Edgar Filing: LEVEL 8 SYSTEMS INC

Level 8 September 30, 2006 Form 10-Q

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, 2006.

[ ]	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 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. YES X NO _

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one)

Large accelerated filer o Accelerated Filer o Non accelerated filer ý

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

Yes o No ý

48,039,947 common shares, $.001 par value, were outstanding as of November 7, 2006.

Level 8 Systems, Inc.

Index

PART I. Financial Information	Page Number

Item 1. Financial Statements

Consolidated balance sheets as of September 30, 2006 (unaudited) and December 31, 2005	3

Consolidated statements of operations for the three and nine months ended September 30, 2006 and 2005 (unaudited)	4

Consolidated statements of cash flows for the nine months ended September 30, 2006 and 2005 (unaudited)	5

Consolidated statements of comprehensive loss for the three and nine months ended September 30, 2006 and 2005 (unaudited)	6

Notes to consolidated financial statements (unaudited)	7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	16

Item 3. Quantitative and Qualitative Disclosures about Market Risk	26

Item 4. Controls and Procedures	27

PART II. Other Information	27


SIGNATURE	29

Part I. Financial Information

Item 1. Financial Statements

LEVEL 8 SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

	September 30, 2006				December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	102		$	29
Assets of operations to be abandoned		73			131
Trade accounts receivable, net		153			18
Prepaid expenses and other current assets		30			53
Total current assets		358			231
Property and equipment, net		14			10
Total assets	$	372		$	241
LIABILITIES AND STOCKHOLDERS' (DEFICIT)
Current liabilities:
Senior reorganization debt	$	2,559		$	2,559
Convertible bridge notes		2,865			1,760
Short-term debt		3,697			3,481
Accounts payable		2,652			2,528
Accrued expenses:
Salaries, wages, and related items		1,011			1,036
Other		2,745			2,193
Liabilities of operations to be abandoned		418			490
Deferred revenue		46			78
Total current liabilities		15,993			14,125
Long-term debt		134			131
Senior convertible redeemable preferred stock		1,061			1,061
Total liabilities		17,188			15,317
Stockholders' (deficit):
Preferred stock		--			--
Common stock		48			48
Additional paid-in-capital		210,594			210,594
Accumulated other comprehensive loss		(5	)		(3	)
Accumulated deficit		(227,453	)		(225,715	)
Total stockholders' (deficit)		(16,816	)		(15,076	)
Total liabilities and stockholders' (deficit)	$	372		$	241

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

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LEVEL 8 SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Revenue:
Software	$	100		$	11		$	207		$	385
Maintenance		23			45			101			106
Services		125			28			541			207
Total operating revenue		248			84			849			698

Cost of revenue
Software		3			1			8			14
Maintenance		50			82			163			278
Services		135			202			429			680
Total cost of revenue		188			285			600			972

Gross margin (loss)		60			(201	)		249			(274	)

Operating expenses:
Sales and marketing		104			135			301			555
Research and product development		150			201			393			715
General and administrative		261			267			709			780
(Gain) on disposal of asset		(24	)		--			(24	)		--
Total operating expenses		491			603			1,379			2,050
Loss from operations		(431	)		(804	)		(1,130	)		(2,324	)

Other income (expense):
Interest expense		(219	)		(155	)		(599	)		(422	)
Other income/(expense)		3			16			(9	)		34
Loss before provision for income taxes		(647	)		(943	)		(1,738	)		(2,712	)
Income tax provision		--			--			--			--

Net loss	$	(647	)	$	(943	)	$	(1,738	)	$	(2,712	)

Net loss per share applicable to common shareholders—basic and diluted	$	(0.01	)	$	(0.02	)	$	(0.04	)	$	(0.06	)

Weighted average common shares outstanding -- basic and diluted		48,016			44,407			48,016			43,781

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

Page 4

LEVEL 8 SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Nine Months Ended September 30,
		2006			2005
Cash flows from operating activities:
Net loss	$	(1,738	)	$	(2,712	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		9			8
Stock compensation expense		--			101
Provision for doubtful accounts		--			(12	)
Gain/(loss) on disposal of assets		23			--
Changes in assets and liabilities:
Trade accounts receivable and related party receivables		(135	)		145
Assets and liabilities - discontinued operations		(37	)		(41	)
Prepaid expenses and other assets		23			86
Accounts payable and accrued expenses		648			539
Deferred revenue		(32	)		10
Net cash used in operating activities		(1,239	)		(1,876	)

Cash flows from investing activities:
Purchases of equipment		(13	)		--

Cash flows from financing activities:
Borrowings under credit facility, term loans, notes payable		1,432			1,837
Repayments of term loans, credit facility and notes payable		(105	)		(55	)
Net cash provided by financing activities		1,327			1,782
Effect of exchange rate changes on cash		(2	)		3
Net increase (decrease) in cash and cash equivalents		73			(91	)
Cash and cash equivalents:
Beginning of period		29			107
End of period	$	102		$	16

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

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LEVEL 8 SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Net loss	$	(647	)	$	(943	)	$	(1,738	)	$	(2,712	)
Other comprehensive loss, net of tax:
Foreign currency translation adjustment		(1	)		--			(5	)		3
Comprehensive loss	$	(648	)	$	(943	)	$	(1,743	)	$	(2,709	)

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

Page 6

LEVEL 8 SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(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 Level 8 Systems, Inc.'s (the "Company") Annual Report on Form 10-K for the year ended December 31, 2005. 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 generally accepted accounting principles of 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 $3,681,000 and $9,761,000 in the past two years and has experienced negative cash flows from operations for each of the past three years. For the nine months ended September 30, 2006, the Company incurred a loss of $1,738,000 and had a working capital deficiency of $15,635,000. The Company’s future revenues are entirely dependent on acceptance of Cicero software, 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 favorable to the Company or its

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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.

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 2006, 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 $1,300,000 during the next twelve months to maintain planned operations. 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 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. .

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

Effective January 1, 2006 the Company adopted Statement of Financial Accounting Standards (“SFAS”) No.123(R), “Share-Based Payment”, using the modified prospective application transition method. The modified prospective application transition method requires compensation cost to be recognized beginning on the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date. As such, prior periods will not reflect restated amounts. Prior to January 1, 2006, we accounted for all of our stock option plans in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. No stock-based employee compensation expense related to stock options or our stock purchase plans was reflected in Net Earnings/(Loss) prior to January 1, 2006. We did however recognize stock compensation expense for stock awards made to non employees under SFAS 123. SFAS 123R requires us to report the tax benefit from the tax deduction that is in excess of recognized compensation costs (excess tax benefits) as a financing cash flow. Prior to January 1, 2006, the benefit resulting from disqualifying dispositions of incentive stock options will not be recognized until the net operating loss carryforwards related to these deductions can be used. When the Company utilizes the net operating loss related to these deductions, the tax benefit will be reflected in additional paid-in capital and not as a reduction of tax expense. The total amount of these deductions included in the net operating loss carryforwards is $21,177,000.

Underwater, or out-of-the-money, options are considered to be anti-dilutive, in that it would be illogical for option holders to exercise options at a price higher than what it would cost them to buy shares on the open market. During the three and nine months ended September 30, 2006 and 2005, all stock options were out-of- the money. As a result, there was no cash received for exercisable stock options and no income tax benefit recognized for the three months and nine months ended September 30, 2006.

The following table sets forth certain information as of September 30, 2006, about shares of the Company’s common stock, par value $.001 (the“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 and the Outside Director Stock Option Plan. The Company’s stockholders approved all of the Company’s Equity Compensation Plans.

Page 8

	Shares
Outstanding on January 1, 2006		5,900,897
Granted		--
Exercised		--
Forfeited		(1,105,600	)
Outstanding on September 30, 2006		4,795,297

Weighted average exercise price of outstanding options	$	1.20
Shares available for future grants on September 30, 2006		3,519,160

NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS No. 154 requires that changes in accounting principle be retrospectively applied. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not believe adoption of this statement will have a material impact on the Company’s financial statements.

NOTE 3. SENIOR REORGANIZATION DEBT

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 exercise of their existing warrants at an exercise price of $0.10 per share as part of a recapitalization merger plan. Under the terms of the offer, which expired on December 31, 2004, warrant holders who lent an amount equal to their exercise price, received a Senior Reorganization Note in exchange. As of December 31, 2005, the Company had raised $2,559,000. Upon approval of the recapitalization merger by the Company’s shareholders 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 million would receive additional replacement warrants and in addition, Early Adopter Warrants, at a ratio of 2:1 for each existing warrant in respect of which they lent the exercise price, with a strike price of $0.10 per share. Upon approval of the recapitalization merger, each lender in the Note and Warrant Offering would receive additional warrants automatically exercisable into shares of Cicero common stock. If the merger proposal is not approved, the Notes will immediately become due and payable.

The Company has revised its plans to effect a recapitalization merger as contemplated by the filing of its S-4 registration statement. As a result, the Company has decided to pursue a Proxy Solicitation from its shareholders to effect the recapitalization by amending its certificate of incorporation rather than to proceed with the recapitalization merger. The Company will also obtain consent from the Senior Note holders that the trigger event for conversion of their Notes and warrants is effectiveness of the recapitalization and for the additional warrants to be exercised for shares of Level 8 common stock rather than Cicero. Should the proxy solicitation fail to garner the required approval, the Notes will immediately become due and payable. The Special Meeting of Stockholders to which the proxy solicitation pertains, will be held on November 16, 2006.

NOTE 4. CONVERTIBLE BRIDGE DEBT

In 2005, the Company entered into several Convertible Bridge Notes to a consortium of investors. These notes bear interest at 10% and mature at various dates beginning on September 15, 2005. The Notes are

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convertible into shares of Cicero, Inc. common stock upon effectiveness of the proposed recapitalization merger. The conversion rate on the Notes is $0.025. As of December 31, 2005, the Company had raised $1,760,000 of Convertible Bridge Notes and as of September 30, 2006 the Company has raised an additional $1,105,000 for a total of $2,865,000. If the merger proposal is not approved, the Notes will immediately become due and payable.

The Company intends to obtain consent from the holders of the convertible bridge debt to amend the trigger event for conversion of their Convertible Bridge Notes to the effectiveness of the recapitalization and for the Convertible Bridge Notes to be convertible into shares of Level 8 common stock rather than Cicero.

NOTE 5. SHORT TERM DEBT

Notes payable, long-term debt, and notes payable to related party consist of the following:

(dollars in thousands)	September 30, 2006		December 31, 2005
Term loan (a)	$	1,971	$	1,971
Note payable; related party (b)		9		9
Notes payable (c)		725		509
Short term convertible note (d)		265		265
Short term convertible note, related party (e)		727		727
	$	3,697	$	3,481

(a)

The Company has a $1,971,000 term loan bearing interest at LIBOR plus 1.5% (approximately 6.13% at September 30, 2006). Interest is payable quarterly. 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 October 30, 2006. The Company and the Guarantor are in negotiations to extend the guaranty and maturity on the note. See Note 10 Subsequent Events.

(b)	From time to time the Company entered into promissory notes with the Company's Chief Information Officer, Anthony Pizi. As of September 30, 2006, the Company is indebted to Mr. Pizi in the amount of $9,000. The notes bear interest at 12% per annum.

(c)

The Company entered into a revolving credit facility with a group of private investors and from time to time has issued a series of short term promissory notes with these private lenders, which provide for short term borrowings both secured and unsecured by accounts receivable. As of September 30, 2006, the Company has issued short term notes totaling $196,000. The Company also entered into a short term promissory note with interest at 10% per annum with Liraz Systems Ltd, the sole guarantor on the Company’s term loan, in the amount of $178,000. 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 24% 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 $30,000 with Mr. Bruce Miller, a member of the Company’s Board of Directors. 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 May 2004, the Company entered into convertible loans aggregating $185,000 from several investors. 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 with another investor in the amount of $50,000. 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.

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(e) The Company entered into convertible promissory notes with Anthony Pizi, the Company’s 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 $100,000. 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 $112,000. 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 $15,000 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.

In March 2004, the Company entered into a convertible loan agreement with Mark and Carolyn Landis, in the principal amount of $125,000. 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 $125,000. 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 $100,000. 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 $150,000. 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 6. 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 first three months of fiscal year 2006 or 2005. Because of the Company's recurring losses, the deferred tax assets have been fully offset by a valuation allowance.

NOTE 7. LOSS PER SHARE

Basic loss per share is computed based upon the weighted average number of common shares outstanding. Diluted earnings/(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 and preferred stock.

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The following table sets forth the reconciliation of net loss to loss available to common stockholders (in thousands, except per share amounts):

	Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Net loss applicable to common stockholders, as reported	$	(647	)	$	(943	)	$	(1,738	)	$	(2,712	)
Less: Total stock based employee compensation expense under fair value based method for all awards, net of related tax effects		--			(40	)		--			(201	)
	$	(647	)	$	(983	)	$	(1,738	)	$	(2,913	)
Basic and diluted loss per share:
Net loss per share applicable to common shareholders	$	(0.01	)	$	(0.02	)	$	(0.04	)	$	(0.07	)

Weighted common shares outstanding - basic and diluted		48,016			44,407			48,016			43,781

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,
	2006		2005
Stock options, common share equivalent		4,795,297		7,258,647
Warrants, common share equivalent		19,376,075		19,953,406
Preferred stock, common share equivalent		8,504,611		9,133,723
		32,675,983		36,345,776

NOTE 8. 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. The non-GAAP measures presented may not be comparable to similarly titled measures reported by other companies.

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The table below presents information about reported segments for the three and nine months ended September 30, 2006 and 2005 (in thousands):

	Three Months Ended September 30, 2006									Three Months Ended September 30, 2005
	Desktop Integration			Messaging and Application Engineering			Total			Desktop Integration			Messaging and Application Engineering			Total
Total revenue	$	247		$	1		$	248		$	73		$	11		$	84
Total cost of revenue		188			--			188			285			--			285
Gross margin (loss)		59			1			60			(212	)		11			(201	)
Total operating expenses		488			26			514			576			27			603
Segment profitability (loss)	$	(429	)	$	(25	)	$	(454	)	$	(788	)	$	(16	)	$	(804	)

	Nine Months Ended September 30, 2006									Nine Months Ended September 30, 2005
		Desktop Integration			Messaging and Application Engineering			Total			Desktop Integration			Messaging and Application Engineering			Total
Total revenue	$	843		$	6		$	849		$	678		$	20		$	698
Total cost of revenue		600			--			600			972			--			972
Gross margin (loss)		243			6			249			(294	)		20			(274	)
Total operating expenses		1,332			71			1,403			1,967			83			2,050
Segment profitability (loss)	$	(1,089	)	$	(65	)	$	(1,154	)	$	(2,261	)	$	(63	)	$	(2,324	)

A reconciliation of total segment operating expenses to total operating expenses for the three and nine months ended September 30 (in thousands):

	Three Months Ended September 30,					Nine Months Ended September 30,
		2006			2005		2006			2005
Total segment operating expenses	$	514		$	603	$	1,403		$	2,050
(Gain) on disposal of asset		(23	)		--		(24	)		--
Total operating expenses	$	491		$	603	$	1,379		$	2,050

A reconciliation of total segment profitability (loss) to loss before provision for income taxes for the three and nine months ended September 30 (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Total segment profitability (loss)	$	(454	)	$	(804	)	$	(1,154	)	$	(2,324	)
Gain on disposal of asset		23			--			24			--
Interest and other income/(expense), net		(216	)		(139	)		(608	)		(388	)
Total loss before income taxes	$	(647	)	$	(943	)	$	(1,738	)	$	(2,712	)

The following table presents a summary of assets by segment (in thousands):

	September 30,
	2006		2005
Desktop Integration	$	14	$	7
Messaging and Application Engineering		--		--
Total assets	$	14	$	7

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NOTE 9. 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, the Company agreed to assign the note receivable from the sale of Geneva to EM Software Solutions, Inc., with recourse equal to the unpaid portion of the note receivable should the note obligor, EM Software Solutions, Inc., default on future payments. The current unpaid principal portion of the note receivable assigned is approximately $154,000 and 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 $131,000.

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 $200,000 and is included in accounts payable. Subsequent to June 30, 2004, we settled this litigation. Under the terms of the settlement agreement, we agreed to pay a total of $189,000 plus interest over a 19-month period ending November 15, 2005. The Company is in the process of negotiating a series of payments for the remaining liability of approximately $80,000.

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 was approximately $247,000. In October 2004, we reached a settlement agreement wherein we agreed to pay $160,000 over a 24-month period ending September 2006. The Company has recently modified that agreement to extend the monthly payments until September 2007.

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 was approximately $65,000. 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 $200,000, and is included in accounts payable, over a 31-month period ending October 2007.

In March 2005, we were notified that EM Software Solutions, Inc. is seeking damages amounting to approximately $300,000 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 disagree with this allegation, will aggressively defend our position and accordingly, have not reserved for this contingency. There has been no further communication from EM Software Solutions, Inc. on this matter.

In April 2005, we were notified that Critical Mass Mail, Inc had filed a claim against us for failure to pay certain liabilities under an Asset Purchase Agreement dated January 9, 2004. We in turn filed that Critical Mass Mail, Inc, failed to deliver certain assets and other documents under the same Asset purchase agreement. We had already reserved the potential liability under the Agreement as part of the asset purchase accounting. On March 1, 2006, Critical Mass Mail amended their complaint and is seeking damages of approximately $600,000 for our failure to timely register the underlying securities issued in the Asset Purchase. Although our legal counsel is unable to predict the outcome of this matter, we believe that the probability of an unfavorable outcome is remote based upon the facts as presented 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.

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NOTE 10. SUBSEQUENT EVENTS

On October 30, 2006, our indebtedness to Bank Hapoalim matured and the sole guaranty of such indebtedness by Liraz Systems, Ltd. will expire on November 30, 2006. The Company is currently in discussions with Liraz to extend its guaranty and the maturity of the bank debt until October 2007.

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

Level 8 Systems, Inc. is a provider of business integration software, known as Cicero, which enables organizations to integrate new and existing information and processes at the desktop. Our 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, Level 8 also provides technical support, training and consulting services as part of its commitment to providing its customers with industry-leading integration solutions. Level 8’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. Level 8 offers services around its integration software products.

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

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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.

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.

RESULTS OF OPERATIONS

The table below presents information about reported segments for the three and nine months ended September 30, 2006 and 2005 (in thousands):

	Three Months Ended September 30, 2006									Three Months Ended September 30, 2005
	Desktop Integration			Messaging and Application Engineering			Total			Desktop Integration			Messaging and Application Engineering			Total
Total revenue	$	247		$	1		$	248		$	73		$	11		$	84
Total cost of revenue		188			--			188			285			--			285
Gross margin (loss)		59			1			60			(212	)		11			(201	)
Total operating expenses		488			26			514			576			27			603
Segment profitability (loss)	$	(429	)	$	(25	)	$	(454	)	$	(788	)	$	(16	)	$	(804	)

	Nine Months Ended September 30, 2006									Nine Months Ended September 30, 2005
Desktop Integration		Desktop Integration			Messaging and Application Engineering			Total			Desktop Integration			Messaging and Application Engineering			Total
Total revenue	$	843		$	6		$	849		$	678		$	20		$	698
Total cost of revenue		600			--			600			972			--			972
Gross margin (loss)		243			6			249			(294	)		20			(274	)
Total operating expenses		1,332			71			1,403			1,967			83			2,050
Segment profitability (loss)	$	(1,089	)	$	(65	)	$	(1,154	)	$	(2,261	)	$	(63	)	$	(2,324	)

THREE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2005.

Total Revenues. Total revenues increased $164,000, or 195.2%, from $84,000 to $248,000, for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005. The

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increase in revenues is primarily attributable to increases in software license revenue as well as increases in professional service revenues from current engagements.

Total Cost of Revenue. Total cost of revenue decreased $97,000, or 34%, from $285,000 to $188,000, for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005. The decrease is due to the reduction of three full time employees, and the associated overheads.

Total Gross Margin. Gross margin was $60,000, or 24.2%, for the three months ended September 30, 2006 as compared to the gross margin loss of ($201,000), or (239%) for the three months ended September 30, 2005. The positive change in the gross margin as a percentage of revenues is due to the decrease in cost of services due to the reduction of three full time employees, and the associated overheads.

Total Operating Expenses. Total operating expenses decreased $112,000, or 18.6% from $603,000 to $491,000 for the three months ended September 30, 2006, as compared with the three months ended September 30, 2005. The decrease in total operating expenses is due to 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.

Desktop Integration Segment.

Total Revenues. Total Desktop Integration System revenue increased approximately $174,000, or 238% from $73,000 to $247,000 for the three months ended September 30, 2006 compared with the three months ended September 30, 2005. The increase in revenues is due to an increase in license revenues plus an increase in service revenues. In the same period for 2005, license revenues were minimal and there was only one small service project underway.

Total Cost of Revenues. Total Desktop Integration System cost of revenue decreased approximately $97,000, or 34% from $285,000 to $188,000 for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005. The primary costs of revenue 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 revenue was a reduction in headcount and associated overheads.

Gross Margin. Gross margin increased from a loss of ($212,000) to a margin of $59,000 for the three months ended September 30, 2005 as compared with the three months ended September 30, 2006. The positive change in the gross margin is due to the decrease in cost of services due to the reduction of three full time employees, and the associated overheads along with the impact of increased revenues in software licenses and services during the period.

Total Operating Expenses. Total operating expenses decreased $88,000, or 15% from $576,000 to $488,000 for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005. The decrease in total operating expenses is due to the reduction in headcount and associated overheads and an overall reduction in the costs of business fees and a dependency on third party services.

Messaging and Application Engineering Segment.

Total Revenues. Total Messaging and Application Engineering revenue decreased approximately $10,000 or 91% from $11,000 to $1,000 for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005. The decrease in total Messaging and Application Engineering revenue while not significant, was primarily the result of non renewal of annual maintenance agreements from existing customers.

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Total Cost of Revenue. Messaging and Application Engineering did not incur cost of revenue for the three months ended September 30, 2006 or 2005.

Gross Margin. Gross margin decreased from $11,000 to $1,000 for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005. The decrease in gross margin is primarily attributable to the decline in renewals of annual maintenance agreements as noted above.

Total Operating Expenses. Total operating expenses remained consistent at $27,000 for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005.

Segment Profitability. Segment profitability represents loss before income taxes, interest and other income (expense) gain (loss) on disposal of assets. Segment profitability (loss) for the three months ended September 30, 2006 was approximately ($454,000) as compared to ($804,000) for the same period of the previous year. The decrease in the loss before income taxes, interest and other income and expense, and gain or loss on sale of assets is primarily attributable to the reduction in headcount and associated overheads as well as the increases in revenues in the period.

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.

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 collectibility 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 $89,000, or 809% for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005 and is primarily attributable to one software license contract in the current period and minor software revenues in the prior period.

Software Product Gross Margins. The gross margin on software products for the three months ended September 30, 2006 was 97.0 % as compared to the gross margin of 90.1% for the three months ended

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September 30, 2005 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, 2006 decreased by approximately $22,000, or 48.8%, from $45,000 to $23,000 as compared to the three months ended September 30, 2005. The decrease in overall maintenance revenues is due to the non renewal of one maintenance contract for the Cicero product within the Desktop Integration segment and to a lesser extent, several small non renewals for the Ensuredmail product. The Desktop Integration segment accounted for approximately 95.6% of total maintenance revenue for the quarter ended September 30, 2006.

Maintenance Gross Margin. Gross margin (loss) on maintenance products for the three months ended September 30, 2006 was (117.4)% compared with (82.2)% for the three months ended September 30, 2005. Cost of maintenance is comprised of personnel costs and related overhead for the maintenance and support of the Company’s software products

Services.

Services Revenue. Service revenue increased $97,000, or 346%, from $28,000 to $125,000 for the three months ended September 30, 2006 as compared with the three months ended September 30, 2005. The increase in service revenues is a result of two integration services projects in process relating to Cicero software. Approximately 100% of services revenues is directly related to the Desktop Integration Segment. There were no services revenues related to the Messaging and Application Segment for the three months ended September 30, 2006 and September 30, 2005. 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 and therefore do not require any significant service labor to install.

Services Gross Margin. Services gross margin (loss) was (8)% for the three months ended September 30, 2006 compared with gross margin (loss) of (621)% for the three months ended September 30, 2005. The improvement in gross margin was primarily attributable to the increase in service billings noted above as well as a reduction in costs through reduction in headcount.

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, 2006 decreased by approximately $31,000, or 22.9%, from $135,000 to $104,000 as compared with the three months ended September 30, 2005. The reductions in sales and marketing are primarily attributable to a reduction in the Company’s sales and marketing workforce and sales compensation structure. Specifically, the Company changed the compensation structure to lower fixed costs and increased 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 $51,000, or 25.4%, from $201,000 to $150,000 for the three months ended September 30, 2006 as compared to the three months ended September 30, 2005. The decrease in costs for the quarter reflects the reduction 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 three months ended September 30, 2006 decreased by approximately $7,000, or 2.6%, over the same period in the prior year. The reason for the decrease in costs is the reduction of headcount offset by an increase in corporate costs relating to the Company’s Plan of Reorganization.

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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 third quarter of 2006 or 2005. Because of the Company’s recurring losses, the deferred tax assets have been fully offset by a valuation allowance.

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

NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED WITH THE NINE MONTHS ENDED SEPTEMBER 30, 2005.

Total Revenues. For the nine months ended September 30, 2006, total revenues increased $151,000, or 21.6% compared with the nine months ended September 30, 2005. The overall increase in revenues is the result of a decrease in software license revenues offset by an increase in service revenues. The Company had one significant software installation in the first nine months of 2005 while in 2006, the Company had significant professional service contracts but no significant software license agreements.

Total Gross Margin. Gross margin was 29.3% for the nine months ended September 30, 2006 compared with a gross margin (loss) of (60.7)% for the nine months ended September 30, 2005. The primary reasons for the increase in the gross margin as a percentage of revenues are the increases in service related projects coupled with the reduction in cost of professional services and associated overheads.

Desktop Integration Segment.

Total Revenues. Total Desktop Integration System revenue increased approximately $165,000, or 24% from $678,000 to $843,000 for the nine months ended September 30, 2006 compared with the nine months ended September 30, 2005. Software product revenue decreased for the Cicero product within the Desktop Integration segment and reflects the addition of one significant new customer in April 2005 and no significant new customers in 2006. Service revenues increased by $334,000 and reflects a number of active consulting engagements in process in 2006.

Total Cost of Revenue. Total Desktop Integration System cost of revenue decreased approximately $372,000, or 38% from $972,000 to $600,000 for the nine months ended September 30, 2006 compared with the nine months ended September 30, 2005. The decrease in total Desktop Integration System cost of revenue results from a reduction in headcount and associated overheads.

Gross Margin (loss). Gross margin increased $537,000 from a gross margin loss of ($294,000) to a margin of $243,000 for the nine months ended September 30, 2006, as compared with the nine months ended September 30, 2005. The increase in total Desktop Integration System gross margin results from the reduction in headcount and associated overheads and the increase in revenues in the period from service consulting contracts.

Total Operating Expenses. Total operating expenses decreased $635,000, or 32% from $1,967,000 to $1,332,000 for the nine months ended September 30, 2006, as compared with the nine months ended September 30, 2005. 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 as well as significant reductions in headcount and associated overheads in the research and development area.

Messaging and Application Engineering Segment.

Total Revenues. Total Messaging and Application Engineering revenue decreased approximately $14,000 or 70% from $20,000 to $6,000 for the nine months ended September 30, 2006 compared with the nine months ended September 30, 2005. The decrease in total Messaging and Application Engineering revenue, while minor in total, reflects the Company’s limited success with its Ensuredmail product.

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Total Cost of Revenues. Total Messaging and Application Engineering cost of revenue was $0 for each period.

Gross Margin (loss). Gross margin decreased from $20,000 to $14,000 for the nine months ended September 30, 2006, as compared with the nine months ended September 30, 2005.

Total Operating Expenses. Total operating expenses decreased $12,000, or 14% from $83,000 to $71,000 for the nine months ended September 30, 2006, as compared with the nine months ended September 30, 2005

Software Products.

Software Product Revenue. Software product revenue decreased approximately $178,000 or 46%, from $385,000 to $207,000 for the nine months ended September 30, 2006 as compared with the nine months ended September 30, 2005. The Desktop Integration segment accounted for approximately 99.5% of total software product revenue for the nine months ended September 30, 2006. The Messaging and Application Engineering segment accounted for less than 1% of total software product revenues for the same period. The decrease 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 and no significant new customers during 2006.

Software Product Gross Margin. The gross margin on software products for the nine months ended September 30, 2006 was 96% compared with 96.3% for the nine months ended September 30, 2005. 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.

Maintenance

Maintenance Revenue. Maintenance revenue decreased by approximately $5,000 or 4.7%, from $106,000 to $101,000 for the nine months ended September 30, 2006 compared with the nine months ended September 30, 2005. The decrease in overall maintenance revenues is primarily due to the amortized impact of a non renewal of maintenance support agreement from a customer.

The Desktop Integration segment accounted for approximately 95% of total maintenance revenue for the nine months ended September 30, 2006. The Messaging and Application Engineering segment accounted for approximately 5% 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 and the cost of third-party contracts for the maintenance and support of the Company’s software products. Gross margin (loss) on maintenance products for the nine months ended September 30, 2006 was (61.4)% compared with (162)% for the nine months ended September 30, 2005. The reduction in the gross margin (loss) is attributable to the reduction of costs associated with maintenance support such as headcount and related overheads.

Services.

Services Revenue. Services revenue increased $334,000 or 160%, from $207,000 to $541,000 for the nine months ended September 30, 2006 as compared with the nine months ended September 30, 2005. The increase in service revenues is attributable to new contractual engagements with Merrill Lynch and IBM.

Services Gross Margin. Services gross margin was 20.7% for the nine months ended September 30, 2006 as compared with a gross margin (loss) of (228)% for the nine months ended September 30, 2005. The increase in gross margin for services was primarily attributable to the increase in service revenues in the period as well as the reduction of associated costs to provide those services.

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Sales and Marketing. Sales and marketing expenses for the nine months ended September 30, 2006 decreased by approximately $254,000 or 46%, from $555,000 to $301,000 as compared with the nine months ended September 30, 2005. The reductions in sales and marketing are primarily attributable to a reduction in the Company’s sales and marketing workforce and sales compensation structure. 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 $322,000 or 45%, from $715,000 to $393,000 in the nine months ended September 30, 2006 as compared to the same period in 2005. The decrease in costs in 2006 reflects the reduction in headcount by three employees, 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, 2006 decreased by approximately $71,000 or 9.1% 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.

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 three quarters of 2006 or 2005. 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, 2006 was approximately ($1,154,000) as compared to ($2,324,000) for the same period of the previous year. The decrease in the loss before income taxes, interest and other income and expense, gain on disposal of asset and impairment charges is primarily attributable to the reduction in overall costs to run the business - headcounts and related overheads.

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

LIQUIDITY AND CAPITAL RESOURCES

Cash

Cash and cash equivalents increased to $102,000 at September 30, 2006 from $29,000 at December 31, 2005.

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The Company generated $73,000 of cash for the nine months ended September 30, 2006.

Net cash used by Operating Activities. Cash used by operations for the nine months ended September 30, 2006 was $1,239,000 compared with $1,876,000 used by operations for the nine months ended September 30, 2005. Cash used for the nine months ended September 30, 2006 was primarily comprised of the loss from operations of approximately $1,738,000, offset by non-cash charges for depreciation and amortization of approximately $9,000. In addition, the Company’s cash increased by $23,000 from the reduction in prepaid expenses and other assets and approximately $648,000 for the increase in accounts payable and accrued expenses from vendors for services rendered. Additionally $135,000 of cash was used as a result of an increase in accounts receivable.

Net cash used for Investing Activities The Company purchased $13,000 of equipment for operations for the nine months ended September 30, 2006.

Net cash provided by Financing Activities. Cash provided by financing activities for the nine months ended September 30, 2006 was approximately $1,327,000 as compared with approximately $1,782,000 for the nine months ended September 30, 2005. Cash provided from financing activities for the nine months ended September 30, 2006 was comprised primarily of the extension of the Convertible Bridge Notes.

Liquidity

The Company funded its cash needs during the nine months ended September 30, 2006 with cash on hand from December 31, 2005 and with the cash realized from Convertible Bridge Notes. From July 2005 through September 2006, the Company entered into several Convertible Bridge Notes with a consortium of investors. As of September 30, 2006, the Company had raised $2,865,000 of Convertible Bridge Notes. Under the terms of these Notes, holders will convert their Notes into 2,261,230,724 shares of Level 8 Systems common stock upon effectiveness of the proposed recapitalization merger. If the recapitalization is not effected, the Notes will immediately become due and payable. As described above, the Company has decided to seek a Proxy Solicitation to amend its charter to increase its authorized shares rather than to proceed with the recapitalization merger. As part of the Proxy solicitation, the Company is seeking for approval for a reverse stock split on these shares in a range of 20:1 to 100:1. Of the $2,865,000 of Convertible Notes outstanding, approximately $714,000 are held by Directors of the Company.

The Company has a $1,971,000 term loan bearing interest at LIBOR plus 1.5% (approximately 6.13% at September 30, 2006), interest on which is payable quarterly. There are no financial covenants. In November 2005, 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 October 30, 2006. In consideration for the extension of the guaranty, the Company issued 2,400,000 shares of its common stock and granted a warrant to purchase an additional 3,600,000 shares of our common stock at an exercise price of $0.002 per share. The Company and Liraz are in discussions to extend the guaranty and the maturity on the loan until October 2007, although the loan has matured in accordance with its term and the guaranty expires November 30, 2006.

In April 2005, the Company borrowed $30,000 from Mr. Bruce Miller, 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 time to time the Company entered into promissory notes with the Company's Chief Information Officer, Anthony Pizi. As of September 30, 2006, the Company is indebted to Mr. Pizi in the amount of $9,000. The notes bear interest at 12% per annum.

In May 2004, the Company entered into convertible loans aggregating $185,000 from several investors. 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

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warrants expire three years from grant. Also in March 2004, the Company entered into a convertible loan in the amount of $50,000. 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.

The Company entered into convertible promissory notes with Anthony Pizi, the Company’s 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 $100,000. 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 $112,000. 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 $15,000 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.

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 exercise of their existing warrants at an exercise price of $0.10 per share as part of a recapitalization merger plan. Under the terms of the offer, which expired on December 31, 2004, warrant holders who lend an amount equal to their exercise price and received a Senior Reorganization Note in exchange. As of December 31, 2005 the Company had raised $2,559,000. Upon approval of the recapitalization merger by the Company’s shareholders 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 million would receive additional replacement warrants Early Adopter Warrants, at a ratio of 2:1 for each existing warrant in respect of which they lent the exercise price,, 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 Cicero common stock. If the merger proposal is not approved, the Notes will immediately become due and payable.

The Company has incurred losses of approximately $3,681,000 and $9,731,000 in the past two years and has experienced negative cash flows from operations for each of the past three years. For the nine months ended September 30, 2006 the Company incurred an additional loss of approximately $1,738,000 and has a

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working capital deficiency of approximately $15,635,000. The Company’s future revenues are largely dependent on acceptance of a newly developed and marketed product - 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 inimitable nature of the product as well as customer concerns about the financial viability of the Company. The Company is attempting to solve this problem by improving the market’s knowledge and understanding of Cicero through increased marketing and 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 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.

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 2006, 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 $1,300,000 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 Level 8 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 2007. 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 unconsolidated 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

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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 and procedures were effective 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

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 $65,000. 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 $200,000 over a 31-month period ending October 2007.

In April 2005, we were notified that Critical Mass Mail, Inc had filed a claim against us for failure to pay certain liabilities under an Asset Purchase Agreement dated January 9, 2004. We in turn filed that Critical Mass Mail, Inc, failed to deliver certain assets and other documents under the same Asset purchase agreement. We had already reserved the potential liability under the Agreement as part of the asset purchase accounting. On March 1, 2006, Critical Mass Mail amended their complaint and is seeking damages of approximately $600,000 for our failure to timely register the underlying securities issued in the Asset Purchase. 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 2005, the Company entered into several Convertible Bridge Notes with a consortium of investors. 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 at a conversion rate of $0.025. As of December 31, 2005, the Company had raised $1,760,000 of Convertible Bridge Notes and as of September 30, 2006 the Company had raised an additional $1,105,000. If the merger proposal is not approved, the Notes will immediately become due and payable. The Company has decided to pursue a Proxy Solicitation from its shareholders to approve an amendment in the Company’s charter to increase its authorized shares rather than to proceed with the recapitalization merger. The Company will also obtain consent solicitation from the Senior Note holders that the qualifying event for conversion of their Notes and warrants is the successful amendment of the Company’s charter and that their pro rata shares of Level 8 common stock will be substituted for their anticipated shares of Cicero, Inc. Should the proxy solicitation fail to garner the required approval, the Notes will immediately become due and payable.

These securities were issued under the exemption offered by Rule 506 of Regulation D of the Securities Act of 1933.

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

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

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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, 2006

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