10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from         to

Commission file number 001-15757

IMAGEWARE SYSTEMS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware	33-0224167
(State or Other Jurisdiction of Incorporation or	(IRS Employer Identification No.)
Organization)

10883 Thornmint Road

San Diego, CA 92127

(Address of Principal Executive Offices)

(858) 673-8600

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

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

o Large accelerated filer o Accelerated filer x Non-accelerated filer

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

The number of shares of Common Stock, with $0.01 par value, outstanding on November 17, 2006 was 13,621,941.

IMAGEWARE SYSTEMS, INC. INDEX

PART I.	FINANCIAL INFORMATION
	ITEM 1.	FINANCIAL STATEMENTS (UNAUDITED)
		Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005
		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005
		Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2006 and 2005
		Notes to Condensed Consolidated Financial Statements
	ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk
	ITEM 4.	Controls and Procedures
PART II.	OTHER INFORMATION
	ITEM 1A.	Risk Factors
	ITEM 6.	Exhibits
SIGNATURES

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PART I

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

IMAGEWARE SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, except share data)

	September 30, 2006			December 31, 2005
	(Unaudited)
ASSETS
Current Assets:
Cash	$	276		$	741
Accounts receivable, net of allowance for doubtful accounts of $477 (unaudited) and $478 at September 30, 2006 and December 31, 2005, respectively	967			1,340
Costs and estimated earnings in excess of billings on uncompleted contract	322			—
Inventory	91			208
Other current assets	294			219
Total Current Assets	1,950			2,508
Property and equipment, net	362			424
Other assets	779			738
Intangible assets, net of accumulated amortization	145			218
Goodwill	3,416			3,416
Total Assets	$	6,652		$	7,304
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	1,511		$	690
Deferred revenue	1,635			1,084
Accrued expenses	1,054			1,035
Notes payable to third parties, net of discount	1,144			—
Total Current Liabilities	5,344			2,809
Pension obligation	1,199			1,130
Total Liabilities	6,543			3,939
Shareholders’ equity:
Preferred stock, $.01 par value, 4,000,000 shares authorized; 750,000 shares designated as Series B convertible redeemable preferred stock, 389,400 shares issued, and 239,400 (unaudited) and 249,400 shares outstanding at September 30, 2006 and December 31, 2005, respectively; liquidation preference $598,500 (unaudited) and $623,500 at September 30, 2006 and December 31, 2005, respectively	2			2
Common stock, $.01 par value, 50,000,000 shares authorized; 13,628,645 (unaudited) and 13,554,366 shares issued at September 30, 2006 and December 31, 2005, respectively, and 13,621,941 (unaudited) and 13,547,662 shares outstanding at September 30, 2006 and December 31, 2005, respectively	135			134
Additional paid in capital	68,954			67,650
Treasury stock, at cost - 6,704 shares	(64		)	(64		)
Accumulated other comprehensive income	(132		)	(35		)
Accumulated deficit	(68,786		)	(64,322		)
Total Shareholders’ equity	109			3,365
Total Liabilities and Shareholders’ Equity	$	6,652		$	7,304

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

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(UNAUDITED)

	THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
	2006			2005			2006			2005
Revenues:
Product	$	1,635		$	1,981		$	6,276		$	5,744
Maintenance	617			524			1,683			1,545
	2,252			2,505			7,959			7,289
Cost of revenues:
Product	501			613			1,695			2,068
Maintenance	213			255			718			750
Gross profit	1,538			1,637			5,546			4,471
Operating expenses:
General & administrative	1,176			1,162			3,587			3,524
Sales and marketing	989			955			3,095			2,719
Research & development	926			855			2,825			2,342
Depreciation and amortization	59			147			248			460
	3,150			3,119			9,755			9,045
Loss from operations	(1,612		)	(1,482		)	(4,209		)	(4,574		)
Interest expense (income), net	156			(31		)	339			(42		)
Other income, net	(5		)	(86		)	(111		)	(135		)
Loss from continuing operations before income taxes	(1,763		)	(1,365		)	(4,437		)	(4,397		)
Income tax expense (benefit)	—			—			—			—
Loss from continuing operations	(1,763		)	(1,365		)	(4,437		)	(4,397		)
Discontinued operations:
Gain from operations of discontinued Digital Imaging Asia Component (including gain on disposal of $233 in 2005)	—			—			—			223
Income tax benefit (expense)	—			—			—			—
Gain on discontinued operations	—			—			—			223
Net loss	$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,174	)
Basic and diluted loss per common share - see note 3	$	(0.13	)	$	(0.10	)	$	(0.33	)	$	(0.34	)
Weighted-average shares (basic and diluted)	13,604,692			13,209,856			13,574,835			12,456,194

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

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

	Nine Months Ended September 30,
	2006			2005
Cash flows from operating activities
Net loss	$	(4,437	)	$	(4,174	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization	248			462
Gain on sale of subsidiary	—			(233		)
Non cash interest and amortization of debt discount and debt issuance costs	284			—
Stock based compensation	912			209
Provision for losses on accounts receivable	14			—
Change in assets and liabilities
Accounts receivable, net	359			2
Costs and estimated earnings in excess of billings on uncompleted contracts	(322		)	—
Inventory	117			244
Other current assets	(35		)	(15		)
Intangible and other assets	(68		)	41
Accounts payable	821			(499		)
Accrued expenses	(7		)	(464		)
Deferred revenue	551			105
Contract costs	—			(424		)
Pension obligation	69			(28		)
Total adjustments	2,943			(600		)
Net cash used in operating activities	(1,494		)	(4,774		)
Cash flows from investing activities
Purchase of property and equipment	(113		)	(244		)
Proceeds from sale of subsidiary net of cash sold and direct transaction costs	—			1,209
Net cash provided by (used in) investing activities	(113		)	965
Cash flows from financing activities
Repayment of notes payable	(215		)	(17		)
Proceeds from issuance of notes payable with warrants	1,550			—
Debt issuance costs	(98		)	—
Proceeds from issuance of common stock, net of issuance costs				3,234
Proceeds from exercised stock options	—			63
Dividends paid	(26		)	(26		)
Net cash provided by financing activities	1,211			3,254
Effect of exchange rate changes on cash	(69		)	(127		)
Net decrease in cash	(465		)	(682		)
Cash at beginning of period	741			2,912
Cash at end of period	$	276		$	2,230
Supplemental disclosure of cash flow information:
Cash paid for interest	$	35		$	—
Summary of non-cash investing and financing activities:
Exchange of common shares for marketable equity securities	$	—		$	231

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

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IMAGEWARE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(IN THOUSANDS)

(UNAUDITED)

	THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
	2006			2005			2006			2005
Net loss	$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,174	)
Other comprehensive income (loss):
Unrealized loss on securities:
Unrealized holding gain (losses) arising during the period	(28		)	15			(28		)	(113		)
Foreign currency translation adjustment	(35		)	(1		)	(69		)	(126		)
Comprehensive loss	$	(1,826	)	$	(1,351	)	$	(4,534	)	$	(4,413	)

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

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IMAGEWARE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1.  DESCRIPTION OF BUSINESS AND OPERATIONS

ImageWare Systems, Inc. (the “Company”), formerly known as ImageWare Software, Inc., utilizes identity management technology to provide stand alone, networked and web-based software solutions for secure credentials, biometrics, law enforcement and professional photography.

Basis of Presentation

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

The accompanying condensed consolidated unaudited financial statements of ImageWare have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements and should be read in conjunction with the consolidated financial statements for the year ended December 31, 2005, and notes thereto included in the Company’s Annual Report on Form 10-KSB, filed with the SEC on April 17, 2006, as amended on May 1, 2006. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments, consisting only of adjustments of a normal recurring nature, necessary for a fair presentation of the Company’s financial position as of September 30, 2006, and its results of operations for the periods presented. These condensed consolidated unaudited financial statements are not necessarily indicative of the results to be expected for the entire year.

Going Concern

As reflected in the accompanying condensed consolidated financial statements, the Company has continuing losses and negative cash flows from operations. These matters raise doubt about the Company’s ability to continue as a going concern.

New financing will be required to fund working capital and operations should the Company be unable to generate positive cash flow from operations in the near future. The Company is exploring the possible sale of equity securities and/or debt financing, and believes that additional financing will be available under terms and conditions that are acceptable to the Company. However, there can be no assurance that additional financing will be available. In the event financing is not available in the time frame required, the Company will be forced to reduce its rate of growth, if any, reduce operating expenses, curtail sales and marketing activities and reschedule research and development projects. In addition, the Company might be required to sell certain of its assets or license its technologies to others. These actions, while necessary for the continuance of operations during a time of cash constraints and a shortage of working capital, could adversely affect the Company’s business.

As a result of the Company’s continuing losses and negative cash flows from operations, the Company currently does not meet certain listing standards of the American Stock Exchange (AMEX) Company Guide.  As a result, the Company may be considered for suspension or delisting from AMEX.  During May 2006, we received notification from AMEX that we were not in compliance with certain sections of the AMEX Company Guide.  To maintain an AMEX listing, we were required to submit a plan to AMEX which demonstrates our ability to regain compliance with the continued listing standards within a maximum of 18 months.  We submitted our plan to AMEX during June 2006.  The Listing Qualifications Department of AMEX evaluated our plan and in September 2006 notified us that we had made a reasonable demonstration in the plan of an ability to regain compliance with the continued listing standards by the end of the plan periods which AMEX determined to be Novembeer 15, 2006 for Section 1003(a)(iv) of the AMEX Company Guide and November 30, 2007 for Sections 1003(a)(i), 10033(a)(ii) and 1003(a)(iii) of the AMEX Company Guide.   Accordingly,  in September 2006, AMEX notified us that they would continue the listing of the Company subject to us making a public announcement disclosing the fact that we are not in compliance with the continued listing standards of the Exchange and that our listing is being continued pursuant to an extension and our providing certain supporting documentation of key elements of our plan.  We made the required public announcement and provided the requested information.  We are subject to periodic review to determine if we

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are making progress consistent with the plan0.  Failure to make progress consistent with the plan or regain compliance with the continued listing standards by the end of the applicable extension periods could result in the AMEX initiating delisting proceedings pursuant to Section 1009 of the AMEX Company Guide.  There is no assurance that we will make progress consistent with the plan, or that we will be able to continue our listing on AMEX. 

In view of the matters described in the preceding paragraphs, recoverability of a major portion of the recorded asset amounts shown in the accompanying condensed consolidated balance sheets is dependent upon continued operations of the Company, which, in turn, is dependent upon the Company’s ability to continue to raise capital and generate positive cash flows from operations. The condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classifications of liabilities that might be necessary should the Company be unable to continue its existence.

The Company operates in markets that are emerging and highly competitive. There is no assurance that the Company will operate at a profit in the future.

Recently Issued Accounting Standards

In July 2006, Financial Accounting Standards Board Interpretation (FIN) No. 48 “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB No. 109,” was issued.  FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, and disclosure requirements for uncertain tax positions.  FIN No. 48 is effective for years beginning after December 15, 2006.  The adoption of FIN No. 48 is not expected to have a material impact on the Company’s financial position, cash flows, or results of operations.

In September 2006, the FASB issued Statement of Financial Accounting Standard 157 “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit fair value measurements. Accordingly, FAS 157 does not require any new fair value measurements. However, for some entities, the application of FAS 157 will change current practice. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We have not yet determined the impact of FAS 157 on our consolidated financial position, results of operations, cash flows or financial statement disclosures.

In September 2006, the FASB issued Statement of Financial Accounting Standard 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“FAS 158”). FAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. It also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. Under FAS 158, the requirement to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures is effective for us as of the end of our first fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for us for our first fiscal year ending after December 15, 2008. We have not yet determined the impact of FAS 158 on our consolidated financial position, results of operations, cash flows or financial statement disclosures.

In September 2006, the SEC staff issued Staff Accounting Bulletin, or SAB, No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”, (“ SAB 108”). SAB 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of determining whether the current year’s financial statements are materially misstated. SAB 108 is effective for fiscal years ending after November 15, 2006. We will initially apply the provisions of SAB 108 in connection with the preparation of our annual financial statements for the year ending December 31, 2006. We have evaluated the potential impact that SAB 108 may have on our financial statements and do not believe the impact of the application of this guidance will be material.

Reclassifications

Certain reclassifications have been made to the prior period balances in order to conform to the current period presentation.

NOTE 2. STOCK BASED COMPENSATION

At September 30, 2006, the Company had three stock-based compensation plans for employees and nonemployee directors which authorize the granting of various equity-based incentives including stock options and restricted stock.

Prior to January 1, 2006, the Company accounted for the measurement and recognition of stock-based compensation under the provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations,

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permitted under Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123). As a result, employee stock option based compensation was included as a pro forma disclosure in the Notes to the Company’s financial statements for prior year periods.

Prior to the adoption of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”, (SFAS No. 123(R)), the Company provided the disclosures required under SFAS No. 123. The pro forma effect on net income and net income per share as if the fair value of stock-based compensation had been recognized as compensation expense for the three and nine month periods ending September 30, 2005 was as follows:

	Three Months Ended September 30,			Nine Months Ended September 30,
(In thousands, except per share data)	2005			2005
Net Loss:
As reported	$	(1,365	)	$	(4,174	)
Stock-based compensation included in net loss	$	70		$	209
Stock-based employee compensation under fair value based method	$	(196	)	$	(480	)
Pro forma net loss	$	(1,491	)	$	(4,445	)
Basic loss per common share:
As reported	$	(0.10	)	$	(0.34	)
Pro forma	$	(0.11	)	$	(0.36	)

On January 1, 2006, the Company adopted the provisions of SFAS 123(R) using the modified prospective transition method.  SFAS 123(R) requires companies to measure and recognized the cost of employee services received in exchange for awards of equity instruments based on the grant date fair value of those awards. For share option instruments issued subsequent to the adoption of SFAS 123(R), compensation cost is recognized ratably using the straight-line attribution method over the expected vesting period. For equity options issued prior to the adoption of SFAS 123(R), compensation cost is recognized using a graded vesting attribution method. In addition, pursuant to SFAS 123(R), we are required to estimate the amount of expected forfeitures when calculating compensation costs, instead of accounting for forfeitures as incurred, which was our previous method. Prior periods are not restated under this transition method. Options previously awarded and classified as equity instruments continue to maintain their equity classification under SFAS 123(R).

The effect of recording stock-based compensation for the three and nine months ended September 30, 2006 was as follows:

	Three Months Ended September 30,			Nine Months Ended September 30,
(In thousands, except per share data)	2006			2006
Stock-based compensation expense by type of award:
Employee stock options	$	143		$	607
Restricted stock grants	$	102		$	305
Total employee stock based compensation	$	245		$	912
Tax effect on stock-based compensation	—			—
Tax effect on net income	—			—
Stock-based compensation included in net loss	$	245		$	912
Effect on loss per common share:
Basic	$	(0.02	)	$	(0.07	)
Diluted	$	(0.02	)	$	(0.07	)

Prior to adopting SFAS No. 123(R), the Company presented all excess tax benefits, if any, resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS No. 123(R) requires cash flows resulting from excess tax benefits to be classified as a financing activity. Excess tax benefits are realized from tax deductions for exercised options in excess of the deferred tax asset attributable to stock compensation costs for such options. The Company did not record any excess tax benefits as a result of adopting SFAS 123(R) in the three and nine months ended

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September 30, 2006 because the Company is currently providing a full valuation on future tax benefits realized in the United States until it can sustain a level of profitability that demonstrates its ability to utilize the assets.

SFAS No. 123(R) requires the use of a valuation model to calculate the fair value of stock-based awards. For the three and nine months ended September 30, 2006, the Company has elected to use the Black-Sholes option-pricing model, which incorporates various assumptions including volatility, expected life, and interest rates. The Company is required to make various assumptions in the application of the Black-Sholes option pricing model. The Company has determined that the best measure of expected volatility is based on the historical weekly volatility of the Company’s common stock. Historical volatility factors utilized in the Company’s Black-Sholes computations range from 83.5% to 98.5%. The Company has elected to estimate the expected life of an award based upon the SEC approved “simplified method” noted under the provisions of Staff Accounting Bulletin No. 107. Under this formula, the expected term is equal to: ((weighted-average vesting term + original contractual term)/2). The expected term used by the Company as computed by this method range from 3.5 years to 6.1 years. The interest rate used is the risk free interest rate and is based upon U. S. Treasury rates appropriate for the expected term. Interest rates used in the Company’s Black-Sholes calculations range from 2.7% to 4.6%. Dividend yield is zero as we do not expect to declare any dividends on our common shares in the foreseeable future.

A summary of the activity under the Company’s stock option plans for the nine months ended September 30, 2006 is as follows:

	Options		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (Years)
Balance at December 31, 2005	1,474,093		$	2.68	8.20
Granted	363,000		$	1.90	9.41
Forfeited	(181,629	)	$	3.08	6.03
Exercised	—		$	—	—
Balance at September 30, 2006	1,655,464		$	2.46	8.03

Options exercisable at September 30, 2006 totaled 788,081 at a weighted-average price of $2.68, with a remaining weighted average contractual term of approximately 7.1 years.

The weighted-average grant date fair value of options granted during the three and nine months ended September 30, 2006 was $1.23 and $1.38, respectively.

The following table sets forth a summary of the status and changes of the Company’s unvested shares related to its stock option plans as of and during the nine months ended September 30, 2006:

	Options		Weighted- Average Grant Date Fair Value Per Share
Balance at December 31, 2005	849,930		$	1.82
Granted	363,000		$	1.38
Vested	(279,209	)	$	1.78
Forfeited	(63,445	)	$	1.95
Balance at September 30, 2006	870,276		$	1.65

At September 30, 2006, the total remaining unrecognized compensation cost related to unvested stock options amounted to approximately $817,074, which will be amortized over the weighted-average remaining requisite service period of 1.87 years.

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NOTE 3.  NET LOSS PER COMMON SHARE

Basic loss per common share is calculated by dividing net loss available to common shareholders for the period by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net loss available to common shareholders for the period by the weighted-average number of common shares outstanding during the period, adjusted to include, if dilutive, potential dilutive shares consisting of convertible preferred stock, stock options and warrants, calculated using the treasury stock method. During the periods ended September 30, 2006 and 2005, the Company has excluded the following securities from the calculation of diluted loss per share, as their effect would have been antidilutive due to the Company’s net loss:

Potential Dilutive Securities:	Number of Common Shares Convertible into at September 30, 2006	Number of Common Shares Convertible into at September 30, 2005
Convertible preferred stock	45,384	47,280
Stock options	793,741	589,577
Warrants	4,680,805	4,469,578

The following table sets forth the computation of basic and diluted loss per share for the three and nine month periods ended September 30, 2006 and 2005 (amounts in thousands except share and per share amounts):

	THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
	2006			2005			2006			2005
Numerator — loss from continuing operations:
Net loss from continuing operations	$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,397	)
Less Series B preferred dividends	(13		)	(13		)	(40		)	(40		)
Net loss from continuing operations available to common shareholders	$	(1,776	)	$	(1,378	)	$	(4,477	)	$	(4,437	)
Numerator — gain (loss) from discontinued operations:
Net gain (loss) discontinued operations	—			—			—			223
Denominator
Weighted-average shares outstanding	13,604,692			13,209,856			13,574,835			12,456,194
Basic and diluted loss per share:
Loss from continuing operations	$	(0.13	)	$	(0.10	)	$	(0.33	)	$	(0.36	)
Discontinued operations	—			—			—			0.02
Net loss per share	$	(0.13	)	$	(0.10	)	$	(0.33	)	$	(0.34	)

NOTE 4.  SEGMENT INFORMATION

The Company is comprised of three reportable segments: Law Enforcement, Identification and Digital Photography. The Law Enforcement segment develops, sells and supports identity management technology used to create booking and investigative software used by law enforcement and public safety agencies to manage criminal history records and investigate crime. The Identification segment develops, sells and supports software and designs systems which utilize identity management technology in the production of smart and secure identification systems and documents. The Digital Photography segment develops digital imaging software for photographic purposes.

Corporate assets are comprised primarily of cash and other assets providing benefits to all business segments.

There are no significant intersegment transactions.

The table below summarizes information about reportable segments for the three and nine months ended September 30, 2006 and 2005:

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	THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
	2006			2005			2006			2005
	(in thousands) (unaudited)						(in thousands) (unuadited)
Net Revenue:
Law Enforcement	$	746		$	719		$	2,821		$	2,326
Identification	1,431			1,123			4,987			4,144
Digital Photography	75			163			151			319
Corporate	—			500			—			500
Total consolidated net sales	$	2,252		$	2,505		$	7,959		$	7,289
Operating loss:
Law Enforcement	$	(523	)	$	(971	)	$	(1,357	)	$	(2,547	)
Identification	(975		)	(903		)	(2,506		)	(2,031		)
Digital Photography	(114		)	(108		)	(346		)	(496		)
Corporate	—			500			—			500
Other unallocated amounts:
Interest expense (income)	156			(31		)	339			(42		)
Other expense (income)	(5		)	(86		)	(111		)	(135		)
Income (loss) before taxes	$	(1,763	)	$	(1,365	)	$	(4,437	)	$	(4,397	)

	September 30, 2006
	(in thousands)
Total Assets by Segment:
Law Enforcement	$	460
Identification	5,330
Digital Photography	40
Total assets for reportable segments	5,830
Corporate	822
Total consolidated assets	$	6,652

NOTE 5. CONTRACT COSTS

The Company recognizes sales and cost of sales on long-term, fixed price contracts involving significant amounts of customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion.  Such amounts are included in the accompanying Balance Sheets at September 30, 2006 and December 31, 2005 under the caption “Costs and estimated earnings in excess of billings on uncompleted contract.”

Costs and estimated billings on uncompleted contracts and related amounts billed as of September 30, 2006 and December 31, 2005 are as follows:

($ in thousands)	September 30,  2006		December 31,  2005
Costs incurred on uncompleted contract	$	157	$	—
Estimated earnings	165		—
	322		—
Less: Billings to date	—		—
	$	322	$	—

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NOTE 6. NOTES PAYABLE

In March 2006, the Company completed a secured debt financing in the aggregate amount of $1,550,000, with net proceeds to Company approximating $1,452,000. The Company issued a series of secured promissory notes aggregating $1,550,000 which bear interest at 8% per annum, with interest compounded monthly and payable quarterly. The principal balance becomes due in one year or earlier upon the occurrence of the following contractually defined events: (i) payments received by the Company in connection with contracts with Grupo Inffinix and Argus Solutions or any affiliate thereof, or any extension, renewal or amendment of such contracts; or (ii) payments made against any new contract signed by the Company which contract amount is in excess of $1,500,000; or (iii) the receipt by the Company of proceeds from the sale of equity or equity-linked securities by the Company; or (iv) receipt of proceeds from the issuance by the Company of any type of debt instruments, including lines of credit. In addition, the Company may prepay the notes in whole or in part upon five days prior written notice.

As a condition to the loan, the Company entered into a security agreement whereby the Company granted a security interest in all of the Company’s goods and equipment, inventory, contract rights and general intangibles, accounts or other obligations owing to the Company, and cash deposit accounts and other investment property to secure payment of the note.

As a condition to the loan, the Company also issued warrants to purchase 387,500 shares of the Company’s common stock. Such warrants have a 5-year term and an exercise price $2.30 per share. Common shares underlying the warrants have piggyback registration rights and cashless exercise after 12 months from closing date if there is no effective registration statement covering the underlying shares.

The Company recorded the secured debt financing net of a discount equal to the fair value allocated to the warrants using the relative fair value method of approximately $419,000. The Company estimated the fair value of the warrants using the Black-Sholes option pricing model and the following assumptions: term of 5 years, a risk free interest rate of 4.52%, a dividend yield of 0%, and volatility of 82%.  During the three and nine months ended September 30, 2006, the Company recorded approximately $105,000 and $227,000 respectively in debt discount amortization which is included as a component of net interest expense in the Company’s Condensed Consolidated Statement of Operations.

NOTE 7. COMMON STOCK

During the three months ended September 30, 2006, the Company issued 18,096 shares of its common stock pursuant to stock-based compensation agreements with certain employees and issued 1,895 shares of its common stock pursuant to the conversion of 10,000 shares of Series B Preferred Stock.

NOTE 8. SUBSEQUENT EVENT

On November 14, 2006, the Company entered into a Securities Purchase Agreement with certain accredited investors (the "Investors") pursuant to which the Company sold to the Investors an aggregate of 2,300 shares of the Company’s Series C 8% Convertible Preferred Stock (the "Series C") at a stated value of $1,000 per share for aggregate gross proceeds of $2,300,000, and issued to the Investors warrants (the "Investor Warrants") to purchase up to an aggregate of 115,000 shares of common stock of the Company with an exercise price of $1.575 per share (the "Financing"). In connection with the Financing, the Company issued to a placement agent and its affiliates warrants to purchase an aggregate of 40,000 shares of common stock of the Company with exercise prices of $1.575 per share (the "Placement Agent Warrants" and, together with the Investor Warrants, the "Warrants"). In connection with the Financing, the Company also entered into a registration rights agreement (the "Registration Rights Agreement") with certain of the Investors, and has agreed to enter into the Registration Rights Agreement with the remaining Investors, pursuant to which the Company has agreed to file a registration statement with the Securities and Exchange Commission covering the resale of certain shares of common stock into which the Series C are convertible as well as the shares of common stock issuable upon exercise of the Placement Agent Warrants. The material terms of the Securities Purchase Agreement, the Registration Rights Agreement, the Warrants and the transactions contemplated thereby were described in the Company’s Form 8-K filed on November 20, 2006 (incorporated by reference into this Report).

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

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors, which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include but are not limited to those items discussed under “Risk Factors” beginning on page 24 and elsewhere in this Quarterly Report.

The following discussion of the financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements included elsewhere within this Quarterly Report. Fluctuations in annual and quarterly results may occur as a result of factors affecting demand for our products such as the timing of new product introductions by us and by our competitors and our customers’ political and budgetary constraints. Due to such fluctuations, historical results and percentage relationships are not necessarily indicative of the operating results for any future period.

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OVERVIEW

ImageWare Systems, Inc. utilizes identity management technology to develop software used to create booking and investigative software, smart and secure identification systems and documents, and software for professional photographers. Our software systems and associated hardware enable our customers to quickly capture, archive, search, retrieve and share digital photographs and associated text records. The following management’s discussion and analysis is based primarily upon our Law Enforcement, Identification and Digital Photography products.

CRITICAL ACCOUNTING ESTIMATES

The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principals generally accepted in the United States of America, or U.S. GAAP. The preparation of these financial statements in accordance with U.S. GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the financial statements and the reported amounts of revenue and expenses during a fiscal period. The SEC considers an accounting policy to be critical if it is important to a company’s financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. Although we believe that our judgments and estimates are appropriate and correct, actual results may differ from those estimates.

The following are our critical accounting policies because we believe they are both important to the portrayal of our financial condition and results of operations and require critical management judgments and estimates about matters that are uncertain. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operations for future periods could be materially affected.

Revenue Recognition

Our revenue recognition policy is significant because our revenue is a key component of our consolidated results of operations. We recognize revenue from the following major revenue sources:

·Long-term fixed-price contracts involving significant customization

·Fixed-price contracts involving minimal customization

·Software licensing

·Sales of computer hardware and identification media

·Postcontract customer support (PCS)

The Company’s revenue recognition policies are consistent with U. S. GAAP including Statements of Position 97-2 “Software Revenue Recognition” and 98-9 “Modification of SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions”, Securities and Exchange Commission Staff Accounting Bulletin 104 , Emerging Issues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”, and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software”. Accordingly, the Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed or determinable, and collectibility is reasonable assured.

We recognize revenue and profit as work progresses on long-term, fixed-price contracts involving significant amount of hardware and software customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Revenue from contracts for which we cannot reliably estimate total costs or there are not significant amounts of customization are recognized upon completion. Determining when a contract should be accounted for using the percentage of completion method involves judgment. Critical items that are considered in this process are the degree of customization and related labor hours necessary to complete the required work as well as ongoing estimates of the future labor hours needed to complete the contract. We also generate non-recurring revenue from the licensing of our software. Software license revenue is recognized upon the execution of a license agreement, upon deliverance, fees are fixed and determinable, collectibility is probable and when all other significant obligations have been fulfilled. We also generate

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revenue from the sale of computer hardware and identification media. Revenue for these items is recognized upon delivery of these products to the customer. Our revenue from periodic maintenance agreements is generally recognized ratably over the respective maintenance periods provided no significant obligations remain and collectibility of the related receivable is probable.

Allowance for Doubtful Accounts

Our management must make estimates of the uncollectibility of our accounts receivables. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer creditworthiness, current economic trends, the age of the accounts receivable balances, and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivables balance was approximately $1,444,000 and our allowance for doubtful accounts was approximately $477,000 as of September 30, 2006.

Valuation Of Goodwill And Other Intangible Assets

We assess impairment of goodwill and identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

·Significant underperformance relative to historical or expected future operating results;

·Significant changes in the manner of our use of the acquired assets or the strategy of our overall business;

·Significant negative industry or economic trends;

When we determine that the carrying value of goodwill and other intangible assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based upon fair value methodologies. Goodwill and other net intangible assets amounted to approximately $3,561,000 as of September 30, 2006.

In 2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” became effective, and as a result we ceased to amortize goodwill. In lieu of amortization, we performed an initial impairment review of our goodwill in June 2002 and an annual impairment review thereafter in the fourth quarter of our fiscal year. Completion of our initial impairment test indicated there was no goodwill impairment. We also performed our annual impairment review as of December 31, 2004 and 2005, based upon our 2005 and 2006 operating plans, respectively. This annual impairment review indicated there was goodwill impairment in our Digital Photography segment as of December 31, 2005, and accordingly, we have recorded an impairment loss in the 2005 Consolidated Statement of Operations. Both of these tests were conducted by determining and comparing the fair value of our reporting units, as defined in SFAS 142, to the reporting unit’s carrying value as of that date. Our reporting units are Law Enforcement, Identification and Digital Photography. We determined that as of September 30, 2006 there were no indicators of potential impairment. There are many management assumptions and estimates underlying the determination of an impairment loss, and estimates using different, but reasonable, assumptions could produce significantly different results. Significant assumptions include estimates of future levels of revenues and operating expenses. Therefore, the timing and recognition of impairment losses by us in the future, if any, may be highly dependent upon our estimates and assumptions. There can be no assurance that goodwill impairment will not occur in the future.

We account for long-lived assets in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement requires that long-lived assets and certain identifiable intangible assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the asset. Assets to be disposed of are reported at the lower of the carrying amount of fair value less costs to sell. In 2005, we recorded an impairment charge of approximately $253,000 related to our intangible asset for certain trademark and tradenames carried in our Identification segment. This loss reflects the amount by which the carrying value of this asset exceeded its estimated fair value determined by the assets’ future discounted cash flows. The impairment loss is recorded as a component of “Operating expenses” in the Statement of Operations for 2005. We determined that as of September 30, 2006 there were no indicators of potential impairment. There are many management assumptions and estimates underlying the

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determination of an impairment loss, and estimates using different, but reasonable, assumptions could produce significantly different results. Significant assumptions include estimates of future levels of revenues and operating expenses. Therefore, the timing and recognition of impairment losses by us in the future, if any, may be highly dependent upon our estimates and assumptions. There can be no assurance that intangible asset impairment will not occur in the future.

Stock-Based Compensation

Upon adoption of SFAS 123R on January 1, 2006, we began estimating the value of employee stock options on the date of grant using the Black-Scholes model. Prior to the adoption of SFAS 123R, the value of each employee stock option was estimated on the date of grant using the Black-Scholes model for the purpose of the pro forma financial disclosure in accordance with SFAS 123. The determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards and the actual and projected employee stock option exercise behaviors. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. We calculated our expected volatility assumption required in the Black-Scholes model based on the historical volatility of our stock. As of January 1, 2006 we have adopted the modified prospective transition method and its effect is included in our three and nine month financial statements for the period ended September 30, 2006.

RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005.

	THREE MONTHS ENDED SEPTEMBER 30,
Net Product Revenues	2006			2005			$ Change			% Change
(dollars in thousands)
Product revenues:
Law Enforcement	$	232		$	225		$	7		3	%
Percentage of total net product revenue	14		%	11		%
Identification	$	1,328		$	1,106		$	222		20	%
Percentage of total net product revenue	81		%	56		%
Digital Photography	$	75		$	150		$	(75	)	(50	)%
Percentage of total net product revenue	5		%	8		%
Patent Licensing	—			500			(500		)	(100	)%
Percentage of total net product revenue	0		%	25		%
Total net product revenues	$	1,635		$	1,981		$	(346	)	(17	)%

The increase in our Law Enforcement product revenues is due to the deployment of our Crime Capture System to law enforcement agencies.  We believe that continued incidents of terrorism has created heightened interest in the ability of law enforcement and other government agencies to be able to efficiently retrieve, analyze and share information from their respective criminal databases.  We anticipate that these factors will increase the overall demand for our law enforcement products and software; however, we cannot predict the timing of the shift in demand.

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Identification revenues generated by our San Diego and Canadian offices increased approximately $444,000 or 50% for the three months ended September 30, 2006 as compared to the corresponding period in 2005.  This increase in revenue is reflective of increased sales of our Biometric Engine and Identification software products in project-oriented work and revenues generated by our IWS Desktop Security products (released in the fourth quarter of 2005), offset by decreases in products sold through our distribution channel.  Identification revenues generated by our German sales office decreased approximately $222,000.  This decrease is reflective of our decision to reorganize our German sales office by closing our existing facility in order to reduce operating expenses.  We intend to pursue project sales opportunities in areas serviced by this office through geographically dedicated sales personnel.  We are of the opinion that foreign markets formerly served by this office will embrace our identification and biometric solutions for large-scale high-end installations.

We continue to be of the opinion that government agencies and private entities will react to heightened security concerns resulting from acts of terrorism by re-evaluating and upgrading their ability to positively identify and track their citizens, employees, consultants and visitors. We anticipate that these factors will increase overall demand for our identification products; however, we cannot predict the timing of the shift in demand.

We feel that we are well positioned for participation in one or more large-scale domestic or international projects which will enable our company to achieve significant product revenue growth in our Identification segment.  In the past twelve months we have retooled our identification products to enable customization for large project applications, added the biometric engine for incorporation into large scale biometric installations and reoriented our organization to direct our resources and capabilities toward establishing a foothold in the market for large-scale secure identification solutions.

The decrease in Digital Photography product revenues is due to lower sales of boxed software during the three months ended September 30, 2006 as compared to the comparable period of 2005.  While we devoted substantial research and development resources upgrading our suite of Digital Photography product offerings in 2005 and 2006, we anticipate that because of changing market dynamics and competitive pressures, product revenues for our Digital Photography segment will not reach 2005 levels.

Our backlog of product orders as of September 30, 2006 was approximately $1,047,000.  At September 30, 2006, we also had maintenance and support backlog of approximately $1,402,000 under existing maintenance agreements.  Product revenue is typically recognized within a three to six month time period depending upon the required degree of customization, if any.  Historically, we have experienced a very minimal risk of order cancellation.  Our revenue from maintenance agreements is generally recognized ratably over the respective maintenance periods provided no significant obligations remain and collectibility of the related receivable is probable.

	THREE MONTHS ENDED SEPTEMBER 30,
Maintenance Revenues	2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance revenues:
Law Enforcement	$	514		$	494		$	20		4	%
Percentage of total net maintenance revenue	83		%	94		%
Identification	$	103		$	17		$	86		506	%
Percentage of total net maintenance revenue	17		%	3		%
Digital Photography	$	—		$	13		$	(13	)	(100	)%
Percentage of total net maintenance revenue	0		%	3		%
Total net maintenance revenues	$	617		$	524		$	93		18	%

The increase in Law Enforcement maintenance revenues is due to the expansion of our installed base in the Law Enforcement market.

The increase in Identification maintenance revenues is due to software maintenance on domestic identification projects.

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Our decrease in Digital Photography maintenance revenues as compared to the corresponding period in 2005 is reflective of the expiration of software maintenance on custom contract programming projects.

	THREE MONTHS ENDED SEPTEMBER 30,
Cost of Product Revenues:	2006			2005			$ Change			% Change
(dollars in thousands)
Cost of Product Revenues:
Law Enforcement	$	165		$	137		$	28		20	%
Percentage of Law Enforcement product revenue	71		%	61		%
Identification	$	333		$	470		$	(137	)	(29	)%
Percentage of Identification product revenue	25		%	43		%
Digital Photography	$	3		$	6		$	(3	)	(50	)%
Percentage of Digital Photography product revenue	4		%	4		%
Patent Licensing	—			—
Percentage of Patent Licensing product revenue	0		%	0		%
Total net product revenues	$	501		$	613		$	(112	)	(18	)%
Percentage of total product revenues	31		%	31		%

The increase in the cost of product revenues for our Law Enforcement segment as a percentage of Law Enforcement product revenues is due primarily to higher fixed costs offset by a product mix with slightly higher percentages of software only solutions for the three months ended September 30, 2006 as compared to the corresponding period in 2005.  Costs of products can vary as a percentage of product revenue from period to period depending upon product mix and the hardware content, print media consumable content and software content included in systems installed during a given period.

The decrease in the cost of product revenues for our Identification segment as a percentage of Identification product revenue is reflective of higher domestic Identification revenues containing software only solutions.   For the three months ended September 30, 2006, software and royalties comprised approximately 88% of Identification product revenues as compared to approximately 77% for the corresponding period in 2005.  Costs of products can vary as a percentage of product revenue from period to period depending upon product mix and the hardware content, print media consumable content and software content included in systems installed during a given period.

	THREE MONTHS ENDED SEPTEMBER 30,
Maintenance cost of revenues	2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance cost of revenues:
Law Enforcement	$	199		$	236		$	(37	)	(16	)%
Percentage of Law Enforcement maintenance revenue	39		%	48		%
Identification	$	14		$	19		$	(5	)	(26	)%
Percentage of Identification maintenance revenue	14		%	112		%
Digital Photography	$	—		$	—		$	—		N/A
Percentage of Digital Photography maintenance revenue	—		%	—		%	—
Total net maintenance revenues	$	213		$	255		$	(42	)	(16	)%
Percentage of total maintenance revenues	35		%	49		%

Cost of maintenance revenues as a percentage of maintenance revenues decreased due primarily to higher maintenance revenues to absorb fixed maintenance costs.  The dollar decrease during the three months ended September 30, 2006 as compared to the corresponding period in 2005 is reflective of a higher percentage of our maintenance revenues being generated from maintenance coverage on software only solutions which typicaly have lower maintenance costs than solution comprised on both software and hardware.

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	THREE MONTHS ENDED SEPTEMBER 30,
Product gross profit	2006			2005			$ Change			% Change
(dollars in thousands)
Product gross profit
Law Enforcement	$	67		$	87		$	(20	)	(23	)%
Percentage of Law Enforcement product revenue	29		%	39		%
Identification	$	995		$	637		$	358		56	%
Percentage of Identification product revenue	75		%	57		%
Digital Photography	$	72		$	144		$	(72	)	(50	)%
Percentage of Digital Photography product revenue	96		%	96		%
Patent Licensing	—			500			(500		)	100	%
Percentage of Patent Licensing product revenue	0		%	100		%
Total net product revenues	$	1,134		$	1,368		$	(234	)	(17	)%
Percentage of total product revenues	69		%	69		%

Total product gross profit decreased due primarily to the 2005 period containing $500,000 of gross profit from patent licensing revenues as compared to no such revenues being generated during the three months ended September 30, 2006.

Law Enforcement gross profit as a percentage of Law Enforcement product revenue decreased due to higher fixed costs, offset by slightly higher percentages of software and royalties in our product mix than the corresponding period of 2005.  Costs of products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and hardware content and print media consumable content included in systems installed during a given period.

Identification gross profit as a percentage of Identification product revenue increased due primarily to increased sales of identification products combined with our product mix containing higher percentages of software (which has lower costs than hardware and consumables) than the comparable period in 2005.  Costs of products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and hardware content and print media consumable content included in systems installed during a given period.

The decrease of $72,000 in gross profit from the Digital Photography product segment is reflective of lower sales of boxed product in the three months ended September 30, 2006, as compared to the corresponding period in 2005.

	THREE MONTHS ENDED SEPTEMBER 30,
Maintenance gross profit	2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance gross profit
Law Enforcement	$	315		$	258		$	57		22	%
Percentage of Law Enforcement maintenance revenue	61		%	52		%
Identification	$	89		$	(2	)	$	91		4,528	%
Percentage of Identification maintenance revenue	86		%	(12		)%
Digital Photography	$	—		$	13		$	(13	)	(100	)%
Percentage of Digital Photography maintenance revenue	—		%	100		%
Total net maintenance revenues	$	404		$	269		$	135		50	%
Percentage of total maintenance revenues	65		%	51		%

Gross margins related to maintenance revenues increased due primarily to higher maintenance revenues to absorb fixed maintenance costs.

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	THREE MONTHS ENDED SEPTEMBER 30,
Operating expenses	2006			2005			$ Change			% Change
(dollars in thousands)
General & administrative	$	1,176		$	1,162		$	14		1	%
Percentage of total net revenue	52		%	46		%
Sales and marketing	$	989		$	955		$	34		4	%
Percentage of total net revenue	44		%	38		%
Research & development	$	926		$	855		$	71		8	%
Percentage of total net revenue	41		%	34		%
Depreciation and amortization	$	59		$	147		$	(88	)	(60	)%
Percentage of total net revenue	3		%	6		%

GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses.  The increase in such expenses, as a percentage of total net revenues, is reflective of lower net revenues during the three months ended September 30, 2006 as compared to the corresponding period in 2005.  The dollar increase of $14,000 is due primarily to approximately $70,000 in stock-based compensation recorded in the three months ended September 30, 2006 pursuant to the implementation of SFAS 123(R) offset by lower personnel expenses due to reduced headcount combined with reduced costs due to the closure of our sales office in Germany.  We are continuing to focus our efforts on achieving additional future operating efficiencies by reviewing and improving upon existing business processes and evaluating our cost structure. We believe these efforts will allow us to gradually decrease our level of general and administrative expenses expressed as a percentage of total revenues.

SALES AND MARKETING.  Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales force.   The increase in such expenses for the three months ended September 30, 2006 as compared to the corresponding period in 2005 is due primarily to approximately $55,000 in stock-based compensation recorded in the three months ended September 30, 2006 pursuant to the implementation of SFAS 123(R).  We anticipate that this level of expenses for sales and marketing will continue through 2006 as we pursue large project solution opportunities.

RESEARCH AND DEVELOPMENT.  Research and development costs consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses increased due primarily to the continued development of our Biometric Engine, the development of our Personal Identity Verification (PIV) solution, the web enablement of our CCS product line, development IWS desktop security program and product enhancements to our Digital Photography software product suite utilizing contract programming services in conjunction with internal research and development resources.  Also contributing to the increase is approximately $15,000 in stock-based compensation recorded in the three months ended September 30, 2006 pursuant to the implementation of SFAS 123(R).  Our level of expenditures in research and development reflects our belief that to maintain our competitive position in markets characterized by rapid rates of technological advancement, we must continue to invest significant resources in new systems and software as well as continue to enhance existing products.

DEPRECIATION AND AMORTIZATION.  Depreciation and amortization decreased primarily due to lower amortization of intangible assets due to such assets being fully amortized.

INTEREST EXPENSE (INCOME), NET.  For the three months ended September 30, 2006, we recognized interest income of $4,000 and interest expense of $160,000. For the three months ended September 30, 2005, we recognized interest income of $32,000 and interest expense of $1,000.  Interest expense for the three months ended September 30, 2006 increased due to interest expense incurred on our secured debt financing consummated in March 2006.

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NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005.

	NINE MONTHS ENDED SEPTEMBER 30,
Net Product Revenues	2006			2005			$ Change			% Change
(dollars in thousands)
Product revenues:
Law Enforcement	$	1,310		$	855		$	455		53	%
Percentage of total net product revenue	21		%	15		%
Identification	$	4,815		$	4,108		$	707		17	%
Percentage of total net product revenue	77		%	72		%
Digital Photography	$	151		$	281		$	(130	)	(46	)%
Percentage of total net product revenue	2		%	5		%
Patent Licensing	—			500			(500		)	(100	)%
Percentage of total net product revenue	0		%	8		%
Total net product revenues	$	6,276		$	5,744		$	532		9	%

The increase in our Law Enforcement product revenues is due to the deployment of our Crime Capture System to law enforcement agencies.  We believe that continued incidents of terrorism has created heightened interest in the ability of law enforcement and other government agencies to be able to efficiently retrieve analyze and share information from their respective criminal databases.  We anticipate that these factors will increase the overall demand for our law enforcement products and software; however, we cannot predict the timing of the shift in demand.

Identification revenues generated by our San Diego and Canadian offices increased approximately $1,164,000, or 34%.  This increase in Identification product revenue is reflective of sales of our Biometric Engine and identification software products into project-oriented work and revenues generated by our IWS Desktop Security products (released in the fourth quarter of 2005), offset by decreases in products sold through our distribution channel.  Identification revenues generated by our German sales office decreased approximately $457,000.   This decrease is reflective of our decision to reorganize our German sales office by closing our existing facility in order to reduce operating expenses.  We intend to pursue project sales opportunities in areas serviced by this office through geographically dedicated sales personnel.  We are of the opinion that foreign markets formerly served by this office will embrace our identification and biometric solutions for large-scale high-end installations.

We continue to be of the opinion that government agencies and private entities will react to heightened security concerns resulting from acts of terrorism by re-evaluating and upgrading their ability to positively identify and track their citizens, employees, consultants and visitors. We anticipate that these factors will increase overall demand for our identification products; however, we cannot predict the timing of the shift in demand.

We feel that we are well positioned for participation in one or more large-scale domestic or international projects which will enable our company to achieve significant product revenue growth in our identification segment.  In the past twelve months we have retooled our identification products to enable customization for large project applications, added the biometric engine for incorporation into large scale biometric installations and reoriented our organization to direct our resources and capabilities toward establishing a foothold in the market for large-scale secure identification solutions.

The decrease in Digital Photography product revenues is due to lower sales of boxed software during the nine months ended September 30, 2006 as compared to the comparable period of 2005.  While we devoted substantial research and development resources upgrading our suite of Digital Photography product offerings in 2005 and 2006, we anticipate that because of changing market dynamics and competitive pressures, product revenues for our Digital Photography segment will not reach 2005 levels.

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	NINE MONTHS ENDED SEPTEMBER 30,
Maintenance Revenues	2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance revenues:
Law Enforcement	$	1,511		$	1,471		$	40		3	%
Percentage of total net maintenance revenue	90		%	95		%
Identification	$	172		$	36		$	136		378	%
Percentage of total net maintenance revenue	10		%	2		%
Digital Photography	$	—		$	38		$	(38	)	(100	)%
Percentage of total net maintenance revenue	0		%	3		%
Total net maintenance revenues	$	1,683		$	1,545		$	138		9	%

Law enforcement maintenance revenues increased due to the expansion of our installed base in the Law Enforcement market.

Identification maintenance revenues increased due to software maintenance on domestic identification projects.  We shifted our strategy in late 2003 to outsource international service and maintenance for hardware.  This shift has enabled us to reduce costs and focus our resources on expanding our international sales effort of Digital Identification, Biometric, Law Enforcement and Digital Photography solutions.

Our decrease in Digital Photography maintenance revenues is reflective of the expiration of software maintenance contracts on custom contract programming projects.

	NINE MONTHS ENDED SEPTEMBER 30,
Cost of Product Revenues:	2006			2005			$ Change			% Change
(dollars in thousands)
Cost of Product Revenues:
Law Enforcement	$	654		$	544		$	110		20	%
Percentage of Law Enforcement product revenue	50		%	64		%
Identification	$	1,034		$	1,514		$	(480	)	(32	)%
Percentage of Identification product revenue	21		%	37		%
Digital Photography	$	7		$	10		$	(3	)	(30	)%
Percentage of Digital Photography product revenue	5		%	3		%
Patent Licensing	—			—			—
Percentage of Patent Licensing product revenue	0		%	0		%
Total net product revenues	$	1,695		$	2,068		$	(373	)	(18	)%
Percentage of total product revenues	27		%	36		%

Total cost of product revenues decreased in dollars and as a percentage of product revenues due primarily to product mix with a greater percentage of product revenues being from sales of software only solutions (which have lower costs than sales of hardware and consumables).

Cost of product revenues for our Law Enforcement segment decreased as a percentage of Law Enforcement product revenues due to a significantly larger revenue base to absorb fixed product costs.   Costs of products also can vary as a percentage of product revenue from period to period depending upon product mix and the hardware content, print media consumable content and software content included in systems installed during a given period.

Domestically, cost of product revenues related to our Identification segment increased approximately $56,000 for the nine month period ended September 30, 2006 as compared with the corresponding period in 2005 due to significantly higher sales of software only solutions (which have lower costs than sales of hardware and consumables).  Internationally, cost of Identification product revenues decreased approximately $535,000.  This decrease is reflective of lower international Identification product sales resulting from our decision to reorganize our German sales office by closing our existing facility in order to reduce operating expenses.

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The percentage decrease in Identification cost of revenues as a percentage of Identification revenues is reflective of a higher percentage of domestic Identification revenues coming from project-oriented work in 2006 which contained higher percentages of software than project-oriented work during the comparable period of 2005.  Software and royalty content was approximately 86% of Identification product revenues for the nine months ended September 30, 2006 as compared to approximately 67% for the corresponding period of 2005.  The 2005 period included higher percentages of equipment, third-party software licenses and contract programming fees for software customization.  Costs of products also can vary as a percentage of product revenue from period to period depending upon product mix and the hardware content, print media consumable content and software content included in systems installed during a given period.

	NINE MONTHS ENDED SEPTEMBER 30,
Maintenance cost of revenues	2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance cost of revenues:
Law Enforcement	$	675		$	697		$	(22	)	(3	)%
Percentage of Law Enforcement maintenance revenue	45		%	47		%
Identification	$	43		$	53		$	(10	)	(19	)%
Percentage of Identification maintenance revenue	25		%	147		%
Digital Photography	$	—		$	—		$	—		N/A
Percentage of Digital Photography maintenance revenue	—		%	—		%
Total net maintenance revenues	$	718		$	750		$	(32	)	(4	)%
Percentage of total maintenance revenues	43		%	49		%

Cost of maintenance revenues in our Law Enforcement segment decreased despite higher Law Enforcement maintenance revenues due to a higher percentage of such maintenance revenues being generated on a maintenance base containing higher percentages of software only solutions which have lower maintenance costs than solution of both hardware and software.

	NINE MONTHS ENDED SEPTEMBER 30,
Product gross profit	2006			2005			$ Change			% Change
(dollars in thousands)
Product gross profit
Law Enforcement	$	656		$	311		$	345		111	%
Percentage of Law Enforcement product revenue	50		%	36		%
Identification	$	3,781		$	2,595		$	1,186		46	%
Percentage of Identification product revenue	79		%	63		%
Digital Photography	$	144		$	271		$	(127	)	(47	)%
Percentage of Digital Photography product revenue	96		%	97		%
Patent Licensing	—			500			(500		)	(100	)%
Percentage of Patent Licensing product revenue	—		%	100		%
Total net product revenues	$	4,581		$	3,677		$	904		25	%
Percentage of total product revenues	73		%	64		%

Total product gross profit as a percentage of product revenues increased primarily due to a higher percentage of total revenues coming from the sale of software (which has lower costs than hardware and consumables) resulting in lower cost of sales as a percentage of product revenues.

Law Enforcement gross profit increased due primarily to a significantly larger revenue base to absorb fixed product costs.  Costs of products can also vary as a percentage of product revenue from quarter to quarter depending upon product mix and hardware content and print media consumable content included in systems installed during a given period.

Identification gross profit as a percentage of Identification product revenue increased due primarily to higher domestic Identification revenues from project-oriented work containing higher percentages of software during the nine months ended September 30, 2006  than comparable project-oriented work during the nine months ended September 30, 2005.  Software and royalty content was approximately 86% of Identification product revenues for the nine months ended September 30, 2006 as compared to approximately 67% for the corresponding period of 2005. Project-oriented work in the

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2005 period contained higher percentages of equipment, third-party software licenses and contract programming fees for software customization.

Gross margins for the Digital Photography product segment decreased due to lower sales of Digital Photography software during the nine month period ended September 30, 2006 as compared to the comparable period in 2005.

	NINE MONTHS ENDED SEPTEMBER 30,
Maintenance gross profit	2006			2005			$ Change			% Change
(dollars in thousands)
Maintenance gross profit
Law Enforcement	$	836		$	773		$	63		8	%
Percentage of Law Enforcement maintenance revenue	55		%	53		%
Identification	$	129		$	(17	)	$	146		859	%
Percentage of Identification maintenance revenue	75		%	(47		)%
Digital Photography	$	—		$	38		$	(38	)	(100	)%
Percentage of Digital Photography maintenance revenue	N/A			100		%
Total net maintenance revenues	$	965		$	794		$	171		22	%
Percentage of total maintenance revenues	57		%	51		%

Gross profit related to maintenance revenues increased due primarily to higher maintenance revenues to absorb fixed maintenance costs.

	NINE MONTHS ENDED SEPTEMBER 30,
Operating expenses	2006			2005			$ Change			% Change
(dollars in thousands)
General & administrative	$	3,587		$	3,524		$	63		2	%
Percentage of total net revenue	45		%	48		%
Sales and marketing	$	3,095		$	2,719		$	376		14	%
Percentage of total net revenue	39		%	37		%
Research & development	$	2,825		$	2,342		$	483		21	%
Percentage of total net revenue	35		%	32		%
Depreciation and amortization	$	248		$	460		$	(212	)	(46	)%
Percentage of total net revenue	3		%	6		%

GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses.  The decrease in such expenses, as a percentage of total net revenues, is reflective of higher total net revenues during the nine months ended September 30, 2006 as compared to the corresponding period in 2005.  The dollar increase of $63,000 is due primarily to approximately $296,000 in stock-based compensation expense recorded in the nine months ended September 30, 2006 pursuant to the implementation of SFAS 123(R) offset by reduced costs due to the closure of our sales office in Germany and lower personnel expenses due to reduced headcount.  We are continuing to focus our efforts on achieving additional future operating efficiencies by reviewing and improving upon existing business processes and evaluating our cost structure. We believe these efforts will allow us to gradually decrease our level of general and administrative expenses expressed as a percentage of total revenues.

SALES AND MARKETING.  Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales force. Such expenses increased as a percentage of total net revenues due primarily to increases in headcount offset by reductions in payments to sales consultants and reduced trade show expenses.  Also contributing to the increase is approximately $233,000 in stock-based compensation recorded in the nine months ended September 30, 2006 pursuant to the implementation of SFAS 123(R).  The increase in headcount reflects required resources needed to pursue large project solution opportunities.  We anticipate that this level of expenses incurred for sales and marketing during the nine months ended September 30, 2006 will continue as we pursue large project solution opportunities.

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RESEARCH AND DEVELOPMENT.  Research and development costs consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses increased due primarily to the continued development of our Biometric Engine, the development of our Personal Identity Verification (PIV) solution, the web enablement of our CCS product line, development IWS desktop security program and product enhancements to our Digital Photography software product suite utilizing contract programming services in conjunction with internal research and development resources.  Also contributing to the increase is approximately $62,000 in stock-based compensation recorded in the nine months ended September 30, 2006 pursuant to the implementation of SFAS 123(R).  Our level of expenditures in research and development reflects our belief that to maintain our competitive position in markets characterized by rapid rates of technological advancement, we must continue to invest significant resources in new systems and software as well as continue to enhance existing products.

DEPRECIATION AND AMORTIZATION.  Depreciation and amortization decreased due primarily to lower amortization of intangible assets due to such assets being fully amortized.

INTEREST EXPENSE (INCOME), NET.  For the nine months ended September 30, 2006, we recognized interest income of $13,000 and interest expense of $352,000. For the nine months ended September 30, 2005, we recognized interest income of $44,000 and interest expense of $2,000.  The increase in interest expense for the nine months ended September 30, 2006 was primarily due to interest expense incurred on our secured debt financing consummated in March 2006.

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2006, we had total current assets of $1,950,000 and total current liabilities of $5,344,000, or negative working capital of $3,394,000.  At September 30, 2006, we had available cash of $276,000 and $106,000 in restricted cash securing our performance on certain software implementation contracts.

Net cash used in operating activities was $1,494,000 for the nine month period ended September 30, 2006 as compared to $4,774,000 for the corresponding period in 2005. We used cash to fund net losses of $2,980,000, excluding non-cash expenses (depreciation, amortization and stock-based compensation) of $1,457,000 for the nine months ended September 30, 2006.  We used cash to fund net losses of $3,736,000, excluding non-cash expenses (depreciation, amortization, and stock-based compensation) of $671,000 offset by non-operating income (gain on sale of subsidiary) of $233,000 for the nine months ended September 30, 2005.  For the nine months ended September 30, 2006, we generated cash of $50,000 through reduction in current assets and generated cash of $1,436,000 through increases in current liabilities and deferred revenues, excluding debt.  For the nine months ended September 30, 2005, we generated cash of $271,000 from decreases in current assets and used cash of $1,309,000 for reductions in current liabilities and deferred revenues, excluding debt.

Net cash used in investing activities was $113,000 for the nine months ended September 30, 2006.  Net cash provided by investing activities was $965,000 for the nine months ended September 30, 2005.  For the nine months ended September 30, 2006, we used cash to fund capital expenditures of computer equipment, software and furniture and fixtures of approximately $113,000.  The level of equipment purchases resulted primarily from the replacement of older equipment. For the nine months ended September 30, 2005, we used cash to fund capital expenditures of computer equipment and software, furniture and fixtures and leasehold improvements of approximately $224,000.  For the nine months ended September 30, 2005, we generated cash of $1,300,000 from the sale of our wholly-owned Singapore subsidiary, Digital Imaging Asia Pacific, offset by cash sold and direct transaction costs of $91,000.

Net cash provided by financing activities was $1,211,000 for the nine month period ended September 30, 2006 as compared to $3,254,000 for the corresponding period in 2005.  For the nine months ended September 30, 2006, we generated cash of $1,550,000 from the issuance of secured notes payable and incurred debt issuance costs of 98,000.  For the nine months ended September 30, 2006, we used cash of $215,000 for the repayment of our secured notes payable and used cash of $26,000 for the payment of dividends on our Series B Preferred Stock.   For the nine months ended September 30, 2005, we generated cash of $3,234,000 from the sale of our common stock in a private placement.  We also generated cash of $63,000 from the exercise of stock options and used cash of $17,000 for the repayments of notes payable and $26,000 for the payment of dividends on our Series B Preferred Stock. 

We conduct operations in leased facilities under operating leases expiring at various dates through 2009. In conjunction with our performance on various software installation and implementation contracts, we are contingently liable under an irrevocable letter of credit in the amount of $106,000. The letter of credit expires on December 26, 2008.  We also have secured notes payable due during the next twelve months of approximately $1,335,000.

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The report of our independent accountants included with our Annual Report as filed with the Commission on April 17, 2006, contained an explanatory paragraph regarding our ability to continue as a going concern.  We are seeking additional financing that we believe is necessary to fund our working capital requirements for at least the next twelve months in conjunction with the successful implementation of our business plan. Our business plan includes, among other things, the monitoring and controlling of operating expenses, collection of significant trade and other accounts receivables, and controlling of capital expenditures. If we are unable to secure additional financing or successfully implement our business plan, we will be required to seek funding from alternate sources and/or institute cost reduction measures. We may seek to sell equity or debt securities, secure a bank line of credit, or consider strategic alliances. The sale of equity or equity-related securities could result in additional dilution to our shareholders. There can be no assurance that additional financing, in any form, will be available at all or, if available, will be on terms acceptable to us. In addition, our ability to raise additional capital may be dependent upon our common stock continuing to be quoted on the American Stock Exchange. There can be no assurance that we will be able to satisfy the criteria for continued listing on the American Stock Exchange. Insufficient funds may require us to delay, scale back or eliminate some or all of our activities, and if we are unable to obtain additional funding there is substantial doubt about our ability to continue as a going concern.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Exchange Risk

Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates.  Changes in foreign currency exchange rates have an impact on our results of operations. Our exposure to adverse movements in foreign currency exchange rates is primarily related to our subsidiaries operating expense, primarily in Canada and Germany, denominated in the respective local currency. We currently do not enter into forward exchange contracts to hedge exposures denominated in foreign currencies and do not use derivative financial instruments for trading or speculative purposes. The effect of an immediate 10% change in foreign currency exchange rates should not have a material effect on our future operating results or cash flows; however, a long term change in foreign currency rates would likely result in increased technical support and engineering expenses. The vast majority of our sales are transacted in U. S. dollars.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.  Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended.  Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded, based upon their evaluation as of the end of the period covered by this report, that our disclosure controls and procedures are effective in ensuring that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Changes in internal controls.  There has been no change in our internal control over financial reporting during the fiscal quarter ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II

ITEM 1A.  RISK FACTORS

Our results of operations and financial condition are subject to numerous risks and uncertainties described in our Annual Report on Form 10-KSB for our fiscal year ended December 31, 2005, filed on April 17, 2006 and as amended on May 1, 2006, and incorporated herein by reference.  You should carefully consider these risk factors in conjunction with the other information contained in this report.  Should any of these risks materialize, our business, financial condition and future prospects could be negatively impacted.  As of September 30, 2006, there have been no material changes to the disclosures made on the above-referenced Form 10-KSB, as amended, except as follows:

WE HAVE HAD NET LOSSES IN OUR FIVE MOST RECENT FISCAL YEARS AND CURRENTLY HAVE STOCKHOLDER’S EQUITY OF LESS THAN $6,000,000, AND AS A RESULT, AMEX MAY CONSIDER SUSPENDING OR DELISTING OUR SECURITIES FROM THE EXCHANGE.

The AMEX Company Guide provides that AMEX will normally consider suspending dealings in, or removing from the list, securities of a company which sustains net losses in its five most recent fiscal years and has  stockholders’ equity of less than $6,000,000, unless the company has total market capitalization of at least $50,000,000, or total assets and revenue of $50,000,000. We have sustained net losses during our five most recent fiscal years, and as of the year ended December 31, 2005, our stockholders’ equity dropped to $3,365,602, from $8,266,219 for the year ended December 31, 2004. We do not meet the alternative minimum market capitalization or total asset and revenue requirements. As a result, we may be considered for suspension or delisting from AMEX. During May 2006, we received notification from AMEX that we were not in compliance with certain sections of the AMEX Company Guide.  To maintain an AMEX listing, we were required to submit a plan to AMEX which demonstrates our ability to regain compliance with the continued listing standards within a maximum of 18 months.  We submitted our plan to AMEX during June 2006.  The Listing Qualifications Department of AMEX evaluated our plan and in September 2006 notified us that we had made a reasonable demonstration in the plan of an ability to regain compliance with the continued listing standards by the end of the plan periods which AMEX determined to be Novembeer 15, 2006 for Section 1003(a)(iv) of the AMEX Company Guide and November 30, 2007 for Sections 1003(a)(i), 10033(a)(ii) and 1003(a)(iii) of the AMEX Company Guide.   Accordingly,  in September 2006, AMEX notified us that they would continue the listing of the Company subject to us making a public announcement disclosing the fact that we are not in compliance with the continued listing standards of the Exchange and that our listing is being continued pursuant to an extension and our providing certain supporting documentation of key elements of our plan.  We made the required public announcement and provided the requested information.  We are subject to periodic review to determine if we are making progress consistent with the plan.  Failure to make progress consistent with the plan or regain compliance with the continued listing standards by the end of the applicable extension periods could result in the AMEX initiating delisting proceedings pursuant to Section 1009 of the AMEX Company Guide.  There is no assurance that we will make progress consistent with the plan , or that we will be able to continue our listing on AMEX. 

WE HAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALING APPROXIMATELY $67.0 MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.

As of September 30, 2006, we had an accumulated deficit of $68.8 million, and these losses may continue in the future. We may need to raise capital to cover these losses, and financing may not be available to us on favorable terms. We expect to continue to incur significant sales and marketing, research and development, and general and administrative expenses. As a result, we will need to generate significant revenues to achieve profitability and we may never achieve profitability.

THE HOLDERS OF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS AND PRIVILEGES THAT ARE SENIOR TO THE COMMON STOCK, AND WE MAY ISSUE ADDITIONAL SHARES OF PREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON THE MARKET VALUE OF THE COMMON STOCK.

Our Board of Directors has the authority to issue a total of up to 4,000,000 shares of preferred stock and to fix the rights, preferences, privileges, and restrictions, including voting rights, of the preferred stock, which typically are senior to the rights of the common shareholders, without any further vote or action by you and the other common shareholders. Your rights will be subject to, and may be adversely affected by, the rights of the holders of the preferred stock that have been issued, or might be issued in the future. Preferred stock also could have the effect of making it more difficult for a third party to acquire a majority of the outstanding voting stock of ImageWare. This could delay, defer, or prevent a change in control. Furthermore, holders of preferred stock may have other rights, including economic rights, senior to the common stock. As a

27

result, their existence and issuance could have a material adverse effect on the market value of the common stock. We have in the past issued, and, may from time to time in the future issue, preferred stock for financing or other purposes with rights, preferences, or privileges senior to the common stock.The provisions of our outstanding Series B Preferred Stock prohibit the payment of dividends on the common stock unless the dividends on those preferred shares are first paid. In addition, upon a liquidation, dissolution or sale of ImageWare’s business, the holders of the Series B Preferred Stock will be entitled to receive, in preference to any distribution to the holders of common stock, initial distributions of $2.50 per share, plus all accrued but unpaid dividends.

Pursuant to the terms of our Series B Preferred Stock we are obligated to pay cumulative cash dividends on shares of Series B Preferred Stock from legally available funds at the annual rate of $0.2125 per share, payable in two semi-annual installments of $0.10625 each, which cumulative dividends must be paid prior to payment of any dividend on our Common Stock. As of September 30, 2006, the Company had cumulative undeclared dividends of approximately $22,000.

ITEM 6. EXHIBITS

(a)	EXHIBITS
10.1	Commercial Lease between Union Bank of California as Trustee for Quest Group Trust VII and ImageWare Systems, Inc. dated September 7, 2006
31.1	Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of the Chief Executive Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of the Chief Financial Officer provided pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	IMAGEWARE SYSTEMS, INC.
Date: November 20, 2006	By:	/s/ Wayne Wetherell
		Wayne Wetherell, Chief Financial Officer (on behalf of the Registrant and as Registrant’s Principal Financial and Accounting Officer)

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EX-10.1

Exhibit 10.1

Standard Form of OFFICE BUILDING LEASE Developed by PORTLAND METROPOLITAN ASSOCIATION OF BUILDING OWNERS AND MANAGERS

OFFICE LEASE

This lease, made and entered into at Portland, Oregon, this 7th day of September 2006 by and between

LANDLORD: Union Bank of California as Trustee for Quest Group Trust VII

and

TENANT: ImageWare Systems, Incorporated

Landlord hereby leases to Tenant the following: approximately 3,470 rentable square feet, known as Suite      (the Premises), located at 9200 S.E. Sunnybrook Blvd., Clackamas, Oregon, containing approximately 103,734 rentable square feet (the Building), calculated using a load factor of (15%) fifteen percent.

Tenant’s Proportion Share for purposes of Section 19 shall be 3.35%.

This lease is for a term of thirty-seven (37) months commencing October 1, 2006 and continuing through October 31, 2009 at a Monthly Base Rental as follows:

October 1, 2006 through October 31, 2006	Free Rent
November 1, 2006 through September 30, 2007	$6,940.00 per month ($24.00 per square foot annually)
October 1, 2007 through September 30, 2008	$7,229.17 per month ($25.00 per square foot annually)
October 1, 2008 through October 31, 2009	$7,373.75 per month ($25.50 per square foot annually)

Rent is payable in advance on the first day of each month.

Landlord and Tenant covenant and agree as follows:

1.1Delivery of Possession.

Should Landlord be unable to deliver possession of the Premises on the date fixed for the commencement of the term, commencement will be deferred and Tenant shall owe no rent until notice from Landlord tendering possession to Tenant, unless such delay is caused by Tenant Delay as defined in the Addendum.  If possession is not so tendered within 90 days following commencement of the term, unless due to Tenant Delay, then Tenant may elect to cancel this lease by notice to Landlord within 10 days following expiration of the 90-day period.  Landlord shall have no liability to Tenant for delay in delivering possession, nor shall such delay extend the term of this lease in any manner unless the parties execute a written extension agreement.

2.1Rent Payment.

Tenant shall pay the Base Rent for the Premises and any additional rent provided herein without deduction or offset.  Rent for any partial month during the lease term shall be prorated to reflect the number of days during the month that Tenant occupies the Premises.  Additional rent means amounts determined under Section 19 of this Lease and any other sums payable by Tenant to Landlord under this Lease.  Rent not paid when due shall bear interest at the rate of one-and-one-half percent per month until paid.  Landlord may at its option impose a late charge of $.05 for each $1 of rent for rent payments made more than 10 days late in lieu of interest for the first month of delinquency, without waiving any other remedies available for default.  Failure to impose a late charge shall not be a waiver of Landlord’s rights hereunder.

3.1Lease Consideration.

Upon execution of the lease Tenant has paid the Base Rent for the first full month of the lease term for which rent is payable and in addition has paid the sum of $7,373.75 as lease consideration.  Landlord may apply the lease consideration to pay the cost of performing any obligation which Tenant fails to perform within the time required by this lease, but such application by Landlord shall not be the exclusive remedy for Tenant’s default.  If the lease consideration is applied by Landlord, Tenant shall on demand pay the sum necessary to replenish the lease consideration to its original amount. To the extent not applied by Landlord to cure defaults by Tenant, the lease consideration shall be applied to costs at the end of the lease term, including but not limited to, repairs in excess of “normal wear and tear” and reconciliation of operating expenses. Any portion of the lease consideration not used to cover the end of term expenses shall be refundable. If Tenant is in default under this Lease more than two (2) times within any twelve-month period, irrespective of whether or not such default is cured, then without limiting Landlord’s other rights and remedies provided for in this Lease or at law or equity, the lease consideration shall automatically be increased by an amount equal to three (3) times the original lease consideration.

4.1Use.

Tenant shall use the Premises as business for a general office use and for no other purpose without Landlord’s written consent.  In connection with its use, Tenant shall at its expense promptly comply and cause the Premises to comply with all applicable laws, ordinances, rules and regulations of any public authority and shall not annoy, obstruct, or interfere with

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the rights of other tenants of the Building.  Tenant shall create no nuisance nor allow any objectionable fumes, noise, or vibrations to be emitted from the Premises.  Tenant shall not conduct any activities that will increase Landlord’s insurance rates for any portion of the Building or that will in any manner degrade or damage the reputation of the Building.

4.2Equipment.

Tenant shall install in the Premises only such office equipment as is customary for general office use and shall not overload the floors or electrical circuits of the Premises or Building or alter the plumbing or wiring of the Premises or Building.  Landlord must approve in advance the location of and manner of installing any wiring or electrical, heat generating or communication equipment or exceptionally heavy articles.  All telecommunications equipment, conduit, cables and wiring, additional dedicated circuits and any additional air conditioning required because of heat generating equipment or special lighting installed by Tenant shall be installed and operated at Tenant’s expense.  Landlord shall have no obligation to permit the installation of equipment by any telecommunications provider whose equipment is not then servicing the Building.

4.3Signs.

No signs, awnings, antennas, or other apparatus shall be painted on or attached to the Building or anything placed on any glass or woodwork of the Premises or positioned so as to be visible from outside the Premises without Landlord’s written approval as to design, size, location, and color.  All signs installed by Tenant shall comply with Landlord’s standards for signs and all applicable codes and all signs and sign hardware shall be removed upon termination of this lease with the sign location restored to its former state unless Landlord elects to retain all or any portion thereof.

5.1Utilities and Services.

Landlord will furnish water and electricity to the Building at all times and will furnish heat and air conditioning (if the Building is air conditioned) during the normal Building hours as established by Owner.  Janitorial service will be provided in accordance with the regular schedule of the Building, which schedule and service may change from time to time.  Tenant shall comply with all government laws or regulations regarding the use or reduction of use of utilities on the Premises.  Interruption of services or utilities shall not be deemed an eviction or disturbance of Tenant’s use and possession of the Premises, render Landlord liable to Tenant for damages, or relieve Tenant from performance of Tenant’s obligations under this lease.  Landlord shall take all reasonable steps to correct any interruptions in service.  Electrical service furnished will be 110 volts unless different service already exists in the Premises.  Tenant shall provide its own surge protection for power furnished to the Premises.

5.2Extra Usage.

If Tenant uses excessive amounts of utilities or services of any kind because of operation outside of normal Building hours, high demands from office machinery and equipment, nonstandard lighting, or any other cause.  Landlord may impose a reasonable charge for supplying such extra utilities or services, which charge shall be payable monthly by Tenant in conjunction with rent payments.  In case of dispute over any extra charge under this paragraph, Landlord shall designate a qualified independent engineer whose decision shall be conclusive on both parties.  Landlord and Tenant shall each pay one-half of the cost of such determination.

5.3Security.

Landlord may but shall have no obligation to provide security service or to adopt security measures regarding the Premises, and Tenant shall cooperate with all reasonable security measures adopted by Landlord.  Tenant may install a security system within the leased Premises with Landlord’s written consent, which will not be unreasonably withheld.  Landlord will be provided with an access code to any security system and shall not have any liability for accidentally setting off Tenant’s security system.  Landlord may modify the type or amount of security measures or services provided to the Building or the Premises at any time.

6.1Maintenance and Repair.

Landlord shall have no liability for failure to perform required maintenance and repair unless written notice of such maintenance or repair is given by Tenant and Landlord fails to commence efforts to remedy the problem in a reasonable time and manner.  Landlord shall have the right to erect scaffolding and other apparatus necessary for the purpose of making repairs, and Landlord shall have no liability for interference with Tenant’s use because of repairs and installations.  Tenant shall have no claim against Landlord for any interruption or reduction of services or interference with Tenant’s occupancy, and no such interruption or reduction shall be construed as a constructive or other eviction of Tenant.  Repair of damage caused by negligent or intentional acts or breach of this lease by Tenant, its employees or invitees shall be at Tenant’s expense.

6.2Alterations.

Tenant shall not make any alterations, additions, or improvements to the Premises, change the color of the interior, or install any wall or floor covering without Landlord’s prior written consent which may be withheld in Landlord’s sole discretion.  Any such improvements, alterations, wiring, cables or conduit installed by Tenant shall at once become part of the Premises and belong to Landlord except for removable machinery and unattached movable trade fixtures.  Landlord may at its option require that Tenant remove any improvements, alterations, wiring, cables or conduit installed by or for Tenant and restore the Premises to the original condition upon termination of this lease.  Landlord shall have the right to approve the contractor used by Tenant for any work in the Premises, and to post notices of nonresponsibility in connection with work being performed by Tenant in the Premises.  Work by Tenant shall comply with all laws then applicable to the Premises.

7.1Indemnity.

Tenant shall not allow any liens to attach to the Building or Tenant’s interest in the Premises as a result of its activities.  Tenant shall indemnify and defend Landlord and its managing agents from any claim, liability, damage, or loss occurring on the Premises, arising out of any activity by Tenant, its agents, or invitees or resulting from Tenant’s failure to comply

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with any term of this lease.  Neither Landlord nor its managing agent shall have any liability to Tenant because of loss or damage to Tenant’s property or for death or bodily injury caused by the acts or omissions of other Tenants of the Building, or by third parties (including criminal acts).

7.2Insurance.

Tenant shall carry liability insurance with limits of not less than two Million Dollars ($2,000,000) combined single limit bodily injury and property damage which insurance shall have an endorsement naming Landlord and Landlord’s managing agent, if any, as an additional insured, cover the liability insured under paragraph 7.1 of this lease and be in form and with companies reasonably acceptable to Owner.  Prior to occupancy, Tenant shall furnish a certificate evidencing such insurance, which shall state that the coverage shall not be cancelled or materially changed without 10 days advance notice to Landlord and Landlord’s managing agent, if any.  A renewal certificate shall be furnished at least 10 days prior to expiration of any policy.

8.1Fire or Casualty.

“Major Damage” means damage by fire or other casualty to the Building or the Premises which causes the Premises or any substantial portion of the Building to be unusable, or which will cost more than 25 percent of the pre-damage value of the Building to repair, or which is not covered by insurance.  In case of Major Damage, Landlord may elect to terminate this lease by notice in writing to the Tenant within 30 days after such date.  If this lease is not terminated following Major Damage, or if damage occurs which is not Major Damage, Landlord shall promptly restore the Premises to the condition existing just prior to the damage.  Tenant shall promptly restore all damage to tenant improvements or alterations installed by Tenant or pay the cost of such restoration to Landlord if Landlord elects to do the restoration of such improvements.  Rent shall be reduced from the date of damage until the date restoration work being performed by Landlord is substantially complete, with the reduction to be in proportion to the area of the Premises not useable by Tenant.

8.2Waiver of Subrogation.

Tenant shall be responsible for insuring its personal property and trade fixtures located on the Premises and any alterations or tenant improvements it has made to the Premises.  Neither Landlord, its managing agent nor Tenant shall be liable to the other for any loss or damage caused by water damage, sprinkler leakage, or any of the risks that are or could be covered by a special all risk property insurance policy, or for any business interruption, and there shall be no subrogated claim by one party’s insurance carrier against the other party arising out of any such loss.  This waiver is binding only if it does not invalidate the insurance coverage of either party hereto.

9.1Eminent Domain.

If a condemning authority takes title by eminent domain or by agreement in lieu thereof to the entire Building or a portion sufficient to render the Premises unsuitable for Tenant’s use, then either party may elect to terminate this lease effective on the date that possession is taken by the condemning authority.  Rent shall be reduced for the remainder of the term in an amount proportionate to the reduction in area of the Premises caused by the taking.  All condemnation proceeds shall belong to Landlord, and Tenant shall have no claim against Landlord or the condemnation award because of the taking.

10.1Assignment and Subletting.

This lease shall bind and inure to the benefit of the parties, their respective heirs, successors, and assigns, provided that Tenant shall not assign its interest under this lease or sublet all or any portion of the Premises without first obtaining Landlord’s consent in writing.  This provision shall apply to all transfers by operation of law including but not limited to mergers and changes in control of Tenant.  No assignment shall relieve Tenant of its obligation to pay rent or perform other obligations required by this lease, and no consent to one assignment or subletting shall be a consent to any further assignment or subletting.  Landlord shall not unreasonably withhold its consent to any assignment or subletting provided the effective rental paid by the subtenant or assignee is not less than the current scheduled rental rate of the Building for comparable space and the proposed Tenant is compatible with Landlord’s normal standards for the Building.  If Tenant proposes a subletting or assignment to which Landlord is required to consent under this paragraph, Landlord shall have the option of terminating this lease and dealing directly with the proposed subtenant or assignee, or any third party.  If an assignment or subletting is permitted, any cash profit, or the net value of any other consideration received by Tenant as a result of such transaction shall be paid to Landlord promptly following its receipt by Tenant.  Tenant shall pay any costs incurred by Landlord in connection with a request for assignment or subletting, including reasonable attorneys’ fees.

11.1Default.

Any of the following shall constitute a default by Tenant under this lease:

(a)Tenant’s failure to pay rent or any other charge under this lease within 10 days after it is due, or failure to comply with any other term or condition within 20 days following written notice from Landlord specifying the noncompliance.  If such noncompliance cannot be cured within the 20-day period, this provision shall be satisfied if Tenant commences correction within such period and thereafter proceeds in good, faith and with reasonable diligence to effect compliance as soon as possible.  Time is of the essence of this lease.

(b)Tenant’s insolvency, business failure or assignment for the benefit of its creditors.  Tenant’s commencement of proceedings under any provision of any bankruptcy or insolvency law or failure to obtain dismissal of any petition filed against it under such laws within the time required to answer; or the appointment of a receiver for all or any portion of Tenant’s properties or financial records.

(c)Assignment or subletting by Tenant in violation of paragraph 10.1.

(d)Vacation or abandonment of the Premises without the written consent of Landlord or failure to occupy the Premises within 20 days after notice from Landlord tendering possession.

11.2Remedies for Default.

In case of default as described in paragraph 11.1 Landlord shall have the right to the following remedies, which are intended to be cumulative and in addition to any other remedies provided under applicable law:

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(a)Landlord may at its option terminate the lease by notice to Tenant.  With or without termination, Landlord may retake possession of the Premises and may use or relet the Premises without accepting a surrender or waiving the right to damages.  Following such retaking of possession, efforts by Landlord to relet the Premises shall be sufficient if Landlord follows its usual procedures for finding tenants for the space at rates not less than the current rates for other comparable space in the Building.  If Landlord has other vacant space in the Building, prospective tenants may be placed in such other space without prejudice to Landlord’s claim to damages or loss of rentals from Tenant.

(b)Landlord may recover all damages caused by Tenant’s default which shall include an amount equal to rentals lost because of the default, lease commissions paid for this lease, and the unamortized cost of any tenant improvements installed by Landlord to meet Tenant’s special requirements.  Landlord may sue periodically to recover damages as they occur throughout the lease term, and no action for accrued damages shall bar a later action for damages subsequently accruing.  Landlord may elect in any one action to recover accrued damages plus damages attributable to the remaining term of the lease.  Such damages shall be measured by the difference between the rent under this lease and the reasonable rental value of the Premises for the remainder of the term, discounted to the time of judgement at the prevailing interest rate on judgements.

(c)Landlord may make any payment or perform any obligation, which Tenant has failed to perform, in which case Landlord shall be entitled to recover from Tenant upon demand all amounts so expended, plus interest from the date of the expenditure at the rate of one-and-one-half percent per month.  Any such payment or performance by Landlord shall not waive Tenant’s default.

12.1Surrender.

On expiration or early termination of this lease Tenant shall deliver all keys to Landlord and surrender the Premises vacuumed, swept, and free of debris and in the same condition as at the commencement of the term subject only to reasonable wear from ordinary use.  Tenant shall remove all of its furnishings and trade fixtures that remain its property and repair all damage resulting from such removal.  Failure to remove shall be an abandonment of the property, and Landlord may dispose of it in any manner without liability.  If Tenant fails to vacate the Premises when required, including failure to remove all its personal property, Landlord may elect either: (i) to treat Tenant as a tenant from month to month, subject to the provisions of this lease except that rent shall be one-and-one-half times the total rent being charged when the lease term expired, and any option or other rights regarding extension of the term or expansion of the Premises shall no longer apply; or (ii) to eject Tenant from the Premises and recover damages caused by wrongful holdover.

13.1Regulations.

Landlord shall have the right but shall not be obligated to make, revise and enforce regulations or policies consistent with this lease for the purpose of promoting safety, health (including moving, use of common areas and prohibition of smoking), order, economy, cleanliness, and good service to all tenants of the Building.  All such regulations and policies shall be complied with as if part of this lease.

14.1Access.

During times other than normal Building hours Tenant’s officers and employees or those having business with Tenant may be required to identify themselves or show passes in order to gain access to the Building.  Landlord shall have no liability for permitting or refusing to permit access by anyone.  Landlord may regulate access to any Building elevators outside of normal Building hours.  Landlord shall have the right to enter upon the Premises at any time by passkey or otherwise to determine Tenant’s compliance with this lease, to perform necessary services, maintenance and repairs or alterations to the Building or the Premises, or to show the Premises to any prospective tenant or purchasers.  Except in case of emergency such entry shall be at such times and in such manner as to minimize interference with the reasonable business use of the Premises by Tenant.

14.2Furniture and Bulky Articles.

Tenant shall move furniture and bulky articles in and out of the Building or make independent use of the elevators only at times approved by Landlord following at least 24 hours written notice to Landlord of the intended move.  Landlord will not unreasonably withhold its consent under this paragraph.

15.1Notices.

Notices between the parties relating to this lease shall be in writing, effective when delivered, or if mailed, effective on the second day following mailing, postage prepaid, to the address for the party stated in this lease or to such other address as either party may specify by notice to the other.  Notice to Tenant may always be delivered to the Premises. Rent shall be payable to Landlord at the same address and in the same manner, but shall be considered paid only when received.

16.1Subordination and Attornment.

This lease shall be subject to and subordinate to any mortgages, deeds of trust, or land sale contracts (here after collectively referred to as encumbrances) now existing against the Building.  At Landlord’s option this lease shall be subject and subordinate to any future encumbrance hereafter placed against the Building (including the underlying land) or any modifications of existing encumbrances, and Tenant shall execute such documents as may reasonably be requested by Landlord or the holder of the encumbrance to evidence this subordination.  If any encumbrance is foreclosed, then if the purchaser at foreclosure sale gives to Tenant a written agreement to recognize Tenant’s lease, Tenant shall attorn to such purchaser and this Lease shall continue.

16.2Transfer of Building.

If the Building is sold or otherwise transferred by Landlord or any successor, Tenant shall attorn to the purchaser or transferee and recognize it as the lessor under this lease, and, provided the purchaser or transferee assumes all obligations hereunder, the transferor shall have no further liability hereunder.

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16.3Estoppels.

Either party will within 10 days after notice from the other execute, acknowledge and deliver to the other party a certificate certifying whether or not this lease has been modified and is in full force and effect; whether there are any modifications or alleged breaches by the other party; the dates to which rent has been paid in advance, and the amount of any security deposit or prepaid rent; and any other facts that may reasonably be requested.  Failure to deliver the certificate within the specified time shall be conclusive upon the party of whom the certificate was requested that the lease is in full force and effect and has not been modified except as may be represented by the party requesting the certificate.  If requested by the holder of any encumbrance, or any ground lessor, Tenant will agree to give such holder or lessor notice of and an opportunity to cure any default by Landlord under this lease.

17.1 Attorneys’ Fees.

In any litigation arising out of this lease, the prevailing party shall be entitled to recover attorneys’ fees at trial and on any appeal.  If Landlord incurs attorneys’ fees because of a default by Tenant, Tenant shall pay all such fees whether or not litigation is filed.

18.1Quiet Enjoyment.

Landlord warrants that so long as Tenant complies with all terms of this lease it shall be entitled to peaceable and undisturbed possession of the Premises free from any eviction or disturbance by Landlord.  Neither Landlord nor its managing agent shall have any liability to Tenant for loss or damages arising out of the acts, including criminal acts, of other tenants of the Building or third parties, nor any liability for any reason which exceeds the value of its interest in the Building.

19.1Additional Rent-Tax Adjustment.

Whenever for any July 1 — June 30 tax year the real property taxes levied against the Building and its underlying land exceed those levied for the 2005-2006 tax year, then the monthly rental for the next succeeding calendar year shall be increased by one-twelfth of such tax increase times Tenant’s Proportionate Share.  “Real property taxes” as used herein means all taxes and assessments of any public authority against the Building and the land on which it is located, the cost of contesting any tax and any form of fee or charge imposed on Landlord as a direct consequence of owning or leasing the Premises, including but not limited to rent taxes, gross receipt taxes, leasing taxes, or any fee or charge wholly or partially in lieu of or in substitution for ad valorem real property taxes or assessments, whether now existing or hereafter enacted.  If any portion of the Building is occupied by a tax-exempt tenant so that the Building has a partial tax exemption under ORS 307.112 or a similar statute, then real property taxes shall mean taxes computed as if such partial exemption did not exist.  If a separate assessment or identifiable tax increase arises because of improvements to the Premises, then Tenant shall pay 100 percent of such increase.

19.3Operating Expense Adjustment.

Tenant shall pay as additional rent Tenant’s Proportionate Share of the amount by which operating expenses for the Building increase over those experienced by Landlord during the calendar year 2006 (base year).  Effective January 1 of  each year Landlord shall estimate the amount by which operating expenses are expected to increase, if any, over those incurred in the base year.  Monthly rental for that year shall be increased by one-twelfth of Tenant’s share of the estimated increase.  Following the end of each calendar year, Landlord shall compute the actual increase in operating expenses and bill Tenant for any deficiency or credit Tenant with any excess collected.  As used herein “operating expenses” shall mean all costs of operating and maintaining the Building as determined by standard real estate accounting practice, including, but not limited to:  all water and sewer charges; the cost of natural gas and electricity provided to the Building; janitorial and cleaning supplies and services; administration costs and management fees; superintendent fees; security services, if any; insurance premiums; licenses, permits for the operation and maintenance of the Building and all of its component elements and mechanical systems; the annual amortized capital improvement cost (amortized over such a period as Landlord may select but not shorter than the period allowed under the Internal Revenue Code and at a current market interest rate) for any capital improvements to the Building required by any governmental authority or those which have a reasonable probability of improving the operating efficiency of the Building. In the event the Building is not at least ninety-five percent (95%) occupied, the Landlord will gross up all Operating Expenses for the base year and the comparison year to the level they would have been at had the Building been ninety-five percent (95%) occupied.

19.4Disputes.

If Tenant disputes any computation of additional rent or rent adjustment under paragraphs 19.1 through 19.3 of this lease, it shall give notice to Landlord not later than one year after the notice from Landlord describing the computation in question, but in any event not later than 30 days after expiration or earlier termination of this lease.  If Tenant fails to give such a notice, the computation by Landlord shall be binding and conclusive between the parties for the period in question.  If Tenant gives a timely notice, the dispute shall be resolved by an independent certified public accountant selected by Landlord whose decision shall be conclusive between the parties.  Each party shall pay one-half of the fee for making such determination except that if the adjustment in favor of Tenant does not exceed ten percent of the escalation amounts for the year in question, Tenant shall pay (i) the entire cost of any such third-party determination; and (ii) Landlord’s out-of-pocket

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costs and reasonable expenses for personnel time in responding to the audit.  Nothing herein shall reduce Tenant’s obligations to make all payments as required by this lease.

20.1Complete Agreement; No Implied Covenants.

This lease and the attached Exhibits and Schedules if any, constitute the entire agreement of the parties and supersede all prior written and oral agreements and representations and there are no implied covenants or other agreements between the parties except as expressly set forth in this Lease.  Neither Landlord nor Tenant is relying on any representations other than those expressly set forth herein.

20.2Space Leased AS IS.

Unless otherwise stated in this Lease, the Premises are leased AS IS in the condition now existing with no alterations or other work to be performed by Landlord.

20.3Captions.

The titles to the paragraphs of this lease are descriptive only and are not intended to change or influence the meaning of any paragraph or to be part of this lease.

20.4Nonwaiver.

Failure by Landlord to promptly enforce any regulation, remedy or right of any kind under this Lease shall not constitute a waiver of the same and such right or remedy may be asserted at any time after Landlord becomes entitled to the benefit thereof notwithstanding delay in enforcement.

20.5Exhibits.

The following Exhibits are attached hereto and incorporated as a part of this lease:

Exhibit A	The Premises
Exhibit B	Description of Land
Exhibit C	Space Plan
Exhibit D	Building Standards
Exhibit E	Janitorial Specifications and HVAC Holiday Schedule
Exhibit F	Rules and Regulations for Office Lease
Addendum A	Additional Provisions
Billing Information

IN WITNESS WHEREOF, the duly authorized representatives of the parties have executed this lease as of the day and year first written above.

LANDLORD: Union Bank of California as Trustee for Quest Group Trust VII

By:
	Jason Kaufman
Title:	Assistant Vice President

Address for notices:	Address for rent:
Quest Property Management	Quest Group Trust VII
One SW Columbia, Suite 435	P.O. Box 5037-221
Portland, Oregon 97258	Portland, Oregon 97208

TENANT: as Trustee for Quest Group Trust VII

By:

Title:

Address for notices:

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EXHIBIT A

The Premises

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EXHIBIT B

Description of the Land

PARCEL I:

A tract of land located in the Northwest one-quarter of Section 4, Township 2 South, Range 2 East of the Willamette Meridian, in the County of Clackamas and State of Oregon, and being more particularly described as follows:

Commencing at an iron pipe at the intersection of the Northwest line of the William T. Matlock Donation Land Claim No. 37 and the Northwesterly line of that parcel of land described in Deed Records 71-18673, Clackamas County Deed Records, being the Northwesterly line of State Highway I-205, said iron pipe lying South68o 09’ 42” West 698.90 feet distance from the Northerly corner of the William T. Matlock Donation Land Claim No. 37; thence South 68o 09’ 42” West 613.59 feet to the true point of beginning; thence South 68o 09’ 42” West 106.34 feet; thence North 53o 27’ 55” West 136.44 feet; thence North 79o 44’ 56” West 274.14 feet; thence North 60o 49’ 33” West 157.21 feet; thence North 16o 04’ 47” East 148.56 feet; thence South 85o 07’ 07”  West 127.83 feet; thence 01o 11’ 32” West 125.27 feet to the Southwest corner of that tract of land described in Warranty Deed to Clackamas Water District, Warranty Deed recorded July 2, 1982, Fee No. 82-18306; thence along the Southerly line of said Water District Tract North 89o 48’ 44” East 100.02 feet to the Southeast corner of said Water District Tract; thence along the Easterly line of said Water District Tract North 01o 14’ 54” West 97.79 feet; thence North 89o 52’ 24” East 246.94 feet; thence South 01o 01’ 11” East 160.00 feet; thence North 88o 58’ 49” East 246.94 feet; thence South 01o 01’ 11” East 200.00 feet; thence North 88o 58’ 49” East 65.00 feet; thence South 01o 01’ 11” East 65.00 feet; thence North 88o 58’ 49” East 150.00 feet; thence South 01o 01’ 11” East 104.15 feet to the true point of beginning.

EXCEPTING THEREFROM that certain tract conveyed to Sisters of Providence in Oregon doing business as Providence Medical Center, by Deed recorded as Fee No. 93-01240, Clackamas County Deed Records.

ALSO EXCEPTING THEREFROM that portion lying Westerly of the Easterly line of Oak Bluff Avenue as described in Deed recorded as Recorder’s Fee No. 96-074103.

AND FURTHER EXCEPTING THEREFROM any portion of the above property described in Bargain and Sale Deed recorded September 18, 1998, as Recorder’s Fee No. 98-087434.

PARCEL II:

A track of land located in the Northwest one-quarter of Section 4, Township 2 South, Range 2 East of the Willamette Meridian, in the County of Clackamas and State of Oregon, and being more particularly described as follows:

Commencing at an iron pipe at the intersection of the Northwest line of the William T. Matlock Donation land Claim No. 37 and the Northwesterly line of that parcel of land described in Deed Records 71-18673, Clackamas County Deed Records, being the Northwesterly line of State Highway I-205, said iron pipe lying South 68o 09’ 42” West 698.90 feet distance from the Northerly corner of the William T. Matlock Donation Land Claim No. 37; thence South 68o 09’ 42” West 613.59 feet and North 01o 01’ 11” West 104.15 feet to the true point of beginning; thence South 88o 58’ 49” West 150.00 feet; thence North 01o 01’ 11” West 65.00 feet; thence South 88o 58’ 49” West 65.00 feet; thence North 01o 01’ 11” West 200.00 feet;  thence South 88o 58’ 49” West 135.00 feet; thence North 01o 01’ 11” West 160.00 feet; thence North 89o 52’ 24” East 265.03 feet; thence South 01o 01’ 11” East 355.87 feet; thence North 88o 58’ 49” East 85.00 feet; thence South 01o 01’ 11” East 65.00 feet to the true point of beginning.

EXCEPTING THEREFROM that certain tract conveyed to Sisters of Providence in Oregon doing business as Providence Medical Center, by Deed recorded as Fee No. 93-01240, Clackamas County Deed Records.

AND FURTHER EXCEPTING THEREFROM any portion of the above property described in Bargain and Sale Deed recorded September 18, 1998 as Recorder’s Fee No. 98-087434.

PACRCEL III:

An access easement including the terms and provisions created by instrument recorder September 15, 1998, as Recorder’s Fee No. 98-085958, over the following described land:

A parcel of land lying in the Northwest one-quarter of Section 4, Township 2 South, Range 2 East, of the Willamette Meridian, in the County of Clackamas and State of Oregon and being a portion of and lying within that property deeded to Sisters of Providence in Oregon and DBA Providence via Document No. 93-01240, recorded January 8, 1993, said parcel being that portion of said Providence property included in a strip of land variable in width, lying on the Southerly side of the relocated center line of Sunybrook Road, which center line is described in Parcel I of that instrument recorded September 15, 1998, as Recorder’s Fee No. 98-085958.

The widths in meters of the strip of land above referred to are as follows:

Station to Station	Width on Southerly Side of Center Line
11+229.765  11+230.098	19.825m (65.04’) in a straight line to 41.00m (134.51’)
11+230.098  11+250.00	41.00m (134.51’) parallel to center line
11+250.00  11+250.00	41.00 (134.51’) in a straight line to 19.821M (65.03’)

EXCEPT THEREFROM that portion of said property lying within the existing right-of-way of Sunnybrook Road.

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EXHIBIT C

The Space Plan

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EXHIBIT D

Building Standards

1.SUITE ENTRY DOOR:  Solid core hardwood, cherry veneer entry doors from core area.

2.  CEILING:  Building standard 2’ x 4’, U.S.G. #3575 acoustical tile in a white 15/16 exposed flange grid ceiling system. Ceiling height first floor 9’-10” minimum; second through fourth floors 9’-00.

3.WINDOW COVERING:  Building standard vertical blinds on all exterior windows.

4.INTERIOR WALLS: 2-1/2” metal stud with one layer 5/8” gypsum board each side taped and finished smooth.

5.WALL PAINT:  Acrylic satin latex enamel, building standard color.  Manufacturer is Rodda Laysen eggshell or Miller 6200 series or equal.

6.INTERIOR OFFICE DOORS:  Building standard, cherry solid core door with latch set.  Hardware finish is bright chrome.

7.LIGHTING:   One fixture every 80 square feet, not to exceed Oregon Energy Code.

8.  FLOOR COVERING:  Building standard carpeting will be 32 ounce, anti-static direct, glue down carpet, solid color, plush-cut pile by Designweave.

9.HEATING, VENTILATING AND AIR CONDITIONING:  Ductwork, supply, return grilles and thermostats; separate zones for conference rooms, corner offices and private offices. Perimeter zones to be fan powered VAV with electric reheat.  Interior zones to be cooling only VAV.  No cross zoning between tenants or between interior and perimeter zones.  All lunch rooms and break rooms to have exhaust fans.

10.ELECTRICAL OUTLETS:   Building standard wall duplex outlets at the rate of two (2) for each 150 square feet of leased area on a shared circuit, not to exceed eight.

11.TELEPHONE OUTLETS:   Building standard telephone outlets consist of a four square box with a ¾” conduit stubbed above ceiling at two per 250 square feet of leased area.

12.PLUMBING:  None included in building standard items within Tenant’s leased area but available at Tenant’s expense.  Restrooms, showers and water fountains provided in common areas by Landlord.

13.SUITE IDENTIFICATION:  Landlord will determine suite number identification per building standard graphic system.

14.SPACE PLANNING:  All necessary space planning to design the building standards.

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EXHIBIT E

Janitorial Specifications and HVAC Holiday Schedule

TENANT OFFICE AREA

FIVE TIMES PER WEEK: Sunday through Thursday evenings.

1. Gather waste paper and place for disposal.

2.Empty and wash ashtrays.

3.Sweep and/or dust mop floor surfaces.

4.Vacuum clean all carpeted traffic areas.  Spot clean as necessary.

5.Dust chairs, tables and other office furniture, but not desk.

6.Dust lights and other flat surfaces within reach.

7.Dust counters, file cabinets and telephones.

8.Properly arrange furniture in offices.

9.Remove fingerprints from doors and partition glass.

10.Check doors and windows upon completion of work.

11.Polish brass push plates.

12.Sweep stairways.

13.Leave only designated night lights on.

ONE TIME PER WEEK

1.Dust high partition ledges and moldings.

2.Clean door kick plates and trashcans.

3.Dust panel walls and wood doors.

4.Edge all carpeted areas on a rotating basis.

ONE TIME PER MONTH

Clean, wax and polish composition floors.

ONCE EVERY SIX MONTHS

Clean exterior of perimeter windows.

ONE TIME PER YEAR

Clean interior of perimeter windows and relites in tenant spaces

RESTROOMS

FIVE TIMES PER WEEK

1.Clean restrooms, wash basins, dispensers and chrome platings.

2.Clean mirrors and frames.

3.Wet mop floors.

4.Sanitize toilets, toilet seats and urinals.

5.Dust ledges and partitions.

6.Refill all dispensers.

ONE TIME PER MONTH

Wash walls and doors.

ONE TIME PER YEAR

Machine scrub and seal restroom floors.

LOBBIES, STAIRWAYS, AND ELEVATORS

FIVE TIMES PER WEEK

1.Wet mop or vacuum main entrance lobby floors.

2.Spot wash walls and doors.

3.Vacuum elevator.

Please Initial Landlord                 Tenant                

11

4.Damp wipe or dust elevator walls, and polish call button plates.

5.Clean elevator doors and thresholds.

6.Check exit doors and lights in stairways and corridors.

7.Clean and polish main entrance doors.

ONE TIME PER WEEK

Clean elevator walls and ceiling.

ONE TIME PER  MONTH

1.Dust high ledges and partitions.

2.Wet mop all stairs.

3.Clean and polish composition floors.

ONE TIME PER YEAR

Professionally clean common area carpet.

HVAC HOLIDAY SCHEDULE

The HVAC will not be in operation on the following holidays:

New Years Day

Memorial Day

Independence Day / July 4

Labor Day

Veterans Day

Thanksgiving Day

Christmas Day

A schedule setting forth the days of observance of the foregoing holidays will be furnished by the Lessor upon request.

Please Initial Landlord                 Tenant                

12

EXHIBIT F

Rules and Regulations For Office Lease

GENERAL RULES

1.   Tenant shall not suffer or permit the obstruction of any Common Areas, including but not limited to driveways, walkways and stairways.

2.   Landlord reserves the right to refuse access to any persons Landlord in good faith judges to be a threat to the safety, reputation, or property of the Project and its occupants.

3.   Tenant shall not make or permit any noise or odors that annoy or interfere with other lessees or persons having business within the Project.

4.   Tenant shall not keep animals or birds within the premises, and shall not bring bicycles, motorcycles, skateboards, or other vehicles into areas not designated as authorized for same.

5.   Tenant shall not make, suffer or permit litter except in appropriate receptacles for that purpose.

6.   Tenant shall not alter any lock or install new or additional locks or bolts without prior authorization from Landlord.

7.   Tenant shall be responsible for the inappropriate use of any toilet rooms plumbing, or other utilities.  No foreign substances of any kind are to be inserted therein.

8.   Tenant shall not deface the walls, partitions, or other surfaces of the premises or Project.

9.   Tenant shall not suffer or permit anything in or around the premises or Building(s) that causes excessive vibration or floor loading in any part of the Project.

10. Tenant shall not employ any service or contractor for services or work to be performed within the premises, except as approved by the Landlord.

11. Landlord reserves the right to close and lock the Project on Saturdays, Sundays, and legal holidays, and on other days between the hours of 6 P.M. and 8 A.M. of the following day.  If Tenant uses the Premises during such periods, Tenant shall be responsible for securely locking any doors it may have opened for entry.

12. Tenant shall return all keys at the termination of its tenancy and shall be responsible for the cost of replacing any keys that are lost.

13. No Tenant, employee or invitee shall go upon the roof of the Building(s).

14. Tenant shall not suffer or permit smoking or carrying of lighted cigars or cigarettes in areas reasonably designated by Landlord or by applicable governmental agencies as non-smoking areas.

15. Tenant shall not use any method of heating or air conditioning other than as provided by Landlord.

16. Tenant shall not install, maintain, or operate any vending machines on the premises without Landlord ‘s written consent.

17. The Premises shall not be used for lodging.

18. Tenant shall comply with all safety, fire protection and evacuation regulations established by Landlord or any governmental agency.

19. Landlord reserves the right to waive any one of these rules or regulations, and/or as to any particular Tenant, and any such waiver shall not constitute a waiver of any other rule or regulation or any subsequent application thereof to such Tenant.

20. Tenant assumes all risks from theft or vandalism and agrees to keep its Premises locked as may be required.

21. Landlord reserves the right to make such other reasonable rules and regulations as it may from time to time deem necessary for the appropriate operation and safety of the Project and its occupants. Tenant agrees to abide by these and such rules and regulations.

PARKING RULES

1.     Parking areas shall be used only for parking by vehicles which have a “Quest Property Management Parking Permit”, if applicable.

2.     Vehicles permitted shall be no longer than full size passenger automobiles or pick up trucks and shall herein be called “Permitted Size Vehicles.”

3.     Tenant shall not permit or allow any vehicles that belong to or are controlled by Tenant or Tenant ‘s employees, suppliers, shippers, customers, or invitees to be loaded, unloaded, or parked in areas other than those designated by Landlord for such activities.

4.     Landlord reserves the right to relocate all or a part of parking spaces from floor to floor within one floor, and/or to reasonably adjacent offsite locations(s), and to reasonably allocate them between compact and standard size spaces, as long as the same complies with applicable laws, ordinances, and regulations.

5.     Users of the parking area will obey all posted signs and park only in the areas designated for vehicle parking.

6.     Unless other wise instructed, every person using the parking area is required to park and lock his own vehicle. Landlord will not be responsible for any damage to vehicles, injury to persons, or loss of property, all of which the party using the parking area assumes risks.

7.     The maintenance, washing, waxing or cleaning of vehicles in the parking area(s) or Common Area is prohibited.

8.     Tenant shall be responsible for seeing that all of its employees, agents, and invitees comply with the applicable parking rules, regulations, laws and agreements.

9.     Landlord reserves the right to modify these rules and/or adopt such other reasonable and non-discriminatory rules and regulations, laws and agreements.

10.   Such parking use as is herein provided is intended merely as a license only and no bailment is intended or shall be created hereby.

Please Initial Landlord                 Tenant                

13

ADDENDUM A

Addendum to Office Lease, dated March      , 2006,

in which Union Bank of California as Trustee for Quest Group Trust VII is referred to as Landlord and ImageWare Systems, Incorporated is referred to as Tenant.

ADDITIONAL PROVISIONS TO THE LEASE:

1.  Commencement Date. Tenant warrants and agrees that Tenant, at Tenant ‘s expense, has made all necessary inquiries and has or will take all action as required in order to occupy and use the premises in the manner contemplated by Tenant.  Such action shall include but not be limited to, the obtaining of a business license and the installation of any applicable utilities deemed necessary for Tenant ‘s use.  By executing the Lease, Tenant agrees to be responsible for all the terms and conditions of the Lease, including their payment of rent, from the Lease commencement date or from the date possession is tendered to Tenant, or occupancy is assumed, whichever is earlier, regardless of whether or not Tenant has commenced or completed any action required by Tenant herein. Landlord shall not be responsible to Tenant in any manner whatsoever for any delay to Tenant in obtaining such approvals or installations as may be required herein; where such approval or installation is beyond the reasonable control of Landlord.

2.  Tenant Improvements:

Landlord will provide a turnkey building out of the space plan identified in Exhibit C utilizing building standard improvements set forth in Exhibit D.

3.   Loitering. Tenant(s) and their guests and/or licensees shall not loiter, or congregate in or about the premises in any area not specifically designed and intended for such purposes.  By way of example and not by way of limitation, areas in which loitering or congregating shall not be allowed are parking areas, driveways, stairways, walkways, passageways, hallways, storage areas, entrances to the buildings of others, areas of construction and maintenance, and office areas.

4. Tenant Delays.  All dates by which Landlord is to complete the Tenant Improvements and/or deliver possession of the Premises to Tenant shall be extended by the number of days of delay occasioned by Tenant Delays.  “Tenant Delays” are defined as delays caused by acts or omissions of Tenant or its agents, including, but not limited to, delays caused by not providing the Preliminary Plan or additional information needed by the architect to complete the Plans in a timely manner, requests for changes to the Plans, by requests for incorporation of materials for which lead times exceed the time allowed for incorporation under Landlord’s then current schedule, and/or by delaying more than two (2) Business Days in approving any sample, substitution, or other item for which Landlord requests approval.   Landlord shall be deemed to complete each of its obligations on the date the same would have been completed absent Tenant Delays.  Tenant shall reimburse Landlord within thirty (30) days of request for all cost increases and other expenses caused by Tenant Delays.  Tenant acknowledges that the installation or completion of above Building Standard work, including long lead-time items, may delay substantial completion of the Tenant Improvements.  In the event Landlord agrees to any requested changes to the Plans, then (I) any additional costs resulting from the change shall be paid by Tenant to Landlord upon Landlord’s approval of the change, and (ii) any delays in substantial completion of the Tenant Improvements as a result of the change shall be deemed Tenant Delays.

5. Administration Fee.  Should Landlord be in the position of incurring any costs including loss of rents on behalf of Tenant, or should Tenant not fulfill any obligations of which he is liable and of which Landlord incurs cost thereof, Tenant shall be liable not only for costs incurred, but in addition shall be liable for a twenty percent (20%) surcharge above and beyond said actual costs.  Any costs incurred due to lock changes by Tenant shall be Tenant ‘s responsibility.

6.  Rules & Regulations. Tenant hereby agrees to abide by and conform to the rules and regulations attached hereto as Exhibit F.

7.  Parking. The Tenant shall be allowed a parking ratio of a maximum of 4 spaces per 1,000 rentable square feet leased on a non-reserved basis in common with the other tenants of the Building in the Building parking lot.  Tenant shall not park cars in the Building parking lot in excess of the parking ratio at any time during the Term of the Lease.  The Landlord anticipates enforcing tenant’s parking rights with the use of parking tags, and reserves the right to tow violators without notice. Landlord reserves the right to charge Tenant a fee for replacement of parking tags.

8.  Signage.  The Landlord will provide Building standard signage for the Tenant at the Tenant’s main entry door and on the Lobby directory sign.

Receipt of a copy is hereby acknowledged.  The undersigned acknowledges that this lease agreement, and the attached addendum(s) constitute the entire agreement between Landlord and Tenant.  Any and all representations by Landlord or its agents that are not written in the lease document are not a part of the lease agreement.

ACKNOWLEDGED AND ACCEPTED BY:

LANDLORD: Union Bank of California		TENANT: ImageWare Systems, Incorporated
as Trustee for Quest Group Trust VII
BY:		BY:
	Jason Kaufman, Assistant Vice President		Wayne Wetherell, Sr. VP & CFO
Date:		Date:		September 7, 2006

Please Initial Landlord                 Tenant                

14

BILLING INFORMATION SHEET

Please fill out the following information:

Company: ImageWare Systems, Inc.

Local Contact Person: David Harding

Phone:  (858) 405-8035 Fax: (503) 698-4408

Premises Address:

Billing Address: 10883 Thornmint Rd., San Diego, CA 92127

Contact: Paul Mosman

Phone:  (858) 673-8600 x126 Fax:   (858) 673-1770

Notice Address: 10883 Thornmint Rd., San Diego, CA 92127

Contact: Paul Mosman

Phone:(858) 673-8600 x126             Fax:  (858) 673-1770

After Hours Emergency Contact:

Name:   David Harding

Phone:   (503) 392-4629  or (949) 279-2374

Please Initial Landlord                 Tenant                

15

EX-31.1

Exhibit 31.1

CERTIFICATION

I, S. James Miller, certify that:

1.I have reviewed this quarterly report on Form 10-Q of ImageWare Systems, Inc.;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)[Reserved]

(c)evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated:	November 20, 2006	/s/ S. James Miller
		S. James Miller
		Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Wayne G. Wetherell, certify that:

1.I have reviewed this quarterly report on Form 10-Q of ImageWare Systems, Inc.;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)[Reserved]

(c)evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated:	November 20, 2006	/s/ Wayne G. Wetherell
		Wayne G. Wetherell
		Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350, as adopted), S. James Miller, Jr., Chief Executive Officer of ImageWare Systems, Inc. (the “Company”), hereby certifies that, to the best of his knowledge:

1.The Company’s quarterly report on Form 10-Q for the period ended September 30, 2006 (the “Report”) fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended; and

2.The information contained in the Report fairly presents, in all material respects, the financial condition of the Company at the end of the periods covered by the Report and the results of operations of the Company for the periods covered by the Report.

Dated:  November 20, 2006

/s/ S. James Miller

S. James Miller, Jr.
Chief Executive Officer

A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to ImageWare Systems, Inc. and will be furnished to the Securities and Exchange Commission or its staff upon request.

EX-32.2

Exhibit 32.2

CERTIFICATION

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350, as adopted), Wayne Wetherell Chief Financial Officer of ImageWare Systems, Inc. (the “Company”), hereby certifies that, to the best of his knowledge:

1.The Company’s quarterly report on Form 10-Q for the period ended September 30, 2006 (the “Report”) fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended; and

2.The information contained in the Report fairly presents, in all material respects, the financial condition of the Company at the end of the periods covered by the Report and the results of operations of the Company for the periods covered by the Report.

Dated:  November 20, 2006

/s/ Wayne Wetherell

Wayne Wetherell
Chief Financial Officer

A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to ImageWare Systems, Inc. and will be furnished to the Securities and Exchange Commission or its staff upon request.