10-K 1 v140526_10k.htm Unassociated Document


 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

 
Form 10-K

(Mark One)

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008
or

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                        to                        .

Commission File Number 000-30715

CoSine Communications, Inc.
(Exact name of registrant as specified in its charter)

Delaware
94-3280301
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification Number)
   
61 East Main Street, Suite B
Los Gatos, California
95030
(Address of principal executive offices)
(Zip Code)

Registrant’s telephone number including area code:
(408) 399-6494

Securities Registered Pursuant to Section 12(b) of the Act:
None

Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $.0001 Par Value
(Title of each class)

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ¨     No x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes ¨     No x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   ¨

Indicate by check mark whether the Company is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a small reporting company. See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act:

Large accelerated filer ¨
Accelerated filer ¨
   
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Small reporting company x
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes x     No ¨

The aggregate market value of the voting and non voting common equity held by non-affiliates of the Registrant was $11,757,213 based on the number of shares held by non-affiliates as of February 12, 2009, and based on the reported last sale price of common stock on June 30, 2008, which is the last business day of the Registrant’s most recently completed second fiscal quarter. Shares of stock held by officers, directors and 5 percent or more stockholders have been excluded in that such persons may be deemed to be affiliates.  This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of February 12, 2009, there were 10,090,635 shares of the Registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

 Portions of the Proxy Statement for our 2009 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

 
 

 

COSINE COMMUNICATIONS, INC.

FORM 10-K
Year Ended December 31, 2008

TABLE OF CONTENTS

   
Page
     
Part I
     
Item 1.
Business
3
Item 1A
Risk Factors
6
Item 1B
Unresolved Staff Comments
9
Item 2.
Properties
9
Item 3.
Legal Proceedings
9
Item 4.
Submission of Matters to a Vote of Security Holders
10
     
Part II
     
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
10
Item 6.
Selected Financial Data
12
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
13
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
21
Item 8.
Financial Statements and Supplementary Data
22
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
41
Item 9A.
Controls and Procedures
41
Item 9B.
Other Information
42
     
Part III
     
Item 10.
Directors, Executive Officers and Corporate Governance
42
Item 11.
Executive Compensation
42
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
42
Item 13.
Certain Relationships and Related Transactions and Director Independence
42
Item 14.
Principal Accountant Fees and Services
43
     
Part IV
     
Item 15.
Exhibits and Financial Statement Schedules
43
 
Signatures
44
 
Exhibit Index
45

 
2

 

SAFE HARBOR STATEMENT UNDER
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This Annual Report on Form 10-K contains forward-looking statements.  We use words such as "anticipate," "believe," "plan," "expect," "future," "intend" and similar expressions to identify forward-looking statements.  These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements.  Factors that might cause such a difference include, but are not limited to, failure to achieve revenue growth and profitability, our ability to identify and acquire new business operations, the time and costs required to identify and acquire new business operations, management and board interest in and distraction due to identifying and acquiring new business operations, and the reactions, either positive or negative, of investors and others to our strategic direction and to any specific business opportunity selected by us, all as are discussed in more detail in the section entitled "Risk Factors" on pages 7 to 10 of this report, as well as the other risk factors discussed in that section.  Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date hereof.  We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements.  Readers should carefully review the risk factors described in other documents that we file from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that we file in fiscal year 2009.

PART I

Item 1.  Business

Overview

CoSine Communications, Inc. ("CoSine" or the "Company," which may be referred to as "we," "us" or "our") was incorporated in California on April 14, 1997 and in August 2000 was reincorporated in the State of Delaware. We were a provider of carrier network equipment products and services until the fourth quarter of fiscal year 2004 during which time we discontinued our product lines, took actions to lay off most of our employees, terminated contract manufacturing arrangements, contractor and consulting arrangements and various facility leases, and sold, scrapped or wrote-off our inventory, property, and equipment. From the fourth quarter of fiscal year 2004 through December 31, 2006, our business consisted primarily of a customer support capability for our discontinued products provided by a third party. In March 2006, we sold the rights to our patent portfolio, and in November 2006, we sold the remaining intellectual property rights to our carrier network equipment products and services.  We terminated all customer service operations effective December 31, 2006 and do not intend to offer customer support services for our discontinued products in the future.  We are currently attempting to redeploy our existing assets by identifying and acquiring one or more new business operations with existing or prospective taxable earnings that can be offset by use of our net operating loss carry-forwards (“NOLs”). No candidate for acquisition has yet been identified, and no assurance can be given that we will find suitable candidates, and if we do, that we will be able to utilize our existing NOLs.

Current Business

In July 2005 after discontinuing our product lines, we completed a comprehensive review of strategic alternatives, including a sale of the Company, a sale or licensing of intellectual property, a redeployment of our assets into new business ventures, or a winding-up and liquidation of the business and a return of capital.  Our board of directors approved a plan to enhance stockholder value by redeploying our existing assets and resources to identify and acquire one or more new business operations, while continuing to support our existing customers.  With the termination of our customer service operations effective December 31, 2006 our current business involves the redeployment of our existing assets to acquire one or more operating businesses with existing or prospective taxable earnings that can be offset by use of our NOLs.  No candidate for acquisition has yet been identified, and no assurance can be given that we will find suitable candidates, and if we do, that we will be able to utilize our existing NOLs.

To protect our NOLs, on September 1, 2005, we entered into a stockholders rights plan which provided for a dividend distribution of one preferred share purchase right for each outstanding share of our common stock which, when exercisable, would allow its holder to purchase from us one one-hundredth of a share of our Series A Junior Participating Preferred Stock, par value $0.0001, for a purchase price of $3.00. Each fractional share of this preferred stock would give the stockholder approximately the same dividend, voting and liquidation rights as does one share of our common stock.  The purchase rights become exercisable after the acquisition or attempted acquisition of 5% or more of our outstanding common stock without the prior approval of our board of directors. The dividend was paid to our stockholders of record at the close of business on September 12, 2005.  Our board of directors adopted the stockholders rights plan to protect stockholder value by protecting our stockholders from coercive takeover practices or takeover bids that are inconsistent with their best interests, and by protecting our ability to carry forward our NOLs.

 
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On August 31, 2007, we amended the stockholders rights plan. The amendment extends the expiration date of the purchase rights from September 1, 2007 until September 1, 2009, unless earlier redeemed, exchanged, or amended by the board of directors. The amendment was not made in response to any pending takeover bid for us. 

To further protect our NOLs, at our 2005 Annual Meeting of Stockholders, the stockholders approved an amendment to our Certificate of Incorporation.  The amendment restricts certain acquisitions of our securities which could impair or limit our ability to utilize our NOLs. Although the transfer restrictions imposed on our securities are intended to reduce the likelihood of an impermissible ownership change, no assurance can be given that such restrictions would prevent all transfers that would result in an impermissible ownership change. This amendment generally restricts and requires prior approval of our board of directors of direct and indirect acquisitions of our equity securities if such an acquisition will affect the percentage of our capital stock that is treated as owned by a 5% stockholder. The restrictions will generally only affect persons trying to acquire a significant interest in our common stock in order to help assure the preservation of our NOLs.

In efforts to reduce our operating expenses while executing our redeployment strategy, on June 15, 2007, our board of directors approved an agreement (the “Services Agreement”) with SP Corporate Services, LLC (“SP”) pursuant to which SP provides us, on a non-exclusive basis, a full range of executive, financial and administrative support services and personnel, including the services of a Chief Executive Officer, Chief Financial Officer, Secretary, Principal Executive Officer, and Principal Accounting Officer, maintenance of our corporate office and records, periodic reviews of transactions in our stock to assist in preservation of our NOLs, and related executive, financial, accounting, and administrative support services. Under the Services Agreement, we pay SP a monthly fee of $17,000 in exchange for SP's services. SP is responsible for compensating and providing all applicable employment benefits to any SP personnel in connection with providing services under the Services Agreement. We reimburse SP for reasonable and necessary business expenses of ours incurred by SP, and we are responsible for payment of fees related to audit, tax, legal, stock transfer, insurance broker, investment advisor, and banking services provided to us by third party advisors. The Services Agreement has a term of one year and automatically renews for successive one year periods unless otherwise terminated by either party. The Services Agreement is also terminable by us upon the death of Terry R. Gibson or his resignation as our Chief Executive Officer, Chief Financial Officer or Secretary of the Company. Under the Services Agreement, SP and its personnel are entitled to the same limitations on liability and indemnity rights available under our charter documents to any other person performing such services for us. During fiscal year 2007, prior to the effectiveness of the Services Agreement, we incurred approximately $24,500 per month in performing the services which are to be performed by SP under the Services Agreement. The Service Agreement became effective as of July 1, 2007 and was renewed on July 1, 2008.

SP is affiliated with Steel Partners II, L.P., our largest stockholder, by virtue of SP’s President, Warren Lichtenstein, serving as the sole executive officer and managing member of Steel Partners, L.L.C., the general partner of Steel Partners II, L.P. SP is a wholly owned subsidiary of Steel Partners Ltd., also controlled by Mr. Lichtenstein.

Pursuant to the Services Agreement, Terry R. Gibson serves as our Chief Executive Officer, Chief Financial Officer, Secretary, Principal Executive Officer, and Principal Accounting Officer as an employee of SP.  SP is responsible for compensating Mr. Gibson, including providing him with all applicable employment benefits to which he may be entitled, for his serving as our Chief Executive Officer, Chief Financial Officer, Secretary, Principal Executive Officer, and Principal Accounting Officer and for any other services he may provide to us under the Services Agreement.

Prior Business

Until September 2004, we developed, marketed and sold a communications platform designed to enable carrier network service providers to rapidly deliver a portfolio of communications services to business and consumer customers.  We marketed our carrier network products through our direct sales force and through resellers to network service providers in Asia, Europe and North America.

We did not generate sufficient revenue to fund our communications platform product operations and were unable to increase our revenue in order to reduce our cash consumption and remain a viable and competitive supplier of communications platform products.  We formally discontinued our communications platform products in fiscal year 2004 and ceased all our related customer support services as of December 31, 2006.

 
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Products, Services and Technology

Until late 2004, we were a supplier of network carrier products and services.  We formally discontinued our product lines in fiscal year 2004, sold the rights to our patent portfolio in March 2006, sold the remaining rights to our carrier network intellectual property in November 2006 and ceased all our customer support services as of December 31, 2006.

Customers

Effective December 31, 2006, we ceased all customer service operations.  During the year ended December 31, 2006, we recognized revenue from seven customers.  At December 31, 2007 and 2008, we had no customers.

Sales and Marketing

We ceased all sales and marketing activities in September 2004.  We had no sales and marketing employees at December 31, 2008.

Customer Service and Support

Beginning in the fourth quarter of fiscal 2004, we provided transition support services to our existing customers through a third party contractor.  We ceased providing customer support services effective December 31, 2006.  We had no employees in customer service and support at December 31, 2008.

Research and Development

We ceased all research and development activities in September 2004, other than to offer our existing customers transition support services, as provided by a third party contractor through December 31, 2006.   We had no employees in research and development at December 31, 2008.

We have not incurred any research and development expenses for the years ended December 31, 2008, 2007 and 2006, respectively.

Manufacturing

We ceased all manufacturing activities in December 2004 and had no employees in manufacturing at December 31, 2008.

Backlog

Historically, our backlog included purchase orders from customers with approved credit status, representing products and services we planned to deliver within 12 months, plus our then current balance of deferred revenue.  We had no backlog at December 31, 2008, 2007 and 2006.

Competition

With the termination of our customer service operations effective December 31, 2006, our current business involves the redeployment of our existing assets to acquire one or more operating businesses with existing or prospective taxable earnings that can be offset by use of our NOLs.  No candidate for acquisition has yet been identified, and no assurance can be given that we will find suitable candidates, and if we do, that we will be able to utilize our existing NOLs.  We are encountering competition from other entities seeking to acquire profitable businesses.  Such entities include private equity companies, blank check companies, leveraged buyout funds, as well as operating businesses seeking acquisitions.  Many of these entities are well established and have extensive experience identifying and effecting business combinations directly or through affiliates.  Moreover, many of these entities possess greater financial, technical, human, and other resources than us.

 
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Intellectual Property

In March 2006, we sold the rights to our patent portfolio for cash consideration of $180,000, retaining a royalty-free license allowing us to continue to use our former patent portfolio in support of our existing customers.  In November 2006, we sold the remaining intellectual property rights related to our carrier networking products and services for consideration of $80,000, retaining rights to support our existing customers through December 31, 2006.  We ceased providing customer support services effective December 31, 2006.

Employees

We had no employees at December 31, 2008.

Executive Officers of the Registrant

Terry R. Gibson, 55, has served as our Chief Executive Officer since January 16, 2005, as our Secretary since September 23, 2004, and as our Executive Vice President and Chief Financial Officer since joining us in 2002.  Mr. Gibson is a Managing Director of SP, an affiliate of Steel Partners II, L.P., our largest shareholder.  Pursuant to a service agreement between the Company and SP, effective July 1, 2007, Mr. Gibson terminated his employment with us and joined SP as a Managing Director, however, he continues to serve as our Chief Executive Officer, Chief Financial Officer, Secretary, Principal Executive Officer, and Principal Accounting Officer as an employee of SP.  Prior to joining us, Mr. Gibson served as Chief Financial Officer of Calient Networks, Inc. from May 2000 to December 2001.  He served as Chief Financial Officer of Ramp Networks, Inc. from March 1999 to May 2000 and as Chief Financial Officer of GaSonics, International, from June 1996 through March 1999.  He has also served as Vice President and Corporate Controller of Lam Research Corporation from February 1991 through June 1996.  Mr. Gibson holds a B.S. in Accounting from the University of Santa Clara.

Available Information

Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"), as amended, are available, free of charge, on our Investor Relations web site at www.cosinecom.com/investorrelations.aspx as soon as practicable after  such materials are filed with or furnished to the Securities Exchange Commission.  The information posted on our web site is not incorporated into this Annual Report.

Item 1A.  Risk Factors

Our future results and the market price for our stock are subject to numerous risks, many of which are driven by factors that we cannot control or predict. The following discussion, as well as other sections of this Annual Report on Form 10-K including Item 7 – Management's Discussion and Analysis of Financial Condition and Results of Operations, describes certain risk factors related to our business.  You should carefully consider the risk factors described below in conjunction with the other information in this document.
 
We have sold our operating assets, our patent portfolio, and our intellectual property and are executing a redeployment strategy.  There can be no assurance that the redeployment strategy will increase shareholder value, and we may decide to liquidate.
 
In July 2005, we approved a plan to redeploy our existing resources to identify and acquire one or more new business operations. In March 2006, we sold the rights to our patent portfolio, and in November 2006, we sold the remaining intellectual property rights related to our carrier network equipment products and services. In December 2006, we discontinued our customer service business. If we are not successful in executing our redeployment strategy we will continue to incur operating losses and negative cash flow and may at some point decide to liquidate and return the net proceeds to our stockholders. In the case of a liquidation or bankruptcy, we would need to hold back or distribute assets to cover liabilities before paying stockholders, which may therefore reduce or delay the proceeds that stockholders may receive for their ownership in us. However, we believe we have adequate cash resources to continue to realize our assets and discharge our liabilities as a company through 2009. 
 
Failure to execute our redeployment strategy could cause our stock price to decline.
 
Our stock price may decline due to any or all of the following potential occurrences:

 
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·
we may not be able to find suitable acquisition candidates or may not be able to acquire suitable candidates with our limited financial resources;

 
·
we may not be able to utilize our existing NOLs to offset future earnings;

 
·
we may have difficulty retaining our board of directors or attracting suitable qualified candidates should a director resign.

We will incur significant costs in connection with our evaluation of suitable acquisition candidates.

As part of our plan to redeploy our assets, our management is seeking, analyzing and evaluating potential acquisition and merger candidates. We will incur significant costs, such as due diligence and legal and other professional fees and expenses, as part of these redeployment efforts. Notwithstanding these efforts and expenditures, we cannot give any assurance that we will identify an appropriate acquisition opportunity in the near term, or at all.

We will likely have no operating history in our new line of business, which is yet to be determined, and therefore we will be subject to the risks inherent in establishing a new business.

We have not identified what our new line of business will be and, therefore, we cannot fully describe the specific risks presented by such a business. It is likely that we will have had no operating history in the new line of business and it is possible that the target company may have a limited operating history in its business. Accordingly, there can be no assurance that our future operations will generate operating or net income, and as such our success will be subject to the risks, expenses, problems, and delays inherent in establishing a new line of business for us. The ultimate success of such new business cannot be assured.

We may be unable to realize the benefits of our net operating loss carry-forwards ("NOLs").

NOLs may be carried forward to offset federal and state taxable income in future years and eliminate income taxes otherwise payable on such taxable income, subject to certain adjustments. Based on current federal corporate income tax rates, our NOLs and other carry-forwards could provide a benefit to us, if fully utilized, of significant future tax savings. However, our ability to use these tax benefits in future years will depend upon the amount of our otherwise taxable income. If we do not have sufficient taxable income in future years to use the tax benefits before they expire, we will lose the benefit of these NOLs permanently. Consequently, our ability to use the tax benefits associated with our substantial NOLs will depend significantly on our success in identifying suitable acquisition candidates, and once identified, successfully consummating an acquisition of these candidates.

Additionally, if we underwent an ownership change, the NOLs would be subject to an annual limit on the amount of the taxable income that may be offset by our NOLs generated prior to the ownership change. If an ownership change were to occur, we may be unable to use a significant portion of our NOLs to offset taxable income. In general, an ownership change occurs when, as of any testing date, the aggregate of the increase in percentage points is more than 50 percentage points of the total amount of a corporation's stock owned by "5-percent stockholders," within the meaning of the NOLs limitations, whose percentage ownership of the stock has increased as of such date over the lowest percentage of the stock owned by each such "5-percent stockholder" at any time during the three-year period preceding such date. In general, persons who own 5% or more of a corporation's stock are "5-percent stockholders," and all other persons who own less than 5% of a corporation's stock are treated, together, as a single, public group "5-percent stockholder," regardless of whether they own an aggregate of 5% of a corporation's stock.

The amount of NOLs that we have claimed has not been audited or otherwise validated by the U.S. Internal Revenue Service (“IRS”). The IRS could challenge our calculation of the amount of our NOLs or our determinations as to when a prior change in ownership occurred and other provisions of the Internal Revenue Code may limit our ability to carry forward our NOLs to offset taxable income in future years. If the IRS was successful with respect to any such challenge, the potential tax benefit of the NOLs to us could be substantially reduced.

Certain transfer restrictions implemented by us to preserve our net operating loss carryforwards may not be effective or may have some unintended negative effects.

On November 15, 2005, at our 2005 Annual Meeting of Stockholders, our stockholders approved an amendment to our Amended and Restated Certificate of Incorporation to restrict certain acquisitions of our securities in order to help assure the preservation of our NOLs. The amendment generally restricts direct and indirect acquisitions of our equity securities if such acquisition will affect the percentage of our capital stock that is treated as owned by a "5-percent stockholder."

 
7

 

Although the transfer restrictions imposed on our capital stock are intended to reduce the likelihood of an impermissible ownership change, there is no guarantee that such restrictions would prevent all transfers that would result in an impermissible ownership change. The transfer restrictions also will require any person attempting to acquire a significant interest in us to seek the approval of our board of directors. This may have an "anti-takeover" effect because our board of directors may be able to prevent any future takeover. Similarly, any limits on the amount of capital stock that a stockholder may own could have the effect of making it more difficult for stockholders to replace current management. Additionally, because the transfer restrictions will have the effect of restricting a stockholder's ability to dispose of or acquire our common stock, the liquidity and market value of our common stock might suffer.

We could be required to register as an investment company under the Investment Company Act of 1940, which could significantly limit our ability to operate and acquire an established business.

The Investment Company Act of 1940 (the "Investment Company Act") requires registration, as an investment company, for companies that are engaged primarily in the business of investing,  reinvesting,  owning, holding, or trading securities. We have sought to qualify for an exclusion from registration including the exclusion available to a company that does not own "investment securities" with a value exceeding 40% of the value of its total assets on an unconsolidated basis, excluding government securities and cash items. This exclusion, however, could be disadvantageous to us and/or our stockholders. If we were unable to rely on an exclusion under the Investment Company Act and were deemed to be an investment company under the Investment Company Act, we would be forced to comply with substantive requirements of the Investment Company Act, including: (i) limitations on our ability to borrow; (ii) limitations on our capital structure; (iii) restrictions on acquisitions of interests in associated companies; (iv) prohibitions on transactions with affiliates; (v) restrictions on specific investments; (vi) limitations on our ability to issue stock options; and (vii) compliance with reporting, record keeping, voting, proxy disclosure, and other rules and regulations. Registration as an investment company would subject us to restrictions that would significantly impair our ability to pursue our fundamental business strategy of acquiring and operating an established business. In the event the SEC or a court took the position that we were an investment company, our failure to register as an investment company would not only raise the possibility of an enforcement action by the SEC or an adverse judgment by a court, but also could threaten the validity of corporate actions and contracts entered into by us during the period we were deemed to be an unregistered investment company. Moreover, the SEC could seek an enforcement action against us to the extent we were not in compliance with the Investment Company Act during any point in time.

We may issue a substantial amount of our common stock in the future which could cause dilution to new investors and otherwise adversely affect our stock price.

A key element of our growth strategy is to make acquisitions. As part of our acquisition strategy, we may issue additional shares of common stock as consideration for such acquisitions. These issuances could be significant. To the extent that we make acquisitions and issue our shares of common stock as consideration, your equity interest in us will be diluted. Any such issuance will also increase the number of outstanding shares of common stock that will be eligible for sale in the future. Persons receiving shares of our common stock in connection with these acquisitions may be more likely to sell off their common stock, which may influence the price of our common stock. In addition, the potential issuance of additional shares in connection with anticipated acquisitions could lessen demand for our common stock and result in a lower price than might otherwise be obtained. We may issue common stock in the future for other purposes as well, including in connection with financings, for compensation purposes, in connection with strategic transactions, or for other purposes.

Our customers may sue us because we discontinued our products and may not meet all our contractual commitments.
 
Certain of our customer contracts contained provisions relating to the availability of products, spare parts, and services for periods up to ten years. We have worked with our customers to aid in a smooth transition, but our customers may choose to sue us for breach of contract.

 
8

 

If we cannot obtain director and officer liability insurance in acceptable amounts for acceptable rates, we may have difficulty recruiting and retaining qualified directors and officers.

Like most other public companies, we carry insurance protecting our officers and directors against claims relating to the conduct of our business. This insurance covers, among other things, the costs incurred by companies and their management to defend against and resolve claims relating to management conduct and results of operations, such as securities class action claims. These claims typically are expensive to defend against and resolve.  We pay significant premiums to acquire and maintain this insurance, which is provided by third-party insurers, and we agree to underwrite a portion of such exposures under the terms of the insurance coverage.  One consequence of the current economic downturn and decline in stock prices has been a substantial increase in the number of securities class actions and similar claims brought against public corporations and their management, including the company and certain of its current and former officers and directors. Consequently, insurers providing director and officer liability insurance have in recent periods sharply increased the premiums they charge for this insurance, raised retentions (that is, the amount of liability that a company is required to pay to defend and resolve a claim before any applicable insurance is provided), and limited the amount of insurance they will provide. Moreover, insurers typically provide only one-year policies. The insurance policies that may cover any current securities claims against us have a $500,000 retention.  As a result, the costs we incur in defending such claims will not be reimbursed until they exceed $500,000. The policies that would cover any future claims may not provide any coverage to us and may cover the directors and officers only in the event we are unwilling or unable to cover their costs in defending against and resolving any future claims. As a result, our costs in defending any future claims could increase significantly. Particularly in the current economic environment, we cannot assure you that in the future we will be able to obtain sufficient director and officer liability insurance coverage at acceptable rates and with acceptable deductibles and other limitations. Failure to obtain such insurance could materially harm our financial condition in the event that we are required to defend against and resolve any future or existing securities class actions or other claims made against us or our management arising from the conduct of our operations. Further, the inability to obtain such insurance in adequate amounts may impair our future ability to retain and recruit qualified officers and directors.

Our earnings are sensitive to fluctuations in interest rates.

Our business no longer generates any revenues as we ceased all customer operations as of December 31, 2006.  Our net income depends on the amount of interest paid on the investment of our cash in cash equivalents and other short term investments.  Accordingly, our earnings are subject to risks and uncertainties surrounding changes in the interest rate environment

Item 1B.  Unresolved Staff Comments

None.

Item 2.  Properties

We lease approximately 1,000 square feet of office space in Los Gatos, California under an operating lease.   Effective July 1, 2007 our lease payments are made by SP, an affiliated company, in connection with a management services agreement.

Item 3.  Legal Proceedings

On November 15, 2001, we along with certain of our officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re CoSine Communications, Inc. Initial Public Offering Securities Litigation, Case No. 01 CV 10105. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against us and each of the directors and officers who signed the registration statement relating to the initial public offering. The plaintiffs seek unspecified monetary damages and other relief. Similar lawsuits concerning more than 300 other companies' initial public offerings were filed during 2001, and this lawsuit is being coordinated with those actions in the Southern District of New York before Judge Shira A. Scheindlin.

On or about July 1, 2002, an omnibus motion to dismiss was filed in the coordinated litigation on behalf of the issuer defendants, of which we and our named officer and directors are a part, on common pleading issues. In October 2002, pursuant to stipulation by the parties, the Court entered an order dismissing our named officers and directors from the action without prejudice. On February 19, 2003, the Court dismissed the Section 10(b) and Rule 10b-5 claims against us but did not dismiss the Section 11 claims against us.

In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the Court for approval.  On August 31, 2005, the Court preliminarily approved the settlement. In December 2006, the appellate court overturned the certification of classes in the six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings.  Because class certification was a condition of the settlement, it was unlikely that the settlement would receive final Court approval.  On June 25, 2007, the Court entered an order terminating the proposed settlement based upon a stipulation among the parties to the settlement.  Plaintiffs have filed amended master allegations and amended complaints and moved for class certification in the six focus cases.  Defendants moved to dismiss the amended complaints and have opposed class certification.  On March 26, 2008, the Court denied the defendants’ motion to dismiss the amended complaints.   It is uncertain whether there will be any revised or future settlement.

 
9

 

On December 5, 2006, the Court of Appeals for the Second Circuit reversed the court's October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings. On June 25, 2007, the Court entered an order terminating the proposed settlement based upon a stipulation among the parties to the settlement.  Plaintiffs have filed amended master allegations and amended complaints in the six focus cases, which the defendants in those cases have moved to dismiss.   On March 26, 2008, the Court largely denied the defendants’ motion to dismiss the amended complaints. It is uncertain whether there will be any revised or future settlement.   If we are not successful in our defense of this lawsuit, we could be forced to make significant payments to the plaintiffs and their lawyers, and such payments could have a material adverse effect on our business, financial condition, and results of operations if not covered by our insurance carrier.

On October 9, 2007, a purported CoSine shareholder filed a complaint for violation of Section 16(b) of the Securities Exchange Act of 1934, which prohibits short-swing trading, against the Company's IPO underwriters.   The complaint, Vanessa Simmonds v. The Goldman Sachs Group, et al., Case No. C07-1629, filed in the District Court for the Western District of Washington, seeks the recovery of short-swing profits.  The Company is named as a nominal defendant.  No recovery is sought from the Company.  The plaintiff, Vanessa Simmonds, has filed similar lawsuits in the District Court for the Western District of Washington alleging short-swing trading in the stock of 54 other companies.  On July 25, 2008, a majority of the named issuer companies, including CoSine, jointly filed a motion to dismiss plaintiff's claims. The motion to dismiss was heard on January 16, 2009, and we are awaiting a ruling.

      Even if the above claims are not successful, the litigation could result in substantial costs and divert management's attention and resources, which could adversely affect our business, results of operations and financial position.

In the ordinary course of business, we are involved in disputes and legal proceedings involving contractual obligations, employment relationships, and other matters.  Except as described above, we do not believe there are any pending or threatened disputes or legal proceedings that will have a material impact on our financial position or results of operations.

Item 4.  Submission of Matters to a Vote of Security Holders

None.

PART II

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock currently trades in the over the counter market and is quoted on the Pink Sheets Electronic Quotation Service under the symbol “COSN.PK.”  Our common stock had been traded on the NASDAQ National Market under the symbol COSN from our initial public offering in September 2000 through June 15, 2005, when we were de-listed from the NASDAQ National Market System.  There was no public market for our common stock prior to our September 2000 initial public offering.

The following table sets forth the high and low sales price of our common stock in the years ended December 2008 and 2007.  Our common stock was de-listed from NASDAQ National Market System on June 15, 2005.  The following table sets forth the range of high and low bid information of our common stock.  The high and low bid quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission, and may not represent actual transactions.

 
10

 

   
High
   
Low
 
2007
           
First quarter
  $ 3.75     $ 2.94  
Second quarter
  $ 3.70     $ 3.32  
Third quarter
  $ 3.57     $ 2.86  
Fourth quarter
  $ 2.96     $ 2.46  
2008
               
First quarter
  $ 2.75     $ 2.20  
Second quarter
  $ 2.85     $ 2.40  
Third quarter
  $ 2.70     $ 2.45  
Fourth quarter
  $ 2.35     $ 1.55  
 
Stockholders

According to the records of our transfer agent, at February 12, 2009 we had approximately 345 shareholders of record.  The majority of our shares are held in approximately 2,800 customer accounts held by brokers and other institutions on behalf of stockholders.

Dividends

To date, we have not declared or paid any cash dividends on our common stock.  Our current policy is to retain future earnings, if any, for use in the operations, and we do not anticipate paying any cash dividends in the foreseeable future.

Securities Authorized for Issuance under Equity Compensation Plans

The following table summarizes equity compensation plans that were approved and not approved by the stockholders as of December 31, 2008:

EQUITY COMPENSATION PLAN INFORMATION

   
Number of Securities
         
Number of Securities
 
   
to be Issued Upon
   
Weighted-Average
   
Remaining Available for
 
   
Exercise of Outstanding
   
Exercise Price of
   
Future Issuance Under
 
   
Options, Warrants and
   
Outstanding Options,
   
Equity Compensation
 
Plan category
 
Rights
   
Warrants and Rights
   
Plans (1)
 
                   
Equity compensation plans approved by stockholders  
    161,000 (2)    $ 7.28 (2)      1,922,735 (3)
Equity compensation plans not approved by stockholders (4)  
                893,990  
                         
Total  
    161,000     $ 7.28       2, 816,725  

(1) 
These numbers exclude shares listed under the column heading "Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights."
(2) 
Includes 5,000 shares subject to outstanding options under the 1997 Stock Plan, 112,000 shares subject to outstanding options under the 2000 Stock Plan, and 44,000 shares subject to outstanding options under the Director Plan.
(3) 
Includes 1,918,735 shares available for future issuance under the 2000 Stock Plan, and 4,000 shares available for future issuance under the Director Plan.
(4) 
The only equity compensation plan not approved by stockholders is the 2002 Stock Plan (the "2002 Plan").  The board of directors adopted the 2002 Plan in January 2002 to make available for issuance certain shares of our common stock that have been (i) previously issued pursuant to the exercise of stock options granted under the 1997 Plan and (ii) subsequently reacquired by us pursuant to repurchase rights contained in restricted stock purchase agreements or pursuant to optionee defaults on promissory notes issued in connection with the exercise of such options ("Reacquired Shares").  Under the terms of the 1997 Plan and the 2000 Plan, these Reacquired Shares would not otherwise have been available for reissuance.  No shares that were not previously issued under the 1997 Plan and subsequently reacquired by us have been or will be reserved for issuance under the 2002 Plan.  A maximum of 1,000,000 shares may be reserved for issuance under the 2002 Plan.  An aggregate of 335,791 shares were initially reserved for issuance under the 2002 Plan upon its adoption.  These shares consisted of Reacquired Shares as of the date of adoption.  Additional shares that become Reacquired Shares after the date of adoption of the 2002 Plan, up to a maximum of 664,209 additional shares, will also become available for issuance under the 2002 Plan.  The provisions of the 2002 Plan are substantially similar to those of the 2000 Plan, except that the 2002 Plan does not permit the grant of awards to officers or directors and does not permit the grant of Incentive Stock Options.  The 2002 Plan provides for the grant of nonstatutory stock options to employees (excluding officers) and consultants.  Stock options granted under the 2002 Plan will be at prices not less than the fair value of the common stock at the date of grant.  The term of each option, generally 10 years or less, will be determined by CoSine.
 
11

 
Use of Proceeds of Registered Securities

On September 25, 2000, in connection with our initial public offering, a Registration Statement on Form S-1 (File No. 333-35938) was declared effective by the Securities and Exchange Commission, pursuant to which 1,150,000 shares of our common stock were offered and sold for our account at a price of $230 per share, generating gross offering proceeds of $264.5 million.  The managing underwriters were Goldman, Sachs & Co., Chase Securities Inc., Robertson Stephens, Inc. and JP Morgan Securities Inc. Our initial public offering closed on September 29, 2000.  The net proceeds of the initial public offering were approximately $242.5 million after deducting approximately $18.5 million in underwriting discounts and approximately $3.5 million in other offering expenses.

We did not pay directly or indirectly any of the underwriting discounts or other related expenses of the initial public offering to any of our directors or officers, any person owning 10% or more of any class of our equity securities, or any of our affiliates. We have used approximately $220 million of the funds from the initial public offering to fund our operations.  We expect to use the remaining net proceeds for general corporate purposes, including funding our operations, our working capital needs, and potential acquisitions pursuant to our redeployment strategy.  Pending further use of the net proceeds, we have invested them in short-term, interest-bearing, investment-grade securities.

Item 6.  Selected Financial Data

The selected financial data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the related notes. The selected statements of operations data for the years ended December 31, 2008, 2007 and 2006 and the selected balance sheet data as of December 31, 2008 and 2007, are derived from, and are qualified by reference to, the audited financial statements included elsewhere in this Annual Report on Form 10-K.  The selected statements of operations data for the fiscal years ended prior to December 31, 2006, and the selected balance sheet data prior to December 31, 2007, are derived from our audited financial statements that are not included in this Annual Report on Form 10-K.  The historical results presented below are not necessarily indicative of future results.

   
Years Ended December 31,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
   
(In thousands, except per share data)
 
Statements of Operations Data:
                             
Revenue
  $     $     $ 1,361     $ 3,315     $ 9,675  
Cost of revenue
                1,663       2,049       7,086  
Gross profit (loss)
                (302 )     1,266       2,589  
Operating expenses:
                                       
Research and development
                      103       15,078  
Sales and marketing
                      105       10,052  
General and administrative
    721       781       1,316       3,227       6,064  
Restructuring and impairment charges
                      (91 )     8,909  
Total operating expenses
    721       781       1,316       3,344       40,103  
Loss from operations
    (721 )     (781 )     (1,618 )     (2,078 )     (37,514 )
Other income (expense):
                                       
Interest income
    678       1,180       1,101       678       489  
Interest expense
                (4 )           (3 )
Other
    28             918       (46 )     (276 )
Total other income
    706       1,180       2,015       632       210  
Income (loss) before income tax provision (benefit)
    (15 )     399       397       (1,446 )     (37,304 )
Income tax provision (benefit)
          ( 17 )     ( 52 )     ( 228 )     33  
Net income (loss)
  $ (15 )   $ 416     $ 449     $ (1,218 )   $ 37,337 )
Basic net income (loss) per common share
  $ 0.00     $ 0.04     $ 0.04     $ (0.12 )   $ (3.70 )
Diluted net income (loss) per common share
  $ 0.00     $ 0.04     $ 0.04     $ (0.12 )   $ (3.70 )
Shares used in computing basic net income (loss) per common share
    10,091       10,091       10,091       10,094       10,082  
Shares used in computing diluted net income (loss) per common share
    10,091       10,115       10,096       10,094       10,082  
                                         
Balance Sheet Data:
                                       
Cash, cash equivalents and short-term investments
  $ 23,152     $ 23,119     $ 22,857     $ 23,166     $ 24,913  
Working capital
    23,019       22,927       22,477       22,353       23,214  
Total assets
    23,282       23,231       23,036       23,840       27,823  
Total stockholders’ equity
    23,022       22,930       22,477       22,603       23,364  
 
12

 
Quarterly financial information (unaudited):

   
2008
   
2007
 
   
1st
Quarter
   
2nd
Quarter
   
3rd
Quarter
   
4th
Quarter
   
1st
Quarter
   
2nd
Quarter
   
3rd
Quarter
   
4th
Quarter
 
   
(In thousands, except per share data)
 
Revenue
  $     $     $     $     $     $     $     $  
Gross profit (loss)
                                               
Net income (loss)
  $ 53     $ 22     $ 2     $ (92 )   $ 94     $ 122     $ 127     $ 73  
Basic and diluted net income (loss) per  share
  $ 0.01     $ 0.00     $ 0.00     $ (.01 )   $ 0.01     $ 0.01     $ 0.01     $ 0.01  

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

OVERVIEW

Our strategy is to enhance stockholder value by pursuing opportunities to redeploy our assets through an acquisition of one or more operating businesses with existing or prospective taxable earnings that can be offset by use of our net operating loss carry-forwards (“NOLs”).

We were a provider of carrier network equipment products and services until the fourth quarter of fiscal year 2004 during which time we discontinued our product lines, took actions to lay off most of our employees, terminated contract manufacturing arrangements, contractor and consulting arrangements and various facility leases, and sold, scrapped or wrote-off our inventory, property and equipment. In July 2005, we completed a comprehensive review of strategic alternatives, including a sale of the Company, a sale or licensing of intellectual property, a redeployment of our assets into new business ventures, or a winding-up and liquidation of the business and a return of capital.  At that time, the board of directors approved the strategy of redeploying our existing resources to identify and acquire one or more new business operations.  In 2006, we completed the wrap-up of our carrier services business, providing customer support services for our discontinued products through December 31, 2006, at which time we terminated all customer support offerings.  We also sold the remaining assets of our carrier network products business with the sale of our patent portfolio in March 2006 and the sale of the rights to the related intellectual property in November 2006.

Due to the adoption of our redeployment strategy, the information appearing below, which relates to prior periods, may not be indicative of the results that may be expected for any subsequent periods.  The year ended December 31, 2008 primarily reflects, and future periods prior to a redeployment of our assets are expected to primarily reflect, general and administrative expenses and transaction expenses associated with the continuing administration of the Company and its efforts to redeploy its assets.

13

 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES

General

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities.  On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, inventory valuation, long-lived assets, warranties and equity issuances.  Additionally, the audit committee of our board of directors reviews these critical accounting estimates at least annually.  We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances.  These estimates form the basis for certain judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates.

The following accounting policies are significantly affected by the judgments and estimates we use in the preparation of our  financial statements.

Revenue Recognition

Historically, prior to discontinuing our products, most of our sales were generated from complex arrangements.  Recognizing revenue in these arrangements required our making significant judgments, particularly in the areas of customer acceptance and collectibility.

Certain of our historic product sales arrangements required formal acceptance by our customers.  In such cases, we did not recognize revenue until we received formal notification of acceptance.  Although we worked closely with our customers to help them achieve satisfaction with our products prior to and after acceptance, the timing of customer acceptance could greatly affect the timing of the recognition of our revenue.

While the end user of our product was normally a large network service provider, we also sold products and services through small resellers and to small network service providers in Asia, Europe, and North America.  To recognize revenue before we received payment, we were required to assess that collection from the customer was probable.  If we could not satisfy ourselves that collection was probable, we deferred revenue recognition until we collected payment.

Through December 31, 2006, our business consisted primarily of customer service revenue.  We recorded revenue as earned for customer service revenue once we satisfied ourselves that collection from the customer were probable.  If we could not satisfy ourselves that collection was probable, we deferred revenue recognition until we collected payment.
 
Fair Value Measurements
 
      Effective January 1, 2008, we adopted Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements” (“SFAS No. 157”) to measure the fair value of our financial assets and financial liabilities.  SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. 
 
       SFAS No. 157 establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs).  The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3).  The three levels of the fair value hierarchy under SFAS No. 157 are described below:
Level 1:  Quoted prices (unadjusted) in active markets for identical assets or liabilities.  We used Level 1 assumptions for our cash and cash equivalents and short term investments, which are traded in an active market.  The valuations are based on quoted prices that are readily and regularly available in an active market, and accordingly, a significant degree of judgment is not required.    
Level 2:  Directly or indirectly observable market based inputs used in models or other valuation methodologies.  As of December 31, 2008, we did not have any Level 2 financial assets or liabilities.
Level 3: Unobservable inputs that are supported by little or no market data and require the use of significant management judgment.  As of December 31, 2008, we did not have any Level 3 financial assets or liabilities. 

14


Impact of Equity Issuances on Operating Results

Equity issuances have a material impact on our operating results.  The equity issuances that have affected operating results to date include warrants granted to customers and suppliers, stock options granted to employees and consultants, and stock issued in lieu of cash compensation to suppliers.

Our cost of revenue, operating expenses and interest expense were affected significantly by charges related to warrants and options issued for services.

In the second quarter of 2004, we issued to a reseller a warrant to acquire 254,489 shares of our common stock at an exercise price of $4.65 per share.  The warrant had a two-year term beginning May 28, 2004 and vested ratably over the term.  If during the two-year term (1) any person or entity had acquired a greater than 50% interest in us or the ownership or control of more than 50% of our voting stock or (2) we had sold substantially all of our intellectual property assets, the warrant would have become exercisable.  Even if the reseller did not immediately exercise the warrant upon the occurrence of such an event that made the warrant exercisable (a “trigger event”), the reseller would have been entitled to securities, cash and property to which it would have been entitled upon the consummation of the trigger event, less the aggregate price applicable to the warrant.  We calculated the fair value of the warrant to be approximately $487,000 using the Black-Scholes option pricing model, using a volatility factor of .97, a risk-free interest rate of 2.5%, and an expected life of two years.  The fair value of the warrant was being amortized over the two-year expected life of the warrant.  During the years ended December 31, 2006 and 2005, we amortized $100,000 and $339,000, respectively, to cost of revenue.   The warrant was fully amortized in the year ended December 31, 2006 and the warrant expired unexercised in May 2006.

Income Taxes

We account for income taxes using the liability method under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. We adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB statement 109, on January 1, 2007.  This Interpretation clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in our financial statements.  The Interpretation also provides guidance for the measurement and classification of tax positions, interest and penalties, and requires additional disclosure on an annual basis.  The cumulative effect of the change had no impact on the balance sheet or statement of operations. Following implementation, the ongoing recognition of changes in measurement of uncertain tax positions will be reflected as a component of income tax expense. Interest and penalties incurred associated with unresolved income tax positions will continue to be included in other income (expense).

RESULTS OF OPERATIONS

Revenue

We ceased all customer operations on December 31, 2006.  In 2005 and 2006, our revenues were earned primarily from our customer service contracts.  We recognized product revenue at the time of shipment or delivery (depending on shipping terms), assuming that persuasive evidence of an arrangement existed, the sales price was fixed or determinable and collection was probable, unless we had future obligations for installation or require customer acceptance, in which case revenue was deferred until these obligations were met.  Our product incorporated software that was not incidental to the related hardware and, accordingly, we recognized revenue in accordance with the American Institute of Certified Public Accountants issued Statement of Position 97-2 “Software Revenue Recognition.”  For arrangements that included the delivery of multiple elements, the revenue was allocated to the various products based on “vendor-specific objective evidence” (VSOE) of fair value.  We established VSOE based on either the price charged for the product when the same product was sold separately or for products not yet sold separately, based on the list prices of such products individually established by management with the relevant authority to do so.

Revenue from perpetual software licenses was recognized upon shipment or acceptance, if required.  Revenue from one-year term licenses was recognized on a straight-line basis over the one-year license term.  Post-delivery technical support, such as on-site service, phone support, parts and access to software upgrades, when and if available, was provided under separate support services agreements.  In cases where the support services were sold as part of an arrangement including multiple elements, we allocated revenue to the support service based on the VSOE of the service and recognized it on a straight-line basis over the service period.  Revenue from consulting and training services was recognized as the services were provided.

15


Amounts billed in excess of revenue recognized were included as deferred revenue in the accompanying balance sheets.

Revenue from customers by geographic region for the years ended December 31, 2008, 2007 and 2006 was as follows, in thousands:

   
2008
   
%
   
2007
   
%
   
2006
   
%
 
North America
  $           $           $ 1,211       89 %
Asia/Pacific
                                   
Europe
                            150       11 %
Total revenue
  $           $           $ 1,361       100 %

Hardware, software and service revenue for the years ended December 31, 2008, 2007, and 2006 was as follows, in thousands:

   
2008
   
%
   
2007
   
%
   
2006
   
%
 
Hardware
  $           $           $        
Software
                                   
Service
                            1,361       100 %
                                                 
Total revenue
  $           $           $ 1,361       100 %

        We had no revenue in 2008 or 2007, as we discontinued all service offerings at December 31, 2006.

In 2006, all of our revenue was earned from our customer service contracts.  The decline in revenue as compared to the prior year is due to the fact that our customers continued their transition from the discontinued CoSine products to other suppliers and, as a result, the demand for our services decreased during the year.   See "Outlook" section on page 20 and "Risk Factors" section on pages 6 to 9.

Non-Cash Charges and Credits Related to Equity Issuances

We amortized $34,000, $39,000 and $140,000 of non-cash charges related to equity issuances to cost of revenue, operating expenses and interest expense, for the years ended December 31, 2008, 2007 and 2006, respectively.

Below is a reconciliation of non-cash charges related to equity issuances for the years ended December 31, 2008, 2007, and 2006, affecting our cost of revenue, operating expenses and interest expense, in thousands:

   
Years ended December 31,
 
   
2008
   
2007
   
2006
 
Amortization of charges related to warrants or stock options issued to non-employees in conjunction with lease, debt, and reseller agreements
  $     $     $ 100  
Employee stock-based compensation
    34       39       40  
Net non-cash charges related to equity issuances
  $ 34     $ 39     $ 140  

Equity-related charges, which are largely dependent on our quarterly stock price, may cause our expenses to materially fluctuate from quarter-to-quarter and year-to-year.

16

 
Cost of Revenue

Cost of revenue includes all costs of producing our sold products, including the costs of outsourced manufacturing, software royalties, shipping, warranties, related manufacturing overhead costs and the costs of providing our service offerings, including personnel engaged in providing maintenance and consulting services to our customers.  To the extent that the value of inventory is written down, this was reflected in cost of revenue.  We have also incurred non-cash charges and credits related to equity issuances including amortization of a warrant issued to a reseller in 2004.  We outsourced the majority of our manufacturing and repair operations and customer support capabilities.  A significant portion of our cost of revenue consists of payments to our contract manufacturers and third party customer support service provider.  Historically, we conducted manufacturing engineering, final assembly, configuration testing, and documentation control at our facilities in Redwood City, California.

There were no customer operations effective December 31, 2006, no revenue and no charges to cost of revenue after that date.

Cost of revenue for the year ended December 31, 2006 was $1.7 million.  Cost of revenue included $1.6 million for the cost of our third party customer support service provider, and $0.1 million for amortization of a warrant issued to a reseller in 2004.

Gross Profit

For the years ended December 31, 2008, 2007, and 2006, gross profit (loss) was nil, nil and ($0.3) million, respectively.

 The decrease in gross profit for the year ended December 31, 2007 compared to December 31, 2006 is due to the cessation of all business activities as of December 31, 2006.

Research and Development Expenses

Research and development expenses consist primarily of salaries and related personnel costs, fees paid to contractors and outside service providers, and the costs of laboratory equipment and prototypes related to the design, development and testing of our products.  We discontinued all research and development in 2005.
 
Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries and related expenses for personnel engaged in sales, marketing and customer evaluations, as well as the costs associated with customer evaluations and trials and other promotional and marketing expenses.  We discontinued all sales and marketing in 2005.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and related expenses for executive, finance, legal, accounting, and human resources personnel as well as other corporate expenses, including non-cash charges related to equity issuances.

General and administrative expenses were $721,000, $781,000 and $1,316,000 for the years ended December 31, 2008, 2007, and 2006, respectively.

General and administrative expense decreased by $60,000, $535,000 and $1,911,000 for the years ended December 31, 2008, 2007, and 2006, respectively.  The decreases are due primarily to our decision in September 2004 to discontinue our products and lay off all of our employees to conserve cash.  The majority of our general and administrative employees were laid off in October and November of 2004, and substantially all employees were laid-off by December 31, 2004. Between December 31, 2004 and July 1, 2007, our administrative functions were performed by our chief executive officer and a consultant.

17

 
As of July 1, 2007, our administrative functions are performed under an agreement (the “Services Agreement”) with SP Corporate Services, LLC (“SP”) pursuant to which SP provides us, on a non-exclusive basis, a full range of executive, financial, and administrative support services and personnel, including the services of our executive officers. The Service Agreement became effective as of July 1, 2007.  Pursuant to the Services Agreement, Terry R. Gibson terminated his employment with us, effective as of June 30, 2007, but continues to serve as our Chief Executive Officer, Chief Financial Officer, Secretary, Principal Executive Officer, and Principal Accounting Officer as an employee of SP.  Under the Services Agreement, we pay SP a monthly fee of $17,000 in exchange for SP's services.  SP is responsible for compensating and providing all applicable employment benefits to any SP personnel, including Mr. Gibson, in connection with providing services under the Services Agreement. We reimburse SP for reasonable and necessary business expenses of ours incurred by SP, and we are responsible for payment of fees related to audit, tax, legal, stock transfer, insurance broker, investment advisor, and banking services provided to us by third party advisors. The Services Agreement has a term of one year and automatically renews for successive one year periods unless otherwise terminated by either party. The Services Agreement is also terminable by us upon the death of Terry R. Gibson or his resignation as our Chief Executive Officer, Chief Financial Officer, or Secretary of the Company. Under the Services Agreement, SP and its personnel are entitled to the same limitations on liability and indemnity rights available under our charter documents to any other person performing such services for us.

General and administrative non-cash charges (credits) related to equity issuances were $34,000, $39,000 and $40,000 for the years ended December 31, 2008, 2007 and 2006, respectively.

Interest Income and Other Expense

For the year ended December 31, 2008, interest income was $678,000 as compared to $1.2 million at December 31, 2007 and $1.1 million at December 31, 2006.  The decrease is due to lower interest rates in 2008 as compared to 2007 and 2006.

Other Income

     For the year ended December 31, 2006, other income includes primarily $640,000 gain on liquidation of foreign subsidiaries.  The gain is due to the cumulative effect of gains and losses on translation of foreign subsidiaries’ financial statements into United States dollars.  The gain, which had been deferred prior to the year ended December 31, 2006, was recognized in 2006 with the liquidation of the subsidiaries.  The liquidations were completed in connection with the cessation of our service operations.  Other income in 2006 also included $180,000 and $80,000 in connection with the sale of our patent portfolio and intellectual property, respectively.

Interest Expense

For the years ended December 31, 2008, 2007, and 2006, respectively, interest expense was nil, nil and $4,000.

Income Tax Provision

Credits for income taxes of nil, ($17,000), and ($52,000) for the years ended December 31, 2008, 2007, and 2006, respectively, were comprised entirely of foreign corporate income taxes, which are a function of our operations in subsidiaries in various countries.  The credits in 2007 and 2006 relate to the liquidation of foreign subsidiaries, and completion of the related tax settlements.

We have not recognized any benefit from the future use of net operating loss carry-forwards for these periods, or for any other periods, since our incorporation.  We are not recognizing the potential tax benefits of our net operating loss carry-forwards because we do not have sufficient evidence that we will generate adequate profits to use them.

Use of the net operating loss and tax credit carry-forwards may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, and similar state provisions.  The annual limitation may result in the expiration of net operating loss and tax credit carry-forwards before utilization.

LIQUIDITY AND CAPITAL RESOURCES

In 2006, we completed the wrap-up of our carrier services business.  We also sold the remaining assets of our carrier networks products business with sale of our patent portfolio in March 2006 and the sale of the rights to the related intellectual property in November 2006 (see Note 7 of the Notes to Financial Statements).  We have adopted a strategy of seeking to enhance stockholder value by pursuing opportunities to redeploy our assets through an acquisition of one or more operating businesses with existing or prospective taxable earnings that can be offset by use of our net operating loss carry-forwards. Based on our $23.2 million in cash and short term investments at December 31, 2008 and on our cost reduction activities, we believe that we possess sufficient liquidity and capital resources to fund our operations and working capital requirements for at least the next 12 months. However, our restructuring activities and our new redeployment of assets strategy raise substantial doubt as to our ability to continue as a going concern.  See “Liquidity and Redeployment Strategy” in Note 1 of the Notes to Financial Statements.  See “Outlook” on page 20 and “Risk Factors” on pages 6 to 9, which describes our redeployment of assets strategy.

18


We will continue to prepare our financial statements on the assumption that we will continue as a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business.  As such, the financial statements do not include any adjustments to reflect possible future effects of the recoverability and classification of assets or the amounts and classification of liabilities that may result from any decisions made with respect to an assessment of our strategic alternatives.  If at some point we were to decide to pursue alternative plans, we may be required to present the financial statements on a different basis.  As an example, if we were to decide to pursue a liquidation and return of capital, it would be appropriate to prepare and present financial statements on the liquidation basis of accounting, whereby assets are valued at their estimated net realizable values and liabilities are stated at their estimated settlement amounts.

Cash, Cash Equivalents and Short-Term Investments

At December 31, 2008, cash, cash equivalents and short-term investments were $23.2 million, as compared to $23.1 million at December 31, 2007.

Operating Activities

      We used $40,000 in cash in operations in the year ended December 31, 2008, generated $264,000 cash from operations in the year ended December 31, 2007, and used $334,000 in cash for operations for the year ended December 31, 2006.  The reduction in cash generated from operations in 2008 as compared to 2007 is due to the decline in interest income in 2008 as compared to 2007. The improvement in 2007 as compared to 2006 is due primarily due to decreases in accrued liabilities in 2006 as we completed our restructuring activities.

Investing Activities

     We used $3.5 million in investing activities for the year ended December 31, 2008 due to net purchases of short-term investments. For the year ended December 31, 2007, we generated $7.2 million in cash from investing activities due to net sales and maturities of short-term investments. For the year ended December 31, 2006, we used $6.9 million in cash to fund an increase in our short term investments.

Financing Activities

       We had no financing activities during the years ended December 31, 2008, 2007, or 2006.

Off-Balance Sheet Arrangements

       We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material affect.

Contractual Obligations

We have future financial obligations related to (1) an operating lease and (2) purchase obligations. These obligations as of December 31, 2008 are summarized as follows, (in thousands of dollars):

Contractual
Obligations
 
Total
   
2009
   
2010
   
2011-2012
   
After 2012
 
Unconditional purchase obligations
  $ 89.0     $ 89.0     $     $     $  
Operating leases
    13.0       13.0                    
                                         
Total contractual cash obligations
  $ 102.0     $ 102.0     $ 0.0     $ 0.0     $ 0.0  
 
19

 
 Our operating lease obligations as of December 31, 2008 consist of an office lease expiring at the end of April 2009.  However, effective July 1, 2007 our lease payments are made by SP Corporate Services LLC, as affiliated company, in connection with a management services agreement.
 
Our unconditional purchase obligations relate to executive, financial and administrative support services, and personnel provided by SP Corporate Services LLC under an agreement which became effective as of July 1, 2007 (the "Services Agreement").  Under the Services Agreement, we pay SP Corporate Services LLP a monthly fee of $17,000 in exchange for SP Corporate Services LLP’s services. The Services Agreement has a term of one year and automatically renews for successive one year periods unless otherwise terminated by either party.

OUTLOOK

         Our board of directors, on completion of a comprehensive review of strategic alternatives, has approved a plan to redeploy our existing resources to identify and acquire one or more new business operations.  Our redeployment strategy will involve the acquisition of one or more operating businesses with existing or prospective taxable earnings that can be offset by use of our net operating loss carry-forwards (“NOLs”).  As of this date, no candidate has been identified, and no assurance can be given that we will find suitable candidates, and if we do, that we will be able to utilize our existing NOLs.

At December 31, 2008, we had $23.2 million in cash, and cash equivalents and short-term investments.  Cash used by operations during the year ended December 31, 2008 was $40,000. We believe we possess sufficient liquidity and capital resources to fund our operations and working capital requirements for at least the next 12 months.

Recent Accounting Pronouncements

In February 2007, the FASB issued FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 creates a “fair value option” under which an entity may elect to record certain financial assets or liabilities at fair value upon their initial recognition. Subsequent changes in fair value would be recognized in earnings as those changes occur. The election of the fair value option would be made on a contract-by contract basis and would need to be supported by concurrent documentation or a preexisting documented policy. SFAS 159 requires an entity to separately disclose the fair value of these items on the balance sheet or in the footnotes to the financial statements and to provide information that would allow the financial statement user to understand the impact on earnings from changes in the fair value. SFAS 159 is effective for us beginning with fiscal year 2008. We did not make any elections for fair value accounting and therefore, we did not record a cumulative-effect adjustment to our opening accumulated deficit balance.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007),  Business Combinations (“SFAS 141(R)”). SFAS 141(R) changes accounting for acquisitions that close beginning in 2009. More transactions and events will qualify as business combinations and will be accounted for at fair value under the new standard. SFAS 141(R) promotes greater use of fair values in financial reporting. Some of the changes will introduce more volatility into earnings. SFAS 141(R) is effective for fiscal years beginning on or after December 15, 2008. We are currently assessing the impact that SFAS 141(R) may have on our financial position, results of operations, and cash flows.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160,  Noncontrolling Interests in Consolidated Financial Statements  (“SFAS 160”), an amendment of ARB No. 51. SFAS 160 will change the accounting and reporting for minority interests which will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. We are currently assessing the impact that SFAS 160 may have on our financial position, results of operations, and cash flows.

In December 2007, the FASB issued EITF Issue 07-1 Accounting for Collaborative Arrangements (EITF 07-1). Collaborative arrangements are agreements between parties to participate in some type of joint operating activity. The task force provided indicators to help identify collaborative arrangements and provides for reporting of such arrangements on a gross or net basis pursuant to guidance in existing authoritative literature. The task force also expanded disclosure requirements about collaborative arrangements. Conclusions within EITF 07-1 are to be applied retroactively. This issue is effective for financial statements issued for fiscal years beginning after December 15, 2008 and is to be applied retrospectively for all collaborative arrangements existing as of the effective date. We are currently assessing the impact that EITF 07-1 may have on our financial position, results of operations, and cash flows.

20


           In October 2008, the FASB issued FASB Staff Position No. 157-3, (“Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”)). FSP 157-3 clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 became effective immediately, including prior periods for which financial statements have not been issued. Therefore, the Company adopted the provisions of FSP 157-3 in its financial statements in the quarter ended December 31, 2008. The adoption did not have an impact on the Company's results or operations or financial condition.

Item 7A.  Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity

We do not currently use derivative financial instruments for speculative trading or hedging purposes.  In addition, we maintain our cash equivalents in government and agency securities, debt instruments of financial institutions and corporations, and money market funds.  Our exposure to market risks from changes in interest rates relates primarily to corporate debt securities.  We place our investments with high quality credit issuers and, by policy, limit the amount of the credit exposure to any one issuer.

Our general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk.  All highly-liquid investments with a maturity of less than three months at the date of purchase are considered to be cash equivalents, and all investments with maturities of three months or greater are classified as available-for-sale and considered to be short-term investments.

A sensitivity analysis was performed on our December 31, 2008 investment portfolio based on a modeling technique that measures hypothetical fair market value changes that would result from a parallel shift in the yield curve of plus 100 basis points.  Based on this analysis, a hypothetical 100 basis point increase in interest rates would result in a $42,000 decrease in the fair value of our investments in debt securities as of December 31, 2008.

Exchange Rate Sensitivity

All of our revenue, all of our expenses and all of our other income are denominated in U.S. dollars.
 
21

 
Item 8.  Financial Statements and Supplementary Data

REPORT OF BURR, PILGER & MAYER LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
CoSine Communications, Inc.
 
We have audited the accompanying balance sheets of CoSine Communications, Inc. (the “Company”) as of December 31, 2008 and 2007 and the related statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. The financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor have we been engaged to perform, an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting.  Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CoSine Communications, Inc. as of December 31, 2008 and 2007 and the results of its operations and its flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1 and Note 6 to the financial statements, on January 1, 2007 the Company changed its method of accounting for uncertain tax positions as a result of adopting Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109”.

As discussed in Note 1 to the financial statements, the Company’s actions in September 2004 in connection with its ongoing evaluation of strategic alternatives, to terminate most of its employees and discontinue production activities in an effort to conserve cash raise substantial doubt about its ability to continue as a going concern. Management’s plans as to these matters are also described in Note 1.  The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amount and classification of liabilities that may result from the outcome of this uncertainty.

/s/ Burr, Pilger & Mayer LLP

Palo Alto, California
February 17, 2009

22

 
COSINE COMMUNICATIONS, INC.

BALANCE SHEETS
(In thousands, except for share and per share data)

 
                                                              
 
December 31,
2008
   
December 31,
2007
 
             
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 9,155     $ 12,709  
Short-term investments
    13,997       10,410  
Interest receivable
    96       73  
Prepaid expenses and other current assets
    31       36  
Total current assets
    23,279       23,228  
Long term deposit
    3       3  
    $ 23,282     $ 23,231  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Current liabilities:
               
Accounts payable
  $ 207     $ 204  
Other accrued liabilities
     53        97  
Total current liabilities
     260        301  
                 
Commitments and contingencies (Notes 2 and 3)
               
                 
Stockholders' equity:
               
Preferred stock, no par value, 3,000,000 shares authorized, no shares  issued and outstanding
           
Common stock, $0.0001 par value, 22,000,000 shares authorized; 10,090,635 shares issued and outstanding at December 31, 2008 and 2007
     1        1  
Additional paid-in capital
    539,060       539,026  
Accumulated other comprehensive income
    88       15  
Accumulated deficit
    (516,127 )     (516,112 )
Total stockholders' equity
    23,022       22,930  
    $ 23,282     $ 23,231  

See accompanying notes to financial statements.
 
23


COSINE COMMUNICATIONS, INC.

STATEMENTS OF OPERATIONS
(In thousands, except for per share data)

   
Years Ended December 31,
 
   
2008
   
2007
   
2006
 
Revenue:
                 
Product
  $     $     $  
Service
                1,361  
Total revenue
                1,361  
Cost of revenue (1)
                1,663  
Gross profit (loss)
                (302 )
Operating expenses:
                       
General and administrative (2)
    721       781        1,316  
Total operating expenses
    721       781       1,316  
Loss from operations
    (721 )     (781 )     (1,618 )
Other income (expense):
                       
Interest income
    678       1,180       1,101  
Interest expense
                (4 )
Other (3)
    28             918  
Total other income
    706       1,180       2,015  
(Loss) income before income tax benefit
    (15 )     399       397  
Income tax  (benefit)
          ( 17 )     ( 52 )
Net (loss) income
  $ (15 )   $ 416     $ 449  
Basic net income (loss) per share
  $ (0.00 )   $ 0.04     $ 0.04  
Diluted net income (loss) per share
  $ (0.00 )   $ 0.04     $ 0.04  
                         
Shares used to calculate net income (loss) per share:
                       
                         
Basic
    10,091       10,091       10,091  
Diluted
    10,091       10,115       10,096  
 

 
(1)
Cost of revenue includes nil, nil and $100 of non-cash charges related to equity issuances in 2008, 2007, and 2006, respectively.
(2)
General and administrative expenses include $34 , $39 and $40 in non-cash charges related to equity issuances in 2008, 2007, and 2006, respectively.
(3)
Other income includes gain on disposal of subsidiaries of $640 in 2006.

See accompanying notes to financial statements.

 
24

 

COSINE COMMUNICATIONS, INC.
STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share data)

                     
Accumulated
             
               
Additional
   
Other
         
Total
 
   
Common Stock
   
Paid-in
   
Comprehensive
   
Accumulated
   
Stockholders’
 
   
Shares
   
Amount
   
Capital
   
Income
   
Deficit
   
Equity
 
Balance at December 31, 2005
    10,090,635     $ 1     $ 538,947     $ 632     $ (516,977 )   $ 22,603  
Stock based compensation
                40                   40  
Components of comprehensive income (loss):
                                               
Net income
                            449       449  
Unrealized gain on investments, net of tax
                      25             25  
Translation adjustment, net of tax
                      (640 )           (640 )
Total comprehensive income (loss)
                      (615 )     449       (166 )
Balance at December 31, 2006
    10,090,635       1       538,987       17       (516,528 )     22,477  
Stock based compensation
                39                   39  
Components of comprehensive income (loss):
                                               
Net income
                            416       416  
Unrealized loss on investments, net of tax
                      (2 )           (2 )
Total comprehensive income (loss)
     —                   (2 )     416       414  
Balance at December 31, 2007
    10,090,635       1       539,026       15       (516,112 )     22,930  
Stock based compensation
                34                   34  
Components of comprehensive income (loss):
                                               
Net loss
                            (15 )     (15 )
Unrealized gain on investments, net of tax
                      73             73  
Total comprehensive income
                      73       (15 )     57  
Balance at December 31, 2008
    10,090,635     $ 1     $ 539,060     $ 88     $ (516,127 )   $ 23,022  

See accompanying notes to financial statements.

 
25

 

COSINE COMMUNICATIONS, INC.

STATEMENTS OF CASH FLOWS
(In thousands)

   
Years Ended December 31,
 
   
2008
   
2007
   
2006
 
Operating activities:
                 
Net (loss) income
  $ (15 )   $ 416     $ 449  
Adjustments to reconcile net (loss) income to net cash (used) generated in operating activities:
                       
Stock compensation expense
    34       39       40  
Amortization of warrants issued for services
                100  
Gain on liquidation of foreign subsidiaries
                (640 )
    Change in operating assets and liabilities:
                       
Accounts receivable trade
          55       41  
Interest receivable
    (23 )     (5 )     141  
Prepaid expenses and other current assets
    5       20       63  
Long-term deposits and other assets
          (3 )     150  
Accounts payable
    3       (116 )     83  
Other accrued liabilities
    (44 )     (142 )     (635 )
Deferred revenue
     —        —        (126 )
Net cash (used) generated in operating activities
     ( 40 )      264        (334 )
Investing activities:
                       
Purchase of short-term investments
    (30,729 )     (27,318 )     (20,013 )
Proceeds from sales and maturities of short-term investments
     27,215       34,556       13,137  
Net cash (used in) generated in investing activities
     ( 3,514 )     7,238       (6,876 )
Net (decrease) increase in cash and cash equivalents
    (3,554 )     7,502       (7,210 )
Cash and cash equivalents at the beginning of the period
     12,709       5,207       12,417  
Cash and cash equivalents at the end of the period
  $ 9,155     $ 12,709     $ 5,207  
Supplemental information:
                       
Cash paid for interest
  $     $     $ 4  

See accompanying notes to financial statements.

 
26

 

COSINE COMMUNICATIONS, INC.

NOTES TO FINANCIAL STATEMENTS

1.  Summary of Significant Accounting Policies

Description of Business

CoSine Communications, Inc. ("CoSine" or the "Company," which may be referred to as "we," "us," or "our") was incorporated in California on April 14, 1997 and in August 2000 was reincorporated in the State of Delaware. We were a provider of carrier network equipment products and services until the fourth quarter of fiscal year 2004 during which time we discontinued our product lines, took actions to lay off most of our employees, terminated contract manufacturing arrangements, contractor and consulting arrangements and various facility leases, and sold, scrapped or wrote-off our inventory, property and equipment. As a result of these activities, our business consisted primarily of a customer support capability for our discontinued products provided by a third party.  We continued such support activities through December 31, 2006, at which time we ceased all customer support services. In 2006 we sold our patent portfolio and the intellectual property related to our carrier products and service business. We continue to seek to redeploy our existing resources to identify and acquire one or more new business operations with existing or prospective taxable earnings that can be offset by use of our net operating loss carry-forwards ("NOLs").

Liquidity and Redeployment Strategy

The accompanying financial statements have been prepared in conformity with U.S. generally accepted accounting principles, which contemplate continuation of the Company as a going concern. However, at December 31, 2008, we have an accumulated deficit of $516 million. As of December 31, 2006, we ceased our customer service capability.  Our actions in the fourth quarter of fiscal year 2004 to terminate most of our employees and discontinue production activities in an effort to conserve cash raise substantial doubt about our ability to continue as a going concern.  The financial statements do not include any adjustments to reflect the possible future effects relating to the recoverability and classification of the recorded asset amounts or amounts and classification of liabilities that might result from the outcome of this uncertainty.

In July 2005, we completed a comprehensive review of strategic alternatives, including a sale of CoSine, a sale or licensing of intellectual property, a redeployment of our assets into new business ventures, or a winding-up and liquidation of the business and a return of capital.  The board of directors approved a plan to redeploy our existing resources to identify and acquire one or more new business operations, while continuing to support our existing customers and continuing to offer our intellectual property for license or sale.  We continued to provide customer support services through December 31, 2006, at which time we terminated customer support operations.  During 2006, we sold the rights to our patent portfolio and the intellectual property related to our carrier products and service business.  We continue to pursue our redeployment strategy, which involves the acquisition of one or more operating businesses with existing or prospective taxable earnings that can be offset by use of our NOLs.

Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes.  Actual results could differ from these estimates.  Estimates are used in accounting for, but are not limited to, revenue recognition, allowance for doubtful accounts, inventory valuations, long-lived asset valuations, accrued liabilities including warranties, and equity issuances.  Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the financial statements in the period of determination.

Significant Concentrations

Financial instruments that potentially subject us to concentrations of credit risk primarily consist of cash, cash equivalents, and short-term investments. We mitigate investment risk by investing only in government and high quality corporate securities and by limiting the amount of exposure to any one issuer. Deposits held with financial institutions may exceed the amount of insurance provided on such deposits. We are exposed to credit risks in the event of default by these institutions to the extent of the amount recorded on the balance sheet.  We have not experienced any material losses on deposits of cash and cash equivalents.

27


We ceased all customer service operations effective December 31, 2006.  For the year ended December 31, 2006, we recognized revenue from three customers who accounted for 58%, 19% and 11% of total revenue, respectively.  At December 31, 2006 we had two customers who accounted for 67% and 27% of total trade accounts receivable, respectively.

Guarantees

     We may enter into certain types of contracts that require that we indemnify parties against certain third party claims that may arise. These contracts primarily relate to: (i) certain agreements with our officers, directors and employees, under which we may be required to indemnify such persons for liabilities arising out of their employment relationship, (ii) contracts under which we may be required to indemnify customers against loss or damage to property or persons as a result of willful or negligent conduct by our employees or sub-contractors, (iii) contracts under which we may be required to indemnify customers against third party claims that our product infringes a patent, copyright or other intellectual property right and, (iv) procurement or license agreements under which we may be required to indemnify licensors or vendors for certain claims that may be brought against them arising from our acts or omissions with respect to the supplied products or technology.

Generally, a maximum obligation is not explicitly stated.  Because the obligated amounts associated with this type of agreement are not explicitly stated, the overall maximum amount of the obligation cannot be reasonably estimated.  Historically, we have not been obligated to make payments for these obligations, and no liabilities have therefore been recorded for these obligations on our  balance sheets as of December 31, 2008, 2007, and 2006.

Cash, Cash Equivalents and Short-Term Investments

We consider all highly liquid investments purchased with original maturities of three months or less from the date of purchase to be cash equivalents. Investments with maturities in excess of three months and less than one year are considered to be short-term investments.  We determine the appropriate classification of cash equivalents and investment securities at the time of purchase.  We have classified our marketable securities as available-for-sale securities in the accompanying financial statements.  Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in a separate component of stockholders’ equity.  Realized gains and losses and declines in value judged to be other-than-temporary, if any, on available-for-sale securities are included in interest income.  Interest on securities classified as available-for-sale is also included in interest income. The cost of securities sold is based on the specific identification method.

We invest excess cash in U.S. government and agency securities, debt instruments of financial institutions and corporations, and money market funds with strong credit ratings.  We have established guidelines about the diversification of our investments and their maturities.
 
Fair Value Measurement
 
On January 1, 2008, we adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements. SFAS 157 applies whenever other statements require or permit assets or liabilities to be measured at fair value. SFAS 157 is effective for fiscal years beginning after November 15, 2007, except for nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis, for which application has been deferred for one year.
 
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The following table summarizes our financial assets measured at fair value on a recurring basis in accordance with SFAS 157 as of December 31, 2008 (in thousands) with comparative balances as of December 31, 2007:
 
December 31, 2008
 
   
Amortized
Cost
   
Unrealized
Gain / 
(Loss)
   
Fair Value
   
Significant Other
Observable Inputs 
(Level 1)
 
Assets:
                       
Cash equivalents:
                       
   Money market funds
  $ 9,074     $     $ 9,074     $ 9,074  
Short-term investments:
                               
   Commercial  paper
  $ 2,645     $ 3     $ 2,648     $ 2,648  
   Corporate obligations
    4,725       (12 )     4,713       4,713  
   U.S. governmental  agency notes
    6,539        97       6,636       6,636  
       Total
  $ 13,909     $ 88     $ 13,997     $ 13,997  
                                 
Liabilities
  $     $     $     $  
 
December 31, 2007
 
   
Amortized
Cost
   
Unrealized
Gain / 
(Loss)
   
Fair Value
   
Significant Other
Observable Inputs 
(Level 1)
 
Assets:
                       
Cash equivalents:
                       
   Money market funds
  $ 12,635     $     $ 12,635     $ 12,635  
Short-term investments:
                               
   Commercial  paper
  $ 6,165     $ 18     $ 6,183     $ 6,183  
   Corporate obligations
     4,230        (3 )      4,227        4,227  
       Total
  $ 10,395     $ 15     $ 10,410     $ 10,410  
                                 
Liabilities
  $     $     $     $  
 
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Our financial assets are valued using market prices on active markets (level 1). Level 1 instrument valuations are obtained from real-time quotes for transactions in active exchange markets involving identical assets.  At December 31, 2008, we did not have any assets with instrument valuations which are not obtained from readily-available pricing sources for comparable instruments (level 2) or assets without observable market values that would require a high level of judgment to determine fair value (level 3).
 
The carrying amounts of certain of the Company’s financial instruments including cash, interest receivable and accounts payable approximate fair value due to their short maturities.

As of December 31, 2008 and 2007, there were net unrealized gains of $88,000 and $15,000, respectively. All available-for-sale securities have contractual maturities of one year or less.

We manage our investments as a single portfolio of highly marketable securities that is intended to be available to meet our current cash requirements.  We have no investments in auction rate securities.

The net unrealized gains related to our portfolio of available-for-sale securities were primarily due to increase in fair value of debt securities as a result of the change in interest rates during 2008 and 2007.

Stock-Based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
 
The Company adopted SFAS 123(R) using the modified prospective transition method. The Company’s financial statements as of December 31, 2008, 2007 and 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the years ended December 31, 2008, 2007 and 2006 was $34,000, $39,000 and $40,000 respectively, which consisted of stock-based compensation expense related to employee stock options.

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s statements of operations. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s statements of operations because the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.
 
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Stock-based compensation expense recognized during the current period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s statements of operations for the years ended December 31, 2008, 2007 and 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the statement of operations for the years ended December 31, 2008, 2007 and 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Upon adoption of SFAS 123(R), the Company selected the Black-Scholes option-pricing model (“Black-Scholes model”) to determine the fair value of share-based awards granted beginning in fiscal 2006, the same model which was previously used for the Company’s pro forma information required under SFAS 123. The Company’s determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Expected volatilities are based on the historical volatility of the Company’s common stock. The Company uses historical data to estimate option exercise and employee terminations. The expected term of the options granted represents the period of time that options are expected to be outstanding, based on historical information. The risk-free interest rate is based on the U.S Treasury zero-coupon issues with remaining terms similar to the expected term of the Company’s equity awards. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore used an expected dividend yield of zero. All of our stock compensation is accounted for as an equity instrument.

Revenue Recognition

In 2006, our revenues were earned primarily from our customer service contracts.  We recognize product revenue at the time of shipment, assuming that persuasive evidence of an arrangement exists, the sales price is fixed or determinable and collection is probable, unless we have future obligations for installation or require customer acceptance, in which case revenue is deferred until these obligations are met.  Our product incorporates software that is not incidental to the related hardware and, accordingly, we recognize revenue in accordance with the American Institute of Certified Public Accountants Statement of Position 97-2 “Software Revenue Recognition.”  For arrangements that include the delivery of multiple elements, the revenue is allocated to the various products based on “vendor-specific objective evidence (“VSOE”)” of fair value.  We establish VSOE based on either the price charged for the product when the same product is sold separately or for products not yet sold separately, based on the list prices of such products individually established by management with the relevant authority to do so.

Revenue from perpetual software licenses is recognized upon shipment or acceptance, if required.  Revenue from one-year term licenses is recognized on a straight-line basis over the one-year license term.  Post delivery technical support, such as on-site service, phone support, parts and access to software upgrades, when and if available, is provided by us under separate support services agreement.  In cases where the support service is sold as part of an arrangement including multiple elements, we allocate revenue to the support service based on the VSOE of the services and recognize it on a straight-line basis over the service period.  Revenue from consulting and training services is recognized as the services are provided.

Amounts billed in excess of revenue recognized are included as deferred revenue in the accompanying consolidated balance sheets.

Cost of Revenue

Cost of revenue is comprised primarily of material, labor, overhead, shipping costs, subcontractor costs, warranty costs, and inventory write-downs.  In addition, cost of revenue includes non-cash charges or credits related to equity issuances.

Income Taxes
 
We account for income taxes using the liability method under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. We adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109, on January 1, 2007.  This Interpretation clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in our financial statements.  The Interpretation also provides guidance for the measurement and classification of tax positions, interest and penalties, and requires additional disclosure on an annual basis.  The cumulative effect of the change had no impact on the balance sheet or statement of operations. Following implementation, the ongoing recognition of changes in measurement of uncertain tax positions will be reflected as a component of income tax expense. Interest and penalties incurred associated with unresolved income tax positions will continue to be included in other income (expense). 

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Net (Loss) Income Per Share

Basic net income (loss) per share is calculated based on the weighted average number of common shares outstanding during the periods presented, less the weighted average shares outstanding that are subject to our right of repurchase.  Diluted net loss per share gives effect to the dilutive effect of common stock equivalents consisting of stock options and warrants (calculated using the treasury stock method) and convertible preferred stock.

The following table presents the calculation of basic and diluted net loss per share for each year (in thousands, except per share data):
 
   
Years ended December 31,
 
   
2008
   
2007
   
2006
 
Numerator:
                 
Net (loss) income
  $ (15 )   $ 416     $ 449  
Denominator:
                       
Weighted average shares outstanding for basic (loss) income per share
     10,091        10,091        10,091  
Add: effect of dilutive securities – stock options
          24       5  
Weighted average shares used in basic and diluted net (loss)  income per share
     10,091        10,115        10,096  
Basic net (loss)  income per share
  $ (0.00 )   $ 0.04     $ 0.04  
Diluted net (loss) income per share
  $ (0.00 )   $ 0.04     $ 0.04  

During all periods presented, we had stock options and warrants outstanding that could potentially dilute earnings per share in the future, but were excluded from the computation of diluted net loss per share, as their effect would have been antidilutive.  These shares amounted to 165,000, 35,000, and 26,000 for the years ended December 31, 2008, 2007, and 2006 respectively.

Segment Reporting

We operate in only one segment: IP Service Delivery Platforms. Substantially all of our assets are located in the United States.

Revenues from customers by geographic region for the years ended December 31, 2008, 2007, and 2006 were as follows (in thousands):
 
Region
 
Revenue
 
       
2008
     
Europe
  $  
Japan                                                              
     
North America                                                              
     
    $  
2007
       
Europe                                                              
  $  
Japan                                                              
     
North America                                                              
     
    $  
         
2006
       
Europe                                                              
  $ 150  
Japan                                                              
     
North America                                                              
    1,211  
    $ 1,361  
 
 
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Recent Accounting Pronouncements

In February 2007, the FASB issued Statement of Financial Accounting Standards (SFAS) Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 creates a “fair value option” under which an entity may elect to record certain financial assets or liabilities at fair value upon their initial recognition. Subsequent changes in fair value would be recognized in earnings as those changes occur. The election of the fair value option would be made on a contract-by-contract basis and would need to be supported by concurrent documentation or a preexisting documented policy. SFAS 159 requires an entity to separately disclose the fair value of these items on the balance sheet or in the footnotes to the financial statements and to provide information that would allow the financial statement user to understand the impact on earnings from changes in the fair value. SFAS 159 is effective for us beginning with fiscal year 2008. We did not make any elections for fair value accounting and therefore, we did not record a cumulative-effect adjustment to our opening accumulated deficit balance.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141(R)”). SFAS 141(R) changes accounting for acquisitions that close beginning in 2009. More transactions and events will qualify as business combinations and will be accounted for at fair value under the new standard. SFAS 141(R) promotes greater use of fair values in financial reporting. Some of the changes will introduce more volatility into earnings. SFAS 141(R) is effective for fiscal years beginning on or after December 15, 2008. We are currently assessing the impact that SFAS 141(R) may have on our financial position, results of operations, and cash flows.
 
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS 160”). SFAS 160 will change the accounting and reporting for minority interests which will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. We are currently assessing the impact that SFAS 160 may have on our financial position, results of operations, and cash flows.
 
In December 2007, the FASB issued EITF Issue 07-1 Accounting for Collaborative Arrangements  (EITF 07-1). Collaborative arrangements are agreements between parties to participate in some type of joint operating activity. The task force provided indicators to help identify collaborative arrangements and provides for reporting of such arrangements on a gross or net basis pursuant to guidance in existing authoritative literature. The task force also expanded disclosure requirements about collaborative arrangements. Conclusions within EITF 07-1 are to be applied retrospectively. This issue is effective for financial statements issued for fiscal years beginning after December 15, 2008 and is to be applied retrospectively for all collaborative arrangements existing as of the effective date. We are currently assessing the impact that EITF 07-1 may have on our financial position, results of operations, and cash flows.

           In October 2008, the FASB issued FASB Staff Position No. 157-3, (“Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”)). FSP 157-3 clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 became effective immediately, including prior periods for which financial statements have not been issued. Therefore, the Company adopted the provisions of FSP 157-3 in its financial statements in the quarter ended December 31, 2008. The adoption did not have an impact on the Company's results or operations or financial condition.

2.  Leases

We lease our facilities under an operating lease which expires in April, 2009 with annual rental of $40,000.  Effective July 1, 2007 our lease payments are made by SP Corporate Services LLC, an affiliated company, in connection with a management services agreement (See Note 5).

Rent expense was nil, $55,000 and $83,000 for the years ended December 31, 2008, 2007, and 2006, respectively, and is calculated on a straight-line basis.
 
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3.  Commitments and Contingencies

On November 15, 2001, we along with certain of our officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re CoSine Communications, Inc. Initial Public Offering Securities Litigation, Case No. 01 CV 10105. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against us and each of the directors and officers who signed the registration statement relating to the initial public offering. The plaintiffs seek unspecified monetary damages and other relief. Similar lawsuits concerning more than 300 other companies' initial public offerings were filed during 2001, and this lawsuit is being coordinated with those actions in the Southern District of New York before Judge Shira A. Scheindlin.

On or about July 1, 2002 an omnibus motion to dismiss was filed in the coordinated litigation on behalf of the issuer defendants, of which we and our named officer and directors are a part, on common pleading issues. In October 2002, pursuant to stipulation by the parties, the Court entered an order dismissing our named officers and directors from the action without prejudice. On February 19, 2003, the Court dismissed the Section 10(b) and Rule 10b-5 claims against us but did not dismiss the Section 11 claims against us.

In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the Court for approval.  On August 31, 2005, the Court preliminarily approved the settlement. In December 2006, the appellate court overturned the certification of classes in the six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings.  Because class certification was a condition of the settlement, it was unlikely that the settlement would receive final Court approval.  On June 25, 2007, the Court entered an order terminating the proposed settlement based upon a stipulation among the parties to the settlement.  Plaintiffs have filed amended master allegations and amended complaints and moved for class certification in the six focus cases.  Defendants moved to dismiss the amended complaints and have opposed class certification.  On March 26, 2008, the Court denied the defendants’ motion to dismiss the amended complaints.   It is uncertain whether there will be any revised or future settlement.

On December 5, 2006, the Court of Appeals for the Second Circuit reversed the court's October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings. On June 25, 2007, the Court entered an order terminating the proposed settlement based upon a stipulation among the parties to the settlement.  Plaintiffs have filed amended master allegations and amended complaints in the six focus cases, which the defendants in those cases have moved to dismiss.   On March 26, 2008, the Court largely denied the defendants’ motion to dismiss the amended complaints. It is uncertain whether there will be any revised or future settlement.   If we are not successful in our defense of this lawsuit, we could be forced to make significant payments to the plaintiffs and their lawyers, and such payments could have a material adverse effect on our business, financial condition, and results of operations if not covered by our insurance carrier.

On October 9, 2007, a purported CoSine shareholder filed a complaint for violation of Section 16(b) of the Securities Exchange Act of 1934, which prohibits short-swing trading, against the Company's IPO underwriters.   The complaint, Vanessa Simmonds v. The Goldman Sachs Group, et al., Case No. C07-1629, filed in the District Court for the Western District of Washington, seeks the recovery of short-swing profits.  The Company is named as a nominal defendant.  No recovery is sought from the Company.  The plaintiff, Vanessa Simmonds, has filed similar lawsuits in the District Court for the Western District of Washington alleging short-swing trading in the stock of 54 other companies.  On July 25, 2008, a majority of the named issuer companies, including CoSine, jointly filed a motion to dismiss plaintiff's claims. The motion to dismiss was heard on January 16, 2009, and we are awaiting a ruling.
 
Even if these claims are not successful, the litigation could result in substantial costs and divert management's attention and resources, which could adversely affect our business, results of operations, and financial position.
 
In the ordinary course of business, we are involved in legal proceedings involving contractual obligations, employment relationships, and other matters.  Except as described above, we do not believe there are any pending or threatened legal proceedings that will have a material impact on our financial position or results of operations.

      We also have unconditional purchase obligations that relate to executive, financial and administrative support services and personnel provided by SP Corporate Services LLC under an agreement which became effective as of July 1, 2007 (the Services Agreement”).  Under the Services Agreement, we pay SP Corporate Services LLC a monthly fee of $17,000 in exchange for SP Corporate Service LLC’s services, rent and personnel.  The Services Agreement has a term of one year and automatically renews for successive one year periods unless otherwise terminated by either party.  The Services Agreement was renewed as of July 1, 2008 for an additional one year term.  For 2009, our total future obligation under this service agreement would be $102,000.

 
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4.  Stockholders’ Equity

Common Stock

We have authorized shares of common stock for future issuance at each year end as follows (in thousands):

   
2008
   
2007
 
Stock options:
           
  Options outstanding                                                                     
   
161
      153  
                 
  Available for future grants                                                                     
    2,816       2,934  
                 
Warrants outstanding                                                                     
    4       4  
      2,981       3,091  

1997 Stock Option Plan

In October 1997, the board of directors adopted the 1997 Stock Plan (“1997 Plan”) for issuance of common stock and grants of options for common stock to employees, consultants, and directors.  Incentive stock options granted under the plan were at prices not less than the fair value of stock at the date of grant, except in the case of a sale to a person who owned stock representing more than 10% of all the voting power of all classes of our stock, in which case the purchase price was 110% of the fair market value of the common stock on the date of grant.  Nonstatutory stock options granted under the 1997 Plan were at prices not less than 85% of the fair value of stock at the date of grant, except in the case of a sale to a person who owned stock representing more than 10% of all the voting power of all classes of stock of CoSine, in which case the purchase price was 110% of the fair market value of the common stock on the date of grant.  Options granted under the 1997 Plan generally vested over four years at a rate of 25% one year from the grant date and ratably monthly thereafter and were to expire 10 years after the grant, or earlier upon termination.  Options could be granted with different vesting terms.

Effective upon the initial public offering, the 1997 Plan was terminated and the shares reserved and unissued under the 1997 Plan were reserved for issuance under the 2000 Plan.

2000 Stock Option Plan

In May 2000, the board of directors adopted the 2000 Stock Plan (“2000 Plan”).  The 2000 Plan was approved by our shareholders before the completion of the initial public offering. The 2000 Plan provides for the grant of incentive stock options to employees, and for the grant of nonstatutory stock options and stock purchase rights to employees, directors, and consultants.  Incentive stock options granted under the 2000 Plan will be at prices not less than the fair value of the common stock at the date of grant.  The term of each option will be determined by the administrator of the plan, generally 10 years or less.

We have authorized 2,215,779 shares of common stock for issuance under the 2000 Plan. At December 31, 2008 and 2007, respectively, a total of 1,922,455 shares were available for future options grants under the 2000 Plan.

2002 Stock Option Plan

In January 2002, the board of directors adopted the 2002 Stock Plan (“2002 Plan”).  The purpose of the 2002 Plan is to make available for issuance certain shares of common stock that have been (i) previously issued pursuant to the exercise of stock options granted under the 1997 Plan and (ii) subsequently reacquired by us pursuant to repurchase rights contained in restricted stock purchase agreements or pursuant to optionee defaults on promissory notes issued in connection with the exercise of such options (“Reacquired Shares”).  Under the terms of the 1997 Plan and the 2000 Plan, these Reacquired Shares would not otherwise have been available for reissuance.  Only shares that were previously issued under the 1997 Plan and subsequently reacquired by us have been or will be reserved for issuance under the 2002 Plan.

We have authorized up to a maximum of 1,000,000 shares of common stock for issuance of Reacquired Shares under the 2002 Plan.  At December 31, 2008 and 2007, a total of 893,990 shares were available for future options grants under the 2002 Plan.
 
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The provisions of the 2002 Plan are substantially similar to those of the 2000 Plan, except that the 2002 Plan does not permit the grant of awards to officers or directors and does not permit the grant of Incentive Stock Options.  The 2002 Plan provides for the grant of nonstatutory stock options to employees (excluding officers) and consultants.  Stock options granted under the 2002 Plan will be at prices not less than the fair value of the common stock at the date of grant.  The term of each option, generally 10 years or less, will be determined by the administrator of the Plan.

2000 Director Option Plan

In May 2000, the board of directors adopted the 2000 Director Option Plan (“Director’s Plan”), which was effective upon the closing of the initial public offering.  At December 31, 2008, and 2007, a total of 48,000 shares of common stock have been authorized for issuance under the Director’s Plan.  At December 31, 2008 and 2007, a total of 4,000 and 10,000 shares, respectively, were available for future options grants under the Director’s Plan.

The Director’s Plan will automatically grant an option to purchase 8,000 shares of common stock to each non-employee director when he or she is first elected to our board of directors following the initial public offering.  The Director’s Plan also provided that each non-employee director who had been a member of the board of directors for at least six months before the date of each annual stockholders’ meeting would receive an automatic annual grant of options to acquire 2,000 shares of common stock.

The options have an exercise price per share equal to the fair market value of common stock at the date of grant and have a term of 10 years.  Initial options vest and become exercisable in four equal annual increments immediately following the date of grant.  Later additional options granted vest and become exercisable on the fourth anniversary of the date of grant.


Impact of the Adoption of SFAS No. 123 (R)

We elected to adopt the modified prospective application method as provided by SFAS No. 123 (R). The effect of recording stock-based compensation for the years ended 2008 and 2007 was as follows (in thousands except per share data):

   
Year Ended
December 31,
2008
   
Year Ended
December 31,
2007
 
             
Stock-based compensation expense 
  $ 34     $ 39  
Tax effect on stock-based compensation
    -       -  
Net effect on net income
  $ 34     $ 39  
Effect on basic and diluted net income per share 
  $ 0.00