UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
 
(Mark One)
þ
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2009.
 
o
TRANSITION REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______ to ________
 
Commission File No. 000-30152
 
  PAYMENT DATA SYSTEMS, INC.  
  (Exact name of registrant as specified in its charter)  
 
Nevada    98-0190072
(State or other jurisdiction of incorporation or organization)         (I.R.S. Employer Identification No.)
     
12500 San Pedro, Ste. 120, San Antonio, TX        78216
(Address of principal executive offices)      (Zip Code)
 
Registrant’s telephone number, including area code (210) 249-4100
 
Securities registered pursuant to Section 12(b) of the Act:    None.  
       
Securities registered pursuant to Section 12(g) of the Act:    Common stock, par value $0.001 per share.  
    (Title of class)  
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   o Yes  þ No
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   o Yes  þ No
 
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.    þ Yes    o No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    o Yes      o No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  o Accelerated filer  o
Non-accelerated filer 
(Do not check if a smaller reporting company)  
o Smaller reporting company  þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    o Yes    þ No
 
The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2009, the last business day of the registrant's second fiscal quarter, was approximately $886,170 based on the closing price reported on such date of the registrant's common stock.
 
As of April 14, 2010, the number of outstanding shares of the registrant's common stock was 125,178,547.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Not applicable.
 
 
 
 

PAYMENT DATA SYSTEMS, INC.

FORM 10-K
For the Year Ended December 31, 2009

INDEX
 
      Page  
  PART I      
Item 1.
Business.
    1  
Item 1A.
Risk Factors.
    5  
Item 2.
Properties.
    9  
Item 3.
Legal Proceedings.
    9  
Item 4.
Removed and Reserved.
       
           
 
PART II
       
           
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.     11  
Item 6.
Selected Financial Data.
    12  
 Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations.
    12  
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
    15  
Item 8.
Financial Statements and Supplementary Data.
    16  
Item 9.
Changes In and Disagreements With Accountants on Accounting and Financial Disclosure.
    30  
Item 9A(T).
Controls and Procedures.
    30  
Item 9B.
Other Information.
    30  
           
 
PART III
       
           
Item 10.
Directors, Executive Officers and Corporate Governance.
    31  
Item 11.
Executive Compensation.
    33  
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
    37  
Item 13.
Certain Relationships and Related Transactions, and Director Independence.
    37  
Item 14.
Principal Accounting Fees and Services.
    38  
           
 
PART IV
       
           
Item 15.
Exhibits, Financial Statement Schedules.
    39  
 
FACTORS THAT MAY AFFECT FUTURE RESULTS

This Annual Report on Form 10-K and the documents incorporated herein by reference contain certain forward-looking statements within the meaning of the Federal Securities Laws. Specifically, all statements other than statements of historical facts included in this Annual Report on Form 10-K regarding our financial performance, business strategy and plans and objectives of management for future operations and any other future events are forward-looking statements and based on our beliefs and assumptions. If used in this report, the words "anticipate," "believe," "estimate", "expect," "intend," and words or phrases of similar import are intended to identify forward-looking statements. Such statements reflect our current view with respect to future events and are subject to certain risks, uncertainties, and assumptions, including, but without limitation, those risks and uncertainties contained in the Risk Factors section of this Annual Report on Form 10-K and our other filings made with the SEC. Although we believe that our expectations are reasonable, we can give no assurance that such expectations will prove to be correct. Based upon changing conditions, any one or more of these events described herein as anticipated, believed, estimated, expected or intended may not occur. All prior and subsequent written and oral forward-looking statements attributable to our Company or persons acting on our behalf are expressly qualified in their entirety by this cautionary statement.

 
 
 

PART I


ITEM 1. BUSINESS.

General

We were founded in July 1998 and incorporated in the State of Nevada. Our primary operations consist of functioning as a processor of electronic payments for other companies. We provide integrated electronic payment processing services to merchants and businesses, including all types of Automated Clearinghouse processing and credit and debit card-based processing services. The Automated Clearinghouse Network is a nationwide electronic funds transfer system that is regulated by the Federal Reserve and provides for the clearing of electronic payments between participating financial institutions. Our Automated Clearinghouse processing services enable merchants or businesses to both disburse and collect funds electronically using e-checks to transfer funds instead of traditional paper checks. An e-check is an electronic debit to a bank checking account that is initiated at the point-of-sale, on the Internet, over the telephone or via a bill payment sent through the mail and is processed using the Automated Clearinghouse network. Our card-based processing services enable merchants to process both traditional card-present, or "swipe," transactions, as well as card-not-present transactions. A traditional card-present transaction occurs whenever a cardholder physically presents a credit or debit card to a merchant at the point-of-sale. A card-not-present transaction occurs whenever the customer does not physically present a payment card at the point-of-sale and may occur over the Internet, mail, fax or telephone. Our electronic payment processing may take place in a variety of forms and situations. For example, our capabilities allow merchants to convert a paper check to an e-check or receive card authorization at the point-of-sale, have their customer service representatives take e-check or card payments from their consumers by telephone, and enable their consumers to make e-check or card payments directly through the use of a web site or by calling an Interactive Voice Response telephone system. We also operate an online payment processing service for consumers under the domain name www.billx.com through which consumers can pay anyone.

We generate revenues by charging fees for the electronic processing of payment transactions and related services. We charge certain merchants for these processing services at a bundled rate based on a percentage of the dollar amount of each transaction and, in some instances, additional fees are charged for each transaction. We charge other merchant customers a flat fee per transaction, and may also charge miscellaneous fees to our customers, including fees for returns, monthly minimums, and other miscellaneous services. We charge consumers that use our billx.com online payment service a flat monthly fee that allows them to make a certain number of payments in a month. We also charge these consumers an additional fee for each payment that exceeds the allowed number of payments in a given month. We operate solely in the United States as a single operating segment.

Industry Background

The use of non-paper based forms of payment by consumers in the United States, such as credit and debit cards, has steadily increased over the past several years. According to the 2007 Federal Reserve Payments Study, the number of electronic payment transactions totaled 62.7 billion in 2006 while the number of checks paid totaled 30.6 billion. Electronic payments now exceed two-thirds of all non-cash payments and are being used more frequently in transactions where paper checks or cash were used in the past. The growth of electronic commerce has made the acceptance of card-based and other electronic forms of payment a necessity for businesses, both large and small, in order to remain competitive. We believe that the electronic payment processing industry will continue to benefit from the following trends:

Favorable Demographics

As consumers age, we expect that they will continue to use the payment technology to which they have grown accustomed. More consumers are beginning to use card-based and other electronic payment methods for purchases at an earlier age. As consumers who have witnessed the wide adoption of card products, technology, and the Internet comprise a greater percentage of the population and increasingly enter the work force, we expect that purchases using electronic payment methods will comprise an increasing percentage of total consumer spending. Because of the Internet’s increasing adoption rate, businesses have a growing opportunity to conduct commerce with their consumers and business partners over the Internet.

Increased Electronic Payment Acceptance by Small Businesses

Small businesses are a vital component of the U.S. economy and are expected to contribute to the increased use of electronic payment methods. The lower costs associated with electronic payment methods are making these services more affordable to a larger segment of the small business market. In addition, we believe these businesses are experiencing increased pressure to accept electronic payment methods in order to remain competitive and to meet consumer expectations. As a result, many of these small businesses are seeking to provide customers with the ability to pay for merchandise and services using electronic payment methods, including those in industries that have historically accepted cash and checks as the only forms of payment for their merchandise and services.
 
 
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Growth in Online Transactions

Market researchers expect continued growth in card-not-present transactions due to the steady growth of the Internet and electronic commerce. According to the U.S. Census Bureau, estimated retail e-commerce sales for 2009 were $134.4 billion, an increase of 2% from $132.2 billion in 2008. The prevalence of the Internet makes having an online presence a basic consideration for those operating a business today. To remain competitive, many companies are seeking to leverage the Internet to provide operational efficiencies, create new revenue opportunities and maximize the longevity and profitability of their customer relationships.

Products and Services

Our service offerings are supported by our systems infrastructure that integrates certain proprietary components with processing systems outsourced to third-party providers to offer our customers a flexible and secure payment process. We utilize a secure sockets layer so that connections and information are secure from outside inspection. We also use 128-bit encryption for all electronic transactions that we process to make information unreadable as it passes over the Internet. Our systems infrastructure allows us to work with our customers to build a customized electronic payment service offering tailored to their specific needs. We have designed and implemented our integrated payment systems to function as gateways between our customers and our third-party processing providers. Our systems provide for interfaces with our customers through which payment data is captured electronically and transferred through the connections we have with our processing providers. Our systems also provide a data warehousing capability so that all of a customer's payment data can be stored in one place to facilitate efficient data retrieval and analysis. We outsource our Automated Clearinghouse transaction processing and card-based transaction processing to third-party providers. Our card-based processing system is capable of connecting with all of the major card-based processors in the United States.

The components of our service offering include all forms of Automated Clearinghouse transaction processing, such as Re-presented Check, which is a consumer non-sufficient funds check that is re-presented for payment electronically rather than through the paper check collection system, and Accounts Receivable Check Conversion, which is a consumer paper check payment that is converted into an e-check. Our customers can initiate Automated Clearinghouse transactions directly using an online terminal accessible through a web site or we can initiate Automated Clearinghouse transactions on their behalf. Our service offering also includes merchant account services for the processing of card-based transactions through the VISA and MasterCard networks, including online terminal services accessed through a web site or retail services accessed via a physical terminal. We offer a proprietary web-based customer service application that combines both Automated Clearinghouse and card processing capabilities and allows companies to process one-time and recurring payments via e-checks or credit cards at the request of their consumers. In addition, we offer an Interactive Voice Response telephone system to companies that accept payments directly from consumers over the telephone using e-checks or credit cards.

In addition to these electronic payment services, we are also aggressively developing and marketing prepaid gift cards and personal spending debit cards. In December 2005, we signed an agreement with MetaPayments Systems, a division of MetaBank, a federally chartered bank, to be our issuing bank for select prepaid debit card programs running on the various card associations and debit networks. We also have an agreement with FSV Payment Systems, a third-party provider, to provide us with backend card processing services for our debit card processing platform. We are working with MetaPayments to develop a series of competitive gift and personal spending card programs. In August 2007, we officially launched our Natalie Gulbis Gift MasterCard program, which features Natalie Gulbis, one of the young stars on the Ladies Professional Golf Association Tour, and we intend to develop other debit card programs.

We also operate a consumer web site focused on providing bill payment services under the domain name www.billx.com and manage all of the related back-end processing through our own proprietary processing engine. Consumers subscribe to the payment service and are allowed to make a certain number of payments each month for a flat monthly fee and are assessed a separate fee for any additional payments made over the limit. Our online payment processing service seeks to provide consumers with an efficient and secure interface for paying and managing bills via the Internet. We also sell this payment portal service as a private label solution to online financial services providers looking to provide online bill payment capabilities as part of their service offering to consumers. We also offer this service to other debit card issuers, as we are able to utilize the bill payment component of this service for payments made via debit cards, a patented process for which we own a perpetual license.

 
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Relationships with Sponsors and Processors

We have agreements with several processors to provide to us, on a non-exclusive basis, transaction processing and transmittal, transaction authorization and data capture, and access to various reporting tools. In order to provide payment processing services for Automated Clearinghouse transactions, we must maintain a relationship with an Originating Depository Financial Institution in the Automated Clearinghouse Network because we are not a bank and therefore not eligible to be an Originating Depository Financial Institution. Similarly, in order to provide payment processing services for Visa and MasterCard transactions, we must be sponsored by a financial institution that is a principal member of the Visa and MasterCard card associations. We have an agreement with TriSource Solutions, LLC through which their member bank sponsors us for membership in the Visa and MasterCard card associations and settles card transactions for our merchants. This agreement may be terminated by the processor if we materially breach the agreement and we do not cure the breach within 30 days, or if we enter bankruptcy or file for bankruptcy.

Under our processing agreement with TriSource Solutions, we are financially liable for all fees, chargebacks and losses related to our card processing merchant customers. If, due to insolvency or bankruptcy of our merchant customers, or for another reason, we are unable to collect from them amounts that have been refunded to the cardholders because the cardholders properly initiated a chargeback transaction to reverse the credit card charges, we must bear the credit risk for the full amount of the cardholder transaction. We utilize a number of systems and procedures to evaluate and manage merchant risk, such as obtaining approval of prospective merchants from our processor and sponsor bank, setting transaction limits and monitoring account activity. We may also require cash deposits and other types of collateral from certain merchants to mitigate any such risk. We maintain a reserve for losses resulting from card processing and related chargebacks. We estimate our potential loss for chargebacks by performing a historical analysis of our chargeback loss experience with similar merchants and considering other factors that could affect that experience in the future, such as the types of card transactions processed and nature of the merchant relationship with their consumers.

We also maintain a separate allowance for doubtful accounts for estimated losses resulting from the inability or failure of our merchant customers to make required payments for fees charged by us. Amounts due from customers may be deemed uncollectible because of merchant disputes, fraud, insolvency or bankruptcy. We determine the allowance for doubtful accounts based on an account-by-account review, taking into consideration such factors as the age of the outstanding receivable, historical pattern of collections and financial condition of the customer. We closely monitor extensions of credit and if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make contractual payments, additional allowances may be required.

Sales and Marketing

We market and sell our products and services through direct contact by our sales personnel, as well as through non-exclusive resellers that act as an external sales force, with minimal direct investment in sales infrastructure and management. Our direct sales effort is coordinated by a sales executive and supported by other employees who function in sales capacities. Our primary market focus is on companies generating high volumes of electronic payment transactions. We tailor our sales efforts to reach this market by pre-qualifying prospective sales leads through direct contact or market research. Our sales personnel typically initiate contact with prospective customers that we identify as meeting our target profile. We also plan to market and sell our celebrity card programs directly to consumers, primarily through the Internet. We intend to continue to analyze our sales and marketing efforts in order to control costs, increase the effectiveness of our sales force, and broaden our reach through reseller initiatives and advantageous alliances.

Customers

Our primary customers are merchants and businesses that use our Automated Clearinghouse and/or card-based processing services in order to provide their consumers with the ability to pay for goods and services without having to use cash or a paper check. These merchant customers operate in a variety of retail industries and are under contract with us to exclusively use the services that we provide to them. Most of our merchant customers have signed long-term contracts, with generally three-year terms, that provide for volume-based transaction fees. Our merchant accounts increased to 482 customers at December 31, 2009 from 335 customers at December 31, 2008. However, our largest customer, Access General Insurance, ceased using our processing services on an exclusive basis during October 2009 and will not generate any significant revenues in 2010. In addition, our second largest customer, Protection One, ceased using our processing services in January 2010. Services provided to Access General Insurance, Protection One and Agency Insurance accounted for approximately 28%, 15% and 6%, respectively, of our total consolidated revenues for the year ended December 31, 2009. Services provided to Access General Insurance, Protection One, Lexicon Marketing, Calsurance and Agency Insurance accounted for approximately 17%, 11%, 9%, 7% and 7%, respectively, of our total consolidated revenues for the year ended December 31, 2008.

 
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Our other customers are consumers geographically dispersed throughout the United States utilizing our billx.com Internet bill payment service on a recurring monthly basis to pay household bills. The service relationship between our billx.com customers and us is not contractual and the fee we charge for the service is not negotiable. We seek to retain customers by providing high service levels. Customers also have incentive to continue using the service once activated due to their investment of time in setting up the service with their personal banking and payment information. The monthly average number of billx.com customers using our online payment service decreased to 511 in 2009 from 716 in 2008.

Competition

The payment processing industry is highly competitive. Many small and large companies compete with us in providing payment processing services and related services to a wide range of merchants. There are a number of large transaction processors, including First Data Merchant Services Corporation, National Processing Company, and Global Payments Inc. that serve a broad market spectrum from large to small merchants and provide banking, automatic teller machine, and other payment-related services and systems in addition to card-based payment processing. There are also a large number of smaller transaction processors that provide various services to small and medium-sized merchants. Many of our competitors have substantially greater capital resources than us and operate as subsidiaries of financial or bank holding companies, which may allow them on a consolidated basis to own and conduct depository and other banking activities that we do not have the regulatory authority to own or conduct. We believe that the principal competitive factors in our market include:

·  
quality of service;
·  
reliability of service;
·  
ability to evaluate, undertake and manage risk;
·  
speed in implementing payment processes;
·  
price and other financial terms; and
·  
multi-channel payment capability.

We believe that our specific focus on providing integrated payment processing solutions to merchants, in addition to our understanding of the needs and risks associated with providing payment processing services electronically, gives us a competitive advantage over other competitors, which have a narrower market perspective, and over competitors of a similar or smaller size that may lack our experience in the electronic payments industry. Furthermore, we believe we present a competitive distinction through the use of our internal technology to provide a single integrated payment storage or warehouse that consolidates, processes, tracks and reports all payments regardless of payment source or channel.

Trademarks

We own federally registered trademarks on the marks Payment Data Systems, Inc. and design. We have also secured domain name registrations for billx.com, billxpress.com, billhelp.com, paymentdatasystems.com, paymentdata.org and paymentdata.com. We rely on a combination of copyright, trademark and trade secret laws, employee and third-party nondisclosure agreements, and other intellectual property protection methods to protect our services and related products.

Patent

In April 2006, we were awarded Patent Number 7,021,530 from the U.S. Patent Office for the technology and method for managing and processing bill payment via a stored-value debit card, check card, signature debit card, PIN-based card or ATM card from a variety of access points. The debit card technology for which we received patent protection allows a cardholder to use their debit or ATM card to pay local, national, or international bills with the card from their electronic balance. Because it does not require linkage to a traditional checking or savings account, this new debit technology is unique in that it allows for use by “unbanked” consumers.

On January 11, 2008, we signed an agreement to sell selected patents and patent applications to PCT Software Data, LLC, including U.S. Patent Number 7,021,530. On January 17, 2008, we completed the sale of selected patents and patent applications to PCT Software Data, LLC for net proceeds of approximately $750,000. The patents and patent applications sold relate to bill payments made with debit and stored value cards. We retained a worldwide, non-exclusive license under the patents for use with all current and future customers.

Employees

As of December 31, 2009, we had 7 full-time employees and 2 part-time employees. We are not a party to any collective bargaining agreements. We believe that our relations with our employees are very good.

 
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ITEM 1A. RISK FACTORS.

An investment in our common stock involves a high degree of risk. You should carefully consider the following risk factors and other information included in this Form 10-K. If any of the following risks actually occur, our business, financial condition or results of operations could be materially and adversely affected and you may lose some or all of your investment.

RISKS RELATED TO OUR BUSINESS

Our independent accountants have issued a going concern opinion and if we cannot obtain additional financing, we may have to curtail operations and may ultimately cease to exist.

Our independent accountants have issued a going concern opinion. Due to continuing operating losses, our current available cash and cash equivalents along with anticipated revenues are likely to be insufficient to meet our anticipated cash needs for the near future. Consequently, our ability to continue as a going concern is likely contingent on us receiving additional funds in the form of equity or debt financing. We currently plan to meet our capital requirements primarily through the issuance of equity securities or new borrowing arrangements. Accordingly, we are aggressively pursuing strategic alternatives. However, financing may not be available in amounts or on terms acceptable to us, if at all. If we cannot raise funds on acceptable terms or achieve positive cash flow, we may be forced to curtail operations or may ultimately cease to exist.

We have generated significant losses and expect to generate operating losses for the foreseeable future, therefore we may not become profitable.

We organized in 1998 and began operations as a public company in 1999 by offering electronic billing services to other companies. After the sale of our primary business in July 2003, we have concentrated on building our electronic payments services operations. We have not been profitable since inception and we may never become profitable. As of December 31, 2009, our accumulated deficit was $54,227,479.

If our security applications are not sufficient to address changing market conditions and customer concerns, we may incur significant losses and be unable to sell our services.

Our use of applications designed for premium data security and integrity to process electronic transactions may not be sufficient to address changing market conditions or the security and privacy concerns of existing and potential customers. If our security applications are breached and sensitive data is lost or stolen, we could incur significant costs to not only assess and repair any damage to our systems, but also to reimburse customers for losses that occur from the fraudulent use of the data. We may also be subject to fines and penalties from the credit card associations in the event of the loss of confidential card information. Adverse publicity raising concerns about the safety or privacy of electronic transactions, or widely reported breaches of our or another provider's security, have the potential to undermine consumer confidence in the technology and could have a materially adverse effect on our business.

If we do not adapt to rapid technological change, our business may fail.

Our success depends on our ability to develop new and enhanced services and related products that meet changing customer needs. The market for our services, however, is characterized by rapidly changing technology, evolving industry standards, emerging competition and frequent new and enhanced software, service and related product introductions. In addition, the software market is subject to rapid and substantial technological change. To remain successful, we must respond to new developments in hardware and semiconductor technology, operating systems, programming technology and computer capabilities. In many instances, new and enhanced services, products and technologies are in the emerging stages of development and marketing, and are subject to the risks inherent in the development and marketing of new software, services and products. We may not successfully identify new service opportunities, and develop and bring new and enhanced services and related products to market in a timely manner. Even if we do bring such services, products or technologies to market, they may not become commercially successful. Additionally, services, products or technologies developed by others may render our services and related products noncompetitive or obsolete. If we are unable, for technological or other reasons, to develop and introduce new services and products in a timely manner in response to changing market conditions or customer requirements, our business may fail.

 
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We rely on our relationship with the Automated Clearinghouse Network and if the Federal Reserve rules were to change, our business could be adversely affected.

We have a contractual relationship with Fifth Third Bank, which is an Originating Depository Financial Institution in the Automated Clearinghouse Network. The Automated Clearinghouse Network is a nationwide batch-oriented electronic funds transfer system that provides for the interbank clearing of electronic payments for participating financial institutions. An Originating Depository Financial Institution is a participating financial institution that must abide by the provisions of the Automated Clearinghouse Operating Rules and Guidelines. Through our relationship with this third-party provider, we are able to process payment transactions on behalf of our customers and their consumers by submitting payment instructions in a prescribed Automated Clearinghouse format. We pay volume-based fees to the third-party provider for debit and credit transactions processed each month, and pay fees for other transactions such as returns and notices of change to bank accounts. These fees are part of our cost structure. If the Federal Reserve rules were to change to introduce restrictions or modify access to the Automated Clearinghouse, our business could be materially adversely affected.

If our third-party card processing providers or our bank sponsors fail to comply with the applicable requirements of Visa and MasterCard credit card associations, we may have to find a new third-party processing provider, which could increase our costs.

Substantially all of the card-based transactions we process involve Visa or MasterCard. If our third-party processing provider, TriSource Solutions, LLC, or our bank sponsor, Merrick Bank, fail to comply with the applicable requirements of the Visa and MasterCard credit card associations, Visa or MasterCard could suspend or terminate their registration. Also, our contract with these third parties is subject to cancellation upon limited notice by either party. The cancellation of our contract, termination of their registration or any changes in the Visa or MasterCard rules that would impair their registration could require us to stop providing such payment processing services if we are unable to obtain another provider or sponsor at similar costs. Additionally, changing our bank sponsor could adversely affect our relationship with our merchants if the new sponsor provides inferior service or charges higher costs.

We depend on Michael R. Long and Louis A. Hoch and if these officers ceased to be active in our management, our business may not be successful.

Our success depends to a significant degree upon the continued contributions of our key management, marketing, service and related product development and operational personnel, including our Chairman, Chief Executive Officer and Chief Financial Officer, Michael R. Long and our President and Chief Operating Officer, Louis A. Hoch. We signed employment agreements with Mr. Long and Mr. Hoch in February 2007 which prohibits them from competing with us for a period of two years upon termination of their employment. Our business may not be successful if, for any reason, either of these officers ceased to be active in our management.

If our software fails, and we need to repair or replace it, or we become subject to warranty claims, our costs could increase.

Our software products could contain errors or "bugs" that could adversely affect the performance of services or damage a user's data. We attempt to limit our potential liability for warranty claims through technical audits and limitation-of-liability provisions in our customer agreements. However, these measures may not be effective in limiting our exposure to warranty claims. We have not experienced a significant increase in software errors or warranty claims. Despite the existence of various security precautions, our computer infrastructure may also be vulnerable to viruses or similar disruptive problems caused by our customers or third parties gaining access to our processing system. If our software fails, and we need to replace or repair it, or we become subject to warranty claims, our costs could significantly increase.

Our business strategy includes identifying businesses and assets to acquire, and if we cannot integrate acquisitions into our company successfully, we may not become profitable.

Our success partially depends upon our ability to identify and acquire undervalued businesses and merchant portfolios within our industry. Although we believe that there are companies and portfolios available for potential acquisition that might offer attractive business opportunities, we may not be able to make any acquisitions, and if we do make acquisitions, they may not be profitable. As a result, our business may not grow and we may not achieve or sustain profitability.

If we do not manage our growth, we may not achieve or sustain profitability.

We may experience a period of rapid growth that could place a significant strain on our resources. In order to manage our growth successfully, we will have to continue to improve our operational, management and financial systems and expand our work force. A significant increase in our customer base may necessitate the hiring of a significant number of additional personnel, qualified candidates for which, at the time needed, may be in short supply. In addition, the expansion and adaptation of our computer and administrative infrastructure will require substantial operational, management and financial resources. Although we believe that our current infrastructure is adequate to meet the needs of our customers in the foreseeable future, we may not be able to expand and adapt our infrastructure to meet additional demand on a timely basis, at a commercially reasonable cost, or at all. If our management is unable to manage growth effectively, hire needed personnel, expand and adapt our computer infrastructure and improve our operational, management, and financial systems and controls, we may not attain or sustain profitability.
 
 
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If we do not manage our credit risks related to our merchant accounts, we may incur significant losses.

We rely on the Federal Reserve's Automated Clearinghouse system for electronic fund transfers and the Visa and MasterCard associations for settlement of payments by credit or debit card on behalf of our merchant customers. In our use of these established payment clearance systems, we generally bear the credit risks arising from returned transactions caused by insufficient funds, stop payment orders, closed accounts, frozen accounts, unauthorized use, disputes, customer charge backs, theft or fraud. Consequently, we assume the credit risk of merchant disputes, fraud, insolvency or bankruptcy in the event we attempt to recover funds related to such transactions from our customers. We have not experienced a significant increase in the rate of returned transactions or incurred any losses with respect to such transactions. We utilize a number of systems and procedures to manage and limit credit risks, but if these actions are not successful in managing such risks, we may incur significant losses.

Current economic conditions could have a materially adverse affect on our business.

Our operations and performance depend to some degree on economic conditions and their impact on levels of consumer spending, which have recently deteriorated significantly in many countries and regions, including the regions in which we operate, and may remain depressed for the foreseeable future. For example, some of the factors that could influence the levels of consumer spending include continuing increases in fuel and other energy costs, conditions in the residential real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could have a material adverse effect on demand for our products and on our financial condition and operating results.

RISKS RELATED TO OUR INDUSTRY

The electronic commerce market is relatively new and if it does not grow, we may not be able to sell sufficient services to make our business viable.

The electronic commerce market is a relatively new and growing service industry. If the electronic commerce market fails to grow or grows slower than anticipated, or if we, despite an investment of significant resources, are unable to adapt to meet changing customer requirements or technological changes in this emerging market, or if our services and related products do not maintain a proportionate degree of acceptance in this growing market, our business may not grow and could even fail. Additionally, the security and privacy concerns of existing and potential customers may inhibit the growth of the electronic commerce market in general, and our customer base and revenues, in particular. Similar to the emergence of the credit card and automatic teller machine industries, we and other organizations serving the electronic commerce market must educate users that electronic transactions use encryption technology and other electronic security measures that make electronic transactions more secure than paper-based transactions.

Changes in regulation of electronic commerce and related financial services industries could increase our costs and limit our business opportunities.

We believe that we are not required to be licensed by the Office of the Comptroller of the Currency, the Federal Reserve Board, or other federal or state agencies that regulate or monitor banks or other types of providers of electronic commerce services. It is possible that a federal or state agency will attempt to regulate providers of electronic commerce services, which could impede our ability to do business in the regulator's jurisdiction. Our business has also been affected by anti-terrorism legislation, such as the Patriot Act. Banking related provisions of the Patriot Act have been implemented as additions to the banking rules regarding monetary instrument sales record keeping requirements and tracking of cash movements. In our capacity as an agent for Meta Payments Systems, a division of MetaBank, a federally chartered savings bank that is the issuing bank for our debit card programs, we are required to comply with these rules. We are also required to implement a Customer Identification Program and establish an Anti-Money Laundering program and to report any suspected money laundering to the appropriate agencies. Our compliance with such regulations increases our responsibilities and costs associated with the administration of our debit card programs. We are also subject to various laws and regulations relating to commercial transactions, such as the Uniform Commercial Code, and may be subject to the electronic funds transfer rules embodied in Regulation E, promulgated by the Federal Reserve Board. Given the expansion of the electronic commerce market, the Federal Reserve Board might revise Regulation E or adopt new rules for electronic funds transfer affecting users other than consumers. Because of growth in the electronic commerce market, Congress has held hearings on whether to regulate providers of services and transactions in the electronic commerce market. It is possible that Congress or individual states could enact laws regulating the electronic commerce market. If enacted, such laws, rules and regulations could be imposed on our business and industry and could increase our costs or limit our business opportunities.

 
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If we cannot compete successfully in our industry, we could lose market share and our costs could increase.

Portions of the electronic commerce market are becoming increasingly competitive. We expect to face growing competition in all areas of the electronic payment processing market. New companies could emerge and compete for merchants of all sizes. We expect competition to increase from both established and emerging companies and that such increased competition could lower our market share and increase our costs. Moreover, our current and potential competitors, many of whom have greater financial, technical, marketing and other resources than us, may respond more quickly than us to new or emerging technologies or could expand to compete directly against us in any or all of our target markets. Accordingly, it is possible that current or potential competitors could rapidly acquire market share. We may not be able to compete against current or future competitors successfully. Additionally, competitive pressures may increase our costs, which could lower our earnings, if any.

RISKS RELATED TO OUR COMMON STOCK

Our stock price is volatile and you may not be able to sell your shares at a price higher than what you paid.

The market for our common stock is highly volatile. In 2009, our closing stock price fluctuated between $0.015 and $0.05. The trading price of our common stock could be subject to wide fluctuations in response to, among other things, quarterly variations in operating and financial results, announcements of technological innovations or new products by our competitors or us, changes in prices of our products and services or our competitors' products and services, changes in product mix, or changes in our revenue and revenue growth rates.

Existing stockholders may experience significant dilution from the sale of securities pursuant to our Investment Agreement with Dutchess.

The sale of shares pursuant to our Investment Agreement with Dutchess may have a dilutive impact on our stockholders. As a result, our net income per share could decrease in future periods and the market price of our common stock could decline. In addition, the lower our stock price is at the time we exercise our put option, the more shares we will have to issue to Dutchess to draw down on the full equity line with Dutchess. If our stock price decreases, then our existing stockholders would experience greater dilution.

Dutchess will pay less than the then-prevailing market price of our common stock, which could cause the price of our common stock to decline.

Our common stock to be issued under our Investment Agreement with Dutchess will be purchased at a 5% discount to the lowest closing best bid price during the five days immediately following our notice to Dutchess of our election to exercise our put right. Dutchess has a financial incentive to sell our common stock immediately upon receiving the shares to realize the profit between the discounted price and the market price. If Dutchess sells our shares, the price of our stock could decrease. If our stock price decreases, Dutchess may have a further incentive to sell the shares of our common stock that it holds. The discounted sales under our Investment Agreement with Dutchess could cause the price of our common stock to decline.

“Penny stock” rules may make buying or selling our securities difficult which may make our stock less liquid and make it harder for investors to buy and sell our shares.

Trading in our securities is subject to the SEC's "penny stock" rules and it is anticipated that trading in our securities will continue to be subject to the penny stock rules for the foreseeable future. The SEC has adopted regulations that generally define a penny stock to be any equity security that has a market price of less than $5.00 per share, subject to certain exceptions. These rules require that any broker-dealer who recommends our securities to persons other than prior customers and accredited investors must, prior to the sale, make a special written suitability determination for the purchaser and receive the purchaser's written agreement to execute the transaction. Unless an exception is available, the regulations require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the risks associated with trading in the penny stock market. In addition, broker-dealers must disclose commissions payable to both the broker-dealer and the registered representative and current quotations for the securities they offer. The additional burdens imposed upon broker-dealers by these requirements may discourage broker-dealers from recommending transactions in our securities, which could severely limit the liquidity of our securities and consequently adversely affect the market price for our securities.

We have adopted certain measures that may make it more difficult for a third party to acquire control of our company.

Our Board of Directors is classified into three classes of directors serving staggered three-year terms. Such classification of the Board of Directors expands the time required to change the composition of a majority of directors and may tend to discourage a proxy contest or other takeover bid for our company. We have also instituted a stockholders rights plan that serves to help prevent a hostile takeover of our company.
 
 
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ITEM 2. PROPERTIES.

As of December 31, 2009, our headquarters and operations were housed in approximately 4,500 square feet of leased office space in San Antonio, Texas. The office lease requires future minimum lease payments of $236,617 through its expiration in October 2012. We believe our existing facilities will be adequate to meet our anticipated needs for the foreseeable future.

ITEM 3. LEGAL PROCEEDINGS.

As previously disclosed, in 2002 the Company recognized a loss on margin loans it guaranteed for Michael R. Long, then Chairman of the Board of Directors and Chief Executive Officer; and Louis A. Hoch, then President and Chief Operating Officer, in the amount of $535,302 and $449,371, respectively. In February 2007, we signed employment agreements with Mr. Long and Mr. Hoch that require each to repay his respective obligation to us in four equal annual payments of cash or stock or any combination thereof. In December 2007, we accepted common stock and stock options valued at $133,826 and $112,343 from Mr. Long and Mr. Hoch, respectively, in satisfaction of their annual payments for 2007 as provided for under their employment agreements.

In December 2008, Mr. Long and Mr. Hoch did not pay us the second annual installment pursuant to their respective employment agreements. They each withheld payment of the installment due because we had deferred payment of their salary increases for 2008 called for under their respective employment agreements. At December 31, 2008, we owed Mr. Long and Mr. Hoch deferred salary of $110,000 and $100,000, respectively, and Mr. Long and Mr. Hoch owed us $133,825 and $112,343, respectively, for the second installment due by December 31, 2008. On March 30, 2009, we accepted 680,715 shares of our common stock valued at $23,825 and 352,658 shares of our common stock valued at $12,343 from Mr. Long and Mr. Hoch, respectively, in partial satisfaction of their annual payment for 2008 as provided for under their employment agreements. The partial payments of $23,825 and $12,343 made to us by Mr. Long and Mr. Hoch, respectively, equaled the difference between the amount each owed to us for the second installment and the amount that we owed to each for deferred salary. The common stock accepted from Mr. Long and Mr. Hoch was valued at $0.035 per share, which was the closing price of the common stock on March 30, 2009.

In December 2009, Mr. Long and Mr. Hoch did not pay us the third annual installment pursuant to their respective employment agreements. They each withheld payment of the installment due because we had partially deferred payment of their salary for 2009 called for under their respective employment agreements. At December 31, 2009, we owed Mr. Long and Mr. Hoch deferred salary for 2009 of $162,385 and $141,808, respectively, and Mr. Long and Mr. Hoch owed us $133,825 and $112,343, respectively, for the third installment due by December 31, 2009.

On August 29, 2008, Tara Patrick p/k/a Carmen Electra, commenced legal action against us in the Superior Court of the State of California for the County of Los Angeles. On October 7, 2008, we removed that case to the United States District Court for the Central District of California – Los Angeles Division. With respect to the suit, the plaintiff alleged that we violated her rights of publicity and breached the terms of our license agreement with her. The plaintiff alleged and sought resulting economic, exemplary and punitive damages, interest, attorneys' fees and costs of court. On November 14, 2008, we filed a counterclaim against Ms. Patrick in the United States District Court for the Central District of California – Los Angeles Division alleging that she breached the terms of our license agreement with her. We alleged and sought to recover damages arising from her breach of the agreement.

On September 15, 2009, we entered into a settlement agreement with Ms. Patrick. Under the terms of the settlement, both parties dismissed the pending litigation, with prejudice, and released all claims against each other. Additionally, we agreed to pay $6,000 to Ms. Patrick and $500 to a charity of her choosing and she agreed to return all 735,295 shares of our common stock received by her under the original license agreement to us. We do not expect to incur any additional expenses associated with this litigation.

On November 12, 2008, we commenced legal action against our former customers Commerce Planet, Inc. and Consumer Loyalty Group, Inc., in the 285 th Judicial District Court of Bexar County, Texas. We alleged that they breached the terms of our services agreement with them and sought to recover economic damages and attorneys' fees. On January 22, 2009, the Court entered a Default Judgment awarding us actual damages in the amount of $140,472 and attorney’s fees in the amount of $4,000. We were also awarded all costs of Court and pre-judgment and post-judgment interest as provided by law. On or about January 1, 2009, Commerce Planet entered into an Asset Purchase Agreement with Morlex, Inc. Pursuant to this agreement, Commerce Planet’s liabilities were assigned to and/or assumed by Morlex, including the debt owed to us. On May 27, 2009, we commenced legal action against Morlex, Inc., in the 285 th Judicial District Court of Bexar County, Texas. On September 2, 2009, the Court entered a Default Judgment awarding us actual damages in the amount of $140,472 and attorney’s fees in the amount of $7,500. We were also awarded all costs of Court and pre-judgment and post-judgment interest as provided by law.

 
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On March 2, 2010, we entered into a settlement agreement with Commerce Planet, Inc. Under the terms of the settlement, Commerce Planet agreed to pay us $75,000 and issue 5,000,000 shares of free trading Commerce Planet common stock to us on or before April 2, 2010. Additionally, both parties released all claims against each other. On March 2, 2010, we received payment of $75,000 from Commerce Planet in accordance with the terms of the settlement. As of the date of this report, the Commerce Planet common stock had not been delivered to us. We intend to pursue any legal means available to us in order to enforce the settlement agreement.

On November 12, 2009, we commenced legal action against our customers Access Insurance Holdings, Inc., Access General Agency, Inc., Access General Insurance Agency of California, Inc., Access General Agency of Pennsylvania, Inc., Access General Agency of Florida, Inc., Access General Insurance Agency of Texas, Inc., Access General Agency of Arizona, Inc. and Access Adjusting Services, Inc. (collectively referred to as “Access General”), in the 285 th Judicial District Court of Bexar County, Texas. We alleged that Access General breached the terms of its services agreements with us by violating the exclusivity provisions contained therein and sought to recover economic damages and attorneys' fees.

On December 30, 2009, we entered into a settlement agreement with Access General. Under the terms of the settlement, Access General agreed to pay us $150,000 to dismiss the pending litigation, with prejudice, and both parties released all claims against each other. Access General also agreed to pay us for actual chargeback amounts and associated fees as incurred. Additionally, Access General agreed to pay us monthly minimum processing fees of $33.00 a month for each of the associated merchant accounts until June 30, 2010. We agreed to indemnify Access General against any third party early termination fees. On December 30, 2009, we received payment of $150,000 from Access General in accordance with the terms of the settlement. We do not expect to incur any additional expenses associated with this litigation.

 
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PART II


ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

Market Information

Our common stock trades under the ticker symbol PYDS on the Over-the-Counter Bulletin Board.

The following table sets forth for the quarterly periods indicated the range of high and low bid prices of our common stock as reported on the Over-the-Counter Bulletin Board:

   
High
   
Low
 
2009
           
First Quarter
  $ 0.040     $ 0.020  
Second Quarter
  $ 0.035     $ 0.015  
Third Quarter
  $ 0.050     $ 0.015  
Fourth Quarter
  $ 0.035     $ 0.015  
                 
2008
               
First Quarter
  $ 0.075     $ 0.040  
Second Quarter
  $ 0.075     $ 0.040  
Third Quarter
  $ 0.055     $ 0.035  
Fourth Quarter
  $ 0.045     $ 0.020  

Holders

As of April 14, 2010, 125,178,547 shares of our common stock are issued and outstanding. As of April 14, 2010, there were approximately 3,000 stockholders of record of our common stock.

Dividends

We have never declared or paid cash or stock dividends and have no plans to pay any such dividends in the foreseeable future, instead, we intend to reinvest our earnings, if any.

Securities Authorized for Issuance under Equity Compensation Plans
 
The following table provides information as of December 31, 2009 with respect to compensation plans (including individual compensation arrangements) under which equity securities of the registrant are authorized for issuance:
 
   
Number of securities to be 
issued upon exercise of 
outstanding options
 
Weighted-average
exercise price of
outstanding options
 
Number of securities
remaining available for
future issuance under
compensation plan
             
Employee Comprehensive Stock
Plan approved by stockholders
  2,881,500   $ 0.17   13,777,168
             
Non-Employee Director
Plan approved by stockholders  
  738,003   $ 0.68   641,997
 
Recent Sales of Unregistered Securities
 
During the quarter ended December 31, 2009, we did not sell any unregistered securities.

 
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Purchases of Equity Securities by the Issuer and Affiliated Purchasers

During the quarter ended December 31, 2009, we did not purchase any securities.

ITEM 6. SELECTED FINANCIAL DATA.

Not applicable.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto, and other financial information included elsewhere in this Form 10-K. This report contains forward-looking statements that involve risks and uncertainties. Actual results in future periods may differ materially from those expressed or implied in such forward-looking statements as a result of a number of factors, including, but not limited to, the risks discussed under the heading "Risk Factors" and elsewhere in this Form 10-K.

Overview

We provide integrated electronic payment processing services to merchants and businesses, including credit and debit card-based processing services and transaction processing via the Automated Clearinghouse Network. We also operate an online payment processing service for consumers under the domain name www.billx.com through which consumers can pay anyone. Since inception, we have incurred operating losses each quarter, and as of December 31, 2009, we have an accumulated deficit of approximately $54.2 million. Our prospects to continue as a going concern must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stages of growth, particularly companies in rapidly evolving markets such as electronic commerce. To address these risks we must, among other things, grow and maintain our customer base, implement a successful marketing strategy, continue to maintain and upgrade our technology and transaction-processing systems, provide superior customer service, respond to competitive developments, attract, retain and motivate qualified personnel, and respond to unforeseen industry developments and other factors. We cannot assure you that we will be successful in addressing such risks, and the failure to do so could have a material adverse effect on our business, prospects, financial condition and results of operations. We believe that our success will depend in large part on our ability to (a) manage our operating expenses, (b) add quality customers to our client base, (c) meet evolving customer requirements and (d) adapt to technological changes in an emerging market. Accordingly, we intend to focus on customer acquisition activities and outsource some of our processing services to third parties to allow us to maintain an efficient operating infrastructure and expand our operations without significantly increasing our fixed operating expenses.

Critical Accounting Policies

General

Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to the reported amounts of revenues and expenses, bad debt, investments, intangible assets, income taxes, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates under different assumptions or conditions. We consider the following accounting policies to be critical because the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change or because the impact of the estimates and assumptions on financial condition or operating performance is material.

 
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Revenue Recognition

Revenue consists primarily of fees generated through the electronic processing of payment transactions and related services, and are recognized as revenue in the period the transactions are processed or when the related services are performed. Merchants may be charged for these processing services at a bundled rate based on a percentage of the dollar amount of each transaction and, in some instances, additional fees are charged for each transaction. Certain merchant customers are charged a flat fee per transaction, while others may also be charged miscellaneous fees, including fees for chargebacks or returns, monthly minimums, and other miscellaneous services. Revenues derived from electronic processing of credit and debit card transactions that are authorized and captured through third-party networks are reported gross of amounts paid to sponsor banks as well as interchange and assessments paid to credit card associations (MasterCard and Visa). Revenue also includes any up-front fees for the work involved in implementing the basic functionality required to provide electronic payment processing services to a customer. Revenue from such implementation fees is recognized over the term of the related service contract. Sales taxes billed are reported directly as a liability to the taxing authority, and are not included in revenue.

Reserve for Losses on Card Processing

If, due to insolvency or bankruptcy of the merchant, or for another reason, we are not able to collect amounts from our card processing merchant customers that have been properly "charged back" by the cardholders, we must bear the credit risk for the full amount of the cardholder transaction. We may require cash deposits and other types of collateral from certain merchants to minimize any such risk. In addition, we utilize a number of systems and procedures to manage merchant risk. Card merchant processing loss reserves are primarily determined by performing a historical analysis of our chargeback loss experience and considering other factors that could affect that experience in the future, such as the types of card transactions processed and nature of the merchant relationship with their consumers. This reserve amount is subject to risk that actual losses may be greater than our estimates. At December 31, 2009, our card merchant processing loss reserve was $205,400. We have not incurred any significant chargeback losses to date. Our estimate for chargeback losses is likely to increase in the future as our volume of card-based transactions processed increases.

Bad Debts

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or failure of our customers to make required payments. We determine the allowance for doubtful accounts based on an account-by-account review, taking into consideration such factors as the age of the outstanding balance, historical pattern of collections and financial condition of the customer. Past losses incurred by us due to bad debts have been within our expectations. In 2009, we recorded $18,435 of bad debt expense. We did not record any bad debt expense in 2008. In 2009 and 2008, we recorded bad debt write-offs of $6,734 and $1,749, respectively, against our allowance for doubtful accounts. At December 31, 2009 and 2008, the balance of the allowance for doubtful accounts was approximately $42,000 and $31,000, respectively. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make contractual payments, additional allowances may be required. Our estimate for bad debt losses is likely to increase in the future as our volume of transactions processed increases.

Valuation of Long-Lived and Intangible Assets

We assess the impairment of long-lived and intangible assets at least annually, and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important, which could trigger an impairment review, include the following: significant underperformance relative to historical or projected future cash flows; significant changes in the manner of use of the assets or the strategy of the overall business; and significant negative industry trends. When management determines that the carrying value of long-lived and intangible assets may not be recoverable, impairment is measured as the excess of the assets’ carrying value over the estimated fair value. No impairment losses were recorded in 2009 or 2008.

Income Taxes

Deferred tax assets and liabilities are recorded based on the difference between the tax bases of assets and liabilities and their carrying amount for financial reporting purposes, as measured by the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred tax assets are computed with the presumption that they will be realizable in future periods when taxable income is generated. Predicting the ability to realize these assets in future periods requires a great deal of judgment by management. It is our judgment that we cannot predict with reasonable certainty that the deferred tax assets as of December 31, 2009 will be realized in future periods. Accordingly, a valuation allowance has been provided to reduce the net deferred tax assets to $0. At December 31, 2009, we had available net operating loss carryforwards of approximately $41.9 million, which expire beginning in the year 2020.

 
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We follow ASC topic 740-10, “Income Taxes.” ASC topic 740-10 clarified the accounting for uncertainty in income taxes recognized in the financial statements by prescribing a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. ASC topic 740-10 provides guidance regarding the recognition, measurement, presentation and disclosure in the financial statements of tax positions taken or expected to be taken on a tax return. ASC topic 740-10 requires that only income tax benefits that meet the “more likely than not” recognition threshold be recognized or continue to be recognized on its effective date. We have not recorded any unrecognized income tax benefits since the adoption of ASC topic 740-10.

New Accounting Standard

On January 21, 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2010-06. ASU 2010-06 amends ASC 820, “Fair Value Measurements,” and adds new requirements for disclosures about transfers in and out of Levels 1 and 2 in the fair value hierarchy and additional disclosures about purchases, sales, issuances and settlements relating to Level 3 fair value measurements. Additionally it clarifies existing fair value disclosures about the level of disaggregation about inputs and valuation techniques used to measure fair value. ASU 2010-06 is generally effective for the first reporting period beginning after December 15, 2009. We do not expect the adoption of ASU 2010-06 to have a significant impact on our consolidated results of operations and financial position.

Results of Operations

Our revenues are principally derived from providing integrated electronic payment services to merchants and businesses, including credit and debit card-based processing services and transaction processing via the Automated Clearinghouse Network. We also operate an online payment processing service for consumers under the domain name www.billx.com and sell this service as a private-label application to resellers. Total revenues for 2009 increased 7% to $3,218,674 from $3,001,487 for 2008. The increase from the prior year was primarily attributable to the increase in revenues generated from card-based processing services due to increased transaction volume. Our merchant accounts increased to 482 customers at December 31, 2009 from 335 customers at December 31, 2008. However, our largest customer, Access General Insurance, ceased using our processing services on an exclusive basis during October 2009 in what we alleged was a violation of its service agreements with us. We commenced legal action in November 2009 against Access General for the breach of its agreements with us and entered into a settlement agreement with Access General in December 2009 (See ITEM 3. Legal Proceedings). Consequently, Access General will not generate any significant revenues for us in 2010. Services provided to Access General accounted for approximately 28% and 17% of our total revenues for 2009 and 2008, respectively. Also, our second largest customer, Protection One, ceased using our processing services in January 2010 and will not generate any significant revenues for us in 2010. Services provided to Protection One accounted for approximately 15% and 11% of our total revenues for 2009 and 2008, respectively. In addition, the monthly average number of consumers using our billx.com online payment service decreased to 511 in 2009 from 716 in 2008. We expect this trend for our online payment service to continue unless our current plan to introduce and establish enhanced value by offering a prepaid MasterCard in conjunction with the service is successful in generating subscriber growth.

Cost of services includes the cost of personnel dedicated to the creation and maintenance of connections to third-party payment processors and fees paid to such third-party providers for electronic payment processing services. Through our contractual relationships with our payment processors, we are able to process Automated Clearinghouse and debit or credit card transactions on behalf of our customers and their consumers. We pay volume-based fees for debit and credit transactions initiated through these processors, and pay fees for other transactions such as returns, notices of change to bank accounts and file transmission. Cost of services was $2,429,629 and $2,422,364 for 2009 and 2008, respectively. The increase from the prior year was due primarily to the increase in fees related to processing the increased card-based transaction volume.

Stock-based compensation expenses decreased to $536,200 for 2009 from $636,175 for 2008. The decrease from the prior year was principally due to stock grants made in prior years that were fully amortized in 2008.

Other selling, general and administrative expenses decreased to $1,157,998 for 2009, from $1,575,032 for 2008. The decrease from the prior year was principally due to lower salary expenses of $360,000 for 2009 pursuant to amended executive employment agreements. On November 12, 2009, Michael Long, Chief Executive Officer and Chief Financial Officer, and Louis Hoch, President and Chief Operating Officer, agreed to reduce their annual base salaries for 2009 to $190,000 from $375,000 and $175,000 from $350,000, respectively.

Depreciation and amortization was $36,517 and $58,216 for 2009 and 2008, respectively. The decrease from the prior year was due to lower depreciation expense related to certain assets that became fully depreciated during 2008 or 2009. We did not capitalize any expenditures during 2009.

Net other income was $150,000 in 2009 compared to net other income of $757,508 in 2008. The change from the prior year was primarily attributable to a $750,000 gain on the sale of certain patents in January 2008.

Income taxes of $11,856 and $11,825 in 2009 and 2008, respectively, represent the amounts incurred under the Texas margin tax.

Net loss decreased to $803,526 in 2009 from $944,617 in 2008, as a result of the items discussed above.
 
 
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Liquidity and Capital Resources

At December 31, 2009, we had $565,597 of cash and cash equivalents, compared to $103,428 of cash and cash equivalents at December 31, 2008. We have incurred substantial losses since inception and have a deficit in net working capital. We believe that our current available cash and cash equivalents along with anticipated revenues may be insufficient to meet our anticipated cash needs for the foreseeable future. Consequently, our ability to continue as a going concern may be contingent on us receiving additional funds in the form of equity or debt financing. We are currently aggressively pursuing strategic financing alternatives.

On June 11, 2007, we entered into an agreement for an equity line of credit with Dutchess Private Equities Fund, LP. Under the terms of the agreement, we may elect to receive as much as $10 million from common stock purchases by Dutchess through August 23, 2012. Through December 31, 2009, we sold 1,535,263 shares of our common stock pursuant to the equity line of credit and received total proceeds, net of issuance costs, of $75,064.

On November 12, 2008, we granted to both Michael Long, Chief Executive Officer and Chief Financial Officer, and Louis Hoch, President and Chief Operating Officer, 6,171,429 shares of our common stock as an annual bonus of $216,000 pursuant to the terms of their respective employment agreements. The number of shares granted to each officer was based on the closing price of the common stock on October 15, 2008, which was $0.035 per share. On November 1, 2009, we granted to both Mr. Long and Mr. Hoch 7,200,000 shares of restricted common stock as an annual bonus of $216,000 pursuant to the terms of their respective employment agreements. The number of shares granted to each officer was based on the closing price of the common stock on October 15, 2009, which was $0.03 per share. We elected to make the bonus payments totally in common stock in order to conserve our cash and to further incent our executive officers to increase shareholder value by raising their ownership stake.

The satisfactory completion of additional sales of common stock to private investors or under our equity line of credit, borrowing funds, or growth of cash flow from operations is essential to provide sufficient cash flows to meet our current operating requirements. The sale of additional equity or convertible debt securities would result in additional dilution to our stockholders, and debt financing, if available, may involve restrictive covenants which could restrict our operations or finances. Financing may not be available in amounts or on terms acceptable to us, if at all. If we cannot raise funds on acceptable terms or achieve positive cash flow, we may not be able to continue to exist, conduct operations, grow market share, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which would negatively impact our business, operating results and financial condition.

Net cash provided by operating activities was $462,169 for 2009 and cash used in operating activities was $748,608 for 2008. Net cash provided by operating activities in 2009 was primarily attributable to the increase in customer deposits payable, which consists of cash held in transit that we collected on behalf of our merchants via the ACH system. Net cash used in operating activities in 2008 was primarily attributable to operating losses generated by growth stage activities and overhead costs. We plan to focus on expending our resources prudently given our current state of liquidity.

There were no cash flows generated by investing activities for the year ended December 31, 2009. Net cash provided by investing activities of $730,582 for 2008 resulted from receiving $750,000 in proceeds from the sale of our patents and making capital expenditures for computer hardware and software of $19,418.

There were no cash flows generated by financing activities for the year ended December 31, 2009. Net cash provided by financing activities for 2008 resulted from receiving $5,857 in net proceeds from the issuance of common stock under our equity line of credit.

Off-Balance Sheet Arrangements

We currently have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Not applicable.

 
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
Report of Independent Registered Public Accounting Firm    17  
       
Consolidated Balance Sheets as of December 31, 2009 and 2008   18  
       
Consolidated Statements of Operations for the years ended
  December 31, 2009 and 2008 
  19  
       
Consolidated Statement of Changes in Stockholders’ Equity (Deficit) for the years ended
  December 31, 2009 and 2008 
  20  
       
Consolidated Statements of Cash Flows for the years ended
  December 31, 2009 and 2008 
  21  
       
Notes to Consolidated Financial Statements    22  

 
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


The Board of Directors and Stockholders
Payment Data Systems, Inc. and Subsidiaries
San Antonio, Texas

We have audited the accompanying consolidated balance sheets of Payment Data Systems, Inc. and Subsidiaries (collectively referred to as “the Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, changes in stockholders' equity (deficit) and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2009 and 2008, and the consolidated results of their operations and cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

The accompanying financial statements of Payment Data Systems, Inc. and Subsidiaries have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 1, the Company has incurred substantial losses since inception, which has led to a deficit in working capital. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements of Payment Data Systems, Inc. and Subsidiaries   do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.


/s/ Akin, Doherty, Klein & Feuge, P.C.

Akin, Doherty, Klein & Feuge, P.C.
San Antonio, Texas
April 14, 2010


 
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PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS

   
December 31,
   
December 31,
 
   
2009
   
2008
 
             
ASSETS
           
Cash and cash equivalents
  $ 565,597     $ 103,428  
Accounts receivable, net
    92,545       158,736  
Prepaid expenses and other
    16,269       20,852  
  Total current assets
    674,411       283,016  
                 
Property and equipment, net
    25,597       62,114  
                 
Other assets:
               
  Related party receivable
    456,168       246,168  
  Other assets
    6,693       16,693  
    Total other assets
    462,861       262,861  
                 
Total Assets
  $ 1,162,869     $ 607,991  
                 
                 
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
               
Current Liabilities:
               
  Accounts payable
  $ 99,738     $ 108,055  
  Accrued expenses
    1,480,929       746,444  
  Customer deposits payable
    449,372       49,800  
  Deferred revenue
    17,336       71,537  
    Total current liabilities
    2,047,375       975,836  
                 
Stockholders' Equity (Deficit):
               
  Common stock, $0.001 par value, 200,000,000 shares authorized; 115,773,691
               
    issued and 110,778,547 and 112,547,215 outstanding
    115,774       115,774  
  Additional paid-in capital
    55,444,770       55,444,770  
  Treasury stock, at cost; 4,995,144 and 3,226,476 shares
    (238,155 )     (176,252 )
  Deferred compensation
    (1,979,416 )     (2,328,184 )
  Accumulated deficit
    (54,227,479 )     (53,423,953 )
    Total stockholders' equity (deficit)
    (884,506 )     (367,845 )
                 
Total Liabilities and Stockholders' Equity (Deficit)
  $ 1,162,869     $ 607,991  
 
See notes to consolidated financial statements.

 
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PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

   
Year ended
   
Year ended
 
   
December 31,
   
December 31,
 
   
2009
   
2008
 
             
Revenues
  $ 3,218,674     $ 3,001,487  
                 
Operating expenses:
               
Cost of services
    2,429,629       2,422,364  
Selling, general and administrative:
               
Stock-based compensation
    536,200       636,175  
Other expenses
    1,157,998       1,575,032  
Depreciation
    36,517       58,216  
Total operating expenses
    4,160,344       4,691,787  
                 
Operating loss
    (941,670 )     (1,690,300 )
                 
Other income (expense):
               
Interest income
    -       9,091  
Interest expense
    -       (423 )
Other income
    150,000       748,840  
Total other income (expense), net
    150,000       757,508  
                 
Loss before income taxes
    (791,670 )     (932,792 )
Income taxes
    11,856       11,825  
                 
Net Loss
  $ (803,526 )   $ (944,617 )
                 
                 
Earnings (Loss) Per Share
               
Basic and diluted net loss per common share:
  $ (0.01 )   $ (0.01 )
Weighted average common shares
               
outstanding - basic and diluted
    111,545,417       96,062,224  
 
See notes to consolidated financial statements.

 
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PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)

                                           
               
Additional
                     
Total
 
   
Common Stock
   
Paid - In
   
Treasury
   
Deferred
   
Accumulated
   
Stockholders'
 
   
Shares
   
Amount
   
Capital
   
Stock
   
Compensation
   
Deficit
   
Equity (Deficit)
 
Balance at December 31, 2007
    80,172,708     $ 80,173     $ 53,758,696     $ (176,052 )   $ (1,558,804 )   $ (52,479,336 )   $ (375,323 )
                                                         
Issuance of common stock – equity
  line of credit
    201,350       201       5,974       -       -       -       6,175  
Issuance of common stock – other
    35,399,633       35,400       1,680,100       -       (1,171,500 )     -       544,000  
Purchase of treasury stock
    -       -       -       (200 )     -       -       (200 )
Deferred compensation
    -       -       -       -       402,120       -       402,120  
Net loss for the year
    -       -       -       -       -       (944,617 )     (944,617 )
                                                         
Balance at December 31, 2008
    115,773,691     $ 115,774     $ 55,444,770     $ (176,252 )   $ (2,328,184 )   $ (53,423,953 )   $ (367,845 )
                                                         
Receipt of treasury stock
    -       -       -       (61,903 )     -       -       (61,903 )
Deferred compensation
    -       -       -       -       348,768       -       348,768  
Net loss for the year
    -       -       -       -       -       (803,526 )     (803,526 )
                                                         
Balance at December 31, 2009
    115,773,691     $ 115,774     $ 55,444,770     $ (238,155 )   $ (1,979,416 )   $ (54,227,479 )   $ (884,506 )
 
See notes to consolidated financial statements.

 
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PAYMENT DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

             
   
Year Ended
   
Year Ended
 
   
December 31, 2009
   
December 31, 2008
 
Operating Activities
           
Net loss
  $ (803,526 )   $ (944,617 )
Adjustments to reconcile net loss
               
  to net cash used in operating activities:
               
Depreciation
    36,517       58,216  
Deferred compensation
    348,768       402,120  
Gain on sale of patents
    -       (750,000 )
Bad debt
    18,435       (200 )
Loss on disposition of assets
    -       1,160  
Non-cash issuance of common stock
    -       515,985  
Changes in current assets and current liabilities:
               
  Accounts receivable
    47,756       (73,059 )
  Prepaid expenses and other
    14,583       30,043  
  Related party receivable
    (246,168 )     (246,168 )
  Accounts payable and accrued expenses
    700,433       248,399  
  Customer deposits payable
    399,572       (30,699 )
  Deferred revenue
    (54,201 )     40,212  
Net cash provided (used) by operating activities
    462,169       (748,608 )
                 
Investing Activities
               
Proceeds from sale of patents
    -       750,000  
Purchases of property and equipment
    -       (19,418 )
Net cash provided (used) by investing activities
    -       730,582  
                 
Financing Activities
               
Principal payments for notes payable
    -       -  
Issuance of common stock, net of issuance costs
    -       5,857  
Net cash provided by financing activities
    -       5,857  
                 
Change in cash and cash equivalents
    462,169       (12,169 )
Cash and cash equivalents, beginning of year
    103,428       115,597  
                 
Cash and Cash Equivalents, End of Year
  $ 565,597     $ 103,428  
                 
                 
Supplemental Disclosures
               
  Cash paid for interest
  $ -     $ -  
  Cash paid for income taxes
    13,790       3,600  
 
See notes to consolidated financial statements.

 
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PAYMENT DATA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009 AND 2008


Note 1. Description of Business and Summary of Significant Accounting Policies

Going Concern: Payment Data Systems, Inc. along with its subsidiaries, Ficentive, Inc., a Nevada corporation, Zbill, Inc., a Nevada corporation and billserv.com-Canada, Inc., a Nevada corporation, (collectively, the “Company”) has incurred substantial losses since inception, which has led to a continuing deficit in working capital. The Company believes its current available cash along with anticipated revenues may be insufficient to meet its anticipated cash needs for the foreseeable future. Consequently, the Company’s ability to continue as a going concern is likely contingent on the Company receiving additional funds in the form of equity or debt financing. Accordingly, the Company is pursuing strategic financing alternatives in addition to its equity line of credit (see Note 4). The sale of equity or convertible debt securities would result in additional dilution to the Company's stockholders, and debt financing, if available, may involve covenants which could restrict operations or finances. There can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all. If the Company cannot raise funds on acceptable terms, or achieve positive cash flow, it may not be able to continue to exist, conduct operations, grow market share, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which would negatively impact its business, operating results and financial condition.

Description of Business : The Company provides integrated electronic payment services, including credit and debit card-based processing services and transaction processing via the automated clearinghouse (“ACH”) network to billers and retailers. In addition, the Company operates an Internet electronic payment processing service for consumers under the domain name www.billx.com.

Principles of Consolidation and Basis of Presentation: The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

The accompanying financial statements have been presented assuming the Company will continue as a going concern.

Use of Estimates: The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition: Revenue consists primarily of fees generated through the electronic processing of payment transactions and related services, and are recognized as revenue in the period the transactions are processed or when the related services are performed. Merchants may be charged for these processing services at a bundled rate based on a percentage of the dollar amount of each transaction and, in some instances, additional fees are charged for each transaction. Certain merchant customers are charged a flat fee per transaction, while others may also be charged miscellaneous fees, including fees for chargebacks or returns, monthly minimums, and other miscellaneous services. Revenues derived from electronic processing of credit and debit card transactions that are authorized and captured through third-party networks are reported gross of amounts paid to sponsor banks as well as interchange and assessments paid to credit card associations (MasterCard and Visa). Revenue also includes any up-front fees for the work involved in implementing the basic functionality required to provide electronic payment processing services to a customer. Revenue from such implementation fees is recognized over the term of the related service contract. Sales taxes billed are reported directly as a liability to the taxing authority, and are not included in revenue.

Cash and Cash Equivalents : The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.

Accounts Receivable: Accounts receivable are reported at outstanding principal net of an allowance for doubtful accounts of approximately $42,000 and $31,000 at December 31, 2009 and 2008, respectively. The allowance is generally determined based on historical trends and an account-by-account review. Accounts are charged off when collection efforts have failed and the account is deemed uncollectible. The Company normally does not charge interest on accounts receivable.

Property and Equipment : Property and equipment are stated at cost. Depreciation and amortization are computed on a straight-line method over the estimated useful lives of the related assets, ranging from three to seven years. Leasehold improvements are amortized over the lesser of the estimated useful lives or remaining lease period. Expenditures for maintenance and repairs are charged to expense as incurred.

 
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Concentration of Credit Risk: Financial instruments that potentially expose the Company to credit risk consist of cash and cash equivalents, and accounts receivable. The Company is exposed to credit risk on its cash and cash equivalents in the event of default by the financial institutions to the extent of balances in excess of amounts that are insured by the FDIC. At December 31, 2009, the Company had uninsured cash amounts of $137,498. Trade receivables potentially subject the Company to concentrations of credit risk. The Company’s customer base operates in a variety of industries and is geographically dispersed, however, the relatively small number of customers increases the risk. The Company closely monitors extensions of credit and credit losses have been provided for in the consolidated financial statements and have been within management's expectations. In 2009, the Company recorded $18,435 of bad debt expense. The Company did not record any bad debt expense in 2008. The Company recorded bad debt write-offs of $6,734 and $1,749 to its allowance for doubtful accounts in 2009 and 2008, respectively. For the year ended December 31, 2009, 49% of total revenues were from sales to three customers. For the year ended December 31, 2008, 51% of total revenues were from sales to five customers.

Fair Value of Financial Instruments: Cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and short-term borrowings are reflected in the accompanying consolidated financial statements at cost, which approximates fair value because of the short-term maturity of these instruments.

Impairment of Long-Lived Assets : The Company periodically reviews, on at least an annual basis, the carrying value of its long-lived assets, including property, plant and equipment, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. To the extent fair value of a long-lived asset, determined based upon the estimated future cash inflows attributable to the asset, less estimated future cash outflows, is less than the carrying amount, an impairment loss is recognized.

Reserve for Losses on Merchant Accounts: Disputes between a cardholder and a merchant periodically arise as a result of, among other things, cardholder dissatisfaction with merchandise quality or merchant services. Such disputes may not be resolved in the merchant’s favor. In these cases, the transaction is “charged back” to the merchant and the purchase price is refunded to the customer through the merchant’s acquiring bank, and charged to the merchant. If the merchant has inadequate funds, the Company must bear the credit risk for the full amount of the transaction. The Company evaluates its risk for such transactions and estimates its potential loss for chargebacks based primarily on historical experience and other relevant factors.

Advertising Costs: Advertising is expensed as incurred. The Company incurred approximately $1,000 in advertising costs in both 2009 and 2008.

Income Taxes: Deferred tax assets and liabilities are recorded based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. The Company is subject to the Texas margin tax.

The Company follows Accounting Standards Codification (“ASC”) Topic 740. The Standard defines the confidence level that a tax position must meet in order to be recognized in the financial statements. ASC 740 requires a two-step approach under which the tax effect of a position is recognized only if it is “more-likely-than-not” to be sustained and the amount of tax benefit recognized is equal to the largest tax benefit that is greater than 50% likely of being realized upon ultimate settlement of the tax position. This approach requires the Company to exercise considerable judgment and estimates are inherent. ASC 740 also requires that the amount of interest expense to be recognized related to uncertain tax positions be computed by applying the applicable statutory rate of interest to the difference between the tax position recognized in accordance with ASC 740 and the amount previously taken or expected to be taken in a tax return.

Stock-Based Compensation : The Company recognizes as compensation expense all share-based payment awards made to employees and directors, including grants of stock options and warrants, based on estimated fair values. Fair value is generally determined based on the closing price of the Company’s common stock on the date of grant.

Net Loss Per Share : Basic and diluted losses per common share are calculated by dividing net loss by the weighted average number of common shares outstanding during the period. Common stock equivalents, which consist of stock options and warrants and the convertible debt, were excluded from the computation of the weighted average number of common shares outstanding for purposes of calculating diluted loss per common share because their effect was antidilutive. See Notes 11 and 12 for disclosure of securities that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been antidilutive for the periods presented.

Recent Accounting Pronouncements:   On January 21, 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2010-06. ASU 2010-06 amends ASC 820, “Fair Value Measurements,” and adds new requirements for disclosures about transfers in and out of Levels 1 and 2 in the fair value hierarchy and additional disclosures about purchases, sales, issuances and settlements relating to Level 3 fair value measurements. Additionally it clarifies existing fair value disclosures about the level of disaggregation about inputs and valuation techniques used to measure fair value. ASU 2010-06 is generally effective for the first reporting period beginning after December 15, 2009. The Company does not expect the adoption of ASU 2010-06 to have a significant impact on its consolidated results of operations and financial position.
 
 
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Subsequent Events: Management has reviewed and evaluated events and transactions which have occurred subsequent to December 31, 2009 through April 14, 2010, the date of issuance of these financial statements. See Note 14 .

Reclassification: Certain reclassifications, all insignificant in amount, have been made to the prior year’s financial statements in order to conform to the current presentation .

Note 2. Stock-Based Compensation

During the year ended December 31, 2008, the Company issued a total of 256,775 shares of common stock under the terms of its Comprehensive Employee Stock Plan to independent contractors providing consulting services to the Company and recorded $14,500 of related expense.

On November 12, 2008, Michael Long, Chief Executive Officer and Chief Financial Officer, and Louis Hoch, President and Chief Operating Officer, were each granted 6,171,429 shares of restricted common stock by the Company as an annual bonus of $216,000 pursuant to the terms of their respective employment agreements. The number of shares granted to each officer was based on the closing price of the common stock on October 15, 2008, which was $0.035 per share.

On November 1, 2009, Mr. Long and Mr. Hoch were each granted 7,200,000 shares of restricted common stock by the Company as an annual bonus of $216,000 pursuant to the terms of their respective employment agreements. The number of shares granted to each officer was based on the closing price of the common stock on October 15, 2009, which was $0.03 per share.

Compensation cost related to non-vested common stock awards will be recognized in future years as follows:
 
Year ending December 31,      
2010   $ 349,000  
2011     349,000  
2012     238,000  
2013     238,000  
2014     238,000  
2015     238,000  
2016     202,000  
2017     127, 000  
Total deferred compensation   $ 1,979 , 000  
 
Note 3. Acquisition of Treasury Stock

On December 29, 2008, the Company purchased 879,121 shares of common stock from CheckFree Investment Corp. for a total of $200 under a Stock Purchase Agreement.

On March 30, 2009, the Company accepted 680,715 shares of the Company’s common stock valued at $23,825 from Michael Long, Chief Executive Officer and Chief Financial Officer, and 352,658 shares of the Company’s common stock valued at $12,343 from Louis Hoch, President and Chief Operating Officer, in partial satisfaction of their annual payment due to the Company for 2008 as provided for under their respective employment agreements (see Note 9).

On September 15, 2009, the Company accepted 735,295 shares of the Company’s common stock valued at $25,735 pursuant to a settlement agreement with Tara Patrick (see Note 13).

 
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Note 4. Equity Line of Credit

On June 11, 2007, the Company entered into an agreement for an equity line of credit with Dutchess Private Equities Fund, LP (“Dutchess”). Under the terms of the agreement, at its election the Company may receive as much as $10 million in common stock purchases by Dutchess over a period of five years. The Company agreed to file with the Securities and Exchange Commission (“SEC”), and have declared effective before any funds may be received under the agreement, a registration statement registering the resale of the shares of the Company’s common stock to be issued to Dutchess. The Company filed a registration statement on Form SB-2 with the SEC on August 23, 2007 to register the resale of these shares. On September 10, 2007, the SEC declared the registration statement effective. During the year ended December 31, 2008, the Company sold 201,350 shares of its common stock pursuant to the equity line of credit and received total proceeds, net of issuance costs, of $5,857. The Company did not sell any shares of its common stock pursuant to the equity line of credit during 2009.

Note 5. Sale of Patents

On January 11, 2008, the Company signed an agreement to sell selected patents and patent applications to PCT Software Data, LLC, subject to customary closing conditions. On January 17, 2008, the Company completed the sale and received proceeds of $750,000. The patents and patent applications sold relate to bill payments made with debit and stored value cards. The Company retained a worldwide, non-exclusive license under the patents for use with all current and future customers.

Note 6. Property and Equipment

The following is a summary of property and equipment at December 31:

   
2009
   
2008
 
             
Furniture and fixtures
  $ 175,856     $ 175,856  
Equipment
    501,577       501,577  
Software
    325,322       325,322  
Leasehold improvements
    15,992       15,992  
Total property and equipment
    1,018,747       1,018,747  
Less: accumulated depreciation
    (993,150 )     (956,633 )
                 
Net property and equipment
  $ 25,597     $ 62,114  

Note 7. Accrued Expenses

Accrued expenses consist of the following balances at December 31:

 
 
2009
   
2008
 
             
Accrued salaries
  $ 1,195,683     $ 311,880  
Reserve for merchant losses
    205,400       209,220  
Accrued commissions
    39,362       144,202  
Accrued taxes
    36,724       77,469  
Other accrued expenses
    3,760       3,673  
                 
Total accrued expenses
  $ 1,480,929     $ 746,444  
 
Note 8. Operating Leases

The Company has a lease for approximately 4,500 square feet that houses its headquarters and operations. Rental expense under the operating lease was approximately $81,000 for each of the years ended December 31, 2009 and 2008. On October 7, 2009, the Company executed a second amendment to this lease agreement. The amendment extended the lease agreement for a period of three years and requires future minimum lease payments of $236,617 through its expiration in October 2012.
 
 
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Note 9. Related Party Transactions and Guarantees

As previously disclosed, in 2002 the Company recognized a loss on margin loans it guaranteed for Michael R. Long, then Chairman of the Board of Directors and Chief Executive Officer; and Louis A. Hoch, then President and Chief Operating Officer, in the amount of $535,302 and $449,371, respectively. In February 2007, the Company signed employment agreements with Mr. Long and Mr. Hoch that require each to repay his respective obligation to us in four equal annual payments of cash or stock or any combination thereof. In December 2007, the Company accepted common stock and stock options valued at $133,826 and $112,343 from Mr. Long and Mr. Hoch, respectively, in satisfaction of their annual payments for 2007 as provided for under their employment agreements.

In December 2008, Mr. Long and Mr. Hoch did not pay the Company the second annual installment pursuant to their respective employment agreements. They each withheld payment of the installment due because the Company had deferred payment of their salary increases for 2008 called for under their respective employment agreements. At December 31, 2008, the Company owed Mr. Long and Mr. Hoch deferred salary of $110,000 and $100,000, respectively, and Mr. Long and Mr. Hoch owed the Company $133,825 and $112,343, respectively, for the second installment due by December 31, 2008. The total amount owed to the Company for the second installment was $246,168 and is classified as Related Party Receivable on the Company’s balance sheet at December 31, 2008. On March 30, 2009, the Company accepted 680,715 shares of the Company’s common stock valued at $23,825 and 352,658 shares of the Company’s common stock valued at $12,343 from Mr. Long and Mr. Hoch, respectively, in partial satisfaction of their annual payment due to the Company for 2008 as provided for under their employment agreements. The partial payments of $23,825 and $12,343 made to the Company by Mr. Long and Mr. Hoch, respectively, equaled the difference between the amount each owed to the Company for the second installment and the amount the Company owed to each for deferred salary. The common stock accepted from Mr. Long and Mr. Hoch was valued at $0.035 per share, which was the closing price of the common stock on March 30, 2009. The common stock accepted from Mr. Long and Mr. Hoch was recorded as treasury stock with a total cost of $36,168.

In December 2009, Mr. Long and Mr. Hoch did not pay the Company the third annual installment pursuant to their respective employment agreements. They each withheld payment of the installment due because the Company had partially deferred payment of their salary for 2009 called for under their respective employment agreements. At December 31, 2009, the Company owed Mr. Long and Mr. Hoch deferred salary for 2009 of $162,385 and $141,808, respectively, and Mr. Long and Mr. Hoch owed the Company $133,825 and $112,343, respectively, for the third installment due by December 31, 2009. The total amount owed to the Company for the unpaid installments is classified as Related Party Receivable on the Company’s balance sheet and was $456,168 and $246,168 at December 31, 2009 and 2008, respectively.

On November 12, 2009, the Company executed amendments to its employment agreements with Michael Long, Chief Executive Officer and Chief Financial Officer, and Louis Hoch, President and Chief Operating Officer. Under the terms of their respective amended employment agreements, Mr. Long and Mr. Hoch agreed to reduce their annual base salaries for 2009 to $190,000 and $175,000, respectively, from $375,000 and $350,000, respectively. The reduction in salary expense for the Company was recorded evenly over the last six months of 2009.

During the years ended December 31, 2009 and 2008, the Company paid Herb Authier a total of $29,077 and $34,250, respectively, for consulting services related to network engineering and administration that he provided to the Company. The amount paid to Mr. Authier in 2009 consisted of $29,077 in cash. The amount paid to Mr. Authier in 2008 consisted of $22,500 in cash and 206,775 shares of the Company’s common stock valued at $11,750. Mr. Authier is the father-in-law of Louis Hoch, the Company’s President and Chief Operating Officer.

 
26
 
 
Note 10. Income Taxes

Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities are as follows at December 31:

   
2009
   
2008
 
             
Gross deferred tax assets:
           
Warrant expense
  $ 3,228,000     $ 3,228,000  
Loss on related party guarantees
    435,000       435,000  
Net operating loss carryforwards
    14,235,000       13,963,000  
Depreciation and other items
    85,000       85,000  
Total deferred tax assets
    17,983,000       17,711,000  
                 
Gross deferred tax liabilities:
               
Other items
    (13,000 )     (14,000 )
Total deferred tax liabilities
    (13,000 )     (14,000 )
                 
Net deferred tax asset
    17,970,000       17,697,000  
Less: valuation allowance
    (17,970,000 )     (17,697,000 )
                 
Net deferred tax asset recorded
  $ -     $ -  

The Company’s federal income tax returns for the years ended December 31, 2004 through December 31, 2009 remain subject to examination by authorities. If applicable, the Company would recognize interest expense and penalties related to uncertain tax positions in interest expense. As of December 31, 2009, the Company had not accrued any interest or penalties related to uncertain tax provisions.

The Company has net operating loss carryforwards for tax purposes of approximately $41.9 million that begin to expire in the year 2020. In October 1999, the Company issued common stock pursuant to a private placement offering. As a result, an ownership change occurred under Section 382 that limits the utilization of pre-change net operating loss carryforwards. Approximately $3.5 million of the total net operating loss is subject to the Section 382 limitations.
The reconciliation of federal income tax computed at the U.S. federal statutory tax rates to total income tax expense is as follows for the year ended December 31:

   
2009
   
2008
 
Tax (benefit) at statutory rate -- 34%
  $ (273,000 )   $ (321,000 )
Change in valuation allowance
    273,000       320,000  
Permanent and other differences
    -       1,000  
                 
Income tax expense
  $ -     $ -  

Note 11. Stock Option and Incentive Plans

Stock Option Plans : The Board of Directors and stockholders approved the 1999 Employee Comprehensive Stock Plan ("Employee Plan") to provide qualified incentive stock options (“ISOs”) and non-qualified stock options (“NQSOs”) as well as restricted stock grants to key employees. Under the terms of the Employee Plan, the exercise price of ISOs must be equal to 100% of the fair market value on the date of grant (or 110% of fair market value in the case of an ISO granted to a 10% stockholder/grantee). There is no price requirement for NQSOs, other than that the option price must exceed the par value of the common stock. The Company has reserved 30,000,000 shares of its common stock for issuance pursuant to the Employee Plan.

The 1999 Non-Employee Director Plan ("Director Plan") was approved by the Board of Directors and stockholders in 1999. Under the Director Plan, non-employee directors may be granted options to purchase shares of common stock at 100% of fair market value on the date of grant. The Company has reserved 1,500,000 shares of its common stock for issuance pursuant to the Director Plan.

Option activity under the Employee Plan and Director Plan is as follows:

   
Number of Shares
   
Weighted Average Exercise Price
 
Outstanding, December 31, 2007
    3,837,836     $ 0.46  
   Granted
    -       -  
   Canceled
    (15,000 )     0.20  
   Exercised
    -       -  
                 
Outstanding, December 31, 2008
    3,822,836       0.46  
   Granted
    -       -  
   Canceled
    (203,333 )     3.75  
   Exercised
    -       -  
                 
Outstanding, December 31, 2009
    3,619,503     $ 0.27  
                 

There was an aggregate of 14,419,165 options to purchase the Company’s common stock available for future grants under the Employee and Director Plans at December 31, 2009. There were no stock options granted during 2009 or 2008.

 
 
27
 
 
Summarized information about stock options outstanding is as follows at December 31, 2009:

         
Options Outstanding
   
Options Exercisable
 
Range of Exercise Prices
   
Options Outstanding
 
Weighted Average Remaining Contractual Life
 
Weighted Average Exercise Price
   
Number of Options
   
Weighted Average Exercise Price
 
$ 0.08 - $0.14       3,230,000  
4.9 years
  $ 0.11       3,230,000     $ 0.11  
$ 0.18 - $0.26       164,500  
3.0 years
  $ 0.18       164,500     $ 0.18  
$ 0.86 - $0.88       87,668  
1.8 years
  $ 0.87       87,668     $ 0.87  
$ 1.88 - $2.07       109,001  
1.1 years
  $ 2.06       109,001     $ 2.06  
$ 11.25       28,334  
0.3 years
  $ 11.25       28,334     $ 11.25  
          3,619,503  
4.6 years
  $ 0.27       3,619,503     $ 0.27  

Employee Stock Purchase Plan : The Company established the 1999 Employee Stock Purchase Plan ("ESPP") under the requirements of Section 423 of the Internal Revenue Code (the "Code") to allow eligible employees to purchase the Company’s common stock at regular intervals. Participating employees may purchase common stock through voluntary payroll deductions at the end of each participation period at a purchase price equal to 85% of the lower of the fair market value of the common stock at the beginning or the end of the participation period. Common stock reserved for future employee purchases under the plan aggregated 755,828 shares at December 31, 2009. There were no shares issued under the ESPP in 2009 or 2008.

401(k) Plan: The Company has a defined contribution plan (the "401(k) Plan") pursuant to Section 401(k) of the Code. All eligible full and part-time employees of the Company who meet certain age requirements may participate in the 401(k) Plan. Participants may contribute between 1% and 15% of their pre-tax compensation, but not in excess of the maximum allowable under the Code. The 401(k) Plan allows for discretionary and matching contributions by the Company. In 2008, the Company made required minimum contributions of $5,914 in total to non-key employees because the 401(k) Plan was determined to be top-heavy.  The Company did not make any contributions in 2009.

Note 12. Stock Warrants

At December 31, 2009, there were outstanding vested warrants that expire on June 2, 2010 to purchase 2,179,121 shares of common stock at an exercise price of $11.38.
 
 
 
28
 
 
 
Note 13. Legal Proceeding

On August 29, 2008, Tara Patrick p/k/a Carmen Electra, commenced legal action against the Company in the Superior Court of the State of California for the County of Los Angeles. On October 7, 2008, the Company removed that case to the United States District Court for the Central District of California – Los Angeles Division. With respect to the suit, the plaintiff alleged that the Company violated her rights of publicity and breached the terms of its license agreement with her. The plaintiff alleged and sought resulting economic, exemplary and punitive damages, interest, attorneys' fees and costs of court. On November 14, 2008, the Company filed a counterclaim against Ms. Patrick in the United States District Court for the Central District of California – Los Angeles Division alleging that she breached the terms of the Company’s license agreement with her. The Company alleged and sought to recover damages arising from her breach of the agreement.

On September 15, 2009, the Company entered into a settlement agreement with Ms. Patrick. Under the terms of the settlement, both parties dismissed the pending litigation, with prejudice, and released all claims against each other. Additionally, the Company agreed to pay $6,000 to Ms. Patrick and $500 to a charity of her choosing and she agreed to return all 735,295 shares of the Company’s common stock received by her under the original license agreement to the Company. The return of this common stock was recorded as an acquisition of treasury stock with a value of $25,735, based on the closing price of the common stock on September 15, 2009, which was $0.035 per share. The Company does not expect to incur any additional expenses associated with this litigation.

On November 12, 2008, the Company commenced legal action against its former customers Commerce Planet, Inc. and Consumer Loyalty Group, Inc., in the 285 th Judicial District Court of Bexar County, Texas. The Company alleged that they breached the terms of its services agreement with it and sought to recover economic damages and attorneys' fees. On January 22, 2009, the Court entered a Default Judgment awarding the Company actual damages in the amount of $140,472 and attorney’s fees in the amount of $4,000. The Company was also awarded all costs of Court and pre-judgment and post-judgment interest as provided by law. On or about January 1, 2009, Commerce Planet entered into an Asset Purchase Agreement with Morlex, Inc. Pursuant to this agreement, Commerce Planet’s liabilities were assigned to and/or assumed by Morlex, including the debt owed to the Company. On May 27, 2009, the Company commenced legal action against Morlex, Inc., in the 285 th Judicial District Court of Bexar County, Texas. On September 2, 2009, the Court entered a Default Judgment awarding the Company actual damages in the amount of $140,472 and attorney’s fees in the amount of $7,500. The Company was also awarded all costs of Court and pre-judgment and post-judgment interest as provided by law.

On March 2, 2010, the Company entered into a settlement agreement with Commerce Planet, Inc. Under the terms of the settlement, Commerce Planet agreed to pay the Company $75,000 and issue 5,000,000 shares of free trading Commerce Planet common stock to the Company on or before April 2, 2010. Additionally, both parties released all claims against each other. On March 2, 2010, the Company received payment of $75,000 from Commerce Planet in accordance with the terms of the settlement. As of the date of this report, the Commerce Planet common stock had not been delivered to the Company. The Company intends to pursue any legal means available to it in order to enforce the settlement agreement.

On November 12, 2009, the Company commenced legal action against our customers Access Insurance Holdings, Inc., Access General Agency, Inc., Access General Insurance Agency of California, Inc., Access General Agency of Pennsylvania, Inc., Access General Agency of Florida, Inc., Access General Insurance Agency of Texas, Inc., Access General Agency of Arizona, Inc. and Access Adjusting Services, Inc. (collectively referred to as “Access General”), in the 285 th Judicial District Court of Bexar County, Texas. The Company alleged that Access General breached the terms of its services agreements with the Company by violating the exclusivity provisions contained therein and sought to recover economic damages and attorneys' fees.

On December 30, 2009, the Company entered into a settlement agreement with Access General. Under the terms of the settlement, Access General agreed to pay the Company $150,000 to dismiss the pending litigation, with prejudice, and both parties released all claims against each other. Access General also agreed to pay the Company for actual chargeback amounts and associated fees as incurred. Additionally, Access General agreed to pay the Company monthly minimum processing fees of $33.00 a month for each of the associated merchant accounts until June 30, 2010. The Company agreed to indemnify Access General against any third party early termination fees. On December 30, 2009, the Company received payment of $150,000 from Access General in accordance with the terms of the settlement. The Company does not expect to incur any additional expenses associated with this litigation.

Note 14. Subsequent Events

On April 12, 2010, the Company executed amendments to its employment agreements with Michael Long, Chief Executive Officer and Chief Financial Officer, and Louis Hoch, President and Chief Operating Officer. Under the terms of their respective amended employment agreements, Mr. Long and Mr. Hoch agreed to reduce their annual base salaries for 2010 to $24,000 each from $375,000 and $350,000, respectively and change the annual bonus limit from 100% of current salary to 100% of the highest salary received in any year of the agreement.

 
29
 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

None.

ITEM 9A(T). CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

Our management evaluated, with the participation of our Chief Executive Officer / Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Annual Report on Form 10-K. Based on that evaluation, our Chief Executive Officer / Chief Financial Officer concluded that our disclosure controls and procedures as of December 31, 2009 are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our Chief Executive Officer / Chief Financial Officer, as appropriate, to allow timely decisions regarding required reasonable assurance that such information is accumulated and communicated to our management. Our disclosure controls and procedures are designed to provide reasonable assurance that such information is accumulated and communicated to our management. Our disclosure controls and procedures include components of our internal control over financial reporting. Management's assessment of the effectiveness of our internal control over financial reporting is expressed at the level of reasonable assurance that the control system, no matter how well designed and operated, can provide only reasonable, but not absolute, assurance that the control system's objectives will be met.

Management’s Report on Internal Control Over Financial Reporting

Our management evaluated, with the participation of our Chief Executive Officer / Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this annual report on Form 10-K. Based on that evaluation, our Chief Executive Officer / Chief Financial Officer concluded that our disclosure controls and procedures as of December 31, 2009 are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our Chief Executive Officer / Chief Financial Officer, as appropriate, to allow timely decisions regarding required reasonable assurance that such information is accumulated and communicated to our management. Our disclosure controls and procedures are designed to provide reasonable assurance that such information is accumulated and communicated to our management. Our disclosure controls and procedures include components of our internal control over financial reporting. Management's assessment of the effectiveness of our internal control over financial reporting is expressed at the level of reasonable assurance that the control system, no matter how well designed and operated, can provide only reasonable, but not absolute, assurance that the control system's objectives will be met.

Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting that occurred during the quarter ended December 31, 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

ITEM 9B. OTHER INFORMATION.

None.

 
30
 

PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.

The following persons are executive officers and/or directors of our Company:

Michael R. Long, age 65 - Chief Executive Officer, Chief Financial Officer and Chairman of the Board

Mr. Long has been our Chief Executive Officer and Chairman of the Board since July 1998. In addition, Mr. Long has been our Chief Financial Officer since September 2003. Mr. Long has more than thirty years of senior executive management and systems development experience in six publicly traded companies, as well as experience operating a systems consulting business. Before assuming the top position with our Company, Mr. Long was Vice President of Information Technology at Billing Concepts, Inc., the largest third party billing clearinghouse for the telecommunications industry. Mr. Long's career experience also includes financial services industry business development for Anderson Consulting and several executive positions in publicly traded telecommunications and financial services companies.

Louis A. Hoch, age 44 - President, Chief Operating Officer and Vice Chairman of the Board

Mr. Hoch has been our President, Chief Operating Officer, and Director since July 1998 and also serves as Vice Chairman of the Board. Mr. Hoch has more than fifteen years of management experience in large systems development; earning him national recognition as an expert in call centers, voice-systems and computer telephony integration. Mr. Hoch has held various key management positions with U.S. Long Distance, Billing Concepts, Inc. and Anderson Consulting. Mr. Hoch holds a BBA in Computer Information Systems and an MBA in International Business Management, both from Our Lady of the Lake University Business School.

Ken Keller, age 44 - Vice President, Chief Technology Officer

Mr. Keller joined Payment Data Systems in June 2003 and has been our Vice President, Chief Technology Officer since January 2008. Mr. Keller has over eighteen years of experience in the development and delivery of specialized high volume transaction-based systems. Prior to joining our Company in 2003, he served in a variety of key leadership and executive technical roles at Billserv, Inc. Prior to Billserv, Inc., Mr. Keller was employed in the telecommunications industry with companies such as US Long Distance, LCI International, Qwest Communications and Broadwing, specializing in enterprise wide database development and implementation. Mr. Keller earned a BBA in Information Technology from the University of Texas - San Antonio.

Larry Morrison, age 50 - Vice President, Business Development

Mr. Morrison has been our Vice President, Business Development since July 2003. Mr. Morrison has over twenty-five years of experience in all aspects of sales and sales management. Before joining our Company to oversee all sales and marketing functions, Mr. Morrison served as a major accounts executive for a tier one telecommunications provider and vice president of sales and operations for a major two-way communications firm. His background also includes management and implementation of large government communication systems installations both domestic and abroad.

Peter G. Kirby, Ph.D. SPHR CM, age 70 - Director

Dr. Kirby has been our Director since June 2001. Dr. Kirby distinguished himself in professional and community activities in a career that spanned over thirty-five years. He is an accomplished public speaker and has provided consulting services to Fortune 100 firms. Dr. Kirby has published numerous works in the fields of management, decision-making and human resources. He has been a director on many university advisory councils and boards and has served on many charitable committees and foundations. Dr. Kirby retired in 2006 as a tenured professor of Management at Our Lady of the Lake University in San Antonio, Texas, where he taught for seventeen years. Dr. Kirby served as Chair of the QFN Economic Development Corporation, a Canadian corporation, from April 2007 to May 2008.

SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Under U.S. securities laws, directors, officers and beneficial owners of more than 10% of our common stock must report their initial ownership of the common stock, and any changes in that ownership, to the Securities and Exchange Commission, or SEC. The SEC has designated specific due dates for these reports. Directors, officers and greater-than-10% beneficial owners are required by SEC regulations to furnish us with copies of all Section 16(a) forms they file. To our knowledge, based solely on a review of copies of such reports furnished to us, we believe all Section 16(a) filing requirements applicable to our directors, officers and greater-than-10% beneficial owners were complied with during our fiscal year ended December 31, 2009.

 
31
 
 
CODE OF ETHICS

We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions. Our code of ethics is filed as Exhibit 14.1 to our Annual Report on Form 10-K for the year ended December 31, 2003. We will provide a copy of our code of ethics to any person without charge, upon request. Requests should be addressed to: Payment Data Systems, Inc., Attn: Investor Relations Department, 12500 San Pedro, Suite 120, San Antonio, Texas 78216.

PROCEDURE FOR NOMINATING DIRECTORS

We have not made any material changes to the procedures by which security holders may recommend nominees to our Board of Directors.

We consider recommendations for Director candidates from our Directors, officers, employees, stockholders, customers and vendors. Stockholders wishing to nominate individuals to serve as directors may submit such nominations, along with a nominee's qualifications, to our Board of Directors at Payment Data Systems, Inc., 12500 San Pedro, Suite 120, San Antonio, Texas, 78216, and the Board of Directors will consider such nominee. The Board of Directors selects the Director candidates slated for election. We do not have a Nominating Committee in light of resource allocations made by the Board of Directors in its business judgment.

AUDIT COMMITTEE

The Audit Committee, established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended, is currently comprised of our only independent director, Dr. Peter Kirby, and it operates under a written charter adopted by our Board of Directors. Dr. Kirby meets the independence standards for independent directors under the rules of the Nasdaq Stock Market published in the Nasdaq Marketplace Rules. The composition of the Audit Committee, the attributes of its members and the responsibilities of the Committee, as reflected in its charter, are intended to be in accordance with applicable requirements for corporate audit committees. The Committee reviews and assesses the adequacy of its charter on an annual basis.

As set forth in more detail in its charter, the Audit Committee’s purpose is to assist the Board of Directors in its general oversight of our financial reporting, internal control and audit functions. Management is responsible for the preparation, presentation and integrity of our financial statements, accounting and financial reporting principles and internal controls and procedures designed to ensure compliance with accounting standards, applicable laws and regulations. Akin, Doherty, Klein & Feuge, P.C., our independent auditing firm, is responsible for performing an independent audit of the consolidated financial statements in accordance with standards of the Public Company Accounting Oversight Board.

The Audit Committee members are generally not professional accountants or auditors, and their functions are not intended to duplicate or to certify the activities of management and the independent auditor, nor can the Audit Committee certify that the independent auditor is “independent” under applicable rules. The Audit Committee serves a board-level oversight role, in which it provides advice, counsel and direction to management and the auditors on the basis of the information it receives, discussions with management and the auditors and the experience of the Audit Committee’s members in business, financial and accounting matters.

Among other matters, the Audit Committee monitors the activities and performance of our internal and external auditors, including the audit scope, external audit fees, auditor independence matters and the extent to which the independent auditor may be retained to perform non-audit services. The Audit Committee and the Board of Directors have ultimate authority and responsibility to select, evaluate and, when appropriate, replace our independent auditor. The Audit Committee also reviews the results of the internal and external audit work with regard to the adequacy and appropriateness of our financial, accounting and internal controls. Management and independent auditor presentations to and discussions with the Audit Committee also cover various topics and events that may have significant financial impact or are the subject of discussions between management and the independent auditor. In addition, the Audit Committee generally oversees our internal compliance programs.

In overseeing the preparation of our financial statements, the Audit Committee has had access to our management to review and discuss all financial statements prior to their issuance and to discuss significant accounting issues. Management advised the Audit Committee that all financial statements were prepared in accordance with U.S. generally accepted accounting principles. The Audit Committee has met with our independent auditors with regard to our audited financial statements for the year ended December 31, 2009. For the year ended December 31, 2009, the Audit Committee did receive the independent auditor’s letter and written disclosures required by the Independence Standards Board Standard No. 1 (Independence Discussions with Audit Committees).

For the year ended December 31, 2009, the only member of the Audit Committee was Dr. Kirby. The Audit Committee met four times in relation to the year ended December 31, 2009. We do not have an audit committee financial expert serving on our Audit Committee because we have been unable to replace the independent director serving as the audit committee financial expert after his resignation during 2003. We are still seeking an independent director to serve as the audit committee financial expert.
 
 
32
 
 
ITEM 11. EXECUTIVE COMPENSATION.

SUMMARY COMPENSATION

The following table shows the compensation earned during the fiscal years ended December 31, 2009 and 2008 by
(i) our Principal Executive Officer, or PEO; and (ii) our two most highly compensated executive officers, other than our PEO.  We refer to the individuals included below as our “named executive officers.”

Summary Compensation Table for the Fiscal Years Ended December 31, 2009 and 2008

 
 
 
Name and Principal Position
(a)
 
 
Year
Ended
Dec.  31,
(b)
 
 
 
 
Salary
($)(5)
(c)
   
 
 
 
Bonus
($)(1)
(d)
   
 
 
Stock Awards
($)(2)
(e)
   
 
 
Option Awards
($)(3)
(f)
   
 
Nonequity Incentive Plan Compensation
($)
(g)
   
Nonqualified Deferred Compensation Earnings
($)
(h)
   
 
 
All Other Compensation
($)(4)
(i)
   
 
 
 
Total
($)
(j)
 
                                                     
Michael R. Long
                                                   
Chairman, Chief
 
2009
    190,000       216,000       131,592       -       -       -       12,117       549,709  
Executive Officer
 
2008
    300,000       216,000       149,966       -       -       -       12,117       678,083  
and Chief Financial Officer
                                                                   
                                                                     
Louis A. Hoch
                                                                   
Vice Chairman,
 
2009
    175,000       216,000       151,776       -       -       -       2,520       545,296  
President and
 
2008
    275,000       216,000       168,451       -       -       -       2,520       661,971  
Chief Operating Officer
                                                                   
                                                                     
Ken Keller
                                                                   
Vice President,
 
2009
    104,200       -       16,356       -       -       -       1,052       121,608  
Chief Technology
 
2008
    104,200       27,500       18,906       -       -       -       2,121       152,727  
Officer
                                                                   
                                                                     

(1)  
On November 1, 2009, we granted Mr. Long and Mr. Hoch 7,200,000 shares of common stock each as an annual bonus valued at $216,000 pursuant to the terms of their respective employment agreements. On November 12, 2008, we granted Mr. Long and Mr. Hoch 6,171,429 shares of common stock each as an annual bonus valued at $216,000 pursuant to the terms of their respective employment agreements. On January 9, 2008, we granted 500,000 shares of common stock to Mr. Keller valued at $27,500.
(2)  
Amount recognized for financial statement reporting purposes. On February 27, 2007, we executed employment agreements with Mr. Long and Mr. Hoch and subsequently issued 500,000 shares of common stock to each under the terms of their respective employment agreements. We also issued 2,500,000 shares of common stock to each as a long-term incentive under the terms of their respective employment agreements. The incentive stock is restricted and vests annually over five years in increments of 500,000 shares beginning on February 28, 2009. On January 9, 2008, we granted our named executive officers a total of 17,050,000 shares of restricted common stock as follows: Mr. Long, 7,750,000 shares; Mr. Hoch, 7,750,000 shares; and Mr. Keller, 1,550,000 shares. This stock vests on January 9, 2018.
(3)  
There were no stock options granted to any of our named executive officers during fiscal year 2009 or 2008.
(4)  
Reflects premiums paid for term life insurance coverage. The amount for Mr. Keller in 2008 also includes a required minimum contribution of $1,069 to Mr. Keller’s 401(k) Plan account because the 401(k) Plan was determined to be top-heavy.
(5)  
Pursuant to the terms of their respective employment agreements, we agreed to increase the annual base salaries of Mr. Long and Mr. Hoch by the amounts of $110,000 and $100,000, respectively, for the 2008 fiscal year. We have deferred payment of the $110,000 and $100,000 increases to Mr. Long and Mr. Hoch, respectively, until a future date. On November 12, 2009, we executed amendments to our employment agreements with Michael Long, Chief Executive Officer and Chief Financial Officer, and Louis Hoch, President and Chief Operating Officer. Under the terms of their respective amended employment agreements, Mr. Long and Mr. Hoch agreed to reduce their annual base salaries for 2009 to $190,000 and $175,000, respectively, from $375,000 and $350,000, respectively.

 
33
 

Narrative to Summary Compensation Table

Named Executive Officer Employment Agreements

We entered into an employment agreement with Michael R. Long effective February 27, 2007. Under the agreement, Mr. Long serves as our Chairman of the Board, Chief Executive Officer and Chief Financial Officer. The agreement provides for base annual salaries of $190,000 for 2007, $300,000 for 2008 and $375,000 for 2009, 2010 and 2011. In addition, Mr. Long will receive an annual bonus of $216,000 during the term of the agreement to be paid in cash or stock at our sole discretion. Upon execution of the agreement, Mr. Long received cash of $15,000, 500,000 shares of common stock from our Employee Stock Plan, and 2,500,000 shares of restricted common stock that vest annually in increments of 500,000 shares beginning on February 28, 2009. On November 12, 2009, we executed an amendment to our employment agreement with Mr. Long. Under the terms of the amended employment agreement, Mr. Long agreed to reduce his annual base salary for 2009 to $190,000 from $375,000. On April 12, 2010, we executed another amendment to our employment agreement with Mr. Long. Under the terms of the amended employment agreement, Mr. Long agreed to reduce his annual base salary for 2010 to $24,000 from $375,000 and change the annual bonus limit from 100% of current salary to 100% of the highest salary received in any year of the agreement.

We entered into an employment agreement with Louis A. Hoch effective February 27, 2007. Under the agreement, Mr. Hoch serves as our Vice Chairman of the Board, President and Chief Operating Officer. The agreement provides for base annual salaries of $175,000 for 2007, $275,000 for 2008 and $350,000 for 2009, 2010 and 2011. In addition, Mr. Hoch will receive an annual bonus of $216,000 during the term of the Agreement to be paid in cash or stock at our sole discretion. Upon execution of the agreement, Mr. Hoch received cash of $15,000, 500,000 shares of common stock from our Employee Stock Plan, and 2,500,000 shares of restricted common stock that vest annually in increments of 500,000 shares beginning on February 28, 2009. On November 12, 2009, we executed an amendment to our employment agreement with Mr. Hoch. Under the terms of the amended employment agreement, Mr. Hoch agreed to reduce his annual base salary for 2009 to $175,000 from $350,000. On April 12, 2010, we executed another amendment to our employment agreement with Mr. Hoch. Under the terms of the amended employment agreement, Mr. Hoch agreed to reduce his annual base salary for 2010 to $24,000 from $350,000 and change the annual bonus limit from 100% of current salary to 100% of the highest salary received in any year of the agreement.

We do not have an employment agreement with Mr. Keller.

 
34
 
 
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END

The following table shows grants of unexercised stock options and unvested stock by grant date outstanding on December 31, 2009, the last day of our fiscal year, to each of the named executive officers included in the Summary Compensation Table.

Outstanding Equity Awards at Fiscal Year-End Table for the Fiscal Year Ended December 31, 2009

 
 
 
 
 
 
Name
(a)
Option awards (1)
Stock awards (1)
Number of securities underlying unexercised options (#) exercisable
(b)
Number of securities underlying unexercised options (#) unexercisable
(c)
 
Option exercise price
($)
(e)
 
 
 
Option expiration date
(f)
Number of shares or units of stock that have not vested
(#)(2)
(g)
 
Market value of shares or units of stock that have not vested
($)(3)
(h)
Michael R. Long
           
12/30/2003
400,000
-
0.14
12/30/2013
-
-
12/29/2005
381,833
-
0.082
12/29/2015
1,355,972
27,119
12/27/2006
-
-
-
-
2,500,611
50,012
2/27/2007
-
-
-
-
2,500,000
50,000
1/09/2008
-
-
-
-
7,750,000
155,000
             
Louis A. Hoch
           
12/30/2003
425,000
-
0.14
12/30/2013
-
-
12/29/2005
586,147
-
0.082
12/29/2015
2,081,536
41,631
12/27/2006
-
-
-
-
4,083,333
81,667
2/27/2007
-
-
-
-
2,500,000
50,000
1/09/2008
-
-
-
-
7,750,000
155,000
             
Ken Keller
           
6/10/2003
85,000
-
0.085
6/10/2013
-
-
12/30/2003
90,000
-
0.14
12/30/2013
-
-
12/29/2005
102,492
-
0.082
12/29/2015
363,971
7,279
12/27/2006
-
-
-
-
538,333
10,767
1/09/2008
-
-
-
-
1,550,000
31,000
             

(1)  
We do not have any equity incentive plan awards.
(2)  
Unvested common stock granted on December 29, 2005 vests on December 29, 2015, unvested common stock granted on December 27, 2006 vests on December 27, 2016 and unvested common stock granted on January 9, 2008 vests on January 9, 2018. Unvested common stock granted on February 27, 2007 vests annually over five years in increments of 500,000 shares beginning on February 28, 2009. Mr. Long and Mr. Hoch each chose to defer vesting of the increment of 500,000 shares that was granted to each of them on February 27, 2007 and scheduled to vest on February 28, 2009.
(3)  
Calculated using the Over-the-Counter Bulletin Board, or OTCBB, closing price of $0.02 per share of our common stock on December 31, 2009.

 
35
 
 
Narrative to Outstanding Equity Awards at Fiscal Year-End Table

Retirement Benefits

We do not have any qualified or non-qualified defined benefit plans. We do have a tax-qualified defined contribution plan pursuant to Section 401(k) of the Internal Revenue Code. All of our eligible full and part-time employees who meet certain age requirements may participate in this 401(k) plan. Participants may contribute between 1% and 15% of their pre-tax compensation. The 401(k) plan allows for us to make discretionary and matching contributions. We made no such contributions during 2009 or 2008. In 2008, we made a required minimum contribution of $1,069 to Mr. Keller because the 401(k) Plan was determined to be top-heavy.

Non-qualified Deferred Compensation

We do not have any non-qualified defined contribution plans or other deferred compensation plans.

Potential Payments Upon Termination or Change of Control

Our employment agreements with Mr. Long and Mr. Hoch each provide that upon termination of his employment with us due to death or disability, involuntary termination without cause, termination for good reason or default by us, termination due to non-renewal of the agreement, or change of control, he is entitled to deferred compensation. This deferred compensation shall be the amount which is calculated as the greater of the base salary payments that each would have received had his employment continued for the remaining term of the agreement (including yearly increases calculated at the maximum increase for the prior two years), or an amount equal to 2.95 times the higher annual compensation earned by him in the past two years. In addition to this compensation, each shall be entitled to all of the benefits otherwise provided in his agreement during that period of time which is the greater of the remaining term of the agreement, or one year, and an amount equal to the pro rata portion of his bonus compensation for the year in which his employment is terminated. In addition, all stock options and restricted stock granted to each executive become fully vested upon his termination for any of these reasons. Also, in consideration of the executive’s obligations for a period of two years after the termination of his employment under a non-competition clause in the employment agreement, he shall be paid an amount equal to 2 times the base salary paid to him in the year prior to the expiration of the agreement.
 
DIRECTOR COMPENSATION
 
The following table sets forth a summary of the compensation earned by our independent director in fiscal 2009.

Director Compensation Table for the Fiscal Year Ended December 31, 2009
 
 
 
 
 
Name
(a)
Fees earned or paid in cash
($)
(b)
 
 
Stock
awards
($)(1)
(c)
 
 
Option
awards
($)(2)
(d)
 
Non-equity incentive plan compensation
($)
(e)
Non-qualified deferred compensation earnings
($)
(f)
 
 
All other compensation
($)
(g)
 
 
 
Total
($)
(h)
               
Peter G. Kirby
-
6,348
-
-
-
-
6,348
 
(1)  
Amount recognized for financial statement reporting purposes. At December 31, 2009, Dr. Kirby had outstanding 500,000 shares of common stock with a grant date fair value of $27,500 granted on January 9, 2008 that vest on January 9, 2018, 400,000 shares of common stock with a grant date fair value of $36,000 granted on December 27, 2006 that vest on December 27, 2016 and 300,000 shares of common stock with a grant date fair value of $60,000 granted on March 28, 2005 that vested one-third on each of March 28, 2006, March 28, 2007 and March 28, 2008.
(2)  
At December 31, 2009, Dr. Kirby had outstanding options to purchase 618,000 shares of our common stock.

Narrative to Director Compensation Table

We do not have an agreement with our independent director, Dr. Peter G. Kirby, to compensate him for his service on our Board of Directors. Mr. Long and Mr. Hoch receive no compensation for serving on our Board of Directors due to their status as officers of our Company. On January 9, 2008, we granted Dr. Kirby 500,000 shares of common stock that vest on January 9, 2018.

 
36
 
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth, to our knowledge, certain information concerning the beneficial ownership of our common stock as of April 14 2010 by each stockholder known by us to be (i) the beneficial owner of more than 5% of the outstanding shares of our common stock, (ii) each current director, (iii) each of the named executive officers included in the Summary Compensation Table, and (iv) all of our directors and current executive officers as a group:

Name and address of beneficial owner
 
Amount and Nature of
Beneficial Ownership
 
Percent of Class (1)
5% Stockholder
               
Robert Evans, P.O. Box 56, Williamsville, IL 62693
   
11,520,000
     
9.2
%
                 
Named Executive Officers and Directors
               
Louis A. Hoch
   
33,085,021
(2)
   
26.2
%
Michael R. Long
   
30,610,461
(3)
   
24.3
%
Ken Keller
   
3,409,982
(4)
   
2.7
%
Peter G. Kirby
   
1,818,500
(5)
   
1.4
%
All executive officers and directors as a group (5 people)
   
71,111,454
(6)
   
55.5
%

(1)  
Based on a total of 125,178,547 shares of common stock issued and outstanding on April 14, 2010.

(2)  
Includes 1,011,147 shares that Mr. Hoch has the right to acquire upon the exercise of stock options.

(3)  
Includes 781,833 shares that Mr. Long has the right to acquire upon the exercise of stock options.

(4)  
Includes 277,492 shares that Mr. Keller has the right to acquire upon the exercise of stock options.

(5)  
Includes 618,000 shares that Dr. Kirby has the right to acquire upon the exercise of stock options.

(6)  
The address of all individual directors and executive officers is c/o Payment Data Systems, Inc., 12500 San Pedro, Suite 120, San Antonio, Texas 78216.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
 
TRANSACTIONS WITH RELATED PERSONS

In December 2002, we recognized losses of $535,302 and $449,371 under loan guarantees we made to collateralize margin loans for Michael R. Long, then Chairman of the Board of Directors and Chief Executive Officer, and Louis A. Hoch, then President and Chief Operating Officer, respectively, for which they were obliged to repay us. In February 2007, we entered into employment agreements with Mr. Long, our Chairman of the Board, Chief Executive Officer and Chief Financial Officer, and Mr. Hoch, our President and Chief Operating Officer, that require each executive officer to repay his respective obligation to us in four equal annual payments of cash or stock or any combination thereof. On December 29, 2007, we accepted common stock and stock options valued at $133,826 and $112,343 from Mr. Long and Mr. Hoch, respectively, in satisfaction of their annual payments for 2007 as provided for under their employment agreements. Mr. Long’s payment consisted of 1,285,714 shares of our common stock valued at $96,429 and options to purchase a total of 898,334 shares of our common stock at exercise prices ranging from $0.18 to $2.81 per share. These options were valued at $37,397. Mr. Hoch’s payment consisted of 1,061,041 shares of our common stock valued at $79,623 and options to purchase a total of 765,000 shares of our common stock at exercise prices ranging from $0.18 to $2.81 per share. These options were valued at $32,720. The common stock accepted from Mr. Long and Mr. Hoch was valued at $0.075 per share, which was the closing price of our common stock on December 19, 2007. We recorded the common stock accepted from Mr. Long and Mr. Hoch as treasury stock with a total cost of $176,052. We determined the fair value of each stock option accepted from Mr. Long and Mr. Hoch using the Black-Scholes option-pricing model. We canceled the options accepted from Mr. Long and Mr. Hoch on December 29, 2007 and recorded a total direct charge to equity of $70,117. In December 2008, Mr. Long and Mr. Hoch did not pay us the second annual installment pursuant to their respective employment agreements. They each withheld payment of the installment due because we had deferred payment of their salary increases for 2008 called for under their respective employment agreements. At December 31, 2008, we owed Mr. Long and Mr. Hoch deferred salary of $110,000 and $100,000, respectively, and Mr. Long and Mr. Hoch owed us $133,825 and $112,343, respectively, for the second installment due by December 31, 2008. The total amount owed to us for the second installment was $246,168 and is classified as Related Party Receivable on our balance sheet at December 31, 2008. On March 30, 2009, we accepted 680,715 shares of our common stock valued at $23,825 and 352,658 shares of our common stock valued at $12,343 from Mr. Long and Mr. Hoch, respectively, in satisfaction of a portion of their annual payments for 2008 as provided for under their employment agreements. The common stock accepted from Mr. Long and Mr. Hoch was valued at $0.035 per share, which was the closing price of the common stock on March 30, 2009.
 
 
37
 
 
In December 2009, Mr. Long and Mr. Hoch did not pay us the third annual installment pursuant to their respective employment agreements. They each withheld payment of the installment due because the Company had partially deferred payment of their salary for 2009 called for under their respective employment agreements. At December 31, 2009, the Company owed Mr. Long and Mr. Hoch deferred salary of $162,385 and $141,808, respectively, and Mr. Long and Mr. Hoch owed the Company $133,825 and $112,343, respectively, for the third installment due by December 31, 2009. The total amount owed to the Company for the unpaid installments was $456,168 and is classified as Related Party Receivable on the Company’s balance sheet at December 31, 2009.

During the years ended December 31, 2009 and 2008, we paid Herb Authier a total of $29,077 and $34,250, respectively, for consulting services related to network engineering and administration that he provided to the Company. The amount paid to Mr. Authier in 2009 consisted of $29,077 in cash. The amount paid to Mr. Authier in 2008 consisted of $22,500 in cash and 206,775 shares of the Company’s common stock valued at $11,750. Mr. Authier is the father-in-law of Louis Hoch, the Company’s President and Chief Operating Officer.

DIRECTOR INDEPENDENCE

During the fiscal year ended December 31, 2009, Michael R. Long, Louis A. Hoch and Peter G. Kirby served on our Board of Directors. Dr. Kirby was our sole independent board member as determined pursuant to the independence standards set forth in the Marketplace Rules of the Nasdaq Stock Market. We are currently traded on the Over-the-Counter Bulletin Board, which does not require that a majority of the board be independent.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.

Fees Paid to the Independent Accountants

The aggregate fees billed to us for professional accounting services, including the audit of our annual consolidated financial statements by our principal accountant for the fiscal years ended December 31, 2009 and 2008 included in our Form 10-K, are set forth in the table below.
 
    2009     2008  
Audit fees   $ 48,600     $ 54,000  
Tax fees      3, 500       3, 750  
Total fees     $ 52, 100     $ 57 ,750  
 
For purposes of the preceding table, the professional fees are classified as follows:

• Audit Fees—These are fees for professional services billed for the audit of the consolidated financial statements included in our Form 10-K filings, the review of consolidated financial statements included in our Form 10-Q filings, comfort letters, consents and assistance with and review of documents filed with the SEC. The fees in the 2009 column include amounts billed to us through April 14, 2010 for the year ended December 31, 2009 and the fees in the 2008 column include amounts billed to us through April 14, 2010 for the years ended December 31, 2008.

• Tax Fees—These are fees for professional services rendered by our independent accountant for tax compliance, tax planning and tax advice. Tax compliance involves preparation of original and amended tax returns. Tax planning and tax advice encompass a diverse range of subjects, including assistance with tax audits and appeals, tax advice related to dispositions, and requests for rulings or technical advice from taxing authorities.

Audit Committee’s Pre-Approval Policies and Procedures

We may not engage our independent accountant to render any audit or non-audit service unless our Audit Committee approves the service in advance. All of the services performed by our independent accountant described above were approved in advance by our Audit Committee.

 
38
 
 
PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
 
(a)(1) Consolidated Financial Statements.
 
The following documents are filed in Part II, Item 8 of this annual report on Form 10-K:
 
Report of Independent Registered Public Accounting Firm
 
Consolidated Balance Sheets as of December 31, 2009 and 2008
 
Consolidated Statements of Operations for the years ended December 31, 2009 and 2008
 
Consolidated Statements of Changes in Stockholders’ Equity (Deficit) for the years ended December 31, 2009 and 2008
 
Consolidated Statements of Cash Flows for the years ended December 31, 2009 and 2008
 
Notes to Consolidated Financial Statements
 
(a)(2) Financial Statement Schedules.
 
All financial statement schedules have been omitted as they are not required, not applicable, or the required information is otherwise included.
 
(a)(3) Exhibits.
 
Exhibit
Number
  Description
     
3.1   Amended and Restated Articles of Incorporation (included as exhibit 3.1 to the Form 10-KSB filed March 31, 2006, and incorporated herein by reference).
     
3.2   Amended and Restated By-laws (included as exhibit 3.2 to the Form 10-KSB filed March 31, 2006, and incorporated herein by reference).
     
4.1   Amended and Restated 1999 Employee Comprehensive Stock Plan (included as exhibit 10.1 to the Form 8-K filed January 3, 2006, and incorporated herein by reference).
     
4.2   Amended and Restated 1999 Non-Employee Director Plan (included as exhibit 10.2 to the Form 8-K filed January 3, 2006, and incorporated herein by reference).
     
4.3  
Employee Stock Purchase Plan (included as exhibit 4.3 to the Form S-8 filed February 23, 2000, and incorporated herein by reference).
     
4.4  
Registration Rights Agreement between the Company and Dutchess Private Equities Fund, LP, dated June 6, 2004 (included as exhibit 10.9 to the Form SB-2 filed June 18, 2004, and incorporated herein by reference).
     
4.5   Rights Agreement between the Company and American Stock Transfer & Trust Company, dated February 28, 2007 (included as exhibit 4.1 to the Form 8-K filed March 5, 2007, and incorporated herein by reference).
     
10.1   Lease Agreement between the Company and Frost National Bank, Trustee for a Designated Trust, dated August 22, 2003 (included as exhibit 10.3 to the Form 10-Q filed November 14, 2003, and incorporated herein by reference).
     
10.2   Employment Agreement between the Company and Michael R. Long, dated February 27, 2007 (included as exhibit 10.1 to the Form 8-K filed March 2, 2007, and incorporated herein by reference).
     
10.3   Employment Agreement between the Company and Louis A. Hoch, dated February 27, 2007 (included as exhibit 10.2 to the Form 8-K filed March 2, 2007, and incorporated herein by reference).
 
 
39
 
 
Exhibit
Number
  Description
     
10.4   Investment Agreement between the Company and Dutchess Private Equities Fund, LP, dated June 4, 2004 (included as exhibit 10.8 to the Form SB-2 filed June 18, 2004, and incorporated herein by reference).
     
10.5   Placement Agent Agreement between the Company, Charleston Capital Corporation, and Dutchess Private Equities Fund, LP, dated June 4, 2004 (included as exhibit 10.10 to the Form SB-2 filed June 18, 2004, and incorporated herein by reference).
     
10.6   Affiliate Office Agreement between the Company and Network 1 Financial, Inc. (included as exhibit 10.11 to the Form SB-2 filed April 28, 2004, and incorporated herein by reference).
     
10.7   Warrant Agreement between the Company and Kubra Data Transfer LTD, dated as of September 30, 2004 (included as exhibit 10.1 to the Form 8-K filed October 6, 2004, and incorporated herein by reference).
     
10.8   Promissory Note between the Company and Dutchess Private Equities Fund, II, LP, dated August 21, 2006 (included as exhibit 10.1 to the Form 8-K filed August 25, 2006, and incorporated herein by reference).
     
10.9   Stock Purchase Agreement between the Company and Robert D. Evans, dated January 18, 2007 (included as exhibit 10.1 to the Form 8-K filed January 23, 2007, and incorporated herein by reference).
     
10.10   Stock Purchase Agreement between the Company and Robert D. Evans, dated March 1, 2007 (included as exhibit 10.1 to the Form 8-K filed March 5, 2007, and incorporated herein by reference).
     
10.11   Amended Investment Agreement between the Company and Dutchess Private Equities Fund, Ltd., dated August 21, 2007 (included as exhibit 10.16 to the Form 8-K filed August 23, 2007, and incorporated herein by reference).
     
10.12   Amended Registration Rights Agreement between the Company and Dutchess Private Equities Fund, Ltd., dated August 21, 2007 (included as exhibit 10.2 to the Form 8-K filed August 23, 2007, and incorporated herein by reference).
     
10.13   Trademark and Domain Name Purchase Agreement between the Company and Alivio Holdings, LLC, dated November 14, 2005 (included as exhibit 10.1 to the Form 8-K filed November 17, 2005, and incorporated herein by reference).
     
10.14   First Amendment to Employment Agreement between the Company and Michael R. Long, dated November 12, 2009 (included as exhibit 10.15 to the Form 10-Q filed November 16, 2009, and incorporated herein by reference).
     
10.15    First Amendment to Employment Agreement between the Company and Louis A. Hoch, dated November 12, 2009 (included as exhibit 10.16 to the Form 10-Q filed November 16, 2009, and incorporated herein by reference).
     
10.16   Second Amendment to Employment Agreement between the Company and Michael R. Long, dated April 12, 2010 (filed herewith).
     
10.17   Second Amendment to Employment Agreement between the Company and Louis A. Hoch, dated April 12, 2010 (filed herewith).
     
14.1   Code of Ethics (included as exhibit 14.1 to the Form 10-K filed March 30, 2004, and incorporated herein by reference).
     
16.1   Letter from Ernst and Young LLP to the Securities and Exchange Commission dated February 10, 2004 (included as exhibit 16.1 to the Form 8-K filed February 11, 2004, and incorporated herein by reference).
     
21.1   Subsidiaries of the Company (included as exhibit 21.1 to the Form 10-K filed March 31, 2008, and incorporated herein by reference).
     
23.1   Consent of Akin Doherty Klein & Feuge, P.C., Independent Registered Public Accounting Firm (filed herewith).
     
31.1   Certification of the Chief Executive Officer/Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
     
32.1   Certification of the Chief Executive Officer/Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
 
 
40
 
 
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
  Payment Data Systems, Inc.  
       
 
By:
/s/ R. Long  
    Michael R. Long  
   
Chairman of the Board, Chief Executive Officer, and
Chief Financial Officer
 
       
  Date: April 14, 2010  

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
 
       
 
By:
/s/ Michael R. Long  
    Michael R. Long  
   
Chairman of the Board, Chief Executive Officer, and
Chief Financial Officer (principal executive officer and
principal financial and accounting officer)
 
       
  Date: April 14, 2010  
       
       
  By:  /s/ Louis A. Hoch  
    Louis A. Hoch  
   
President, Chief Operating Officer, and
Director
 
       
  Date: April 14, 2010  
       
       
  By:  /s/ Peter G. Kirby  
   
Peter G. Kirby
Director
 
       
  Date: April 14, 2010  
 
41
 
Exhibit 10.16
 
Second Amendment to Employment Agreement

This Second Amendment (“Second Amendment”), to the Employment Agreement (the "Agreement") dated February 27, 2007 between Payment Data Systems, Inc. ("PDS") and Michael R. Long (“Executive") is entered into this 12th day of April, 2010 and is m ade part of the Agreement which is hereby amended as follows:

1.            Definitions.   All capitalized terms used herein and not expressly defined herein shall have the respective meanings given to such terms in the Agreement.

2.            Entire Agreement.   Except as expressly modified by this Second Amendment, the Agreement shall be and remain in full force and effect in accordance with its terms and shall constitute the legal, valid, binding and enforceable obligations of PDS and Executive.

3.            Successors and Assigns.   This Second Amendment shall be binding upon and inure to the benefit of the successors and permitted assigns of the parties hereto.

4.            Section References.   Section titles and references used in this Second Amendment shall be without substantive meaning or content of any kind whatsoever and are not a part of the agreements among the parties hereto evidenced hereby.

5.           Now, therefore, in consideration of the mutual covenants set forth herein and for other good and valuable consideration, the adequacy, receipt and sufficiency of which are hereby acknowledged:
 
a.  
The Base Salary as set forth in Schedule 4(a)(i) of Schedule 1 to the Agreement is hereby amended to be $24,000 per annum in year 2010.
 
b.  
Schedule 4(b) of Schedule 1 of the Agreement is replaced in its entirety with, “BONUS: Not to exceed 100% of the highest salary received in any year of the Agreement as described in Schedule 4(a)(i) of Schedule 1.”

This Second Amendment amends the Agreement as set forth herein. All previously existing obligations under the Agreement are hereby reaffirmed in all respects.

In witness thereof, the parties hereto have caused this Second Amendment to the Agreement to be executed on the day and year first above written .
 
Payment Data Systems, Inc.     Executive  
           
 By: /s/ Louis A. Hoch           By: /s/ Michael R. Long  
Name: Louis A. Hoch    Name: Michael R. Long  
Title:    President & COO        

Exhibit 10.17
 
Second Amendment to Employment Agreement

This Second Amendment (“Second Amendment”), to the Employment Agreement (the "Agreement") dated February 27, 2007 between Payment Data Systems, Inc. ("PDS") and Louis A. Hoch (“Executive") is entered into this 12th day of April, 2010 and is m ade part of the Agreement which is hereby amended as follows:

1.            Definitions.   All capitalized terms used herein and not expressly defined herein shall have the respective meanings given to such terms in the Agreement.

2.            Entire Agreement.   Except as expressly modified by this Second Amendment, the Agreement shall be and remain in full force and effect in accordance with its terms and shall constitute the legal, valid, binding and enforceable obligations of PDS and Executive.

3.            Successors and Assigns.   This Second Amendment shall be binding upon and inure to the benefit of the successors and permitted assigns of the parties hereto.

4.            Section References.   Section titles and references used in this Second Amendment shall be without substantive meaning or content of any kind whatsoever and are not a part of the agreements among the parties hereto evidenced hereby.

5.           Now, therefore, in consideration of the mutual covenants set forth herein and for other good and valuable consideration, the adequacy, receipt and sufficiency of which are hereby acknowledged:

a.  
The Base Salary as set forth in Schedule 4(a)(i) of Schedule 1 to the Agreement is hereby amended to be $24,000 per annum in year 2010.
 
b.  
Schedule 4(b) of Schedule 1 of the Agreement is replaced in its entirety with, “BONUS: Not to exceed 100% of the highest salary received in any year of the Agreement as described in Schedule 4(a)(i) of Schedule 1.”

This Second Amendment amends the Agreement as set forth herein. All previously existing obligations under the Agreement are hereby reaffirmed in all respects.

In witness thereof, the parties hereto have caused this Second Amendment to the Agreement to be executed on the day and year first above written .

Payment Data Systems, Inc.     Executive  
           
 By: /s/ Michael R. Long    By: /s/ Louis A. Hoch  
Name: Michael R. Long    Name: Louis A. Hoch  
Title:    CEO & CFO        
 
EXHIBIT 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
We consent to the incorporation by reference in the Registration Statements (Form SB-2 No. 333-145656) of Payment Data Systems, Inc.; (Form S-8 No. 333-122312) pertaining to the Amended and Restated 1999 Employee Comprehensive Stock Plan of Payment Data Systems, Inc. and the 1999 Non-Employee Director Plan of Payment Data Systems, Inc.; and (Form S-8 No. 333-30958) pertaining to the Employee Stock Purchase Plan of Payment Data Systems, Inc. of our report dated April 14, 2010, with respect to the consolidated financial statements of Payment Data Systems, Inc. included in the Annual Report (Form 10-K) for the year ended December 31, 2009.
 
/s/ Akin, Doherty, Klein & Feuge, P.C.

AKIN, DOHERTY, KLEIN & FEUGE, P.C.
San Antonio, Texas
April 14, 2010


 
EXHIBIT 31.1
 
CERTIFICATION PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
(18 U.S.C. SECTION 1350)
 
I, Michael R. Long, certify that:

1.  I have reviewed this annual report of Payment Data 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.  As the registrant’s certifying officer, I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

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

(b)  Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)  Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report my 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 (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.  As the registrant’s certifying officer, I have disclosed, based on my 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: April 14, 2010
   
     
 
/s/ Michael R. Long                                
  Michael R. Long  
  Chief Executive Officer,  
  Chief Financial Officer  
  and Principal Accounting Officer  
 
EXHIBIT 32.1
 
CERTIFICATION PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
(18 U.S.C. SECTION 1350)

Pursuant to section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code), the undersigned officer of Payment Data Systems, Inc., a Nevada corporation (the “Company”), does hereby certify, to such officer's knowledge, that:

The Annual Report on Form 10-K for the year ended December 31, 2009 (the “Form 10-K”) of the Company fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and the information contained in the Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Company.
 
 
Dated: April 14, 2010
     
       
 
By:  /s/ Michael R. Long                               
    Michael R. Long  
    Chief Executive Officer,  
    Chief Financial Officer  
    and Principal Accounting Officer