form10q_16780.htm

ARKADOS GROUP, INC. & SUBSIDIARIES

NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS

Nine Months Ended February 28, 2010 and 2009

(Unaudited)

NOTE 1 - DESCRIPTION OF BUSINESS

Arkados Group, Inc. (the “Company”), a development stage enterprise, is a fabless semiconductor company providing integrated system-on-chip solutions that directly support networking, smart grid and multimedia applications. Arkados, “the HomePlug Applications Company,” delivers a universal platform that enables the effortless networking of home entertainment and computer devices using standard electricity lines. We also license some ingredient technologies for wireless multimedia solutions. The Company’s system-on-chip solutions are uniquely designed to drive a wide variety of powerline-communication solutions such as utility company applications, and powerline-enabled consumer electronics and home computing products, such as stereo components, radios, speakers, MP3 players, computers, televisions, gaming consoles, security cameras and cable and DSL modems. With Arkados’ solutions, customers can bring numerous sophisticated, full-featured products to market faster at a lower overall development cost using a single platform: the company’s versatile and programmable ArkTIC® platform. Arkados solutions leverage the benefits of standard powerline communications technologies that are used worldwide for in-building and to-the-home Broadband Powerline (“BPL”) applications. Arkados is a founding member of the HomePlug Powerline Alliance, “HomePlug” an independent trade organization which has developed global specifications for high-speed powerline communications, and a founding member of the IEEE P1901 Working Group operating under the umbrella of the IEEE Standards Association (IEEE-SA), a major contributor to the world's leading professional association for the advancement of technology Institute of Electrical and Electronics Engineers (IEEE), the world’s leading professional association for the advancement of technology.

The attached summary consolidated financial information does not include all disclosures required to be included in a complete set of financial statements prepared in conformity with accounting principles generally accepted in the United States of America. Such disclosures were included with the financial statements of the Company at May 31, 2009, and included in its report on Form 10-K. Such statements should be read in conjunction with the data herein.

The summary consolidated financial information reflects all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results for the interim period expected for the year.

As of February 28, 2010, $17,626,658 of secured debt, of which $4,979,689 is held by related parties is in default, as is $1,739,166 principal and interest on unsecured notes. In addition, as of February 28, 2010, $3,362,528 of salary remains due to our employees and our accounts payable was approximately $1,737,245, of which $1,684,210 was over 90 days. In February, 2010, we entered into agreements with the holders of the secured debt giving us until March 31, 2010 to conclude financing and debt restructuring transactions without the threat of such holders taking action to enforce their rights under the instruments defining the secured debt and, related transaction documents granting the holders of such debt a security interest in substantially all of our property and under law. The agreements expired on March 31, 2010. We are negotiating with the holders of each class of debt to extend or fashion forbearance agreements that will run to April 30, 2010, and compromises or conversion of outstanding debt into equity to facilitate raising additional investor capital. We are attempting to reach an agreement with the holders of our secured debt as to the terms and conditions upon which they would agree to accept partial payment of principal and convert the balance (or all) of secured debt to equity, however, there is no binding agreement on anyone’s part to do so and no assurance can be given that the terms will be acceptable to the holders of all of the secured debt. If the holders of a material amount of debt do not accept terms of settlement or conversion into equity acceptable to new investors we will not be able to obtain financing and will have to suspend operations or seek protection under the Bankruptcy Code.

We have also received indications of interest from potential private investors concerning the terms and conditions upon which they would make an investment in Arkados, including the terms upon which the secured debt and other debt would have to be compromised and converted for them to make such investments, but there is no binding commitment on anyone’s part to complete the transactions. Finally, without commitment on anyone’s part, we have discussed converting a substantial portion of past due compensation with our employees if the financing and restructuring of our debt can be completed. Pending the completion of these transactions, we are financing operations by issuing bridge notes to investors that would participate in an equity financing if the debt can be restructured. If the financing proceeds, these investors would be able to make the equity investment in Arkados at a discount of 33% from the price other investors are offered. In the event the financing is not completed, the bridge notes are due with interest at the annual rate of 8% on March 31, 2010. The Company is presently working with the note holders to extend the due date until April 30, 2010.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation – The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has incurred net losses of over $40.4 million since inception including a net loss in excess of $6.7 million for the year ended May 31, 2009 and $9.4 million for the nine months ended February 28th, 2010. Additionally, the Company had a net working capital deficiency and shareholders’ deficiencies at February 28th, 2010 and May 31, 2009 and negative cash flow from operations since inception. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management expects to incur additional losses in the foreseeable future and recognizes the need to raise capital to remain viable. The accompanying consolidated financial statements do not include any adjustments that might be necessary should the Company be unable to continue as a going concern.

Principles of consolidation – The consolidated financial statements include the accounts of Arkados Group, Inc. and its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.

Business combinations – We account for acquired businesses using the purchase method of accounting which requires that the assets and liabilities assumed be recorded at the date of acquisition at their respective fair values. Because of the expertise required to value intangible assets and intellectual property research and development “IPR&D”, we typically engage a third party valuation firm to assist management in determining those values. Valuation of intangible assets and IPR&D entails significant estimates and assumptions including, but not limited to: determining the timing and expected costs to complete projects, estimating future cash flows from product sales, and developing appropriate discount rates and probability rates by project. We believe that the fair values assigned to the assets acquired and liabilities assumed are based on reasonable assumptions. To the extent actual results differ from those estimates, our future results of operations may be affected by incurring charges to our statements of operations. Additionally, estimates for purchase price allocations may change as subsequent information becomes available

Fair Value of Financial Instruments – The carrying value of cash, accounts receivable, other receivables, accounts payable and accrued expenses approximate their fair values based on the short-term maturity of these instruments. The Company can not estimate the fair value of the remaining outstanding payroll taxes penalties and interest recorded in connection with the merger, or its’ long term debt, as a result of the undercapitalized nature of the Company..

Reclassification – Certain amounts have been reclassified to conform to the current period’s presentation. The allocation of costs between Research & Development Expenses and General Administration Expenses has been changed to incorporate all costs of Research & Development including personnel costs, facility cost, and direct research costs for parts and services. Formerly, only direct research expenses for parts and services were included under the caption “Research and Development Expenses”. These reclassifications had no effect on previously reported net earnings.

Revenue Recognition – The Company derives revenues from two sources – sales of products and revenues from services in the form of custom development activities. For product sales, revenue is recognized when our products are shipped to our customers. For sales related to development, the Company has recorded revenues pursuant to a number of long term development contracts. The revenues are earned and recorded based on pre-determined milestones. When revenues within a pre-determined milestone have been partially earned, the Company records such progress billings as “Revenues earned not yet billed.” Such revenues are billable under the terms of the arrangement once the milestone has been fully completed. The Company also monitors estimated costs to complete its obligation to fulfill the terms of such long term contracts and compares such costs to the expected revenues to be earned to ensure that estimated losses are recorded on a timely basis.

Loss Per Share – Basic net loss per common share is computed by dividing net loss by the weighted average number of shares of common stock outstanding. Vested stock options totaling 16,235,562 and vested warrants totaling 11,735,004 have not been included since there is a net loss and the effect of including these options and warrants would be anti-dilutive.

Tax Provision – No tax provision is required at this time since the company expects to be in a tax loss position at year-end May 31, 2010 and has net operating losses from previous years. The Company has established a 100% valuation allowance against the deferred tax asset.

In December 2007, the Company sold $4,967,706 of its State Net Operating Loss carry forwards under the State of New Jersey’s Technology Business Tax Certificate Transfer Program (the “Program”). The Program allows qualified technology and biotechnology businesses in New Jersey to sell unused amounts of net operating loss carry forwards and defined research and development tax credits for cash. The proceeds from the sale in 2007 were $400,149. This amount has been recorded as a tax benefit in the consolidated statements of operations in 2008. The State renews the Program annually and limits the aggregate proceeds to $10,000,000. We cannot be certain if we will be able to sell any of our remaining or future carry forwards under the Program.

On September 9, 2008, the Company was approved for the sale of its 2007 Net Operating Losses of approximately $4,200,000 under the Program in addition to the sale of its Research and Development Tax Credits. The actual sale and receipt of funds was received in the first half of December 2008

Accounting for Uncertainty of Income Taxes (“FIN 48”) – In June 2006, the Company adopted guidance for the Financial Accounting Standards Board issued Interpretation , Accounting for Uncertainty in Income Taxes (“FIN 48”). This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes a recognition threshold of more-likely-than-not to be sustained upon examination. Measurement of the tax uncertainty occurs if the recognition threshold has been met. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Arkados conducts business in the U.S. and, therefore, files U.S. and New Jersey income tax returns. In the normal course of business, the Company is subject to examination by taxing authorities. At present, there are no ongoing audits or unresolved disputes with the various tax authorities with whom the Company files. Given the Company’s substantial net operating loss carryforwards (“NOLs”, which are subject to a full valuation allowance) as well as the historical operating losses, the adoption of FIN 48 on June 1, 2007 did not have any effect on our financial position, results of operations or cash flows as of February 28, 2010.

Stock Options –. The Company adopted Guidance for, “Share Based Payments.” The guidance requires companies to expense the value of employee stock options and similar awards and applies to all outstanding and vested stock-based awards.

In computing the impact, the fair value of each option is estimated on the date of grant based on the Black-Scholes options-pricing model utilizing certain assumptions for a risk free interest rate; volatility; and expected remaining lives of the awards. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and the Company uses different assumptions, the Company’s stock-based compensation expense could be materially different in the future. In addition, the Company is required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. In estimating the Company’s forfeiture rate, the Company analyzed its historical forfeiture rate, the remaining lives of unvested options, and the amount of vested options as a percentage of total options outstanding. If the Company’s actual forfeiture rate is materially different from its estimate, or if the Company reevaluates the forfeiture rate in the future, the stock-based compensation expense could be significantly different from what we have recorded in the current period. The impact of applying such guidance approximated $1, 022,063, respectively, in additional compensation expense during the nine months ended February 28, 2010. Such amount is included general and administrative expenses on the statement of operations.

In accordance with the guidance for share based payments, the fair value of each option grant has been estimated as of the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:

	For Nine Months Ended	For Nine Months Ended
	February28, 2010	February 28, 2009
Risk free interest rate	2.57-2.71	1.94-2.76%
Expected life	3-5 years	3-5 years
Dividend rate	0.0%	0.00%
Expected volatility	223-294%	64.00 - 194.00%

Recently Issued Accounting Pronouncements

In April 2009, FASB issued guidance in the Financial Instruments Topic of the Codification on interim disclosures about fair value of financial instruments. The guidance requires disclosures about the fair value of financial instruments for both interim reporting periods, as well as annual reporting periods. The guidance is effective for all interim and annual reporting periods ending after June 15, 2009 and shall be applied prospectively. The adoption of this guidance had no impact on our financial statements as of February 28, 2010 other than additional disclosure.

The FASB issued guidance in the Subsequent Events Topic of the Codification in May 2009. The guidance is intended to establish general standards for, and disclosure of, events that occur after the balance sheet date but before financial statements are issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. The guidance is effective for interim or annual financial periods ending after June 15, 209 and is required to be adopted prospectively. We adopted this guidance effective for the quarter ended August 31, 2009. The adoption of this guidance had no impact on our financial statements as February 28, 2010, other than the additional disclosure.

In June 2009, the FASB issued guidance which will amend the Consolidation Topic of the Codification. The guidance addresses the effects of eliminating the qualifying special-purpose entity (QSPE) concept and responds to concerns over the transparency of enterprises’ involvement with variable interest entities (VIE’s). The guidance is effective beginning on January 1, 2010. We do not expect the adoption of this guidance to have an impact on our financial statements.

In August 2009, the FASB issued guidance for, “Measuring Liabilities at Fair Value” (ASU 2009-05) ASU 2009-05 amends the Fair Value Measurements and Disclosures Topic of the FASB Accounting Standards Codification by providing additional guidance clarifying the measurement of liabilities a fair value. ASU 2009-05 was effective for us for the reporting period ending May 31, 2009. We do not expect the adoption of ASU 2009-05 to have an impact on our financial statements.

All other new accounting pronouncements have been deemed not to be relevant.

NOTE 3 – REVENUE RECOGNITION

During the three and nine month periods ended February 28, 2010 and 2009 and the same periods of the prior fiscal year, the Company sold and delivered $0 and $0 of chips and $0 and $35,115, respectively, to customers. In addition, during the three and nine month period ended February 28, 2010 and the same period of the prior fiscal year, the Company recognized revenues related to development contracts in the amounts of approximately $46,346 and $173,246 and $ 163,765 and $583,325 respectively. The revenue was recognized as was an amount for cost of goods sold amount that was calculated based upon the estimated costs the Company incurred to deliver the products. These costs were, for the most part, related to labor, outside fabrication services, and supplies and materials.

Note 4 - ACCRUED EXPENSES AND OTHER LIABILITIES

As of February 28, 2010 and May 31, 2009, accrued expenses and other liabilities consist of the following approximate amounts:

	Nine Months Ended February 28, 2010		Year Ended May 31, 2009
Accounts Payable	$	1,737,245	$	1,743,289
Accrued Compensation		4,106,241		2,389,805
Accrued Interest Payable		2,554,235		489,212
Liabilities Assumed under Merger agreement		34,673		34,673
Accrued Other		156,096		164,667

	$	8,588,490	$	4,821,646

NOTE 5 – CONVERTIBLE DEBENTURES AND RELATED PARTY PAYABLES

2004 6% Convertible Notes - During the period from October to November 2005, the Company borrowed $500,000 from certain of its existing stockholders for working capital needs and such obligation is represented by notes. The notes, recorded as Related Party Payables, bore interest at 6% per annum and contained certain conversion features which would have been triggered if the Company had sold equity at or above $1.25 per share. No expense was recorded for the beneficial conversion feature, since conversion price was always at or above market. The notes’ maturity was initially October 15, 2005, which was extended from time to time by the holders. In February 2006, the Company and holders of $175,000 of the outstanding principal of the notes agreed to discharge the Company’s obligations for 160,765 shares of common stock and the payment of $81,018. The remaining $325,000 of principal outstanding was held by an affiliate of the Company’s Chairman of the Board. On June 30, 2006, the principal and interest on the remaining $325,000 due were forgiven in exchange for an equivalent amount of 6% secured convertible debentures and warrants.

2005 6% Convertible Notes - During the period from July 7, 2005 to September 23, 2005, the Company raised $912,500 and $154,000, respectively, of gross proceeds from the private placement of an aggregate of 10.665 units (the “Units”) each consisting of $100,000 principal amount 6% convertible subordinated promissory notes (the “6% Notes”) and 14,286 detached warrants (the “Warrants”) to purchase a like number of shares of the Company’s common stock, for $0.35 per share. The Company issued an aggregate of 152,359 Warrants to the purchasers of the Units, which have been valued at $74,802 and will be amortized as interest expense over the term of the 6% Notes. In addition, the Company issued 238,213 common stock warrants exercisable at $0.65 as part compensation to the placement agent, which have been valued at $111,668 and will be amortized as interest expense along with other

expenses of the offering. Both the $0.35 and $0.65 Warrants have a “net exercise” provision that permits the holder to convert the Warrants into shares of the Company’s common stock. The 6% Notes (1), when issued were due July 7, 2007 with interest at the annual rate of 6% from the date of original issuance (increasing to 12% per annum from an event of default as defined in the 6% Notes); (2) are unsecured obligations of the Company and subordinated to senior secured loans to the Company (if any) from banks, finance companies and similar institutions that extend credit in the regular cause of such institution’s business; (3) are convertible, subject to certain conditions and at two different price levels ($1.125 and $1.575 for a period of twenty trading days following the bid price of common stock closing above $1.50 and $2.50, respectively, for a period of five consecutive trading days), into shares of common stock; and (4) may be redeemed by the Company in certain limited circumstances described below prior to maturity. Since the beneficial conversion feature of the 6% Notes is (at the lowest price) at a price greater than the market price of the stock upon issuance of the 6% Notes, no value has been estimated or recorded for the beneficial conversion feature.

On July 6, 2007, the Company reached an agreement with more than the requisite holders of 2/3 of the outstanding $1,066,500 principal amount of 6% Notes to extend the due date of the Notes to June 30, 2008. In exchange for the amendment, the Company agreed to issue approximately 188,200 three year warrants to purchase shares of the Company’s common stock for $0.85 per share and lowered conversion prices in the Notes to $0.85. In connection with the amendments, the Company retained entered into a Solicitation Agreement with Trident Partners, Ltd., who served as placement agent for the Notes in 2005, to solicit the consent of Note holders that were their customers. Under the Solicitation Agreement, the Company paid Trident $25,000 and issued Trident 137,656 Warrants for their successful efforts.

On July 9, 2008, the Company reached an agreement with the holders of more than the requisite of the outstanding $1,066,500 principal amount of 6% Notes (the “Notes”) due June 30, 2008 to extend the due date of the 6% Notes to June 30, 2009. In exchange for the amendment, the Company agreed to exchange approximately 876,100 shares of common stock, pro rata, for notes in the original principal amount of $313,214. The debt was converted at $0.35 versus $0.85 in the original agreement.

The Company did not pay the $999,733 principal and interest due on the 6% when due on June 30, 2009 and, accordingly the 6% Notes accrue interest at the penalty rate of 12% per annum from the date of default. The Company has discussed forbearance or conversion with Trident, who was the placement agent for the sales of the 6% Notes to investors and who has twice served as Solicitation Agent in obtaining an extension of the 6% and while neither Trident or any of the holders of the 6% have agreed to any extension or conversion, none of them have taken any judicial collection action.

During the first half of 2008, the Company borrowed $855,000 at the times set forth below, on an unsecured basis from affiliates of the Company’s Chairman and two non-employee directors, with the understanding that these advances would be exchanged for additional 6% Secured Debentures and related warrants. On December 15, 2007, this related party debt was converted to additional principal of the 6% Secured Debentures on substantially the same terms as the 6% Secured Debentures previously issued by the Company.

From March 1, 2008 through November 30, 2009, the Company borrowed $197,700 from two directors. $187,700 of these advances were due on demand with interest at the annual rate of 6%. $10,000 is due on January 31, 2010 and is at an interest rate of 8% per annum.

6% Secured Debentures - On December 19, 2005, the Company borrowed $267,900 from one of the accredited investors that ultimately purchased 6% secured convertible debentures (the “6% Secured Debentures”) in the December 28, 2005 financing. The loan was made on an unsecured basis, was due on demand and was forgiven in exchange for $267,900 of 6% secured convertible debenture due December 28, 2008 (the “6% Secured Debentures”). On December 28, 2005, the Company issued $2.0 million aggregate principal amount authorized $3.5 million 6% secured convertible debenture due December 28, 2008 (the “6% Secured Debentures”) to three institutional investors. The 6% Secured Debentures had, at the time they were issued, a term of three years and were to mature on December 28, 2008, pay interest at the rate of 6% per annum, payable semi-annually on January 1 and July 1 of each year beginning July 1, 2006, and are secured by a grant of a security interest into substantially all of the Company’s assets.

The 6% Secured Debentures were, at the time they were issued convertible at any time at the option of the holder into shares of the Company’s common stock at a price of $0.85 per share, subject to adjustment as set forth therein. If after the effective date of the registration statement we agreed to file under the Securities Act (the “Registration”), the closing price for the Company’s common stock exceeds $1.70 for any 20 consecutive trading days, then the Company may, within one trading day after the end of such period, require the holders of the 6% Secured Debentures to immediately convert all or part of the then outstanding principal amount of their 6% Secured Debentures. As a result of later amendments to facilitate equity financing in July 2008, principal and accrued and unpaid interest on one third of the outstanding principal amount of 6% Secured Convertible Debentures ($2,845,815), and related warrants were exchanged for identical securities, except that the conversion and exercise prices of the newly issued securities is $0.25 rather than $0.85. The terms of the conversion rights also contain certain dilution provisions.

The Company reviewed the accounting for registration rights terms relating to the shares of common stock issuable upon the conversion and exercise, respectively, of the 6% Secured Convertible Debentures and related warrants under the FASB guidance. The Company granted demand registration rights to the purchasers of the 6% Secured Debentures which requires the Company to file an initial registration statement under the Securities Act 45 days following demand made by the holders of 60% of the securities eligible for registration under the agreement. Under the registration rights agreement, the Company incurs a penalty if it fails to file such a registration statement within 45 day following such a demand or if the SEC had not declared the registration effective 90 days after filing. The holders of the 6% Secured Debentures have not demanded registration. The Company believes it can comply with a demand for registration in a timely manner and therefore no accrual for possible penalties under the registration rights agreement has been made.

On December 28, 2005, pursuant to the purchase agreements with the purchasers of the 6% Secured Debentures, the Company issued warrants to purchase an aggregate of 941,176 shares of common stock for $1.00 per share, on or prior to December 28, 2010 and short term warrants to purchase up to an aggregate of 941,176 additional shares of common stock for $0.85 per share, each subject to anti-dilution adjustments, including a “full ratchet down” to the purchasers of the 6% Secured Debentures. The short term warrants are exercisable at any time prior to the earlier of December 28, 2007 and twelve months after the effective date of the Registration Statement. If no effective registration statement is obtained after one year, then such warrants have a cashless exercise option feature.

On March 31, 2006, the Company issued $500,000 additional principal of the 6% Secured Debentures to a limited liability company owned equally by the wife of our chairman and another director on substantially the same terms as the 6% Secured Debentures issued on December 28, 2005.

A debt discount was recorded of $47,504 and $161,640, respectively for such short and long term warrants issued with these 6% Secured Debentures. The amortization recorded attributed to the debt discounts amounted to $22,547 and has been recorded as interest expense for the year ended May 31, 2006.

The Company received an advance of $500,000 from one of the holders of 6% Secured Debentures on June 1, 2006. The advance was due on demand and forgiven in exchange for $500,000 principal amount of 6% Secured Debentures and related warrants on June 30, 2006.

The Company issued $1,773,471 aggregate principal amount of 6% Secured Debentures on June 30, 2006. The consideration received by the Company for the Secured Debentures consisted of $500,000 cash, forgiveness of repayment of the $500,000 advance received June 1, 2006, forgiveness of $773,470 related party debt due to Andreas Typaldos, the Company’s Chairman and principal shareholder and a limited partnership controlled by his wife. The debentures have a term of three years and mature on December 28, 2008. The 6% Secured Debentures pay interest at the rate of 6% per annum, initially payable semi-annually on January 1 and July 1 of each year beginning January 1, 2007. In January 2007, the 6% Secured Debentures were amended to provide that interest payable on January 1, 2007 and July 1, 2007 would be added to principal. These debentures are on substantially the same terms as, and rank pari passu to, an aggregate of $3,875,884 of 6% Secured Debentures outstanding as of May 31, 2006. The Company issued 834,575 short term and 834,574 long term warrants to the purchasers of the 6% Secured Debentures and entered into a security agreement granting the purchasers a security interest in its assets to secure the Company’s obligations under the debentures. Obligations under the debentures are guaranteed by the Company’s two wholly-owned operating subsidiaries. The debt discount for such short and long term warrants issued with these 6% Secured Debentures and the related amortization attributed to the debt discount amounts are reflected as interest expense for the three month period ending August 31, 2008.

A debt discount was recorded of $34,819 and $104,020, respectively for such short and long term warrants issued with these 6% Secured Debentures on June 30, 2006.

On June 30, 2006, the Company signed a letter amendment to the consulting agreement with Andreas Typaldos dated May 21, 2004. The amendment removed the condition that the Company raise $1,000,000 of equity financing before paying consulting fees that accrued at the rate of $15,000 per month commencing June 1, 2006 as an inducement for Mr. Typaldos forgiving the $360,000 of accrued and unpaid fees in exchange for the $360,000 principal amount of 6% Secured Debentures and related warrants.

On August 18, 2006, the Company entered into an amendment agreement with the holders of $3,875,884 principal amount of 6% Secured Debentures outstanding as of May 31, 2006, including a limited liability company owned by the wife of our Chairman, and one of our directors. The Amendment agreement made material changes to the securities purchase agreements, warrants, registration rights agreements, security agreements and other ancillary documents we executed in connection with an aggregate of $3,875,884 of 6% debentures the Company sold during the period from December 28, 2005 to March 31, 2006. The material changes give the holders the same rights of redemption in the event of a cash purchase of our assets as those held by the of $1,773,470.83 aggregate principal amount of 6% Secured Debentures issued on June 30, 2006, and thereafter. As a result of the Amendment, all of the 6% Secured Debentures and warrants must be redeemed by the Company at a premium if it agrees to sell all of the Company’s assets to a third party for cash and cash equivalents. In addition, as a result of the amendment, all holders of the 6% Secured Debentures have the right to have shares of Common Stock issuable upon conversion of the debentures and exercise of the related warrants registered for resale under the Securities Act of 1933 within 60 days after receiving written demand of the holders of 60.1% of such securities and have it declared effective 90 days thereafter.

March 12, 2007	$	20,000
March 28, 2007		150,000
April 15, 2007		115,000
April 30, 2007		70,000
May 10,2007		380,000
May 31, 2007		529,106
Total during the 4th quarter of 2007	$	1,264,106

During the first half of 2008, the Company borrowed $855,000 at the times set forth below, on an unsecured basis from affiliates of the Company’s Chairman and two non-employee directors, with the understanding that these advances would be exchanged for additional 6% Secured Debentures and related warrants. Such an exchange is subject to the consent of the holders of outstanding 6% Secured Debentures or the satisfaction of the holders’ pre-emptive rights.

July 10, 2007	$	215,000
August 3, 2007		150,000
August 22, 2007		50,000
August 27, 2007		20,000
August 31, 2007		50,000
September 28, 2007		100,000
October 16, 2007		60,000
October 30, 2007		90,000
November 7, 2007		70,000
November 19, 2007		50,000
Total during the 1st half of 2008	$	855,000

On December 15, 2007, this related party debt was converted to additional principal of the 6% Secured Debentures on substantially the same terms as the 6% Secured Debentures previously issued by the Company. The Company issued 402,353 short-term and 402,353 long-term warrants to the purchasers of the 6% Secured Debentures. Based on the issuance date of the debentures, debt discounts were recorded in the third quarter of 2008 in the amount of $118,723, respectively for 402,353 short and 402,353 long term warrants issued with these 6% Secured Debentures.

The amortization recorded attributed to all the debt discounts amounted to $88,323 and has been recorded as interest expense for the quarter ended August 31, 2008.

The Company also agreed to amend the 10,065,210 warrants outstanding and issued with the then outstanding 6% Secured Debentures to be consistent with the 804,706 new warrants issued December 15, 2007 by extending the expiration date from an outside date of December 28, 2010 to December 28, 2012 and removing any restriction on exercising the warrants on a cashless basis or any provision which accelerates the expiration date if the shares issuable on exercise of the warrants are registered for resale under the Securities Act.

During the quarter ended February 28, 2008, a deferred expense was recorded in the amount of $774,789 for the extension of the expiration date of the warrants to December 28, 2012. The amortization recorded was $51,653 and has been recorded as interest expense for the quarter ended August 31, 2008.

On April 2, 2008, the Company entered into a Waiver and Amendment Agreement with the holders of $9,283,461 issued principal amount of 6% secured convertible debentures due December 28, 2008. Pursuant to the Waiver and Amendment, the Holders agreed to waive all potential defaults caused by our not making a scheduled interest payment of approximately $255,000 which became due under the terms of the Debentures, as previously amended on March 3, 2008. The Holders agreed to add the interest due to principal and make such a waiver in exchange for the Company issuing additional Debentures equal to 10% of the principal amount of the Debentures held by the Holders (after adding the past due interest to principal).

As of February 28, 2010, there was a total of $17,626,658 in principal and interest due on the Secured Debentures, including an interest penalty of $1,842,721, a default penalty of $3,622,083 and 9,328,494 warrants outstanding. The interest and default penalties resulted from the Company’s failure to pay the interest and principal due on the Secured Debentures on the extended due date of June 30, 2009. As a result, the principal obligation increased to 130% of the principal balance and the interest rate increased from 6% to 18%.

Other Obligations - As a consequence of the Company raising an aggregate of $3 million of financing since June 2004, pursuant to the Company’s May 2004 employment agreement with its chief executive officer, $91,875 of deferred salary payments for the period from May 2004 to January 2006 representing 24.5% of his agreed salary for such period and a bonus of $65,333 was due December 29, 2005. While the deferred salary of $91,875 has been paid, the bonus of $65,333 remains outstanding. The Company’s chief executive officer temporarily waived the right to receive immediate payment of the $65,333 until May 31, 2007. The Company’s failure to pay this bonus and other amounts due under the employment agreement gives the chief executive the right to terminate the agreement and continue to receive salary at the annual rate of $300,000 for twelve months following the date of such termination.

Included in accrued expenses and other liabilities as of February 28, 2010 is unpaid accrued payroll of $3,362,528 (which includes approximately seventeen months of payroll for non-executive employees in the amount of $1,545,505 and approximately twenty five months of unpaid executive payroll in the amount of $1,751,690 and an unpaid bonus of $65,333 due to the Company’s CEO since December 2005) and unpaid expense reimbursement of approximately $35,000 due to executive officers.

Related Party Activities - As of February 28, 2010, the Company has reported a related party payable in the amount of $247,700 which represents funds that were advanced to the Company by two of the Directors of the Company.

In aggregate, $4,979,689 of the $17,626,658 of principal and interest due on the 18% Secured Debentures is due to related parties.

NOTE 6 – PAYROLL LIABILITIES

On January 17, 2006, the Company paid an aggregate of $873,993 of payroll liabilities of the company from which it acquired assets in 2004 at a public foreclosure sale, representing all of the fiduciary funds due. The Company had agreed to pay up to $1.2 million of such liabilities and accrued an additional $600,000 in the event there were any additional claims related to interest and penalties pursuant to its 2004 merger agreement. Currently, there is $937,000 still recorded on the Company’s books as due and outstanding for the federal and state tax authorities for penalties and interest under such agreement. The Company does not believe that it has a legal obligation to pay anything more to any taxing authority, but until such clearance is received from the appropriate agencies or the statute of limitation has expired, the Company has elected to keep the liability on its books.

NOTE 7 – DEFERRED FINANCING EXPENSES

The Company capitalizes financing expenses of legal fees, finders fees, value of warrants as extension fees in connection with the related convertible debt financing. These fees will be amortized over the related term of the convertible debt instruments issued in such financing, which approximates two years.

NOTE 8 – EQUITY BASED COMPENSATION

Effective June 1, 2005, the Company adopted Guidance for “Accounting for Stock-Based Compensation”. Compensation based stock option and warrant activity for warrants and qualified and unqualified stock options are summarized as follows:

	Shares		Weighted Average Exercise Price
Outstanding at May 31, 2009		19,961,797	$	0.27
Granted		—		—
Exercised		—		—
Expired or cancelled		—		—
Outstanding at February 28, 2010		19,961,797	$	0.27

Information, at date of issuance, regarding stock option grants during the period ended February 28, 2010 is summarized as follows:

Weighted-

Average

Exercise

Price

Weighted-

Average

Fair

Value

Period ended February 28, 2010

Exercise price exceeds market price

—

Exercise price equals market price

—

Exercise price is less than market price

—

No stock option grants were made during the six months period ended February 28, 2010.

The compensation expense attributed to the issuance of the options and warrants is recognized as they vest or are otherwise earned. The Company has recorded $1,022,063 of compensation for options vested / earned in the nine month period ended February 28, 2010 for employees. No options were granted during the nine month period ended February 28, 2010. Outstanding stock options and warrants are exercisable for three to ten years from the grant date. The employee stock option plan stock options are exercisable for ten years from the grant date and vest over various terms from the grant date to three years.

The issuance of warrants attributed to debt issuances are summarized as follows:

	Shares		Weighted Average Exercise Price
Outstanding at May 31, 2009		11,735,004	$	0.63
Granted		—		—
Exercised		—		—
Expired or cancelled		—		—
Outstanding at February 28, 2010		11,735,004	$	0.63

Information, at date of issuance, regarding warrant grants during the period ended February 28, 2010.

Weighted-

Average

Exercise

Weighted-

Average

Fair

Value

Period ended February 28, 2010

Exercise price exceeds market price

—

Exercise price equals market price

—

Exercise price is less than market price

—

No warrants were issued during the quarter ended February 28, 2010.

Interest expense attributed to the aforementioned warrants is being amortized over the ratable term of each respective debt arrangement. See “NOTE 4 – CONVERTIBLE DEBENTURES AND RELATED PARTY PAYABLES,” above.

NOTE 9 – SUBSEQUENT EVENTS

The Company borrowed the sum of $60,000 from Cooper Barrons, a private investment firm, in December, 2009. Cooper Barrons is controlled by Harris Cohen, a director of the Company. The original loan was due on demand. On March 29, 2010, Cooper Barrons agreed to accept a promissory note in the principal amount of $60,000 from the Company to represent the loan. The note is due with interest at the rate of 8% per annum on April 30, 2010, or on the earlier occurrence of a default, as defined in the note. In the event of default, penalty interest will be due on the note at the rate of $100 per day and the note provides for certain mandatory pre-payments of principal in the event the Company receives financing or cash revenue from its operations in excess of budgeted monthly operating critical expenses. Payment of principal and interest is subordinated to the obligation to the holders of the Company’s outstanding Debentures. The Board of Directors of the Company determined that the terms of the note are no more favorable to Cooper Barrons that that which could have been obtained from an unaffiliated lender. A copy of the note is filed as Exhibit 10.1 to this report.

On March 29, 2010, the Board of Directors approved the payment of consulting fees to Harris Cohen in the amount of $7,000 for the period from December 1, 2009 to January 31, 2010 and continuing fees of $3,000 per month for his service as the sole member of a committee of independent directors to make recommendations to the board concerning matters relating to the outstanding Debentures. The Board granted additional compensation to Mr. Cohen in the form of a agreement to issue a five- year warrant on the successful debt restructuring, financing and possible recapitalization of the Company to purchase 150,000 shares of the Company’s common equity (as constituted after such transactions) for $0.05 per share. A copy of the Board consent relating to this transaction is filed as Exhibit 10.2 to this report.

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

Overview

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the Company’s financial condition and results of operations. The MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes thereto.

Arkados Products

Our highly integrated semiconductors provide the internet or network connections over existing electric lines for new consumer electronic products (such as stereo systems, television sets, intercoms and personal iPods®) and smart grid applications. Our solutions can also be used for bridging legacy products with newer home networking and broadband communications technologies.

We have designed our turnkey solutions to be used inside products for both consumers and industry. For example, consumer products can use Arkados solutions as part of a connected home entertainment and computing network, while industry can implement Arkados solutions as a part of a utility company’s “smart grid” and “green energy” solutions.

We are a “fabless” semiconductor company, meaning we design semiconductors without the capital requirements of owning and operating a fabrication facility; Arkados semiconductors are made from our designs by independent fabricators. We offer our customers complete hardware and software design solutions that allow them to build devices that will distribute audio, video, voice, and data content throughout the whole house, building, or “smart-grid” infrastructure.

Arkados solutions offer a completely different approach than our competitors. Our solutions incorporate a processor and multiple interfaces into the same chip that houses HomePlug communication technology, as well as provide application-level software that runs on the chip. We believe this “system-on-a-chip” approach provides a more cost-effective and more flexible strategy to bring products to market for our customers.

● Comprehensive platform solutions.

Our platform solutions consist of an integrated package of hardware, firmware and software designed to enable our customers to develop differentiated products in a cost-effective manner with a short time-to-market. In addition to a high-performance SoC, we plan to provide our customers with customizable, high functionality firmware, and software development kits to allow them to rapidly develop and differentiate their products. As a result, we would be able to reduce our customers’ investment in costly and time-consuming internal firmware and software development for their products, and from having to source different firmware and software for their end products from multiple suppliers.

● Customizable firmware and software.

Our firmware, which is sold as a bundled solution with our SoCs, includes a real-time operating system and a set of application-specific modules that support a wide range of functions including Web-based management, audio distribution, traffic classifications, etc. Our software platform includes a comprehensive suite of components, such as device link libraries and drivers, tools, sample code and documentation to create applications that would allow a wide range of networking devices and networked multimedia appliances.

● Targeted, high-performance SoCs.

Our SoC solutions are specifically designed for the powerline communication market. They are driven by function-specific blocks that allow simultaneous execution of complex operations, such as transmission of data over power lines and MPEG audio decoding and playback. Our SoCs support most major peripheral connection protocols, including USB, Ethernet, Infrared, I2S, and a number of specialized and general purpose interfaces. This support enables connectivity to a variety of playback, display and content-creation devices including cameras, PCs, televisions and car and home audio systems.

Arkados solutions have been shown in a number of public venues, including the 2008/2009/2010 International Consumer Electronics Show, Computex 2009, CeBIT 2009, CEDIA Expo 2009, Electronic House Expo 2009, and other conferences. The Company’s prototypes or products have been publicly announced and/or demonstrated by Analog Devices, Channel Vision, Checkolite, Corporate Systems Engineering, devolo AG, Freescale, GigaFast, GoodWay, IOGEAR, NuVo, Meiloon, PAC Electronics, Russound, Tatung, Zinwell, and Zylux. Many of these companies are suppliers to top tier brands in the market place. Tatung’s service provider business has used the Arkados chip in WiMAX-to-Powerline demonstrations. Several of these relationships, among others, have progressed into sales of chips, software development services, and related revenue.

We have also been involved with our customers in projects related to Smart Grid applications. Smart Grids have received increased attention due to the recently enacted American Recovery and Reinvestment Act (ARRA) of 2009. The act includes $4.5

billion focused on smart grid related activities and smart meters, and $7.3 billion to support expanding access to broadband in underserved communities. Arkados has already reported service revenue related to smart grid development projects. As early as October 2007, Arkados and MainNet Communications announced plans to jointly develop applications to improve the reliability and efficiency of electrical grids, connect consumer electronic devices over power lines, enable energy-saving initiatives, and deliver Broadband content to homes and offices. Arkados has also provided solutions for components intended to implement energy-saving programs (such as temperature control, smart thermostats, and demand-driven load control) that were used in trials of a “green power” application with Corporate Systems Engineering.

Excellent User Experience

We believe our solutions create easy-to-install and easy-to-use products since connectivity occurs through the existing electrical outlets and electrical wires. For the end user, products that use Arkados solutions connect to each other by simply plugging in, while also being reliable and secure.

Volume Semiconductor Sales

We have experienced the beginning of semiconductor sales. Most of our current revenue has come from design and development agreements, but we expect that such agreements will lead to volume semiconductor orders, but we cannot assure you that they will. We are targeting the sale of our powerline connectivity products to a broad range of communications, computing and consumer electronics ODMs/OEMs, but we have not yet derived significant product revenue from these customers, partly due to the lengthy process of developing and producing finished products.

Technology

Arkados is committed to building standards-based solutions. Currently, Arkados SoCs are based on the specifications developed by the HomePlug Powerline Alliance and TIA-1113 standards. Our planned HomePlug® AV based AI-2100 SoC, which is being developed and manufactured under an agreement with STMicroelectronics, is designed be interoperable with many established powerline standards: TIA-1113/HomePlug 1.0, HomePlug AV, HomePlug GP (“Green PHY”), and the recently confirmed IEEE 1901 Draft Standard. The chip also designed to offer support for the Inter System Communication Protocol (ISP) as defined by the IEEE P1901 Working Group.

System-on-Chip Semiconductors

Arkados has a number of design wins that employ our first SoC, the Arkados AI-1100, which we started marketing in Fiscal 2007. The device supports applications such as whole-house music streaming, whole-house internet access, and can be used in IPTV set-top boxes designed to decode and display standard definition video content -- from sources as varied as surveillance cameras and YouTube -- on regular TVs throughout the home. This turnkey solution features a programmable MAC and an on-chip ARM 9 application processor. Its fully HomePlug 1.0 compliant MAC/PHY and Arkados extensions and software provide increased performance and future proofing.

Our next generation SoC, the AI-2100, will be backwards compatible with our current chip and it will feature an enhanced embedded Quality of Service (QoS) engine which supports video flows for low jitter, lip synch and low latency delivery. The chip is being developed and manufactured under an agreement with STMicroelectronics.

Software

In our view, today’s digital products are incomplete without an array of software components that enable both device-to-device communications and robust product features. We provide our customers with a host of software components that run directly on our chips, further reducing development time. These software components include application-level features (such as our Direct-to-Speaker™ multi-channel audio synchronization, networking and internet, online gaming, etc.) embedded application support software (audio compression/decompression, internet radio support, GUI support, video drivers, etc.), Quality of Service engine, traffic management, and TCP/IP components.

Market Opportunities

Arkados solutions are offered to the following markets:

●	the retail consumer electronics market and the whole-home custom installation market

●	the smart grid market

●	the subscription services market.

The Growing Digital Home: Networked Consumer Electronics

As broadband access to the home is becoming ubiquitous, home networking and connectivity demands for digital home applications continues to grow – extending the internet, and the services that travel on it, to every corner of the house.

The promise of sending high-speed digital communications over common power lines is now being realized, and Arkados’ products serve several large and growing markets: retail consumer electronic products, whole-house audio installations, smart-grid utility company applications, broadband-over-powerline internet access, and the distribution of internet-based services.

The Arkados AI-1100 is the first HomePlug 1.0 compliant system-on-chip targeted for the retail consumer electronics market.

Coupled with software to create full turnkey solutions for its customers, the Arkados AI-1100 has already received a number of design wins, and is the engine behind the creation of reasonably-priced multi-room audio and video distribution products for the retail consumer market. Products in the market now feature iPod® docking stations and powered speakers that can be placed anywhere in the home, with no additional wiring needed.

As a subset of this market, the whole-house audio market category has been particularly active. Arkados’ solutions offer a way to create both retail and custom audio systems with features and functionality heretofore available only in multi-thousand dollar custom audio installations. Arkados’ customers include Devolo AG, Checkolite, IOGEAR, Gigafast, Nuvo, Russound, Tatung, and Zinwell.

Two customers in particular, Russound and Nuvo have begun marketing campaigns for their whole-house systems that use the Arkados chips and software. Both systems have won major industry awards from CEDIA, CePRO, and CES. Russound selected the AI-1100 for use in its iBridge Power Dock, and Russound’s Collage Powerline Media and Intercom System system is currently shipping, and in the hands of custom installers..

These high-end custom audio systems, which address the existing home market (expanding from their primary market target of newly constructed homes), can feature up to 12 separate audio zones and can process a wide range of sources of audio content which can be streamed from any digital or legacy analog source.

Arkados’ chips can also power cameras, video endpoints, and sensors for other installed home systems, such as for surveillance systems.

Smart Energy and Utility Company Applications

Another large potential market for Arkados’ solutions relates to energy conservation, the “green” applications that help utility companies and their customers save both money and energy. For example, “Smart Grid” applications (Green Energy, demand response, energy efficiency and grid modernization – i.e., reduction of carbon emissions) and home/building automation (such as controlling air conditioner thermostats remotely) represent large and attractive opportunities given today’s surging energy costs. Arkados has design wins at MainNet and Corporate Systems Engineering.

Services

An additional immediate potential market for the Arkados platform is for subscription music services. Arkados software and chips enable the distribution of Internet music services (e.g., Rhapsody, Yahoo! Music, AOL Music, Shoutcast services). The Company is actively working on reference designs and business strategies to address this rapidly developing market. Russound’s Collage system already offers a feature that connects to Rhapsody music service.

Corporate Background

On May 24, 2004, we filed a merger certificate completing the acquisition of Miletos, Inc., a previously unaffiliated Delaware corporation (the “Merger”). The consideration for this Merger was 16,090,577 restricted shares of our common stock and the assumption of certain liabilities of Miletos’ predecessor and former controlling equity holders. The merger was completed according to the terms of an Agreement and Plan of Merger dated as of May 7, 2004. Miletos merged into a wholly owned subsidiary we formed for the merger which then changed its name to “Arkados, Inc.”.

On March 3, 2007 we completed the merger of Arkados Wireless Technologies, Inc., our wholly owned subsidiary (“Merger Sub”) with Aster Wireless, Inc. a Delaware corporation (“Aster”) pursuant to an Agreement and Plan of Merger dated February 13, 2007 by and among Merger Sub and Arkados Group, Inc. In this merger, we acquired synergistic talent and technology which has helped improve the reliability and quality of audio streaming in our current generation chipset and we believe will help deliver our next-generation chips to market more quickly, with richer capabilities. This will translate to a better competitive position in the marketplace. The technology enhances the reliable distribution of multimedia content, potentially over multiple distribution media, and is designed to be embedded in new consumer electronics products and accessories for audio, video distribution, set-top boxes and other multimedia entertainment appliances.

Industry Background

Music, movies, the electrical “smart grid”, and a wide range of communication services are experiencing a fundamental shift. The distribution of content to products, and in some cases the products themselves, is transitioning from traditional methods. Digital content is requires a new digital distribution model.

Arkados’ Standards-based Solutions

Arkados’ solutions are designed to directly address this opportunity by enabling electrical power sockets to be turned into high-speed network ports, thereby providing a high-speed pathway through which digital information can travel inside a home, to the home, and on the smart grid. We believe that this shift creates demand for new products, and new products will require new types of advanced semiconductors that incorporate digital technologies, supporting such functions as communication, application processing, and media rendering.

Our ArkTIC® family of turnkey hardware and software solutions is designed to address these requirements. In particular, Arkados has implemented a method that uses power lines as a pathway for digital information, allowing end users to truly achieve “plug-and-play” simplicity without the hassles of custom-installed networks, or the problems associated with wireless solutions such as dropouts, unreliable coverage, and security issues.

Standards-compliance Creates Market and Product Confidence

Members of the Arkados team have been active in establishing standards for the powerline communications industry since the year 2000.

Standards are important for a number of reasons, but especially when both consumers and service providers or utility companies may be installing different pieces of the ecosystem. This is the case within the powerline communications and smart grid industries. Wireless standards, for example, have brought about a ubiquitous, interoperable and affordable standard for portable data communication, which resulted in greatly accelerated market growth.

Members of the Arkados team participated in the creation of the HomePlug Powerline Alliance, an independent industry association. The Alliance’s mission is to enable and promote rapid availability, adoption and implementation of cost effective, interoperable and standards-based home powerline networks and products. Formed in 2000, the Alliance developed the HomePlug 1.0 specification that unified product vendors in support of a single powerline solution for home networking. In 2008, the technology of the HomePlug 1.0 specification was adopted by the Telecommunication Industry Association as TIA-1113 standard. In 2005, the Alliance ratified HomePlug AV specification that enables 200Mbps class communication over power lines. In March 2010, the IEEE (the world’s leading standards-setting body) announced that the draft IEEE P1901 Broadband over Power Line (BPL) standard, which contains HomePlug AV technology, entered the final stage before it is an official IEEE standard. Arkados HomePlug AV chips will be interoperable with the IEEE 1901 standard.

Market Analyst In-Stat believes that powerline communication will be a potentially important technology for multimedia networking, as the technology could provide a home network backbone. Arkados has worked in significant ways to develop the HomePlug specifications including in-home technologies (HomePlug 1.0, HomePlug AV, and HomePlug AV2), to-the-home technologies ( HomePlug BPL for broadband over powerline), and HomePlug Command &Control (C&C) and HomePlug GP (“Green PHY”) for low-speed command and control and Smart Grid applications.

Arkados is a Contributing Member of the HomePlug alliance. Members of the Arkados team hold leadership positions in the Alliance and in several HomePlug working groups. Oleg Logvinov, our president and CEO, serves as the Chief Strategy Officer of the HomePlug Alliance. Mr. Logvinov is also a past president of the Alliance, having been succeeded by Matthew Theall of Intel. Additionally, Jim Reeber, our Director of Marketing has served as Chair of the Worldwide Marketing Working Group since 2003; Grant Ogata, our Executive Vice President of Worldwide Operations, has served as the Chairman of HomePlug Command and Control Working Group and was instrumental in spearheading the alliance’s efforts to develop a specification for a low-cost command and control technology in his role as the working group chair. Jim Allen, our Vice President of Standardization and Advance Planning, is the chair of the HomePlug Smart Energy Technical Working Group.

The HomePlug technology now dominates the marketplace. Market analyst In-Stat forecasted that by 2010, the technology based on HomePlug specifications will hold 85% of the worldwide market for powerline communications. The HomePlug Powerline Alliance has brought together both personal computer and consumer electronics companies on a global scale. Membership in the Alliance has grown to include over 70 industry-leading companies. HomePlug Sponsor companies include Atheros, Cisco; Comcast; Duke Energy, GE Energy, part of General Electric Co.; Gigle Networks; Motorola; NEC Electronics; and SPiDCOM Technologies. Besides Arkados, contributor members include Corporate Systems Engineering; Renesas; Texas Instruments; and YiTran Communications.

Arkados is also a member of the IEEE P1901 working group that is focused on the development of powerline communication Physical Layer (PHY) and Media Access Control (MAC) specifications. Jim Allen was recently elected to serve as Vice Chair of the Working Group. Mr. Logvinov was recently elected to serve as a member of IEEE SA Standards Board.

Working with the HomePlug Powerline Alliance, the Arkados team has contributed to the development of a number of specifications that were contributed to standards organizations, such as the Telecommunications Industry Association.

Strategic Relationships

Fiscal 2009 brought a number of significant announcements that solidified our relationships with STMicroelectronics, and Tatung. Each of these relationships allows Arkados to bring value to our customers.

In October 2008, Arkados and STMicroelectronics announced that they reached an agreement to develop and manufacture a 200 Mbit per second, HomePlug AV wideband powerline modem System-on-Chip (SoC). The introduction of this device is timed to take place to meet the market’s needs for communications solutions that help to implement Smart Grid and Green Energy applications. The agreement specifies that both ST and Arkados will market a version of the device specifically targeted at “bridging” applications such as Ethernet-to-Powerline adapters, or other applications where only a MAC/PHY implementation is needed. Arkados will continue to focus on marketing the chip for more full-featured connected media applications such as whole-house audio, IPTV, and segments of the smart-grid market. This agreement allows Arkados to complete the design and manufacturing of the state-of-the-art chip without making the costly investment of taping out a new chip. ST is contributing to the investment for the development and manufacturing for the Arkados-designed chip. In return, ST receives the rights to market the chip through its worldwide distribution network.

We have also entered into go-to-market strategies with a number of ODMs and other technology companies. Since many companies in this space target the same customer base as we do, we plan to collaborate to create solutions and offer even greater turnkey value for OEMs. We have announced relationships and strategies with several companies, including GigaFast and Tatung.

Arkados’ relationship with Tatung, the $7B global ODM, constitutes a one-stop shop for the industry’s technology and manufacturing needs for distributing digital content in homes. Together, the companies deliver complete product solutions to consumer product manufacturers. Tatung has used Arkados chips to publically demonstrate products that combine HomePlug® powerline communications, WiMAX technologies, and fully connected solutions (including Smart Meters and In-home Displays) that bridge Smart Energy, Internet connectivity, and connected consumer electronics.

Manufacturing

We currently use Fujitsu Japan for all of our wafer fabrication and assembly, and Fujitsu and GDA Technologies for a portion of our design and testing. This “fabless” manufacturing strategy is designed to allow us to concentrate on our design strengths, minimize fixed costs and capital expenditures, access advanced manufacturing facilities, and provide flexibility on sourcing multiple leading-edge technologies through strategic alliances. We expect to qualify each product, participate in process and package development, define and control the manufacturing process at our suppliers where possible and practicable, develop or participate in the development of test programs, and perform production testing of products in accordance with our quality management system. If possible, we plan to use multiple foundries, assembly houses, and test houses. Our efforts to develop multiple sources of supply have been hindered by our lack of adequate working capital.

In connection with the development of our next generation chip, we have entered into a development agreement with STMicroelectronics. The agreement allows Arkados to complete the design and manufacturing of without making the costly investment of taping out a new chip. STMicroelectronics is contributing to the investment for the development and manufacturing for the Arkados-designed chip. The new chips will be sold by ST Microelectronics, under its own branding, and by Arkados as the next generation ArkTIC® chip.

Research and Development

We have focused on R&D since our inception. Our company has placed significant value on the work done by our engineering staff, and we continue to create new software solutions, technology implementations, system-on-chip semiconductors, and the creation and development of intellectual property, that focus on helping our customers to get full-featured connected products to market quickly and at a lower cost.

We concentrate our research and development efforts on the design and development of new products for each of our principal markets. As of February 2, 2010, 12 of our 16 employees are dedicated to research and development. Research and development expenditures were $2,069,179, $1,987,313, and $1,920,898 in the years ended May 31, 2009, 2008 and 2007, respectively.

Our 2007 acquisition of Aster Wireless, near Rochester, NY strengthened our intellectual property portfolio and added three R&D employees to those working in New Jersey. Since the acquisition, one member of the group has left the company. The intellectual property that was developed by Aster through years of R&D under the guidance of industry giants such as Kodak® has allowed us to introduce new products complementary to our existing product offerings. An example is our offering of a license to an implementation of the 802.15.3b Wireless Multimedia MAC, which is available to any developer interested in jumpstarting their development process, and bringing digital home multimedia products to market more quickly. With these developments, Arkados continues to offer a best-in-class platform for media-centric applications that demand reliable delivery of time-sensitive data.

We also fund certain research activities focused on other emerging product opportunities. Our future success is highly dependent upon our ability to develop complex new products, to transfer new products to volume production in a timely fashion, to introduce them to the marketplace ahead of the competition, to maintain competitive features, and to have them selected for design into products of leading systems manufacturers, all of which are challenged by our lack of working capital and diversion of management’s time and attention from Arkados’ business to emergency financing and debt restructuring.

Our future success may also depend on assisting our customers with integration of our components into their new products, including providing support from the concept stage through design, launch, and production ramp. In this new converged marketplace, we believe the role of the traditional semiconductor provider is changing, and we have positioned ourselves as a platform provider that becomes an integral part of our customer’s product development process. We believe that our focus on application related features and software may contribute to our success.

Patents, Licenses and Trademarks

Our patent portfolio reflects our innovative development efforts and our forecasts of how we envision the market will evolve. We have been awarded 12 U.S. Patents, which we believe is an indicator that we have developed a good understanding regarding key industry developments. We believe our patents not only help us to safeguard our intellectual property, but will help us to position our company as a leader in this space. We believe that some of our recently awarded patents are integral to the implementation of powerline communication networks, which may create value in our company given the global market for this technology and the vast number of potential players in the marketplace.

We rely on trade secret, patent, copyright, and trademark laws to protect our intellectual property in our products and technology. We intend to continue this practice in the future. In addition to our issued U.S. patents, we have multiple pending U.S. patent applications, and various corresponding international patents and applications.

Intellectual Property Portfolio

Examples of our IP portfolio include methods for increasing resistance to noise, allowing more robust transmissions, maximizing throughput, and several product-level applications such as adaptors and connectivity devices. We believe our patent portfolio will provide a competitive edge in the areas of the technology based on such new standards such as IEEE1901 and upcoming ITU G.hn standards.

Our IP Portfolio continues to grow. We diligently protect our inventions with US and International patents. Currently, we have been issued 12 patents by the United States Patent & Trademark Office, and have 22 pending applications. We also prosecute our valuable IP on an international basis, and currently have 7 Pending International Applications.

We have registered trademarks for Arkados® and ArkTIC® and the Arkados logo. We have other trademark applications pending: Direct to Speaker™ and Whole House Audio in a Box™.

As a member of the HomePlug Alliance, we are obligated to license Necessary Patent Claims (intellectual property rights without the use of which products cannot conform to the HomePlug specifications) to any member of the alliance (including competitors) on a reasonable and non-discriminatory basis (known as RaND) as defined in the alliance’s Sponsor Agreement and Contributor Agreement. Under our license and development agreements, we retain title to our patents, patent applications and other licensed technology, and to any improvements that we develop.

To complement our own research and development efforts, we have also licensed, and expect to continue to license, from third parties a variety of intellectual property and technologies important to our business.

Although we have not received any notification from third parties that we are infringing any of their intellectual property, there may be third party patents or other intellectual property that we are infringing. If that were the case, third parties could assert infringement claims against us or seek an injunction on the sale of any of our products in the future. If such infringement were found to exist, we may attempt to acquire the requisite licenses or rights to use such technology or intellectual property. However, we cannot assure you that such licenses or rights could be obtained on favorable terms or at all.

Competition

Arkados faces intense competition as a solution provider, a technology developer of standards-based powerline technologies, as well as from other technologies also focused on our target markets. We believe we have had success despite our lack of capital and therefore manpower because of our ability to develop SoC/software solutions that help our customers to create full-featured products that are cost-effective and can be brought to market quickly.

Differentiation of Arkados Solutions

Some manufacturers have attempted to add HomePlug-based chips to their existing products. This “bolt-on” approach often leads to products that are functional; however, the end product can be very expensive with decreased margins.

Arkados’ solutions offer a completely different approach. By incorporating a processor and multiple interfaces into the same chip that houses HomePlug communication technology, and by providing application level software that runs on the chip, Arkados presents a more cost-effective and more flexible strategy to bring products to market.

Building on the architecture of the HomePlug 1.0 chip that offered a wide range of advantages over the competition, Arkados recently announced a HomePlug AV System-on-Chip to provide an even greater range of differentiation and advantages. This chip is called the AI-2100, which will be developed and marketed in conjunction with STMicroelectronics.

Business Environment

Markets for our products are highly competitive and we expect that competition will continue to increase. We compete with other semiconductor suppliers that offer standard semiconductors, application-specific integrated circuits, and fully customized integrated circuits, including embedded software, chip, and board-level products.

Our competitive strategy has been to provide cost-effective integrated products bundled with software that is designed to support a turnkey approach for a variety of applications. We believe this approach, coupled with the benefits of powerline communications technology, allows us to effectively compete due the following aspects:

●

Due to embedded HomePlug standard technology, we believe our product performance includes unique features such as whole-house connectivity, high throughput, ease of setup, and Quality-of-service mechanisms that preserve a positive end-user experience

●

Due to the integration of our system-on-chip and firmware solutions, we believe our potential customers will benefit from quicker time-to-market, a competitive bill-of-materials cost, an enhanced feature set, and lower development costs

●

Due to our reliance on international technology standards, we believe our solutions are able comply with regulatory requirements on a global basis

We face competition both from established players that are beginning to focus on powerline networking technology, as well as recent entrants in the field. Some of these competitors create solutions that are compliant with HomePlug Alliance specifications, while other competitors’ products are based on proprietary technologies. Immediate key competitors in the HomePlug powerline networking portion include Afa Technologies, Atheros Communications, Inc. (who recently acquired HomePlug chipmaker Intellon Corporation), Gigle Networks, Maxim Integrated Products Inc., Sigma Designs (who recently acquired Coppergate, a company that previously acquired a team of HomePlug technology specialists from Conexant) and SPiDCOM Technologies. DS2 and Panasonic build powerline ICs that are incompatible with the HomePlug standard.

We expect to face additional competition from new entrants in each of our markets, which may include both large domestic and international integrated circuit manufacturers and smaller, emerging companies. Many of our competitors have substantially greater financial, engineering, manufacturing, marketing, technical, distribution and other resources, broader product lines, greater intellectual property rights, and longer relationships with customers than we have.

In addition, there are organizations worldwide may attempt to create technology standards that compete with the industry specifications established by the HomePlug Powerline Alliance. These include the Institute of Electrical and Electronics Engineers (IEEE) and the International Telecommunication Union (ITU) which may adopt standards different from, and incompatible with, the technology inside our products. We also participate in these standards efforts. Other industry organizations promote powerline communications, such as the Universal Powerline Association, the Consumer Electronics Powerline Communication Alliance (CEPCA) and the High Definition Powerline Communications (HD-PLC) Alliance. They have also established technology or coexistence specifications that may conflict with the HomePlug specifications.

As a provider of powerline home connectivity integrated circuits, we face additional competition from other home connectivity technologies such as twisted pair cable, coaxial cable and wireless media. Despite the broad array of different technologies deployed to date, we believe those technologies that do not require new wires such as HomePNA, MoCA, 802.11 and other wireless alternatives, will provide competition to powerline solutions.

In network and media processors, its competitors include Conexant, Cirrus Logic, Micrel, Texas Instruments, Atmel, and Sharp.

Results of Operations

We have not had significant revenue from operations since inception and, as of February 28, 2010, we are still a development stage company. Furthermore, we have financed operating losses since September 2004 with the proceeds primarily from related party lending from our major stockholder and affiliated lenders, as well as other stockholders and lenders, and from a capital raise to qualified investors through a retail brokerage firm. From December 2005 to December 31, 2007, we sold an aggregate $9,283,461 of 6% secured convertible debentures due December 28, 2008 of which $6,145,884 was purchased by institutional investors, $3,092,577 by our directors and their relatives and $45,000 was issued to settle an equivalent amount of legal fees.. During the fiscal year 2006, we paid down a substantial portion of outstanding short term debt and other liabilities and have issued approximately 600,000 shares of our common stock in satisfaction of approximately $406,000 of short term liabilities. During the period from June 1, 2007 to August 31, 2008, we raised $855,000 in cash from advances that were satisfied by issuing 6% secured convertible debentures. Despite these milestones in improving our financial position, our business plan to aggressively market our chips remains constrained by our limited capital resources.

We require additional funding to finance inventory, support operations for the expansion of our research and development efforts, and the expansion of our management team and sales and marketing organization. In March, 2007, we acquired the assets of Aster Wireless, Inc., retained four of the engineering staff as employees and one person as a consultant, which significantly added to our engineering capability and skill sets. The acquisition has added approximately $45,000 of monthly operating expenses and no material revenue.

We use Fujitsu Japan for all of our wafer fabrication and assembly, and Fujitsu and GDA Technologies for a portion of our design and testing. This “fabless” manufacturing strategy is designed to allow us to concentrate on our design strengths, minimize fixed costs and capital expenditures, access to advanced manufacturing facilities, and provide flexibility on sourcing multiple leading-edge technologies through strategic alliances. We expect to qualify each product, participate in process and package development, define and control the manufacturing process at our suppliers where possible and practicable, develop or participate in the development of test programs, and perform production testing of products in accordance with our quality management system. If possible, we plan to use multiple foundries, assembly houses, and test houses.

If we are unable to raise funds to finance our working capital needs, we will not have the capital necessary for ongoing operations and for making our chip ready for mass production, we could lose professional staff necessary to develop our products and the value of our technology could be impaired. In addition, the lack of adequate funding could jeopardize our development and delivery schedule of our planned products. Such delays could in turn jeopardize relationships with our current customers, strategic partners and prospective suppliers.

Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended May 31, 2009 which could materially affect our business, financial condition or future results. There have been no other material changes during the quarter ended February 28, 2010 to the risk factors discussed in the periodic reports noted above that have not already been disclosed in the Company’s most recently filed 10-K.

Results of Operations

For The Three Months Ended February 28, 2010

During the three month period ended February 28, 2010, we had total revenue of $46,346 compared to $198,900 for the same period in 2009. As of February 28, 2010, there was approximately $0 in backlog. Total operating expenses for the three month period ended February 28, 2010 were $1,142,879 compared to total operating expenses for the same period in fiscal 2009 of $1,811,691. In both periods, the most significant expenses were personnel, professional fees and research related expenses.

We failed to pay the interest and principal due on the Secured Debentures on the extended due date of June 30, 2009. As a result, the principal obligation increased to 130% of the principal balance, which the Company recognized as a default penalty of $3,622,083 in the quarter ended August 31, 2009, and interest increased from the rate of 6% to the penalty rate of at 18% per annum for the quarter ended February 28, 2010 and the nine month period February 28, 2010. Aggregate interest fot the three and month periods on Secured Debentures was of $733,133 and $1,990,890, respectively.

For The Nine Months Ended February 28, 2010

During the nine month period ended February 28, 2010, we had total revenue of $173,246, compared to $583,325 for the same period in fiscal 2009. $173,246 of revenue in the nine months ended February 28, 2010 was related to development agreement s with two customers as compared with $583,325 of development revenue in the same period ended February 29, 2009 from six customers. Total operating expenses for the nine month period ended February 28, 2010 were $3,480,806 compared to total operating expenses for the same period in fiscal 2009 totaling $4,115,057. The Company failed to pay the interest and principal due on the Secured Debentures on the extended due date of June 30, 2009. As a result, the principal obligation increased to 130% of the principal balance resulting in a default penalty of $3,622,083 booked in the quarter ended August 31, 2009 and additional penalty interest at 18% per annum for the quarter ended August 31, 2009 and the nine month period February 28th, 2010 in the amounts of $359,399 and $1,990,890, respectively.

Liquidity and Capital Resources

Our principal source of operating capital has been provided in the form of equity investments and the private placement of debt securities, coupled with warrants and related party loans. We do not have any significant sources of revenue from our operations. No assurance can be given that we can engage in any public or private sales of our equity or debt securities to raise working capital. We have depended, in part, upon loans from our present stockholders or management and there can be no assurances that our present stockholders or management will make any additional loans to us. If we are not able to raise capital in the near term we will have to curtail our operations and our business and potential value could be substantially impaired.

There can be no assurance that our efforts to raise additional capital will be successful, or even if successful will fund our planned operations or capital commitments.

At February 28, 2010, we had $533 in cash and negative working capital of $26.5 million, compared to $10,000 in cash and negative working capital of $18 million at May 31, 2009. Working capital reflects the short-term maturities of all of the secured 18% convertible debentures.

We began the transition from development stage company in fiscal year ended May 31, 2008 by generating revenue of $855,676 and generated $763,040 of revenue in the fiscal year ended May 31, 2009. During Fiscal 2009, we obtained a second extension of convertible subordinated notes which expired June 30, 2009, obtained a limited waiver of anti-dilution rights held the holders of secured convertible notes to facilitate equity financing, and added Harris Cohen to our board of directors. As of February 28, 2010, $17,568,857 of secured debt, of which $ 4,963,359 is held by related parties is in default, as is $1,201,555 principal and interest on unsecured notes. In addition, as of February 28, 2010, $3,362,528 of salary remains due to our employees and of our accounts payable balance of approximately $1, 737,245, $1,684,210 was over 90 days.

We are attempting to reach an agreement with the holders of our secured debt as to the terms and conditions upon which they would agree to accept partial payment of principal and convert the balance (or all) of secured debt to equity, however, there is no binding agreement on anyone’s part to do so and no assurance can be given that the terms will be acceptable to the holders of all of the secured debt. If the holders of a material amount of debt do not accept terms of settlement or conversion into equity acceptable to new investors we will not be able to obtain financing and will have to suspend operations or seek protection under the Bankruptcy Code.

We have also received indications of interest from potential private and strategic investors concerning the terms and conditions upon which they would make an investment in Arkados, including the terms upon which the secured debt and other debt would have to be compromised and converted for them to make such investments, but there is no binding commitment on anyone’s part to complete the transactions. Finally, without commitment on anyone’s part, we have discussed converting a substantial portion of past due compensation with our employees if the financing and restructuring of our debt can be completed. In the absence of financing and debt restructuring, our operations are severely constrained and we may have to suspend operations altogether. In addition, unless the terms of financing and restructuring is acceptable to our general trade creditors, we remain at the risk of creditors filing an involuntary petition pursuant to the U.S. Bankruptcy Code. Every aspect of our business remains constrained by our limited capital resources and the threat of having to cease operations as a result of our lack of capital. If we are unable to raise funds to finance our working capital needs, we will not have the capital necessary for ongoing operations and for making our chip ready for mass production and we could lose professional staff necessary to develop our products and the value of our technology could be impaired. In addition, the lack of adequate funding will jeopardize our development and delivery schedule of our planned products. Such delays could in turn jeopardize relationships with our current customers, strategic partners and prospective suppliers. Pending the completion of these transactions, we are financing operations by issuing bridge notes to investors that would participate in an equity financing if the debt can be restructured. If the financing proceeds, these investors would be able to make the equity investment in Arkados at a discount of 33% from the price other investors are offered. Most of the bridge notes were due with interest at the annual rate of 8% on March 31, 2010 and a small portion was due January 31, 2010. We are seeking extension agreements from the holders of all of the bridge notes to extend the due date to April 30, 2010..

While a substantial portion of the net proceeds of these financing activities was initially used to repay pre-existing debt, all of the proceeds during the fiscal year 2008 were used to support Arkados’ operations. There is no assurance that the holders of the Secured Debentures will continue to provide additional funds to us, that future equity financing will be available or that future financing will not be impeded by the anti-dilution provisions of the documents. Our ability to continue our operations depends on our ability to obtain financing. If adequate funds are not available on acceptable terms, we may not be able to retain existing and/or attract new employees, support product development and fabrication, take advantage of market opportunities, develop or enhance new products, pursue acquisitions that would complement our existing product offerings or enhance our technical capabilities to develop new products or execute our business strategy.

On July 2, 2009 we received notice from a law firm representing approximately 45% of our outstanding 6% secured convertible debentures due June 28, 2009 (the “Debentures”) were in default by reason of non-payment. This event triggers an “Event of Default” under the terms of the Debentures on July 8, 2009, absent payment in full. The Event of Default entitles the holders of the Debentures to redemption at the rate of 130% of the principal and accrued interest outstanding, interest on unpaid interest and principal at the rate of 18% per annum commencing on July 8, 2009 and reimbursement for expenses incurred enforcing the obligations.

We have been negotiating for an infusion of equity capital, restructuring of our secured and unsecured debt and the holders of the Debentures have indicated that they are inclined to work with the company in this regard. Although there can be no assurance that the forbearance, financing or restructuring of our debt can be achieved, we continue to work closely with representatives of the holders of the Debentures to maintain the company as an ongoing business, which includes preserving our current operations and relationships with existing customers, partners and suppliers.

As of July 6, 2009 the $1,066,500 principal amount of 6% Convertible Subordinated Notes (the “Notes”) due June 30, 2009 were also in default by reason on non-payment. Under the terms of the Notes, the interest rate increases to 12% during the period the Notes are in default and the holders are entitled to the costs of collection. We plan to discuss forbearance or extension of the due dates of the Notes, as well as conversion of the Notes into equity with the holders and their representatives, but there can be no assurance that any such agreement can be reached.

Our lack of working capital has constrained and can be expected to continue to constrain all aspects of our operations. As design solutions are completed for existing customers, our need to finance the purchase of chip inventory will increase. If we are unable to finance the purchase of chip inventory, we will not be able to fulfill sale commitments and will not be able to recognize revenue on firm orders; such failures will have an adverse impact on our important technical relationships and future marketing efforts. In additional to general efforts to raise capital to support our operations, we will explore arrangements specifically relating to inventory that may be costly (in the case of a factoring arrangement), require the consent of holders of secured debt and may involve the licensing of technology in exchange for manufacturing services.

We continue to seek financing to meet the commitments either in the form of the sale of equity, additional secured or unsecured debt and any combination of the foregoing. There is no assurance sufficient financing to meet these commitments will be available, and, if they are not met, our business could be suspended or, upon a material default in our obligations to the holders of our convertible secured debt, face the acceleration of our obligations and the seizure of our assets to satisfy the debt.

Commitments

We do not have any commitments which are required to be disclosed in tabular form as of February 28, 2010

Critical Accounting Policies

Financial Reporting Release No. 60 requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. Our accounting policies are described in Note 2 of the notes to our consolidated financial statements included in this report. Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, which 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. The following is a brief discussion of the more significant accounting policies and methods used by us. In addition, Financial Reporting Release No. 67 was recently released by the SEC to require all companies to include a discussion to address, among other things, liquidity, off-balance sheet arrangements, contractual obligations and commercial commitments.

Basis of Presentation

Our consolidated financial statements have been prepared assuming we will continue as a going concern despite substantial doubt as to our ability to do so. Management anticipates losses in the foreseeable future and plans to finance losses by raising additional capital. If we are unable to continue as a going concern, adjustments would have to be made to the carrying value of assets.

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as amended (“SAB 101”). SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured. Under the provisions of SAB 101, we recognize revenue when products are shipped, and the collection of the resulting receivable is probable. If revenues are from a long term arrangement, revenues are recognized when pre-determined milestones, which generally are related to substantial scientific or technical achievement, are accomplished.

Accounting for Stock Based Compensation

The computation of the expense associated with stock-based compensation requires the use of a valuation model. The accounting guidance for stock based compensation is a new and very complex accounting standard, the application of which requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as stock price volatility, expected option lives, and expected option forfeiture rates, to value equity-based compensation. We currently use a Black-Scholes option pricing model to calculate the fair value of its stock options. We primarily use historical data to determine the assumptions to be used in the Black-Scholes model and have no reason to believe that future data is likely to differ materially from historical data. However, changes in the assumptions to reflect future stock price volatility and future stock award exercise experience could result in a change in the assumptions used to value awards in the future and may result in a material change to the fair value calculation of stock-based awards. The guidance requires the recognition of the fair value of stock compensation in net income. Although every effort is made to ensure the accuracy of our estimates and assumptions, significant unanticipated changes in those estimates, interpretations and assumptions may result in recording stock option expense that may materially impact our financial statements for each respective reporting period.

Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements.

Item 3. Quantitative And Qualitative Disclosures About Market Risk

Item 4T. Controls and Procedures.

The Company’s management evaluated, with the participation of the Company’s principal executive and principal financial officer, the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as ofFebruary 28, 2010. Based on this evaluation, the Company’s principal executive and principal financial officer concluded that the Company’s disclosure controls and procedures were not effective as of February 28, 2010.

There has been no change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company’s fiscal quarter ended February 28, 2010 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

In connection with the preparation of our annual financial statements, our management performed an assessment of the effectiveness of internal control over financial reporting as of May 31, 2009. Management’s assessment included an evaluation of the design of our internal control over financial reporting and testing of the operational effectiveness of those controls. Based on this evaluation, management determined that, as of May 31, 2009, there were material weaknesses in our internal control over financial reporting. The material weaknesses identified during management’s assessment were (i) a lack of sufficient internal accounting expertise to provide reasonable assurance that our financial statements and notes thereto, are prepared in accordance with generally accepted accounting principles (GAAP) and (ii) a lack of segregation of duties to ensure adequate review of financial statement preparation. In light of these material weaknesses, management concluded that, as of May 31, 2009, we did not maintain effective internal control over financial reporting. As defined by the Public Company Accounting Oversight Board Auditing Standard No. 5, a material weakness is a deficiency or a combination of deficiencies, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected.

In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the relationship between the benefit of desired controls and procedures and the cost of implementing new controls and procedures.

The consolidated financial statements as of and for the period ended February 28, 2010 include all adjustments identified as a result of the evaluation performed.

Changes In Internal Control Over Financial Reporting

None.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

There has been no material change in any of the matters set forth in Item 3. of our Form 10-K report for the fiscal year ended May 31, 2009 and no new litigation commenced since the filing of our Form 10-K that would be required to be disclosed in response to this Item.

As of February 28, 2010, $3,362,528 of compensation and reimbursements for expenses is due to our employees and our accounts payable was approximately $1,737,860 of which $1,679,249 was over 90 days old Accordingly, some of our general creditors have commenced actions and many may initiate litigation to collect past due amounts for materials and services. While individual actions may involve more than 10% of our current assets of $8,325 as of February 28, 2010, the aggregate amount of the claims do not exceed the amounts we have recorded as current liabilities. We evaluate each case on what we believe is its merits and respond by either offering to pay less than the amount owed, offering to settle for the issuance of shares of our common stock, or raise counterclaims or defenses to the action, as we deem appropriate.

The outcome of any litigation is inherently uncertain and we are required under our certificate of incorporation, bylaws and employment agreements to indemnify our officers and directors for certain liabilities, including the cost of defending litigation brought against them in their capacity as such. Nevertheless, a portion of our indemnification liability is insured and shares of our common stock were escrowed at the time of the merger in which Arkados is the surviving corporation, to indemnify us against certain claims being made in the above actions.

Item 5. Other Information.

We borrowed the sum of $60,000 from Cooper Barrons, a private investment firm, in December, 2009. Cooper Barrons is controlled by Harris Cohen, a director of the Company. The original loan was due on demand. On March 29, 2010, Cooper Barrons agreed to accept a promissory note in the principal amount of $60,000 from us to represent the loan. The note is due with interest at the rate of 8% per annum on April 30, 2010, or on the earlier occurrence of a default, as defined in the note. In the event of default, penalty interest will be due on the note at the rate of $100 per day and the note provides for certain mandatory pre-payments of principal in the event we receive in financing or cash revenue from operations in excess of budgeted monthly operating critical expenses. Payment of principal and interest is subordinated to the obligation to the holders of our outstanding Debentures. Our Board of Birectors determined that the terms of the note are no more favorable to Cooper Barrons that that which could have been obtained from an unaffiliated lender. A copy of the note is filed as Exhibit 10.1 to this report.

On March 29, 2010, the Board of Directors approved the payment of consulting fees to Harris Cohen in the amount of $7,000 for the period from December 1, 2009 to January 31, 2010 and continuing fees of $3,000 per month for his service as the sole member of a committee of independent directors to make recommendations to the board concerning matters relating to the outstanding Debentures. The board granted additional compensation to Mr. Cohen in the form of a agreement to issue a five- year warrant on the successful debt restructuring, financing and possible recapitalization of the Company to purchase 150,000 shares of the Company’s common equity (as constituted after such transactions) for $0.05 per share. A copy of the Board consent relating to this transaction is filed as Exhibit 10.2 to this report.

Item 6. Exhibits.

(a) Exhibits.

10.1

Senior Subordinated Note due April 30, 2010.

10.2

Consent of the Board of Directors dated March 29, 20101

31.1

Certification of Chief Executive Officer of Periodic Report pursuant to Rule 13a-14a and Rule 15d-14(a).

31.2

Certification of Chief Financial Officer of Periodic Report pursuant to Rule 13a-14a and Rule 15d-14(a).

32.1

Certificate of Chief Executive Officer pursuant to 18 U.S.C. Section 1350

32.2

Certificate of Chief Financial Officer pursuant to 18 U.S.C. Section 1350

_____________________

1 Relates to compensation of directors.

Delaware	22-3586087
(State or other jurisdiction of	(IRS Employer
incorporation or organization)	Identification No.)

	28-Feb-10			31-May-09
Assets
Current assets

Cash	$	533		$	10,371
Accounts receivable		7,792			72,815
Inventory		-			29,819

Total current assets		8,325			113,005
Equipment, net		30,181			36,181
Deferred financing expenses, net		349,439			533,330
Intangible assets, net		159,165			216,902
Other assets		35,768			56,228

	$	582,878		$	955,646

Liabilities and Stockholders’ Deficiency

Current liabilities:
Accrued expenses and other liabilities	$	8,588,490		$	4,821,646
Related Party Borrowings		247,700			187,700
Notes Payable		659,952			206,802
Current portion convertible debentures and penalties		16,119,306			12,448,967
Payroll taxes and related penalties and interest payable		936,906			936,906

Total current liabilities		26,552,354			18,602,021

Stockholders’ deficiency
Convertible preferred stock - $.0001 par value; 5,000,0000 shares authorized, zero shares outstanding
Common stock, $.0001 par value; 100,000,000 shares authorized 32,738,397 and 32,738,397, respectively, issued and outstanding		3,274			3,274
Additional paid-in capital		22,714,187			21,638,124
Treasury stock		(16,000	)		(16,000	)
Accumulated Deficit during Development Stage		(48,670,937	)		(39,271,774	)
Total stockholder’s deficiency		(25,969,476	)		(17,646,375	)
	$	582,878		$	955,646

	For the Three Months Ended 28-Feb-09			For the Three Months Ended 28-Feb-10			For the Nine Months Ended 28-Feb-09			For the Nine Months Ended 28-Feb-10			Cumulative during the Development Stage (March 24, 2004 to February 28,2010)
Net Sales	$	198,900		$	46,346		$	583,325		$	173,246		$	2,870,374
Cost of Goods Sold		197,638			46,346			473,207			172,352			1,892,556
Gross Profit		1,262			-			110,117			894			977,818
Research and Development Expenses		412,392			671,241			1,100,121			2,030,220			10,651,7140
General and Administrative Expenses		1,399,298			471,637			3,014,936			1,450,585			20,043,586

Net Loss From Operations		(1,810,428	)		(1,142,879	)		(4,004,939	)		(3,479,911	)		(29,717,481	)

Other Income (Expenses):

Secured Debt Default Penalty
Interest Expense		(384,645	)		(835,609	)		(1,337,944	)		(5,919,253	)		(11,517,752
Net Loss Before Income Taxes		(2,195,073	)		(1,978,489	)		(5,342,883	)		(9,399,165	)		(41,235,233	)
Benefit for Income Taxes		(441,413	)		-			(441,413	)		-			(841,562	)
Net Loss	$	(1,753,660	)	$	(1,978,489	)	$	(4,901,470	)	$	(9,399,165	)	$	(40,393,671	)

Net Loss per share - Basic and diluted	$	(0.06	)	$	(0.06	)	$	(0.17	)	$	(0.29	)

Weighted Average of Common Shares Outstanding

- Basic and diluted		31,341,162			32,738,697			29,647,141			32,738,697

	For the Nine Months Ended 28-Feb-09			For the Nine Months Ended 28-Feb-10			Cumulative During the Development Stage (March 24, 2004 to February 28, 2010)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Loss	$	(4,901,471	)	$	(9,399,165	)	$	(40,393,671	)
Adjustments to reconcile net loss to net cash provided by (used) in operating activities
Depreciation and Amortization		442,975			63,737			1,556,569
Share Based Compensation Expense		1,629,514			1,076,065			10,947,820
Warrants and beneficial conversion rights with debt		142,130						627,716
Debt and Interest Penalty					3,670,339			4,675,040
(Increase ) decrease) in:
Accounts Receivable		(122,427	)		65,023			(7,792	)
Inventory		(31,138	)		29,819			630
Deferred Expenses		277,583			183,891			608,933
Prepaid and Other Assets:		48,123			20,460			(82,981	)
Increase (decrease) in:
Payroll Taxes and Related Penalties and Interest		---			---			(22,916	)
Related Party Payable		(23,717	)		---			---
Accounts Payable and Accrued Expenses		1,717,300			3,766,844			8,573,775
Net Cash Provided used in Operating Activities		(821,128	)		(522,987	)		(13,516,877	)
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of capital expenditures and Patents		(5,242	)		---			(140,671	)
Net Cash Used in Investing Activities		(5,242	)		---			(140,671	)
CASH PROVIDED BY FINANCING ACTIVITIES
Loan payable - related party		10,000			---			1,586,726
Note Payable		107,250			513,150			844,952
Contribution of capital		810,038			---			1,232,646
Exercise of stock options		---			---			1,756
Proceeds from convertible debt		---			---			1,876,588
Repayment of debt		(125,000	)		---			(469,256	)
Issuance of Debentures		---			---			9,533,411
Repayment of related party debt		---			---			(949,027	)
Net Cash Provided by in Financing Activities		802,288			513,150			13,657,796
NET (DECREASE) INCREASE IN CASH		(24,082	)		(9,838	)		248
Cash, beginning of the period		24,480			10,371			285
Cash, end of the period	$	398		$	533		$	533

SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for interest	$	1480		$	---

Conversion of accrued interest to debt	$	673,049		$	---

Dated: April 2, 2010	ARKADOS GROUP, INC.



	By:	/s/ Oleg Logvinov
		Oleg Logvinov
		President and Chief Executive Officer



	By:	/s/ Larry L Crawford
		Larry L Crawford, Chief Financial Officer
		(Principal Financial and Accounting Officer)


PART I—FINANCIAL INFORMATION

	Item 1.	Financial Statements	4

		Consolidated Balance Sheets as of February 28, 2010 (unaudited) and May 31, 2009	4

		Consolidated Statements of Operations Cumulative During the Development Stage (March 24, 2004 to February 28, 2010) and for the Three and Nine Months Ended February 28, 2010 and 2009 (UNAUDITED)	5

		Consolidated Statements of Cash Flows – Cumulative During the Development Stage (March 24, 2004 to February 28, 2010) and for the Nine Months Ended February 28, 2010 and 2009 (UNAUDITED)	6

		Notes to Consolidated Financial Statements (unaudited)	7

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	29

	Item 4T	Controls and Procedures	29
PART II—OTHER INFORMATION

	Item 1	Legal Proceedings	30

	Item 5.	Other Information	30

	Item 6.	Exhibits	30


Signatures			31