Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20549**

 

**FORM 10-Q**

 

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

**of theSecurities Exchange Act of 1934**

 

**x****     ****For the Quarterly Period Ended September 30,2008**

 

**OR**

 

**o****        ****Transition Report Pursuant to Section 13or 15(d)**

**of theSecurities 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)  |       |                                  |

 

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

(Address ofprincipal executive office)

 

**913-621-9500**

(Registrant’stelephone number)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yes xNo  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company.   See definition of “large accelerated filer”,“accelerated filer” and “smaller reporting company” in Rule 12b-2 of theExchange Act.

 
| Large Accelerated Filer  o | Accelerated Filer  x | Non-Accelerated  Filer  o | Smaller Reporting  Company o |
|---------------------------------|---------------------------|--------------------------------|------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theAct).

Yes o  No x

 

The number of sharesoutstanding of registrant’s common stock at October 20, 2008:

 

| **Class**                     | ** ** | **Outstanding** |
|-------------------------------|------------|-----------------|
| Common Stock,  $.01 par value |       | 35,545,178      |

 

 

 

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**EPIQ SYSTEMS, INC.**

**FORM 10-Q**

**QUARTER ENDED SEPTEMBER 30, 2008**

 

**CONTENTS**

 
|                                     |                                                                                                                                           | **Page** |
|------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------|----------|
|                                     |                                                                                                                                           |     |
| **PART I - FINANCIAL  INFORMATION** |                                                                                                                                           |
|                                     |                                                                                                                                           |     |
| Item 1.                                  | Condensed Consolidated  Financial Statements                                                                                                   |     |
|                                     |                                                                                                                                           |     |
|                                     | Condensed Consolidated  Statements of Income –   Three and nine months ended September 30, 2008 and 2007 (Unaudited)            | 1        |
|                                     |                                                                                                                                           |     |
|                                     | Condensed Consolidated  Balance Sheets –   September 30, 2008 and December 31, 2007 (Unaudited)                            | 2        |
|                                     |                                                                                                                                           |     |
|                                     | Condensed  Consolidated Statement of Changes in Stockholders’ Equity –   Nine months ended September 30, 2008 (Unaudited)  | 3        |
|                                     |                                                                                                                                           |     |
|                                     | Condensed  Consolidated Statements of Cash Flows –   Nine months ended September 30, 2008 and 2007 (Unaudited)                  | 4        |
|                                     |                                                                                                                                           |     |
|                                     | Notes to  Condensed Consolidated Financial Statements (Unaudited)                                                                              | 5        |
|                                     |                                                                                                                                           |     |
| Item 2.                                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                    | 22       |
|                                     |                                                                                                                                           |     |
| Item 3.                                  | Quantitative  and Qualitative Disclosures about Market Risk                                                                                    | 34       |
|                                     |                                                                                                                                           |     |
| Item 4.                                  | Controls and  Procedures                                                                                                                       | 35       |
|                                     |                                                                                                                                           |
| **PART II - OTHER  INFORMATION**    |                                                                                                                                           |
|                                     |                                                                                                                                           |     |
| Item 1.                                  | Legal Proceedings                                                                                                                              | 36       |
|                                     |                                                                                                                                           |     |
| Item 1A.                                 | Risk Factors                                                                                                                                   | 36       |
|                                     |                                                                                                                                           |     |
| Item 6.                                  | Exhibits                                                                                                                                       | 36       |
|                                     |                                                                                                                                           |
| Signatures                               | 37                                                                                                                                             |
|                                          |                                                                                                                                                |          |  |

 

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**PART I- FINANCIAL INFORMATION**

 

**ITEM 1.     CondensedConsolidated Financial Statements.**

 

**EPIQ SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

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

**(Unaudited)**

** **
| ** **                                                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **REVENUE:**                                                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Case management  services                                                                                         |       | $                                                    | 33,576     |                                                | $          | 26,536 |   | $ | 98,300 |   | $ | 71,069 |   |
| Case management  bundled products and services                                                                    |       | 4,488                                                |       | 6,728                                               |       | 14,242 |   | 20,139 |   |
| Document  management services                                                                                     |       | 13,768                                               |       | 5,921                                               |       | 40,129 |   | 21,242 |   |
| Operating  revenue before reimbursed direct costs                                                                 |       | 51,832                                               |       | 39,185                                              |       | 152,671 |   | 112,450 |   |
| Operating  revenue from reimbursed direct costs                                                                   |       | 7,051                                                |       | 5,662                                               |       | 20,065 |   | 17,730 |   |
| Total Revenue                                                                                                     |       | 58,883                                               |       | 44,847                                              |       | 172,736 |   | 130,180 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **OPERATING  EXPENSES:**                                                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Direct costs of  services (exclusive of depreciation and amortization shown separately below)                     |       | 19,526                                               |       | 9,355                                               |       | 62,791 |   | 30,101 |   |
| Direct cost of bundled products and services (exclusive of depreciation  and amortization shown separately below) |       | 910                                                  |       | 998                                                 |       | 2,765 |   | 2,782 |   |
| Reimbursed direct  costs                                                                                          |       | 6,986                                                |       | 5,593                                               |       | 19,988 |   | 17,625 |   |
| General and  administrative                                                                                       |       | 17,865                                               |       | 16,208                                              |       | 51,165 |   | 44,383 |   |
| Depreciation and  software and leasehold amortization                                                             |       | 4,273                                                |       | 3,272                                               |       | 11,836 |   | 9,071 |   |
| Amortization of  identifiable intangible assets                                                                   |       | 2,271                                                |       | 2,352                                               |       | 6,874 |   | 7,228 |   |
| Other operating  expense (income)                                                                                 |       | 1                                                    |       | 565                                                 |       | (1,511 | ) | 565 |   |
| Total Operating  Expenses                                                                                         |       | 51,832                                               |       | 38,343                                              |       | 153,908 |   | 111,755 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **INCOME  FROM OPERATIONS**                                                                                       |       | 7,051                                                |       | 6,504                                               |       | 18,828 |   | 18,425 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **EXPENSE  (INCOME) RELATED TO FINANCING:**                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                                                                                                   |       | (39                                                  | )          | (10                                                 | )          | (219 | ) | (42 | ) |
| Interest expense                                                                                                  |       | 406                                                  |       | 2,168                                               |       | 1,338 |   | 10,615 |   |
| Net Expenses  Related to Financing                                                                                |       | 367                                                  |       | 2,158                                               |       | 1,119 |   | 10,573 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **INCOME  BEFORE INCOME TAXES**                                                                                   |       | 6,684                                                |       | 4,346                                               |       | 17,709 |   | 7,852 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **PROVISION  FOR INCOME TAXES**                                                                                   |       | 2,690                                                |       | 1,922                                               |       | 7,904 |   | 3,485 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **NET  INCOME**                                                                                                   |       | $                                                    | 3,994      |                                                | $          | 2,424 |   | $ | 9,805 |   | $ | 4,367 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **NET  INCOME PER SHARE INFORMATION:**                                                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                                                             |       | $                                                    | .11        |                                                | $          | .08 |   | $ | .28 |   | $ | .15 |   |
| Diluted                                                                                                           |       | $                                                    | .10        |                                                | $          | .07 |   | $ | .26 |   | $ | .14 |   |
|                                                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **WEIGHTED  AVERAGE COMMON SHARES OUTSTANDING:**                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                                                             |       | 35,512                                               |       | 30,185                                              |       | 35,409 |   | 29,770 |   |
| Diluted                                                                                                           |       | 41,120                                               |       | 36,704                                              |       | 41,368 |   | 31,803 |   |

 

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

 

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**EPIQ SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

**(Unaudited)**

 
| ** **                                                                                                                                                                                          | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
|                                                                                                                                                                                                |       |                             |       |                            |       |
| **ASSETS**                                                                                                                                                                                          |       |                             |       |                            |       |
| **CURRENT ASSETS:**                                                                                                                                                                                 |       |                             |       |                            |       |
| Cash and cash equivalents                                                                                                                                                                           |       | $                                | 6,816      |                            | $          | 13,415 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $1,926 and $1,437,  respectively                                                                                                |       | 52,464                           |       | 33,925                          |       |
| Prepaid expenses                                                                                                                                                                                    |       | 4,917                            |       | 2,888                           |       |
| Other current assets                                                                                                                                                                                |       | 1,093                            |       | 4,571                           |       |
| Total Current Assets                                                                                                                                                                                |       | 65,290                           |       | 54,799                          |       |
|                                                                                                                                                                                                |       |                             |       |                            |       |
| **LONG-TERM ASSETS:**                                                                                                                                                                               |       |                             |       |                            |       |
| Property, equipment and leasehold improvements, net                                                                                                                                                 |       | 37,551                           |       | 32,403                          |       |
| Software development costs, net                                                                                                                                                                     |       | 10,746                           |       | 9,808                           |       |
| Goodwill                                                                                                                                                                                            |       | 265,258                          |       | 260,684                         |       |
| Identifiable  intangible assets                                                                                                                                                                     |       | 29,470                           |       | 34,310                          |       |
| Other                                                                                                                                                                                               |       | 1,241                            |       | 790                             |       |
| Total Long-term Assets                                                                                                                                                                              |       | 344,266                          |       | 337,995                         |       |
| **Total Assets**                                                                                                                                                                                    |       | $                                | 409,556    |                            | $          | 392,794 |   |
|                                                                                                                                                                                                |       |                             |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                      |       |                             |       |                            |       |
| **CURRENT LIABILITIES:**                                                                                                                                                                            |       |                             |       |                            |       |
| Accounts payable                                                                                                                                                                                    |       | $                                | 10,754     |                            | $          | 7,401 |   |
| Accrued compensation                                                                                                                                                                                |       | 4,903                            |       | 7,430                           |       |
| Deposits                                                                                                                                                                                            |       | 1,596                            |       | 1,618                           |       |
| Deferred revenue                                                                                                                                                                                    |       | 5,283                            |       | 1,234                           |       |
| Other accrued expenses                                                                                                                                                                              |       | 3,049                            |       | 2,389                           |       |
| Current maturities of long-term obligations                                                                                                                                                         |       | 3,023                            |       | 3,326                           |       |
| Total Current Liabilities                                                                                                                                                                           |       | 28,608                           |       | 23,398                          |       |
|                                                                                                                                                                                                |       |                             |       |                            |       |
| **LONG-TERM LIABILITIES:**                                                                                                                                                                          |       |                             |       |                            |       |
| Deferred income taxes                                                                                                                                                                               |       | 20,085                           |       | 19,390                          |       |
| Other long-term liabilities                                                                                                                                                                         |       | 8,119                            |       | 8,058                           |       |
| Long-term obligations (excluding current maturities)                                                                                                                                                |       | 55,793                           |       | 58,266                          |       |
| Total Long-term Liabilities                                                                                                                                                                         |       | 83,997                           |       | 85,714                          |       |
|                                                                                                                                                                                                |       |                             |       |                            |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                                                   |       |                             |       |                            |       |
|                                                                                                                                                                                                |       |                             |       |                            |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                                      |       |                             |       |                            |       |
| Common stock -  $0.01 par value; 100,000,000 shares authorized; issued and outstanding –35,535,296  and 35,276,569 shares at September 30, 2008 and December 31, 2007,  respectively |       | 355                              |       | 353                             |       |
| Additional paid-in capital                                                                                                                                                                          |       | 236,437                          |       | 231,984                         |       |
| Accumulated other comprehensive (loss) income                                                                                                                                                       |       | (987                             | )          | 4                               |       |
| Retained earnings                                                                                                                                                                                   |       | 61,146                           |       | 51,341                          |       |
| Total Stockholders’ Equity                                                                                                                                                                     |       | 296,951                          |       | 283,682                         |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                 |       | $                                | 409,556    |                            | $          | 392,794 |   |

 

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

 

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**EPIQ SYSTEMS, INC.**

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

**(In Thousands)**

**(Unaudited)**

 
| ** **                                     | ** ** | **September 30, 2008** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
|                                           |       |                             |       |
| COMMON SHARES (100,000 authorized):            |       |                             |       |
| Shares, beginning of year                      |       | 35,277                           |       |
| Shares issued upon exercise of options         |       | 258                              |       |
|                                           |       |                             |       |
| Shares, end of period                          |       | 35,535                           |       |
|                                           |       |                             |       |
| COMMON STOCK – PAR VALUE $0.01 PER SHARE: |       |                             |       |
| Balance, beginning of year                     |       | $                                | 353        |   |
| Proceeds from exercise of options              |       | 2                                |       |
|                                           |       |                             |       |
| Balance, end of period                         |       | 355                              |       |
|                                           |       |                             |       |
| ADDITIONAL PAID-IN CAPITAL:                    |       |                             |       |
| Balance, beginning of year                     |       | 231,984                          |       |
| Proceeds from exercise of options              |       | 1,727                            |       |
| Share-based income tax benefit                 |       | 287                              |       |
| Share-based compensation expense               |       | 2,439                            |       |
|                                           |       |                             |       |
| Balance, end of period                         |       | 236,437                          |       |
|                                           |       |                             |       |
| ACCUMULATED OTHER COMPREHENSIVE (LOSS) INCOME: |       |                             |       |
| Balance, beginning of year                     |       | 4                                |       |
| Foreign currency translation adjustment        |       | (991                             | )          |
|                                           |       |                             |       |
| Balance, end of period                         |       | (987                             | )          |
|                                           |       |                             |       |
| RETAINED EARNINGS:                             |       |                             |       |
| Balance, beginning of year                     |       | 51,341                           |       |
| Net income                                     |       | 9,805                            |       |
|                                           |       |                             |       |
| Balance, end of period                         |       | 61,146                           |       |
|                                           |       |                             |       |
| TOTAL STOCKHOLDERS’ EQUITY                |       | $                                | 296,951    |   |

 

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

 

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**EPIQSYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(InThousands)**

**(Unaudited)**

** **
| ** **                                                                               | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
|                                                                                     |       |                                                    |       |   |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                |       |                                                    |       |   |   |
| Net  income                                                                              |       | $                                                       | 9,805      |   | $ | 4,367 |   |
| Adjustments  to reconcile net income to net cash from operating activities:              |       |                                                    |       |   |   |
| Share-based  compensation expense                                                        |       | 2,439                                                   |       | 1,809 |   |
| Expense  (benefit) for deferred income taxes                                             |       | 358                                                     |       | (1,778 | ) |
| Depreciation  and software and leasehold amortization                                    |       | 11,836                                                  |       | 9,071 |   |
| Change  in valuation of embedded option and convertible debt                             |       | (1,208                                                  | )          | 2,190 |   |
| Amortization  of identifiable intangible assets                                          |       | 6,874                                                   |       | 7,228 |   |
| Other                                                                                    |       | 990                                                     |       | 1,376 |   |
| Changes  in operating assets and liabilities, net of effects from business  acquisition: |       |                                                    |       |   |   |
| Trade  accounts receivable                                                               |       | (19,289                                                 | )          | (2,818 | ) |
| Prepaid  expenses and other assets                                                       |       | 1,134                                                   |       | (1,815 | ) |
| Accounts  payable and other liabilities                                                  |       | 4,730                                                   |       | 424 |   |
| Excess  tax benefit related to share-based compensation                                  |       | (120                                                    | )          | (594 | ) |
| Income  taxes                                                                            |       | 519                                                     |       | 3,976 |   |
| Net  cash provided by operating activities                                               |       | 18,068                                                  |       | 23,436 |   |
|                                                                                     |       |                                                    |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                |       |                                                    |       |   |   |
| Purchase  of property, equipment, and leasehold improvements                             |       | (12,873                                                 | )          | (12,160 | ) |
| Software  development costs                                                              |       | (4,625                                                  | )          | (3,467 | ) |
| Cash  paid for business acquisition, net of cash acquired                                |       | (4,762                                                  | )          | 250 |   |
| Other                                                                                    |       | 30                                                      |       | 29 |   |
| Net  cash used in investing activities                                                   |       | (22,230                                                 | )          | (15,348 | ) |
|                                                                                     |       |                                                    |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                |       |                                                    |       |   |   |
| Proceeds  from revolver                                                                  |       | 3,000                                                   |       | 39,000 |   |
| Payments  on revolver                                                                    |       | (3,000                                                  | )          | (40,000 | ) |
| Principal  payments under long-term debt                                                 |       | (3,389                                                  | )          | (18,834 | ) |
| Excess  tax benefit related to share-based compensation                                  |       | 120                                                     |       | 594 |   |
| Proceeds  from exercise of share options                                                 |       | 1,729                                                   |       | 8,732 |   |
| Debt  issuance costs                                                                     |       | (795                                                    | )          | — |   |
| Net  cash used in financing activities                                                   |       | (2,335                                                  | )          | (10,508 | ) |
|                                                                                     |       |                                                    |       |   |   |
| Effect  of exchange rate changes on cash                                                 |       | (102                                                    | )          | — |   |
|                                                                                     |       |                                                    |       |   |   |
| **NET DECREASE IN CASH AND CASH EQUIVALENTS**                                            |       | (6,599                                                  | )          | (2,420 | ) |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR**                                         |       | 13,415                                                  |       | 5,274 |   |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                             |       | $                                                       | 6,816      |   | $ | 2,854 |   |

 

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

 

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**EPIQSYSTEMS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

 

***Principlesof Consolidation***

 

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

 

***Natureof Operations***

 

We are a provider ofintegrated technology solutions for the legal profession.  Our solutions streamline the administrationof bankruptcy, litigation, financial transactions and regulatory compliancematters.  We offer innovative technologysolutions for electronic discovery, document review, legal notification, claimsadministration and controlled disbursement of funds.  Our clients include law firms, corporatelegal departments, bankruptcy trustees and other professional advisors whorequire innovative technology, responsive service and deep subject-matterexpertise.

 

***ComprehensiveIncome***

 

Statement of FinancialAccounting Standards No. 130, *Reporting ComprehensiveIncome*, establishes requirements for reporting and displaying comprehensiveincome and its components.  Ouraccumulated other comprehensive (loss) income is included as a separatecomponent of stockholders’ equity on our condensed consolidated balancesheets.  Other comprehensive income isdiscussed in note 6 of the condensed financial statements.

 

***RevenueRecognition***

 

We have agreements with clients pursuant to which wedeliver various 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 direct notification and media campaign and advertisingmanagement in which we coordinate notification through various media outlets,such as print, radio and television, to potential parties of interest for aparticular client engagement; and

 

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

 

*Non-Software Arrangements*

 

Servicesrelated to electronic discovery and settlement administration are billed basedon volume and are evaluated pursuant to Emerging Issues Task Force (EITF)00-21, *Revenue Arrangements with MultipleDeliverables*.  For thesecontractual 

 

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arrangements,we have identified each deliverable service element.  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 any otherservices/deliverables.  We have alsoobtained 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 similar services.  Lastly, our arrangements do not includegeneral rights of return.  Accordingly,each of the service elements in our multiple element case and documentmanagement arrangements qualifies as a separate unit of accounting under EITF00-21.  We allocate revenue to thevarious units of accounting in our arrangements based on the fair value of eachunit of accounting, which is generally consistent with the stated prices in ourarrangements. As we have evidence of an arrangement, revenue for each separateunit of accounting is recognized each period in accordance with StaffAccounting Bulletin Topic 13, *RevenueRecognition* (SAB Topic 13). Revenue is recognized as the services are rendered, our fee becomesfixed and determinable, and collectability 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 7 bankruptcy trustee arrangements, weprovide our trustee clients with a software license, hardware lease, hardwaremaintenance, and postcontract customer support (PCS) services, all at no chargeto the trustee.  The trustees place theirliquidated estate deposits with a financial institution with which we have anarrangement.  We earn contingent monthlyfees from the financial institutions based on the dollar level of averagemonthly deposits held by the trustees with that financial institution,  from the financial institution related to thesoftware license, hardware lease, hardware maintenance, and PCS.  We account for the software license and PCSelements in accordance 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 as a component of case management servicesrevenue.  Revenue related to PCS isentirely contingent on the placement of liquidated estate deposits by thetrustee with the financial institution. Accordingly, we recognize this contingent usage based revenue consistentwith the guidance provided by the American Institute of Certified PublicAccountants’ Technical Practice Aid (TPA) 5100.76, *Fair Valuein Multiple-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 evidence that an arrangement exists, serviceshave been rendered, the price is fixed and determinable, and collectability isreasonably assured.

 

We also provide our trusteeclients 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 an ArrangementContains a Lease*, we account for this hardware as a lease.  As the hardware maintenance arrangement is anexecutory contract similar to an operating lease, we use guidance related tocontingent rentals in operating lease arrangements for hardware maintenance aswell as for the hardware lease.  Sincethe payments under all of our arrangements are contingent upon the level oftrustee deposits and the delivery of upgrades and other services and thereremain important uncertainties regarding the amount of unreimbursable costs yetto be incurred by us, we account for the hardware lease as an operating leasein accordance with SFAS 13, *Accounting forLeases*.  Therefore, all leasepayments, based on the estimated fair value of hardware provided, were accountedfor as contingent rentals under EITF Issue No. 98-9, *Accounting for Contingent Rent* and SABTopic 13, which requires that we recognize rental income when the changes inthe factor on which the contingent lease payment is based actually occur.  This occurs 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 income as a component of “case management services”revenue.

 

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*Reimbursements*

 

We haverevenue related to the reimbursement of certain costs, primarily postage.  Consistent with guidance provided by EITF No. 01-14,*Income Statement Characterization of ReimbursementsReceived for “Out-of-Pocket” Expenses Incurred*, reimbursed postageand other reimbursable direct costs are recorded gross in the consolidatedstatements of income as “Operating revenue from reimbursed direct costs” and as“Reimbursed direct costs”, respectively.

 

***Recent Accounting Pronouncements***

 

In September 2006, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards No. 157,*Fair Value Measurements*, (SFAS157).  SFAS 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair valuemeasurements.  SFAS 157 is effective forfinancial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years.  The adoption of SFAS 157 as of January 1,2008 did not have a material impact on our financial position, results ofoperations, or cash flows.  In February 2008,FASB issued Staff Position 157-1, *Application of FASBStatement No. 157 to FASB Statement No. 13 and Other AccountingPronouncements That Address Fair Value Measurements for Purposes of LeaseClassification or Measurement under Statement 13* (FSP 157-1).  FSP 157-1 excludes from the scope of SFAS 157accounting pronouncements that address fair value measurements for purposes oflease classification or measurement. This scope exception does not apply to assets acquired and liabilitiesassumed in a business combination that are required to be measured at fairvalue, regardless of whether those assets and liabilities are related toleases.  FSP 157-1 was effective upon theinitial adoption of SFAS 157.  Adoptionof FSP 157-1 as of January 1, 2008 did not have a material impact on ourfinancial position, results of operations, or cash flows.  In February 2008, FASB issued StaffPosition 157-2, *Effective Date of FASB Statement No. 157*,(FSP 157-2) which, as of February 12, 2008, indefinitely delayed theeffective date of SFAS 157 for nonfinancial assets and nonfinancialliabilities, except for items that are recognized or disclosed at fair value inthe financial statements on a recurring basis. Management is still evaluating the impact, if any, that the adoption ofFSP 157-2 will have on our financial position, results of operations, or cashflows.

 

In December 2007, FASB issued Statement ofFinancial Accounting Standards No. 141(R), *Business**Combinations* (SFAS 141(R)).  SFAS 141(R) establishes guidelines forthe recognition and measurement of assets, liabilities and equity in businesscombinations.  SFAS 141(R) iseffective for financial statements issued for fiscal years beginning after December 15,2008.  Management is still evaluating theimpact, if any, that the adoption of SFAS 141(R) will have on ourfinancial position, results of operations, or cash flows.

 

In December 2007, FASB issued Statement ofFinancial Accounting Standards No, 160, *Noncontrolling Interest InConsolidated Financial Statements*, (SFAS 160).  SFAS 160 changes the way in whichnoncontrolling interests in subsidiaries are measured and classified on thebalance sheet.  SFAS 160 is effective forfinancial statements issued for fiscal years beginning after December 15,2008.  Management anticipates that theadoption of SFAS 160 will not have a material effect on our financial position,results of operations, or cash flows.

 

In March 2008, FASB issued Statement of FinancialAccounting Standards No. 161, *Disclosures AboutInstruments and Hedging Activities* – amendment of FASB Statement No. 133(SFAS 161).  SFAS 161 changes thedisclosure requirements for derivative instruments and hedging activities.  SFAS 161 is effective for financialstatements issued for fiscal years beginning after November 15, 2008.  As SFAS 161 relates only to disclosure,management anticipates that the adoption of SFAS 161 will not have a materialeffect on our financial position, results of operations, or cash flows.

 

In May, 2008, FASB issued Statement of FinancialAccounting Standards No. 162, *The Hierarchy of GenerallyAccepted Accounting Principles*(SFAS 162).  SFAS 162 identifies the sources of accountingprinciples and the framework for selecting the principles used in thepreparation of financial statements of nongovernmental entities that arepresented in conformity with generally accepted accounting principles.  SFAS 162 is effective 60 days following theSEC’s approval of the PCAOB’s amendments to U.S. Auditing Standards (AU) Section 411,*The Meaning**of PresentFairly in Conformity With Generally Accepted Accounting Principles*.  Management is still evaluating the impact, ifany, that the adoption of SFAS 162 will have on our financial position, resultsof operations, or cash flows.

 

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In June, 2008, FASBissued Statement of Financial Accounting Standards No. 163, *Accounting for Financial Guarantee**InsuranceContracts*.  SFAS 163 requiresthat an insurance enterprise recognize a claim liability prior to an event ofdefault when there is evidence that credit deterioration has occurred in aninsured financial obligation.  SFAS 163is effective for financial statements issued for fiscal years beginning after December 15,2008.  Management anticipates that theadoption of SFAS 163 will not have a material effect on our financial position,results of operations, or cash flows.

 

In April 2008, FASBissued FSP FAS142-3, *Determination of theUseful Life of Intangible Assets*. FSP FAS 142-3 provides guidance on determining the useful life of arecognized intangible asset.  FSP FAS142-3 is effective for financial statements issued for fiscal years beginningafter December 15, 2008.  Managementis still evaluating the impact, if any, that the adoption of FSP FAS 142-3 willhave on our financial position, results of operations, or cash flows.

 

**NOTE 2:   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-Qfor interim 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 for the year endedDecember 31, 2007.

 

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 September 30,2008, the changes in stockholders’ equity for the nine month period ended September 30,2008, the results of operations for the three and nine month periods ended September 30,2008 and 2007, and cash flows for the nine month periods ended September 30,2008 and 2007.

 

The results of operationsfor the three and nine month periods ended September 30, 2008 are notnecessarily indicative of the results to be expected for the entire year.

 

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

 

Identifiableintangible assets subject to amortization as of September 30, 2008 and December 31,2007 consisted of the following (in thousands):

 
| ** **              | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Gross Carrying  Amount**  | ** ** | **Accumulated  Amortization**   | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Customer  contracts     |       | $                                | 40,249     |                            | $          | 21,190 |   | $ | 39,287 |   | $ | 17,863 |   |
| Trade names             |       | 745                              |       | 745                             |       | 745 |   | 745 |   |
| Non-compete  agreements |       | 28,558                           |       | 18,147                          |       | 27,526 |   | 14,640 |   |
|                    |       | $                                | 69,552     |                            | $          | 40,082 |   | $ | 67,558 |   | $ | 33,248 |   |

 

Aggregateamortization expense related to identifiable intangible assets was $2.3 millionand $2.4 million for the three month periods ended September 30, 2008 and2007, respectively and was $6.9 million and $7.2 million for the nine monthperiods ended September 30, 2008 and 2007, respectively.  Amortization expense related to identifiableintangible assets for 2008 and the following five years is estimated as follows(in thousands):

 
| **Year Ending  December 31,** | ** ** | **Estimated  Amortization  Expense** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| 2008                                    |       | $                                    | 9,118      |   |
| 2009                                    |       | 7,709                                |       |
| 2010                                    |       | 6,764                                |       |
| 2011                                    |       | 4,832                                |       |
| 2012                                    |       | 4,652                                |       |
| 2013                                    |       | 3,070                                |       |
|                                    |       | $                                    | 36,145     |   |

 

Asof September 30, 2008 and December 31, 2007, goodwill had a carryingvalue of $265.3 million and $260.7 million, respectively.  The $4.6 million increase in goodwill resultsfrom the acquisition, in April 2008, of an electronic discovery businessin the United Kingdom, partially offset by a reversal of a FIN 48 tax liabilityas certain federal and state tax returns were closed under the statute oflimitations.  Goodwill by segment isdisclosed in note 9 of the condensed consolidated financial statements.

 

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### **NOTE 4:   DERIVATIVES**

 

A portion of ourbankruptcy trustee revenue is subject to variability based on fluctuations inshort-term interest rates.  During 2007,in order to limit our economic exposure to market fluctuations in interestrates we purchased one month LIBOR based interest rate floor options with atotal notional amount of $800 million and initial contractual maturity of threeyears. We accounted for this transaction pursuant to the guidance contained inStatement of Financial Accounting Standards No. 133, *Accountingfor Derivative Instruments and Hedging Activities*, as amended andinterpreted (SFAS 133).  SFAS 133requires that all derivative instruments be recorded on the balance sheet atfair value.  As the interest rate flooroptions were not designated as an accounting hedge, changes in the fair valueof the derivatives were recorded each period in current earnings.  For the year ended December 31, 2007,the change in the fair value of the interest rate floor options was recognizedas an unrealized gain of $1.1 million and was included as a component of otheroperating income.  During February 2008,we sold the interest rate floor options and realized a $3.5 million gain.  The $2.4 million difference between therealized gain of $3.5 million and the previously recognized gain of $1.1million is included as a component of other operating income on theaccompanying condensed consolidated statements of income.  We currently do not hold any interest ratefloor options, other derivatives, or auction rate securities.

 

### **NOTE 5:  INDEBTEDNESS**

 

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

 
| ** **                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                           | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Senior revolving  loan                                               |       | $                      | —     |                  | $          | — |   |
| Contingent  convertible subordinated debt, including embedded option |       | 52,750                 |       | 53,958                |       |
| Other                                                                |       | 6,066                  |       | 7,634                 |       |
| Total  indebtedness                                                  |       | $                      | 58,816     |                  | $          | 61,592 |   |

 

***CreditFacilities***

 

As of September 30,2008, our credit facility, with KeyBankNational Association as administrative agent, consisted of a $100.0million senior revolving loan.  Therewere no amounts due under the senior revolving loan as of September 30,2008.

 

During July 2008, weamended and restated our credit facility with a new credit facility.  The amended and restated credit facility,with KeyBank National Association as administrative agent, consists of a $100.0million senior revolving loan.  Thefacility matures in July 2011.  Duringthe term of the credit facility, we have the right, subject to compliance withour covenants, to increase the senior revolving loan to $175.0 million.  The amended credit facility is secured byliens on our real property and a significant portion of our personalproperty.  Interest on the amended creditfacility is generally based on a spread, not to exceed 325 basis points, overthe LIBOR rate.  Our amended creditfacility contains financial covenants related to earnings before interest,provision for income taxes, depreciation, amortization and other adjustments asdefined in the agreements (EBITDA) and total debt.  In addition, our credit facility alsocontains financial covenants related to senior debt, fixed charges, and workingcapital.  As of September 30, 2008,we were in compliance with all financial covenants.

 

***ContingentConvertible Subordinated Notes***

 

During June 2004, weissued $50.0 million of contingent convertible subordinated notes with a fixed4% per annum interest rate and an original maturity of June 15, 2007.  The holders of the notes had the right toextend the maturity date by up to three years. In April 2007, the holders exercised this right and the notes’maturity date was extended to June 15, 2010.  If we change our capital structure (forexample, through a stock dividend or stock split) while the notes areoutstanding, the conversion price will be adjusted on a consistent basis and,accordingly, the number of shares of common stock we would issue on conversionwill be adjusted.  The notes areconvertible into 4.3 million shares of our common stock at a price of 

 

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approximately $11.67 pershare.  We have the right to require thatthe holders of the notes convert to equity if our share price exceeds the$23.33 on a weighted average basis for 20 consecutive days.

 

Under SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*,the right to extend the maturity of the contingent convertible subordinatednotes was accounted for as an embedded option subject to bifurcation.  The embedded option was initially valued at$1.2 million and the contingent convertible subordinated note balance wasreduced by the same amount.  Theconvertible subordinated note was accreted approximately $0.1 million eachquarter such that the contingent convertible subordinated note balance,exclusive of the embedded option value, totaled $50.0 million as of the June 15,2007 original maturity date.  On ouraccompanying condensed consolidated statements of income, this accretion was acomponent of interest expense.  Theembedded option was revalued at each period end based on the probabilityweighted discounted cash flows related to the additional 4% interest ratepayments resulting from the three year extension of the contingent convertiblesubordinated notes maturity.  During April 2007,the holders of the convertible subordinated notes exercised this right toextend and we performed a final valuation to estimate the fair value of theembedded option as of the approximate date of the extension.  The estimated fair value of the embeddedoption at this date, included as a component of the contingent convertiblesubordinated note, was approximately $4.8 million.  The $4.8 million estimated fair value of theembedded option is amortized as a credit to interest expense over the period tothe extended maturity, which is June 15, 2010.  If any contingent convertible notes areconverted into shares of our common stock prior to June 15, 2010, theunamortized embedded option value related to those shares will be recognized asa gain in the period the conversion occurs. The above changes related to the carrying value of the contingentconvertible subordinated note, the estimated fair value of the embedded option,and the amortization of the fair value of the embedded option do not affect ourcash flow.

 

***ScheduledPrincipal 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 September 30(in thousands):

 
| 2009  |   | $      | 3,023  |   |
|-------|--------|--------|--------|--------|
| 2010  |   | 55,235 |   |
| 2011  |   | 547    |   |
| 2012  |   | 11     |   |
| 2013  |   | — |   |
| Total |   | $      | 58,816 |   |

 

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**NOTE 6:   OTHER COMPREHENSIVE INCOME**

 

The following table showsthe computation of comprehensive income:

 
| ** **                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net income                                |       | $                                                    | 3,994      |                                                | $          | 2,424 |   | $ | 9,805 |   | $ | 4,367 |   |
| Foreign currency  translation adjustments |       | $                                                    | (1,027     | )                                                   | $          | (21 | ) | $ | (991 | ) | $ | 38 |   |
| Total  comprehensive income               |       | $                                                    | 2,967      |                                                | $          | 2,403 |   | $ | 8,814 |   | $ | 4,405 |   |

 

Thechanges in the company’s cumulative foreign currency translation adjustmentwere not adjusted for income taxes, as they relate to specific indefiniteinvestments in foreign subsidiaries.

 

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**NOTE 7:   SHARE-BASED COMPENSATION**

 

During June 2004, our 2004 Equity Incentive Planwas approved by our shareholders and replaced our 1995 Stock Option Plan, as amended(the “1995 Plan”). During June 2006, an amendment to the 2004 EquityIncentive Plan was approved by our shareholders. The 2004 Equity IncentivePlan, as amended, (the “2004 Plan”) limits the combined grant of options toacquire shares of common stock, stock appreciation rights, and restricted stockunder the 2004 Plan to 7,500,000 shares. Any grant under the 2004 Plan thatexpires or terminates unexercised, becomes unexercisable or is forfeited willbe available for future grants unless, in the case of options granted, relatedstock appreciation rights are exercised. At September 30, 2008, there wereapproximately 1,701,000 shares of common stock available for futureequity-related grants under the 2004 Plan. Although various forms of equityinstruments may be issued, to date we have issued only incentive share optionsand nonqualified share options under this Plan. These share options, which havea contractual term of 10 years, are issued with an exercise price equal to thegrant date closing market price of our common stock. The vesting periods rangefrom immediate to 5 years. Share options which vest over 5 years generally vesteither 20% per year over the first five anniversaries of the grant date or 25%per year on the second through fifth anniversaries of the grant date. Sharesvesting over a shorter period will generally vest 100% as of the designatedvesting date. We issue new shares to satisfy share option exercises. We do notanticipate that we will repurchase shares on the open market during the nextyear for the purpose of satisfying share option exercises.

 

Following is informationrelated to exercisable share options and share options expected to vest as of September 30,2008 (shares and aggregate intrinsic value in thousands):

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
|                                 |       |       |       |                                   |       |                                                |       |                            |       |
| Options  exercisable                 |       | 5,452      |       | $                                      | 10.27      |                                                | 5.85       |                            | $          | 19,491 |   |
| Options  vested and expected to vest |       | 7,450      |       | $                                      | 11.24      |                                                | 6.51       |                            | $          | 21,184 |   |

 

The aggregate intrinsicvalue was calculated using the difference between the September 30, 2008market price and the grant price for only those awards that have a grant pricethat is less than the September 30, 2008 market price.

 

The weighted averagegrant-date fair value of options granted during the three months ended September 30,2008 and 2007 were $4.76 and $6.64, respectively. The total intrinsic value ofoptions exercised during the three months ended September 30, 2008 and2007 were $0.1 million and $0.7 million, respectively. During the three monthsended September 30, 2008 and 2007, we received cash for payment of thegrant price of exercised options of approximately $0.4 million and $0.5million, respectively, and we anticipate we will realize a tax benefit relatedto these exercised options of approximately $0.4 million and less than $0.3million, respectively.

 

During the three monthsended September 30, 2008 and 2007, we recognized share-based compensationexpense, which is a non-cash charge, of approximately $1.0 million and $0.8million, respectively, of which $0.2 million and $0.2 million, respectively, isincluded under the caption “Direct costs of services” and $0.8 million and $0.6million, respectively, is included under the caption “General andadministrative” on the accompanying condensed consolidated statements ofincome. During the three months ended September 30, 2008 and 2007, werecognized a net tax benefit of approximately $0.4 million and $0.3 million,respectively, related to aggregate share-based compensation expense recognizedduring the same period.

 

The weighted averagegrant-date fair value of options granted during the nine months ended September 30,2008 and 2007 were $5.82 and $5.35, respectively. The total intrinsic value ofoptions exercised during the nine months ended September 30, 2008 and 2007were $2.3 million and $6.2 million, respectively. During the nine months ended September 30,2008 and 2007, we received cash for payment of the grant price of exercisedoptions of approximately $1.7 million and $8.7 million, respectively, and weanticipate we will realize a tax benefit related to these exercised options ofapproximately $0.9 million

 

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and $1.6 million,respectively. The cash received for payment of the grant price is included as acomponent of cash flow from financing activities. The tax benefit related tothe option exercise price in excess of the option fair value at grant date isseparately disclosed as a component of cash flow from financing activities onthe consolidated statement of cash flows; the remainder of the tax benefit isincluded as a component of cash flow from operating activities.

 

During the nine months ended September 30, 2008and 2007, we recognized share-based compensation expense, which is a non-cashcharge, of approximately $2.4 million and $1.8 million, respectively, of which$0.7 million and $0.6 million, respectively, is included under the caption “Directcosts of services” and $1.7 million and $1.2 million, respectively, is includedunder the caption “General and administrative” on the accompanying condensedconsolidated statements of income. During the nine months ended September 30,2008 and 2007, we recognized a net tax benefit of approximately $0.9 millionand $0.6 million, respectively, related to aggregate share-based compensationexpense recognized during the same period. As of September 30, 2008, therewas $11.2 million of total unrecognized compensation cost related to nonvestedshare-based compensation arrangements, which will be recognized over aweighted-average period of 3.4 years.

 

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**NOTE 8:   NET INCOME PER SHARE**

 

Basic net income pershare is computed by dividing net income available to common shareholders bythe weighted average number of common shares outstanding for the period. Dilutednet income per share is computed by dividing net income available to commonshareholders, increased by the amount of interest expense, net of tax, relatedto outstanding convertible debt, by the weighted average number of outstandingcommon shares and incremental shares that may be issued in future periodsrelated to outstanding share options and convertible debt, if dilutive. Whencalculating incremental shares related to outstanding share options, we applythe treasury stock method. The treasury stock method assumes that proceeds,consisting of the amount the employee must pay on exercise, compensation costattributed to future services and not yet recognized, and excess tax benefitsthat would be credited to additional paid-in capital on exercise of the shareoptions, are used to repurchase outstanding shares at the average market pricefor the period. The treasury stock method is applied only to share grants forwhich the effect is dilutive.

 

The computationsof basic and diluted net income per share are as follows (in thousands, exceptper share data):

 
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
| ** **                      | ** ** | **Net  Income**                                          | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per  Share  Amount** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per  Share  Amount** | ** ** |
|                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Basic  net income per share     |       | $                                                        | 3,994      |   | 35,512 |   | $ | .11 |   | $ | 2,424 |   | 30,185 |   | $ | .08 |   |
|                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Effect  of dilutive securities: |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Share  options                  |       |                                                     |       | 1,322 |   |   |   |   |   | 2,233 |   |   |   |
| Convertible  debt               |       | 305                                                      |       | 4,286 |   |   |   | 305 |   | 4,286 |   |   |   |
|                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Diluted  net income per share   |       | $                                                        | 4,299      |   | 41,120 |   | $ | .10 |   | $ | 2,729 |   | 36,704 |   | $ | .07 |   |

 

#### **For the three month periods ended September 30,2008 and 2007, weighted-average outstanding share options totalingapproximately 2.9 million and 0.6 million shares of common stock, respectively,were antidilutive and therefore not included in the computation of dilutedearnings per share.**

 
| ** **                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                      | ** ** | **Net  Income**                                         | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per  Share  Amount** | ** ** | **Net  Income** | ** ** | **Weighted  Average  Shares  Outstanding** | ** ** | **Per  Share  Amount** | ** ** |
|                            |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Basic  net income per share     |       | $                                                       | 9,805      |   | 35,409 |   | $ | .28 |   | $ | 4,367 |   | 29,770 |   | $ | .15 |   |
|                            |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Effect  of dilutive securities: |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Share  options                  |       |                                                    |       | 1,673 |   |   |   |   |   | 2,033 |   |   |   |
| Convertible  debt               |       | 908                                                     |       | 4,286 |   |   |   | — |   | — |   |   |   |
|                            |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Diluted  net income per share   |       | $                                                       | 10,713     |   | 41,368 |   | $ | .26 |   | $ | 4,367 |   | 31,803 |   | $ | .14 |   |

 

#### **For the nine month periods ended September 30,2008 and 2007, weighted-average outstanding share options totalingapproximately 1.8 million and 1.3 million shares of common stock wereantidilutive and, therefore, not included in the computation of dilutedearnings per share. For the nine months ended September 30, 2007, we didnot assume conversion of the contingent convertible subordinated convertiblenotes as the effect would have been antidilutive.**

 

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**NOTE 9:   SEGMENT REPORTING**

 

In the first quarter of2008, we revised the structure of our reporting segments to reflect a change inthe nature of the financial information provided to our chief operatingdecision makers resulting from a change in the structure of our internalorganization. The segment measure of profit for the three and nine months endedSeptember 30, 2007 has been restated in accordance with our neworganization structure, including the changes in certain internal financialreporting information. We have three reporting segments: (i) electronicdiscovery, (ii) bankruptcy, and (iii) settlement administration. Ourelectronic discovery business provides processing and search and reviewservices to corporations and the litigation department of law firms. Produceddocuments are made available primarily through a hosted environment, and ourDocuMatrixTM software allows for efficient plaintiff and defendant counselreview and data requests. Our bankruptcy segment provides solutions thataddress the needs of trustees to administer bankruptcy proceedings and ofdebtor corporations that file a plan of reorganization. Our settlementadministration segment provides managed services including legal notification,claims administration and controlled disbursement.

 

Each segment’sperformance is assessed based on earnings before interest, taxes, depreciationand amortization, other operating income, and share-based compensation expense.In management’s evaluation of performance, certain costs, such as compensationfor administrative staff and executive management, are not allocated by segmentand, accordingly, the following reporting segment results do not include suchunallocated costs. Intersegment revenues are not considered material to thesegment reporting information. Assets reported within a segment are thoseassets that can be identified to a segment and primarily consist of tradereceivables, property, equipment and leasehold improvements, software,identifiable intangible assets and goodwill. Cash, tax-related assets, andcertain prepaids and other assets are not allocated to our segments. Althoughwe can and do identify long-lived assets such as property, equipment andleasehold improvements, software, and identifiable intangible assets toreporting segments, we do not allocate the related depreciation andamortization to the segment as management evaluates segment performanceexclusive of these non-cash expenses.

 

Following is a summary ofsegment information (in thousands):

 
| ** **                                        | ** ** | **Three Months Ended September 30, 2008** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic  Discovery**                                          | ** ** | **Bankruptcy** | ** ** | **Settlement  Administration** | ** ** | **Total** | ** ** |
|                                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue:                                          |       |                                                               |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                                                  | 15,104     |   | $ | 13,180 |   | $ | 23,548 |   | $ | 51,832 |   |
| Operating  revenue from reimbursed direct costs   |       | 30                                                                 |       | 946 |   | 6,075 |   | 7,051 |   |
| Total revenue                                     |       | 15,134                                                             |       | 14,126 |   | 29,623 |   | 58,883 |   |
|                                              |       |                                                               |       |   |   |   |   |   |   |
| Direct costs,  general and administrative costs   |       | 8,452                                                              |       | 7,435 |   | 22,922 |   | 38,809 |   |
| Segment  performance measure                      |       | $                                                                  | 6,682      |   | $ | 6,691 |   | $ | 6,701 |   | $ | 20,074 |   |

 

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| ** **                                        | ** ** | **Three Months Ended September 30, 2007** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic  Discovery**                                          | ** ** | **Bankruptcy** | ** ** | **Settlement  Administration** | ** ** | **Total** | ** ** |
|                                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue:                                          |       |                                                               |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                                                  | 13,003     |   | $ | 14,868 |   | $ | 11,314 |   | $ | 39,185 |   |
| Operating  revenue from reimbursed direct costs   |       | 24                                                                 |       | 1,083 |   | 4,555 |   | 5,662 |   |
| Total revenue                                     |       | 13,027                                                             |       | 15,951 |   | 15,869 |   | 44,847 |   |
|                                              |       |                                                               |       |   |   |   |   |   |   |
| Direct costs,  general and administrative costs   |       | 6,916                                                              |       | 7,536 |   | 11,691 |   | 26,143 |   |
| Segment  performance measure                      |       | $                                                                  | 6,111      |   | $ | 8,415 |   | $ | 4,178 |   | $ | 18,704 |   |

 

Following is areconciliation of our segment performance measure to income before income taxes(in thousands):

 
| ** **                                            | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                            | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
|                                                  |       |                                                     |       |   |   |
| Segment  performance measure                          |       | $                                                        | 20,074     |   | $ | 18,704 |   |
| Corporate and  unallocated expenses                   |       | (5,435                                                   | )          | (5,216 | ) |
| Share-based  compensation expense                     |       | (1,043                                                   | )          | (795 | ) |
| Depreciation and  software and leasehold amortization |       | (4,273                                                   | )          | (3,272 | ) |
| Amortization of  intangible assets                    |       | (2,271                                                   | )          | (2,352 | ) |
| Other operating  expense                              |       | (1                                                       | )          | (565 | ) |
| Interest expense,  net                                |       | (367                                                     | )          | (2,158 | ) |
| Income before  income taxes                           |       | $                                                        | 6,684      |   | $ | 4,346 |   |

 
| ** **                                        | ** ** | **Nine Months Ended September 30, 2008** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic  Discovery**                                         | ** ** | **Bankruptcy** | ** ** | **Settlement  Administration** | ** ** | **Total** | ** ** |
|                                              |       |                                                              |       |   |   |   |   |   |   |
| Revenue:                                          |       |                                                              |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                                                 | 44,619     |   | $ | 39,043 |   | $ | 69,009 |   | $ | 152,671 |   |
| Operating  revenue from reimbursed direct costs   |       | 151                                                               |       | 2,647 |   | 17,267 |   | 20,065 |   |
| Total revenue                                     |       | 44,770                                                            |       | 41,690 |   | 86,276 |   | 172,736 |   |
|                                              |       |                                                              |       |   |   |   |   |   |   |
| Direct costs,  general and administrative costs   |       | 23,630                                                            |       | 21,561 |   | 72,816 |   | 118,007 |   |
| Segment  performance measure                      |       | $                                                                 | 21,140     |   | $ | 20,129 |   | $ | 13,460 |   | $ | 54,729 |   |

 

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| ** **                                        | ** ** | **Nine Months Ended September 30, 2007** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Electronic  Discovery**                                         | ** ** | **Bankruptcy** | ** ** | **Settlement  Administration** | ** ** | **Total** | ** ** |
|                                              |       |                                                              |       |   |   |   |   |   |   |
| Revenue:                                          |       |                                                              |       |   |   |   |   |   |   |
| Operating  revenue before reimbursed direct costs |       | $                                                                 | 35,339     |   | $ | 45,913 |   | $ | 31,198 |   | $ | 112,450 |   |
| Operating  revenue from reimbursed direct costs   |       | 49                                                                |       | 3,633 |   | 14,048 |   | 17,730 |   |
| Total revenue                                     |       | 35,388                                                            |       | 49,546 |   | 45,246 |   | 130,180 |   |
|                                              |       |                                                              |       |   |   |   |   |   |   |
| Direct costs,  general and administrative costs   |       | 17,612                                                            |       | 22,619 |   | 38,035 |   | 78,266 |   |
| Segment  performance measure                      |       | $                                                                 | 17,776     |   | $ | 26,927 |   | $ | 7,211 |   | $ | 51,914 |   |

 

Following is areconciliation of our segment performance measure to income before income taxes(in thousands):

 
| ** **                                            | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                            | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
|                                                  |       |                                                    |       |   |   |
| Segment  performance measure                          |       | $                                                       | 54,729     |   | $ | 51,914 |   |
| Corporate and  unallocated expenses                   |       | (16,263                                                 | )          | (14,816 | ) |
| Share-based  compensation expense                     |       | (2,439                                                  | )          | (1,809 | ) |
| Depreciation and  software and leasehold amortization |       | (11,836                                                 | )          | (9,071 | ) |
| Amortization of  intangible assets                    |       | (6,874                                                  | )          | (7,228 | ) |
| Other operating  income (expense)                     |       | 1,511                                                   |       | (565 | ) |
| Interest  expense, net                                |       | (1,119                                                  | )          | (10,573 | ) |
| Income before  income taxes                           |       | $                                                       | 17,709     |   | $ | 7,852 |   |

 

Following are totalassets by segment (in thousands):

 
| ** **                 | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|----------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                 | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Electronic  Discovery      |       | $                            | 141,877    |                        | $          | 132,030 |   |
| Bankruptcy                 |       | 178,484                      |       | 178,937                     |       |
| Settlement  Administration |       | 67,795                       |       | 52,724                      |       |
| Corporate and  unallocated |       | 21,400                       |       | 29,103                      |       |
| Total  consolidated assets |       | $                            | 409,556    |                        | $          | 392,794 |   |

 

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Following is goodwill bysegment (in thousands):

 
| ** **                 | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|----------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Goodwill**               |       |                         |       |                        |       |
| Electronic  Discovery      |       | $                            | 80,574     |                        | $          | 76,048 |   |
| Bankruptcy                 |       | 151,700                      |       | 151,700                     |       |
| Settlement  Administration |       | 32,984                       |       | 32,936                      |       |
| Total goodwill             |       | $                            | 265,258    |                        | $          | 260,684 |   |

 

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**NOTE 10:   SUPPLEMENTAL CASH FLOW INFORMATION**

 

Supplemental cashflow information is as follows (in thousands):

 
| ** **                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
|                                                                         |       |                                                    |       |   |   |
| Cash paid for:                                                               |       |                                                    |       |   |   |
| Interest                                                                     |       | $                                                       | 2,250      |   | $ | 7,937 |   |
| Income taxes  paid, net                                                      |       | 7,027                                                   |       | 1,253 |   |
| Non-cash  investing and financing transactions:                              |       |                                                    |       |   |   |
| Capitalized  lease obligations incurred                                      |       | —                                                  |       | 2,566 |   |
| Property,  equipment, and leasehold improvements accrued in accounts payable |       | 1,034                                                   |       | 768 |   |
| Obligation  incurred in purchase transactions                                |       | 1,682                                                   |       |   |   |
|                                                                              |            |                                                         |            |  |  |  |  |

 

**NOTE 11:   ACQUISITIONS**

 

On April 4, 2008,our wholly-owned subsidiary, Epiq Systems Holding B.V., acquired all the equityof Uberdevelopments Limited and its wholly-owned operating subsidiary, PinpointGlobal Limited (collectively, “Pinpoint”), an electronic discovery businesswith operations in the United Kingdom. The value of the transaction was $7.1million, consisting of $4.9 million of cash, $1.7 million of deferred paymentsand $0.5 million of capitalized transaction costs. Certain revenue targets weresatisfied as of September 30, 2008, requiring an additional future paymentof £1,000,000 ($1.7 million). The additional payment was recorded as a purchaseprice adjustment. Additionally, if certain other revenue targets are satisfiedprior to the second and third anniversary dates of the agreement, we will berequired to make additional payments. The aggregate amount of such paymentswould be within the range of £160,000 to £400,000 (as of September 30,2008, approximately $0.3 million to $0.7 million) and will be recorded ascompensation expense when the contingency is resolved. The preliminaryallocation of the purchase price is as follows: $0.3 million to net assets,$1.1 million to customer contracts, $1.1 million to non-compete agreements,$0.7 million to establish a deferred tax liability related to the acquiredintangible assets, and $5.3 million to goodwill. The allocation of the purchaseprice to the assets and liabilities acquired will be finalized as necessary, upto one year after the acquisition closing date, when information that is knownto be available or obtainable is obtained. The purchase price in excess of thevalue of the acquired identifiable net assets reflects the strategic value weplaced on Pinpoint as this acquisition facilitates the expansion of ourelectronic discovery business in the United Kingdom.

 

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 the acquiredentities are included within our electronic discovery segment. The pro formaresults of the acquired entities for the period January 1, 2008 throughthe date of acquisition are not material to our consolidated results ofoperations.

 

**NOTE 12:   LEGAL PROCEEDINGS**

 

**Purported Derivative ShareholderComplaints**

 

On July 29, 2008,the Alaska Electrical Pension Fund (“AEPF”) filed a putative shareholderderivative action in the U.S. District Court for the District of Kansas (CivilAction No. 08-CV-2344 CM/JPO), alleging on behalf of Epiq Systems thateach of our current directors and certain current and former executive officersand directors engaged in misconduct regarding stock option grants. A secondshareholder derivative action was filed by Capstone Asset Management Company (“Capstone”)in the U.S. District Court for the District of Kansas on September 9, 2008(Civil Action No. 08-CV-2418 KHV/JPO), against the company and certain ofour current and former officers, employees and directors. In each complaint,the company was named as a nominal defendant. The complaints assert similarclaims, including among other things that the company backdated certain stockoptions from July 1997 through January 2006, and that the individualdefendants either participated in the backdating or permitted it to occur,violations of generally accepted accounting principles as a result of the 

 

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alleged backdating ofoptions, related claims of false and misleading proxy statements and annualreports filed by the company under the Securities Exchange Act of 1934, also asa result of the alleged backdating of options, and various violations of statelaw, breaches of fiduciary duty of loyalty and insider trading in companystock. AEPF is seeking among other things, unspecified money damages, an accountingfor profits obtained from the alleged backdating of options, specified changesin our corporate governance policies, punitive damages and rescission of theallegedly backdated options.

 

On September 29,2008, Capstone voluntarily dismissed their complaint, without prejudice. On October 7,2008, the company and the individual defendants filed a motion to dismiss theAEPF complaint on the following grounds: (i) the plaintiff lacks standingto assert claims regarding any backdating prior to July 31, 2001, i.e.,the date on which plaintiff first claims to have acquired company shares, (ii) applicationof the statutes of limitation that govern plaintiff’s claims reduces plaintiff’scase to a single alleged instance of backdating involving the grant of anoption to a single non-defendant employee on January 3, 2006, (iii) thecomplaint fails to plead sufficient facts to state any plausible claim that thedefendants backdated any stock options and thus fails to meet the minimumpleading requirements established under the Private Securities LitigationReform Act of 1995 or the applicable Federal Rules of Civil Procedure,which failure mandates dismissal of all of plaintiff’s claims, and (iv) thecomplaint fails to meet the pleading standards that apply to any of itsindividual federal and state-law claims, which separately mandate dismissal ofthe entire case.

 

The court has not ruledyet on our motion to dismiss the AEPF complaint. We believe the claims arewithout merit and intend to defend against them vigorously. No amounts havebeen recorded in the accompanying condensed consolidated financial statementsassociated with this matter.

 

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**ITEM 2.    Management’s Discussion and Analysis ofFinancial 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 this Form 10-Q.

 

### **Overview**

 

We are a provider ofintegrated technology solutions for the legal profession. Our solutionsstreamline the administration of bankruptcy, litigation, financial transactionsand regulatory compliance matters. We offer innovative technology solutions forelectronic discovery, document review, legal notification, claimsadministration and controlled disbursement of funds. Our clients include lawfirms, corporate legal departments, bankruptcy trustees and other professionaladvisors who require innovative technology, responsive service and deepsubject-matter expertise.

 

We have three reportingsegments: electronic discovery, bankruptcy, and settlement administration.

 

***Electronic Discovery Segment***

 

Our electronic discoverybusiness provides processing and search and review services to corporations andthe litigation departments of law firms. Our eDataMatrixTM software analyzes,filters, deduplicates and produces documents for review. Produced documents aremade available primarily through a hosted environment, and our DocuMatrixTMsoftware allows for efficient plaintiff and defendant counsel review and datarequests.

 

Our customers aretypically large corporations that use our products and services cooperativelywith their legal counsel to manage the electronic discovery process for complexlitigation matters.

 

The substantial increaseof electronic documents by businesses has changed the dynamics of how attorneyssupport discovery in complex litigation matters. According to the 2008Socha-Gelbmann Electronic Discovery Survey, the 2007 domestic commercialelectronic discovery revenues were estimated at $2.8 billion, an approximate43% increase from 2006. According to this same source, the market is expectedto continue to grow at year over year annual rates of 21% for 2008 and 20% for2009. Due to the complexity of cases, the volume of data that is maintainedelectronically, and the volume of documents that are produced in all types oflitigation, it is anticipated that law firms will become increasingly relianton electronic evidence management systems to organize and manage the litigationdiscovery process.

 

Significant sources of revenue include:

 

·                  Feesrelated to the conversion of data into an organized, searchable electronicdatabase. The amount we earn varies primarily on the size (number of documents)and complexity of the engagement; and

 

·                  Hostingfees based on the amount of data stored.

 

***BankruptcySegment***

 

Our bankruptcy businessprovides solutions that address the needs of Chapter 7, Chapter 11, and Chapter13 bankruptcy trustees to administer bankruptcy proceedings and of debtorcorporations that file a plan of reorganization.

 

·                  Chapter7 is a liquidation bankruptcy for individuals or businesses that, as measuredby the number of new cases filed in 2007, accounted for approximately 60% ofall bankruptcy filings. In a Chapter 7 case, the debtor’s assets are liquidatedand the resulting cash proceeds are used by the Chapter 7 bankruptcy trustee topay creditors. Chapter 7 cases typically last several years.

 

·                  Chapter11 is a reorganization model of bankruptcy for corporations that, as measuredby the number of new cases filed in fiscal 2007, accounted for approximately 1%of all bankruptcy filings. Chapter 11 generally allows a company, oftenreferred to as the debtor-in-possession, to continue operating under a plan ofreorganization to restructure its business and to modify payment terms of bothsecured and unsecured obligations. Chapter 11 cases may last several years. Key

 

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participantsinclude the debtor-in-possession, the debtor’s counsel, the creditors, thecreditors’ counsel, and the bankruptcy judge.

 

·                  Chapter13 is a reorganization model of bankruptcy for individuals that, as measured bythe number of new cases filed in 2007, accounted for approximately 39% of allbankruptcy filings. In a Chapter 13 case, debtors make periodic cash paymentsinto a reorganization plan and a Chapter 13 bankruptcy trustee uses these cashpayments to make monthly distributions to creditors. Chapter 13 cases typicallylast between three and five years.

 

Our end-user customersare debtor corporations that file a plan of reorganization and professionalbankruptcy trustees. TheExecutive Office for United States Trustees, a division of the U.S. Departmentof Justice, appoints all bankruptcy trustees. A United States Trustee isappointed in most federal court districts and generally has responsibility foroverseeing the integrity of the bankruptcy system. The bankruptcy trustee’sprimary responsibilities include liquidating the debtor’s assets or collectingfunds from the debtor, distributing the collected funds to creditors pursuantto the orders of the bankruptcy court and preparing regular status reports forthe Executive Office for United States Trustees and for the bankruptcy court. Trusteesmanage an entire caseload of bankruptcy cases simultaneously.

 

Significant sources of revenue include:

 

·                  Datahosting fees and volume-based fees related to the management of large volumesof electronic data in support of a legal proceeding;

 

·                  Casemanagement professional service fees and other support service fees related tothe administration of cases, including data conversion, claims processing,claims reconciliation, professional consulting services, and settlementadministration;

 

·                  Deposit-basedfees, earned primarily on a percentage of Chapter 7 total liquidated assetsplaced on deposit with a designated financial institution by our trusteeclients, to whom we provide, at no charge, software licenses, limited hardwareand hardware maintenance, and postcontract customer support (PCS) services. Thefees we earn based on total liquidated assets placed on deposit by our trusteeclients may vary based on fluctuations in short-term interest rates;

 

·                  Documentmanagement legal noticing services to parties of interest in bankruptcymatters, including direct notification and media campaign and advertisingmanagement in which we coordinate notification, primarily through print mediaoutlets, to potential parties of interest for a particular client engagement;and

 

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

 

***SettlementAdministration Segment***

 

Our settlementadministration segment provides managed services, including legal notification,claims administration and controlled disbursement.

 

Class action andmass tort refer to litigation in which class representatives bring a lawsuitagainst a defendant company or other persons on behalf of a large group ofsimilarly affected persons (the class). Mass tort refers to class action casesthat are particularly large or prominent. The class action and mass tortmarketplace is significant, with estimated annual tort claim costs ofapproximately $250 billion in 2006, according to an update study issued in 2007by Towers Perrin. Administrative costs, which include costs, other than defensecosts, incurred by either the insurance company or self-insured entity in theadministration of claims, comprise approximately 20% of this total. Keyparticipants in this marketplace include law firms that specialize inrepresenting class action and mass tort plaintiffs and other law firms thatspecialize in representing defendants. Class action and mass tortlitigation is often complex and the cases, including administration of anysettlement, may last several years.

 

Our customers are corporations that are administeringthe settlement or resolution of class action cases. We sell our servicesdirectly to those customers and other interested parties, including legalcounsel, which often provide access to these customers.

 

Significant sources of revenue include:

 

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·                  Feescontingent upon the month-to-month delivery of case management services such asclaims processing, claims reconciliation, professional services, call centersupport, and controlled disbursements. The amount we earn varies primarily onthe size and complexity of the engagement;

 

·                  Legalnoticing services to parties of interest in class action matters, includingmedia campaign and advertising management, in which we coordinate notificationthrough various media outlets, such as print, radio and television, topotential parties of interest for a particular client engagement; and

 

·                Reimbursement for costs incurredrelated to postage on mailing services.

 

**CriticalAccounting Policies**

 

In our Annual Report on Form 10-Kfor the year ended December 31, 2007, we disclose accounting policies,referred to as critical accounting policies, that require management to usesignificant judgment or that require significant estimates. Managementregularly reviews the selection and application of our critical accountingpolicies. There have been no updates to the critical accounting policiescontained in our Annual Report on Form 10-K for the year ended December 31,2007.

 

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**Resultsof Operations for the Three Months Ended September 30, 2008 Compared withthe Three Months Ended September 30, 2007**

 

### **Consolidated Results**

 

### ***Revenue***

 

Total revenue of $58.9million for the three months ended September 30, 2008 increasedapproximately $14.1 million, or 31%, compared to $44.8 million of revenue forthe same period in the prior year.  Aportion of our total revenue consists of reimbursement for direct costs weincur, such as postage related to document management services.  We reflect the operating revenue from thesereimbursed direct costs as a separate line item on our accompanying condensedconsolidated statements of income. Although operating revenue from reimbursed direct costs may fluctuatesignificantly from quarter to quarter, these fluctuations have a minimal effecton our income from operations as we realize little or no margin from thisrevenue.  Operating revenue exclusive ofoperating revenue from reimbursed direct costs, which we refer to as operatingrevenue before reimbursed direct costs, increased approximately 32% to $51.8million for the three months ended September 30, 2008 compared to $39.2million for the same period in the prior year. The increase primarily relates to a $2.1 million increase in electronicdiscovery operating revenue before reimbursed direct costs combined with a$12.2 million increase in settlement administration operating revenue beforereimbursed direct costs, partly offset by a $1.7 million decrease in bankruptcyoperating revenue before reimbursed direct costs.  Changes by segment are discussed below.

 

### ***Operating Expenses***

 

Direct costs of services,exclusive of depreciation and amortization, increased by approximately $10.1million to approximately $19.5 million for the three months ended September 30,2008 compared with $9.4 million during the same period in the prior year.  This increase primarily results from a $6.2million increase in the cost of outside services, primarily related totelephone, mailing and temporary help services, a $1.9 million increase inlegal noticing, and a $0.9 million increase in production supplies.  Changes by segment are discussed below.

 

Direct cost of bundledproducts and services, exclusive of depreciation and amortization, totaledapproximately $0.9 million for the three months ended September 30, 2008compared with $1.0 million during the same period in the prior year.  Changes by segment are discussed below.

 

Reimbursed direct costsincreased by approximately $1.4 million, or 25%, to $7.0 million for the threemonths ended September 30, 2008 compared with $5.6 million during the sameperiod in the prior year.  This increasedirectly corresponds to the increase in operating revenue from reimburseddirect costs.  Changes by segment arediscussed below.

 

General andadministrative costs increased approximately 10% to $17.9 million for the threemonths ended September 30, 2008 compared with $16.2 million for the sameperiod in the prior year.  The increaseis primarily due to a $0.7 million increase in compensation, commission andbenefits expense primarily resulting from expanded staffing to supportincreased operating revenue, a $0.3 million increase related to travel expense,a $0.6 million increase related to professional services, and a $0.2 millionincrease in share-based compensation. Changes by segment are discussed below.

 

Depreciation and softwareand leasehold amortization costs increased approximately 30% to $4.3 millionfor the three months ended September 30, 2008 compared with $3.3 millionfor the same period in the prior year primarily as a result of increasedsoftware amortization and hardware depreciation largely related to increasedcapital expenditures within our electronic discovery segment.

 

Amortization ofidentifiable intangible assets, compared with the same period in the prioryear, decreased to $2.3 million for the three months ended September 30,2008 compared with $2.4 million for the same period in the prior year.  Certain customer contracts and trade namesbecame fully amortized, which were partly offset by an increase in non-competeamortization resulting from our second quarter acquisition of an electronic discoverybusiness in the United Kingdom.

 

Other operating expenses,which include the mark-to-market adjustment for purchased interest rate flooroptions, totaled $0.6 million for the three months ended September 30,2007.  A portion of our bankruptcytrustee pricing is tied to short-term interest rates, and an increase ordecrease in the short-term interest rate may result in corresponding changes inbankruptcy 

 

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trustee revenue.  To mitigate our interest rate risk, duringthe third quarter of 2007 we purchased, for $1.6 million, LIBOR based interestrate floors with strike prices ranging from 1.75% to 2.75% and a notional valueof $800 million.  These instruments werenot designated as accounting hedges.  Atthe end of each period, we estimate the fair value of these instruments and thechange in the market value is recognized as a component of other operating expense.  The adjustment for the three months ended September 30,2007 resulted in recognition of $0.6 million of expense.  During the three months ended March 31,2008, we terminated these interest rate floor options in order to lock in theunrealized gain and, as a result, received cash of approximately $5.1 millionand recognized an incremental gain during the quarter of $2.4 million.

 

***InterestExpense***

 

We recognized interestexpense of $0.4 million for the three months ended September 30, 2008compared with $2.2 million for the same period in the prior year.  The $1.8 million decrease in interest expenseresults primarily from our repayment in the fourth quarter of 2007 of thecredit facility revolving loan with the proceeds of a November 2007 commonstock offering.

 

***IncomeTaxes***

 

Our tax expense as apercent of pre-tax income was 40.2% during the three months ended September 30,2008 compared with tax expense as a percent of pre-tax income of 44.2% for thesame period in the prior year.  Thedecrease in our effective tax rate compared with the same period in the prioryear is due primarily to recording in 2008 discrete adjustments relating torecognizing $0.2 million of previously unrecognized tax benefits and adjusting2007 tax credits to what was claimed on our return.  During the third quarter 2008, we alsoreduced our overall estimated tax rate to reflect a greater mix of our incomebeing taxed in lower state tax jurisdictions compared to 2007.  Our tax rate is higher than the statutoryfederal rate of 35% primarily due to state taxes.  We have significant operations located in NewYork City that are subject to state and local tax rates that are higher thanthe tax rates assessed by other jurisdictions where we operate.

 

It is reasonably possiblethat we will recognize approximately $1.0 million of previously unrecognizedtax benefits as a result of anticipated lapses in the statute of limitationsduring 2009 within twelve months of our reporting date.  If recognized, the $1.0 million of taxbenefits would affect the effective tax rate in 2009.

 

***NetIncome***

 

Our net income wasapproximately $4.0 million for the three months ended September 30, 2008compared with net income of approximately $2.4 million for the same period inthe prior year. The $1.6 million increase is primarily the result of a $12.6million increase in operating revenue before reimbursed direct costs, a $1.8million decrease in interest expense and a $0.6 million decrease in otheroperating expenses during the three months ended September 30, 2008compared with the same period in the prior year, partly offset by a $10.2million increase in direct cost of services, a $1.7 million increase in generaland administrative expenses, a $1.0 million increase in depreciation andsoftware amortization, and a $0.8 million increase in income tax expense duringthe three months ended September 30, 2008 compared with the same period inthe prior year.

 

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***ElectronicDiscovery Segment***

 

Electronic discoveryoperating revenue before reimbursed direct costs increased $2.1 million, orapproximately 16%, to $15.1 million for the three months ended September 30,2008 compared to $13.0 million for the same period in the prior year.  This increase is primarily attributable toadditional projects from existing clients as well as an expansion of our clientbase, resulting in an increase in hosting and processing revenue of approximately$2.1 million.

 

Electronic discoverydirect and administrative expenses increased approximately 23% to $8.5 millionfor the three months ended September 30, 2008 compared with approximately$6.9 million for the same period in the prior year.  This increase is primarily a result of a $1.3million increase in compensation, commission and benefits expense resultingfrom expanded staffing to support increased operating revenue, and a $0.1million increase in bad debt expense.

 

***BankruptcySegment***

 

Bankruptcy operatingrevenue before reimbursed direct costs decreased approximately $1.7 million, or11%, to $13.2 million for the three months ended September 30, 2008compared to $14.9 million for the same period in the prior year.  This decrease is primarily the result of a$2.2 million decrease in our deposit-based fees resulting primarily from adecline in short-term interest rates combined with lower bankruptcy depositscompared to the prior year, a $0.7 million decrease in noticing and claimspreference services, partly offset by a $1.0 million increase in professionalservices.  Revenue from our bankruptcytrustee business could continue to be lower with comparable periods in theprior year if short-term interest rates remain at current levels.  This effect could be partly mitigated by anincrease in bankruptcy filings which could result in an increase in thebankruptcy trustee deposit portfolio. Noticing services depend on the timing of a case and will fluctuate fromperiod to period.  The professionalservices increase results primarily from an increase in Chapter 11 bankruptcyretentions.

 

Bankruptcy direct andadministrative expenses decreased approximately $0.1 million to $7.4 millionfor the three months ended September 30, 2008 compared with approximately$7.5 million in the same period in the prior year.  This decrease is primarily attributable to a$0.3 million decrease in compensation costs, and a $0.1 million decrease inreimbursed expenses, partly offset by a $0.3 million increase in outside productioncosts and services.

 

***Settlement AdministrationSegment***

 

Settlement administrationoperating revenue before reimbursed direct costs increased approximately 108%,to $23.5 million for the three months ended September 30, 2008 compared to$11.3 million for the same period in the prior year.  This increase is primarily the result of a$9.2 million increase in call center revenue and direct mailing revenue,primarily related to a large contract, a $3.5 million increase in professionalservices, and a $2.1 million increase in legal notification revenue, partlyoffset by a $2.4 million decrease in transaction processing revenue.

 

Settlement administrationdirect and administrative expenses, including reimbursed direct costs,increased $11.2 million, or approximately 96%, to $22.9 million for the threemonths ended September 30, 2008 compared to $11.7 million for the sameperiod in the prior year.  This increaseis primarily the result of a $7.0 million increase in call center, outsideservice, and mailing supplies costs to support the large contract referencedabove, a $1.9 million increase in the cost of legal noticing that is directlyrelated to the increase in legal noticing revenue, a $1.5 million increase inreimbursable expenses, and a $0.4 million increase in compensation, commissionand benefit expense.

 

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**Resultsof Operations for the Nine Months Ended September 30, 2008 Compared withthe Nine Months Ended September 30, 2007**

 

### **Consolidated Results**

 

### ***Revenue***

 

Total revenue of $172.7million for the nine months ended September 30, 2008 increasedapproximately 33% compared to $130.2 million of revenue for the same period inthe prior year.  A portion of our totalrevenue consists of reimbursement for direct costs we incur, such as postagerelated to document management services. We reflect the operating revenue from these reimbursed direct costs as aseparate line item on our accompanying condensed consolidated statements ofincome.  Although reimbursed operatingrevenue may fluctuate significantly from quarter to quarter, these fluctuationshave a minimal effect on our income from operations as we realize little or nomargin from this revenue.  Operating revenueexclusive of operating revenue from reimbursed direct costs, which we refer toas operating revenue before reimbursed direct costs, increased approximately36% to $152.7 million for the nine months ended September 30, 2008compared to $112.5 million for the same period in the prior year.  The increase primarily relates to a $9.3million increase in electronic discovery operating revenue before reimburseddirect costs combined with a $37.8 million increase in settlementadministration operating revenue before reimbursed direct costs, partly offsetby a $6.9 million decrease in bankruptcy operating revenue before reimburseddirect costs.  Changes by segment arediscussed below.

 

### ***Operating Expenses***

 

Direct costs of services,exclusive of depreciation and amortization, increased by approximately 109% to$62.8 million for the nine months ended September 30, 2008 compared with$30.1 million during the same period in the prior year.  This increase primarily results from a $20.4million increase in the cost of outside services, primarily related totelephone, mailing and temporary help services, a $6.3 million increase inlegal noticing, and a $3.0 million increase in production supplies.  Changes by segment are discussed below.

 

Direct cost of bundledproducts and services, exclusive of depreciation and amortization, wereapproximately $2.8 million for both the nine months ended September 30,2008 and September 30, 2007. Changes by segment are discussed below.

 

Reimbursed direct costsincreased to $20.0 million for the nine months ended September 30, 2008compared with $17.6 million during the same period in the prior year.  This increase directly corresponds to theincrease in operating revenue from reimbursed direct costs.  Changes by segment are discussed below.

 

General andadministrative costs increased by approximately $6.8 million, or 15%, to $51.2million for the nine months ended September 30, 2008 compared with $44.4million for the same period in the prior year. The increase is primarily due to a $1.7 million increase incompensation, commission and benefits expense primarily resulting from expandedstaffing, a $1.7 million increase related to travel expense, a $1.5 millionincrease related to professional services, a $0.8 million increase in bad debt expense,and a $0.5 million increase in share-based compensation.  Changes by segment are discussed below.

 

Depreciation and softwareand leasehold amortization costs increased approximately $2.7 million, or 30%,to $11.8 million for the nine months ended September 30, 2008 comparedwith $9.1 million for the same period in the prior year primarily as a resultof increased software amortization expense and increased hardware depreciationlargely related to our electronic discovery segment.

 

Amortization of identifiableintangible assets decreased by approximately $0.3 million, or 4%, to $6.9million for the nine months ended September 30, 2008 compared with $7.2million for the same period in the prior year, primarily as a result of certaincustomer contracts and trade names that became fully amortized, partly offsetby an increase in non-compete amortization resulting from our second quarteracquisition of an electronic discovery business in the United Kingdom.

 

Other operating income of$1.5 million includes a $2.4 million gain related to interest rate flooroptions purchased during 2007, partly offset by $0.9 million of acquisitionrelated expenses consisting of non-capitalized acquisition related expenses forlegal services, executive compensation, indirect and general costs, accountingservices, and valuation services related to the second quarter acquisition ofan electronic discovery business in the United Kingdom.  We did not incur any acquisition 

 

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related expenses duringthe nine months ended September 30, 2007. A portion of our bankruptcy trustee pricing is tied to short-terminterest rates, and an increase or decrease in the short-term interest rate mayresult in corresponding changes in bankruptcy trustee revenue.  To mitigate our interest rate risk, duringthe third quarter of 2007 we purchased, for $1.6 million, LIBOR based interestrate floors with strike prices ranging from 1.75% to 2.75% and a notional valueof $800 million.  These instruments werenot designated as accounting hedges.  Atthe end of each period, we estimate the fair value of these instruments and thechange in market value is recognized as a component of other operatingincome.  The adjustment for the yearended December 31, 2007 resulted in the recognition of $1.1 million ofincome.  During the three months ended March 31,2008, we terminated these interestrate floor options in order to lock in the gain and, as a result, received cashof approximately $5.1 million and recognized an incremental gain during thequarter of $2.4 million.  Otheroperating expense of $0.6 million for the nine months ended September 30,2007 is a result of the mark-to-market adjustment for purchased interest ratefloor options.

 

***InterestExpense***

 

We recognized interestexpense of $1.1 million for the nine months ended September 30, 2008compared with $10.6 million for the same period in the prior year.  The $9.5 million decrease is primarilyrelated to a $5.4 million decrease in interest expense related to our creditfacility, a $3.2 million decrease in expense related to the value of oursubordinated convertible note holders’ option to extend the maturity of the subordinatedconvertible notes from June 15, 2007 to June 15, 2010, and a $0.5million decrease in loan fee amortization. The fair value of the option to extend maturity was derived primarilyfrom the estimated future cash flows related to the payment of the 4% interestfor an additional three years. Accordingly, during the nine months ended September 30, 2007, theadjustment to the fair value of the option resulted in recognition of $2.0million of interest expense.  During April 2007,the holders of the contingent convertible subordinated notes exercised theirright to extend the maturity of the convertible notes.  As a result, we will continue to payinterest, at a rate of 4% per annum, during the extension period on anyconvertible notes that remain outstanding (the holders of the convertible notesmay chose at any time to convert some or all of the notes into our commonshares — see note 5 of the notes to the condensed consolidated financialstatements for additional information regarding this conversion right).  We estimated the fair value of the optionimmediately prior to the note holders’ vote to extend and recorded a finaladjustment to the fair value of the option to extend the subordinatedconvertible notes’ maturity.  We arecurrently amortizing the exercise date fair value of the option as a reductionto interest expense over the term of the extension.  During the nine months ended September 30,2008, we recognized a reduction to interest expense of approximately $1.2million related to the amortization of the carrying value of the option toextend the maturity term subsequent to the extension date.  The $5.4 million decrease in credit facilityinterest expense results from our repayment and termination of the creditfacility term loan and the repayment in full of the credit facility revolvingloan during 2007 with the proceeds of a common stock offering in November 2007.  The $0.5 million decrease in loanamortization expense is primarily the result of the completion of theamortization of fees related to the contingent convertible subordinated debtand the credit facility term loan during 2007.

 

***IncomeTaxes***

 

Our income tax expense asa percent of pre-tax income was 44.6% during the nine months ended September 30,2008 compared with tax expense as a percent of pre-tax income of 44.4% for thesame period in the prior year.  Theincrease in our effective tax rate compared with the same period in the prioryear is due primarily to recording in 2008 additional uncertain tax positionsrelated to FIN 48 state taxes and to reduced tax benefits realized on theexercise of incentive stock options.  Ourtax rate is higher than the statutory federal rate of 35% primarily due tostate taxes.  We have significantoperations located in New York City that are subject to state and local taxrates that are higher than the tax rates assessed by other jurisdictions wherewe operate.

 

It is reasonably possiblethat we will recognize approximately $1.0 million of previously unrecognizedtax benefits as a result of anticipated lapses in the statute of limitationsduring 2009 within twelve months of our reporting date.  If recognized, the $1.0 million of taxbenefits would affect the effective tax rate in 2009.

 

***NetIncome***

 

Our net income wasapproximately $9.8 million for the nine months ended September 30, 2008compared with net income of approximately $4.4 million for the same period inthe prior year.  The $5.4 millionincrease is primarily the result of a $40.2 million increase in operatingrevenue before reimbursed direct costs, a $9.5 million decrease in net interestexpense, and the 

 

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recognition of a $2.4million gain on the termination of the interest rate floor instruments, partlyoffset by an $32.7 million increase in direct cost of services, a $6.8 millionincrease in general and administrative expenses, a $4.4 million increase inincome tax expense, a $2.7 million increase in depreciation and softwareamortization, and a $0.9 million increase in other operating expenses duringthe nine months ended September 30, 2008 compared with the same period inthe prior year.

 

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***ElectronicDiscovery Segment***

 

Electronic discoveryoperating revenue before reimbursed direct costs increased $9.3 million, orapproximately 26%, to $44.6 million for the nine months ended September 30,2008 compared to $35.3 million for the same period in the prior year.  This increase is primarily attributable toadditional projects from existing clients as well as an expansion of our clientbase, resulting in an increase in hosting and processing revenue ofapproximately $9.1 million and a $0.2 million increase in professionalservices.

 

Electronic discoverydirect and administrative expenses increased approximately 34% to $23.6 millionfor the nine months ended September 30, 2008 compared with $17.6 millionfor the same period in the prior year. This increase is primarily a result of a $3.5 million increase incompensation, commission and benefits expense resulting from expanded staffingto support increased operating revenue, a $0.6 million increase in softwaresupport costs, a $0.5 million increase in building and equipment lease expense,primarily related to data center expansion, a $0.3 million increase inprofessional services, a $0.3 million increase in bad debt expense, a $0.2million increase in promotion expense, and a $0.1 million increase inreimbursed expenses.

 

***BankruptcySegment***

 

Bankruptcy operatingrevenue before reimbursed direct costs decreased 15% to $39.0 million for thenine months ended September 30, 2008 compared to $45.9 million for thesame period in the prior year.  Thisdecrease is primarily the result of $5.9 million decrease in our bankruptcytrustee deposit-based fees and a $1.7 million decrease in noticing services,partly offset by a $0.9 million increase in professional services.  The $5.9 million decrease in bankruptcytrustee deposit fees results primarily from a decline in short-term interestrates combined with lower bankruptcy deposits. Revenue from our bankruptcy trustee business could continue to be lowerwith comparable periods in the prior year if short-term interest rates do notincrease.  This effect could be partlymitigated by an increase in bankruptcy trustee revenue as an increase in bankruptcyfilings which could result in an increase in the bankruptcy trustee depositportfolio.  Noticing services depend onthe timing of a case and will fluctuate from period to period.

 

Bankruptcy direct andadministrative expenses decreased approximately $1.0 million, or approximately4%, to approximately $21.6 million for the nine months ended September 30,2008 compared with approximately $22.6 million in the same period in the prioryear. This decrease is primarily attributable to a $1.0 million decrease inreimbursed expenses and a $1.0 million decrease in compensation costs, partlyoffset by a $0.7 million increase in bad debt expense.

 

***SettlementAdministration Segment***

 

Settlement administrationoperating revenue before reimbursed direct costs increased $37.8 million, orapproximately 121%, to $69.0 million for the nine months ended September 30,2008 compared to $31.2 million for the same period in the prior year. Thisincrease is primarily the result of a $29.7 million increase in call centerrevenue and direct mailing revenue, primarily related to a large contract, a$7.2 million increase in legal notification revenue resulting from severallarge cases, and a $5.9 million increase in professional services, partlyoffset by a $3.9 million decrease in transaction processing revenue.

 

Settlement administrationdirect and administrative expenses, including reimbursed direct costs,increased approximately $34.8 million, or 92%, to $72.8 million for the ninemonths ended September 30, 2008 compared to $38.0 million for the sameperiod in the prior year.  This increaseis primarily the result of a $23.4 million increase in call center, outsideservice, and mailing supplies costs to support the large contract referencedabove, a $6.3 million increase in the cost of legal noticing that is directlyrelated to the increase in legal noticing revenue, a $3.3 million increase inreimbursable expenses, a $0.7 million increase in compensation, commissions andbenefits, and a $0.6 million increase in outside services.

 

**Liquidity and Capital Resources**

 

***OperatingActivities***

 

During the nine monthsended September 30, 2008, our operating activities provided net cash ofapproximately $18.1 million.  The primarysources of cash from operating activities was net income of $9.8 million,adjusted for non-cash charges and credits, primarily depreciation andamortization, of $21.3 million, and changes in operating assets and liabilitiesthat 

 

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decreased our operatingcash flow by $13.0 million, primarily as a result of an increase in accountsreceivable, which is a use of cash, partly offset by increases in accountspayable and income taxes, which represent sources of cash.  Trade accounts receivable increasedapproximately $19.3 million, primarily related to an increase related to alarge settlements administration customer. Trade accounts receivable will fluctuate from period to period dependingon the timing of sales and collections. Accounts payable and other liabilities increased approximately $4.7million, primarily related to costs associated with servicing a largesettlements administration customer. Accounts payable will fluctuate from period to period depending on thetiming of purchases and payments.  Theeffect of income taxes will fluctuate from period to period depending on theaccrual related to the current tax expense and the timing of estimated taxpayments made or refunds received.

 

***InvestingActivities***

 

During the nine monthsended September 30, 2008, we used cash of approximately $12.9 million forpurchases of property and equipment, primarily computer hardware and purchasedsoftware licenses for our electronic discovery business and purchased computerhardware for our bankruptcy trustee business. Enhancements to our existing software and development of new software isessential to our continued growth and, during the nine months ended September 30,2008, we used cash of approximately $4.6 million to fund internal costs relatedto development of software for which technological feasibility has beenestablished.  We also used cash of $4.8million to fund the acquisition of an electronic discovery business located inthe United Kingdom.  We anticipate thatcash generated from operations will be adequate to fund our anticipatedproperty, equipment and software spending for the foreseeable future.

 

***FinancingActivities***

 

During the nine monthsended September 30, 2008, we used cash to pay approximately $2.6 millionas a principal reduction on our deferred acquisition notes and $0.8 million inclosing costs as part of our amended credit facility.  This financing use of cash was partly offsetby $1.8 million of net proceeds from stock issued in connection with the exerciseof employee stock options.  We alsorecognized a portion of the tax benefit related to the exercise of stockoptions as a financing source of cash.

 

As of September 30,2008, our indebtedness consisted of $52.7 million (including the fair value of theembedded option) from the contingent convertible subordinated notes, whichbears interest at 4% based on the $50.0 million principal amount, andapproximately $6.1 million of obligations related to capitalized leases anddeferred acquisition price.  During 2007,the term of our contingent convertible subordinated notes was extended to June 2010.  The notes will require use of $50.0 millionof cash at the extended maturity date if the note holders do not convert thenotes into shares of our common stock. The holders of the contingent convertible subordinated notes have theright to convert at a price of approximately $11.67 per share.  If any or all the notes are converted intoshares of our common stock prior to the scheduled maturity of those notes, thenthere will be no cash requirements associated with those converted notes, otherthan the regular payment of interest earned prior to the conversion date.

 

As of September 30,2008, we did not have any borrowings under our $100.0 million senior revolvingloan.  During the term of the creditfacility, we have the right, subject to compliance with our covenants, toincrease the senior revolving loan to $175.0 million.  Interest on the credit facility is generallybased on a spread, not to exceed 325 basis points, over the LIBOR rate.  As of September 30, 2008, significantcovenants, all as defined within our credit facility agreement, include aleverage ratio not to exceed 3.00 to 1.00, a fixed charge coverage ratio of notless than 1.25 to 1.00, and a current ratio of not less than 1.50 to 1.00.  As of September 30, 2008, we were incompliance with all financial covenants.

 

Covenants contained in our credit facility and in ourcontingent convertible subordinated notes include limitations to consummate anacquisition should we pursue acquisitions in the future.  Pursuant to the terms of our credit facility,we generally cannot incur indebtedness outside the credit facility, with theexceptions of capital leases and subordinated debt, with a limit of $100.0 millionof aggregate subordinated debt. Furthermore, for any acquisition we must be able to demonstrate that, ona pro forma basis, we would be in compliance with our covenants during the fourquarters prior to the acquisition and bank permission must be obtained for anyacquisition for which cash consideration exceeds $80.0 million or totalconsideration exceeds $125.0 million.

 

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**Off-balance Sheet Arrangements**

 

We generally do not utilize off-balance sheetarrangements in our operations; however, we enter into operating leases in thenormal course of business.  Our operatinglease obligations are disclosed in note 6 of the notes to consolidatedfinancial statements contained in our Annual Report on Form 10-K for theyear ended December 31, 2007.

 

**Recent Accounting Pronouncements**

 

In September 2006, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 157,*Fair Value Measurements*, (SFAS157).  SFAS 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.  SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 andinterim periods within those fiscal years. The adoption of SFAS 157 as of January 1, 2008 did not have amaterial impact on our financial position, results of operations, or cashflows.  In February 2008, FASBissued Staff Position 157-1, *Application of FASBStatement No. 157 to FASB Statement No. 13 and Other AccountingPronouncements That Address Fair Value Measurements for Purposes of LeaseClassification or Measurement under Statement 13* (FSP 157-1).  FSP 157-1 excludes from the scope of SFAS 157accounting pronouncements that address fair value measurements for purposes oflease classification or measurement.  Thisscope exception does not apply to assets acquired and liabilities assumed in abusiness combination that are required to be measured at fair value, regardlessof whether those assets and liabilities are related to leases.  FSP 157-1 was effective upon the initialadoption of SFAS 157.  Adoption of FSP157-1 as of January 1, 2008 did not have a material impact on ourfinancial position, results of operations, or cash flows.  In February 2008, FASB issued StaffPosition 157-2, *Effective Date of FASB Statement No. 157*,(FSP 157-2) which, as of February 12, 2008, indefinitely delayed theeffective date of SFAS 157 for nonfinancial assets and nonfinancialliabilities, except for items that are recognized or disclosed at fair value inthe financial statements on a recurring basis. Management is still evaluating the impact, if any, that the adoption ofFSP 157-2 will have on our financial position, results of operations, or cashflows.

 

In December 2007, FASB issued Statement ofFinancial Accounting Standards No. 141(R), *Business**Combinations* (SFAS 141(R)).  SFAS 141(R) establishes guidelines forthe recognition and measurement of assets, liabilities and equity in businesscombinations.  SFAS 141(R) iseffective for financial statements issued for fiscal years beginning after December 15,2008.  Management is still evaluating theimpact, if any, that the adoption of SFAS 141(R) will have on ourfinancial position, results of operations, or cash flows.

 

In December 2007, FASB issued Statement ofFinancial Accounting Standards No, 160, *Noncontrolling Interest InConsolidated Financial Statements*, (SFAS 160).  SFAS 160 changes the way in whichnoncontrolling interests in subsidiaries are measured and classified on thebalance sheet.  SFAS 160 is effective forfinancial statements issued for fiscal years beginning after December 15,2008.  Management anticipates that theadoption of SFAS 160 will not have a material effect on our financial position,results of operations, or cash flows.

 

In March 2008, FASB issued Statement of FinancialAccounting Standards No. 161, *Disclosures AboutInstruments and Hedging Activities* – amendment of FASB Statement No. 133(SFAS 161).  SFAS 161 changes thedisclosure requirements for derivative instruments and hedging activities.  SFAS 161 is effective for financialstatements issued for fiscal years beginning after November 15, 2008.  As SFAS 161 relates only to disclosure,management anticipates that the adoption of SFAS 161 will not have a materialeffect on our financial position, results of operations, or cash flows.

 

In May, 2008, FASB issued Statement of FinancialAccounting Standards No. 162, *The Hierarchy of GenerallyAccepted Accounting Principle* (SFAS 162).  SFAS 162 identifies the sources of accountingprinciples and the framework for selecting the principles used in thepreparation of financial statements of nongovernmental entities that arepresented in conformity with generally accepted accounting principals.  SFAS 162 is effective 60 days following theSEC’s approval of the PCAOB’s amendments to U.S. Auditing Standards (AU) Section 411,*The Meaning**of PresentFairly in Conformity With Generally Accepted Accounting Principles*.  Management is still evaluating the impact, ifany, that the adoption of SFAS 162 will have on our financial position, resultsof operations, or cash flows.

 

In June, 2008, FASBissued Statement of Financial Accounting Standards No. 163, *Accounting for Financial Guarantee**InsuranceContracts*.  SFAS 163 requiresthat an insurance enterprise recognize a claim liability prior to an event ofdefault when there is evidence that credit deterioration has occurred in aninsured financial obligation.  SFAS 163is effective for 

 

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financial statementsissued for fiscal years beginning after December 15, 2008.  Management anticipates that the adoption ofSFAS 163 will not have a material effect on our financial position, results ofoperations, or cash flows.

 

In April 2008, FASB issued FSP FAS142-3, *Determination of the Useful Life of Intangible Assets*.  FSP FAS 142-3 provides guidance ondetermining the useful life of a recognized intangible asset.  FSP FAS 142-3 is effective for financialstatements issued for fiscal years beginning after December 15, 2008.  Management is still evaluating the impact, ifany, that the adoption of FSP FAS142-3 will have on our financial position,results of operations, or cash flows.

 

**Forward-Looking Statements**

 

In this report, in otherfilings with the SEC and in press releases and other public statements by ourofficers throughout the year, Epiq Systems, Inc. makes or will makestatements that plan for or anticipate the future.  These forward-looking statements includestatements about our future business plans and strategies, and other statementsthat are not historical in nature.  Theseforward-looking statements are based on our current expectations.  In this Quarterly Report on Form 10-Q,we make statements that plan for or anticipate the future.  Many of these 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 of1933, as amended, 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 thatcould cause actual results and experience to differ materially from the anticipatedresults or other expectations expressed in our forward-looking statements.  These factors include (1) any materialchanges in our total number of client engagements and the volume associatedwith each engagement, (2) any material changes in our client’s depositportfolio or the services required or selected by our clients in engagements, (3) materialchanges in the number of bankruptcy filings, class action filings or mass tortactions each year, (4) risks associated with handling of confidential dataand compliance with information privacy laws, (5) changes in or theeffects of pricing structures and arrangements, (6) risks associated withthe integration of acquisitions into our existing business operations, (7) risksassociated with our indebtedness, (8) risks associated with the applicationof complex accounting rules to unique transactions, including the riskthat good faith application of those rules and audits of those results maybe later reversed by new interpretations of those rules or new viewsregarding the application of those rules, and (9) other risks detailedfrom time to time in our SEC filings, including our annual report on Form 10-K.  In addition, there may be other factors notincluded in our SEC filings that may cause actual results to differ materiallyfrom any forward-looking statements. We undertake no obligations to update anyforward-looking statements contained herein to reflect future events ordevelopments.

 

**ITEM 3.          Quantitativeand Qualitative Disclosures About Market Risk.**

 

The principal marketrisks to which we are exposed include interest rates under our senior revolvingcredit facility, foreign exchange rates giving rise to translation, andfluctuations in short-term interest rates on a portion of our bankruptcytrustee revenue.

 

Interest on our seniorrevolving credit facility is generally based on a spread, not to exceed 325basis points over the LIBOR rate. There were no amounts due under our seniorrevolving credit facility as of September 30, 2008, thereby we had nomarket risk exposure.

 

We have limitedoperations in London, therefore, a portion of our revenues and expenses areincurred in a currency other than U.S. dollars.   We do not utilizehedge instruments to manage the exposures associated with fluctuating currencyexchange rates.  The company’s operatingresults are exposed to changes in exchange rates between the U.S. dollar andthe British Pound.  When the U.S. dollarweakens against foreign currencies, the dollar value of revenues and expensesdenominated in foreign currencies increases. When the U.S. dollar strengthens, the opposite situation occurs.

 

As of December 31,2007 we had market risk exposure to interest rates as we held interest ratefloor options with a notional value of $800 million.  During February 2008,we sold the interest rate floor options and realized a $3.5 million gain,thereby eliminating our market risk exposure related to theseinstruments.  We currently do not hold any interest rate floor options orother derivatives.

 

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**ITEM 4.          Controlsand Procedures.**

 

***DisclosureControls and Procedures***

 

Anevaluation was carried out by the Epiq Systems, Inc.’s Chief ExecutiveOfficer and Chief Financial Officer of the effectiveness of the design andoperations of the company’s disclosure controls and procedures as defined inExchange Act Rule 13a-15(e).  Basedon this evaluation, our management, including the CEO and CFO, concluded thatour disclosure controls and procedures are effective.  Disclosure controls and procedures aredesigned to ensure that information required to be disclosed by the company inits periodic filings with the SEC is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules andforms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by the company in the reportsthat it files or submits to the SEC is accumulated and communicated to company’smanagement, including its principal executive and principal financial officers,or persons performing similar functions, as appropriate to allow timelydecisions regarding required disclosure.

 

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

 

Therehave been no changes in our internal controls over financial reporting duringthe quarter ended September 30, 2008, that have materially affected, orare reasonably likely to materially affect, our internal controls overfinancial reporting.

 

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**PART II- OTHER INFORMATION.**

 

**ITEM 1**.          **LegalProceedings.**

 

On July 29, 2008,the Alaska Electrical Pension Fund (“AEPF”) filed a putative shareholderderivative action in the U.S. District Court for the District of Kansas (CivilAction No. 08-CV-2344 CM/JPO), alleging on behalf of Epiq Systems thateach of our current directors and certain current and former executive officersand directors engaged in misconduct regarding stock option grants.  A second shareholder derivative action wasfiled by Capstone Asset Management Company (“Capstone”) in the U.S. DistrictCourt for the District of Kansas on September 9, 2008 (Civil Action No. 08-CV-2418KHV/JPO), against the company and certain of our current and former officers,employees and directors.  In eachcomplaint, the company was named as a nominal defendant.  The complaints assert similar claims,including among other things that the company backdated certain stock optionsfrom July 1997 through January 2006, and that the individualdefendants either participated in the backdating or permitted it to occur,violations of generally accepted accounting principles as a result of thealleged backdating of options, related claims of false and misleading proxystatements and annual reports filed by the company under the SecuritiesExchange Act of 1934, also as a result of the alleged backdating of options,and various violations of state law, breaches of fiduciary duty of loyalty andinsider trading in company stock.  AEPFis seeking among other things, unspecified money damages, an accounting forprofits obtained from the alleged backdating of options, specified changes inour corporate governance policies, punitive damages and rescission of theallegedly backdated options.

 

On September 29,2008, Capstone voluntarily dismissed their complaint, without prejudice.  On October 7, 2008, the company and theindividual defendants filed a motion to dismiss the AEPF complaint on thefollowing grounds: (i) the plaintiff lacks standing to assert claimsregarding any backdating prior to July 31, 2001, i.e., the date on whichplaintiff first claims to have acquired company shares, (ii) applicationof the statutes of limitation that govern plaintiff’s claims reduces plaintiff’scase to a single alleged instance of backdating involving the grant of anoption to a single non-defendant employee on January 3, 2006, (iii) thecomplaint fails to plead sufficient facts to state any plausible claim that thedefendants backdated any stock options and thus fails to meet the minimumpleading requirements established under the Private Securities LitigationReform Act of 1995 or the applicable Federal Rules of Civil Procedure,which failure mandates dismissal of all of plaintiff’s claims, and (iv) thecomplaint fails to meet the pleading standards that apply to any of itsindividual federal and state-law claims, which separately mandate dismissal ofthe entire case.

 

The court has not ruledyet on our motion to dismiss the AEPF complaint.  We believe the claims are without merit andintend to defend against them vigorously. No amounts have been recorded in the accompanying condensed consolidatedfinancial statements associated with this matter.

 

**ITEM 1A**.       **RiskFactors.**

 

There have been nomaterial changes in our Risk Factors from those disclosed in our 2007 AnnualReport on Form 10-K.

 

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

 

31.1         Certifications of ChiefExecutive Officer of the Company under Rule 13a-14(a), as adopted pursuantto Section 302 of the Sarbanes-Oxley Act of 2002.

 

31.2         Certifications of ChiefFinancial Officer of the Company under Rule 13a-14(a), as adopted pursuantto Section 302 of the Sarbanes-Oxley Act of 2002.

 

32.1         Certifications of CEO andCFO pursuant to 18 U.S.C. Section 1350.

 

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**SIGNATURES**

 

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

 
| ** ** | ** **            |   |                    | **Epiq Systems, Inc.**                          |
|------------|-----------------------|--------|-------------------------|------------------------------------------------------|
|       |                  |   |                    |                                                 |
| Date:      | October 30, 2008 |   | /s/ Tom W. Olofson      |
|       |                  |   |                    | Tom W. Olofson                                       |
|       |                  |   |                    | Chairman of the Board                                |
|       |                  |   |                    | Chief Executive Officer                              |
|       |                  |   |                    | Director                                             |
|       |                  |   |                    | (Principal Executive  Officer)                       |
|       |                  |   |                    |                                                 |
|       |                  |   |                    |                                                 |
| Date:      | October 30, 2008 |   | /s/ Elizabeth M. Braham |
|       |                  |   |                    | Elizabeth M. Braham                                  |
|       |                  |   |                    | Executive Vice  President, Chief Financial Officer   |
|       |                  |   |                    | (Principal  Financial & Accounting Officer) |

 

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