10-Q 1 level8qtr32005.htm LEVEL 8 SYSTEMS 2005 QTR 3 Level 8 Systems 2005 Qtr 3




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

FORM 10-Q


(Mark one)
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005.

[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from  to  


Commission File Number 0-26392


LEVEL 8 SYSTEMS, INC.
(Exact name of registrant as specified in its charter)


Delaware
11-2920559
(State or other jurisdiction of incorporation or organization)
(I.R.S Employer Identification Number)


1433 State Highway 34, Building C; Farmingdale, New Jersey
07727
(Address of principal executive offices)
   (Zip Code)

(732) 919-3150
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15d 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES _ NO X

Indicate the number of shares outstanding in each of the issuer’s classes of common stock, as of the latest practicable date.

45,010,835 common shares, $.001 par value, were outstanding as of October 31, 2005.




Level 8 Systems, Inc.
Index
 
PART I. Financial Information
Page
Number
   
ItItem 1. Financial Statements
  
   
Consolidated balance sheets as of September 30, 2005 (unaudited) and December 31, 2004
1
   
Consolidated statements of operations for the three months and nine months ended
 
September 30, 2005 and 2004 (unaudited)
2
   
Consolidated statements of cash flows for the nine months ended September 30, 2005
 
and 2004 (unaudited)
3
   
Consolidated statements of comprehensive loss for the three months and nine months
  
ended September 30, 2005 and 2004 (unaudited)
4
   
Notes to consolidated financial statements (unaudited)
5
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
15
   
ItItem 3. Quantitative and Qualitative Disclosures about Market Risk
26
   
Item 4. Controls and Procedures
26
   
PART II. Other Information
27
   
   
SIGNATURE
30
   
 


Part I. Financial Information
Item 1. Financial Statements

LEVEL 8 SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)

   
September 30,
2005
    
December 31,
2004
  
ASSETS
              
Current assets:
              
Cash and cash equivalents
  
$
16
  
$
107
  
Assets of operations to be abandoned
    
133
    
148
  
Trade accounts receivable, net
    
19
    
152
  
Prepaid expenses and other current assets
    
22
    
108
  
Total current assets
    
190
    
515
  
Property and equipment, net
    
7
    
15
  
Total assets
  
$
197
  
$
530
  
LIABILITIES AND STOCKHOLDERS' (DEFICIT)
              
Current liabilities:
              
Senior reorganization debt
  
$
2,559
  
$
1,548
  
Convertible bridge notes
    
1,053
    
--
  
Short-term debt
    
3,390
    
3,646
  
Accounts payable
    
2,394
    
2,351
  
Accrued expenses:
              
Salaries, wages, and related items
    
1,142
    
879
  
Other
    
2,049
    
1,725
  
Liabilities of operations to be abandoned
    
480
    
536
  
Deferred revenue
    
95
    
85
  
Total current liabilities
    
13,162
    
10,770
  
Long-term debt
    
131
    
250
  
Senior convertible redeemable preferred stock
   
1,136
    
1,367
  
Total liabilities
    
14,429
    
12,387
  
Stockholders' (deficit):
              
Preferred Stock
    
--
    
--
  
Common Stock
    
45
    
43
  
Additional paid-in capital
    
210,474
    
210,142
  
Accumulated other comprehensive loss
    
(5
)
  
(8
)
Accumulated deficit
    
(224,746
)
  
(222,034
)
Total stockholders' (deficit)
    
(14,232
)
  
(11,857
)
Total liabilities and stockholders' (deficit)
  
$
197
  
$
530
  

The accompanying notes are an integral part of the consolidated financial statements.


Page 1





LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share amounts)
(unaudited)


   
Three Months Ended September 30,
  
Nine Months Ended
September 30,
  
   
2005
  
2004 
  
2005
  
2004 
  
Revenue:
                          
Software
  
$
11
  
$
9
  
$
385
  
$
117
  
Maintenance
    
45
    
76
    
106
    
222
  
Services
    
28
    
88
    
207
    
167
  
Total operating revenue
    
84
    
173
    
698
    
506
  
                           
Cost of revenue:
                          
Software
    
1
    
65
    
14
    
4,473
  
Maintenance
    
82
    
90
    
278
    
288
  
Services
    
202
    
235
    
680
    
801
  
Total cost of revenue
    
285
    
390
    
972
    
5,562
  
                           
Gross margin (loss)
    
(201
)
  
(217
)
  
(274
)
  
(5,056
)
                           
Operating expenses:
                          
Sales and marketing
    
135
    
258
    
555
    
940
  
Research and product development
    
201
    
283
    
715
    
882
  
General and administrative
    
267
    
349
    
780
    
1,265
  
(Gain) on disposal of assets
    
--
    
(3
)
  
--
    
(3
)
Impairment of intangible assets
    
--
    
--
    
--
    
587
  
Total operating expenses
    
603
    
887
    
2,050
    
3,671
  
Loss from operations
    
(804
)
  
(1,104
)
  
(2,324
)
  
(8,727
)
                           
Other income (expense):
                          
Interest income
    
--
    
1
    
--
    
3
  
Interest expense
    
(155
)
  
(75
)
  
(422
)
  
(164
)
Change in fair value of warrant liability
    
--
    
--
    
--
    
198
  
Other income/(expense)
   
16
    
(26
)
  
34
    
72
  
Loss before provision for income taxes
    
(943
)
  
(1,204
)
  
(2,712
)
  
(8,618
)
Income tax provision
    
--
    
--
    
--
    
--
  
                           
Loss from continuing operations
    
(943
)
  
(1,204
)
  
(2,712
)
  
(8,618
)
Loss from discontinued operations
    
--
    
(7
)
  
--
    
(23
)
Net loss
 
$
(943
)
$
(1,211
)
$
(2,712
)
$
(8,641
)
                           
Loss per share from continuing operations - basic and diluted
    
(0.02
)
  
(0.03
)
  
(0.06
)
  
(0.25
)
Loss per share from discontinued operations - basic and diluted
    
(0.00
)
  
(0.00
)
  
(0.00
)
  
(0.00
)
Net loss per share applicable to common shareholders - basic and diluted 
  
$
(0.02
)
$
(0.03
)
$
(0.06
)
$
(0.25
)
                           
Weighted average common shares outstanding - basic and diluted
    
44,407
    
37,253
    
43,781
    
34,334
  


The accompanying notes are an integral part of the consolidated financial statements.

Page 2


LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

   
Nine Months Ended
September 30,
  
   
2005
  
2004
  
Cash flows from operating activities:
              
Net loss
 
$
(2,712
)
$
(8,641
)
Adjustments to reconcile net loss to net cash used in operating activities:
              
Depreciation and amortization
    
8
    
4,284
  
Change in fair value of warrant liability
    
-
    
(198
)
Stock compensation expense
    
101
    
162
  
Impairment of intangible assets
    
-
    
587
  
Provision for doubtful accounts
    
(12
)
  
(13
)
Other
          
(3
)
Changes in assets and liabilities, net of assets acquired and liabilities assumed:
              
Trade accounts receivable and related party receivables
    
145
    
(19
)
Assets and liabilities - discontinued operations
    
(41
)
  
59
  
Prepaid expenses and other assets
    
86
    
256
  
Accounts payable and accrued expenses
    
539
    
829
  
Deferred revenue
    
10
    
128
  
Net cash used in operating activities
    
(1,876
)
  
(2,569
)
Cash flows from financing activities:
              
Proceeds from issuance of common shares, net of issuance costs
    
-
    
1,247
  
Proceeds from exercise of warrants
    
-
    
112
  
Borrowings under credit facility, term loans, and notes payable
    
1,837
    
1,575
  
Repayments of term loans, credit facility and notes payable
    
(55
)
  
(348
)
Net cash provided by financing activities
    
1,782
    
2,586
  
Effect of exchange rate changes on cash
    
3
    
1
  
Net increase (decrease) in cash and cash equivalents
    
(91
)
  
18
  
Cash and cash equivalents:
              
Beginning of period
    
107
    
19
  
End of period
  
$
16
  
$
37
  



The accompanying notes are an integral part of the consolidated financial statements.

Page 3



LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)

   
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
  
   
2005
  
2004
  
2005
  
2004
  
Net loss
  
$
(943
)
$
(1,211
)
$
(2,712
)
$
(8,641
)
Other comprehensive income, net of tax:
                          
Foreign currency translation adjustment
    
--
    
9
    
3
    
(5
)
Comprehensive loss
  
$
(943
)
$
(1,202
)
$
(2,709
)
$
(8,646
)


The accompanying notes are an integral part of the consolidated financial statements.

Page 4

LEVEL 8 SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except per share data)
(unaudited)

NOTE 1. INTERIM FINANCIAL STATEMENTS

The accompanying financial statements are unaudited, and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles of the United States of America have been condensed or omitted pursuant to those rules and regulations. Accordingly, these interim financial statements should be read in conjunction with the audited financial statements and notes thereto contained in the Annual Report on Form 10-K for the year ended December 31, 2004 of Level 8 Systems, Inc. (the "Company"). The results of operations for the interim periods shown in this report are not necessarily indicative of results to be expected for other interim periods or for the full fiscal year. In the opinion of management, the information contained herein reflects all adjustments necessary for a fair statement of the interim results of operations. All such adjustments are of a normal, recurring nature. Certain reclassifications have been made to the prior year amounts to conform to the current year presentation.

The year-end condensed balance sheet data was derived from audited financial statements in accordance with the rules and regulations of the SEC, but does not include all disclosures required for financial statements prepared in accordance with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All of the Company's subsidiaries are wholly owned for the periods presented.

Liquidity

The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred losses of $9,761 and $10,006 in each of the past two calendar years and has experienced negative cash flows from operations for each of the past three years. For the nine months ended September 30, 2005, the Company incurred a loss of $2,712 and had a working capital deficiency of $12,972. The Company’s future revenues are largely dependent on acceptance of Cicero, which has had limited success in commercial markets to date. Accordingly, there is substantial doubt that the Company can continue as a going concern. In order to address these issues and to obtain adequate financing for the Company’s operations for the next twelve months, the Company is actively promoting and expanding its Cicero related product line and continues to negotiate with customers that have expressed an interest in the Cicero technology. The Company is experiencing difficulty increasing sales revenue largely because of the market’s lack of knowledge of Cicero as well as customer concerns about the financial viability of the Company. Cicero is a new “category defining” product in that most Enterprise Application Integration (EAI) projects are performed at the server level and Cicero’s integration occurs at the desktop without the need to open or modify the underlying code for those applications being integrated. Many companies are not aware of this new technology and tend to look toward more traditional and accepted approaches. The Company is attempting to solve the former problem by increased marketing and by leveraging its limited number of reference accounts. The Company is attempting to address the financial concerns of potential customers by pursuing strategic partnerships with companies that have significant financial resources although the Company has not experienced significant success to date with this approach. Additionally, the Company is seeking additional equity capital or other strategic transactions in the near term to provide additional liquidity. There can be no assurance that management will be successful in executing these strategies as anticipated or in a timely manner or that increased revenues will reduce further operating losses. If the Company is unable to significantly increase cash flow or obtain additional financing, it will likely be unable to generate sufficient capital to fund operations for the next twelve months and may be required to pursue other means of financing that may not be on terms

Page 5

favorable to the Company or its stockholders. These factors among others may indicate that the Company will be unable to continue as a going concern for a reasonable period of time.

The financial statements presented herein do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company has recently negotiated an additional financing of up to $1,500 with certain existing and new investors at terms similar to the existing Senior Reorganization debt. Management expects that it will be able to raise additional capital and to continue to fund operations and also expects that increased revenues will reduce its operating losses in future periods, however, there can be no assurance that management’s plan will be executed as anticipated.

Use of Accounting Estimates

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

Stock-Based Compensation

The Company has adopted the disclosure provisions of SFAS 123 and has applied Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for its stock-based compensation plans. Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant dates for awards under the plan consistent with the method required by SFAS No. 123, the Company’s net loss and diluted net loss per common share would have been the pro forma amounts indicated below.

   
Three Months Ended
 September 30,
  
Nine Months Ended
September 30,
  
   
2005
  
2004
  
2005
  
2004
  
Net loss applicable to common stockholders
  
$
(943
)
$
(1,211
)
$
(2,712
)
$
(8,641
)
Less: Total stock based employee compensation expense under fair value based method for all awards, net of related tax effects
    
(40
)
  
(121
)
  
(201
)
  
(556
)
Pro forma loss applicable to common stockholders
  
$
(983
)
$
(1,332
)
$
(2,913
)
$
(9,197
)
Loss per share:
                          
Basic and diluted, as reported
 
$
(0.02
)
$
(0.03
)
$
(0.06
)
$
(0.25
)
Basic and diluted, pro forma
 
$
(0.02
)
$
(0.04
)
$
(0.07
)
$
(0.27
)


The fair value of the Company's stock-based awards to employees was estimated as of the date of the grant using the Black-Scholes option-pricing model, using the following weighted-average assumptions for the quarter and nine months ended September 30, 2005 as follows:

Expected life (in years)
    
7.63 years
  
Expected volatility
    
141.432
%
Risk free interest rate
    
4.125
%
Expected dividend yield
    
0
%


The following table sets forth certain information as of September 30, 2005, about shares of Common Stock outstanding and available for issuance under the Company’s existing equity compensation plans: the Level 8 Systems, Inc. 1997 Stock Option Incentive Plan, the 1995 Non-Qualified Option Plan and the Outside Director Stock Option Plan. The Company’s stockholders approved all of the Company’s Equity Compensation Plans.

Page 6


   
Shares
  
Outstanding on January 1, 2005
    
7,488,639
  
Granted
    
252,929
  
Exercised
    
(252,929
)
Forfeited
    
(229,992
)
Outstanding on September 30, 2005
    
7,258,647
  
         
Weighted average exercise price of outstanding options
  
$
1.27
  
Shares available for future grants on September 30, 2005
    
1,706,135
  
 

NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, FASB issued SFAS No. 123R, “Share-Based Payment.”  This statement is a revision of SFAS No. 123 and supersedes APB No. 25 and its related implementation guidance.  SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions.  The statement requires entities to recognize compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards (with limited exceptions).  SFAS No. 123R is effective for the first annual reporting period that begins after June 15, 2005, although earlier adoption is encouraged.

The Company expects to adopt SFAS No. 123R in the quarterly period beginning on January 1, 2006.  The Company is evaluating the two methods of adoption allowed under SFAS 123R: the modified-prospective transition method and the modified-retrospective transition method, and has not quantified the effect of the adoption on the consolidated financial statements.


NOTE 3. ACQUISITIONS

In January 2004, the Company acquired substantially all of the assets and certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software company. Under the terms of the purchase agreement, the Company issued 2,027,027 shares of common stock at a price of $0.37. The total purchase price of the assets being acquired plus certain liabilities assumed was $750, and has been accounted for by the purchase method of accounting. The Company agreed to register the common stock for resale under the Securities Act of 1933, as amended.

The purchase price was allocated to the assets acquired and liabilities assumed based on the Company’s estimates of fair value at the acquisition date. The Company assessed the net realizable value of the Ensuredmail software technology acquired and determined the purchase price exceeded the amounts allocated to the software technology acquired by approximately $587. This excess of the purchase price over the fair values of the assets acquired was allocated to goodwill, and, because it was deemed impaired, charged to the Statements of Operations for the period ended March 31, 2004. (See Note 4.)


NOTE 4. SOFTWARE PRODUCT TECHNOLOGY

In accordance with SFAS 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed", the Company completed an assessment of the recoverability of the Cicero product technology. This assessment was performed during 2004, due to the Company’s continued operating losses and the limited software revenue generated by the Cicero technology over the previous twelve to eighteen months. The Company was in negotiations with customers to purchase licenses, which would have a significant impact on the cash flows from the Cicero technology and the Company. Since the negotiations had been in process for several months and expected completion of the transactions had been delayed,  the  Company   had reduced  its  cash  flow  projections.  Historical  cash  flows  generated  by  the  Cicero
Page 7

technology do not support the long-lived asset and accordingly the Company impaired the unamortized book value of the technology in excess of the expected net realizable value for the year ended December 31, 2004. This charge, in the amount of $2,844, was recorded as software amortization for the year ended December 31, 2004.

As noted above, in January 2004, the Company acquired substantially all of the assets assumed and certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail. In accordance with SFAS 86, the Company completed an assessment of the recoverability of the Ensuredmail product technology. The total purchase price of the assets was $750 plus certain liabilities assumed. The Company has assessed the net realizable value of the Ensuredmail software technology acquired. The purchase price exceeded the amounts allocated to the software technology by approximately $587. This excess of the purchase price over the fair values of the assets acquired was allocated to goodwill and charged to the Statement of Operations for the period ended March 31, 2004. This assessment was also completed during 2004, due to the Company’s revised cash flow projections from software revenue. These revised cash flow projections do not support the long-lived asset and accordingly the Company has impaired the unamortized book value of the technology in excess of the expected net realizable value. This charge, in the amount of $154, was recorded as software amortization for the year ended December 31, 2004.


NOTE 5. SENIOR REORGANIZATION DEBT

In 2004, the Company announced a Note and Warrant Offering in which warrant holders of the Company common stock were offered a one-time exercise of their existing warrants at an exercise price of $0.10 per share as part of a recapitalization merger plan which the Company currently intends to propose to its shareholders. Under the terms of the Offer, which expired on December 31, 2004, warrant holders who elect to convert, would tender their exercise price in cash and receive a Note Payable in exchange. Upon approval of the recapitalization merger by the Company’s shareholders at an annual meeting anticipated to be held in late 2005, these Notes would be cancelled, and the existing warrants deemed exercised. In addition, those warrant holders who elected to lend the Company the first $1,000 of warrants would receive additional replacement warrants, early Adopter warrants, at a ratio of 2:1 for each warrant exercised, with a strike price of $0.10 per share. In addition, upon approval of the recapitalization merger, each lender in the Note and Warrant Offering would receive additional warrants automatically exercisable into shares of common stock.

As of December 31, 2004, the Company has raised a total of $1,548 from the Note and Warrant Offering. An additional $67 was in transit to the Company. In March 2005, the Company extended the Note and Warrant Offering under the same terms as the initial offering other than no holders received early Adopter warrants. The Company was able to secure an additional $944, of which $310 related to non-cash transactions, in Senior Reorganization Debt under the financing, for a total of $2,559. If the merger proposal is not approved, the Notes will immediately become due and payable.


NOTE 6. CONVERTIBLE BRIDGE DEBT

In July 2005, the Company agreed to issue Convertible Bridge Notes to a consortium of investors, up to $1,500. These notes bear interest at 10% and mature at various dates beginning on September 15, 2005. The Notes are convertible into shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger. Since the Company has not effected the recapitalization merger by October 31, 2005, the conversion rates on the Notes is $0.0314. Should the recapitalization merger become effective after December 31, 2005, the conversion rate will be amended to $0.025. As of September 30, 2005, the Company has issued $1,053 of Convertible Bridge Notes. An additional $239 was in transit to the Company.


Page 8


NOTE 7. SHORT TERM DEBT

Notes payable, long-term debt, and notes payable to related party consist of the following:
   
September 30, 2005
  
December 31, 2004
  
Term loan (a)
  
$
1,971
  
$
1,971
  
Note payable; related party (b)
    
69
    
69
  
Notes payable (c)
    
358
    
644
  
Short term convertible note (d)
    
265
    
235
  
Short term convertible notes, related party (e)
    
727
    
727
  
   
$
3,390
  
$
3,646
  

(a)
The Company has a $1,971 term loan bearing interest at LIBOR plus 1% (approximately 4.43% at September 30, 2005). Interest is payable semi-annually. There are no financial covenants and the term loan is guaranteed by Liraz Systems Ltd., the Company’s former principal shareholder. The loan matured on November 3, 2005.

(b)
From time to time the Company borrowed money from the Company's Chief Information Officer. The notes bear interest at 12% per annum. As of September 30, 2005, the Company is indebted to Anthony Pizi, the Company’s former Chairman and CEO and current Chief Information Officer, in the amount of $69.

(c)
The Company does not have a revolving credit facility and from time to time has issued a series of short term promissory notes with private lenders, which provide for short term borrowings both secured and unsecured by accounts receivable. In addition, the Company has settled certain litigation and agreed to a series of promissory notes to support the obligations. The notes bear interest between 10% and 12% per annum.

(d) The Company entered into convertible notes with private lenders. The notes bear interest between 12% and 18% per annum and allow for the conversion of the principal amount due into common stock of the Company. In April 2005, the Company entered into a convertible loan in the amount of $30 with a member of the Company’s Board of Directors. Under the term of this agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 428,571 shares of our common stock at a conversion price of $0.07 per share. In May 2004, the Company entered into convertible loans aggregating $185 from several investors including a member of the Company’s Board of Directors. Under the terms of these agreements, the loans bear interest between 1% and 1.5% per month and are convertible upon the option of the note holder into an aggregate of 578,125 shares of our common stock and warrants to purchase an aggregate of 578,125 shares of our common stock exercisable at $0.32. The warrants expire three years from grant. Also in March 2004, the Company entered into a convertible loan in the amount of $50. Under the terms of this agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 135,135 shares of our common stock and warrants to purchase 135,135 shares of our common stock at an exercisable price of $0.37 per share. All such warrants expire three years from the date of grant.

(e) The Company entered into convertible promissory notes with Anthony Pizi, the Company’s Chief Information Officer and Mark and Carolyn Landis, who are related by marriage to Anthony Pizi, and Mr. Landis is the Company’s Chairman of the Board of Directors.

In April 2004, the Company entered into a convertible loan agreement with Mr. Pizi in the amount of $100. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 270,270 shares of our common stock and warrants to purchase 270,270 shares of our common stock exercisable at $0.37. The warrants expire in three years from the date of grant. In June 2004, the Company entered into a convertible promissory note with Mr. Pizi in the face amount of $112. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 560,000 shares of our common stock and warrants to purchase 560,000 shares of our common stock at $0.20 per share. Also in June 2004, Mr. Pizi entered into a second convertible promissory note in the face amount of $15 which bears interest at 1% per month and is convertible into 90,118 shares of our common stock and warrants to purchase 90,118 shares of our common stock at $0.17 per share. All such warrants expire three years from the date of grant.
Page 9

In March 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis, in the principal amount of $125. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 446,429 shares of our common stock and warrants to purchase 446,429 shares of our common stock exercisable at $0.28. The warrants expire in three years from the date of grant. In June 2004, we entered into a convertible loan agreement with Mark and Carolyn Landis, in the amount of $125. Under the terms of the agreement, the loan bears interest at 1% per month and also is convertible upon the option of the note holder into 781,250 shares of our common stock and warrants to purchase 781,250 shares of our common stock exercisable at $0.16. The warrants expire in three years from the date of grant. In October 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis in the amount of $100. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 1,000,000 shares of our common stock and warrants to purchase 2,000,000 shares of the Company’s common stock exercisable at $0.10. The warrants expire in three years. In November 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis in the amount of $150. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 1,875,000 shares of our common stock and warrants to purchase 1,875,000 shares of the Company’s common stock exercisable at $0.08. All such warrants expire three years from the date of grant.


NOTE 8. STOCKHOLDERS’ EQUITY

As described in Note 3, Acquisitions, in January 2004, the Company acquired substantially all of the assets and assumed certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software company. Under the terms of the purchase agreement, the Company issued 2,027,027 shares of common stock at a price of $0.37 per share. The total purchase price of the assets acquired and liabilities assumed was $750 and have been accounted for by the purchase method of accounting.

Also in January 2004, and simultaneously with the asset purchase of Critical Mass Mail, Inc., the Company completed a Securities Purchase Agreement with several new investors as well as certain investors of Critical Mass Mail, Inc., wherein the Company raised $1,247 through the sale of 3,369,192 shares of common stock at a price of $0.37 per share. As part of the financing, the Company has also issued warrants to purchase 3,369,192 shares of the Company’s common stock at an exercise price of $0.37. The warrants expire three years from the date of grant.


NOTE 9. INCOME TAXES

The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The Company's effective tax rate differs from the statutory rate primarily due to the fact that no income tax benefit was recorded for the net loss for the third quarter of fiscal year 2005 or 2004. Because of the Company's recurring losses, the deferred tax assets have been fully offset by a valuation allowance.


NOTE 10. LOSS PER SHARE

Basic loss per share is computed based upon the weighted average number of common shares outstanding. Diluted (loss) per share is computed based upon the weighted average number of common shares outstanding and any potentially dilutive securities. Potentially dilutive securities outstanding during the periods presented include stock options,  warrants

Page 10

and preferred stock.

The following table sets forth the reconciliation of net loss to loss available to common stockholders:

   
Three Months Ended September 30,
  
Nine Months Ended September 30,
  
 
  
2005
  
2004
  
2005
  
2004
  
Net loss, as reported
  
$
(943
)
$
(1,211
)
$
(2,712
)
$
(8,641
)
Accretion of preferred stock
    
--
    
--
    
--
    
--
  
Loss applicable to common stockholders, as adjusted
  
$
(943
)
$
(1,211
)
$
(2,712
)
$
(8,641
)
                           
Basic and diluted loss per share:
                          
Loss per share from continuing operations
  
$
(0.02
)
$
(0.03
)
$
(0.06
)
$
(0.25
)
Loss per share from discontinued operations
    
--
    
--
    
--
    
--
  
Net loss per share applicable to common shareholders
  
$
(0.02
)
$
(0.03
)
$
(0.06
)
$
(0.25
)
                           
Weighted common shares outstanding - basic and diluted
    
44,407
    
37,253
    
43,781
    
34,334
  

The following table sets forth the potential shares that are not included in the diluted net loss per share calculation because to do so would be anti-dilutive for the periods presented:

   
September 30,
  
   
2005
  
2004
  
Stock options, common share equivalent
    
7,258,647
    
7,488,639
  
Warrants, common share equivalent
    
19,953,406
    
18,482,625
  
Preferred stock, common share equivalent
    
9,133,723
    
14,062,137
  
 
    
36,345,776
    
40,033,401
  

Accretion of the preferred stock arises as a result of the beneficial conversion feature realized in the sale of preferred stock.


NOTE 11. SEGMENT INFORMATION AND GEOGRAPHIC INFORMATION

Management makes operating decisions and assesses performance of the Company’s operations based on the following reportable segments: Desktop Integration segment and Messaging and Application Engineering segment.

The principal product in the Desktop Integration segment is Cicero. Cicero is a business integration software product that maximizes end-user productivity, streamlines business operations and integrates disparate systems and applications.

The products that comprise the Messaging and Application Engineering segment are the encryption technology products, Email Encryption Gateway, Software Development Kit (SDK), Digital Signature Module, Business Desktop, and Personal Desktop.

Segment data includes a charge allocating all corporate-headquarters costs to each of its operating segments based on each segment's proportionate share of expenses. The Company evaluates the performance of its segments and allocates resources to them based on earnings (loss) before interest and other income/(expense), taxes, and in-process research and development.

While segment profitability should not be construed as a substitute for operating income or a better indicator of liquidity than cash flows from operating activities, which are determined in accordance with accounting principles generally accepted in the United States of America, it is included herein to provide additional information with respect to our ability to meet our future debt service, capital expenditure and working capital requirements. Segment profitability is not necessarily a measure of our ability to fund our cash needs.

Page 11

The non-GAAP measures presented may not be comparable to similarly titled measures reported by other companies.

The table below presents information about reported segments for the three months and nine months ended September 30, 2005 and 2004:
   
Three Months Ended September 30, 2005
  
Three Months Ended September 30, 2004
  
   
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Total revenue
  
$
73
  
$
11
  
$
84
  
$
164
  
$
9
  
$
173
  
Total cost of revenue
    
285
    
--
    
285
    
390
    
--
    
390
  
Gross margin (loss)
    
(212
)
  
11
    
(201
)
  
(226
)
  
9
    
(217
)
Total operating expenses
    
576
    
27
    
603
    
812
    
78
    
890
  
Segment profitability (loss)
  
$
(788
)
$
(16
)
$
(804
)
$
(1,038
)
$
(69
)
$
(1,107
)

   
Nine Months Ended September 30, 2005
  
Nine Months Ended September 30, 2004
  
   
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Total revenue
  
$
678
  
$
20
  
$
698
  
$
469
  
$
37
  
$
506
  
Total cost of revenue
    
972
    
--
    
972
    
5,348
    
214
    
5,562
  
Gross margin (loss)
    
(294
)
  
20
    
(274
)
  
(4,879
)
  
(177
)
  
(5,056
)
Total operating expenses
    
1,967
    
83
    
2,050
    
2,771
    
316
    
3,087
  
Segment profitability (loss)
  
$
(2,261
)
$
(63
)
$
(2,324
)
$
(7,650
)
$
(493
)
$
(8,143
)

Reconciliation of total segment operating expenses to total operating expenses for the quarters ended September 30:
   
Three Months Ended September 30,
  
Nine Months Ended September 30,
  
   
2005
  
2004
  
2005
  
2004
  
Total segment operating expenses
  
$
603
  
$
890
  
$
2,050
  
$
3,087
  
(Gain) on disposal of assets
    
--
    
(3
)
  
--
    
(3
)
Impairment of intangible assets
    
--
    
--
    
--
    
587
  
Total operating expenses
  
$
603
  
$
887
  
$
2,050
  
$
3,671
  

A reconciliation of total segment (loss) to loss before provision for income taxes for the quarters ended September 30:
   
Three Months Ended September 30,
  
Nine Months Ended September 30,
  
   
2005
  
2004
  
2005
  
2004
  
Total segment loss
  
$
(804
)
$
(1,107
)
$
(2,324
)
$
(8,143
)
Change in fair value of warrant liability
    
--
    
--
    
--
    
198
  
Gain on disposal of assets
    
--
    
3
          
3
  
Impairment of intangible assets
    
--
    
--
    
--
    
(587
)
Interest and other income/(expense), net
    
(139
)
  
(100
)
  
(388
)
  
(89
)
Total loss before income taxes
  
$
(943
)
$
(1,204
)
$
(2,712
)
$
(8,618
)


Page 12


The following table presents a summary of assets by segment:

       
   
September 30,
2005
  
December 31,
2004
  
Desktop Integration
  
$
7
  
$
15
  
Messaging and Application Engineering
    
--
    
--
  
Total assets
  
$
7
  
$
15
  


NOTE 12. CONTINGENCIES
 
Litigation. Various lawsuits and claims have been brought against us in the normal course of our business. In January 2003, an action was brought against us in the Circuit Court of Loudon County, Virginia, for a breach of a real estate lease. The case was settled in August 2003. Under the terms of the settlement agreement, we agreed to assign a note receivable with recourse equal to the unpaid portion of the note should the note obligor default on future payments. The unpaid balance of the note was $545 and it matures in December 2007. We assessed the probability of liability under the recourse provisions using a weighted probability cash flow analysis and have recognized a long-term liability in the amount of $131.
 
In October 2003, we were served with a summons and complaint in Superior Court of North Carolina regarding unpaid invoices for services rendered by one of our subcontractors. The amount in dispute was approximately $200 and is included in accounts payable. On May 12, 2004, we settled this litigation. Under the terms of the settlement agreement, we agreed to pay a total of $189 plus interest over a 19-month period ending November 15, 2005.
 
In March 2004, we were served with a summons and complaint in Superior Court of North Carolina regarding a security deposit for a sublease in Virginia. The amount in dispute is approximately $247. In October 2004, we reached a settlement agreement wherein we agreed to pay $160 over a 24-month period ending October 2006.
 
In August 2004, we were notified that we were in default under an existing lease agreement for office facilities in Princeton, New Jersey. The amount of the default is approximately $65. Under the terms of the lease agreement, we may be liable for future rents should the space remain vacant. We have reached a settlement agreement with the landlord which calls for a total payment of $200 over a 20-month period ending July 2006.
 
In March 2005, we were notified that EM Software Solutions, Inc. may seek damages amounting to approximately $300 resulting from alleged misrepresentations made by us as part of the sale of the Geneva Enterprise Integrator asset sale in December 2002. The basis of the claim involves EM Software’s inability to secure renewals on maintenance contracts. We believe that the probability of an unfavorable outcome is remote and accordingly we have not reserved for this contingency.

Under the indemnification clause of the Company’s standard reseller agreements and software license agreements, the Company agrees to defend the reseller/licensee against third party claims asserting infringement by the Company’s products of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay any judgments entered on such claims against the reseller/licensee.


Page 13


NOTE 13: Subsequent Events:
 
On November 3, 2005, Liraz Systems, Ltd. sole guaranty of the Company's indebtedness to Bank Hapoalim expired and the bank loan matured.  The Company is currently in discussions with Liraz to extend their guaranty and the maturity on the bank debt until November 2006.
Page 14

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

This information should be read in conjunction with the condensed consolidated financial statements and related notes contained in this Report. Level 8 Systems, Inc. (the "Company") presents its annual consolidated financial statements on the basis of its fiscal year ending December 31.

This discussion contains forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, as amended, which reflects the Company’s expectation or belief concerning future events that invoke risks or uncertainties. The forward-looking statements relate to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities, liquidity and capital resources and other matters. A variety of factors could cause the Company’s actual results to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements including the following:

 
·
market acceptance of the Cicero product and successful execution of the new strategic direction;
 
 
·
general economic or business conditions may be less favorable than expected, resulting in, among other things, lower than expected revenues;
 
 
·
trends in sales of our products and general economic conditions may affect investors' expectations regarding our financial performance and may adversely affect our stock price;
 
 
·
our future results may depend upon the continued growth and business use of the Internet;
 
 
·
we may lose market share and be required to reduce prices as a result of competition from its existing competitors, other vendors and information systems departments of customers;
 
 
·
we may not have the ability to recruit, train and retain qualified personnel;
 
 
·
rapid technological change could render the Company's products obsolete;
 
 
·
loss of any one of our major customers could adversely affect our business; our products may contain undetected software errors, which could adversely affect our business;
 
 
·
because our technology is complex, we may be exposed to liability claims;
 
 
·
we may be unable to enforce or defend our ownership and use of proprietary technology;
 
 
·
because we are a technology company, our common stock may be subject to erratic price fluctuations; and
 
 
·
we may not have sufficient liquidity and capital resources to meet changing business conditions.
 
Reference should be made to such factors and all forward-looking statements are qualified in their entirety by the above cautionary statements. Although we believe that these forward-looking statements are based upon reasonable assumptions, we can give no assurance that our goals will be achieved. Given these uncertainties, prospective investors are cautioned not to place undue reliance on these forward-looking statements. These forward-looking statements are made as of the date of this quarterly report. We assume no obligation to update or revise them or provide reasons why actual results may differ.


Page 15



GENERAL INFORMATION

The Company is a provider of business integration software that enables organizations to integrate new and existing information and processes at the desktop with Cicero. Business integration software addresses the emerging need for a company's information systems to deliver enterprise-wide views of the company's business information processes.

In addition to software products, the Company also provides technical support, training and consulting services as part of its commitment to providing its customers with industry-leading integration solutions. The Company’s consulting team has in-depth experience in developing successful enterprise-class solutions as well as valuable insight into the business information needs of customers in the Global 5000. The Company offers services around its integration software products.  

The Company's results of operations include the operations of the Company and its subsidiaries. During 2002, the Company identified the assets of the Systems Integration segment as being held for sale and thus a discontinued operation. Accordingly, the assets and liabilities have been reclassified to assets held for sale and the results of operations of that segment are now reclassified as gain or loss from discontinued operations.

In 2004, the Company acquired Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally certified email encryption technology. Ensuredmail products are available as an integrated feature of the Company’s desktop application integration solution, Cicero. The purchase price was allocated to the assets acquired and liabilities assumed based on the Company’s estimates of fair value at the acquisition date. The Company assessed the net realizable value of the Ensuredmail software technology acquired and determined the purchase price exceeded the amounts allocated to the software technology acquired by approximately $587. This excess of the purchase price over the fair values of the assets acquired was allocated to goodwill, and, because it was deemed impaired, charged to the Statements of Operations for the period ended March 31, 2004.

Unless otherwise indicated, all information is presented in thousands (‘000s).

Page 16


RESULTS OF OPERATIONS

The table below presents information about reported segments for the three and nine months ended September 30, 2005 and 2004:
   
Three Months Ended September 30, 2005
  
Three Months Ended September 30, 2004
  
   
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Total revenue
  
$
73
  
$
11
  
$
84
  
$
164
  
$
9
  
$
173
  
Total cost of revenue
    
285
    
--
    
285
    
390
    
--
    
390
  
Gross margin (loss)
    
(212
)
  
11
    
(201
)
  
(226
)
  
9
    
(217
)
Total operating expenses
    
576
    
27
    
603
    
812
    
78
    
890
  
Segment profitability (loss)
  
$
(788
)
$
(16
)
$
(804
)
$
(1,038
)
$
(69
)
$
(1,107
)


   
Nine Months Ended September 30, 2005
  
Nine Months Ended September 30, 2004
  
   
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Desktop Integration
  
Messaging and Application Engineering
  
Total
  
Total revenue
  
$
678
  
$
20
  
$
698
  
$
469
  
$
37
  
$
506
  
Total cost of revenue
    
972
    
--
    
972
    
5,348
    
214
    
5,562
  
Gross margin (loss)
    
(294
)
  
20
    
(274
)
  
(4,879
)
  
(177
)
  
(5,056
)
Total operating expenses
    
1,967
    
83
    
2,050
    
2,771
    
316
    
3,087
  
Segment profitability (loss)
  
$
(2,261
)
$
(63
)
$
(2,324
)
$
(7,650
)
$
(493
)
$
(8,143
)


THREE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2004.

Total Revenues. Total revenues decreased $89, or 51.5%, from $173 to $84, for the three months ended September 30, 2005 as compared with the three months ended September 30, 2004. The decrease in revenues is primarily the result of two factors: a reduction in maintenance revenue from the loss of one annual renewal and a reduction in billable service revenues in the current quarter.

Total Cost of Revenue. Total cost of revenue decreased $105, or 26.9%, from $390 to $285, for the three months ended September 30, 2005 as compared with the three months ended September 30, 2004.

Total Gross Margin. Gross margin decreased from a loss of $217 to a loss of $201 for the three months ended September 30, 2005, as compared with the three months ended September 30, 2004,.

Total Operating Expenses. Total operating expenses decreased $287, or 32% from $890 to $603 for the three months ended September 30, 2005, as compared with the three months ended September 30, 2004. The decrease in total operating expenses was the reduction in headcount and associated overheads and an overall reduction in the costs of business fees and a dependency on third party services.

Segments. Management makes operating decisions and assesses performance of the Company’s operations based on the following reportable segments: Desktop Integration segment and Messaging and Application Engineering segment.


Page 17

Desktop Integration Segment.

Total Revenues. Total Desktop Integration System revenue decreased approximately $91, or 55% from $164 to $73 for the three months ended September 30, 2005 compared with the three months ended September 30, 2004. The decrease in revenues is primarily the result a reduction in maintenance revenue from the loss of one annual maintenance renewal and a reduction in billable service revenues in the current quarter.

Total Cost of Revenues. Total Desktop Integration System cost of revenue decreased approximately $105, or 27% from $390 to $285 for the three months ended September 30, 2005 compared with the three months ended September 30, 2004. The primary costs of revenues is royalty payments based on a percentage of software sales, personnel costs and related overhead for maintenance revenue, and personnel costs and related overhead, and travel expenses associated with the generation of service revenue. The primary reason for the decrease in cost of revenues was the reduction in headcount and associated overheads.

Gross Margin (loss). Gross loss decreased from a loss of $226 to a loss of $212 for the three months ended September 30, 2005, as compared with the three months ended September 30, 2004.

Total Operating Expenses. Total operating expenses decreased $236, or 29% from $812 to $576 for the three months ended September 30, 2005, as compared with the three months ended September 30, 2004. The primary reason for the decrease in total operating expenses was the reduction in the sales and marketing workforce and the change in the sales compensation structure to lower fixed costs and increase variable revenue-success based costs.

Messaging and Application Engineering Segment.
Total Revenues. Total Messaging and Application Engineering revenue increased approximately $2, or 22% from $9 to $11 for the three months ended September 30, 2005 compared with the three months ended September 30, 2004. The increase in total Messaging and Application Engineering revenue, while small in total dollars, reflects the slight success of the Company’s Ensuredmail product.

Total Cost of Revenues. Messaging and Application Engineering did not incur cost of revenues for the three months ended September 30, 2005 or for the three months ended September 30, 2004.

Gross Margin (loss). Gross margin increased from $9 to $11 for the three months ended September 30, 2005, as compared with the three months ended September 30, 2004. The increase in the gross margin while small in total dollars reflects the slight success of the Ensuredmail product.

Total Operating Expenses. Total operating expenses decreased $51, or 65% from $78 to $27 for the three months ended September 30, 2005, as compared with the three months ended September 30, 2004. The primary reason for the decrease in total operating expenses was the reduction in January 2005 of one employee plus associated overhead costs.

Segment Profitability. Segment profitability represents loss before income taxes, interest and other income (expense) gain (loss) on sale of assets, and impairment charges. Segment profitability (loss) for the three months ended September 30, 2005 was approximately ($804) as compared to ($1,107) for the same period of the previous year. The decrease in the loss before income taxes, interest and other income and expense, gain or loss on sale of assets and impairment charges is primarily attributable to the reduction in headcount and associated overheads.

Segment profitability is not a measure of performance under accounting principles generally accepted in the United States of America, and should not be considered as a substitute for net income, cash flows from operating activities and other income or cash flow statement data prepared in accordance with accounting principles generally accepted in the United States of America, or as a measure of profitability or liquidity. We have included information concerning segment profitability as one measure of our cash flow and historical ability to service debt and because we believe investors find this
Page 18

information useful. Segment profitability as defined herein may not be comparable to similarly titled measures reported by other companies.

Revenue. The Company has three categories of revenue: software products, maintenance, and services. Software products revenue is comprised primarily of fees from licensing the Company's proprietary software products. Maintenance revenue is comprised of fees for maintaining, supporting, and providing periodic upgrades to the Company's software products. Services revenue is comprised of fees for consulting and training services related to the Company's software products.

The Company's revenues vary from quarter to quarter, due to market conditions, the budgeting and purchasing cycles of customers and the effectiveness of the Company’s sales force. The Company typically does not have any material backlog of unfilled software orders and product revenue in any quarter is substantially dependent upon orders received in that quarter. Because the Company's operating expenses are based on revenue levels that are relatively fixed over the short term, variations in the timing of the recognition of revenue can cause significant variations in operating results from quarter to quarter.

We generally recognize revenue from software license fees when our obligations to the customer are fulfilled, which is typically upon delivery or installation. Revenue related to software maintenance contracts is recognized ratably over the terms of the contracts. Revenues from services are recognized on a time and materials basis as the services are performed and amounts due from customers are deemed collectible and non-refundable. The revenue recognition rules pertaining to software arrangements are complicated and certain assumptions are made in determining whether the fee is fixed and determinable and whether collectability is probable. Should our actual experience with respect to collections differ from our initial assessment, there could be adjustments to future results.

Software Products.
Software Product Revenue. Software product revenue increased approximately $2, or 22.2% from $9 to $11 for the three months ended September 30, 2005 as compared with the three months ended September 30, 2004. The Desktop Integration segment accounted for approximately 73% of total software product revenue for the quarter ended September 30, 2005. The Messaging and Application Engineering segment accounted for 27% of total software product revenues for the same period.

Software Product Gross Margins. The gross margin on software products for the three months ended September 30, 2005 was 91 % as compared to the gross margin loss of (622) % for the three months ended September 30, 2004 and reflects the accrual of royalty payments offset by revenues. Cost of software is composed of royalties to third parties, and to a lesser extent, production and distribution costs.


Maintenance.
Maintenance Revenue. Maintenance revenue for the three months ended September 30, 2005 decreased by approximately $31, or 40.8%, from $76 to $45 as compared to three months ended September 30, 2004. The decline in overall maintenance revenues is primarily due to the non-renewal of one maintenance contract for the Cicero product within the Desktop Integration segment which occurred in the first quarter of 2005. The Desktop Integration segment accounted for approximately 82% of total maintenance revenue for the quarter ended September 30, 2005.

The percentage of total maintenance revenues for the Messaging and Application Engineering segment increased from 3% for the three months ended September 30, 2004 to 18% for the three months ended September 30, 2005. The increase is attributed to the slight success of the Company’s Ensuredmail product.

Maintenance Gross Margin. Gross margin (loss) on maintenance products for the three months ended September 30, 2005 was (82)% compared with (18)% for the three months ended September 30, 2004. The increase in gross margin (loss) is attributable to the decline in maintenance revenues from 2004 to 2005. Cost of maintenance is comprised of personnel costs and related overhead for the maintenance and support of the Company’s software products.

Page 19

Services.
Services Revenue. Service revenue decreased $60, or 68%, from $88 to $28 for the three months ended September 30, 2005 as compared with the three months ended September 30, 2004. The decrease in service revenues is a result of no substantial integration projects in the third quarter of 2005. Services revenues related to the Desktop Integration Segment was $28 for the three months ended September 30, 2005 compared with $82 for the three months ended September 30, 2004. There were no services revenues related to the Messaging and Application Segment for the three months ended September 30, 2005 and September 30, 2004. Revenues are expected to increase for the Desktop Integration segment as the Cicero product gains acceptance. The Messaging and Application Engineering segment service revenues should continue to be insignificant as the majority of the relevant products are commercial off-the-shelf applications.

Services Gross Margin. Services gross margin (loss) was (621)% for the three months ended September 30, 2005 compared with (167)% for the three months ended September 30, 2004. The increase in gross margin loss was primarily attributable to the decrease in service billings noted above.

Sales and Marketing. Sales and marketing expenses primarily include personnel costs for salespeople, marketing personnel, travel and related overhead, as well as trade show participation and promotional expenses. Sales and marketing expenses for the three months ended September 30, 2005 decreased by approximately $123, or 48%, from $258 to $135 as compared with the three months ended September 30, 2004. The reductions in sales and marketing are primarily attributable to a reduction in the Company’s sales and marketing workforce and sales compensation structure in March 2004. Specifically, the Company changed the compensation structure to lower fixed costs and increase variable success-based costs.

All sales and marketing expense are related to the Desktop Integration segment.

Research and Development. Research and product development expenses primarily include personnel costs for product authors, product developers and product documentation and related overhead. Research and development expense decreased by approximately $82, or 29%, from $283 to $201 for the three months ended September 30, 2005 as compared to the three months ended September 30, 2004. The decrease in costs for the quarter reflects the reduction in January 2005, in headcount by one employee, plus associated overheads.

General and Administrative. General and administrative expenses consist of personnel costs for the legal, financial, human resources, and administrative staff, related overhead, and all non-allocable corporate costs of operating the Company. Our principal executive offices are located in Farmingdale, New Jersey and the remaining general and administrative staff is located in Cary, North Carolina. General and administrative expenses for the quarter ended September 30, 2005 decreased by approximately $82, or 24%, over the same period in the prior year. The reason for the decrease in costs is the reduction of headcount and an overall reduction in the costs of business fees and a dependency on third party services.
 
Change in Fair Value of Warrant Liability. The Company has recorded a warrant liability for derivatives in accordance with EITF 00-19 for its common stock warrants with redemption features outside the control of the Company. The fair value of the warrants as of September 30, 2005 has been determined using valuation techniques consistent with the valuation performed as of December 31, 2004 and recorded as a warrant liability. As of September 30, 2004 the Company has calculated that no warrant liability exists.

Provision for Taxes. The Company’s effective income tax rate for continuing operations differs from the statutory rate primarily because an income tax benefit was not recorded for the net loss incurred in the first and second quarters of 2005 or 2004. Because of the Company’s recurring losses, the deferred tax assets have been fully offset by a valuation allowance.


Page 20


NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED WITH THE NINE MONTHS ENDED SEPTEMBER 30, 2004.

Total Revenues. For the nine months ended September 30, 2005, total revenues increased $192, or 38% compared with the nine months ended September 30, 2004. The increase in revenues is attributed to an increasing acceptance of the Company’s Cicero software solution.

Total Gross Margin. Gross margin losses were (39)% for the nine months ended September 30, 2005 compared with (999)% for the nine months ended September 30, 2004. The primary reason for the reduction in the gross margin (loss) as a percentage of revenues is the impairment of the remaining unamortized software costs of the Cicero technology in June 2004.

Desktop Integration Segment.

Total Revenues. Total Desktop Integration System revenue increased approximately $209, or 45% from $469 to $678 for the nine months ended September 30, 2005 compared with the nine months ended September 30, 2004. The increase in software product revenue for the Cicero product within the Desktop Integration segment reflects the addition of one significant new customer in April 2005.

Total Cost of Revenues. Total Desktop Integration System cost of revenue decreased approximately $4,376, or 82% from $5,348 to $972 for the nine months ended September 30, 2005 compared with the nine months ended September 30, 2004. The decrease in total Desktop Integration System cost of revenue results from the impairment of the remaining unamortized software costs of the Cicero technology in June 2004.

Gross Margin (loss). Gross margin/(losses) decreased $4,585, or 94%, from ($4,879) to ($294) for the nine months ended September 30, 2005, as compared with the nine months ended September 30, 2004. The decrease in total Desktop Integration System gross margin loss results from the impairment of the remaining unamortized software costs of the Cicero technology in June 2004.

Total Operating Expenses. Total operating expenses decreased $804, or 29% from $2,771 to $1,967 for the nine months ended September 30, 2005, as compared with the nine months ended September 30, 2004. The primary reason for the decrease in total operating expenses was the reduction in the sales and marketing workforce and the change in the sales compensation structure to lower fixed costs and increased variable revenue-success based costs.

Messaging and Application Engineering Segment.

Total Revenues. Total Messaging and Application Engineering revenue decreased approximately $17, or 46% from $37 to $20 for the nine months ended September 30, 2005 compared with the nine months ended September 30, 2004. The decrease in total Messaging and Application Engineering revenue, while minor in total, is a result of the non renewal of maintenance for our GIB product.

Total Cost of Revenues. Total Messaging and Application Engineering cost of revenue decreased approximately $214, or 100% from $214 to $0 for the nine months ended September 30, 2005 compared with the nine months ended September 30, 2004. The decrease in total Messaging and Application Engineering cost of revenue results from the impairment of the remaining unamortized software costs of the Ensuredmail software technology product in the Messaging and Application Engineering segment.

Gross Margin (loss). Gross margin increased from a gross margin loss of ($177) to a gross margin of $20 for the nine months ended September 30, 2005, as compared with the nine months ended September 30, 2004. The decrease in total Messaging and Application Engineering cost of revenue results from the impairment of the remaining unamortized software
Page 21

 costs of the Ensuredmail software technology product in the Messaging and Application Engineering segment.

Total Operating Expenses. Total operating expenses decreased $233 or 74% from $316 to $83 for the nine months ended September 30, 2005, as compared with the nine months ended September 30, 2004. The primary reason for the decrease in total operating expenses was the reduction of in January 2005 of one employee plus associated overhead costs.

Software Products.
Software Product Revenue. Software product revenue increased approximately $268, or 229%, from $117 to $385 for the nine months ended September 30, 2005 as compared with the nine months ended September 30, 2004. The Desktop Integration segment accounted for approximately 99% of total software product revenue for the nine months ended September 30, 2005. The Messaging and Application Engineering segment accounted for 1% of total software product revenues for the same period. The increase in software product revenue is primarily attributable to the addition of one new significant customer for the Cicero product within the Desktop Integration segment in April 2005.

Software Product Gross Margin. The gross margin/(loss) on software products for the nine months ended September 30, 2005 was 96% compared with (3,723)% for the nine months ended September 30, 2004. This increase in gross margin reflects the amortization of acquired software not offset by revenues. Cost of software is composed primarily of amortization of software product technology, amortization of capitalized software costs for internally developed software and royalties to third parties, and to a lesser extent, production and distribution costs. Historical cash flows generated by the Cicero technology did not support the long-lived asset and, accordingly, the Company impaired the unamortized book value of the technology in excess of the expected net realizable value during the period ended June 30, 2004.

Maintenance
Maintenance Revenue. Maintenance revenue decreased by approximately $116, or 52%, from $222 to $106 for the nine months ended September 30, 2005 compared with the nine months ended September 30, 2004. The decline in overall maintenance revenues is primarily due to the non-renewal of one maintenance contract for the Cicero product within the Desktop Integration segment.

The Desktop Integration segment accounted for approximately 87% of total maintenance revenue for the nine months ended September 30, 2005. The Messaging and Application Engineering segment accounted for approximately 13% of total maintenance revenues for the same period. The majority of the Desktop Integration maintenance as a percentage of the total is directly tied to the percentage composition of the revenue streams between the Desktop segment and the Messaging segment.

Maintenance Gross Margin. Cost of maintenance is comprised of personnel costs and related overhead for the maintenance and support of the Company’s software products. Gross margin (loss) on maintenance products for the nine months ended September 30, 2005 was (162)% compared with (30)% for the nine months ended September 30, 2004. The increase in gross margin (loss) is attributable to the decline in maintenance revenues from 2004 to 2005 and specifically, one customer who chose not to renew their maintenance agreement in January 2005.

Services.
Services Revenue. Services revenue increased $40, or 24%, from $167 to $207 for the nine months ended September 30, 2005 as compared with the nine months ended September 30, 2004. The increase in service revenues is attributable to pilot engagements and the deployment and installation of our software at a new customer during the nine month period.

Services Gross Margin. Services gross margin (loss) was (229)% for the nine months ended September 30, 2005 as compared with (380)% for the nine months ended September 30, 2004. The increase in gross margin for services was primarily attributable to the increase in service revenues in the period.

Page 22


Sales and Marketing. Sales and marketing expenses for the nine months ended September 30, 2005 decreased by approximately $385, or 41%, from $940 to $555 as compared with the nine months ended September 30, 2004. The reductions in sales and marketing are primarily attributable to a reduction in the Company’s sales and marketing workforce and sales compensation structure in March 2004. Specifically, the Company changed the compensation structure to lower fixed costs and increase variable success-based costs.

Sales and marketing expenses primarily include personnel costs for salespeople, marketing personnel, travel and related overhead, as well as trade show participation and promotional expenses. The Company's emphasis for the sales and marketing groups will be the Desktop Integration segment.

Research and Development. Research and development expense decreased by approximately $167, or 19%, from $882 to $715 in the nine months ended September 30, 2005 as compared to the same period in 2004. The decrease in costs in 2005 reflects the reduction in headcount, plus associated overheads. Research and product development expenses primarily include personnel costs for product authors, product developers and product documentation and related overhead.

General and Administrative. General and administrative expenses consist of personnel costs for the legal, financial, human resources, and administrative staff, related overhead, and all non-allocable corporate costs of operating the Company. Our principal executive offices are located in Farmingdale, New Jersey and the remaining general and administrative staff is located in Cary, North Carolina. General and administrative expenses for the nine months ended September 30, 2005 decreased by approximately $485, or 38% over the same period in the prior year. The reason for the decrease in costs is the reduction of headcount and an overall reduction in the costs of business fees and a dependency on third party services.
 
Change in Fair Value of Warrant Liability. The Company has recorded a warrant liability for derivatives in accordance with EITF 00-19 for its common stock warrants with redemption features outside the control of the Company. As of September 30, 2005, the warrant liability had a fair value of $0 and has been determined using valuation techniques consistent with the valuation performed as of December 31, 2004. As of September 30, 2004, the Company has calculated that no warrant liability exists.

Provision for Taxes. The Company’s effective income tax rate for continuing operations differs from the statutory rate primarily because an income tax benefit was not recorded for the net loss incurred in the first and second quarters of 2005 or 2004. Because of the Company’s recurring losses, the deferred tax assets have been fully offset by a valuation allowance.

Segment Profitability. Segment profitability represents loss before income taxes, interest and other income (expense) gain (loss) on sale of assets, and impairment charges. Segment profitability (loss) for the nine months ended September 30, 2005 was approximately ($2,324) as compared to ($8,143) for the same period of the previous year. The decrease in the loss before income taxes, interest and other income and expense, gain or loss on sale of assets and impairment charges is primarily attributable to the impairment of the Company’s software technology in 2004.

Segment profitability is not a measure of performance under accounting principles generally accepted in the United States of America, and should not be considered as a substitute for net income, cash flows from operating activities and other income or cash flow statement data prepared in accordance with accounting principles generally accepted in the United States of America, or as a measure of profitability or liquidity. We have included information concerning segment profitability as one measure of our cash flow and historical ability to service debt and because we believe investors find this information useful. Segment profitability as defined herein may not be comparable to similarly titled measures reported by other companies.

Impact of Inflation. Inflation has not had a significant effect on the Company’s operating results during the periods presented.

Page 23


LIQUIDITY AND CAPITAL RESOURCES
Cash

Cash and cash equivalents decreased to $16 at September 30, 2005 from $107 at December 31, 2004. The Company utilized $91 of cash for the nine months ended September 30, 2005.

Net cash used by Operating Activities. Cash used by operations for the nine months ended September 30, 2005 was $1,876 of cash compared with $2,569 used by operations for the nine months ended September 30, 2004. Cash used for the nine months ended September 30, 2005 was primarily comprised of the loss from operations of approximately $2,712, offset by non-cash charges for depreciation and amortization of approximately $8 and stock compensation expense of $101. In addition, the Company’s cash increased by approximately $145 and $86 from the reduction in accounts receivable and prepaid expenses and other assets respectively, and approximately $539 for the increase in accounts payable and accrued expenses from vendors for services rendered.

Net cash provided by Financing Activities. Cash provided by financing activities for the nine months ended September 30, 2005 was approximately $1,782 as compared with approximately $2,586 for the nine months ended September 30, 2004. Cash provided from financing activities for the nine months ended September 30, 2005 was comprised primarily of the proceeds of an additional round of investment from several new investors, offset by repayments of the Company’s short-term debt in the amount of $55.

Liquidity

The Company funded its cash needs during the quarter ended September 30, 2005 with cash on hand from June 30, 2005, and with the cash realized from a Note and Warrant Offering and Extended Note and Warrant Offering.

The Company has a $1,971 term loan bearing interest at LIBOR plus 1% (approximately 4.43% at September 30, 2005), interest on which is payable semi-annually. There are no financial covenants. In September 2004, the Company and Liraz Systems Ltd. agreed to extend its guaranty on the term loan and with Bank Hapoalim, and to extend the maturity date on the loan to November 3, 2005. In consideration for the extension of the guaranty, the Company issued 3,942,000 shares of our common stock to Liraz at the time of the extension. The Company and Liraz are in discussions to extend the guaranty and the maturity on the loan until November 2006, although the loan has formally matured and the guaranty expired.

In April 2005, the Company borrowed $30 from a member of the Company’s Board of Directors pursuant to a convertible loan agreement. Under the term of this agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 428,571 shares of our common stock at a conversion price of $0.07 per share.

From July through September 2005, the Company entered into several Convertible Bridge Notes with a consortium of investors. As of September 30, 2005, the Company had raised $1,053 of Convertible Bridge Notes of which $312 was from various members of the Company’s Board of Directors. Under the terms of these Notes, holders will convert their Notes into 33,526,184 shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger.
 
In March 2004, the Company borrowed $125, pursuant to a convertible loan agreement with Mark and Carolyn Landis. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 446,429 shares of our common stock and warrants to purchase 446,429 shares of our common stock exercisable at $0.28. The warrants expire in three years from the date of grant. In June 2004, we entered into a convertible loan agreement with Mark and Carolyn Landis, in the amount of $125. Under the terms of the agreement, the loan bears interest at 1% per month and also is convertible upon the option of the note holder into 781,250 shares of our common stock and warrants to purchase 781,250 shares of our common stock exercisable at $0.16. The warrants expire in three years from the date of grant. In October 2004, the Company borrowed $100 pursuant to a convertible loan agreement with Mark and Carolyn Landis. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the

Page 24

option of the note holder into 1,000,000 shares of our common stock and warrants to purchase 2,000,000 shares of the Company’s common stock exercisable at $0.10. The warrants expire in three years. In November 2004, the Company borrowed $150 pursuant to a convertible loan agreement with Mark and Carolyn Landis. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 1,875,000 shares of our common stock and warrants to purchase 1,875,000 shares of the Company’s common stock exercisable at $0.08. The warrants expire in three years.

In April 2004, the Company borrowed $100 pursuant to a convertible loan agreement with Mr. Pizi. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 270,270 shares of our common stock and warrants to purchase 270,270 shares of our common stock exercisable at $0.37. The warrants expire in three years from the date of grant. In June 2004, the Company entered into a convertible promissory note with Mr. Pizi in the face amount of $112. Under the terms of the agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 560,000 shares of our common stock and warrants to purchase 560,000 shares of our common stock at $0.20 per share. Also in June 2004, the Company borrowed an additional $15 from Mr. Pizi which bears interest at 1% and is convertible into 90,118 shares of our common stock and warrants to purchase 90,118 shares of our common stock at $0.17 per share. These warrants expire three years from the date of grant.

In May 2004, the Company borrowed $185 from several investors including a member of the Company’s Board of Directors pursuant to convertible loan agreements. Under the terms of the agreements the loans bear interest between 1% and 1.5% per month and are convertible into an aggregate of 578,125 shares of the Company’s common stock and warrants to purchase an aggregate of 578,125 shares of our common stock exercisable at $0.32. The warrants expire in three years.

Also in May 2004, the Company pledged certain accounts receivables with an investor for the face amount of $135 which bears interest at 1% per month and warrants to purchase 211,214 shares of our common stock at a conversion rate of $0.32 per share.

The Company has incurred losses of approximately $9,800 and $10,000 in each of the past two calendar years and has experienced negative cash flows from operations for each of the past three years. For the nine months ended September 30, 2005 the Company incurred an additional loss of approximately $2,712 and has a working capital deficiency of approximately $12,972. The Company’s future revenues are largely dependent on acceptance of Cicero. Accordingly, there is substantial doubt that the Company can continue as a going concern. In order to address these issues and to obtain adequate financing for the Company’s operations for the next twelve months, the Company is actively promoting and expanding its product line and continues to negotiate with significant customers that have demonstrated interest in the Cicero technology. The Company is experiencing difficulty increasing sales revenue largely because of the market’s lack of knowledge of Cicero as well as customer concerns about the financial viability of the Company. The Company is attempting to solve the former problem by increased marketing and by leveraging its limited number of reference accounts. The Company is attempting to address the financial concerns of potential customers by pursuing strategic partnerships with companies that have significant financial resources although the Company has not experienced significant success to date with this approach. Additionally, the Company is seeking additional equity capital or other strategic transactions in the near term to provide additional liquidity. The Company has completed a Note and Warrant Offering in December 2004 and an extension to the Note and Warrant offering in March 2005 wherein it has raised a total of approximately $2,559. Under the terms of the Offers, warrant holders of Level 8’s common stock were offered a one-time conversion of their existing warrants at a conversion price of $0.10 per share as part of a recapitalization merger plan which the Company currently intends to propose to its shareholders. Those warrant holders who elected to convert, tendered their conversion price in cash and received a Note Payable in exchange. Upon approval of the recapitalization merger by the Company’s shareholders, anticipated at an annual meeting to be held in late 2005 or earlier, these Notes would convert into common shares of Cicero, Inc., the surviving corporation in the proposed merger. In addition, the note holders would receive additional warrants automatically convertible into common shares of Cicero, Inc. These funds were used to finance the operations of the Company. In June 2005, the Company was required to extend the Note and Warrant Offering under similar terms in an

Page 25

effort to raise cash and sustain operations. The Company had successfully secured an additional $98 in financing. In July 2005, the Company negotiated an additional financing of up to $1,000 with certain existing and new investors at terms similar to the Note and Warrant offerings issued. In August 2005, Level 8 revised the offer and issued Convertible Bridge Notes up to $1,500, in which the note holders will receive shares of Cicero common stock at a conversion price of $0.0314 (equivalent of $0.00157 for Level 8 shares), assuming the recapitalization merger is completed prior to December 31, 2005. If the recapitalization merger is completed after December 31, 2005, the Convertible Bridge Note holders will receive shares of Cicero common stock at a conversion price of $0.025 (equivalent to $0.00125 for Level 8). As of September 30, 2005, the Company has raised a total of $1,053, of which $204 is related to non-cash transactions. There can be no assurance that management will be successful in continued execution of these strategies as anticipated or in a timely manner or that increased revenues will reduce further operating losses. If the Company is unable to significantly increase cash flow or obtain additional financing, it will likely be unable to generate sufficient capital to fund operations for the next twelve months and may be required to pursue other means of financing that may not be on terms favorable to the Company or its stockholders.  If we are unable to increase cash flow or obtain financing, we may not be able to generate enough capital to fund operations for the next twelve months. We do not believe that we currently have sufficient cash on hand to finance operations for the next twelve months. At our current rates of expense and assuming revenues for the next twelve months at the annualized rate of revenue for the first nine months of 2005, we will be able to fund planned operations with existing capital resources for a minimum of four months and experience negative cash flow of approximately $2,000,000 during the next twelve months to maintain planned operations.

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements presented herein do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

The Company also intends to use its capital to continue to make investment in research and development on its Cicero product while enhancing efficiencies in this area. Cicero (version 6.1) was released October 2005, and includes a new integrated debugging suite for runtime problem diagnosis.  This toolset includes new trace, history, and exception viewers and enhancements to event, repository, and context viewers.  Cicero 6.1 also provides support for application pooling and creates Cicero-aware applications, which provides direct access to the action libraries to applications.  The next major release is expected to update the application code to provide more flexibility and performance improvements with the Cicero integration platform.  This release will also include direct support for database platforms such as Microsoft SQL and additional support for the Citrix environment.  This is tentatively scheduled for release during second quarter 2006.  Other enhancements and products related to Cicero are defined by priority based on customer need.


OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have any off-balance sheet arrangements. We have no subsidiaries or other unconsolidated limited purpose entities, and we have not guaranteed or otherwise supported the obligations of any other entity.


Item 3. Quantitative and Qualitative Disclosures about Market Risk

As the Company has sold most of its European based business and has closed several European sales offices, the majority of revenues are generated from US sources. The Company expects that trend to continue for the next year. As such, there is minimal foreign currency risk at present. Should the Company continue to develop a reseller presence in Europe and Asia, that risk will be increased.

Item 4. Controls and Procedures

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls

Page 26

and procedures were effective as of the end of the period covered by this report. There have not been any changes in the Company’s internal control over financial reporting during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.


Part II. Other Information

Item 1. Legal Proceedings

Various lawsuits and claims have been brought against the Company in the normal course of business.

In January 2003, an action was brought against us in the Circuit Court of Loudon County, Virginia, for a breach of a real estate lease. The case was settled in August 2003. Under the terms of the settlement agreement, we agreed to assign a note receivable with recourse equal to the unpaid portion of the note should the note obligor default on future payments. The unpaid balance of the note is $309 and it matures in December 2007. We assessed the probability of liability under the recourse provisions using a weighted probability cash flow analysis and have recognized a long-term liability in the amount of $131.

In October 2003, we were served with a summons and complaint in Superior Court of North Carolina regarding unpaid invoices for services rendered by one of our subcontractors. The amount in dispute was approximately $200 and is included in accounts payable. Subsequent to March 31, 2004, we settled this litigation. Under the terms of the settlement agreement, we agreed to pay a total of $189 plus interest over a 19-month period ending November 15, 2005.

In March 2004, we were served with a summons and complaint in Superior Court of North Carolina regarding a security deposit for a sublease in Virginia. The amount in dispute is approximately $247. In October 2004, we reached a settlement agreement wherein we agreed to pay $160 over a 24-month period ending October 2006.

In August 2004, we were notified that we were in default under an existing lease agreement for office facilities in Princeton, New Jersey. The amount of the default is approximately $65. Under the terms of the lease agreement, we may be liable for future rents should the space remain vacant. We have reached a settlement agreement with the landlord which calls for a total payment of $200 over a 20-month period ending July 2006.

In March 2005, we were notified that EM Software Solutions, Inc. is seeking damages amounting to approximately $300 resulting from alleged misrepresentations made by us as part of the sale of the Geneva Enterprise Integrator asset sale in December 2002. The basis of the claim involves EM Software’s inability to secure renewals on maintenance contracts. We believe that the probability of an unfavorable outcome is remote and accordingly we have not reserved for this contingency.


Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

In 2004, the Company announced a Note and Warrant Offering in which warrant holders of Level 8’s common stock were offered a one-time conversion of their existing warrants at a conversion price of $0.10 per share as part of a recapitalization merger plan which the Company currently intends to propose to its shareholders at the Company’s next annual meeting. Under the terms of the Offer, which expired on December 31, 2004, warrant holders who elect to convert, would tender their conversion price in cash and receive a Note Payable in exchange. Upon approval of the recapitalization merger by the Company’s shareholders at an annual meeting anticipated to be held in late 2005, these Notes would convert into common shares of Cicero, Inc., the surviving corporation in the proposed merger. In addition, those warrant holders who elected to convert the first $1,000 of warrants would receive additional replacement warrants at a ratio of 2:1 for each warrant convert-

Page 27

ed, with a strike price of $0.10 per share. In addition, upon approval of the recapitalization merger, each warrant holder would be entitled to additional warrants to purchase common stock in Cicero, Inc.

As of June 30, 2005, the Company had raised a total of $2,559 from its Note and Warrant Offerings. The Notes and Warrants were issued in reliance upon the exemption from registration under Rule 506 of Regulation D and on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 for transactions by an issuer not involving a public offering.

In March 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis, who are related by marriage to Anthony Pizi, the Company’s former Chairman and Chief Executive Officer and currently its Chief Information Officer, in the amount of $125. Under the terms of the agreement, the loan is convertible into 446,429 shares of our common stock and warrants to purchase 446,429 shares of our common stock exercisable at $0.28. The warrants expire in three years. We also entered into convertible loan agreements with two other individual investors, each in the face amount of $50,000. Under the terms of the agreement, each loan is convertible into 135,135 shares of our common stock and warrants to purchase 135,135 shares of our common stock at $0.37 per share. The warrants expire in three years.

In January 2004, the Company acquired substantially all of the assets and certain liabilities of Critical Mass Mail, Inc., d/b/a Ensuredmail, a federally certified encryption software company. Under the terms of the purchase agreement, the Company issued 2,027,027 shares of common stock at a price of $0.37. The total purchase price of the assets and certain liabilities being acquired was $750 and has been accounted for by the purchase method of accounting. These shares were issued in reliance upon the exemption from registration under Rule 506 of Regulation D and on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 for transactions by an issuer not involving a public offering.

Also in January 2004, and simultaneously with the asset purchase of Critical Mass Mail, Inc., the Company completed a Securities Purchase Agreement with several new and existing investors as well as certain investors of Critical Mass Mail, Inc. wherein the Company raised $1,247 through the sale of 3,369,192 shares of common stock at a price of $0.37 per share. As part of the financing, the Company has also issued warrants to purchase 3,369,192 shares of the Company’s common stock at an exercise price of $0.37. The warrants expire three years from the date of grant. These shares were issued in reliance upon the exemption from registration under Rule 506 of Regulation D and on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 for transactions by an issuer not involving a public offering.

In April 2005, the Company entered into a convertible loan from a member of the Company’s Board of Directors in the amount of $30. Under the terms of this agreement, the loan bears interest at 1% per month and is convertible upon the option of the note holder into 428,571 shares of our common stock at a conversion price of $0.07 per share.

In July 2005, the Company agreed to issue Convertible Bridge Notes to a consortium of investors, up to $1,500. These notes bear interest at 10% and mature at various dates beginning on September 15, 2005. The Notes are convertible into shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger. Since the Company has not effected the recapitalization merger by October 31, 2005, the conversion rates on the Notes is $0.0314. Should the recapitalization merger become effective after December 31, 2005, the conversion rate will be amended to $0.025. As of September 30, 2005, the Company has issued $1,053 of Convertible Bridge Notes. An additional $239 was in transit to the Company.
 
Item 3. Defaults Upon Senior Securities
None

Item 4. Submission of Matters to a Vote of Security Holders
None

Item 5. Other Information
None

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits


Page 28


Exhibit No.
 
Description
31.1
Certification of Chief Executive Officer/Chief Financial Officer pursuant to Rule 13a-14(a) (filed herewith).
32.1
Certification of John P. Broderick pursuant to 18 USC § 1350, as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith).

(b) Reports on Form 8-K

On July 27, 2005, the Company filed a Form 8-K reporting the resignations and appointments of members to the Company’s Board of Directors.

Page 29


SIGNATURE
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
LEVEL 8 SYSTEMS, INC.
 
    
By: /s/ John P. Broderick  
John P. Broderick
Chief Executive Officer
Date: November 14, 2005