UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

ý                                 Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2006

OR

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

Commission File Number 000-50464

LECG CORPORATION

(Exact name of registrant as specified in its charter)

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 ý  No o

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

Large accelerated filer o   Accelerated filer ý  Non-accelerated filer o

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

Yes  o No ý

As of July 31, 2006, there were 24,500,146 shares of the registrant’s common stock outstanding.

LECG CORPORATION

FORM 10-Q

PART I  FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LECG CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

For the Quarters and Six Months Ended June 30, 2006 and 2005

(in thousands, except per share data)

(unaudited)

See notes to condensed consolidated financial statements

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LECG CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

June 30, 2006 and December 31, 2005

(in thousands, except share data)

(unaudited)

See notes to condensed consolidated financial statements

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LECG CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Six Months Ended June 30, 2006 and 2005

(in thousands)

(unaudited)

See notes to condensed consolidated financial statements

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LECG CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The accompanying consolidated financial statements include the accounts of LECG Corporation and its wholly owned subsidiary, LECG, LLC, (collectively, the “Company”, “Companies” or “LECG”).

The Company provides expert services, including economic and financial analysis, expert testimony, litigation support and strategic management consulting to a broad range of public and private enterprises. Services are provided by academics, recognized industry leaders and former high-level government officials (collectively, “experts”) with the assistance of a professional support staff. These services are provided primarily in the United States from the Company’s headquarters in Emeryville, California and its 25 other offices across the country. The Company also has international offices in Argentina, Belgium, Canada, France, Italy, New Zealand, South Korea, Spain, and the United Kingdom.

The condensed consolidated statements of income for the quarters and six months ended June 30, 2006 and 2005, the condensed consolidated balance sheet as of June 30, 2006 and the condensed consolidated statements of cash flows for the six months ended June 30, 2006 and 2005 are unaudited. In the opinion of management, these statements include all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of LECG’s consolidated financial position, results of operations and cash flows. The December 31, 2005 balance sheet is derived from LECG’s audited financial statements included in its Annual Report on Form 10-K for the year then ended. The results of operations for the quarter ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year. The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the 2005 Annual Report on Form 10-K.

Certain prior period amounts have been reclassified to conform to the current period presentation.

2.              Significant accounting policies

Revenue includes all amounts earned that are billed or billable to clients, including reimbursable expenses, and have been reduced for amounts related to work performed that are estimated to be uncollectible. Revenue primarily arises from time and material contracts, and is recognized in the period in which the services are performed. Expert revenue consists of revenue generated by experts who are employees of the Company as well as revenue generated by experts who are independent contractors. There is no operating, business or other substantive distinction between the Company’s employee experts and the Company’s exclusive independent contractor experts.

The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 Accounting for Income Taxes, under which deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying values of assets and liabilities and their respective tax bases. A valuation allowance is established to reduce the carrying value of deferred tax assets if it is considered more likely than not that such assets will not be realized. A full valuation allowance was provided at December 31, 2005 and June 30, 2006 on the Company’s foreign deferred tax assets related to net operating losses due to the uncertainty that such net operating loss carryforwards will eventually be utilized. For purposes of interim reporting, the Company estimates its annual effective tax rate based on estimated worldwide pre-tax income, permanent differences and credits, and reviews the annual effective tax rate estimate quarterly to determine if actual results require modifying the effective tax rate. Management estimates that the Company’s annual 2006 effective income tax rate will be approximately 40.5%. The Company’s actual effective tax rate for 2005 was 41.0%.

The Company adopted SFAS No.123(R) Share-Based Payment effective January 1, 2006 to account for equity-based compensation and elected the modified prospective method of transition, which requires that compensation expense be recorded at the beginning of the first quarter of adoption of SFAS No. 123(R) for all unvested stock options and restricted stock based upon

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the previously disclosed SFAS No. 123 methodology and amounts. Under SFAS No. 123(R), the cost of employee services received in exchange for an award of equity instruments is measured based on the grant-date fair value of the award and is recognized over the service period defined by the terms of the award. The Company has previously used the Black-Scholes option pricing model for disclosure requirements under SFAS No. 123 to estimate the fair value of options granted prior to adopting SFAS No. 123(R), and continues to use this option pricing model to value new option grants.

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 liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company’s financial statements contain various estimates including, but not limited to, estimates for unrealizable revenue, estimates for advances considered unrecoverable from experts on the expert model, valuation allowance on deferred tax assets, discretionary and performance-based bonuses and contingent payments for businesses acquired. Actual results could differ materially from those estimates.

3.              Net income per share and share amounts

Basic net income per common share is computed by dividing the net income for the period by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income for the period by the weighted average number of common and common equivalent shares outstanding during the period, using the treasury stock method. Common equivalent shares, comprised of common shares issuable upon the exercise of options and unvested restricted stock, are included in the diluted net income per common share calculation to the extent these shares are dilutive.

The following is a reconciliation of net income and the number of shares used in the basic and diluted earnings per share computations (in thousands, except per share amounts).

The following number of common stock equivalents was excluded from the calculation of diluted net income per share, as these shares were antidilutive: 3.2 million and 3.1 million for the quarter and six months ended June 30, 2006, respectively and 2.0 million for the quarter and six months ended June 30, 2005.

LECG adopted SFAS No. 123(R) Share-Based Compensation as of January 1, 2006, and has elected to use the modified prospective method for accounting for equity-based compensation, which requires companies to record compensation expense for the unvested portion of previously issued awards that remain outstanding at the initial date of adoption, and to record compensation expense for any awards issued, modified or settled after January 1, 2006. Equity-based compensation expense was $1,647,903 for the quarter ended June 30, 2006; of which, $1,068,139 was included in cost of revenues and $579,764 was included in operating expenses. The total income tax benefit recognized in the income statement for equity-based compensation was $667,401 for the quarter ended June 30, 2006. Equity-based compensation expense was $3,268,871 for the six months ended June 30, 2006; of which, $2,070,540 was included in cost of revenues and $1,198,331 was included in operating expenses. The total income tax benefit recognized in the income statement for equity-based compensation was $1,323,893 for the six months ended June 30, 2006.

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The Company has a 2003 Stock Option Plan (the “Plan”), under which restricted shares and non-qualified options may be granted to employees and non-employee experts to purchase, in the aggregate, up to 4,365,000 common shares. The Plan provides for increases in the number of shares available for issuance on the first day of each calendar year, equal to the lesser of:

•                                          4% of the outstanding shares of common stock on the first day of the fiscal year;

•                                          1,250,000 shares; or

•                                          a lesser amount as may be determined by the Board of Directors.

As of June 30, 2006, 1,083,430 shares were available for grant under the Plan.

Options issued under the Plan generally have an exercise price equal to the closing market price of the underlying stock on the date of grant. Vesting is based on service periods that range from 1.0 to 8.5 years, with five and seven years being the most common. Options granted under the Plan expire ten years from the date of grant.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that employs the assumptions and inputs appearing in the table below. Certain inputs are presented as the range of values for that input used throughout the periods presented. Expected volatility is measured using the historical volatility of LECG’s stock price from the time of its initial public offering in November 2003 through the option’s grant date. Expected life is an estimate based on the vesting term and the original contractual term. The expected dividend rate is 0%, as LECG expects that no dividends will be paid during the term of the options granted and outstanding, and the risk-free interest rate is based on published yields on U.S. Treasury securities with maturities commensurate with the expected term of the option.

A summary of option activity under the Plan as of June 30, 2006, and changes during the six months then ended is as follows:

The weighted-average grant-date fair value of options granted during the quarter and six months ended June 30, 2006 was $9.20 and $8.86, respectively. The total intrinsic value of options exercised during the quarter and six months ended June 30, 2006 was $700,051and $2,170,970, respectively.

As of June 30, 2006, total unrecognized compensation cost related to non-vested options granted under the Plan was $25,670,764, which is expected to be recognized over a weighted average period of 5.6 years.

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Equity-based compensation for the quarter and six months ended June 30, 2005

The Company recognized equity-based compensation in 2005 using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees for options granted to employees. Accordingly, compensation cost related to option grants to employees is measured as the excess, if any, of the fair value of the Company’s stock at the date of the grant over the option exercise price and such cost is charged to operations over the related option vesting period. SFAS No. 123 Accounting for Stock-Based Compensation (“SFAS 123”) required that companies record compensation cost for equity-based compensation to non-employees based on fair values. Accordingly, the Company records compensation cost for options granted to non-employees using a fair value based method over the related option-vesting period.

SFAS 123 required the disclosure of pro forma net income and net income per share had the Company adopted the fair value method since the Company’s inception. If the computed values of the Company’s equity-based awards to employees had been amortized to expense over the vesting period of the awards (based upon the weighted average assumptions described above), net income would have been (in thousands, except per share data):

The Company issued 140,625 shares of its common stock on August 1, 2003 to employees of the Company at a grant date fair value of $14.40 that will cliff-vest on August 1, 2008, provided these individuals are employed by LECG through that date. The equity-based compensation cost recognized in connection with these shares was $101,250 and $202,500 for the quarter and six months ended June 30, 2006, respectively, all of which was included in cost of revenues. The total income tax benefit recognized in the income statement in connection with these shares was $41,006 and $82,013 for the quarter and six months ended June 30, 2006, respectively. As of June 30, 2006, total unrecognized compensation cost related to restricted stock was $843,750, which is expected to be recognized over 2.1 years.

Comprehensive income represents net income plus other comprehensive income resulting from changes in foreign currency translation. The reconciliation of LECG’s comprehensive income for the quarters and six months ended June 30, 2006 and 2005 is as follows (in thousands):

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On May 9, 2006, the Company purchased the business (including certain assets, experts and professional staff) of BMB Mack Barclay, Inc. and affiliates (“Mack Barclay”), an expert services firm specializing in complex economic and accountancy issues in business and litigation environments. The purchase price was comprised of $12.95 million paid in cash at closing and the issuance of 13,291 unregistered shares of LECG common stock with a fair value of $250,000. The preliminary allocation of the purchase price, including an estimated $500,000 of acquisition costs, was as follows:

•                  $11.1 million to goodwill,

•                  $1.4 million to contract rights (twelve month amortization),

•                  $850,000 to other identifiable intangible assets (7 year amortization), and

•                  $371,000 to net current assets and equipment.

If specified annual performance targets are achieved through April 2011, the Company will make additional payments of up to $8.8 million by no later than July 2011. Additional goodwill will be recorded in subsequent periods if such performance targets are met.

Supplemental pro forma disclosures of the results of operations for the quarters and six months ended June 30, 2006 and 2005 as if the acquisition of Mack Barclay had been completed as of the beginning of the periods presented is as follows (in thousands, except per share data). The unaudited pro forma results are not necessarily indicative of future earnings or earnings that would have been reported had the acquisition been completed as presented:

Goodwill relates to the Company’s business acquisitions, reflecting the excess of purchase price over fair value of identifiable net assets acquired. SFAS No. 142 Goodwill and Other Intangible Assets provides that goodwill and intangible assets with indefinite lives must be tested for impairment at least annually, or whenever events or changes in circumstances indicate the carrying amounts of these assets may not be recoverable.

For purposes of testing for impairment of goodwill, the Company determined that it has one reporting unit based on the

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similarity of operations throughout its individual offices. The Company’s business acquisitions have been integrated within the structure of the organization, are not separately distinguishable and do not represent separate reporting units. The Company performs its goodwill impairment test annually as of October 1 by using the quoted market price of LECG’s common stock to determine the fair value of its entity-level goodwill relative to the carrying value of shareholders’ equity. Based on the test performed on October 1, 2005, the Company concluded that goodwill was not impaired.

The balance in goodwill as June 30, 2006 and 2005 and changes in the carrying amount of goodwill for the six months ended June 30, 2006 and 2005 are as follows (in thousands):

(1) Other changes represent finalization of transaction costs and valuation of intangible assets.

Other intangible assets that are separable from goodwill and have determinable useful lives are valued separately and amortized over their expected useful lives. Other intangible assets consist principally of customer relationships, customer contracts, non-compete agreements and trade processes and are generally amortized over periods ranging from six months to 20 years. Other intangible assets as of June 30, 2006 were (in thousands):

The estimated future amortization expense of other intangible assets as of June 30, 2006 is as follows (in thousands):

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8.              Commitments and contingencies

In June 2004, National Economic Research Associates, Inc., or NERA, and its parent company, Marsh & McLennan Companies, Inc., filed a complaint against the Company and one of our experts. This action arises out of the Company's hiring of a professional in March 2004 who was formerly employed by NERA. The complaint alleges that during and after his employment with NERA, this expert violated contractual commitments and fiduciary duties to NERA. The complaint further alleges that the Company interfered with NERA's contractual relations and advantageous business relationship, misappropriated confidential business information and goodwill, and engaged in unfair and deceptive trade practices. The complaint asks for unspecified damages and disgorgement of wrongful gain, invalidation of an indemnification agreement provided to this expert by the Company and contains a demand for a jury trial.

In August 2004, the Company served a motion to dismiss the breach of contract, tortious interference with contractual relations and the unfair and deceptive trade practices counts, which motion has been denied. The Company has filed an answer to the complaint denying the substantive allegations of the complaint. The parties have served initial discovery requests, including interrogatories and document requests and discovery is ongoing. However, the Company is not able to determine the outcome or resolution of the complaint, or to estimate the amount or potential range of loss with respect to this complaint.

The Company has a dispute with Navigant Consulting, Inc. arising out of its management led buyout of certain of the assets and liabilities of LECG, Inc. from Navigant Consulting and LECG, Inc. In the management led buyout, the Company acquired substantially all of the assets and assumed certain liabilities of LECG, Inc. pursuant to an asset purchase agreement with Navigant Consulting and LECG, Inc. dated September 29, 2000. Under the asset purchase agreement, up to $5.0 million of the purchase price was deferred contingent upon whether specific individuals listed on a schedule to the asset purchase agreement had an employment, consulting, contracting or other relationship with the Company on September 29, 2001. Navigant Consulting contends that it is entitled to a payment of approximately $4.9 million plus interest with respect to the contingent purchase price amount. On several occasions before and after September 29, 2001, the Company notified Navigant Consulting that several of the individuals listed on the schedule to the asset purchase agreement did not have an employment, consulting, contracting or other relationship with the Company on September 29, 2001. If Navigant Consulting initiates legal proceedings against the Company, a decision against the Company could harm its financial results and financial position.

The Company has made commitments in connection with current and prior years acquisitions that will require the Company to make additional payments and recognize additional goodwill if specified performance targets are met. The Company has also made commitments that will require the Company to make guaranteed purchase price payments. In addition, the Company has made commitments to make bonus compensation payments if specified performance targets are achieved.

In connection with the Company’s May 2006 acquisition of the business of Mack Barclay, if specified annual performance targets are achieved through April 2011, the Company will make additional payments of up to $8.8 million by no later than July 2011. As a result of achieving specified performance targets through June 30, 2006, the Company recognized $276,000 of additional goodwill in the six months ended June 30, 2006, to be paid in July 2007.

In connection with the Company’s December 2005 acquisition of the business of Lancaster Consulting LLC (“Lancaster”), if specified annual performance targets are achieved through December 2009, the Company will make additional payments of up to $1.35 million by no later than March 2010. As a result of achieving specified performance targets through June 30, 2006, the Company recognized $150,000 of additional goodwill in the six months ended June 30, 2006, to be paid in March 2007.

In connection with the Company’s November 2005 acquisition of the business of Neilson Elggren LLP (“Neilson”), if specified annual performance targets are achieved through October 2010, the Company will make additional payments of up to $3.75 million by no later than January 2011. An additional payment of up to $1.5 million will also be made in December 2010 if higher targets are met by no later than October 2010. As a result of achieving specified performance targets through June 30, 2006, the Company recognized $841,000 of additional goodwill ($731,000 in the six months ended June 30, 2006), to be paid in January 2007.

In connection with the Company’s August 2005 acquisition of the business of Bates Private Capital Incorporated (“Bates”), if specified annual performance targets are achieved through July 2011, the Company will make additional payments of up to $13.0 million by no later than September 2011. As a result of achieving specified performance targets through June 30, 2006, the Company recognized $3.0 million of additional goodwill ($1.7 million in the six months ended June 30, 2006), to be paid in September 2006.

In connection with the Company’s March 2004 acquisition of Low Rosen Taylor Soriano (“LRTS”), as a result of achieving specified performance targets for 2006, the Company recognized $715,000 of additional goodwill in the six months ended June 30, 2006, to be paid in February 2007.

In connection with the Company’s August 2003 acquisition of Center for Forensic Economic Studies (“CFES”), as a result of achieving specified performance targets in 2005, the Company made an additional purchase price payment of $1.8 million in August 2006. As a result of achieving specified performance targets in 2006, the Company has recognized $1.9 million of additional goodwill in the six months ended June 30, 2006, to be paid in August 2007. As a result of achieving specified performance targets in 2005 and 2006, the Company paid bonus compensation of $560,000 in August 2006. In addition, if specified performance targets are achieved in 2006 and 2007, the Company will pay bonus compensation of up to $580,000 in August 2007.

In connection with the hiring of certain experts and professional staff in March 2004, the Company paid $5.7 million in March 2006 as specified performance targets were achieved in 2005, and the Company agreed to pay performance bonuses of up to $5.7 million in March 2007 if specified performance targets are achieved in 2006. Because the unearned portion of the bonus payments are recoverable in the event the experts leave the Company prior to March 2011, all such bonus payments are subject to amortization from the time the bonus is recognized through March 2011. The Company believes it is probable that the 2006 performance criteria will be met for the $5.7 million bonus payable in March 2007, and has recognized a performance bonus and associated liability of $5.7 million and related amortization expense in the six months ended June 30, 2006.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and other parts of this Quarterly Report on Form 10-Q concerning our future business, operating and financial condition and statements using the terms “believes,” “expects,” “will,” “could,” “plans,” “anticipates,” “estimates,” “predicts,” “intends,” “potential,” “continue,” “should,” “may,” or the negative of these terms or similar expressions are “forward-looking” statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based upon our current expectations as of the date of this Report. There may be events in the future that we are not able to accurately predict or control that may cause actual results to differ materially from expectations. Information contained in these forward-looking statements is inherently uncertain, and actual performance is subject to a number of risks, including but not limited to, (1) our ability to successfully attract, integrate and retain our experts and professional staff, (2) dependence on key personnel, (3) successful management of professional staff, (4) dependence on growth of our service offerings, (5) our ability to maintain and attract new business, (6) successful management of additional hiring and acquisitions, (7) potential professional liability, (8) intense competition and (9) risks inherent in international operations. Further information on these and other potential risk factors that could affect our financial results may be described from time to time in our periodic filings with the Securities and Exchange Commission and include those set forth in this Report under “Risk Factors.” We cannot guarantee any future results, levels of activity, performance or achievement. We undertake no obligation to update any of these forward-looking statements after the date of this Report.

We provide expert services. Our highly credentialed experts and professional staff address complex, unstructured business and public policy problems. We deliver independent expert testimony and original authoritative studies in both adversarial and non-adversarial environments. We conduct economic, financial and statistical analyses to provide objective opinions and strategic advice to legislative, judicial, regulatory and business decision makers. Our skills include factual and statistical analyses and report preparation and presentation, electronic discovery and data collection and forensic accounting. Our experts are renowned academics, former senior government officials, experienced industry leaders, technical analysts and seasoned consultants. We are organized and operate in a manner that is attractive to our experts by providing them with autonomy, flexibility and the support of a highly capable professional staff.

An important element of our growth strategy is the recruitment and hiring of additional experts either by direct hiring or business acquisitions. Such hiring is designed to deepen our existing service offerings and to add new experts and related professional staff to new service areas. The following table summarizes the change in the number of experts and professional staff since June 30, 2005:

In May 2006, we acquired substantially all of the assets of BMB Mack Barclay, Inc. and affiliates, an expert services firm specializing in complex economic and accountancy issues in business and litigation environments. The purchase price was comprised of $12.95 million paid in cash and 13,291 unregistered shares of our common stock with a fair value of $250,000. In addition, if specified performance targets are achieved through April 2011, we will make additional payments of up to $8.8 million by no later than July 2011.

Operations

We derive our revenue primarily from professional service fees that are billed at hourly rates on a time and expense basis. Revenue related to these services is recognized when the earnings process is complete and collectibility is reasonably assured.

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Our revenue for the quarters presented is comprised of:

•                  Fees for the services of our professional staff;

•                  Fees for the services of our experts;

•                  Performance-based expert fees; and

•                  Amounts we charge for services provided by others, and costs that are reimbursable by clients, including but not limited to travel, document reproduction and subscription data services

The following table summarizes our revenue from these sources by quarter for the most recent eight quarters (in thousands).

(1) Relates primarily to the Insurance Claims Group, whose experts and certain staff departed in September 2005.

Compensation and project costs are comprised of:

•                  Salary, bonuses, taxes and benefits of all professional staff and salaried experts;

•                  Compensation to experts based on a percentage of their individual professional fees;

•                  Compensation to experts based on specified revenue and gross margin performance targets;

•                  Fees earned by experts and other business generators as project origination fees;

•                  Costs that are reimbursable by clients, including but not limited to travel, document reproduction and subscription data services; and

•                  Amortization of signing and performance bonuses that are subject to vesting over time

Hourly fees charged by the professional staff that support our experts, rather than the hourly fees charged by our experts, generate a majority of our gross profit. Most of our experts are compensated based on a percentage of their billings from 30% to 100%, averaging approximately 72% of their individual billings on particular projects in the three months ended June 30, 2006. Experts are paid when we have received payment from our clients. Any outstanding advances previously paid to experts are deducted from such payments. In some cases, we guarantee an expert’s draw at the inception of employment for a period of time, ranging from one to two years. In such cases, if the expert’s earnings do not exceed their draws within a reasonable period of time prior to the end of the guarantee period, we recognize an estimate of the compensation expense we will ultimately incur by the end of the guarantee period. Some of our experts are compensated based on a percentage of performance targets such as revenue or gross margin associated with the expert’s engagements. Experts not on either of these compensation models are compensated on a salary plus performance based bonus model.

Because of the manner in which we pay our experts, our gross profit is significantly dependent on the margin on our professional staff revenue. The number of professional staff assigned to a project will vary depending on the size, nature and duration of each engagement. We manage our personnel costs by monitoring engagement requirements and utilization of our professional staff. As an inducement to encourage experts to utilize our professional staff, experts generally receive project origination fees. Such fees are based primarily on a percentage of the collected professional staff fees. In the three months ended June 30, 2006, these fees have averaged 10% of professional staff revenues. Experts are required, with some exceptions approved by us, to use our professional staff unless the skills required to perform the work are not available within the Company. In these instances we engage outside individual or firm-based consultants, who are typically compensated on an hourly basis. Both the revenue and cost resulting from the services provided by these outside consultants are recognized in the period in which the services are performed. Such services are not a material component of our revenue.

Hiring experts sometimes involves the payment of cash signing bonuses. In some cases, the payment of a portion of a signing bonus is deferred until a future date. Signing bonuses are recognized at the time the payment is made or the obligation to pay such bonus is incurred, and are generally amortized over the term defined in the employment agreement for the period during which they could be recovered from the employee if he or she were to leave us prior to a specified date. We have also paid or are obligated to pay to certain experts

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performance bonuses that are subject to recovery of unearned amounts if the expert leaves prior to a specified date. Like signing bonuses, performance bonuses are amortized over the period that the bonus can be recovered, and we recognize such performance bonuses at the time we determine that it is considered more likely than not that the performance criteria will be met. Most of our agreements allow us to recover signing and performance bonuses over periods generally ranging from one to eight years.

CRITICAL ACCOUNTING POLICIES

Revenue includes all amounts earned that are billed or billable, including reimbursable expenses, and have been reduced for amounts related to work performed that are estimated to be uncollectible. Revenue primarily arises from time and material contracts, which is recognized in the period the services are performed. Expert revenue consists of revenue generated by experts who are our employees and revenue generated by experts who are independent contractors. There is no operating, business or other substantive distinction between our employee experts and our exclusive independent contractor experts.

Effective January 1, 2006, we adopted SFAS No. 123(R) Share-Based Payment using the modified prospective transition method and began accounting for our equity-based compensation using a fair-valued based recognition method. Under SFAS No. 123(R), the cost of employee services received in exchange for an award of equity instruments is measured based on the grant-date fair value of the award and is recognized over the service period defined by the terms of the award. Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life, expected dividend rate, risk-free interest rate and forfeiture rate. We develop our estimates based on historical data and market information which can change significantly over time.

We use the Black-Scholes option valuation model to value employee stock awards. We calculate stock price volatility using historical closing prices of our stock from November 2003, the time of our initial public offering, through the grant date of the options being valued. Forfeiture rate assumptions are also derived from historical data. We recognize compensation expense using the straight-line amortization method for share-based compensation awards with graded vesting. Had we used alternative valuation methodologies, the amount we expense for equity awards could be significantly different.

We account for income taxes in accordance with SFAS No. 109 Accounting for Income Taxes, under which deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying values of assets and liabilities and their respective tax bases. In accordance with SFAS No. 109, a valuation allowance is established to reduce the carrying value of deferred tax assets if it is considered more likely than not that such asset will not be realized. Significant management judgment is required in determining if it is more likely than not that we will be able to utilize the potential tax benefit represented by our deferred tax assets. Consideration is given to evidence such as the history of prior year taxable income, expiration periods for net operating losses and our projections. A full valuation allowance was provided at December 31, 2005 and June 30, 2006 on the Company’s foreign deferred tax assets related to net operating losses due to the uncertainty they will eventually be utilized.

Our annual effective tax rate is determined based on estimated worldwide pre-tax income, permanent differences and credits, and is reviewed quarterly to determine if actual results require modifying the effective tax rate. We have estimated our 2006 annual effective income tax rate to be 40.5%.

Goodwill and identifiable intangibles

Goodwill was recorded at the time of the management buyout in September 2000. Additional goodwill and identifiable intangibles were recorded related to acquisitions made through June 30, 2006. We determined that we have one reporting unit based on several factors, one of which was the similarity of operations throughout our individual offices. We evaluate our acquisitions on an individual basis to determine if the business acquired represents a separate reporting unit, as defined by SFAS No. 142 Goodwill and Other Intangible Assets, for purposes of assigning goodwill and performing subsequent impairment testing. Thus far, our business acquisitions have been integrated within the structure of our organization and our individual offices share similar economic characteristics, and consequently are aggregated for purposes of identifying our reporting units. We assess the impairment of goodwill at least annually, and whenever events or significant changes in circumstance indicate that the carrying value may not be recoverable. Factors that we consider important in determining whether to perform an impairment review include significant underperformance relative to forecasted operating results and significant negative industry or economic trends. If we determine that the carrying value of goodwill may not be recoverable, then we will assess impairment based

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on our quoted market price and measure the amount of impairment based on fair value. If a portion of a reporting unit that constitutes a business, as defined under accounting principles generally accepted in the United States, has been disposed of by sale or abandonment, goodwill associated with that business is included in the carrying amount of that business in determining the gain or loss on disposal. For the 2005 annual goodwill impairment test, we used the quoted market price of our common stock and compared our fair value to the carrying value of our equity. At October 1, 2005, we concluded that there was no impairment to our goodwill.

Intangible assets that are separable from goodwill and have determinable useful lives are valued separately and amortized over their expected useful lives. Intangible assets consist principally of customer-related intangibles, including customer relationships and contract rights, as well as non-compete agreements and trade processes, and are amortized over six months to 20 years.

We assess the impairment of intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If we determine that the carrying value of an intangible asset may not be recoverable, then we will assess impairment based on a projection of undiscounted future cash flows. At December 31, 2005, we concluded that there was no impairment to our identifiable intangible assets.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our financial statements contain various estimates including, but not limited to, estimates for unrealizable revenue, estimates for advances considered unrecoverable from experts on the expert model, valuation allowance on deferred tax assets, discretionary and performance-based bonuses and contingent payments for businesses acquired. Actual results could differ from those estimates.

RESULTS OF OPERATIONS

Quarter ended June 30, 2006 compared to quarter ended June 30, 2005

Revenue for the second quarter of 2006 increased $16.5 million, or 23%, to $89.1 million from $72.5 million for the same period of 2005. The increase included a $16.3 million, or 24% increase in expert and professional staff revenue, excluding performance-based services. The increase in expert and professional staff revenue resulted from a 31% increase in the number of expert and professional staff billable hours, partially offset by a 6% decrease in the average hourly billing rate. Underlying the growth in billable hours is the addition of 54 experts and 159 professional staff members since June 2005 as a result of our recruitment efforts and the acquisitions of the businesses of Bates in August 2005, Neilson in November 2005, and Lancaster and Beach in December 2005, and Mack Barclay in May 2006. The decrease in average hourly billing rates is due to changes in the expert and staff mix and lower average billing rates for staff hired in connection with our acquisition of Bates in August 2005, partially offset by rate increases. Our total international operations contributed $2.2 million to the overall growth in revenue in the second quarter of 2006. Revenue from our international operations represents 14% of total revenue for the second quarter of 2006 compared to 15% of total revenue in the second quarter of 2005.

Cost of services for the second quarter of 2006 increased $9.8 million, or 20%, to $58.6 million from $48.8 million for the second quarter of 2005. Our gross margin percentage was 34.2% in the second quarter of 2006 as compared with 32.8% for the same period of 2005. Contributing to the gross margin increase is a reduction in the average project origination fee percentage earned by experts to 10% in the second quarter of 2006 from 12% in the second quarter of 2005; a lower percentage of low-margin contingent fee and reimbursable expense revenue as compared with the same period last year; and a higher proportion of professional staff versus expert revenues. Offsetting these factors is an increase in equity-based compensation of $927,000 in the second quarter of 2006 in connection with adopting SFAS No. 123(R) as of January 1, 2006. Expert and professional staff compensation and related costs increased $7.5 million, as we added 54 experts and 159 professional staff since June 2005. Our growth in revenues contributed directly to the increase in expert compensation as a majority of our experts are paid a percentage of their own billings plus a percentage of professional staff billings on cases they originate. Project origination fees paid to experts increased by $477,000, consistent with the growth in professional staff revenue in the second quarter of 2006 as compared to the second quarter of 2005, and bonus compensation for salaried experts and professional staff increased $791,000 due to an increase in professional staff headcount and performance-based bonus compensation for certain experts.

Contributing to the increase in cost of services is the amortization of signing and performance bonuses of $2.0 million in the second quarter of 2006, representing an increase of $360,000 as compared to the second quarter of 2005. The increase in amortization is primarily due to the recognition of performance bonuses totaling $5.7 million, subject to achieving 2006 performance criteria that we estimate

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to be probable and consequently paid in March 2007.

Operating expenses

Operating expenses in the second quarter of 2006 increased $5.5 million, or 39%, to $19.7 million from $14.1 million for the same quarter of 2005. Contributing to the increase in general and administrative expenses was $2.3 million of salary, bonus and related payroll taxes due primarily to overall salary increases, and the addition of approximately 63 administrative staff since June 2005, including the hiring of a Chief Operating Officer in May 2006. Also included in the increase in compensation is an increase in bonus compensation for management and administrative staff of $398,000 due to increased administrative headcount and increased management bonuses for 2006 as compared to 2005. We expect that additional administrative staff will be hired to accommodate future growth in our domestic and international operations. Contributing to the increase in operating expenses was an increase of $580,000 of equity-based compensation expense following the adoption of SFAS 123(R) as of January 1, 2006. Personnel costs and recruiting fees recognized in connection with hiring experts and professional staff decreased by $149,000. We will continue to incur fees for recruiting as we pursue our growth strategy of attracting high-level experts and professional staff in practice areas where we are well established, as well as practice areas new to LECG.

Our facilities costs increased $519,000 in connection with the expansion of existing offices and the opening of five new offices since June 2005. Costs related to computers, telecommunications and supplies increased $315,000 due to increased personnel and the growth in our operations. Depreciation and amortization expense increased $1.0 million, primarily due to intangible assets acquired in connection with the acquisitions of Bates in August 2005, Neilson in November 2005 and Mack Barclay in May 2006. Marketing and related costs increased $412,000 as the result of our expanded marketing activities and branding initiatives designed to increase the awareness of the LECG brand. Outside services including legal, accounting and personnel service fees increased $541,000.

We have had no outstanding debt throughout 2005 and the six months ended June 30 2006 on our term loan or revolving credit facility. Interest expense is comprised primarily of amortization of fees paid in connection with our credit facility which was amended in July 2005.

We account for income taxes in accordance with SFAS No. 109 Accounting for Income Taxes. We estimate that our annual effective tax rate for 2006 will be 40.5% and have recognized income tax expense of $4.4 million for the second quarter of 2006. We are entitled to a deduction for federal and state income taxes when non-qualified stock options are exercised. We have recognized a reduction of current taxes payable of $282,000 for options exercised in the second quarter of 2006 and have reduced deferred tax assets by $15,000 and increased additional paid in capital by $267,000.

Six months ended June 30, 2006 compared to six months ended June 30, 2005

Revenue for the six months ended June 30, 2006 increased $31.3 million, or 22%, to $173.5 million from $142.3 million for the same period of 2005. The increase included a $30.7 million, or 23% increase in expert and professional staff revenue. The increase in expert and professional staff revenue resulted from a 30% increase in the number of expert and professional staff billable hours, partially offset by a 6% decrease in the average hourly billing rate. Underlying the growth in billable hours is the addition of 54 experts and 159 professional staff members since June 2005 as a result of our recruitment efforts and the acquisitions of the businesses of Bates in August 2005, Neilson in November 2005, Lancaster and Beach in December 2005 and Mack Barclay in May 2006. The decrease in average hourly billing rates is due to changes in the expert and staff mix and lower average billing rates for staff hired in connection with our acquisition of Bates in August 2005, partially offset by rate increases. Our total international operations contributed $3.3 million to the overall growth in revenue in the six months ended June 30, 2006. Revenue from our international operations represents 14% of total revenue for the six months ended June 30, 2006 compared to 15% of total revenue in the same period of 2005.

Cost of services for the six months ended June 30, 2006 increased $20.1 million, or 21%, to $115.0 million from $94.9 million for the same period of 2005. Our gross margin percentage was 33.7 % for the six months ended June 30, 2006 as compared with 33.3% for the same period of 2005. Contributing to the gross margin increase is a reduction in the percentage of project origination fees earned by experts to 11% in the six months ended June 30, 2006 from 12% for the same period of 2005; a lower percentage of low-margin contingent fee and reimbursable expense revenue as compared with the same period last year; and a higher proportion of professional staff versus expert revenues. Offsetting these factors was an increase in equity-based compensation of $1.8 million following the

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adoption of SFAS No. 123(R) as of January 1, 2006. Expert and professional staff direct compensation and related costs increased $15.4 million, as we added 54 experts and 159 professional staff since June 2005. Our growth in revenues contributed directly to the increase in expert compensation as a majority of our experts are paid a percentage of their own billings plus a percentage of professional staff billings on cases they originate. Project origination fees paid to experts increased by $944,000, consistent with the growth in professional staff revenue in the six months ended June 30, 2006 as compared with the same period of 2005, and bonus compensation for salaried experts and professional staff increased $1.1 million due to an increase in professional staff headcount and performance based bonus compensation for certain experts.

Contributing to the increase in cost of services is amortization of signing and performance bonuses of $4.1 million in the six months ended June 30, 2006, representing an increase of $609,000 as compared with the same period of 2005. The increase in amortization is primarily due to the recognition of performance bonuses totaling $5.7 million, subject to achieving 2006 performance criteria that we estimate to be probable and consequently paid in March 2007.

Operating expenses

Operating expenses in the six months ended June 30, 2006 increased $9.7 million, or 34%, to $38.5 million from $28.8 million for the same period of 2005. Contributing to the increase in general and administrative expenses was $3.7 million of salary, bonus and related payroll taxes due primarily to overall salary increases and the addition of approximately 63 administrative staff since June 2005 and our Chief Operating Officer in May 2006. We expect that additional administrative staff will continue to be hired as our growth continues. Equity-based compensation expense increased $1.2 million following the adoption of SFAS No. 123(R). Bonus compensation for management and administrative staff of $1.5 million for the six months ended June 30, 2006 was $391,000 higher than that recognized in the same period of 2005 due to higher headcount and increased management bonuses. Personnel costs and recruiting fees recognized in connection with hiring experts and professional staff for the six months ended June 30, 2006 decreased $165,000 as compared to the same period of 2005. We will continue to incur fees for recruiting as we pursue our growth strategy of attracting high-level experts and professional staff in practice areas where we are well established, as well as practice areas new to LECG.

Our facilities costs increased $826,000 in connection with the expansion of existing offices and the opening of five new offices since June 2005. Costs related to computers, telecommunications and supplies increased $596,000 due to increased personnel and the growth in our operations. Depreciation expense and amortization of intangible assets increased by $1.4 million, primarily due to the intangible assets acquired in connection with the acquisitions of Bates in August 2005, Neilson in November 2005 and Mack Barclay in May 2006. Marketing and related costs increased $818,000 as the result of our expanded marketing activities and branding initiatives designed to increase the awareness of the LECG brand. Outside services including legal, accounting and personnel service fees increased $994,000; $317,000 of which were incurred in the first quarter of 2006 in connection with our unsuccessful efforts to complete a significant acquisition, as previously disclosed.

We have had no outstanding debt on our term loan or revolving credit facility throughout 2005 and the six months ended June 30 2006. Interest expense is comprised primarily of amortization of fees paid in connection with our credit facility which was amended in July 2005.

We account for income taxes in accordance with SFAS No. 109 Accounting for Income Taxes. We estimate that our annual effective tax rate for 2006 is approximately 40.5% and have recognized income tax expense of $8.2 million for the same six months ended June 30, 2006. We are entitled to a deduction for federal and state income taxes when non-qualified stock options are exercised. We have recognized a reduction of current taxes payable of $875,000 for options exercised in the six months ended June 30, 2006 and have reduced deferred tax assets by $277,000 and increased additional paid in capital by $598,000.

As of June 30, 2006, we had $17.0 million in cash and cash equivalents, primarily in money market accounts. Our primary financing need will continue to be to fund the growth in our operations. An important element of our growth strategy is the recruitment of additional experts and our expansion into new geographical areas and service areas. We expect to continue to search for and acquire top-level experts and talented professional staff in order to deepen our existing areas of service and add new ones. The growth in the number of experts and scope of operations has been accomplished through a mix of individual hires, group hires and acquisitions. Our May 2006 acquisition of Mack Barclay and our 2005 acquisitions of Cook in March, Bates in August, Neilson in November, and Beach and Lancaster in December 2005 contributed to our growth in 2006 and 2005.

Our current sources of liquidity are our cash on hand and cash generated by operations before signing and performance bonus

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payments. In addition, we have a revolving credit facility, which expires May 31, 2008 that provides for a maximum borrowing capacity of $50 million, $10 million of which can be used to secure letters of credit. As of June 30, 2006, we had no outstanding borrowings, and we had outstanding letters of credit of $1.7 million.

Net cash used by operations in the six months ended June 30, 2006 was $3.1 million compared to $5.4 million provided by operations in the six months ended June 30, 2005. The primary sources and uses of cash from operations in the six months ended June 30, 2006 were net income of $12.0 million, which included non-cash expenses of $10.7 million. We paid $9.0 million in signing and performance bonuses in the six months ended June 30, 2006. Signing bonuses and bonuses with performance criteria are an integral part of our recruitment and retention effort. We will likely continue to use signing and performance bonuses in our efforts to recruit and retain highly valued experts and professional staff. Substantially all of the signing bonuses and certain performance bonuses issued have vesting periods ranging from one to eight years, whereby we are entitled to recover the signing bonus on a pro rata basis in the event the recipient leaves prior to the end of the vesting period. Adding to cash flow from operations was a $3.5 million increase in accrued compensation due to the timing of payments to experts and bonus accruals. This was offset by an increase in accounts receivable of $18.6 million resulting from the increase in expert and professional staff revenue. Various factors impact the average collection period of receivables including billing activities associated with new clients, consultancy on matters relating to bankruptcy, and international operations. Net cash used by operating activities in the six months ended June 30, 2005 resulted from net income of $11.2 million, which included non-cash expenses of $5.7 million. This was offset by an increase in accounts receivable of $11.2 million and payments of $4.8 million for signing bonuses in the six months ended June 30, 2005.

Net cash used by investing activities was $18.3 million for the six months ended June 30, 2006 as compared to $8.9 million for the six months ended June 30, 2005. Cash used in investing activities in the six months ended June 30, 2006 and 2005 included the following acquisition related payments (in thousands):

(1) Finalization of transaction costs incurred.

Investing activities in the six months ended June 30, 2006 also included investments in leasehold improvements and fixed assets of $1.7 million, related primarily to expansion of existing offices as well as hardware and software additions. We invested $3.9 million in leasehold improvements and hardware and software costs associated with our internal systems and operations in the six months ended June 30, 2005.

Net cash provided by financing activities for the six months ended June 30, 2006 was $2.2 million, consisting of $1.5 million of proceeds from the exercise of options and $160,000 from the issuance of 9,108 shares of common stock in connection with our Employee Stock Purchase Plan. We also realized $598,000 of tax benefit from option exercises and equity compensation plans.

Net cash provided by financing activities for the six months ended June 30, 2005 was $5.0 million, as the result of: $1.3 million of net proceeds from our sale of an additional 74,375 shares of our common stock in January 2005 following our secondary offering in December 2004, $925,000 from the issuance of 63,112 shares of common stock in connection with our Employee Stock Purchase Plan and $2.7 million of proceeds from the exercise of options.

We have made commitments in connection with our acquisitions and certain expert agreements that will require us to make additional payments and bonus compensation payments if specified performance targets are achieved. In addition, we have made

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commitments to make bonus compensation payments if specified performance targets are achieved. The following summarizes new commitments and additional purchase price recognized as a result of achieving specified performance targets during the six months ended June 30, 2006 in connection with our acquisitions and certain expert agreements.  (See note 7 of the condensed consolidated financial statements contained in this Quarterly Report on form 10-Q for a schedule of goodwill recognized in the six months ended June 30, 2006.)

In connection with our May 2006 acquisition of Mack Barclay, if specified annual performance targets are achieved through April 2011, we will make additional payments of up to $8.8 million by no later than July 2011. As a result of achieving specified performance targets through June 30, 2006, we recognized $276,000 of additional purchase price in the six months ended June 30, 2006, to be paid in July 2007.

In connection with our December 2005 acquisition of Lancaster, if specified annual performance targets are achieved through December 2009, we will make additional payments of up to $1.35 million by no later than March 2010. As a result of achieving specified performance targets through June 30, 2006, we recognized $150,000 of additional purchase price in the six months ended June 30, 2006, to be paid in March 2007.

In connection with our November 2005 acquisition of the business of Neilson, if specified annual performance targets are achieved through October 2010, we will make additional payments of up to $3.75 million by no later than January 2011. An additional payment of up to $1.5 million will also be made in December 2010 if higher targets are met by no later than October 2010. As a result of achieving specified performance targets through June 30, 2006, we recognized $841,000 ($731,000 in the six months ended June 30, 2006) of additional purchase price, to be paid in January 2007.

In connection with our August 2005 acquisition of the business of Bates, if specified annual performance targets are achieved through July 2011, we will make additional payments of up to $13.0 million by no later than September 2011. As a result of achieving specified performance targets through June 30, 2006, we recognized $3.0 million of additional purchase price ($1.7 million in the six months ended June 30, 2006), to be paid in September 2006.

In connection with our March 2004 acquisition of EA, if specified annual performance targets are achieved in 2006, we will make additional payments of up to $2.55 million by no later than March 2007. As a result of achieving specified performance targets through December 2005, we paid $1.8 million in March 2006 and recognized an additional $73,000 of goodwill in the six months ended June 30, 2006.

In connection with our March 2004 acquisition of LRTS, as a result of achieving specified annual performance targets for 2006, we recognized $715,000 of additional purchase price in the six months ended June 30, 2006, to be paid in February 2007.

In connection with our August 2003 acquisition of CFES, as a result of achieving specified annual performance targets in 2005, we made an additional purchase price payment of $1.8 million in August 2006. As a result of achieving specified performance targets in 2006, we recognized $1.9 million of additional purchase price in the six months ended June 30, 2006, to be paid in August 2007. As a result of achieving specified performance targets in 2005 and 2006, we paid bonus compensation of $560,000 in August 2006. In addition, if specified performance targets are achieved in 2006 and 2007, we will pay bonus compensation of up to $580,000 in August 2007.

In connection with the hiring of certain experts and professional staff in March 2004, we paid $5.7 million in March 2006 as specified performance targets were achieved in 2005, and we have agreed to pay performance bonuses of up to $5.7 million in March 2007 if specified performance targets are achieved in 2006. All such bonus payments are subject to amortization from the time the bonuses are recognized through March 2011, as the unearned portion of the bonus payments are recoverable in the event the experts leave prior to March 2011. We believe it is probable that the 2006 performance criteria will be met.

We believe our cash on hand, funds generated by operations and the amounts available to us under our revolving credit facility will provide adequate cash to fund our anticipated cash needs, at least through the next twelve months. Thereafter, we anticipate that our future cash requirements will be funded with cash generated from operations and additional debt, as needed. Cash payments for signing and performance bonuses and acquisitions could affect our anticipated cash needs. We currently anticipate that we will retain all of our earnings, if any, for development of our business and do not anticipate paying any cash dividends in the foreseeable future.