                   |       | Pro forma   |       | $                                                          | (0.29      | ) |

 

Pro forma amounts presented here are based on actualearnings and consider only the effects of estimated fair values of stockoptions.  For the three months endedMarch 31, 2005, we did not assume conversion of the convertible notes orexercise of share-based options as the effect was antidilutive.

15

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**NOTE7:   NET LOSS PER SHARE**

Basic net loss per shareis computed by dividing net income available to common shareholders by theweighted average number of common shares outstanding for the period.  Diluted net loss 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 relating to outstanding stock options andconvertible debt, if dilutive.  Whencalculating incremental shares related to outstanding stock options, we applythe 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 options, are used to repurchase outstandingshares at the average market price for the period.  The treasury stock method is applied only toshare grants for which the effect is dilutive.

The computationsof basic and diluted net loss per share are as follows (in thousands, exceptper share data):
|                                 | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **Net Loss**                                    | ** ** | **Weighted  Average  Shares   Outstanding** | ** ** | **Per Share  Amount** | ** ** | **Net Loss** | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per Share  Amount** | ** ** |
|                            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Basic net loss  per share       |       | $                                                    | (1,749     | ) | 19,284 |   | $ | (0.09 | ) | $ | (2,128 | ) | 17,887 |   | $ | (0.12 | ) |
|                            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Effect of  dilutive securities: |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Stock options                   |       |                                                 |       | — |   |   |   |   |   | — |   |   |   |
| Convertible debt                |       | —                                               |       | — |   |   |   | — |   | — |   |   |   |
|                            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Diluted net loss  per share     |       | $                                                    | (1,749     | ) | 19,284 |   | $ | (0.09 | ) | $ | (2,128 | ) | 17,887 |   | $ | (0.12 | ) |

 

#### For the three months endedMarch 31, 2006 and 2005, we did not assume conversion of the convertible debtor exercise of any share-based options as the effect would be anti-dilutive.

#### **NOTE 8:   OPERATING LEASES**

We have non-cancelableoperating leases for office space at various locations expiring at varioustimes through 2015.  Each of the leasesrequires us to pay all executory costs (property taxes, maintenance andinsurance).  Additionally, we havenon-cancelable operating leases for office equipment and automobiles expiringthrough 2009.

Future minimum leasepayments during each of the twelve months ending March 31 are as follows (inthousands):

| 2007                         |   | $      | 5,159  |   |
|------------------------------|--------|--------|--------|--------|
| 2008                         |   | 4,683  |   |
| 2009                         |   | 4,250  |   |
| 2010                         |   | 3,553  |   |
| 2011                         |   | 3,520  |   |
| Thereafter                   |   | 15,969 |   |
| Total minimum lease payments |   | $      | 37,134 |   |

 

Expense related tooperating leases was approximately $1.2 million and $0.7 million for the threemonths ended March 31, 2006 and 2005, respectively.

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**NOTE9:   SEGMENT REPORTING**

We have two operatingsegments: (i) case management and (ii) document management.  Case management solutions provide clientswith integrated technology-based products and services for the automation ofadministrative tasks to address their business requirements related to acase.  Document management solutionsinclude proprietary technology and production services to ensure timely,accurate and complete execution of documents related to a case.

Each segment’sperformance is assessed based on segment revenues less costs directlyattributable to each segment.  Inmanagement’s evaluation of performance, certain costs, such as shared services,administrative staff, and executive management, are not allocated by segmentand, accordingly, the following operating segment results do not include suchunallocated costs.  Assets reportedwithin a segment are those assets used by the segment in its operations andconsist of property, equipment and leasehold improvements, software,identifiable intangible assets and goodwill. All other assets are classified as unallocated.

Following is a summary ofsegment information (in thousands):
| ** **                                                                                               | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                               | ** ** | **Case**                                                       | ** ** | **Document** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                               | ** ** | **Management**                                                 | ** ** | **Management** | ** ** | **Unallocated** | ** ** | **Consolidated** | ** ** |
|                                                                                                     |       |                                                           |       |   |   |   |   |   |   |
| Revenue:                                                                                                 |       |                                                           |       |   |   |   |   |   |   |
| Operating revenue before reimbursed direct costs                                                         |       | $                                                              | 19,586     |   | $ | 12,975 |   | $ | — |   | $ | 32,561 |   |
| Operating revenue from reimbursed direct costs                                                           |       | 781                                                            |       | 4,876 |   | — |   | 5,657 |   |
| Total revenue                                                                                            |       | 20,367                                                         |       | 17,851 |   | — |   | 38,218 |   |
|                                                                                                     |       |                                                           |       |   |   |   |   |   |   |
| Costs and  expenses:                                                                                     |       |                                                           |       |   |   |   |   |   |   |
| Direct costs, general and administrative costs and  depreciation and software and leasehold amortization |       | 11,723                                                         |       | 14,983 |   | 8,421 |   | 35,127 |   |
| Amortization of identifiable intangible assets                                                           |       | 2,250                                                          |       | 517 |   | — |   | 2,767 |   |
| Total operating expenses                                                                                 |       | 13,973                                                         |       | 15,500 |   | 8,421 |   | 37,894 |   |
| Operating income                                                                                         |       | $                                                              | 6,664      |   | $ | 2,351 |   | $ | (8,421 | ) | 324 |   |
| Interest  expense, net                                                                                   |       |                                                           |       |   |   |   |   | 3,264 |   |
|                                                                                                     |       |                                                           |       |   |   |   |   |   |   |
| Loss before  income taxes                                                                                |       |                                                           |       |   |   |   |   | (2,940 | ) |
| Benefit for  income taxes                                                                                |       |                                                           |       |   |   |   |   | (1,191 | ) |
|                                                                                                     |       |                                                           |       |   |   |   |   |   |   |
| Net loss                                                                                                 |       |                                                           |       |   |   |   |   | $ | (1,749 | ) |
|                                                                                                     |       |                                                           |       |   |   |   |   |   |   |
| Depreciation and  amortization expense                                                                   |       | $                                                              | 3,890      |   | $ | 607 |   | $ | 567 |   | $ | 5,064 |   |

 

17

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| ** **                                                                                                | ** ** | **Three Months Ended March 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                | ** ** | **Case**                              | ** ** | **Document** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                | ** ** | **Management**                        | ** ** | **Management** | ** ** | **Unallocated** | ** ** | **Consolidated** | ** ** |
|                                                                                                      |       |                                  |       |   |   |   |   |   |   |
| Revenue:                                                                                                  |       |                                  |       |   |   |   |   |   |   |
| Operating revenue  before reimbursed direct costs                                                         |       | $                                     | 13,068     |   | $ | 6,081 |   | $ | — |   | $ | 19,149 |   |
| Operating revenue from  reimbursed direct costs                                                           |       | 896                                   |       | 4,599 |   | — |   | 5,495 |   |
| Total revenue                                                                                             |       | 13,964                                |       | 10,680 |   | — |   | 24,644 |   |
|                                                                                                      |       |                                  |       |   |   |   |   |   |   |
| Costs and expenses:                                                                                       |       |                                  |       |   |   |   |   |   |   |
| Direct costs, general  and administrative costs and depreciation and software and leasehold  amortization |       | 8,094                                 |       | 8,144 |   | 7,264 |   | 23,502 |   |
| Amortization of  identifiable intangible assets                                                           |       | 1,157                                 |       | 466 |   | — |   | 1,623 |   |
| Total operating  expenses                                                                                 |       | 9,251                                 |       | 8,610 |   | 7,264 |   | 25,125 |   |
| Operating loss                                                                                            |       | $                                     | 4,713      |   | $ | 2,070 |   | $ | (7,264 | ) | (481 | ) |
| Interest expense, net                                                                                     |       |                                  |       |   |   |   |   | 762 |   |
| Loss before income taxes                                                                                  |       |                                  |       |   |   |   |   | (1,243 | ) |
| Provision for income taxes                                                                                |       |                                  |       |   |   |   |   | 885 |   |
|                                                                                                      |       |                                  |       |   |   |   |   |   |   |
| Net loss                                                                                                  |       |                                  |       |   |   |   |   | $ | (2,128 | ) |
|                                                                                                      |       |                                  |       |   |   |   |   |   |   |
| Depreciation and amortization expense                                                                     |       | $                                     | 2,244      |   | $ | 592 |   | $ | 561 |   | $ | 3,397 |   |

 

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**NOTE 10:      RESTATEMENTOF PREVIOUSLY ISSUED FINANCIAL STATEMENTS**

Subsequent to theissuance of our consolidated financial statements for the year ended December31, 2005, management identified an accounting error in its historicalconsolidated financial statements related to the appropriate accountingtreatment for certain complex aspects of revenue recognition, specifically theevaluation of vendor specific objective evidence (VSOE) of fair value forspecified software upgrades provided within a bundled arrangement as requiredby Statement of Position 97-2, *SoftwareRevenue Recognition* (SOP 97-2). As a result, we have restated our financial statements as of December31, 2005 and 2004, and for each of the three years in the period ended December31, 2005, included in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2005, initially filed with the SEC on March 8, 2006, for thequarterly information included in our Annual Report on Form 10-K for the fiscalyear ended December 31, 2005 initially filed with the SEC on March 8, 2006, forthe three months ended March 31, 2006 and 2005, included in our QuarterlyReport on Form 10-Q for the quarter ended March 31, 2006, initially filed withthe SEC on May 9, 2006, for the three and six months ended June 30, 2006 and2005, included in our Quarterly Report on Form 10-Q for the quarter ended June30, 2006, initially filed with the SEC on August 8, 2006, and for the three andnine months ended September 30, 2005, included in our Quarterly Report on Form10-Q for the quarter ended September 30, 2006, filed with the SEC on November14, 2006.

As background, our Chapter 7bankruptcy services end-user customers are professional bankruptcytrustees.  The application of Chapter 7bankruptcy regulations has the practical effect of discouraging trusteecustomers from incurring direct administrative costs for computer systems.  As a result, we provide our Chapter 7 servicesto trustee customers at no direct charge, and our trustee customers maintaindeposit accounts for bankruptcy cases under their administration at adesignated banking institution.  Wehave marketing arrangements with various banks under which we provide Chapter 7trustee case management software and related services and the bank provides theChapter 7 bankruptcy trustee with deposit-related banking services.  Under our primary depository financialarrangement, we primarily receive cash based on the aggregate amount of trusteedeposits maintained at the bank and the number of Chapter 7 trustees withdeposits placed with the bank, which we refer to collectively as volume-basedfees.  These volume-based fees compensateus for the software license, hardware and postcontract customer support (PCS)services that we provide to the Chapter 7 trustees.

Prior to October 1, 2003, our primary financialinstitution engaged us to provide the trustees with software upgrades in thefirst and second quarter of each year. These software upgrades were documented in arrangements that wereseparate from our volume-based fee arrangement. Once the upgrade was delivered to the trustees and we had provided thebank with satisfactory evidence of the delivery, we would invoice the bank forthe agreed upon amount and recognize revenue related to the software upgrade.

In October 2003, weentered into a three year arrangement (the 2003 Arrangement) with our primaryfinancial institution.  As a part of the2003 Arrangement, we continued to perform each of our first and second quarterspecified software upgrades through the term of the arrangement (September 30,2006), and the bank agreed to compensate us for these upgrades on terms similarto our historical terms when we delivered the upgrades on a standalone basis.  As a result, in our previously reportedfinancial statements, we concluded that we had established VSOE for thesoftware upgrades.  Accordingly, werecognized revenue for the software upgrades on delivery.  Revenue related to hardware and hardwaremaintenance was recognized as explained in note 1 above.  As we did not have VSOE for the softwarelicense, we combined the software license with the remaining undeliveredelement, PCS, as a single unit of accounting. Revenue related to PCS was entirely contingent on the placement ofdeposits by the trustee with the financial institution.  Accordingly, we recognized this contingentusage based revenue consistent with the guidance provided by American Instituteof Certified Public Accountants’ Technical Practice Aid (TPA) 5100.76, *Fair Value in Multiple-Element Arrangements ThatInclude Contingent Usage-Based Fees and Software Revenue Recognition*as the fee became fixed or determinable at the time actual usage occurred andcollectibility was probable.  Thisoccurred monthly as a result of the computation, billing and collection ofmonthly deposit fees.  At that time, wehad also satisfied the revenue recognition criteria contained in SAB Topic 13,since we had persuasive evidence that an arrangement existed, services had beenrendered, the price was fixed and determinable, and collectibility wasreasonably assured.

Subsequent to theissuance of the financial statements referenced above, we concluded that,although we historically sold software upgrades on a standalone basis, eachspecified software upgrade should be considered a separate product and,therefore, the price of prior software upgrades cannot be used to establish theprice of future software upgrades.  Asour primary financial institution was the only payee for software upgradesduring the period of the 2003 Arrangement, we were unable to establish VSOE forthe software upgrades.  Under SOP 97-2,if VSOE cannot be established for software upgrades, then consideration receivedunder the 2003 Arrangement, except for consideration related to the provisionof hardware and hardware maintenance, must be deferred until all softwareupgrades have been delivered.  Althoughwe continued to invoice, 

19

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and the bank continued topay, our volume-based fees related to software licenses and post contractcustomer support as well as our semi-annual software upgrades, these amountscannot be recognized as revenue when we provide the services.  Instead, these amounts are recorded asdeferred revenue liability on our condensed consolidated balance sheet.  The ongoing costs related to this arrangementwere recognized as expense when incurred. From inception of the arrangement through March 31, 2006, we recorded asdeferred revenue $66.1 million of amounts invoiced under the 2003 Arrangement.On delivery of the final upgrade during the second quarter of 2006, the onlyremaining undelivered element was PCS services. In accordance with SOP 97-2, on delivery of the final software upgradewe recognized revenue previously deferred on a proportionate basis over thethree year term of the contract.  As thecontract commenced October 1, 2003 and terminated September 30, 2006, werecognized approximately $60.1 million of net deferred revenue related to this arrangementduring the second quarter of 2006 and we recognized $6.0 million of deferredrevenue related to this arrangement during the third quarter of 2006.

With this restatement, we have also reclassifiedrevenue related to software arrangements which include both product (softwarelicense and upgrades) with services (PCS) to a separate line item, “Casemanagement bundled software license, software upgrade and post contractcustomer support services,” within the revenue section of our condensedconsolidated statements of operations. We have also disaggregated direct costs related to operating revenueinto three line items, “Direct costs of services,”  “Reimbursed direct costs,” and “Direct costsof bundled software license, software upgrade and postcontract customer supportservices,” within the costs and expenses section of our condensed consolidatedstatements of income.

Prior to our restatement, our aggregate deferredrevenue was immaterial and was classified as a component of other accruedexpenses. With our restatement, deferred revenue is material and is reflectedas a separate line item on our condensed consolidated balance sheet.  Therefore, we have reclassified deferredrevenue previously included as a component of other accrued expenses to the lineitem deferred revenue.

The restatement alsoaffects taxable income, which resulted in a change to our provision for incometaxes.  In addition, as a result of thedeferral of revenue, which had been included in our taxable income, we haverestated our deferred tax assets and liabilities.

A summary of the significant effects of therestatement is as follows:  (inthousands, except per share data)
|                                                  | ** ** | **March 31, 2006**             | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                       | ** ** | **As   Previously   Reported** | ** ** | **As   Restated** | ** ** |
| **Consolidated  Balance Sheet**                  | ** ** | ** **                               | ** ** | ** ** | ** ** |
|                                             |       |                                     |       |   |   |
| Income taxes  refundable                         |       | $                                        | 3,302      |   | $ | 3,415 |   |
| Deferred income  taxes                           |       | 1,706                                    |       | 27,853 |   |
| Total Current Assets                             |       | 51,241                                   |       | 77,501 |   |
| Total Assets                                     |       | 387,202                                  |       | 413,462 |   |
|                                             |       |                                     |       |   |   |
| Other accrued  expenses                          |       | 4,302                                    |       | 3,387 |   |
| Deferred revenue                                 |       | —                                   |       | 67,027 |   |
| Total Current Liabilities                        |       | 33,992                                   |       | 100,104 |   |
|                                             |       |                                     |       |   |   |
| Retained  earnings                               |       | 49,894                                   |       | 10,042 |   |
| Total Stockholders’ Equity                  |       | 180,733                                  |       | 140,881 |   |
| Total  Liabilities and Stockholders’ Equity |       | 387,202                                  |       | 413,462 |   |
|                                                  |            |                                          |            |  |  |  |  |

 

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**Consolidated Statements ofOperations**
| ** **                                                                                                                                           | ** ** | **Three Months Ended**         | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                           | ** ** | **March 31, 2006**             | ** ** | **March 31, 2005** | ** ** |
| ** **                                                                                                                                           | ** ** | **As   Previously   Reported** | ** ** | **As   Restated** | ** ** | **As   Previously   Reported** | ** ** | **As   Restated** | ** ** |
|                                                                                                                                                 |       |                                     |       |   |   |   |   |   |   |
| Case management  services                                                                                                                            |       | $                                        | 26,024     |   | $ | 18,901 |   | $ | 19,885 |   | $ | 12,807 |   |
| Case management  bundled software license, software upgrade and postcontract customer support  services                                              |       | —                                   |       | 685 |   | — |   | 261 |   |
| Total Revenue                                                                                                                                        |       | 44,656                                   |       | 38,218 |   | 31,461 |   | 24,644 |   |
| Direct costs of  services (exclusive of depreciation and amortization)                                                                               |       | 21,131                                   |       | 14,376 |   | 13,736 |   | 7,247 |   |
| Direct costs of  bundled software license, software upgrade and postcontract customer support  services (exclusive of depreciation and amortization) |       | —                                   |       | 1,035 |   | — |   | 937 |   |
| Reimbursed  direct costs                                                                                                                             |       | —                                   |       | 5,720 |   | — |   | 5,552 |   |
| Income (Loss) from Operations                                                                                                                        |       | 6,762                                    |       | 324 |   | 6,336 |   | (481 | ) |
| Income(Loss) Before Income Taxes                                                                                                                     |       | 3,498                                    |       | (2,940 | ) | 5,574 |   | (1,243 | ) |
| Provision (Benefit) For Income Taxes                                                                                                                 |       | 1,468                                    |       | (1,191 | ) | 2,324 |   | 885 |   |
| Net Income (Loss)                                                                                                                                    |       | 2,030                                    |       | (1,749 | ) | 3,250 |   | (2,128 | ) |
|                                                                                                                                                 |       |                                     |       |   |   |   |   |   |   |
| Net Income  (Loss) per Share                                                                                                                         |       |                                     |       |   |   |   |   |   |   |
| Basic – net income (loss) per share                                                                                                             |       | $                                        | 0.11       |   | $ | (0.09 | ) | $ | 0.18 |   | $ | (0.12 | ) |
| Diluted – net income (loss) per share                                                                                                           |       | $                                        | 0.10       |   | $ | (0.09 | ) | $ | 0.17 |   | $ | (0.12 | ) |
|                                                                                                                                                 |       |                                     |       |   |   |   |   |   |   |
| Weighted Average Common  Shares Outstanding – Diluted                                                                                           |       | 23,325                                   |       | 19,284 |   | 21,112 |   | 17,887 |   |

 

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**ConsolidatedStatements of Cash Flow**
| ** **                                                          | ** ** | **Three Months Ended**         | ** ** |
|---------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                          | ** ** | **March 31, 2006**             | ** ** | **March 31, 2005** | ** ** |
| ** **                                                          | ** ** | **As   Previously   Reported** | ** ** | **As   Restated** | ** ** | **As   Previously   Reported** | ** ** | **As   Restated** | ** ** |
|                                                                |       |                                     |       |   |   |   |   |   |   |
| Cash Flows from  Operating Activities                               |       |                                     |       |   |   |   |   |   |   |
| Net income (loss)                                                   |       | $                                        | 2,030      |   | $ | (1,749 | ) | $ | 3,250 |   | $ | (2,128 | ) |
| Benefit for deferred income taxes                                   |       | —                                   |       | (2,547 | ) | — |   | (2,453 | ) |
| Other                                                               |       | 38                                       |       | 39 |   | 186 |   | (57 | ) |
| Accounts payable and other liabilities                              |       | (1,012                                   | )          | (1,377 | ) | (458 | ) | (459 | ) |
| Deferred revenue                                                    |       | —                                   |       | 6,803 |   | — |   | 6,818 |   |
| Income taxes, including tax benefit from exercise of  stock options |       | 1,743                                    |       | 1,630 |   | 2,035 |   | 3,292 |   |
| Net Cash Provided by  Operating Activities                          |       | 5,656                                    |       | 5,656 |   | 1,707 |   | 1,707 |   |
|                                                                     |            |                                          |            |  |  |  |  |  |  |  |  |  |  |

 

*     *     *

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

This discussion andanalysis should be read in conjunction with the condensed consolidatedfinancial statements and the accompanying notes to the condensed consolidatedfinancial statements included in the Form 10-Q/A and gives effect to therestatement described in note 10 to the condensed consolidated financialstatements.

### **Overview**

Epiq Systems is aprovider of technology-based solutions for the legal and fiduciary servicesindustries. Our products and services assist clients with the administration ofcomplex legal proceedings, including electronic litigation discovery,bankruptcy administration and class action administration. Our clients includeleading law firms, corporations, bankruptcy trustees, and other professionaladvisors who require sophisticated case administration and document managementcapabilities, extensive subject matter expertise and a high service capacity.We provide clients with an integrated offering of both proprietary technologyand value-added services that comprehensively address their extensive businessrequirements.

The substantial increaseof electronic documents in the business community has changed the dynamics ofhow attorneys support discovery in complex litigation matters.  According to the 2005 Socha-GelbmannElectronic Discovery Survey, the 2004 domestic commercial electronic discoveryrevenues were estimated at $832 million, an approximate 94% increase from2003.  According to this same source, themarket is expected to continue to grow at increase 50% to 60% each year from2005 to 2007.  Due to the increasingcomplexity of cases, the increasing volume of data that are maintained electronically,and the increasing volume of documents (both paper and electronic) that areproduced in all types of litigation, law firms are increasingly reliant onelectronic evidence management systems to organize and manage the litigationdiscovery process.

The number of newbankruptcy filings each year may vary based on the level of consumer andbusiness debt, the general economy, interest rate levels and otherfactors.  We believe the level ofconsumer and business debt are important indicators of future bankruptcyfilings.  The most recent availableFederal Reserve *Flow of Funds Accounts ofthe United States*, dated March 9, 2006, reported increases in bothconsumer and business debt outstanding as compared with the same period of theprior year.  The increase in consumerdebt was the result of a significant increase in home mortgage debt, partlyoffset by a slight decline in consumer credit debt.

The class action and masstort marketplace is significant, with estimated annual tort claim costs inexcess of $250 billion according to an update study issued in 2004 by TowersPerrin.  Administrative costs, whichinclude costs, other than defense costs, incurred by either the insurancecompany or self-insured entity in the administration of claims, compriseapproximately 20% of this total.

We have acquired a numberof businesses during the past several years. In January 2003, we acquired BSI to expand our offerings to include anintegrated solution of a proprietary technology platform and professionalservices for Chapter 11 corporate restructurings. In January 2004, we acquiredPoorman-Douglas and expanded our product and service offerings to include classaction, mass tort, and other similar legal proceedings.  In October 2005, we acquired Hilsoft toenhance our expert legal notification services related to class action, masstort and bankruptcy noticing.  InNovember 2005, we acquired nMatrix to expand our product and service offeringsto include electronic litigation discovery.

We have two operatingsegments: case management and document management.

***CaseManagement Segment***

Case management supportfor client engagements may last several years and has a revenue profile thattypically includes a recurring component. Our case management segment generates revenue primarily through the followingservices.

·                  Professionaland support services, including case management, claims processing, specialtybankruptcy consulting, claims administration, and customized programming andtechnology services.

·                  Datahosting fees, volume-based fees, and professional services fees related to themanagement of large volumes of electronic data in support of a legalproceeding.

·                  Proprietaryelectronic discovery software to sort, cleanse, organize and perform searcheson large databases in support of a legal proceeding.

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·                  Softwareinstalled in bankruptcy trustee offices and provided over the internet thatfacilitates the administration of Chapter 7 and Chapter 13 bankruptcy cases.

·                  Databasemaintenance and processing, such as for creditor and class action claims, andconversion of that data into an organized, searchable, electronic database thatwe maintain on our servers and use, with our client, to manage the particularcase.

·                  Callcenter support to process and respond to telephone inquiries related tocreditor and class action claims.

***DocumentManagement Segment***

Document managementrevenue is generally non-recurring due to the unpredictable nature of thefrequency, timing and magnitude of the clients’ business requirements.  Our document management segment generatesrevenue primarily through the following services.

·                  Legalnoticing services to parties of interest in bankruptcy and class actionmatters, including media campaign and advertising management in which wecoordinate notification through various media outlets, such as print, radio andtelevision, to potential parties of interest for a particular clientengagement.

·                  Reimbursementfor costs incurred related to postage on mailing services.

**CriticalAccounting Policies**

We consider ouraccounting policies related to revenue recognition, share-based compensation,business combinations, goodwill, and identifiable intangible assets to becritical policies in understanding our historical and future performance.

***Revenue recognition***.

We have agreements withclients pursuant to which we deliver various case management and documentmanagement services each month.

Significantsources of revenue include:

·                  Feescontingent upon the month-to-month delivery of case management services definedby client contracts, such as claims processing, claims reconciliation,professional services, call center support, and conversion of data into anorganized, searchable electronic database. The amount we earn varies basedprimarily on the size and complexity of the engagement;

·                  Hostingfees based on the amount of data stored;

·                  Deposit-basedfees from financial institutions, primarily based on a percentage of totalliquidated assets placed on deposit at that financial institution by ourbankruptcy trustee clients, to whom we provide, at no charge, softwarelicenses, limited hardware and hardware maintenance, and postcontract customersupport (PCS) services;

·                  Legalnoticing services to parties of interest in bankruptcy and class actionmatters, including media campaign and advertising management in which wecoordinate notification through various media outlets, such as print, radio andtelevision, to potential parties of interest for a particular clientengagement; and

·                  Reimbursementfor costs incurred, primarily related to postage on mailing services.

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*Non-SoftwareArrangements*

Case and documentmanagement services related to electronic discovery, corporate restructuring,and class action revenue, which are billed based on volume, are evaluatedpursuant to Emerging Issues Task Force (EITF) 00-21, *Revenue Arrangements with Multiple Deliverables*.  For each of these contractual arrangements,we have identified the following deliverables and/or services:

·                  ElectronicDiscovery

·               Data processing

·               Hosting

·                  CorporateRestructuring

·               Consulting

·               Claims management

·               Printing andreproduction

·               Mailing andnoticing

·               Document management

·                  Class Action

·               Consulting

·               Notice campaigns

·               Toll free customersupport

·               Web sitedesign/hosting

·               Claimsadministration

·               Distribution

Based on our evaluationof each element, we have determined that each element delivered has standalonevalue to our customers because we or other vendors sell such servicesseparately from any other services/deliverables.  We have also obtained objective and reliableevidence of the fair value of each element based either on the price we chargewhen we sell an element on a standalone basis or based on third-party evidenceof fair value of such services.  Lastly,our arrangements do not include general rights of return.  Accordingly, each of the service elements inour multiple element case and document management arrangements qualifies as aseparate unit of accounting under EITF 00-21. We allocate revenue to the various units of accounting in our arrangementsbased on the fair value of each unit of accounting, which is generallyconsistent with the stated prices in our arrangements. As we have evidence ofan arrangement, revenue for each separate unit of accounting is recognized eachperiod in accordance with Staff Accounting Bulletin Topic 13, *Revenue Recognition* (SAB Topic 13).  As the services are rendered, our fee becomesfixed and determinable, and collectibility is reasonably assured.  Payments received in advance of satisfactionof the related revenue recognition criteria are recognized as a customerdeposit until all revenue recognition criteria have been satisfied.

*SoftwareArrangements*

For our Chapter 7bankruptcy 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 Chapter 7 relatedarrangements 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, *SoftwareRevenue Recognition* (SOP 97-2). Since we have not established vendor specific objective evidence (VSOE)of the fair value of the software license, we do not recognize any revenue ondelivery of the software.  The softwareelement is deferred and included with the remaining undelivered element, whichis PCS services.  This revenue, whenrecognized, is included on our condensed consolidated statements of operationsas a component of “Case management bundled software license, software upgradeand postcontract customer support 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, since we have persuasive 

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evidence that an arrangementexists, services have been rendered, the price is fixed and determinable, andcollectibility is reasonably assured.

We also provide ourtrustees with certain hardware, such as desktop computers, monitors, andprinters, and hardware maintenance.  Weretain ownership of all hardware provided and, based on guidance provided inEITF 01-8, *Determining Whether anArrangement Contains a Lease*, we account for this hardware as alease.  As the hardware maintenancearrangement is an executory contract similar to an operating lease, we useguidance related to contingent rentals in operating lease arrangements forhardware 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 SAB Topic 13, whichrequires that we recognize rental income when the changes in the factor onwhich the contingent lease payment is based actually occur.  This occurred at the end of each period as weachieve our target when deposits are held at the depository financialinstitution as, at that time, evidence of an arrangement exists, delivery hasoccurred, the amount has become fixed and determinable, and collection isreasonably assured.  This revenue, whichis less than ten percent of our total revenue, is included in our condensedconsolidated statements of operations as a component of “Case management services”revenue.

Effective October 1,2003, we entered into an arrangement with our primary depository financialinstitution under which we deliver two specified upgrades annually with thelast specified upgrade to occur in the second quarter of 2006.  This arrangement included specific pricingfor each software upgrade and certain special projects in addition to thecontingent deposit-based pricing related to the software license, hardware,hardware maintenance, and PCS to each trustee client.  Therefore, the software upgrades and specialprojects are part of a bundled arrangement. Each software upgrade is considered a separate and discrete product and,as we do not sell each software upgrade on a standalone basis, we were unableto establish VSOE of the fair value of the software upgrades.  As a result, the licensed software, softwareupgrade, special projects and PCS are a combined unit of accounting.  Revenue for this combined unit of accounting,when recognized, is included as a component of case management servicesrevenue.  Since we do not have VSOE ofthe fair value of each separate upgrade, we have deferred recognition ofsubstantially all revenue under this arrangement until delivery of the finalupgrade.  The ongoing costs related tothis arrangement were recognized as expense when incurred.  When the final upgrade is delivered and theonly remaining undelivered element is PCS services, we will recognize revenueon a pro-rata basis over the term of the agreement.  Payments received in advance of satisfactionof the related revenue recognition criteria are recognized as deferred revenueuntil all revenue recognition criteria have been satisfied.  As of March 31, 2006 and 2005, we hadrecorded on our consolidated balance sheets $66.1 million and $42.0 million,respectively, of deferred revenue under the October 2003 Arrangement.  Once the final upgrade is delivered and theonly remaining undelivered element is PCS, we will recognize income on apro-rata basis over the term of the agreement.

*Reimbursements*

Our case and documentmanagement businesses both have revenue related to the reimbursement of certaincosts, primarily postage.  Consistentwith guidance provided by EITF No. 01-14, *IncomeStatement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred*, reimbursed postage and other reimbursable directcosts are recorded gross as revenue from reimbursed direct costs and asreimbursed direct costs.

***Share-based compensation.***  Effective January 1, 2006, we beganaccounting for share-based compensation under SFAS No. 123R.  SFAS No. 123R requires a public entity tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award and torecognize that cost over the period during which an employee is required toprovide service in exchange for the award. We recognize this expense on a straight-line basis over the requisiteservice period of the last separately vesting portion of the award.  Recognition of share-based compensationexpense had, and will likely continue to have, a material affect on our directcosts and general and administrative line items within our condensedconsolidated statements of operations and also may have a material affect onour deferred income taxes and additional paid-in capital line items within ourcondensed consolidated balance sheets. Adoption of SFAS No. 123R affects the classification within ourcondensed consolidated statement of cash flows of certain tax benefits ascertain tax benefits formerly classified as an operating cash flow are nowclassified as a financing cash flow.  Todate, the only share-based compensation we have issued is share options.

Determining the fairvalue of a share option grant at the date of the award requires the use ofestimates related to expected volatility, expected term of share optionsgranted, expected risk-free interest rate, and the expected dividend rate.  We estimate our expected volatility based onimplied volatilities from traded options on our stock and on our stock’shistorical volatility.  We have estimatedthe expected term of our share options based on the historical exercise patternof groups of 

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employees that havesimilar historical exercise behavior. The expected risk-free interest rate is based on the U.S. Treasury yieldcurve in effect at the time of the grant. Historically, we have not paid dividends and we do not anticipate payingdividends in the foreseeable future; accordingly, our expected dividend rate iszero.  The estimate of fair value atgrant date is not revised based on subsequent experience.  Net share-based compensation expenserecognized is also affected by our estimate of the number of stock optiongrants that will be forfeited prior to vesting and the tax benefit that will berealized if the stock option grants are exercised.  We use historical information to estimateemployee termination and the resulting option forfeiture rate.  These factors are revised based on subsequentexperience, and such revised estimates may have a material impact on ourexpense recognition and adjustments to additional paid-in capital in futureperiods.

***Business combination**accounting****. *We have acquired anumber of businesses during the last several years, and we may acquireadditional businesses in the future. Business combination accounting, often referred to as purchaseaccounting, requires us to determine the fair value of all assets acquired,including identifiable intangible assets, and liabilities assumed.  The cost of the acquisition is allocated tothe assets acquired and liabilities assumed in amounts equal to the fair valueof each asset and liability, and any remaining acquisition cost is classifiedas goodwill.  This allocation processrequires extensive use of estimates and assumptions, including estimates offuture cash flows to be generated by the acquired assets.  Certain identifiable intangible assets, suchas customer lists and covenants not to compete, are amortized on a straight-linebasis over the intangible asset’s estimated useful life.  The estimated useful lives of amortizableidentifiable intangible assets range from 1 to 14 years.  Goodwill and certain other identifiableintangible assets are not amortized. Accordingly, the acquisition cost allocation has had, and will continueto have, a significant impact on our current operating results.

***Goodwill****.*  We assess goodwill,which is not subject to amortization, for impairment as of each July 31 andalso at any other date when events or changes in circumstances indicate thatthe carrying value of these assets may exceed their fair value.  This assessment is performed at a reportingunit level.  A reporting unit is acomponent of a segment that constitutes a business, for which discretefinancial information is available, and for which the operating results areregularly reviewed by management.

A change in events orcircumstances, including a decision to hold an asset or group of assets forsale, a change in strategic direction, or a change in the competitive environmentcould adversely affect the fair value of one or more reporting units.  The estimate of fair value is highlysubjective and requires significant judgment. If we determine that the fair value of any reporting unit is less thanthe reporting unit’s carrying value, then we will recognize an impairmentcharge.  If goodwill on our balance sheetbecomes impaired during a future period, the resulting impairment charge couldhave a material impact on our results of operations and financialcondition.  Our goodwill totaled $249.7million as of March 31, 2006.

***Identifiable intangible assets****.** ***Each period we evaluatewhether events and circumstances warrant a revision to the remaining estimateduseful life of each identifiable intangible asset.  If events and circumstances warrant a changeto the estimate of an identifiable intangible asset’s remaining useful life,then the remaining carrying amount of the identifiable intangible asset wouldbe amortized prospectively over that revised remaining useful life.  Furthermore, information developed during ourannual assessment, or other events and circumstances, may indicate that thecarrying value of one or more identifiable intangible assets is not recoverableand its fair value is less than the identifiable intangible asset’s carryingvalue and would result in recognition of an impairment charge.

A change in the estimateof the remaining life of one or more identifiable intangible assets or theimpairment of one or more identifiable intangible assets could have a materialimpact on our results of operations and financial condition.  Our identifiable intangible assets’ carryingvalue, net of amortization, was $50.3 million as of March 31, 2006.

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**Resultsof Operations for the Three Months Ended March 31, 2006 Compared with the ThreeMonths Ended March 31, 2005**

### **ConsolidatedResults**

### ***Revenue***

Total revenue of $38.2million for the three months ended March 31, 2006 represents a $13.6 million,or an approximate 55% increase, compared to $24.6 million of revenue for thesame 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 operations. Although reimbursed operating revenue and direct costs may fluctuatesignificantly from quarter to quarter, these fluctuations have a minimal effecton our operating income as we realize little or no margin from thisrevenue.  Operating revenue exclusive ofrevenue from reimbursed direct costs, which we refer to as operating revenuebefore reimbursed direct costs, increased approximately 70% to $32.6 millionfor the three months ended March 31, 2006 compared to $19.1 million for thesame period in the prior year.  Allrevenue is directly related to a segment, and changes in revenue by segment arediscussed below.

### ***Costs and Expenses***

Direct costs of services,exclusive of depreciation and amortization, increased to $14.4 million for thethree months ended March 31, 2006 compared with $7.2 million during the sameperiod in the prior year.  Exclusive ofdirect costs related to businesses acquired after March 31, 2005, direct costshad a small increase to approximately $7.5 million for the three months endedMarch 31, 2006 compared with $7.2 million for the same period in the prioryear.  Changes in our segment coststructure are discussed below.

Direct cost of bundledsoftware license, software upgrade and postcontract customer support services,exclusive of depreciation and amortization, increased approximately $0.1million to $1.0 million for three months ended March 31, 2006 compared with$0.9 million for the same period in the prior year primarily as a result ofincreased compensation costs.  Changes inour segment cost structure are discussed below.

Reimbursed direct costsincreased to $5.7 million for the three months ended March 31, 2006 comparedwith $5.6 million during the same period in the prior year.  Exclusive of reimbursed direct costs relatedto recently acquired entities, reimbursed direct costs decreased toapproximately $5.3 million for the three months ended March 31, 2006, comparedwith approximately $5.6 million for the same period in the prior year.  These changes are directly attributable tothe changes in operating revenue from reimbursed direct costs.

General andadministrative costs increased $3.7 million, or approximately 46%, to $11.7million for the three months ended March 31, 2006 compared with $8.0 millionfor the same period in the prior year. Exclusive of costs related to recently acquired entities, general andadministrative costs increased to approximately 13% to $9.0 million for thethree months ended March 31, 2006, compared with approximately $8.0 million forthe same period in the prior year.  Theprimary reasons for the increase in general and administrative costs was therecognition of $0.5 million of share-based compensation expense resulting fromadoption of Statement of Financial Accounting Standards No. 123 (revised) (SFAS123R), *Share-based Payment*,combined with a $0.5 million increase in travel and meeting expense related tothe expansion of our business.

Depreciation andsoftware and leasehold amortization costs increased $0.5 million, orapproximately 29%, to $2.3 million for the three months ended March 31, 2006compared with $1.8 million for the same period in the prior year.  Exclusive of costs related to recentlyacquired entities, depreciation and software and leasehold amortization costswere approximately $1.8 million for both the three months ended March 31, 2006and 2005.

Amortization ofidentifiable intangible assets, compared with the same period in the prioryear, increased $1.1 million to $2.8 million for the three months ended March31, 2006.  All identifiable intangibleassets are directly related to a segment, and changes in amortization ofidentifiable intangible assets by segment are discussed below.

***Interest Expense***

We incurred interestexpense of $3.3 million for the three months ended March 31, 2006 compared withinterest expense of $0.8 million for the same period in the prior year.  The increase in interest expense during thethree months ended March 31, 2006 compared with the same period in the prioryear resulted primarily from an increase in average borrowings outstandingunder our credit facility as a result of our acquisition of the nMatrixelectronic discovery business.  Also contributingto the 

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increase in interest expensewas an increase in the value of the embedded option related to the outstandingconvertible debt during the three months ended March 31, 2006, which resultedin a increase to interest expense, compared with decrease in the value of theembedded option during the three months ended March 31, 2005, which resulted ina decrease to interest expense, and an increase in interest rates during thethree months ended March 31, 2006 compared with the same period in the prioryear.

***Effective Tax Rate***

Our effective tax rate torecord the tax benefit related to our net loss was 40.5% for the three monthsended March 31, 2006 compared with a tax expense related to our net loss at aneffective tax rate of 71.2% for the three months ended March 31, 2005.  We had tax expense related to our net lossfor the three months ended March 31, 2005 as, although we have net lossesbefore income taxes, we are unable to record a tax benefit for certain expensesthat are not deductible for tax purposes. These nondeductible expenses exceed our pre-tax net loss resulting intaxable income and, therefore, resulted in tax expense.  Our 2006 tax rate is higher than thestatutory federal 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 which are higher thanthe tax rates assessed by other jurisdictions where we operate.

***Net Loss***

Our net loss wasapproximately $1.7 million for the three months ended March 31, 2006 comparedwith a net loss of approximately $2.1 million for the same period in the prioryear. This change is primarily the result of a $2.1 million increase in ourincome tax benefit and a $0.8 million improvement in operating income, offsetby a $2.5 million increase in interest expense.

**CaseManagement Segment**

Case management operatingrevenue before reimbursed direct costs increased $6.5 million, or approximately50%, to $19.6 million for the three months ended March 31, 2006 compared to$13.1 million for the same period in the prior year.  During the three months ended March 31, 2006,operating revenue before reimbursed direct costs from businesses acquired afterMarch 31, 2005 totaled $8.6 million. Exclusive of these newly acquired businesses, operating revenues beforereimbursed direct costs decreased by $2.1 million compared to the same periodin the prior year.  This operatingrevenue decrease is primarily attributable to a decline in class action casemanagement revenue, which will vary from period to period based on the size andcomplexity of cases being administered and the timing of class actionsettlements.

Case management directand administrative expenses, including depreciation and software and leaseholdamortization, increased $3.6 million, or approximately 45%, to $11.7 millionfor the three months ended March 31, 2006 compared with $8.1 million for thesame period in the prior year.  Duringthe three months ended March 31, 2006, direct and administrative expenses,including depreciation and software and leasehold amortization, from businessesacquired after March 31, 2005 totaled $4.1 million.  Exclusive of these newly acquired businesses,our direct and administrative expenses, including depreciation and softwareleasehold amortization, decreased by $0.5 million, or 6%, compared to the sameperiod in the prior year.  This decreaseis primarily the result of a decrease in class action direct expenses,primarily as a result of temporary help and outside services expense reductionswhich were required last year to support the administration of a large case,partly offset by an increase in corporate restructuring direct andadministrative expenses, primarily as a result of increased staffing.

Amortization of casemanagement’s identifiable intangible assets increased to $2.2 million for thethree months ended March 31, 2006 compared with $1.2 million for the sameperiod in the prior year.  This increaseis primarily the result of amortization of other intangible assets resultingfrom the acquisition of our electronic discovery business during the threemonth period ended March 31, 2006.

**DocumentManagement Segment**

Document managementoperating revenue before reimbursed direct costs increased $6.9 million, orapproximately 113%, to $13.0 million for the three months ended March 31, 2006compared to $6.1 million for the same period in the prior year.  This increase is primarily attributable tothe inclusion of $6.7 million of legal notification operating revenue beforereimbursed direct costs generated from Hilsoft, which was acquired duringOctober 2005.  Exclusive of Hilsoft,operating revenue before reimbursed direct costs increased $0.2 millionprimarily as a result of an increase in our corporate restructuring operatingrevenues.  Document management revenuescan fluctuate materially from period to period based on clients’ businessrequirements.

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Document managementdirect and administrative expenses, including depreciation and software andleasehold amortization, million increased approximately 84% to approximately$15.0 for the three months ended March 31, 2006 compared with approximately$8.1 million in the same period in the prior year.  This increase is primarily attributable tothe inclusion of $6.3 million of direct and administrative expenses, includingdepreciation and software and leasehold amortization, related to our Hilsoftlegal notification business acquired in October 2005.  Exclusive of Hilsoft, direct andadministrative expenses, including depreciation and software and leaseholdamortization, increased $0.5 million, or 6%, primarily as a result of anincrease in outside services related to corporate restructuring and classaction legal notification.  Outsideservice costs will vary depending on the nature and complexity of servicesprovided.  Document management directexpenses include reimbursed expenses and other operating expenses which aremore variable in nature than case management direct expenses.  Document management expenses will fluctuatefrom quarter to quarter based on document management business requirementsdelivered during each quarter.

Amortization of documentmanagement’s identifiable intangible assets increased 11%, to $0.5 million, forthe three months ended March 31, 2006 compared with the same period in theprior year.  This increase is primarily theresult of amortization of other intangible assets, resulting from theacquisition of our Hilsoft legal notification business, during the three monthperiod ended March 31, 2006.

**Liquidityand Capital Resources**

***Operating Activities***

During the three monthsended March 31, 2006, our operating activities provided net cash of $5.7million.  The primary sources of cashfrom operating activities were adjustments for non-cash charges and credits,primarily depreciation and amortization, of $3.4 million and changes inoperating assets and liabilities, net of effects from business acquisitions,which increased our operating cash flow by $4.0 million primarily as a resultof an increase in the deferred revenue liability partly offset by an increasein trade accounts receivable.  Thesesources of cash were partly offset by our net loss of $1.7 million.  Deferred revenue increased $6.8 millionprimarily as the result of deferral of substantially all of our Chapter 7bankruptcy trustee revenue as we did not satisfy the revenue recognitioncriteria set forth in SOP 97-2.  Thisincrease represents a net source of cash. Receivables, which increased $2.0 million, will fluctuate from period toperiod depending on the timing of collections. This increase represents a net use of cash.

***Investing Activities***

During the three monthsended March 31, 2006, we used cash of approximately $3.0 million to pay forproperty and equipment purchases, including approximately $0.9 million ofpurchases that, in the normal course of business, were made prior to year endbut paid for early this year.  Ourproperty and equipment purchases consisted primarily of computer relatedhardware to support our electronic discovery and bankruptcy businesses.  Enhancements to our existing software anddevelopment of new software is essential to our continued growth and, duringthe three months ended March 31, 2006, we used cash of approximately $0.9million to fund internal costs related to development of software for whichtechnological feasibility has been established. We believe the nature of our current business mix will continue toresult in increased spending for property, equipment and software developmentduring 2006 compared with 2005.  Weanticipate that cash generated from operations will be adequate to fund ouranticipated property, equipment and software spending over the next year.

***Financing Activities***

During the three monthsended March 31, 2006, we paid approximately $8.0 million as a principalreduction on our senior term loan and $1.7 million as a principal reduction onour BSI deferred acquisition price.  Thisfinancing use of cash was partly offset by $1.2 million of net proceeds fromstock issued in connection with the exercise of employee stock options.  As a result of adoption of SFAS 123R, we alsoclassify a portion of the tax benefit, referred to as excess tax benefit, werealize on exercise of employee stock options as a financing cash flow.  The effect of this accounting change duringthe three months ended March 31, 2006 was to recognize $0.1 million of excesstax benefit as a financing cash flow rather than as an operating cash flow.

As of March 31, 2006, ourborrowings consisted of $51.6 million from the contingent convertiblesubordinated notes (including the fair value of the embedded option), $17.0million under our senior term loan, $93.0 million under our senior revolvingloan, and approximately $2.5 million of obligations related to capitalizedleases and deferred acquisition price.

As of March 31, 2006,significant covenants, all as defined within our credit facility agreement,include a leverage ratio not to exceed 3.50 to 1.00, a senior leverage rationot to exceed 2.50 to 1.00, a fixed charge coverage ratio of not less than 1.25to 1.00, and a current ratio of not less than 1.50 to 1.00.  As a result of the restatement, whichresulted in the deferral of a 

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substantial portion ofrevenue as described in note 10, we were not in compliance with these financialcovenants as of March 31, 2006.  As aresult of the recognition of the deferred revenue during the second and thirdquarters of 2006, we were in compliance with all financial covenants as of June30 and September 30, 2006.  The deferralof revenue and subsequent recognition of revenue was not anticipated by us orthe banks at the time we established the current financial covenants in thecredit facility.  On December 14, 2006,we obtained a waiver regarding this event of noncompliance from our creditfacility syndicate.  Accordingly, we haveclassified this debt as current or long-term based on the debt’s originalscheduled maturity.

We believe that the fundsgenerated from operations plus amounts available under our credit facility’ssenior revolving loan will be sufficient over the next year to financecurrently anticipated working capital requirements, software expenditures,property and equipment expenditures, common share price protection payments, ifany, related to common shares issued in conjunction with our acquisition ofnMatrix, interest payments due on our outstanding borrowings, and payments forcontractual obligations (exclusive of our term loan obligation).  Subsequent to March 31, 2006, the $17.0million term loan under our credit facility, with an original maturity of August2006, was paid down to $15.0 million and the maturity was extended to June2007.

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 theexception of capital leases and additional subordinated debt, with a limit of$100.0 million of aggregate subordinated debt.  Furthermore, for anyacquisition we must be able to demonstrate that, on a pro forma basis, we wouldbe in compliance with our covenants during the four quarters prior to theacquisition and we must obtain bank permission for any acquisition for whichcash consideration exceeds $65.0 million or total consideration exceeds $125.0million.

**Off-balance Sheet Arrangements**

As a part of the purchase price consideration toacquire nMatrix, we issued 1.2 million shares of our common stock to theseller.  As explained in note 4 to thecondensed consolidated financial statements, under certain circumstances we maybe required to pay the difference between $20.35 per share and the price atwhich the seller sells the shares. Payments, if any, made under this arrangement will result in cashoutflows.  As discussed under the caption“Liquidity and Capital Resources – Financing Activities” above, we believe cashgenerated from operations plus amounts available under our credit facility’ssenior revolving loan will provide adequate liquidity to make any requiredpayment under this arrangement.  Theshares subject to this arrangement are currently unregistered; however, weanticipate these shares will be registered and available for sale in thefuture.

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**ContractualObligations**

The following table setsforth a summary of our contractual obligations and commitments, excludingperiodic interest payments, for each twelve month period ending March 31(in thousands):
|                                          | ** ** | **Payments Due By Period** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation**          | ** ** | **Total**                                 | ** ** | **Less than  1 Year** | ** ** | **1 – 3 Years** | ** ** | **3 – 5 Years** | ** ** | **More Than   5 Years** | ** ** |
|                                     |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt  and future accretion (1) |       | $                                         | 161,714    |   | $ | 17,593 |   | $ | 144,121 |   | $ | — |   | $ | — |   |
| Employment  agreements (2)               |       | 9,736                                     |       | 4,580 |   | 3,896 |   | 1,260 |   | — |   |
| Capital lease  obligations               |       | 964                                       |       | 950 |   | 14 |   | — |   | — |   |
| Operating leases                         |       | 37,134                                    |       | 5,159 |   | 8,933 |   | 7,073 |   | 15,969 |   |
| Total                                    |       | $                                         | 209,548    |   | $ | 28,282 |   | $ | 156,964 |   | $ | 8,333 |   | $ | 15,969 |   |

 

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(1)         A portion of the BSI andHilsoft purchase price were established in the form of a non-interest bearingnotes, which were discounted using an imputed rate of 5% and 8%, respectively,per annum.  The discounts are accretedover the life of the note and each period’s accretion is added to the principalof the respective note.  The amount inthe above contractual obligation table includes both the notes’ principal, asreflected on our March 31, 2006 condensed consolidated balance sheet, and allfuture accretion.  If certain revenueobjectives are satisfied, we will make additional payments, not to exceed $3.0million, over the next five years to the former owners of Hilsoft.  Such payments, if any, are not included inthe above contractual obligation table. Convertible debt is included at the stated value of the principalredemption and excludes adjustments related to the embedded option, which willnot be paid in cash.  Any conversion toour common stock of part or all of the convertible debt will reduce our cashobligation related to the convertible debt.

(2)         In conjunction withacquisitions, we have entered into employment agreements with certain keyemployees of the acquired companies.

**RecentAccounting Pronouncements**

In March 2006, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standard 156, *Accounting forServicing of Financial Assets*(SFAS 156).  SFAS 156 requires that an entity separatelyrecognize a servicing asset or a servicing liability when it undertakes anobligation to service a financial asset under a servicing contract in certainsituations.  Such servicing assets orservicing liabilities are required to be initially measured at fair value, ifpracticable.  SFAS 156 allows an entityto choose whether to subsequently measure its servicing assets and servicingliabilities using the amortization method or the fair value measurement method.  SFAS is effective for an entity’s firstfiscal year that begins after September 15, 2006 and should be appliedprospectively to all transactions after adoption.  We do not anticipate that adoption of thisstatement will have a material impact on our Consolidated Financial Statements.

In February 2006, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standard 155, *Accounting forCertain Hybrid Financial Instruments—an amendment of FASB Statements No. 133and 140*. (SFAS 155).  SFAS 155allows an entity to make an irrevocable election to measure a financialinstrument with an embedded derivative, referred to as a hybrid financialinstrument, at fair value in its entirety rather than bifurcating andseparately valuing the embedded derivative instrument.  SFAS 155 is effective for all financialinstruments acquired, issued, or subject to a remeasurement (new basis) eventoccurring after the beginning of an entity’s first fiscal year that beginsafter September 15, 2006.  We do notanticipate that adoption of this statement will have a material impact on ourConsolidated Financial Statements.

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**Forward-LookingStatements**

In this report, inother filings with the SEC and in press releases and other public statements byour officers 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. In this Quarterly Report on Form 10-Q/A, we make statements that planfor or anticipate the future.  Many ofthese statements are found in the **“Management’sDiscussion and Analysis of Financial Condition and Results of Operations”**section of this report.

Forward-lookingstatements may be identified by words or phrases such as “believe,” “expect,” “anticipate,”“should,” “planned,” “may,” “estimated,” “goal,” “objective” and “potential.”  Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended,provide a “safe harbor” for forward-looking statements.  Because forward-looking statements involvefuture risks and uncertainties, listed below are a variety of factors that couldcause actual results and experience to differ materially from the anticipatedresults or other expectations expressed in our forward-looking statements.  These factors include (1) risks associatedwith the application of complex accounting rules to unique transactions,including the risk that good faith application of those rules and audits ofthose results may be later reversed by new interpretations of those rules ornew views regarding the application of those rules, (2) any material changes inour total number of client engagements and the volume associated with eachengagement, including the results for 2006 to date in our class action clientengagements, (3) any material changes in our Chapter 7 deposit portfolio, theservices required or selected by our electronic discovery, Chapter 11, Chapter13, class action or mass tort engagements, or the number of cases processed byour Chapter 13 bankruptcy trustee clients, (4) material changes in the numberof bankruptcy filings, class action filings or mass tort actions each year, (5)our reliance on our marketing and pricing arrangements with Bank of America andother depository banks (6) risks associated with the integration ofacquisitions into our existing business operations, (7) risks associated withoutindebtedness, and (8) other risks detailed from time to time in our SECfilings, including our annual report on Form 10-K/A.  In addition, there may be other factors notincluded in our SEC filings that may cause actual results to differ materiallyfrom any forward-looking statements.  Weundertake no obligations to update any forward-looking statements containedherein to reflect future events or developments.

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**ITEM 3.          Quantitative and Qualitative Disclosures About MarketRisk.**

Marketrisk refers to the risk that a change in the level of one or more marketprices, interest rates, indices, volatilities, correlations or other marketfactors, such as liquidity, will result in losses for a certain financialinstrument or group of financial instruments. Our exposure to market risk has not changed significantly since December31, 2005.

**ITEM 4.          Controlsand Procedures.**

***DisclosureControls and Procedures***

Anevaluation was carried out by the Epiq Systems, Inc.’s (the Company’s) ChiefExecutive Officer and Chief Financial Officer of the effectiveness of thedesign and operations of the Company’s disclosure controls and procedures asdefined in Exchange Act Rule 13a-15(e).  Disclosurecontrols and procedures are designed to ensure that information required to bedisclosed by the Company in its periodic filings with the SEC is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms.  Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by the Company inthe reports that it files or submits to the SEC is accumulated and communicatedto Company’s management, including its principal executive and principalfinancial officers, or persons performing similar functions, as appropriate toallow timely decisions regarding required disclosure.

Duringfiscal year 2006, management identified an accounting error in its consolidatedfinancial statements related to determination of the appropriate accountingtreatment for certain complex aspects of revenue recognition, specifically theevaluation of vendor specific objective evidence of fair value for specifiedsoftware upgrades provided within a bundled arrangement as required byStatement of Position 97-2 (SOP 97-2), *Software RevenueRecognition*.  On November 14,2006, our audit committee determined that our previously issued financialstatements for the fiscal years ended December 31, 2005, 2004 and 2003,included in our Annual Report on Form 10-K for the fiscal year ended December31, 2005, for the quarterly information included in our Annual Report on Form10-K for the fiscal year ended December 31, 2005, and for the quarterlyinformation included in our Quarterly Report on Form 10-Q for the quartersended March 31, 2006 and June 30, 2006, should be restated.  The restatement is further discussed in note10 to the accompanying condensed consolidated financial statements.  Management of the company, under thedirection of our CEO and CFO, has reevaluated the effectiveness of ourdisclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)and 15d-15(e)) as of March 31,2006.  As a result of this evaluation,management determined that a material weakness existed in internal control overfinancial reporting.  Specifically,management has concluded that the control deficiency surrounding management’soversight of the determination of the appropriate accounting treatment forcertain complex aspects of revenue recognition, specifically the evaluation ofvendor specific objective evidence of fair value for specified softwareupgrades provided within a bundled arrangement as required by SOP 97-2represented a material weakness in internal control over financialreporting.  Our management, including ourCEO and CFO, concluded that our disclosure controls and procedures were noteffective as of March 31, 2006.

***Changes inInternal Control Over Financial Reporting***

Therehave been no other changes in our internal controls over financial reportingduring the quarter ended March 31, 2006, that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

Afteridentifying the material weakness subsequent to the original issuance of ourAnnual Report on Form 10-K for the fiscal year ended December 31, 2005,management initiated changes to remediate the material weakness describedabove.  We believe that, prior toDecember 31, 2006, we completed our remediation of the aforementioned materialweakness in our internal control over financial reporting.  The completed remediation measures includethe implementation of appropriate controls related to contracts or otherarrangements that are within the scope of SOP 97-2 to provide a writtenanalysis of the appropriate accounting for these contracts or other arrangementand the review of our conclusions with qualified internal accounting personnelor third party accounting experts.  Inaddition, we have provided our accounting staff with additional trainingrelated to generally accepted accounting principles and financial statementreporting matters.

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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 2005 AnnualReport on Form 10-K/A.

**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**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theregistrant has caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|            |             | **Epiq Systems, Inc.**                            |
|------------|------------------|---------------------------------------------------|
| ** ** |             |                                              |
| Date:      | February 8, 2007 |                                              | /s/ Tom W. Olofson |   |   |
|       |             | Tom W. Olofson                                    |
|       |             | Chairman of the Board                             |
|       |             | Chief Executive Officer                           |
|       |             | Director                                          |
|       |             | (Principal Executive Officer)                     |
|       |             |                                              |
|       |             |                                              |
| Date:      | February 8, 2007 |                                              | /s/ Elizabeth M. Braham |   |
|       |             | Elizabeth M. Braham                               |
|       |             | Executive Vice President, Chief Financial Officer |
|       |             | (Principal Financial Officer)                     |
|       |             |                                              |
|       |             |                                              |
| Date:      | February 8, 2007 |                                              | /s/ Douglas W. Fleming |   |
|       |             | Douglas W. Fleming                                |
|       |             | Director of Finance                               |
|       |             | (Principal Accounting Officer)                    |
|            |                  |                                                   |  |  |  |  |  |

 

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