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

FORM 10-Q

þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the quarterly period ended June 30, 2010
   
OR
   
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the transition period from ________________ to ________________

Commission file number 000-25663
 
 Ecosphere Technologies, Inc.
 (Exact name of registrant as specified in its charter)
 
Delaware
  
20-350286
(State or other jurisdiction of
  
(I.R.S. Employer
incorporation or organization)
  
Identification No.)
     
3515 S.E. Lionel Terrace, Stuart, Florida
  
34997
(Address of principal executive offices)
  
(Zip Code)

Registrant’s telephone number, including area code: (772) 287-4846

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 þ No   o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No   o

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

Large accelerated filer
o  
Accelerated filer  
o
         
Non-accelerated filer    
 o  
Smaller reporting company  
þ
       (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No þ

Class
  
Outstanding at August 13, 2010
Common Stock, $0.01 par value per share
  
137,620,838 shares

 
 
 
  
TABLE OF CONTENTS
 
   
Page
  
PART I – FINANCIAL INFORMATION
      
       
Item 1.
Condensed Consolidated Financial Statements (unaudited)
     1  
           
 
Condensed Consolidated Balance Sheets (unaudited)
     1  
           
 
Condensed Consolidated Statements of Operations (unaudited)
     2  
           
 
Condensed Consolidated Statements of Cash Flows (unaudited)
     3  
           
 
Notes to Condensed Consolidated  Financial Statements (unaudited)
     5  
         
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
     25  
           
Item 3.
Qualitative and Quantitative Disclosures about Market Risk
     35  
           
Item 4.
Controls and Procedures
     35  
           
PART II – OTHER INFORMATION
        
         
Item 1.
Legal Proceedings
     36  
           
Item 1A.
Risk Factors
     36  
           
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
     36  
           
Item 3.
Defaults Upon Senior Securities
     37  
           
Item 4.
(Removed and Reserved)
     37  
           
Item 5.
Other Information
     37  
           
Item 6.
Exhibits
     37  
           
SIGNATURES
     39  
  
 
 
 
 
 PART I – FINANCIAL INFORMATION
 
ITEM 1.  FINANCIAL STATEMENTS
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

   
June 30,
    
December 31,
  
   
2010
    
2009
  
   
(Unaudited)
        
Current Assets
            
Cash
   $ 47,171     $ 1,089,238  
Restricted cash
     -       425,000  
Accounts receivable
     674,375       701,999  
Prepaid expenses and other current assets
     161,968       30,656  
Total current assets
     883,514       2,246,893  
       Property and equipment, net
     7,461,827       7,174,919  
       Construction in progress
     1,458,555       764,229  
       Patents, net
     47,274       37,891  
       Deposits
     22,205       22,205  
Total assets
   $ 9,873,375     $ 10,246,137  
 Liabilities, Redeemable Convertible Cumulative Preferred Stock and                
Stockholders’ Deficit                
Current Liabilities
                
Accounts payable
   $ 1,794,145     $ 1,759,308  
Accounts payable - related parties
     32,082       -  
Accrued liabilities
     725,766       705,510  
Insurance premium finance contract
     77,785       -  
Vehicle financing
     77,642       41,339  
Capital lease obligations
     -       13,080  
Due to affiliate
     2,000       2,000  
Deferred revenue
     96,000       672,000  
Notes payable – related parties (net of discount) – current portion
     1,067,111       1,795,376  
Notes payable – third parties (net of discount) – current portion
     50,000       1,616,078  
Fair value of liability for warrant derivative instruments
     1,858,215       6,315,631  
Fair value of liability for embedded conversion option derivative instruments
     -       1,084,908  
Total current liabilities
     5,780,746       14,005,230  
       Restructuring reserve
     79,099       123,436  
       Notes payable - related parties - less current portion
     2,000,000       2,000,000  
Total Liabilities
     7,859,845       16,128,666  
Redeemable convertible cumulative preferred stock series A                
11 shares authorized; 6 shares issued and outstanding, $25,000 per share redemption amount plus dividends in arrears ($1,124,744 at June 30, 2010)     1,124,744        1,137,556   
Redeemable convertible cumulative preferred stock series B                
484 shares authorized; 330 and 355 shares issued and outstanding, respectively, $2,500 per share redemption amount plus dividends in arrears ($2,721,301  at June 30, 2010)     2,721,301        2,742,239   
Commitments and Contingencies (Note 13)
                
                 
Ecosphere Technologies, Inc. Stockholders’ Deficit
                
Common stock, $0.01 par value; 300,000,000 shares authorized; 134,925,557 and 116,830,850 shares issued and outstanding at June 30, 2010 and December 31, 2009, respectively
     1,349,256       1,168,308  
Common stock issuable, $0.01 par value, 1,811,626 and 630,089 issuable at June 30, 2010 and December 31, 2009, respectively
     18,116       6,301  
Additional paid-in capital
     92,287,903       66,349,999  
Accumulated deficit
     (106,287,083 )     (87,893,515 )
Total Ecosphere Technologies, Inc. stockholders’ deficit
     (12,631,808 )     (20,368,907 )
Non-controlling interest in consolidated subsidiary
     10,799,293       10,606,583  
Total stockholder' deficit
     (1,832,515 )     (9,762,324 )
Total liabilities, redeemable convertible cumulative preferred stock,
   $ 9,873,375     $ 10,246,137  
 and stockholders’ deficit
   
The accompanying unaudited notes are an integral part of these condensed consolidated financial statements.
 
 
1
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
   
For The Three Months Ended
June 30,
    
For The Six Months Ended
June 30,
  
   
2010
    
2009
    
2010
    
2009
  
Revenues
   $ 2,138,386     $ 154,041     $ 4,239,253     $ 348,309  
                                 
Cost of revenues
     792,236       121,272       1,538,770       254,749  
                                 
Gross profit
     1,346,150       32,769       2,700,483       93,560  
                                 
Operating expenses
                                
Selling, general and administrative
     3,082,364       2,602,351       5,887,410       4,488,562  
Restructuring charge
     -       548,090       -       548,090  
Total operating expenses
     3,082,364       3,150,441       5,887,410       5,036,652  
                                 
Loss from operations
     (1,736,214 )     (3,117,672 )     (3,186,927 )     (4,943,092 )
                                 
Other income (expense):
                                
Other income
     152       1,378       242       2,756  
Other expense
     -       (1,605 )     -       (1,605 )
Gain (loss) on conversion, net
     (115,505 )     (688,796 )     (133,604 )     (689,249 )
Interest expense
     (327,394 )     (2,465,474 )     (845,330 )     (4,001,142 )
Change in fair value of derivative instruments
     7,009,612       (12,202,160 )     (14,035,239 )     (5,739,159 )
Total other income (expense)
     6,566,865       (15,356,657 )     (15,013,931 )     (10,428,399 )
                                 
Net income (loss)
     4,830,651       (18,474,329 )     (18,200,858 )     (15,371,491 )
                                 
Preferred stock dividends
     (26,250 )     (30,000 )     (53,750 )     (60,000 )
                                 
Net income (loss) applicable to common stock
     4,804,401       (18,504,329 )     (18,254,608 )     (15,431,491 )
                                 
Less: Net (income) loss applicable to non-controlling interest in consolidated subsidiary
     (83,315 )     -       (192,710 )     -  
                                 
Net income (loss) applicable to Ecosphere Technologies, Inc. common stock
   $ 4,721,086     $ (18,504,329 )   $ (18,447,318 )   $ (15,431,491 )
                                 
Net income (loss) per common share applicable to Ecosphere Technologies, Inc. common stock
                                
Basic
   $ 0.04     $ (0.20 )   $ (0.15 )   $ (0.17 )
Diluted
   $ 0.03     $ (0.20 )   $ (0.15 )   $ (0.17 )
 
                                
Weighted average number of common shares outstanding
                                
Basic
     130,212,522       93,684,476       124,907,969       89,282,459  
Diluted
     170,733,321       93,684,476       124,907,969       89,282,459  

The accompanying unaudited notes are an integral part of these condensed consolidated financial statements.
 
 
2
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
   
For the Six Months Ended June 30,
  
   
2010
    
2009
  
OPERATING ACTIVITIES:
            
Net (loss) income applicable to Ecosphere Technologies, Inc, common stock
   $ (18,447,318 )   $ (15,431,491 )
Adjustments to reconcile net income (loss) to net cash used in operating activities:
             .  
Accrued preferred stock dividends
     53,750       60,000  
Depreciation and amortization
     922,345       252,459  
Amortization of debt issue costs
     -       243,792  
Shares issued for settlement
     114,000       -  
Accretion of discount on notes payable
     538,712       1,738,481  
Loss on conversion of accrued interest to stock
     19,604       689,248  
Non-cash compensation expense
     1,896,553       2,185,949  
Interest expense for warrant derivative liability related to new warrants
     -       638,048  
Interest expense for embedded conversion option derivative liability of new convertible notes
     -       932,924  
Expense related to warrant modifications
     93,735       -  
Increase (decrease) in fair value of warrant derivative liability
     10,020,019       3,291,151  
Increase (decrease) in fair value of embedded conversion option derivative liability
     4,015,220       2,448,008  
Noncontrolling interest in consolidated subsidiary
     192,710       -  
Changes in operating assets and liabilities
     -          
Decrease in accounts receivable
     27,624       80,323  
(Increase) decrease in prepaid expenses and other current assets
     43,355       59,245  
(Increase) in debt issue costs and other non-current assets
     (12,006 )     (2,737 )
Increase (decrease) in accounts payable
     80,687       319,568  
Increase in accounts payable - related parties
     32,082       15,015  
(Decrease) in restructuring reserve
     (44,337 )     264,472  
Increase in deferred rent
     -       3,094  
(Decrease) in deferred revenue
     (576,000 )     -  
Increase in accrued expenses
     45,782       771,013  
Net cash used in operating activities
     (983,483 )     (1,441,438 )
INVESTING ACTIVITIES:
                
Redemption of restricted cash
     425,000       -  
Construction in process purchases
     (100,128 )     (201,632 )
Purchase of property and equipment
     (1,800,828 )     (5,792 )
Net cash used in investing activities
     (1,475,956 )     (207,424 )
FINANCING ACTIVITIES:
                
Proceeds from issuance of notes payable and warrants
     -       325,000  
Proceeds from loan advances
     -       862,500  
Warrant modifications in exchange for cash
     756,968       -  
Proceeds from new vehicle financing
     42,000       -  
Proceeds from issuance of notes payable
     -       45,500  
Proceeds from issuance of notes payable to related parties
     -       80,000  
Proceeds from warrant exercises
     1,020,321       75,938  
Repayments of notes payable and insurance financing
     (96,882 )     (46,311 )
Repayments of notes payable to related parties
     (286,258 )     (30,000 )
Repayments of vehicle financing
     (5,697 )     -  
Principal payments on capital leases
     (13,080 )     (18,595 )
Net cash provided by financing activities
     1,417,372       1,294,032  
Net (decrease) in cash
     (1,042,067 )     (354,830 )
Cash, beginning of period
     1,089,238       461,514  
Cash, end of period
   $ 47,171     $ 106,684  

The accompanying unaudited notes are an integral part of these condensed consolidated financial statements.
 
 
3
 
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
SUPPLEMENTAL CASH FLOW INFORMATION      
   
For The Six Months Ended  June 30,
  
   
2010
    
2009
  
Cash paid for interest
   $ 124,388     $ 129,496  
Cash paid for income taxes
   $ -     $ -  
                 
Non-cash investing and financing activities:
                
Accrued preferred stock dividends
   $ 53,750     $ 60,000  
Conversion of convertible debentures to common stock
   $ —     $ 697,442  
Conversion of convertible notes  to common stock
   $ 1,986,667     $ 1,290,002  
Conversion of related party debt to common stock
   $ 539,948     $ 1,050,000  
Reduction of derivative liability for embedded conversion options from conversion of convertible debentures
   $ 5,100,128     $ 1,268,042  
Reduction of derivative liability for warrants from exercise and modification of warrants
   $ 14,571,170     $ 4,809,072  
Common stock issued as payment of accrued interest
   $ 30,462     $ 343,354  
Common stock issued in payment of services or accounts payable
   $ 60,518     $ 85,814  
Series A Redeemable Convertible Cumulative Preferred Stock converted to common stock
   $ 25,000     $ —  
Series B Redeemable Convertible Cumulative Preferred Stock converted to common stock
   $ 62,500     $ 122,500  
                 
The accompanying unaudited notes are an integral part of these condensed consolidated financial statements.
 
 
4
 

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)

1.
NATURE OF OPERATIONS,  BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF OPERATIONS AND BASIS OF PRESENTATION

We were incorporated  in April 1998 in Florida. We reincorporated on September 8, 2006, in Delaware under the name Ecosphere Technologies, Inc. (“Ecosphere” or the “Company”)  Ecosphere is a diversified water engineering and environmental services company.  The Company’s environmental services and technologies can be used in large-scale and sustainable applications across industries, nations and ecosystems.
 
The accompanying unaudited condensed consolidated financial statements include the accounts of Ecosphere, its 90%-owned subsidiary, Ecosphere Systems, Inc. (“ESI”),  its 52.6% owned subsidiary Ecosphere Energy Services LLC (“EES”), and its wholly-owned subsidiaries Ecosphere Envirobotic Solutions, Inc. (“UES”) and  Ecosphere Exploration LLC (“EEX”).  ESI was formed during the first quarter of 2005 to market the Company’s mobile water filtration technologies for disaster relief, homeland security and military applications. UES was formed in October 2005 to pursue the sale of UHP robotic coating removal equipment and technology and to perform contract services in the maritime coating removal industry that demonstrated the capabilities of the underlying technology. Ecosphere Energy Solutions, Inc. (“EES Inc.”)  was organized in November 2006.  It developed and marketed water processing systems to the oil and gas exploration industry using the Company’s patented  Ecosphere Ozonix ® process.  In November 2008, the Company changed the name of EES, Inc. to Ecosphere Energy Services, Inc.   In July 2009, the Company contributed the assets and liabilities of EES, Inc. in exchange for an initial 67% share of EES and EES Inc. ceased operations. In November 2009 EES sold additional ownership interests in EES reducing the Company’s holding to 52.6%.  EEX was formed in March 2010 to develop energy reserves on large tracts of environmentally sensitive sites both onshore and offshore.  Except for EES, all of the Company’s subsidiaries are inactive.
 
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and with the rules and regulations of the U.S Securities and Exchange Commission for interim financial information.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The unaudited condensed consolidated financial statements reflect all normal recurring adjustments, which, in the opinion of management, are considered necessary for a fair presentation of the results for the periods shown. The results of operations for the periods presented are not necessarily indicative of the results expected for the full fiscal year or for any future period. The information included in these unaudited condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis and Plan of Operation contained in this report and the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

PRINCIPALS OF CONSOLIDATION
 
The unaudited condensed consolidated financial statements include the accounts of Ecosphere Technologies, Inc. and its subsidiaries. All significant inter-company balances and transactions have been eliminated in the consolidation.
 
NON-CONTROLLING INTEREST
 
The Company accounts for its less than 100% interest in consolidated subsidiaries in accordance with ASC 810 and accordingly the Company presents non-controlling interests (previously shown as minority interest) as a component of equity on its condensed consolidated balance sheets and reports non-controlling interest net income under the heading “net (income) loss applicable to non-controlling interests in consolidated subsidiary” in the condensed consolidated statements of operations.
 
 
5
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
 
ACCOUNTING FOR DERIVATIVE INSTRUMENTS

In January 2009, the Company adopted the provisions of ASC 815-40 which was ratified by the Financial Accounting Standards Board on June 25, 2008 and became effective for financial statements issued after December 15, 2008.  Earlier application was not permitted.    Under the provisions of ASC 815-40, convertible instruments and warrants, which contain terms that protect holders from declines in the stock price (“reset provisions”), may no longer be exempt from derivative accounting treatment.   As a result, warrants and embedded conversion features of convertible notes are recorded as a liability and are revalued at fair value at each reporting date.  Further, under derivative accounting, the warrants are recorded at their fair value.  If the fair value of t he warrants exceeds the face value of the related debt, the excess is recorded as change in fair value on the issuance date.  Embedded conversion features are valued at their fair value. The fair value of the embedded conversion feature is added to loan discount, in an amount which is the lesser of, the fair value of the embedded conversion feature or the excess of the face value of the debt over the fair value of the attached warrants or any other applicable debt discounts. If the amount of the fair value of embedded conversion feature applied to discount is less than the total fair value of the embedded conversion feature, the remainder will be recorded as change in fair value on the issuance date.

In April 2010, the Company offered holders of warrant derivative instruments the right to extend the expiration date of the warrants for an additional year in exchange for the removal of the repricing feature in the warrant agreement.  Holders of 6,517,186 availed themselves of this opportunity which resulted in a charge to interest expense of $93,735 representing the increase in the fair value of the  warrants resulting from the one year extension of the expiration date.  In addition, holders of warrants to purchase 6,746,173 shares of common stock exercised their cashless exercise rights and were issued 5,834,188 shares of common stock.  Further, since January 1, 2010, holders of warrants to purchase an additional 1,941,044 shares of common stock exercised their warrants for cash.  As a result, the number of warrant derivative instruments has been reduced from 16,911,486 at December 31, 2009 to 1,707,083 as of June 30, 2010.
 
The Company calculated the estimated fair values of the liabilities for warrant derivative instruments at March 31, 2010 and June 30, 2010 with the Black-Scholes option pricing model using the closing prices of the Company’s common stock, $1.50 and $1.24, respectively, and the ranges for volatility, expected term and risk free interest indicated in Table 1 that follows.   During the three months ended March 31, 2010, based upon the estimated fair value, the Company increased the fair value of liability for warrant derivative instruments by $16,391,765 which was recorded as change in derivative liability in other expense.  During the three months ended June 30, 2010, based upon the estimated fair value, the Company decreased the fair value of liability for warrant derivative instruments by $6,371,747 which w as recorded as change in derivative liability in other income for the three months ended June 30, 2010.  As a result, for the six months ended June 30, 2010, the Company recognized a change in derivative liability of $10,020,018 in other expense related to the warrant derivative instruments.
 
The Company calculated the estimated fair values of the liabilities for embedded conversion option derivative instruments at March 31, 2010 and June 30, 2010 with the Black-Scholes option pricing model using the closing prices of the Company’s common stock, $1.50 and $1.24, respectively, and the ranges for volatility, expected term and risk free interest indicated in Table 1 that follows.  Based upon the estimated fair value, the Company increased the fair value of liability for embedded conversion option derivative instruments by approximately $4,653,085 which was recorded as other expense for the three months ended March 31, 2010.  Based upon the estimated fair value, the Company decreased the fair value of liability for embedded conversion option derivative instruments by approximately $637,865 which was reco rded as change in derivative liability in other income expense for the three months ended June 30, 2010.  As a result, for the six months ended June 30, 2010, the Company recognized a change in derivative liability of $4,015,220 in other expense related to the embedded conversion option derivative instruments.  As of June 30, 2010, there are no remaining convertible notes with embedded conversion options derivative instruments outstanding and the Company’s has no further liability for such instruments.
 
 
6
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
 
Table 1
  
Black Scholes Inputs
  
Warrants
                  
   
Warrants Exercised During the Six
Months Ended
 June 30, 2010
    
As of March
31, 2010
    
As of June
30, 2010
  
Volatility
     83.96% - 110.94 %     99.19 %     106.04 %
Expected Term
  
1.00 - 4.52years
    
1.13 - 4.58 years
    
0.89 - 3.78 years
  
Risk Free Interest Rate
     0.35% - 2.24 %     0.45% - 2.31 %     0.28% - 1.31 %
                         
                         
Embedded Conversion Options
                        
 
  
Notes Converted
During the Six
 Months Ended
June 30, 2010
    
As of March
31, 2010
    
As of June
30, 2010
  
Volatility
     83.5% - 110.94 %     99.19 %     N/A  
Expected Term
  
0.001 - 0.4 years
    
0.001 - 0.6 years
       N/A  
Risk Free Interest Rate
     0.001% - 0.20 %     0.001 - 0.23 %     N/A  
 
FAIR VALUE ACCOUNTING
 
We measure our financial assets and liabilities in accordance with generally accepted accounting principles. For certain of our financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities, the carrying amounts approximate fair value due to their short maturities. Amounts recorded for notes payable, net of discount, also approximate fair value because current interest rates available to us for debt with similar terms and maturities are substantially the same.

Effective January 1, 2008, we adopted accounting guidance for financial assets and liabilities. The adoption did not have a material impact on our results of operations, financial position or liquidity. This standard defines fair value, provides guidance for measuring fair value and requires certain disclosures. This standard does not require any new fair value measurements, but rather applies to all other accounting pronouncements that require or permit fair value measurements. This guidance does not apply to measurements related to share-based payments. This guidance discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). The guidance uti lizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:
 
Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.
 
Level 2: Inputs other than quoted prices that are observable, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.
 
Level 3: Unobservable inputs in which little or no market data exists, therefore developed using estimates and assumptions developed by us, which reflect those that a market participant would use.
 
We currently measure and report at fair value the liability for warrant and embedded conversion option derivative instruments.  The fair value liabilities for price adjustable warrants and embedded conversion options have been recorded as determined utilizing Black-Scholes option pricing model.  The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2010:
 
   
Balance at
June 30, 2010
  
Quoted Prices in
Active Markets
for Identical
Assets
  
Significant
Other
Observable
Inputs
  
Significant
Unobservable
Inputs
  
       
(Level 1)
  
(Level 2)
  
(Level 3)
  
Fair value of liability for warrant derivative instruments
   $ 1,858,215     $ —     $ —     $ 1,858,215  
Fair value of liability for embedded conversion option derivative instruments
     —       —       —       —  
Total Financial Liabilities
   $ 1,858,215     $ —     $ —     $ 1,858,215  
 
 
 
 
7
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
 
        The following is a roll-forward for the six months ended June 30, 2010 of the fair value liability of warrant derivative instruments and embedded conversion option derivative instruments:
   
Fair Value of Liability
For Warrant Derivative
Instruments
    
Fair Value of Liability
For Embedded Conversion
Option Derivative Instruments
    
Total
  
Balance December 31, 2009
   $ 6,315,631     $ 1,084,908     $ 7,400,539  
Fair value of new warrants and embedded conversion options
     93,735       -       93,735  
Adjustments for exercises and conversions
     (14,571,170 )     (5,100,128 )     (19,671,298 )
Change in fair value included in other (income) loss
     10,020,019       4,015,220       14,035,239  
Balance at June 30, 2010
   $ 1,858,215     $ -     $ 1,858,215  
 
The Company had no non-financial assets or liabilities measured at fair value as of June 30, 2010.
 
USE OF ESTIMATES
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates in the accompanying unaudited condensed consolidated financial statements include the allowance for doubtful accounts receivable,  estimates of depreciable lives, valuation of property and equipment, estimates of amortization periods for intangible assets, restructuring charges, valuation of discounts on debt, valuation of beneficial conversion feat ures in convertible debt, valuation of equity based instruments issued for other than cash, valuation of derivatives and the valuation allowance on deferred tax assets.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements”.  This update provides amendments to Topic 820 that will provide more robust disclosures about (1) the different classes of assets and liabilities measured at fair value, (2) the valuation techniques and inputs used, (3) the activity in Level 3 fair value measurements, and (4) the transfers between Levels 1, 2, and 3.  The adoption of ASU 2010-06 did not have a material impact on the Company’s consolidated results of operations or financial condition.

In February 2010, the FASB issued ASU 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements”.  This update addresses both the interaction of the requirements of Topic 855, “Subsequent Events”, with the SEC’s reporting requirements and the intended breadth of the reissuance disclosures provision related to subsequent events (paragraph 855-10-50-4).  The amendments in this update have the potential to change reporting by both private and public entities, however, the nature of the change may vary depending on facts and circumstances.  The adoption of ASU 2010-09 did not have a material impact on the Company’s consolidated results of operations or financ ial condition.
In April 2010, the FASB issued ASU No. 2010-13, “Compensation – Stock Compensation”.  This update will clarify the classification of an employee share based payment award with an exercise price denominated in the currency of a market in which the underlying security trades.  This update will be effective for the first fiscal quarter beginning after December 15, 2010, with early adoption permitted.  The Company does not expect the provisions of ASU 2010-13 to have a material effect on the Company’s consolidated results of operations or financial condition.
 
 
8
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
 
 
2.
GOING CONCERN
 
The accompanying unaudited condensed consolidated financial statements were prepared assuming that the Company will continue as a going concern. This basis of accounting contemplates the realization of assets and the satisfaction of liabilities in the normal course of operations. During the six months ended June 30, 2010, the Company incurred a loss from operations of approximately $3.2 million, and used cash in operations of approximately $983,000.   At June 30, 2010, the Company had a working capital deficiency of approximately $4.9 million, a stockholders’ deficit of approximately $1.8 million and had outstanding convertible preferred stock that is redeemable under limited circumstances for approximately $3.8 million (including accrued dividends).  The Company has not attained a level of revenues suffici ent to support recurring expenses, and the Company does not presently have the resources to settle previously incurred obligations. These factors, among others, raise doubt about the Company’s ability to continue as a going concern.

The Company’s continued existence is dependent upon its ability to generate sufficient additional revenue to support operations.  During the six months ended June 30, 2010 the Company received $756,968 to modify terms of certain warrant agreements and received $1,020,321 from warrant holders who exercised their warrants.  In addition, the Company’s 52.6% owned subsidiary had revenues of $4.2 million for the six month period ended June 30, 2010.  As EES receives contracts and work orders to assist energy companies in reducing their use of chemicals to pretreat the water they use in fracturing natural gas wells, we anticipate the need for additional financing or prepayments to fund the manufacturing of the additional equipment that may be needed to fulfill these agreements.  Management is exploring several possible alternative sources for this financing.  The continued support and forbearance of its creditors and preferred shareholders will be required, although this is not assured.
 
The unaudited condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the inability of the Company to continue as a going concern. There are no assurances that the Company will be successful in achieving the above plans, or that such plans, if consummated, will enable the Company to obtain profitable operations or continue as a going concern.
 
3.
PROPERTY AND EQUIPMENT
 
During the six months ended June 30, 2010, the Company completed the manufacture and assembly of its second  Ecos Frac fleet which was delivered to Arkansas to begin processing water being used to fracture natural gas wells in the Fayetteville Shale.  In connection with the delivery of the final units of the second Ecos Frac fleet and the delivery of one other customized piece of equipment, the Company reclassified the cost of manufacturing the equipment, $992,036 from construction in progress to property and equipment and began depreciating the unit.  Depreciation for the six months ended June 30, 2010 relating to these units was $74,118.  Total depreciation expense for the six months ended June 30, 2010 was $919,722.
 
 
9
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
 
 
4.
NOTES PAYABLE
 
During the three months ended March 31, 2010,  secured convertible notes with an aggregate principal amount of $1,812,726 were converted by the note holders.  As such, the Company issued the note holders 5,035,348 shares of the Company’s common stock.

During the three months ended June 30, 2010, secured convertible notes with an aggregate principal amount of $713,889 were converted by the note holders.  As such, the Company issued the note holders 1,983,024 shares of the Company’s common stock.

As of June 30, 2010 the Company had four loans remaining outstanding, one to an unrelated third party for $50,000 and three related party loans amounting to $3,067,111, of which $2,000,000 is a long term debt. In order to preserve working capital, as of June 30, 2010, the Company's subsidiary EES has not made three payments of principal and interest and three payments of interest only in the aggregate amount of $407,000, on notes amounting to $2.8 million. The holder of the notes, a partner in EES, has not made formal demand for payment. As of June 30, 2010, total accrued interest on the related party debt amounted to $85,270. EES anticipates bringing the payments current over the next few months based on additional cash flow from new contracts.
 
5.
RESTRUCTURING RESERVE
 
In June 2009, the Board of Directors approved an exit strategy to close the Company’s New York office in order to reduce operating costs. The Company recognized aggregate restructuring charges related to the office closing in the amount of $548,090 consisting of future lease commitments and employee severance costs in the amount of $246,920 and $301,170, respectively.
 
As of June 30, 2010, the restructuring reserve liability of $79,099 consists of the total restructuring cost of $548,090, less the severance costs paid to date and the net amount of lease payments made to date.  The Company entered into a sublease agreement with a tenant that provides for monthly sublease payments of approximately $10,300 through April 2013, which are being added to the reserve since the initial reserve included a reduction for estimated sub-lease income.
 
The following table summarizes the activity in the restructuring reserve during the six months ended June 30, 2010:
 
 
10
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
 
Restructuring Reserve
      
       
Balance December 31, 2009
   $ 123,436  
Rent payments
     (100,815 )
Sublease payment received
     56,478  
Balance June 30, 2010
   $ 79,099  

6.
REDEEMABLE CONVERTIBLE CUMULATIVE PREFERRED STOCK

Series A

As of June 30, 2010 and December 31, 2009, there were six and seven shares, respectively, of Series A Redeemable Convertible Cumulative Preferred Stock outstanding. The shares are redeemable at the option of the Company at $27,500 per share plus accrued dividends, and the shares became redeemable at the option of the holder in September 2002 at $25,000 per share plus accrued dividends.  The shares may be redeemed at the option of the holder upon the occurrence of a change in control of the Company, by the transfer of greater than 50% of the Company’s common stock.  The shares are convertible each into 24,000 common shares. Accrued dividends totaled $974,744 and $962,557 at June 30, 2010 and December 31, 2009, respectively. During the six months ended June 30, 2010, one holder converted one Series A preferred share into 24,000 shares of  common stock.

Series B

As of June 30, 2010 and December 31, 2009, there were 330 and 355 shares of Series B Redeemable Convertible Cumulative Preferred Stock outstanding, respectively. The shares are redeemable at the option of the Company at $3,000 per share plus accrued dividends, and the shares became redeemable at the option of the holder in September 2002 at $2,500 per share plus accrued dividends.  The shares may be redeemed at the option of the holder upon the occurrence of a change in control of the Company, by the transfer of greater than 50% of the Company’s common stock.  The shares are convertible each into 835 common shares.  Accrued dividends totaled $1,896,282 and $1,854,739 on June 30, 2010 and December 31, 2009, respectively. During the six months ended June 30, 2010,  holders of 25 shares of Series B Preferred Stock  converted their shares of Series B preferred stock into 20,875 shares of common stock.
 
 
11
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)

7.
COMMON STOCK

The Company is authorized to issue up to 300,000,000 shares of its $0.01 par value common stock as of June 30, 2010.

Shares issued

Issuances of the Company’s common stock during the three months ended March 31, 2010 included the following:

Shares Issued Upon Conversion of Convertible Notes

a)  
5,035,348 shares of common stock were issued to convert $1,812,726 of secured convertible notes payable.

Share Issued Upon Conversion of Convertible Preferred Stock

b)  
16,700 shares of common stock were issued upon the conversion of 20 shares of Series B Preferred Stock.  Accordingly, $50,000 was reclassified to equity from temporary equity.

Shares Issued Upon Exercise of Warrants and Options

c)  
1,525,112 shares of common stock were issued upon exercise of warrants and options at exercise prices ranging from $0.15 to $0.44 per share resulting in proceeds to the Company of $367,773.
 
Issuances of the Company’s common stock during the three months ended June 30, 2010 included the following:

Shares Issued Upon Conversion of Convertible Notes

a)  
1,983,024 shares of common stock were issued to convert $713,889 of secured convertible notes payable.
 
 
12
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
Share Issued Upon Conversion of Convertible Preferred Stock

b)  
24,000 shares of common stock were issued upon the conversion of one share of Series A Preferred Stock.  Accordingly, $25,000 was reclassified to equity from temporary equity.
c)  
4,175 shares of common stock were issued upon the conversion of 5 shares of Series B Preferred Stock.  Accordingly, $12,500 was reclassified to equity from temporary equity.
 
Shares Issued Upon Exercise of Warrants and Options

d)  
3,148,251 shares of common stock were issued upon exercise of warrants and options at exercise prices ranging from $0.07 to $0.75 per share resulting in proceeds to the Company of $652,548.
e) 
7,010,011 shares of common stock were issued upon the cashless exercise of 10,898,688 warrants at exercise prices ranging from $0.15 to $1.25 per share and based upon market prices of the Company’s common stock ranging from $0.80 to $1.73 per share.
f) 
35,776 shares of common stock upon the exercise of options to purchase 35,776 shares at an exercise price of $0.41 per share in lieu of receiving wages of $14,668.

Shares Issued for Amounts Payable

g)  
36,975 shares of common stock were issued to a director in exchange for a payable to the director in the amount of $45,850.  The number of shares issued was based upon the fair market value of the Company’s common stock of $1.24 on the date of the settlement.
h)
100,000 shares of common stock were issued as settlement of an agreement for consulting services.  The Company recorded a loss on settlement of $114,000 based upon a fair market value of the Company’s common stock on the date of settlement of $1.14.
i) 
30,160 shares of common stock, with fair market value of $1.01 per share, were issued in payment of accrued interest of $10,858, resulting in a loss on conversion of $19,604.

The Company recognized share-based compensation expense related to restricted stock grants, issued per the terms of the 2006 Equity Incentive Plan of $42,964 for the three months ended March 31, 2010 and $26,973 for the three months ended June 30, 2010. The following table summarizes non-vested restricted stock and the related activity as of June 30, 2010:

 
Shares
  
Weighted
 Average
 Grant-Date
 Fair-Value
  
Non-vested at January 1, 2010
547,559
  
$
0.47
  
Granted
---
  
$
---
  
Vested
357,140
  
$
0.47
  
Forfeited
---
  
$
---
  
           
Unvested at June 30, 2010
190,419
  
$
0.41
  
 
Total unrecognized share-based compensation expense from unvested restricted stock as of June 30, 2010 was $69,750 which is expected to be recognized over the next 2.5 years.
 
 
13
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010
(UNAUDITED)
 
8.
NET INCOME (LOSS) PER SHARE

The Company’s outstanding options and warrants to acquire common stock, shares of common stock which may be issued upon conversion of outstanding redeemable convertible cumulative preferred stock and unvested shares of restricted stock which total 72,712,543 as of June 30, 2010, are not included in the computation of net loss per common share for the six months ended June 30, 2010 because the effects of inclusion would be anti-dilutive.

For the six months ended June 30, 2010, basic net income (loss) per common share applicable to common stockholders were computed on the basis of the weighted average number of common shares outstanding during the period. Diluted net loss per common share applicable to common stockholders were computed on the basis of the weighted average number of common shares and dilutive securities outstanding. Dilutive securities having an anti-dilutive effect on diluted net loss per common share were excluded from the calculation.
 
Basic and diluted net income per share, for the three months ended June 30, 2010, were calculated as follows:
 
   
Basic
    
Diluted
  
Numerator
            
Net income applicable to common stock
   $ 4,721,086     $ 4,721,086  
Preferred stock dividends
     -       26,250  
Convertible debt interest (net of tax)
     -       12,367  
    $ 4,721,086     $ 4,759,703  
                 
Denominator