10-Q 1 doc1.txt 29 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 JUNE 30, 2003 or Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 COMMISSION FILE NUMBER 29947 INTEGRATED INFORMATION SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE 86-0624332 (State of Incorporation) (IRS Employer I.D. No.) 2250 WEST 14TH STREET TEMPE, ARIZONA 85281 (Address of principal executive offices) (480) 752-5000 (Registrant's telephone number) 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 ___ --- The registrant has not been subject to the filing requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934 for the past 90 days. Indicate the number of shares outstanding of each of the issuer's classes of common stock, not including shares held in treasury: AS OF AUGUST 12, 2003, THERE WERE 3,580,151 SHARES OF COMMON STOCK, $0.001 PAR VALUE, OUTSTANDING. INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts)

See accompanying notes to condensed consolidated financial statements INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)

See accompanying notes to condensed consolidated financial statements INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)

See accompanying notes to condensed consolidated financial statements. INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (1) NATURE OF BUSINESS AND BASIS OF PRESENTATION Integrated Information Systems, Inc. and its wholly owned subsidiary provides information technology related professional services to businesses. We help companies implement new technology to improve productivity. In this report, "IIS", "we" or "the Company" means Integrated Information Systems, Inc. and its wholly owned subsidiary. We operate in a highly competitive, consolidating market. The information technology services industry has experienced rapid growth followed by rapid and significant contraction over a relatively short economic cycle. In past periods, our rapid growth phase had required significant investments in infrastructure, facilities, computer and office equipment, human resources and working capital in order to meet the perceived demand. The increased demand did not materialize and since the third quarter of 2000, the market for our services has changed and declined significantly. We have prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the condensed consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2002. The accompanying condensed consolidated financial statements reflect all adjustments (consisting solely of normal, recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of results for the interim periods presented. The results of operations for the three and six month periods ended June 30, 2003 are not necessarily indicative of the results to be expected for any future period or the full fiscal year. (2) LIQUIDITY AND CONTINUED OPERATIONS We have incurred significant losses from operations over the past three years and have a substantial working capital deficit and an accumulated deficit of $91,319,000 as of June 30, 2003. As a result of these and other factors, there are concerns about our liquidity at June 30, 2003. The continuation of the Company is dependent upon our efforts to raise additional capital, increase revenues, reduce expenses, and ultimately, to achieve profitable operations. We have reduced our obligations and expenses through settlements with creditors, landlords and lessors, reduced our work force, and made substantial reductions to general and administrative expenses throughout 2002 and through the second quarter of 2003. During the six months ended June 30, 2003, we obtained the following: - A $500,000 increase to our term loan; - A $1,000,000 Line of Credit with our primary lender; and - $1,000,000 proceeds from sales of preferred stock to an individual who is our majority stockholder and chief executive officer and director of the Company. During the six months ended June 30, 2003, we consummated new settlements with creditors resulting in the settlement of $1,697,000 of obligations for $750,000 in cash and deposits and the issuance of 100,000 shares of Common Stock at $0.85 per share. Furthermore, we have made our cost structure significantly more variable and believe we can continue to reduce expenses if it is required. While we cannot give any assurances that the above actions will be sufficient to ultimately alleviate our liquidity concerns, or that additional borrowings or capital could be obtained under satisfactory terms if they become required, we do believe these actions will enable us to continue as a going concern through December 31, 2003. (3) USE OF ESTIMATES The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to long-term service contracts, bad debts, intangible assets, income taxes, restructuring, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of these condensed consolidated financial statements. We recognize revenue and profit as work progresses on long-term, fixed price contracts using the percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. We follow this method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We recorded goodwill and other intangible assets from acquisitions during 2002 and 2001. We review our intangible assets on a periodic basis to determine if the fair value supports the carrying value of goodwill and other intangible assets. Future adverse changes in market conditions or poor operating results could result in an inability to recover the carrying value of the investments that may not be reflected in the current carrying value of the intangible assets, thereby possibly requiring material impairment charges in the future. The determination of reporting units is integral to the intangible asset impairment test, and requires significant judgments to be made. We record a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. In the event we were to determine that we would be able to realize the deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. We evaluate the requirement for future cash expenditures resulting from contingencies and litigation and record an accrual for contingencies and litigation when exposures can be reasonably estimated and are considered probable. Should the actual results differ from our estimates, revisions to the estimated liability for contingencies and litigation would be required. (4) SUPPLEMENTAL NON-CASH DISCLOSURES Non-cash investing and financing activities for the six months ended June 30, 2003 and 2002 consisted of new capital lease obligations for property and equipment of $0 and $362,000, respectively. In 2002, as a result of acquisitions, we assumed capital lease obligations totaling $24,000, issued Common Stock totaling $338,000 and assumed a $4,750,000 note. (5) NET LOSS PER SHARE At June 30, 2003 and 2002 there were 921,693 and 1,099,896 stock options outstanding, respectively. Because we incurred a net loss in each quarter, all of these options, as well as all warrants, have been excluded from the net loss per share calculation, because their effect would be antidilutive. All options granted had an exercise price equal to the market price on the date of grant. Per share weighted average fair values are based on the date of grant using the Black-Scholes Method. Had we determined compensation cost based on the fair value at the grant date for our stock options under SFAS 123, our net loss would have been increased to the pro forma amounts indicated below (amounts in thousands):

(6) ACCOUNTS RECEIVABLE In October 2002, we entered into a financing agreement with a bank to provide a revolving loan facility. The agreement permits us to sell with recourse trade accounts receivable up to $4,200,000, is due on demand and is subject to certain collateral limitations and covenants primarily related to borrowing issuances. We pay a fee of 1.95% of the face amount of the factored receivables. The agreement is collateralized by substantially all of our assets. The agreement expires on October 14, 2003 with automatic one-year renewals, subject to termination rights. At June 30, 2003, we had outstanding borrowings of $1,177,000. For financial presentation purposes, the related receivable and outstanding recourse liability have been included as an asset and liability, respectively, on the balance sheet. (7) ASSET IMPAIRMENTS, RESTRUCTURING AND OTHER CHARGES During 2001, we recorded asset impairments and restructuring charges totaling $14,882,000. These charges included a charge in the second quarter of 2001 related to underutilized computer equipment and leasehold improvements at our data center used for application outsourcing services and a charge in the fourth quarter of 2001 for expenses incurred in connection with the closing and consolidating of six office locations and abandoned leasehold improvements in an unoccupied seventh location. Additionally, we recorded other charges related to the impairment of inventoried software licenses in the second quarter of 2001. During the first quarter of 2002, commercial real estate markets in some areas continued to be weaker than anticipated, and, accordingly, we re-evaluated our accrual for future cash expenditures for closed office locations. In addition, we executed a series of cost control initiatives to close and consolidate three additional office locations. These activities resulted in asset impairment and restructuring charges totaling $2,751,000 for the first quarter of 2002. In the second quarter of 2002, we recorded additional asset impairment charges totaling $133,000 relating to the closure of an office. During the third quarter of 2002, negotiations with the landlords of each of the closed facilities and the remaining facilities resulted in a restructuring of certain obligations and favorable settlements ultimately consummated in October 2002. Accordingly, we again re-evaluated our accrual for closed office locations resulting in a reduction of the restructuring reserve of $2,773,000. During the fourth quarter of 2002, we completed a restructuring which satisfied the obligations for certain real estate and equipment leases, certain trade payables and accrued expenses for less than their recorded value. We agreed to immediately pay $1,995,000 in cash and $1,221,000 in periodic payments over the next five years satisfying $2,686,000 of recorded accounts payable and accrued expenses, $3,074,000 of capital lease obligations and $229,000 of other non-current liabilities. As a result of the comprehensive settlement, a total of approximately $23.0 million of contractual obligations were satisfied and a reduction of the restructuring reserve of $2,427,000 was recognized in the fourth quarter due to the change in estimation of restructuring charges. We also recognized a gain of $1,268,000 from the settlement of trade payables for less than the face amount. The completion of the comprehensive settlement with creditors was funded by a revolving bank credit facility of $4,200,000 funded through the sale of accounts receivable at a discount of 1.95%, of which $2,481,000 was used to fund the settlement, including a $422,000 cash reserve account related to the receivables financing. To obtain the financing, we pledged substantially all of our assets to the bank as collateral. Additionally, our key-man life insurance policy of $5,000,000 was assigned to the bank, and the bank was given a warrant to purchase 60,000 shares of our Common Stock at $5.00 per share. Our major stockholder and Chief Executive Officer gave a $1.0 million personal guaranty to the bank as credit support, and, in consideration of his guaranty, we have agreed to make quarterly payments to him at an annual rate of 3% of the average outstanding balance under the facility and to issue him, quarterly, warrants to acquire 4,000 shares of our Common Stock for each $1.0 million in average outstanding balance under the facility during the quarter. The warrants will have an exercise price of $5.00 per share and will remain exercisable as long as any amount is guaranteed and for a period of one year thereafter, but for not less than five years from issuance. During the first quarter of 2003, in accordance with the terms of the acquisition agreement with Cunningham Technology Group (CTG), we agreed to indemnify the CTG principals against losses related to the early termination of the lease for their office space estimating the loss to be $160,000. Additionally, we reached a settlement with regard to the escrow account that was held as restricted cash. Accordingly, we again re-evaluated the accrual for closed office locations resulting in a reduction of the restructuring charge of $434,000 in the first quarter of 2003. During the second quarter of 2003, we settled the CTG office space lease agreeing to pay $58,000 in cash and $100,000 in four quarterly payments of $25,000 each. We also realized actual expenses of $12,000 against the closed office leases that had been accrued and determined $31,000 to be in excess of the closed office leases which have all been settled or expired. Accordingly, we re-evaluated the accrual for closed office locations resulting in a reduction of the restructuring reserve of $203,000. As of June 30, 2003, we no longer had any accrued liabilities for the future cash expenditures attributable to these restructuring charges. The activity for the three months ended June 30, is summarized as follows:

(8) LINE OF CREDIT During the second quarter of 2003, we obtained a one-year $1.0 million revolving line of credit. Our Chief Executive Officer gave a limited guaranty of $1.0 million for amounts drawn under the revolving line of credit, and, in exchange, we gave him a warrant for 300,000 shares at market price. As of June 30, 2003, no amount had been drawn against the line of credit. However, during July, 2003 we received net draw downs of $176,000 against the line of credit. See also note 18. (9) NOTE PAYABLE TO BANK At June 30, 2003, we owed $5,241,000 of $5,250,000 available under a long-term note with a bank. The note bears interest at 7.0%, payable quarterly with principal payments beginning in 2004. This amount is reflected net of an $11,000 discount on our Balance Sheet. The note is collateralized by accounts receivable, inventory, equipment, furniture and intellectual property. Future principle payments on the note are (amounts in thousands):

(10) CAPITAL LEASE OBLIGATIONS We are obligated under capital leases primarily for computer and office equipment that expire in 2003 and 2004. The leases meet the various criteria of a capital lease and are, therefore, classified as capital lease obligations. Capital lease obligations reflect the present value of future rental payments, discounted at the interest rate implicit in each of the leases. The leased computer and office equipment has been included in property and equipment at a total cost of $59,000 at June 30, 2003. Accumulated depreciation related to this furniture and equipment was $59,000 at June 30, 2003. We acquired property and equipment and assumed capital lease obligations totaling $0 and $362,000 for the six months ended June 30, 2003 and 2002, respectively. Interest payments under capital lease obligations are generally paid in the period incurred. (11) OPERATING LEASE COMMITMENTS We have entered into various non-cancelable operating lease agreements for office space, and office equipment. The terms of these agreements range from 6 months to 5 years and all of the leases require monthly payments. We are generally responsible for all executory costs including maintenance, insurance, utilities and taxes. Total rent expense was $147,000 and $233,000 for the three months ended June 30, 2003 and 2002, respectively and $489,000 and $1,076,000 for the six months ended June 30, 2003 and 2002, respectively. A summary of the future minimum lease payments under operating leases after June 30, 2003 follows (amounts in thousands):

During 2003, 2002 and 2001, we terminated leases for office space in New York, Boston, Denver, Santa Monica and Irvine, California; Jacksonville, Florida; Alpharetta, Georgia; Tempe, Arizona; and Bangalore, India. The above future minimum lease payments exclude minimum payment amounts for the terminated leases. (12) INCOME TAXES We did not record a provision for federal or state income taxes during the six months ended June 30, 2003 and 2002 due to the net losses reported during those periods. We also did not record a benefit for federal and state income taxes during the six months ended June 30, 2003 and 2002 due to limitations on the use of net operating loss carry forwards. At June 30, 2003, we had net operating loss carry forwards of approximately $65,000,000 for U.S. federal and state income tax purposes that expire in years 2018 through 2022. The difference between the net operating loss carry forwards of approximately $65,000,000 and the accumulated deficit of $91,319,000 at June 30, 2003 is primarily due to timing differences of recognizing certain expenses as required by the tax code compared to the requirements of generally accepted accounting principles. We have recorded a valuation allowance for the deferred tax assets as of June 30, 2003 and December 31, 2002. In assessing the realizability of deferred tax assets, we have considered whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generation of future taxable income during the periods in which those temporary differences become deductible. We considered the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making our assessment. Based upon the level of historical losses and projections for future taxable income/losses over the periods in which the deferred tax assets are deductible, we believe it is more likely than not that we will not realize the benefits of these deductible differences. (13) CONVERTIBLE PREFERRED STOCK In the first and second quarters of 2003, we sold 40,000 shares of Series A 8% Convertible Preferred Stock ("Series A 8%") to our majority stockholder, chief executive officer and director for total proceeds of $400,000. In the second quarter of 2003, we converted the 40,000 shares of Series A 8% into 40,000 shares of Series B 12% Convertible Preferred Stock ("Series B 12%") and we sold an additional 60,000 shares of Series B 12% to the same individual for total proceeds of $600,000. Series A 8% had a par value of $.001, a liquidation value of $30.00 per share, carried a cumulative quarterly dividend of $.80 per share per annum, was convertible into Common Stock at an initial conversion price of $2.50, subject to adjustment for dilutive issuances, and voted only upon conversion. We could require conversion into Common Stock as soon as the 20-day average of the last reported sale of Common Stock reached $10.00 per share or higher. Series B 12% has a par value of $.001, a liquidation value of $30.00 per share, carries a cumulative annual dividend of $1.20 per share, is convertible into Common Stock at an initial conversion price of $1.10, subject to adjustment for dilutive issuances, and votes only upon conversion. We may require conversion into Common Stock as soon as the 20-day average of the last reported sale of Common Stock is $4.40 per share or higher. (14) GOODWILL We have determined that we have only one reporting unit. The fair value of our reporting unit and the related implied fair value of its respective goodwill was established using a market capitalization approach supported by a discounted cash flow approach. In June 2002, we completed the transitional goodwill impairment test, which resulted in a non-cash charge of $3,187,000. All of the charge was related to our acquisitions completed in 2001. The primary factors that resulted in the impairment charge were due to the difficult economic environment in the IT professional services sector and the liquidity and continuation concerns of the Company at that time. The fair value and carrying value of the goodwill of $5,240,000, relating to the acquisitions we completed in the first and fourth quarters of 2002, were tested during our annual measurement date in the fourth quarter of 2002, which resulted in no impairment charges. (15) SIGNIFICANT CUSTOMERS One customer accounted for 8% of total revenue for the six months ended June 30, 2003. One customer accounted for 8% of total revenue for the six months ended June 30, 2002. One customer accounted for 11% of the total accounts receivable balance at June 30, 2003. One customer accounted for 7% of the total accounts receivable Balance at June 30, 2002. (16) CONTINGENCIES AND RELATED PARTY TRANSACTIONS During July and August 2001, four purported class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, certain of its current and former officers and directors (the "Individual Defendants") and the members of the underwriting syndicate involved in our initial public offering (the "Underwriter Defendants"). All four lawsuits have been consolidated for coordination with more than 300 similar cases. The suits generally allege that: (1) the Underwriter Defendants allocated shares of the Company's initial public offering to their customers in exchange for higher than standard commissions on transactions in other securities; (2) the Underwriter Defendants allocated shares of our initial public offering to their customers in exchange for the customers' agreement to purchase additional shares of our Common Stock in the after-market at pre-determined prices; (3) the Company and the Individual Defendants violated section 10(b) of the Securities Exchange Act of 1934 and/or section 11 of the Securities Act of 1933; and (4) the Individual Defendants violated section 20 of the Securities Exchange Act of 1934 and/or section 15 of the Securities Act of 1933. The plaintiffs seek unspecified compensatory damages and other relief. We have sought indemnification from the underwriters of its initial public offering. In July 2002, we, as part of the group of issuers of shares named in the consolidated litigation (the "Issuer Defendants") and the Individual Defendants, filed a motion to dismiss the consolidated amended complaints. The Underwriter Defendants filed motions to dismiss as well. Also in July 2002, the plaintiffs offered to dismiss the Individual Defendants, without prejudice, in exchange for a Reservation of Rights and Tolling Agreement from each Individual Defendant. All of the Individual Defendants in our four lawsuits have entered into such an agreement. On November 1, 2002, the Court heard oral arguments on the motions to dismiss, and in February 2003, the Court dismissed the section 10(b) claims against the Issuer Defendants, but allowed the plaintiffs to continue to pursue the remaining claims. We believe that the claims against the Company are without merit and intend to vigorously defend this matter if it is not settled. In the second quarter of 2003, counsel for the Issuer Defendants, counsel for the Issuer Defendants' insurers, and a plaintiffs' executive committee appointed by the Court entered into a memorandum of understanding ("the "MOU") and related agreements to settle the consolidated class action as against all Issuer Defendants. The MOU provides, generally, that the insurers for the Issuer Defendants will guarantee a recovery (either by settlement or judgment) to the plaintiffs against the Underwriter Defendants, against whom the litigation is still proceeding, of at least $1 billion. Accordingly, if the plaintiffs recover less than $1 billion from the Underwriter Defendants, the insurers for the Issuer Defendants will pay to the plaintiffs the difference between the actual recovery and $1 billion. The entire guaranteed amount, as well as the Issuer Defendants' legal fees incurred since June 1, 2003, will be paid by the insurers. Any settlement amounts and all legal fees paid by the Issuer Defendants will be allocated among the settling Issuer Defendants, and any allocated amounts that exceed the individual D&O policy limits of the individual Issuer Defendants (taking into account any other claims made against such policies) will be the responsibility of the Issuer Defendants. The Company believes, based on the information available to it now, that it is unlikely that the Company's policy limits will be exhausted by the settlement amounts paid by its insurers. A special independent committee of the Company's board of directors was previously formed to consider any settlement of the litigation, and the special committee has voted to approve the terms of the settlement based on the terms of the MOU and related agreements. The settlement remains subject to final approval of individual settlement agreements with each individual Issuer Defendant who has agreed to settle, as well as final approval of the lead plaintiffs and the insurers, and is subject to approval by the Court. It is anticipated that these approvals will take several months to obtain, if obtained at all. The Company anticipates that there will be objections to the settlement, and individual plaintiff class members will be able to opt out of the class action settlement and could conceivable pursue individual claims. There can be no assurance that the settlement will be approved on the terms provided in the MOU, if at all. The foregoing is a general summary of some of the salient points of the MOU and related agreements and is not a complete summary of the specific terms of the proposed settlement. Additionally, we are from time to time, party to various legal proceedings arising in the ordinary course of business. We evaluate such claims on a case-by-case basis, and our policy is to vigorously contest any such claims which we believe are without merit. Our majority stockholder, chief executive officer and director has personally guaranteed our accounts receivable financing, and we have an ongoing, quarterly obligation to pay him cash and issue him warrants for the continuing guaranty, based on the amount of financing guaranteed during the quarter. We sold preferred stock to this same majority stockholder, officer and Director in February, March and April of 2003. In the second quarter of 2003, we sold certain assets, customer contracts and intellectual property of one of our small business offerings to our majority stockholder, chief executive officer and director, and his spouse, and agreed to provide related and specified services to them in connection with the sale. In exchange, the buyers forgave $46,000 in debt owed to them by the Company and assumed the obligation for $22,000 in deferred revenue. We recorded a gain on the transaction of $25,000. An independent committee of the Board was appointed to consider this transaction. The operations that were disposed of were no longer in line with the Company's strategies and offerings, had been partially discontinued, was not profitable (and we believed it would be unlikely to achieve profitability in the foreseeable future, if at all). The special committee of the board concluded that the sale was on terms no less favorable than could have been obtained in a transaction with an unrelated, third party buyer and was less disruptive and more favorable to IIS' ongoing business than a complete discontinuation of the remaining operations of this business offering or further investment in it by the Company. (17) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 2002, the FASB issued Statement of Financial Accounting Standards SFAS No. 146, "Accounting for Exit or Disposal Activities" (SFAS 146). SFAS 146 addresses the recognition, measurement and reporting of costs associated with exit and disposal activities, including restructuring activities. SFAS 146 also addresses recognition of certain costs related to terminating a contract that is not a capital lease, costs to consolidate facilities or relocate employees and termination of benefits provided to employees that are involuntarily terminated under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred compensation contract. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on the financial position or results of operations of the Company. In August 2002, the FASB issued Statements of Financial Accounting Standards No. 147, "Acquisitions of Certain Financial Institutions" (SFAS 147). SFAS 147 requires financial institutions to follow the guidance in SFAS 141 and SFAS 142 for business combinations and goodwill and intangible assets, as opposed to the previously applied accounting literature. This statement also amends SFAS 144 to include in its scope long-term customer relationship intangible assets of financial institutions. The provisions of SFAS 147 do not apply to the Company. (18) SUBSEQUENT EVENTS During July 2003, we received net draw downs of $176,000 against our one-year, $1.0 million revolving line of credit. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS The following discussion contains forward-looking statements based on current expectations, and we assume no obligation to update these statements unless legally required. Because actual results may differ materially from expectations, we caution readers not to place undue reliance on these statements. These statements are based on our estimates, projections, beliefs, and assumptions, and are not guarantees of future performance. A number of factors could cause future results to differ materially from historical results, or from results or outcomes currently expected by us. These factors include: the loss of one or more of our significant clients; an inability to increase our market share; difficulties in maintaining our technology alliances; further reduced demand for IT services, and a continued downturn in economic conditions. These factors and the other matters discussed below under the heading "Factors that May Affect Future Results and Our Stock Price" may cause future results to differ materially from historical results, or from results or outcomes we currently expect or seek. OVERVIEW Since the third quarter of 2000, the market for IT services has changed dramatically and the demand has declined significantly. As part of our effort to adjust our structure to better address the general economic business climate and the slowdown in the IT professional services market, we have closed underperforming or vacant regional offices, reduced staff in remaining offices, recorded material charges related to underutilized data center facility computer equipment and leasehold improvements and developed and began implementing an aggressive growth strategy through acquiring like-minded peer consultancies. We completed four such acquisitions in 2001, two such transactions in 2002 and anticipate additional, similar transactions, in future periods if market conditions and our resources permit. We have operated at a loss for each of the last four years with the exception of the third and fourth quarters of 2002 which were favorably impacted by revisions to our restructuring accruals. The losses, combined with the current market for IT services, have raised concern about our liquidity and continued operations. We continue to reduce our operating expenses in order to improve cash flow from operations. During 2002, we were in default of certain operating and capital lease provisions for failure to make timely payment, had received several default notices during 2002 and had been named in a number of related lawsuits. In May 2002, we implemented a financial restructuring plan designed to settle obligations for vacated facilities, excess equipment leases and accounts payable related to facilities and types of services we were no longer offering to clients, in a manner which would achieve the highest possible recoveries for all creditors and stockholders consistent with our ability to pay and to continue our operations. In October 2002, we completed a restructuring which satisfied the obligations for the related real estate and equipment leases and for certain trade payables for less than their recorded value. We agreed to pay $2.0 million in cash at the close of the restructuring and $1.2 million in periodic payments over the next five years, satisfying $2.9 million of recorded accounts payable and accrued expenses, $3.1 million of capital lease obligations and $229,000 of other non-current liabilities. As a result of the restructuring, a total of approximately $23.0 million of current and future contractual obligations were satisfied. We funded the restructuring by selling all of our current accounts receivable, totaling $2.5 million, through a new bank credit facility at a discount of 1.95%, which left us the ability to sell up to $1.7 million more in current accounts receivable under the same arrangement. To obtain the financing, we pledged substantially all of our assets to the bank and we issued to the bank a warrant to purchase 60,000 shares of our Common Stock at $5.00 per share. Additionally, the Company's key-man life insurance policy of $5,000,000 was assigned to the bank. Mr. James Garvey, our majority stockholder, Chief Executive Officer and one of our directors, gave a $1.0 million personal guaranty to the bank as credit support, and, in consideration of his guaranty, we have agreed to make quarterly payments to him at an annual rate of 3% of the average outstanding balance under the facility and to issue him, quarterly, warrants to acquire 4,000 shares of our Common Stock for each $1.0 million in average outstanding balance under the facility during the quarter. The warrants will have an exercise price of $5.00 per share and will remain exercisable as long as any amount is guaranteed and for a period of one year thereafter, but for not less than five years from issuance. During March and April 2003, we obtained additional credit from our lender for working capital purposes. The bank has loaned us an additional $500,000, which was added to the existing note, deferred principal payments under the note for a year, extended a one-year $1.0 million revolving line of credit and allowed us to retain a greater amount of proceeds from assets sales, with excess proceeds to be applied against the note. To obtain this financing, we cancelled the warrant given in October 2002 and gave the bank a warrant for 300,000 shares at market price and reaffirmed the security interests previously given and the assignment of the key-man life insurance. Additionally, Mr. Garvey gave a limited guaranty of $1.0 million for amounts drawn under the revolving line of credit. In February and April 2003, we sold 100,000 shares of preferred stock to Mr. Garvey for the total proceeds of $1.0 million. Although no assurances can be given, we believe that the capital and financing arrangements received subsequent to December 31, 2002 and the restructuring accomplished in 2002 and 2003 will allow us to continue as a going concern. The remaining unused balance on the credit facility of $2.4 million is available to fund future acquisitions and to support working capital needs; however, availability is dependent upon our ability to generate additional revenues and increase our accounts receivable base. Accordingly, notwithstanding the restructuring, if we are unable to raise additional capital, increase revenues and significantly further reduce operating losses, our business activities may be significantly curtailed. We derive our revenues primarily from the delivery of professional services. We offer our services to clients under time and materials contracts or under fixed fee contracts. For time and materials projects, we recognize revenues based on the number of hours worked by consultants at a rate per hour agreed upon with our clients. We recognize revenues from fixed-price contracts on a percentage-of-completion method based on project hours worked. The percentage of our revenues from fixed-price contracts was approximately 16% and 20% in the three and six months ended June 30, 2003, respectively and approximately 23% and 29%, respectively, in the corresponding periods of 2002. We provide our managed services for a minimum monthly fee and charge extra fees for services that exceed agreed-upon parameters. Revenues from these services are recognized as services are provided. Revenues for services rendered are not recognized until collectibility is reasonably assured. Our cost of revenues consists primarily of employee compensation, outside consulting services and benefits. Selling and marketing expenses consist primarily of compensation and benefits. General and administrative expenses consist primarily of compensation and benefits for our executive management and our finance, administration, legal, information technology, and human resources personnel. General and administrative expenses also include depreciation, bad debt expense and operating expenses such as rent, insurance, telephones, office supplies, travel, outside professional services, training, and facilities costs. We have historically derived and believe that we may continue to derive a significant portion of our revenues from a limited number of clients who may change from period to period (see related discussion below in "Results of Operations"). Any cancellation, deferral, or significant reduction in work performed for our principal clients could harm our business and cause our operating results to fluctuate significantly from period to period. During the three and six months ended June 30, 2003, revenues from our five largest clients represented, when added together, approximately 35% and 32% of revenues, respectively compared with 24% and 29%, respectively, of revenues in the corresponding period in 2002. We incurred a net loss in the three and six months ended June 30, 2003 and in each of the last five years as a result of decreases in revenues (after 2000), investments in infrastructure, and increases in operating expenses and, more recently, as a result of revenues decreasing at a faster rate than operating expenses. Our quarterly revenue, cost of revenues, and operating results have varied in the past due to fluctuations in the utilization of project personnel and are likely to vary significantly in the future. Therefore, we believe that period-to-period comparisons of our operating results may not be indicative of future performance and should not necessarily be relied upon. RECENT ACQUISITIONS As part of our effort to adjust our structure to better address a rapidly changing and declining IT services market, we developed and began implementing an aggressive growth strategy through acquiring like-minded peer consultancies. The acquisition target companies ideally have leading competitive positions in regional and vertical markets, a proven track record of providing Microsoft-based and Novell solutions, a booked backlog of project work for premier clients, managers in place who are capable of leading a regional division for the Company, a working culture and ethic similar to our own and are owned by consultants who intend to remain active in the business. During 2001, we completed a series of transactions with four companies that we believed met our acquisition criteria. To complete these acquisitions we used a combination of cash payments, issuance of our Common Stock and assumption of liabilities and in return hired a total of 121 management and consulting personnel, acquired certain related assets and acquired lease arrangements for office space in the markets in which these consultancy practices operated. In the purchase price allocation, a total of $3,064,000 was recorded as goodwill. During 2002, in connection with the effective date of Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets," we were required to assess the impairment of our recorded goodwill relating to the above acquisitions. As discussed in Note 17 of the Notes to Consolidated Financial Statements, all of the goodwill recorded through December 31, 2001 totaling $3,064,000 and related acquisition costs of $123,000 were written off as a non-cash, cumulative effect of a change in accounting principle. During 2002, we completed a series of transactions with two additional companies, again using a combination of cash payments, issuance of our Common Stock and assumption of liabilities and bank loans. Through these two acquisitions we hired 98 management and consulting personnel and acquired certain related assets and lease agreements for office space and equipment. In the purchase price allocation, a total of $5,241,000 was recorded as goodwill. As part of the 2001 and 2002 acquisitions, intangible assets excluding goodwill totaling $682,000 were acquired consisting of non-compete agreements of $325,000 and employee agreements of $357,000. The non-compete intangible assets will be amortized over their contractual lives, which are generally five years. The employee agreements' intangible assets were amortized over their contractual lives, which were less than one year. The total goodwill recorded for the 2002 acquisitions was $5,240,000. It is estimated that most of this goodwill will be deductible for tax purposes, subject to the utilization of our net operating losses. See note 12. In connection with these acquisitions, we acquired accounts receivable of $1,773,000 and fixed assets of $520,000. The Company issued 214,000 shares of Common Stock valued at $577,000, of which $43,000 was used to repay a portion of an assumed note payable. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis we evaluate our estimates, including those related to intangible assets, long-term service contracts, bad debts, income taxes, restructuring, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. We recognize revenue and profit as work progresses on long-term, fixed price contracts using the percentage-of-completion method, which relies on estimates of total expected contract revenue and costs. We follow this method because reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We record goodwill and other intangible assets from acquisitions. We review our intangible assets on a periodic basis to determine if the fair value supports the carrying value of goodwill and other intangible assets. Future adverse changes in market conditions or poor operating results could result in an inability to recover the carrying value of the investments that may not be reflected in the current carrying value of the intangible assets, thereby possibly requiring material impairment charges in the future. The determination of reporting units needed for the impairment calculation also involves a significant amount of judgment. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. In the event we were to determine that the Company would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. We recorded accruals for the estimated future cash expenditures required from closing our vacated offices. The accruals, through December 31, 2002, include estimates of future rent payments and settlements until the obligation is canceled. Should actual cash expenditures differ from our estimates, revisions to the estimated liability for closing vacated offices would be required. We evaluate the requirement for future cash expenditures resulting from the Company's contingencies and litigation. Should the actual results differ from our estimates, revisions to the estimated liability for contingencies and litigation would be required. RESULTS OF OPERATIONS The following table sets forth selected financial data for the periods indicated expressed as a percentage of revenues:

THREE AND SIX MONTHS ENDED JUNE 30, 2003 COMPARED TO THREE AND SIX MONTHS ENDED JUNE 30, 2002 REVENUES. For the three months ended June 30, 2003, revenues decreased 70.4% to $2.1 million from $7.1 million in the corresponding period of 2002. For the six months ended June 30, 2003, revenues decreased 67.5% to $5.0 million from $15.4 million in the corresponding period of 2002. The decrease is primarily due to continuing weakness in demand in the information technology sector which has resulted in the closure of several of our offices, and to recent general economic conditions caused by geopolitical influences. COST OF REVENUES. Cost of revenues decreased 70.4% to $1.6 million for the three months ended June 30, 2003 from $5.4 million for the corresponding period of 2002. Cost of revenues decreased 68.1% to $3.7 million for the six months ended June 30, 2003 from $11.6 million for the corresponding period of 2002. The decrease is primarily due to a decrease in overall firm staffing. Utilization of consultants in the three months ended June 30, 2003 decreased 10.8% to 58%, from 65% for the corresponding quarter in 2002. Utilization of consultants in the six months ended June 30, 2003 decreased 6.5% to 58%, from 62% for the corresponding period in 2002 due to the same economic conditions mentioned above that have impacted demand for our services. SELLING AND MARKETING EXPENSES. Selling and marketing expenses decreased 28.6% to $0.5 million in the three months ended June 30, 2003 from $0.7 million in the corresponding period in 2002 and as a percentage of revenues increased to 23.9% in 2003 from 10.0% in 2002. Selling and marketing expenses decreased 33.3% to $1.2 million in the six months ended June 30, 2003 from $1.8 million in the corresponding period in 2002 and as a percentage of revenues increased to 23.1% in 2003 from 11.5% in 2002. The decrease in selling and marketing expenses in 2003 was due primarily to the reduction of dedicated sales and marketing personnel in 2003 compared to 2002 as a part of management's cost reduction plan. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses decreased 75.0% to $0.8 million in the three months ended June 30, 2003 from $3.2 million in the corresponding period in 2002 and as a percentage of revenues decreased to 39.8% in 2003 from 45.5% in 2002. General and administrative expenses decreased 61.8% to $3.4 million in the six months ended June 30, 2003 from $8.9 million in the corresponding period in 2002 and as a percentage of revenues increased to 68.0% in 2003 from 57.8% in 2002. The decrease in general and administrative expenses in 2003 was primarily due to management's implementation of its cost reduction plan and was also attributable to a reduction in depreciation and amortization expense of $1,551,000, salary & benefits expense of $1,287,000, rent and equipment lease expense of $1,087,000, legal & accounting expense of $464,000, telephone expense of $397,000, general office expense of $370,000, consulting services of $262,000, a net change in the provision for bad debt expense of $442,000 and other net cost reductions of $147,000. Included in general and administrative expenses during the six months ended June 30, 2003 is a net loss of $542,000 from disposition of property and equipment through sales and the termination of office leases for our Denver and Boston operations. ASSET IMPAIRMENTS AND RESTRUCTURING CHARGES AND LOSS ON DISPOSITION OF ASSETS. During 2001, we recorded a $9.2 million impairment charge related to underutilized computer equipment and leasehold improvements from our data center facility and a $5.7 million charge for expenses incurred in connection with closing and consolidating six office locations. During 2002, in connection with our restructuring efforts and the resulting favorable settlement of certain obligations and lease agreements, we re-evaluated our reserve for closed office locations and recorded a $1.0 million reduction of the restructuring reserve. We also recorded a gain on the settlement of payables of $1.2 million relating to these favorable settlement agreements. During the six months ended June 30, 2003, we again re-evaluated our reserve for closed office locations and recorded a $31,000 reduction of the restructuring reserve. During the six months ended June 30, 2003, as a result of additional restructuring efforts and the resulting favorable settlement of certain obligations, we recorded a gain on settlement of debt of $862,000. INTEREST EXPENSE NET. Interest expense, net of interest income increased 42.0% to $159,000 in the three months ended June 30, 2003 from $112,000 in the corresponding period in 2002. Interest expense, net of interest income increased 40.7% to $325,000 in the six months ended June 30, 2003 from $231,000 in the corresponding period in 2002. The change was due to interest on increased bank borrowing, which were used for acquisitions, financing accounts receivable and debt restructuring. LIQUIDITY AND CAPITAL RESOURCES Since inception, we have primarily funded our operations and investments in property and equipment through cash, capital lease financing arrangements, bank borrowings, and equity financings. In January 2000, we raised $20.2 million, before expenses of $800,000, through a private placement of Series C preferred stock to institutional and other accredited investors. In March and April 2000, we raised an additional $67.5 million (net of underwriting discounts and other offering expenses) through our initial public offering of 989,000 shares of our Common Stock. At June 30, 2003, we had approximately $10,000 in cash and cash equivalents and a $2.7 million working capital deficit, as compared to $1.1 million in cash and cash equivalents and a $2.8 million working capital deficit at December 31, 2002. Net cash used in operating activities for the six months ended June 30, 2003 and 2002 was $1.2 million and $3.9 million, respectively. Cash used in operating activities in each of these periods was the result of net losses, adjusted for non-cash items related to depreciation, amortization, asset impairment and restructuring, and fluctuations in receivables, unbilled and deferred revenues on contracts, prepaid expenses and other current assets, and accounts payable and accrued expenses. Net cash provided by investing activities for the six months ended June 30, 2003 was $331,000, primarily from the sale of excess furniture and equipment. Net cash used in investing activities for the six months ended June 30, 2002 was $489,000, primarily for purchases of computer equipment, furniture and leasehold improvements and in an acquisition of assets of another company totaling $400,000. Net cash used in financing activities for the six months ended June 30, 2003 was $193,000, compared to $210,000 in the corresponding period of 2002. During the six months ended June 30, 2003, we sold 100,000 shares of preferred stock for $1,000,000, made payments on our line of credit and capital leases of $2.0 million, borrowed $500,000 from a bank on a long term note and received $288,000 of previously restricted cash. In the six months ended June 30, 2002, we made payments on capital leases of $902,000 and received $692,000 of previously restricted cash. Non-cash investing and financing activities for the six months ended June 30, 2003 and 2002 consisted of new capital lease obligations for property and equipment of $0 and $362,000, respectively. In 2002, we also assumed a note for $4,750,000 in conjunction with an acquisition. A summary of our contractual cash obligations at June 30, 2003 (adjusted for settlements reached subsequent to quarter end) follows (amounts in thousands):

We have incurred significant losses from operations over the past three years. We have a substantial working capital deficit and an accumulated deficit of $91.3 million as of June 30, 2003. As a result of these and other factors, there are concerns about the liquidity of the Company at June 30, 2003. Our continuation is dependent upon our efforts to raise additional capital, increase revenues, reduce expenses, and ultimately, to achieve profitable operations. We have reduced our obligations and expenses through settlements with creditors, landlords and lessors, reduced our work force, and made substantial reductions to general and administrative expenses throughout 2002 and through the six months ended June 30, 2003. During the six months ended June 30, 2003, we obtained the following: - A $500,000 increase to our term loan; - A $1,000,000 Line of Credit with our primary lender; and - $1,000,000 of proceeds from sales of preferred stock to an officer, director and majority stockholder of the Company. During July 2003, we received net draw downs of $176,000 against the one-year, $1.0 million revolving line of credit. During the six months ended June 30, 2003, we consummated new settlements with creditors resulting in the settlement of $1,697,000 of obligations for $750,000 in cash and deposits and the issuance of 100,000 shares of Common Stock at $0.85 per share. Furthermore, we have made our cost structure significantly more variable and believe we can continue to reduce expenses if it is required. While we cannot give any assurances that the above actions will be sufficient to ultimately alleviate our liquidity concerns, or that additional borrowings or capital could be obtained under satisfactory terms if they become required, we do believe these actions will enable us to continue as a going concern through December 31, 2003. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 2002, the FASB issued Statement of Financial Accounting Standards SFAS No. 146, "Accounting for Exit or Disposal Activities" (SFAS 146). SFAS 146 addresses the recognition, measurement and reporting of costs associated with exit and disposal activities, including restructuring activities. SFAS 146 also addresses recognition of certain costs related to terminating a contract that is not a capital lease, costs to consolidate facilities or relocate employees and termination of benefits provided to employees that are involuntarily terminated under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred compensation contract. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on our financial position or results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK To date, we have not utilized derivative financial instruments or derivative commodity instruments. We do not expect to employ these or other strategies to hedge market risk in 2003. We invest our cash in money market funds, which are subject to minimal credit and market risk. We believe that the market risks associated with these financial instruments are immaterial. All of our revenues are realized currently in U.S. dollars and are from customers primarily in the United States. Therefore, we do not believe that we currently have any significant direct foreign currency exchange rate risk. FACTORS THAT MAY AFFECT FUTURE RESULTS AND OUR STOCK PRICE This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Act of 1934. Forward-looking statements give our current expectations or forecasts of future events. Words such as "expect," "may," "anticipate," "intend," "would," "will," "plan," "believe," "estimate," "should," and similar expressions identify forward-looking statements. Forward-looking statements in this Form 10-Q include express or implied statements concerning our future revenues, expenditures, capital or other funding requirements, the adequacy of our current cash and working capital balances to fund our present and planned operations and financing needs, expansion of and demand for our service offerings, and the growth of our business and operations, as well as future economic and other conditions both generally and in our specific geographic and product and services markets. These statements are based on our estimates, projections, beliefs, and assumptions and are not guarantees of future performance. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public. We caution that the following important factors, among others, could cause our actual results to differ materially from those expressed in forward-looking statements made by or on behalf of us in filings with the Securities and Exchange Commission, press releases, communications with investors, and oral statements. Any of these factors, among others, could also negatively impact our operating results and financial condition and cause the trading price of our Common Stock to decline or fluctuate significantly. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make in our reports filed with the Securities and Exchange Commission and in future public statements and press releases. WE HAVE EXPERIENCED OPERATING LOSSES AND MAY INCUR OPERATING LOSSES IN FUTURE PERIODS, WHICH COULD CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE FURTHER. We had a net loss of approximately $2.7 million for the six months ended June 30, 2003, a net loss of $11.8 million for the year ended December 31, 2002, a net loss of $49.4 million for the year ended December 31, 2001 and a net loss of approximately $25.4 million for the year ended December 31, 2000. If we do not achieve revenue growth and maintain our current cost structure (or reduce costs further), we could experience continuing operating losses. These losses or any fluctuation in our operating results could cause the market value of our Common Stock to decline further. WE HAVE NOT BEEN ABLE TO MAINTAIN A NASDAQ SMALLCAP LISTING, SO OUR COMMON STOCK HAS BECOME EVEN MORE ILLIQUID AND THE VALUE OF OUR SECURITIES MAY DECLINE FURTHER. Nasdaq has, effective April 10, 2003, delisted our Common Stock, and our Common Stock is currently trading on the National Association of Securities Dealers' OTC Bulletin Board (OTCBB). The OTCBB is generally considered less liquid and efficient than Nasdaq, and although trading in our stock is already relatively thin and sporadic, the liquidity of our Common Stock may decline further because smaller quantities of shares will likely be bought and sold, meaning that transactions could be delayed. These factors could result in lower prices and larger spreads in the bid and ask prices for our Common Stock. Reduced liquidity may reduce the value of our Common Stock and our ability to generate additional funding. THERE IS A LIMITED MARKET FOR OUR COMMON STOCK. Currently only a very limited trading market exists for Integrated Information Systems common stock. Our common stock trades on the OTC Bulletin Board under the symbol "IISX." The Bulletin Board is a limited market and subject to substantial restrictions and limitations in comparison to the NASDAQ system. Any broker/dealer that makes a market in our stock or other person that buys or sells our stock could have a significant influence over its price at any given time. The Company intended to pursue the listing of its Common Stock on the new BBX Exchange which was under consideration by Nasdaq, but Nasdaq has recently decided to discontinue it development of the BBX Exchange. As a result, it is unclear how long the OTC Bulletin Board will continue to be available to the Company for the listing of our Common Stock. If the OTC Bulletin Board is no longer available, then we will be forced to trade solely on the pink sheets, a market with very limited liquidity and minimal listing standards. We cannot assure our shareholders that a market for our stock will be sustained. There is no assurance that our shares will have any greater liquidity than shares which do not trade on a public market. OUR COMMON STOCK MAY BE SUBJECT TO PENNY STOCK REGULATION. Our shares may be subject to the provisions of Section 15(g) and Rule 15g-9 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), commonly referred to as the "penny stock" rule. Section 15(g) sets forth certain requirements for transactions in penny stocks and Rule 15g-9(d)(1) incorporates the definition of penny stock as that used in Rule 3a51-1 of the Exchange Act. The Commission generally defines penny stock to be any equity security that has a market price less than $5.00 per share, subject to certain exceptions. Rule 3a51-1 provides that any equity security is considered to be penny stock unless that security is: registered and traded on a national securities exchange meeting specified criteria set by the Commission; authorized for quotation on The NASDAQ Stock Market; issued by a registered investment company; excluded from the definition on the basis of price (at least $5.00 per share) or the registrant's net tangible assets; or exempted from the definition by the Commission. Since our shares are deemed to be "penny stocks", trading in the shares will be subject to additional sales practice requirements on broker-dealers who sell penny stocks to persons other than established customers and accredited investors. WE MAY NEED ADDITIONAL CAPITAL WHICH, IF NOT AVAILABLE TO US, MAY ALTER OUR BUSINESS PLAN OR LIMIT OUR ABILITY TO ACHIEVE GROWTH IN REVENUES AND WHICH, IF AVAILABLE AND RAISED, WOULD DILUTE YOUR OWNERSHIP INTEREST IN US. We incurred negative cash flows from operations in 2002 and, to date, have continued to do so in 2003. Although we believe that we have sufficient cash to fund existing operations for the balance of the year, we are pursuing sources of working capital. Even after consideration of the additional funds raised in 2003, we may need to raise additional funds through public or private equity or debt financings in order to: - address working capital needs if collection of accounts receivable declines; - take advantage of acquisition or expansion opportunities; - develop new services; or - address unanticipated contingencies. Our inability to obtain financing on terms acceptable to us, or at all, may limit our ability to increase revenues or to achieve profitability. Our stock price, like the stock price of many competitors in our industry, has been depressed in recent periods, which could limit our ability to obtain any needed financing on favorable or acceptable terms. In addition, if we are able to raise additional capital through the sale of equity securities or through taking on debt with an equity component, your investment in us would be diluted, which could cause our stock price to further decline. WE ANTICIPATE ACQUIRING MORE BUSINESSES, AND WE MAY INCUR INCREASED OPERATING EXPENSES WITHOUT CORRESPONDING INCREASED REVENUES, WHICH MAY LIMIT OUR ABILITY TO ACHIEVE OR MAINTAIN PROFITABILITY AND CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE. A key component of our business strategy is to acquire like-minded peer consultancies in geographic areas where we do not have a strong presence. We also look for acquisition opportunities, without focusing on increasing our geographic diversity, if there is an opportunity to strengthen a current service offering or add a service offering which complements our current service offerings. The risks of acquisitions include retaining clients, retaining key employees, incurring higher than anticipated transaction expenses and other unexpected expenses and diverting management's attention from daily operations of our business. Acquiring businesses, especially in markets in which we have limited prior experience, is risky. If we do not implement this strategy successfully, we may incur increased operating expenses without increased revenues, which could materially harm our operating results and stock price. WE FACE CHALLENGES IN THE INTEGRATION OF THE BUSINESSES WE HAVE RECENTLY ACQUIRED AND THOSE WE MAY ACQUIRE IN THE FUTURE. We may not experience the anticipated results from the integration of businesses we have acquired. The strategies of cross-marketing service offerings, the opportunities of expanded markets and clients, the development of additional revenue streams, the enhanced ability to raise capital, and the availability of public currency for making strategic acquisitions may not prove to be as advantageous as we expect. This could affect the results of our operations, negatively impact our financial performance and harm our business. BECAUSE THE MARKET FOR OUR SERVICES MAY NOT GROW DURING 2003, WE MAY BE UNABLE TO BECOME PROFITABLE. We offer services in the IT services market, and that market has contracted significantly in recent years. We do not anticipate significant growth in the IT services market in 2003. If demand for our services does not grow in the future, or if we do not capture sufficient market share for these services, we may be unable to achieve profitability. OUR RESULTS OF OPERATIONS MAY VARY FROM QUARTER TO QUARTER IN FUTURE PERIODS AND, AS A RESULT, WE MAY NOT MEET THE EXPECTATIONS OF OUR INVESTORS AND ANALYSTS, WHICH COULD CAUSE OUR STOCK PRICE TO FLUCTUATE OR DECLINE. Our revenues and results of operations have fluctuated significantly in the past and could fluctuate significantly in the future. We incurred net losses of $10.7 million and $2.5 million in the first and second quarters of 2002, respectively, and reported earnings of $0.9 million and $0.5 million in the third and fourth quarters of 2002, respectively and incurred a net loss of $1.7 million and $1.0 million in the first and second quarters of 2003, respectively. Our results may fluctuate due to the factors described in this Form 10-Q, As well as: - the loss of or failure to replace any significant clients; - variation in demand for our services; - higher than expected bad debt write-offs or impairment of our assets, including goodwill; - changes in the mix of services that we offer; and - variation in our operating expenses. A substantial portion of our operating expense is related to personnel costs and overhead, which cannot be adjusted quickly and is, therefore, relatively fixed in the short term. Our operating expenses are based, in significant part, on our expectations of future revenues. If actual revenues are below our expectations, we may not achieve our anticipated operating results. Moreover, it is possible that in some future periods our results of operations may be below the expectations of analysts and investors. In this event, the market price of our Common Stock is likely to decline. IF WE FAIL TO KEEP PACE WITH THE RAPID TECHNOLOGICAL CHANGES THAT CHARACTERIZE OUR INDUSTRY, OUR COMPETITIVENESS WOULD SUFFER, CAUSING US TO LOSE PROJECTS OR CLIENTS AND CONSEQUENTLY REDUCING OUR REVENUES AND THE PRICE OF OUR COMMON STOCK. Our market and the enabling technologies used by our clients are characterized by rapid, frequent, and significant technological changes. If we fail to respond in a timely or cost-effective way to these technological developments, we may not be able to meet the demands of our clients, which would affect our ability to generate revenues and achieve profitability. We have derived, and expect to continue to derive, a large portion of our revenues from creating solutions that are based upon today's leading and developing technologies and which are capable of adapting to future technologies. Our historical results of operations may not reflect our new service offerings and may not give you an accurate indication of our ability to adapt to these future technologies. OUR FAILURE TO MEET CLIENT EXPECTATIONS OR DELIVER ERROR-FREE SERVICES COULD DAMAGE OUR REPUTATION AND HARM OUR ABILITY TO COMPETE FOR NEW BUSINESS OR RETAIN OUR EXISTING CLIENTS, WHICH MAY LIMIT OUR ABILITY TO GENERATE REVENUES AND ACHIEVE OR MAINTAIN PROFITABILITY. Many of our engagements involve the delivery of information technology services that are critical to our clients' businesses. Any defects or errors in these services or failure to meet clients' specifications or expectations could result in: - delayed or lost revenues due to adverse client reaction; - requirements to provide additional services to a client at no or a limited charge; - refunds of fees for failure to meet obligations; - negative publicity about us and our services; and - claims for substantial damages against us. In addition, we sometimes implement critical functions for high profile clients or for projects that have high visibility and widespread usage in the marketplace. If these functions experience difficulties, whether or not as a result of errors in our services, our name could be associated with these difficulties and our reputation could be damaged, which would harm our business. WE MAY LOSE MONEY ON FIXED-PRICE CONTRACTS BECAUSE WE MAY FAIL TO ACCURATELY ESTIMATE AT THE BEGINNING OF PROJECTS THE TIME AND RESOURCES REQUIRED TO FULFILL OUR OBLIGATIONS UNDER OUR CONTRACTS; THE ADDITIONAL EXPENDITURES THAT WE MUST MAKE TO FULFILL THESE CONTRACT OBLIGATIONS MAY CAUSE OUR PROFITABILITY TO DECLINE OR PREVENT US FROM ACHIEVING PROFITABILITY AND COULD REDUCE THE PRICE OF OUR COMMON STOCK. Although we provide consulting services primarily on a time and materials compensation basis, approximately 20% of our consulting revenue was derived from fixed-price, fixed-time engagements in the six months ended June 30, 2003 and approximately 27% and 14% of revenues were derived from fixed-price, fixed-time engagements in 2002 and 2001, respectively. The percentage of our revenues derived from fixed-price, fixed time engagements may increase in the future, as influenced by changes in demand and market conditions. Our failure to accurately estimate the resources required for a fixed-price, fixed-time engagement or our failure to complete our contractual obligations in a manner consistent with our projections or contractual commitments could harm our overall profitability and our business. From time to time, we have been required to commit unanticipated additional resources to complete some fixed-price, fixed-time engagements, resulting in losses on these engagements. We believe that we may experience similar situations in the future. In addition, we may negotiate a fixed price for some projects before the design specifications are finalized, resulting in a fixed price that is too low and causing a decline in our operating results. OUR LACK OF LONG-TERM CONTRACTS WITH CLIENTS AND OUR CLIENTS' ABILITY TO TERMINATE CONTRACTS WITH LITTLE OR NO NOTICE REDUCES THE PREDICTABILITY OF OUR REVENUES AND INCREASES THE POTENTIAL VOLATILITY OF OUR STOCK PRICE. Our clients generally retain us on an engagement-by-engagement basis, rather than under long-term contracts. In addition, our current clients can generally reduce the scope of or cancel their use of our services without penalty and with little or no notice. As a result, our revenues are difficult to predict. Because we incur costs based on our expectations of future revenues, our failure to predict our revenues accurately may cause our expenses to exceed our revenues, which could cause us to incur increased operating losses. Although we try to design and build complete integrated information systems for our clients, we are sometimes retained to design and build discrete segments of the overall system on an engagement-by-engagement basis. Since the projects of our large clients can involve multiple engagements or stages, there is a risk that a client may choose not to retain us for additional stages of a project or that the client will cancel or delay additional planned projects. These cancellations or delays could result from factors related or unrelated to our work product or the progress of the project, including changing client objectives or strategies, as well as general business or financial considerations of the client. If a client defers, modifies, or cancels an engagement or chooses not to retain us for additional phases of a project, we may not be able to rapidly re-deploy our employees to other engagements and may suffer underutilization of employees and the resulting harm to our operating results. Our operating expenses are relatively fixed and cannot be reduced on short notice to compensate for unanticipated variations in the number or size of engagements in progress. The slowing in spending on business and IT consulting initiatives that began in the second half of 2000 continues, and if current or potential clients cancel or delay their IT initiatives, our business and results of operations could be materially adversely affected. WE MAY NOT BE SUCCESSFUL IN RETAINING OUR CURRENT TECHNOLOGY ALLIANCES OR ENTERING INTO NEW ALLIANCES, WHICH COULD HAMPER OUR ABILITY TO MARKET OR DELIVER SOLUTIONS NEEDED OR DESIRED BY OUR CLIENTS AND LIMIT OUR ABILITY TO INCREASE OR SUSTAIN OUR REVENUES AND ACHIEVE OR MAINTAIN PROFITABILITY. We rely on vendor alliances for client referral and marketing opportunities, access to advanced technology and training as well as other important benefits. These relationships are non-exclusive and the vendors are free to enter into similar or more favorable relationships with our competitors. Whether written or oral, many of the agreements underlying our relationships are general in nature, do not legally bind the parties to transact business with each other or to provide specific client referrals, cross-marketing opportunities, or other intended benefits to each other, have indefinite terms, and may be ended at the will of either party. We may not be able to maintain our existing strategic relationships and may fail to enter into new relationships. If we are unable to maintain these relationships, the benefits that we derive from these relationships, including the receipt of important sales leads, cross-marketing opportunities, access to emerging technology training and certifications, and other benefits, may be lost. Consequently, we may not be able to offer desired solutions to clients, which would result in a loss of revenues and our inability to effectively compete for clients seeking emerging or leading technologies offered by these vendors. BECAUSE WE OPERATE IN A HIGHLY COMPETITIVE AND RAPIDLY CHANGING INDUSTRY, COMPETITORS COULD CAUSE US TO LOSE BUSINESS OPPORTUNITIES AND LIMIT OUR ABILITY TO INCREASE OR SUSTAIN REVENUE LEVELS. Although our industry is experiencing significant consolidation, the business areas in which we compete remain intensely competitive and subject to rapid change. We expect competition to continue and to intensify. Our competitors currently fall into several categories and include a range of entities providing both general management and information technology consulting services and internet services. Many of our competitors have longer operating histories, larger client bases, and greater brand or name recognition, as well as greater financial, technical, marketing, and public relations resources. Our competitors may be able to respond more quickly to technological developments and changes in clients' needs. Further, as a result of the low barriers to entry, we may face additional competition from new entrants into our markets. We do not own any technologies that preclude or inhibit competitors from entering the general business areas in which we compete. Existing or future competitors may independently develop and patent or copyright technologies that are superior or substantially similar to our technologies, which may place us at a competitive disadvantage. All of these factors could lead to competitors winning new client engagements that we compete for. If this occurs, our ability to generate increased revenues may be limited and we may not achieve profitability. WE MAY NOT BE ABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS AND, AS A RESULT, WE COULD LOSE COMPETITIVE ADVANTAGES WHICH DIFFERENTIATE OUR SOLUTIONS AND OUR ABILITY TO ATTRACT AND RETAIN CLIENTS. Our success is dependent, in part, upon our intellectual property rights. We rely upon a combination of trade secret, confidentiality and nondisclosure agreements, and other contractual arrangements, as well as copyright and trademark laws to protect our proprietary rights. We have no patents or pending patent applications. We enter into confidentiality agreements with our employees, we generally require that our consultants and clients enter into these agreements, and we attempt to limit access to and distribution of our proprietary information. Nevertheless, we may be unable to deter misappropriation of our proprietary information or to detect unauthorized use and take appropriate steps to enforce our intellectual property rights or proprietary information. We attempt to retain significant ownership or rights to use our internally developed software applications which we can market and adapt through further customization for other client projects. Under some of our client contracts, all of our project developments are the property of the client and we have no right or only limited rights to reuse or provide these developments in other client projects. To the extent that we are unable to negotiate contracts which permit us to reuse code and methodologies, or to the extent that we have conflicts with our clients regarding our ability to do so, we may be unable to provide services to some of our clients within price and timeframes acceptable to these clients. Although we believe that our services, trade or service names, and products do not infringe upon the intellectual property rights of others, claims could be asserted against us in the future. If asserted, we may be unable to successfully defend these claims, which could cause us to cease providing some services or products and limit any competitive advantage we derive from our trademarks or names. If any of these events occur, our ability to differentiate ourselves and compete effectively could be limited and we may lose revenue opportunities. WE OCCASIONALLY AGREE NOT TO PERFORM SERVICES FOR OUR CLIENTS' COMPETITORS, WHICH MAY LIMIT OUR ABILITY TO GENERATE FUTURE REVENUES AND INHIBIT OUR BUSINESS STRATEGY. In order to secure particularly large engagements or engagements with industry leading clients, we have agreed on limited occasions not to perform services, or not to utilize some of our intellectual property rights developed for clients, for competitors of those clients for limited periods of time ranging from one to three years. In our agreement with American Express, our largest client in 2001 and 2000 and a continuing client in 2003 and 2002, we have agreed not to perform services for competitors of American Express for one year after each project completion date and not to assign consultants who have worked on American Express projects to other clients' competitive projects for nine months after completing work for American Express. These non-compete provisions reduce the number of our prospective clients and our potential sources of revenue. These agreements also may limit our ability to execute a part of our business strategy of leveraging our business expertise in discreet industry segments by attracting multiple clients competing in those industries. OUR LONG SALES CYCLES MAKE OUR REVENUES DIFFICULT TO PREDICT, WHICH COULD CAUSE OUR REVENUES OR PROFITABILITY TO BE BELOW ANALYST OR INVESTOR EXPECTATIONS, CAUSING OUR STOCK PRICE TO FLUCTUATE AND DECLINE SIGNIFICANTLY. The timing of our revenues is difficult to predict because of the length and variance of the time required to complete a sale. Our sales cycle typically ranges in length from three months to nine months and is sometimes longer. Prior to retaining us for a project, our clients often undertake an extensive review of their systems, needs, and budgets and may require approval at various levels within their organization. The length or unpredictability of our sales cycle could cause our revenues or profitability to be below the expectations of analysts or investors and our stock price to fluctuate significantly. THE LOSS OF MR. JAMES G. GARVEY, JR., OUR FOUNDER, CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER, MAY HARM OUR ABILITY TO OBTAIN AND RETAIN CLIENT ENGAGEMENTS, MAINTAIN A COHESIVE CULTURE, OR COMPETE EFFECTIVELY. Our success will depend in large part upon the continued services of James G. Garvey, Jr., our founder, Chairman, President, Chief Executive Officer, and our majority stockholder. We have an employment contract with Mr. Garvey. Mr. Garvey is precluded under his agreement from competing against us for one year should he leave us. The loss of Mr. Garvey's services could harm us and cause a loss of investor confidence in our business, which could cause the trading price of our stock to decline. In addition, if Mr. Garvey resigns to join a competitor or to form a competing company, the loss of Mr. Garvey and any resulting loss of existing or potential clients to any competitor could harm our business. If we lose Mr. Garvey, we may be unable to prevent the unauthorized disclosure or use by other companies of our technical knowledge, practices, or procedures. In addition, due to the substantial number of shares of our Common Stock owned by Mr. Garvey, the loss of Mr. Garvey's services could cause investor or analyst concern that Mr. Garvey may sell a large portion of his shares, which could cause a rapid and substantial decline in the trading price of our Common Stock. THE HOLDINGS OF MR. GARVEY MAY LIMIT YOUR ABILITY TO INFLUENCE THE OUTCOME OF DIRECTOR ELECTIONS AND OTHER MATTERS SUBJECT TO A STOCKHOLDER VOTE, INCLUDING A SALE OF OUR COMPANY ON TERMS THAT MAY BE ATTRACTIVE TO YOU. James G. Garvey, Jr., our founder, Chairman, President and Chief Executive Officer, currently owns approximately 58% of our outstanding Common Stock. Mr. Garvey's stock ownership and management positions enable him to exert considerable influence over our Company, including in the election of directors and the approval of other actions submitted to our stockholders. In addition, without the consent of Mr. Garvey, we may be prevented from entering into transactions that could be viewed as beneficial to other stockholders, including a sale of the Company. This could prevent you from selling your stock to a potential acquirer at prices that exceed the market price of our stock, or could cause the market price of our Common Stock to decline. OUR CHARTER DOCUMENTS COULD MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE US, WHICH COULD LIMIT YOUR ABILITY TO SELL YOUR STOCK TO AN ACQUIRER AT A PREMIUM PRICE OR COULD CAUSE OUR STOCK PRICE TO DECLINE. Our certificate of incorporation and by-laws may make it difficult for a third party to acquire control of us, even if a change in control would be beneficial to stockholders. Our certificate of incorporation authorizes our board of directors to issue up to 5,000,000 shares of "blank check" preferred stock. Without stockholder approval, the board of directors has the authority to attach special rights, including voting and dividend rights, to this preferred stock. With these rights, preferred stockholders could make it more difficult for a third party to acquire our Company. Our by-laws do not permit any person other than at least three members of our board of directors, our President, the Chairman of the Board, or holders of at least a majority of our stock to call special meetings of the stockholders. In addition, a stockholder's proposal for an annual meeting must be received within a specified period in order to be placed on the agenda. Because stockholders have limited power to call meetings and are subject to timing requirements in submitting stockholder proposals for consideration at meetings, any third-party takeover or other matter that stockholders wish to vote on that is not supported by the board of directors could be subject to significant delays and difficulties. If a third party finds it more difficult to acquire us because of these provisions, you may not be able to sell your stock at a premium price that may have been offered by the acquirer, and the trading price of our stock may be lower than it otherwise would be if these provisions were not in effect. THE VALUATION MODEL FOR COMPANIES SUCH AS OURS HAS CHANGED, AND OUR INABILITY TO ACHIEVE PROFITABILITY MAY CONTINUE TO MATERIALLY ADVERSELY AFFECT OUR STOCK PRICE. When our stock became publicly traded in 2000, companies in our sector were valued generally upon revenue growth, with little regard for profitability. Companies in our sector are now generally measured on cash flows and profits. If we are unable to achieve profitability and positive cash flow, our stock price will continue to suffer and could further decline, and the liquidity for our stock could deteriorate further as well. OUR STOCK REPURCHASE PLAN MAY ADVERSELY AFFECT THE TRADING VOLUME AND LIQUIDITY OF OUR COMMON STOCK AND COULD CAUSE OUR STOCK PRICE TO DECLINE. In December 2000, our board authorized a stock repurchase plan which authorized us to purchase up to $2 million of our Common Stock on the open market in compliance with applicable SEC regulations. In August 2001, our board authorized an increase in the maximum amount from $2 million to $7 million. During 2001, we repurchased 990,360 shares of our Common Stock at a cost of approximately $5.3 million. We currently have no plan to repurchase additional shares of our Common Stock. However, if we do repurchase more shares of our Common Stock under this plan, the number of shares of our Common Stock outstanding will decrease. This decrease would likely reduce the trading volume of our Common Stock, adversely impacting the liquidity and value of our Common Stock. ITEM 4. CONTROLS AND PROCEDURES Within the 90 days prior to the date of this quarterly report on Form 10-Q, we continued our evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon the results of that evaluation, to date, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be disclosed by us in our periodic reports to the Securities and Exchange Commission. There have been no significant changes in our internal controls or in other facts that could significantly affect our disclosure controls subsequent to the date of their evaluation. Our overall evaluation is not complete and we anticipate that it will take several months to complete. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in Company reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in Company reports filed under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer as appropriate, to allow timely decisions regarding required disclosure. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS During July and August 2001, four purported class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, certain of its current and former officers and directors (the "Individual Defendants") and the members of the underwriting syndicate involved in our initial public offering (the "Underwriter Defendants"). All four lawsuits have been consolidated for coordination with more than 300 similar cases. The suits generally allege that: (1) the Underwriter Defendants allocated shares of the Company's initial public offering to their customers in exchange for higher than standard commissions on transactions in other securities; (2) the Underwriter Defendants allocated shares of our initial public offering to their customers in exchange for the customers' agreement to purchase additional shares of our Common Stock in the after-market at pre-determined prices; (3) the Company and the Individual Defendants violated section 10(b) of the Securities Exchange Act of 1934 and/or section 11 of the Securities Act of 1933; and (4) the Individual Defendants violated section 20 of the Securities Exchange Act of 1934 and/or section 15 of the Securities Act of 1933. The plaintiffs seek unspecified compensatory damages and other relief. We have sought indemnification from the underwriters of its initial public offering. In July 2002, we, as part of the group of issuers of shares named in the consolidated litigation (the "Issuer Defendants") and the Individual Defendants, filed a motion to dismiss the consolidated amended complaints. The Underwriter Defendants filed motions to dismiss as well. Also in July 2002, the plaintiffs offered to dismiss the Individual Defendants, without prejudice, in exchange for a Reservation of Rights and Tolling Agreement from each Individual Defendant. All of the Individual Defendants in our four lawsuits have entered into such an agreement. On November 1, 2002, the Court heard oral arguments on the motions to dismiss, and in February 2003, the Court dismissed the section 10(b) claims against the Issuer Defendants, but allowed the plaintiffs to continue to pursue the remaining claims. We believe that the claims against the Company are without merit and intend to vigorously defend this matter if it is not settled. In the second quarter of 2003, counsel for the Issuer Defendants, counsel for the Issuer Defendants' insurers, and a plaintiffs' executive committee appointed by the Court entered into a memorandum of understanding ("the "MOU") and related agreements to settle the consolidated class action as against all Issuer Defendants. The MOU provides, generally, that the insurers for the Issuer Defendants will guarantee a recovery (either by settlement or judgment) to the plaintiffs against the Underwriter Defendants, against whom the litigation is still proceeding, of at least $1 billion. Accordingly, if the plaintiffs recover less than $1 billion from the Underwriter Defendants, the insurers for the Issuer Defendants will pay to the plaintiffs the difference between the actual recovery and $1 billion. The entire guaranteed amount, as well as the Issuer Defendants' legal fees incurred since June 1, 2003, will be paid by the insurers. Any settlement amounts and all legal fees paid by the Issuer Defendants will be allocated among the settling Issuer Defendants, and any allocated amounts that exceed the individual D&O policy limits of the individual Issuer Defendants (taking into account any other claims made against such policies) will be the responsibility of the Issuer Defendants. The Company believes, based on the information available to it now, that it is unlikely that the Company's policy limits will be exhausted by the settlement amounts paid by its insurers. A special independent committee of the Company's board of directors was previously formed to consider any settlement of the litigation, and the special committee has voted to approve the terms of the settlement based on the terms of the MOU and related agreements. The settlement remains subject to final approval of individual settlement agreements with each individual Issuer Defendant who has agreed to settle, as well as final approval of the lead plaintiffs and the insurers, and is subject to approval by the Court. It is anticipated that these approvals will take several months to obtain, if obtained at all. The Company anticipates that there will be objections to the settlement, and individual plaintiff class members will be able to opt out of the class action settlement and could conceivable pursue individual claims. There can be no assurance that the settlement will be approved on the terms provided in the MOU, if at all. The foregoing is a general summary of some of the salient points of the MOU and related agreements and is not a complete summary of the specific terms of the proposed settlement. Additionally, we are, from time to time, party to various legal proceedings arising in the ordinary course of business. We evaluate such claims on a case-by-case basis, and our policy is to vigorously contest any such claims which we believe are without merit. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On February 26, 2003 and April 2, 2003, we issued to James G. Garvey, Jr., our major shareholder, Chairman, Chief Executive Officer and President, an aggregate of 40,000 shares of Series A 8% Convertible Preferred Stock for aggregate proceeds of $400,000. On April 4, 2003, we issued to Mr. Garvey 40,000 shares of Series B 12% Convertible Preferred Stock in exchange for a like number of shares of the Series A 8% Convertible Preferred Stock and an additional 60,000 shares of Series B 12% Convertible Preferred Stock for aggregate proceeds of $600,000. The aggregate purchase price for the Series B 12% Convertible Preferred Stock issued to Mr. Garvey, including the $400,000 invested in the Series A 8% Convertible Preferred Stock, was $1,000,000. There were no underwriters, and we received proceeds of $1,000,000. In consideration of Mr. Garvey's guarantee of the Company's new $1.0 million revolving line of credit, we issued Mr. Garvey a warrant to purchase 300,000 shares of our Common Stock at the market price on April 4, 2003. The warrant expires thirty days after the guarantee has been extinguished. The shares of preferred stock that were issued on February 26, 2003 were issued by us in reliance on the exemption from registration provided by Section 4(2) or Regulation D of the Securities Act of 1933. The shares and warrant that were issued on April 2 and 4, 2003 were issued by us in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933. Use of proceeds was for general working capital needs. In April 2002, we reached a settlement with a primary creditor resulting in the settlement of $901,000 of obligations for a one-time payment of $200,000 and the issuance of 100,000 shares of Common Stock at $0.95 per share. The shares that were issued were issued by the Company in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933. Use of proceeds was for general working capital needs. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On June 5, 2003, the Company held its annual meeting of stockholders. At the annual meeting, the Company's stockholders elected James G. Garvey, Jr., John M. Blair, Stephen W. Brown, R. Nicholas Loope and Richard M. Gardner as directors of the Company approved an amendment to our certificate of incorporation to reduce the authorized shares of our Common Stock from 100,000,000 to 15,000,000, and ratified the appointment of Hein + Associates LLP as the Company's independent public accountants for the fiscal year ending December 31, 2003. With respect to the approval of our reduction in authorized shares and the ratification of Hein's appointment, 3,018,171 votes were cast in favor, 1,860 were cast against and 16,620 were withheld. With respect to the election of Directors, votes were cast as follows:

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.63 Payment and Tolling Agreement with Phoenix 24th Place, Inc. 10.64 Settlement Agreement and Mutual Release with Cunningham Enterprises, Inc. 10.65 Asset Purchase and Sale Agreement between James G. Garvey, Jr. and Julie Garvey and Integrated Information Systems, Inc. 99.1 Certification of James G. Garvey, Jr., Chairman, Chief Executive Officer and President. 99.2 Certification of Donald H. Megrath, SVP, Chief Financial Officer and Secretary. (b) Reports on Form 8-K - Form 8-K filed May 13, 2003, to file as exhibit 99.1 a press release titled "Integrated Information Systems Issues Letter to Shareholders". SIGNATURES 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. INTEGRATED INFORMATION SYSTEMS, INC. Date: August 13, 2003 /s/ James G. Garvey, Jr. ---------------------------- James G. Garvey, Jr. Chairman of the Board of Directors, Chief Executive Officer and President CERTIFICATION OF THE PRINCIPAL EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, James G. Garvey, Jr., hereby certify that: 1. I have reviewed this quarterly report on Form 10-Q of Integrated Information Systems, Inc. (the Registrant); 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this quarterly report; 4. The Registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and c. disclosed in this quarterly report any change in the Registrant's internal control over financial reporting that occurred during the Registant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Registrant's internal control over financial reporting; and; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of Registrant's board of directors: a. all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial data; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls over financial reporting. Date: August 13, 2003 /s/ James G. Garvey, Jr. ---------------------------- James G. Garvey, Jr. Chairman, Chief Executive Officer and President (Principal Executive Officer) CERTIFICATION OF THE PRINCIPAL FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Donald H. Megrath, hereby certify that: 1. I have reviewed this quarterly report on Form 10-Q of Integrated Information Systems, Inc. (the Registrant); 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this quarterly report; 4. The Registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and have: a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this quarterly report based on such evaluation; and c. disclosed in this quarterly report any change in the Registrant's internal control over financial reporting that occurred during the Registant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Registrant's internal control over financial reporting; and; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of Registrant's board of directors: a. all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial data; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls over financial reporting. Date: August 13, 2003 /s/ Donald H. Megrath ------------------------ Donald H. Megrath Senior Vice President, Chief Financial Officer and Secretary

INTEGRATED INFORMATION SYSTEMS INC 10-Q