Unassociated Document
 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 20–F
 
¨
REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
 
OR
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the fiscal year ended December 31, 2008
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
OR
 
o
SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Date of event requiring this shell company report………….
 
For the transition period from _________________ to ________________
 
Commission file number 000–26495
 
COMMTOUCH SOFTWARE LTD.
(Exact name of Registrant as specified in its charter and
translation of Registrant’s name into English)
 
Israel
(Jurisdiction of incorporation or organization)
 
4A Hazoran Street
Poleg Industrial Park,
P.O. Box 8511
Netanya 42504, Israel
011–972–9–863–6888
(Address of principal executive offices)
 
Ron Ela, CFO, Fax: 011-972-9-8636863. Same address as above.
(Name, Telephone, Email and/or Facsimile number and Address of Company Contact Person)

 
Securities registered or to be registered pursuant to Section 12(b) of the Act.
 
Title of each class
Name of each exchange on which registered
Ordinary Shares, par value NIS 0.15 per share
NASDAQ Capital Market
 
Securities registered or to be registered pursuant to Section 12(g) of the Act: None
 
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act.
 
None
 
 
 

 

 
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report (December 31, 2008).
 
Ordinary Shares, par value NIS 0.15
25,206,659
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes oNo x
 
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes oNo x
 
Note: Checking the above box will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  Check one:
 
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing.
 
U.S. GAAPx
International Financial Reporting Standards as issued by the International Accounting Standards Boardo
           Othero
 
If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow. Item 17 o Item 18 o
 
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes oNo x
 


 
 

 
 
PART I
 
Item 1. Identity of Directors, Senior Management and Advisers.
 
Not applicable.
 
Item 2. Offer Statistics and Expected Timetable.
 
Not Applicable
 
Item 3. Key Information.
 
Unless otherwise indicated, all references in this document to “Commtouch,” “the Company,” “we,” “us” or “our” are to Commtouch Software Ltd. or its wholly–owned subsidiary, Commtouch Inc., as relating to consolidated financial information contained herein.
 
The selected consolidated statements of operations data for the years ended December 31, 2006, 2007 and 2008 and the selected consolidated balance sheet data as of December 31, 2007 and 2008 have been derived from the Consolidated Financial Statements of Commtouch included elsewhere in this report. The selected consolidated statements of operations data for the years ended December 31, 2004 and 2005 and the selected consolidated balance sheet data as of December 31, 2004, 2005 and 2006 have been derived from the Consolidated Financial Statements of Commtouch not included elsewhere in this report. Our historical results are not necessarily indicative of results to be expected for any future period. The data set forth below should be read in conjunction with “Item 5. Operating and Financial Review and Prospects” and the Consolidated Financial Statements and the Notes thereto included elsewhere herein:
 
   
Year Ended December 31,
 
   
2004
   
2005
   
2006
   
2007
   
2008
 
   
(USD in thousands, except per share data)
 
Selected Data:
                             
Revenues
  $ 1,523     $ 3,925     $ 7,234     $ 11,250     $ 14,092  
Operating profit (loss)
  $ (6,223 )   $ (2,656 )   $ (415 )   $ 1,610     $ 1,931  
Net income (loss) attributable to ordinary
                                       
and equivalently participating shareholders
  $ (7,193 )   $ (2,690 )   $ (190 )   $ 2,109     $ 2,270  
Basic net earnings (loss) per share
  $ (0.54 )   $ (0.28 )   $ (0.01 )   $ 0.08     $ 0.09  
Diluted net earnings (loss) per share
  $ (0.54 )   $ (0.28 )   $ (0.01 )   $ 0.08     $ 0.08  
Weighted average number of shares used in
                                       
computing basic net earnings (loss) per share
    13,323       15,802       22,113       24,847       25,619  
Weighted average number of shares used in
                                       
computing diluted net earnings (loss) per share
    13,323       15,802       22,113       27,591       26,929  
Total Assets
  $ 5,479     $ 7,995     $ 11,999     $ 18,210     $ 20,709  
 
FORWARD LOOKING STATEMENTS
 
Except for the historical information contained in this Annual Report, the statements contained in this Annual Report are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, as amended, and other federal securities laws with respect to our business, financial condition and results of operations.  Such forward-looking statements reflect our current view with respect to future events and financial results.
 
 
 

 

We urge you to consider that statements which use the terms “anticipate,” “believe,” “expect,” “plan,” “intend,” “estimate and similar expressions are intended to identify forward-looking statements.  We remind readers that forward-looking statements are merely predictions and therefore inherently subject to uncertainties and other factors and involve known and unknown risks that could cause the actual results, performance, levels of activity, or our achievements, or industry results, to be materially different from any future results, performance, levels of activity, or our achievements, or industry results, expressed or implied by such forward-looking statements. Such forward-looking statements appear in Item 4 – “Information on the Company” and Item 5 – “Operating and Financial Review and Prospects,” as well as elsewhere in this Annual Report. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  Except as required by applicable law, including the securities laws of the United States, we undertake no obligation to update or revise any forward-looking statements to reflect new information, future events or circumstances, or otherwise after the date hereof.  We have attempted to identify significant uncertainties and other factors affecting forward-looking statements in the Risk Factors section that appears below.
 
RISK FACTORS
 
You should carefully consider the following risk factors before you decide to buy our Ordinary Shares. You should also consider the other information in this report. If any of the following risks actually occur, our business, financial condition, operating results or cash flows could be materially adversely affected. This could cause the trading price of our Ordinary Shares to decline, and you could lose part or all of your investment. The risks described below are not the only ones facing us. Additional risks not presently known to us, or that we currently deem immaterial, may also impair our business operations.
 
Business Risks
 
If the market does not continue to respond favorably to our current advanced email defense solutions, including our anti-spam and anti-virus solutions and our new Uniform Resource Locator, or URL filtering solutions, or our future solutions do not gain acceptance, we will fail to generate sufficient revenues.
 
Our success depends on the continued acceptance and use of our advanced email defense solutions and initial interest in and acceptance of our URL filtering solutions by current and new enterprise, Original Equipment Manufacturer or “OEM”, and Internet Service Provider, or ISP customers and technology licensees. We have been selling our anti-spam products for over five years, our Zero-Hour™ virus outbreak detection product for approximately four years, our IP reputation service (our latest version being known as GlobalView™ Mail Reputation) for less than three years and our URL filtering solutions for less than six months.
 
As the markets for email defense and web security products continue to mature and the global economy remains in a recessionary mode, we are seeing increasing competitive pressures and demands for even higher quality products at lower prices.   This increasing demand comes at a time when email and web-based threats are more varied and intensive, challenging even the top end solutions to keep their performance at an industry acceptable high level of accuracy. If our solutions do not continue to evolve to meet market demand, or newer products on the market prove more effective, our business could fail.  Also, if growth in the markets for email and web-based defense solutions begins to slow, our business will suffer dramatically.
 
Continuing unfavorable national and global economic conditions could have a material adverse effect on our business, operating results and financial condition
 
The recent crisis in the financial and credit markets in the United States, Europe and Asia has led to a global economic slowdown, with the economies of the United States and Europe showing significant signs of weakness. If the economies in any part of the world continue to be weak or weaken further, our customers may reduce or postpone their spending significantly. This could result in reductions in sales of our products or services and longer sales cycles, slower adoption of new technologies and increased price competition. In addition, weakness in the end-user market could negatively affect the cash flow of our OEM partners, distributors and resellers who could, in turn, delay paying their obligations to us. This would increase our credit risk exposure and cause delays in our recognition of revenues on future sales to these customers. Specific economic trends, such as declines in the demand for PCs, servers, and other computing devices, or weakness in corporate information technology spending, could have a more direct impact on our business. Any of these events would likely harm our business, operating results and financial condition. If global economic and market conditions, or economic conditions in the United States or other key markets do not improve, or continue to deteriorate, it may have a material adverse effect on our business, operating results and financial condition.
 
 
2

 
 
Tighter governmental enforcement of regulations could decrease the distribution of unsolicited bulk (spam) email and malicious software and decrease demand for our solutions, or increase our cost of doing business.
 
On December 16, 2003, President Bush signed into law the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM Act), which established a framework of administrative, civil, and criminal tools to combat spam. The law establishes both civil and criminal prohibitions to assist in deterring the most offensive forms of spam, including unmarked sexually-oriented messages and emails containing fraudulent headers. Under the law, senders of email are required to honor a request by a consumer not to receive any further unsolicited messages. While past high profile prosecutions of direct marketers seemingly have not had much of a deterrent effect on marketers of unsolicited email, it is not known whether or not future enforcement actions will prove effective.
 
In addition, various state legislatures have enacted laws aimed at regulating the distribution of unsolicited email.
 
These and similar legal measures may have the effect of reducing the amount of unsolicited email and malicious software that is distributed and hence diminish the need for our email defense solutions. Any such developments would have an adverse impact on our revenues.
 
We depend upon OEM partners and resellers and we have a limited concentration of products.
 
We expect to continue to be dependent upon resellers and OEM partners for a significant portion of our revenues, which will be derived from sales of our email defense and URL filtering solutions. Our operating results and financial condition may be materially adversely affected if:
 
• 
Our limited product suite fails to remain attractive to current or prospective distributors;
 
• 
Anticipated orders or royalty payments from these resellers and OEM partners fail to materialize;
 
• 
We are unable to locate and or sign additional OEM partners (given the limited pool of available candidates for   our technology); or
 
• 
Some of the key resellers or OEM partners cease the promotion of our business or begin to promote additional solutions in a layered approach to email defense and URL filtering management.
 
• 
Some of our key OEM partners’ businesses fail as a result of a deepening global economic crisis.
 
Our quarterly operating results may fluctuate, which could adversely affect the value of your investment.
 
A number of factors, many of which are enumerated in this “Risk Factors” section, are likely to cause fluctuations in our operating results or cause our share price to decline. These factors include:
 
 
Our ability to successfully develop and market our email defense and URL filtering solutions to new markets, both domestic and international;
 
 
Our ability to successfully develop and market new, modified or upgraded solutions, as may be needed;
 
 
The continued market acceptance of our email defense solutions and initial acceptance of our URL filtering solutions;
 
 
Our ability to expand our workforce with qualified personnel, as may be needed;
 
 
Unanticipated bugs or other problems affecting the delivery of our solutions to customers;
 
 
The success of our resellers’ and OEM partners’ sales efforts to potential customers;
 
 
The solvency of our resellers and OEM partners and their ability to allocate sufficient resources towards the marketing of our solutions to their potential customers;
 
 
Our OEM partners’ ability to effectively integrate our solutions into their product offerings;
 
 
The rate of adoption of our solutions, especially our new URL filtering solutions, by customers;
 
 
The substantial decrease in information technology spending;
 
 
The pricing of our solutions;
 
 
Our ability to timely collect fees owed by resellers and OEM partners;
 
 
3

 
 
 
A continuing deepening of the global slowdown;
 
 
Sudden, dramatic fluctuations in exchange rates of currencies covering the royalties we collect from our foreign customers versus the currencies utilized in our business (namely, the New Israeli Shekel, U.S. Dollar and EURO);
 
 
Our ability to add cost-effective space and equipment to our current detection centers in a timely and effective manner to match the rate of growth in our business, plus our ability to build new, cost-effective detection centers as worldwide demand for our products may require; and
 
 
The effectiveness of our customer support, whether provided by our resellers and OEM partners, or directly by Commtouch.
 
Our products and services have changed many times since we commenced operations in 1991.  For example, in late 2006, we announced the availability of our IP reputation service, now known as GlobalView Mail Reputation and in late 2008; we released the initial version of our URL filtering solutions. The above described changes in business models required that we adjust our business processes and workforce, which caused fluctuations in our results from operations.
 
We have many established competitors who are offering a multitude of solutions to the problems of spam/virus distribution and web-related security threats.
 
The market for messaging security products remains intensely competitive. This has resulted in pricing pressures and lower operating margins,, which has been a cause in the slowing of our business’ rate of growth.
 
In the market for email defense solutions, there are fewer providers offering somewhat ineffectual “content filtering” solutions (solutions focusing solely on the content of potential spam email) than in the past, and more sophisticated offerings that compete with our solutions. Email defense providers offering forms of software (gateway), multi-functional appliances and managed service solutions and which may be viewed as both competitors and potential customers to Commtouch include Symantec (Brightmail), TrendMicro, McAfee (including the recently acquired Secure Computing) and Cisco (IronPort).  Email defense providers offering solutions on an OEM basis similar to Commtouch’s business model, and which may be viewed as direct competitors, include Cloudmark, Mailshell and Mail-Filters.  As this market continues to develop, it is likely that companies with greater resources than ours will attempt to either enter or increase their presence in this market by acquiring or forming strategic alliances with our competitors or business partners. Some examples of this are the acquisitions of IronPort by Cisco, Secure Computing by McAfee, CipherTrust by Secure Computing, Brightmail by Symantec Corp. and Microsoft of both Frontbridge Technologies and Sybari Software.
 
In the market for web security solutions, there are fewer providers offering somewhat ineffectual “content filtering” solutions (solutions focusing solely on “Black & White” lists) than in the past, and more advanced offerings that compete with our URL filtering solutions. Web security defense providers offering forms of software (gateway), multi-functional appliances and managed service solutions and which may be viewed as both competitors and potential customers to Commtouch include McAfee (Secure Computing), WebSense, IBM (ISS) and  Cisco (Fastdata).  Web defense providers offering solutions on an OEM basis similar to Commtouch’s business model, and which may be viewed as direct competitors, include BrightCloud, RuleSpace and Puresight.  As this market continues to develop, it is likely that companies with greater resources than ours will attempt to either enter or increase their presence in this market by acquiring or forming strategic alliances with our competitors or business partners. Some examples of this are the acquisitions of Fastdata by Cisco, SurfControl by WebSense and Secure Computing by McAfee.
 
Also, there are companies that develop and maintain in-house email defense and web security solutions, such as Google and Yahoo. These and other companies could potentially leverage their existing capabilities and relationships to enter the email and/or web defense industries.
 
 
4

 

Competitors could introduce products with superior features, scalability and functionality at lower prices than our products and could also bundle existing or new products with other more established products that discourage users from purchasing our products. Our market’s level of competition has increased as current competitors have improved the sophistication and effectiveness of their offerings and as new participants have entered the market. In the future, as we expand our offerings, we may encounter increased competition in the development and distribution of these solutions. Some of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and greater financial, technical, sales, marketing and other resources than we do and may enter into strategic or commercial relationships on more favorable terms. New technologies and the expansion of existing technologies may increase competitive pressures on us, and we may not be able to compete successfully against current and future competitors.
 
Our ability to continue to increase our revenues will depend on our ability to successfully execute our sales and business development plan.
 
The complexity of the underlying technological base of email defense and URL filtering solutions, and the current landscape of the markets, require highly trained sales and business development personnel to educate prospective resellers, OEM partners and customers regarding the use and benefits of our solutions. It may take time for our current and future employees, OEM partners and resellers to learn how to most effectively market our solutions. As a result, our sales and business development personnel may not be able to compete successfully against larger, more heavily financed and more experienced sales and business development departments of our competitors.
 
The loss of our key employees would adversely affect our ability to manage our business, therefore causing our operating results to suffer and the value of your investment to decline.
 
Our success depends on the skills, experience and performance of our senior management and other key personnel. The loss of the services of any of our senior management or other key personnel, including Gideon Mantel, our Chief Executive Officer, and Amir Lev, our President and Chief Technical Officer, could materially and adversely affect our business. The loss of our software developers or senior operations personnel may also adversely affect the continued development and support of our email defense and URL filtering solutions, thereby causing our operating results to suffer and the value of your investment to decline.
 
We do not have employment agreements inclusive of set periods of employment with any of our key personnel. We cannot prevent them from leaving at any time. We do not maintain key-person life insurance policies, listing us as a beneficiary, on any of our employees.
 
Our business and operating results could suffer if we do not successfully address potential risks inherent in doing business overseas.
 
As of December 31, 2008, we had sales offices in Israel and the United States. We also are marketing our email defense and URL filtering solutions in international markets by utilizing appropriate distribution channels. However, we may not be able to compete effectively in international markets due to various risks inherent in conducting business internationally, such as:
 
 
Differing technology standards;
 
 
Inability of distribution channels to successfully market our solutions;
 
 
Export restrictions;
 
 
Difficulties in collecting accounts receivable and longer collection periods;
 
 
Unexpected changes in regulatory requirements;
 
 
Political and economic instability;
 
 
Potentially adverse tax consequences;
 
 
The adoption of new legislation-backed penalties, which may discourage the distribution of unsolicited email messages and web security threats; and
 
 
Limited enforcement mechanisms for protecting intellectual property rights.
 
Any of these factors could adversely affect the Company’s prospective international sales and, consequently, business and operating results.
 
 
5

 
 
Technology Risks
 
We have recently entered a new market with our URL filtering solutions, and may not fully appreciate the needs of customers and risks inherent in this new market
 
Historically, Commtouch has focused its products solely on email based solutions.  The recent move into the web defense industry represents our first effort at expansion into a totally new market.  While we have expended resources in educating ourselves about this new market, nevertheless we cannot be 100% certain that we have anticipated all possible issues that might arise with our “in the cloud” technology infrastructure and trends affecting web-based threats.  Should unanticipated issues arise, sales of our URL filtering solutions likely will slow and our business will suffer.
 
We may not have the resources or skills required to adapt to the changing technological requirements and shifting preferences of our customers and their users.
 
Both the email defense and URL filtering industries are characterized by difficult technological challenges, sophisticated distributors of email and web threats, multiple-variant viruses, unique phishing scams and constantly evolving malevolent software distribution practices and targets that could render our solutions and proprietary technology ineffective. Our success depends, in part, on our ability to continually enhance our existing email defense and URL filtering solutions and to develop new solutions, functions and technology that address the potential needs of prospective and current customers and their users. The development of proprietary technology and necessary enhancements entails significant technical and business risks and requires substantial expenditures and lead-time. We may not be able to keep pace with the latest technological developments. We may not be able to use new technologies effectively or adapt to OEM, customer or end user requirements or emerging industry standards. Also, we must be able to act more quickly than our competition, and may not be able to do so.
 
Our solutions may be adversely affected by defects or denial of service attacks, which could cause our OEM partners, customers or end users to stop using our solutions.
 
Our email defense and URL filtering solutions are based in part upon new and complex software and highly advanced computer systems. Complex software and computer systems can contain defects, particularly when first introduced or when new versions are released, and are possible targets for denial of service attacks instigated by “hackers”. Although we conduct extensive testing and implement Internet security processes, we may not discover defects to or vulnerabilities in our software or systems that affect our new or current solutions or enhancements until after they are delivered. Although we have not experienced any material defects or vulnerabilities to date in our email defense and URL filtering offerings, it is possible that, despite testing by us, defects or vulnerabilities may exist in the solutions we provide. These defects or vulnerabilities could cause or lead to interruptions for customers of our solutions, resulting in damage to our reputation, legal risks, loss of revenue, delays in market acceptance and diversion of our development resources, any of which could cause our business to suffer.
 
Our solutions may be adversely affected if we are not able to receive a sufficient sampling of internet traffic or deliver our services to customers.
 
Our email defense and URL filtering solutions are dependent, in part, on the ability of our Detection Centers to analyze, in an automated fashion, live feeds of internet and web related traffic received through our services to customers and other contractual arrangements.  If we were to suffer an unanticipated, substantial decrease in such traffic or our Detection Centers become unavailable for any significant period, the effectiveness of our technologies would drop, and our product offerings would become less attractive.
 
Investment Risks
 
If we will be in need of additional capital, we may not be able to secure additional funds on acceptable terms, or at all, and the Company could fail.
 
We have invested heavily in technology development. We expect to continue to spend financial and other resources on developing and introducing new offerings and maintaining our corporate organizations and strategic relationships. We also expect to invest resources in research and development projects to further enhance our URL categorization and blocking, anti-spam and anti-virus solutions.
 
 
6

 
 
Notwithstanding the Company’s current, solid financial condition, should additional funding become necessary we may be unable to secure capital on acceptable terms, or at all, due to, among other things, difficulties in the capital and credit markets.  In such case, the Company could fail. There can be no assurance that we will be able to raise necessary funds or that we will be able to do so on terms acceptable to us. Even if available on acceptable terms, any such additional funding may result in significant dilution to existing shareholders.
 
If we cannot continue to satisfy NASDAQ’s maintenance requirements, it may delist our Ordinary Shares and we may not have an active public market for our Ordinary Shares. The absence of an active trading market would likely make our Ordinary Shares an illiquid investment.
 
Our Ordinary Shares are quoted on The NASDAQ Capital Market. To continue to be listed, among other requirements, we are required a) to maintain shareholders’ equity of at least $2,500,000, or market value of our outstanding shares (excluding shares held by Company insiders and principal shareholders) of at least $35,000,000, or we must have realized at least $500,000 in net income from continuing operations in our last fiscal year or in two of our last three fiscal years and b) we must maintain a minimum bid price per Ordinary Share of $1.00.  Up through 2006, the Company did not meet the applicable listing requirements on several occasions. The Company believes it has solidified its position on The NASDAQ Capital Market.
 
NASDAQ, in response to the global economic downturn of 2008, suspended its minimum bid requirement temporarily. If that suspension is lifted and/or the Company fails to meet other listing standards due to the significant deterioration of the Company’s business or stock price, we may be at risk for a delisting by NASDAQ from the Capital Market.
 
Our directors, executive officers and principal shareholders will be able to exert significant influence over matters requiring shareholder approval and could delay or prevent a change of control.
 
Our directors and affiliates of our directors, our executive officers and our shareholders who currently individually beneficially own over five percent of the voting power in the Company (together known as “affiliated entities”), beneficially own, in the aggregate, approximately 33.5% of our outstanding Ordinary Shares as of December 31, 2008. Included in the calculation of voting power are warrants and options exercisable by the affiliated entities within 60 days thereof (some of which are underwater as of December 31, 2008). If they vote together (especially if they were to convert all beneficial holdings into shares entitled to voting rights in the Company), these shareholders will be able to exercise significant influence over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership could also delay or prevent a change in control of Commtouch. In addition, conflicts of interest may arise as a consequence of the significant shareholders control relationship with us, including:
 
 
Conflicts between significant shareholders, and our other shareholders whose interests may differ with respect to, among other things, our strategic direction or significant corporate transactions;
 
 
Conflicts related to corporate opportunities that could be pursued by us, on the one hand, or by these shareholders, on the other hand; or
 
 
Conflicts related to existing or new contractual relationships between us, on the one hand, and these shareholders, on the other hand.
 
Substantial sales of our Ordinary Shares could adversely affect our share price and dilute the interests of our existing shareholders.
 
Although the company is currently engaged in a stock buyback plan, any future sale, or availability for sale, of large quantities of our Ordinary Shares may have the effect of depressing our stock’s market price. We continue to maintain various registration statements which cover the resale of shares issued and shares to be issued on the exercise of warrants issued under certain private placements. In particular, the additional Ordinary Shares to be issued if and when outstanding warrants to purchase 791,113 Ordinary Shares (as of December 31, 2008) are exercised will dilute existing shareholders of Ordinary Shares.
 
 
7

 
 
If we fail to honor registration rights for past private placements, we will be subject to payment of liquidated damages.
 
According to registration rights agreements with the selling security holders listed under registration statements on Form F-3 filed by us with the SEC between 2004 and 2006, should we fail to maintain the effectiveness of those registration statements for the periods stated in the respective agreements, we risk having imposed on us liquidated damages as defined in those agreements. For example, one of the agreements provides for liquidated damages of up to one million additional unregistered Series A Preferred Shares (which, given a conversion ratio of one for two and the reverse split effective January 2, 2008, now equals 666,667 unregistered Ordinary Shares).   These liquidated damages would dilute the value of Ordinary Shares held by other shareholders.
 
Intellectual Property Risks
 
If we fail to adequately protect our intellectual property rights or face a claim of intellectual property infringement by a third party, we could lose our intellectual property rights or be liable for significant damages.
 
We regard our patented and patent pending technology, copyrights, service marks, trademarks, trade secrets and similar intellectual property as critical to our success, and rely on patent, trademark and copyright law, trade secret protection and confidentiality or license agreements with our employees and customers to protect our proprietary rights.
 
During 2004, we purchased a United States patent, U.S. Patent No. 6,330,590. During 2005, we filed in the United States two anti-spam related patent applications, claiming priority for prior periods based on filings of U.S. Provisional Patent Applications, and one virus outbreak detection related patent application.  [In early 2009, we abandoned one of the two anti-spam patent applications filed during 2005, as well as the virus outbreak detection patent application]. During 2006, we filed in the United States a patent application relating to the prevention of spam in streaming systems or, in other words, unwanted conversational media sessions (i.e. voice and video related).  During 2008, we filed a U.S. Provisional Patent Application for anti-malware data center aggregate, the subject of which remains unpublished and thus confidential. We may seek to patent certain additional software or other technology in the future. Any such patent applications might not result in patents issued within the scope of the claims we seek, or at all.
 
Despite our precautions, unauthorized third parties may copy certain portions of our technology, reverse engineer or obtain and use information that we regard as proprietary or otherwise infringe or misappropriate our patent or our patent pending technology, trade secrets, copyrights, trademarks and similar proprietary rights.  We may not have the proper resources in order to adequately protect our intellectual property. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as do the laws of the United States. Our means of protecting our proprietary rights in the United States or abroad may not be adequate and competitors may independently develop similar technology.
 
We cannot be certain that our email defense and URL filtering solutions’ software does not infringe issued patents. In addition, because patent applications in the United States are not publicly disclosed until eighteen months after the application is filed, applications previously may have been filed which relate to our solutions.  Therefore, other parties, whether in the United States or elsewhere, may assert infringement claims against us. We may also be subject to legal proceedings and claims from time to time in the ordinary course of our business, including claims of alleged infringement of copyrights, trademarks and other intellectual property rights of third parties by ourselves and our licensees. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources.  We may not have the proper resources in order to adequately defend against such claims.
 
Risks Relating to Operations in Israel
 
We have important facilities and resources located in Israel, which has historically experienced military and political unrest.
 
We are incorporated under the laws of the State of Israel. Our principal research and development facilities are located in Israel. Although the majority of our past sales were made to customers outside Israel, we are nonetheless directly influenced by the political, economic and military conditions affecting Israel. Any major hostilities involving Israel, or the interruption or curtailment of trade between Israel and its present trading partners, could significantly harm our business, operating results and financial condition.
 
 
8

 
 
Since the State of Israel was established in 1948, a number of armed conflicts have occurred between Israel and its Arab neighbors.  Since October 2000, terrorist violence in Israel has increased significantly.  Recently, there has been an escalation in violence among Israel, Hamas, the Palestinian Authority and other groups, as well as extensive hostilities in December 2008 and January 2009 along Israel's border with the Gaza Strip, which resulted in missiles being fired from the Gaza Strip into Southern Israel.   There were also extensive hostilities along Israel's northern border with Lebanon in the summer of 2006. Ongoing and revived hostilities or other Israeli political or economic factors could harm our operations and cause our revenues to decrease.
 
In addition, Israel and some companies doing business with Israel have been the subject of an economic boycott by Arab countries and their close allies since Israel’s establishment. These restrictive laws and policies may have an adverse impact on our operating results, financial condition and expansion of our business.
 
Our results of operations may be negatively affected by the obligation of key personnel to perform military service.
 
Certain of our officers and employees are currently obligated to perform annual reserve duty in the Israel Defense Forces and are subject to being called for active military duty at any time in the event of a national emergency, such as in connection with recent hostilities along Israel's border with the Gaza Strip. Although Commtouch has operated effectively under these requirements since its inception, we cannot predict the effect of these obligations on Commtouch in the future. Our operations could be disrupted by the absence for a significant period of one or more of our officers or key employees due to military service. Any disruption in our operations would harm our business.
 
Because a substantial portion of our revenues historically have been generated in U.S. dollars the EURO, and a portion of our expenses have been incurred in New Israeli Shekels, our results of operations may be adversely affected by currency fluctuations.
 
We have generated a substantial portion of our revenues in U.S. dollars and Euro, and incurred a portion of our expenses, principally salaries and related personnel expenses in Israel, in New Israeli Shekels, or NIS. We anticipate that a significant portion of our expenses will continue to be denominated in Israeli shekels.  As a result, we are exposed to risk to the extent that the value of the U.S. dollar decreases against the NIS and the Euro.  In that event, the U.S. dollar cost of our operations will increase and our U.S. dollar-measured results of operations will be adversely affected, as occurred during portions of 2006 - 2008, when the NIS and the Euro appreciated against the U.S. dollar, which resulted in a significant increase in the U.S. dollar cost of our operational expenses and revenues. We cannot predict the trend for future years. Our operations also could be adversely affected if we are unable to guard against currency fluctuations in the future. To date, we have not engaged in hedging transactions.  In the future, we may enter into currency hedging transactions to decrease the risk of financial exposure from fluctuations in the exchange rate of the dollar against the NIS. These measures, however, may not adequately protect us from material adverse effects if inflation in Israel accelerates.
 
The government programs and benefits which we previously received require us to meet several conditions and may be terminated or reduced in the future.

Prior to 1998, we received grants from the Government of Israel, through the OCS, for the financing of a significant portion of our research and development expenditures in Israel. These grants totaled $0.6 million.  In 2001, we received $0.6 million and in 2002 we received $0.2 million. We did not submit an application for funding during the period 2004 - 2008.  We have not received OCS funding in recent years, but we may apply for additional grants in the future.  The OCS budget has been subject to reductions which may affect the availability of funds for possible future grants. Therefore, we cannot be certain that we will be able to receive future grants in similar amounts, or at all. In addition, the terms of any future OCS grants may be less favorable than our past grants.
 
In order to meet specified conditions in connection with the grants and programs of the OCS, we have made representations to the Israel government about our Israeli operations.  From time to time the conduct of our Israeli operations has deviated from our forecasts.  If we fail to meet the conditions of the grants, including the maintenance of a material presence in Israel, or if there is any material deviation from the representations made by us to the Israeli government, we could be required to refund the grants previously received (together with an adjustment based on the Israeli consumer price index and an interest factor) and would likely be ineligible to receive OCS grants in the future.
 
Under the Law for the Encouragement of Industrial Research and Development, 5744-1984 and the related regulations,  the discretionary approval of an OCS committee is required for any transfer of technology developed with OCS funding or for the transfer of manufacturing rights outside of Israel.  OCS approval is not required for the export of any products resulting from the research and development. There is no assurance that we will receive the required approvals for any proposed future transfer.  Such approvals, if granted, may be subject to the following additional restrictions:
 
 
9

 
 
 
·
a requirement to pay the OCS a portion of the consideration we receive upon any sale of such technology to an entity that is not Israeli.  The scope of the support received, the royalties that were paid by us, the amount of time that elapsed between the date on which the know-how was transferred and the date on which the grants were received, as well as the sale price, will be taken into account in order to calculate the amount of the payment; and
 
 
·
the transfer of manufacturing rights could be conditioned upon an increase in the royalty rate and payment of increased aggregate royalties (up to 300% of the amount of the grant plus interest, depending on the percentage of the manufacturing that is foreign).
 
These restrictions may impair our ability to sell certain of our older technology assets outside of Israel.  The restrictions will continue to apply even after we repay the full amount of royalties payable for the grants.
 
You may have difficulties enforcing a U.S. judgment against us and our executive officers and directors or asserting U.S. securities laws claims in Israel.

We are organized under the laws of Israel, and we maintain significant operations in Israel. In addition, the majority of our directors and executive officers are not residents of the United States and most of their assets and our assets are located outside the United States.  Service of process upon our non-U.S. resident directors or executive officers and enforcement of judgments obtained in the United States against us and our directors and executive officers may be difficult to obtain within the United States.  It may be difficult to assert U.S. securities law claims in original actions instituted in Israel.  Israeli courts may refuse to hear a claim based on a violation of U.S. securities laws because Israel is not the most appropriate forum in which to bring such a claim.  In addition, even if an Israeli court agrees to hear a claim, it may determine that Israeli law and not U.S. law is applicable to the claim.  If U.S. law is found to be applicable, the substance of the applicable U.S. law must be proved as a fact, which can be a time-consuming and costly process.  Certain matters of procedure will also be governed by Israeli law.  Furthermore, there is little binding case law in Israel addressing these matters.

Israeli courts might not enforce judgments rendered outside Israel which may make it difficult to collect on judgments rendered against us. Subject to certain time limitations, an Israeli court may declare a foreign civil judgment enforceable only if it finds that (a) the judgment was rendered by a court which was, according to the laws of the state of the court, competent to render the judgment; (b) the judgment may no longer be appealed; (c) the obligation imposed by the judgment is enforceable according to the rules relating to the enforceability of judgments in Israel and the substance of the judgment is not contrary to public policy; and (d) the judgment is executory in the state in which it was given.

Even if these conditions are satisfied, an Israeli court will not enforce a foreign judgment if it was given in a state whose laws do not provide for the enforcement of judgments of Israeli courts (subject to exceptional cases) or if its enforcement is likely to prejudice the sovereignty or security of the State of Israel.  An Israeli court also will not declare a foreign judgment enforceable if (i) the judgment was obtained by fraud; (ii) there is a finding of lack of due process; (iii) the judgment was rendered by a court not competent to render it according to the laws of private international law in Israel; (iv) the judgment is at variance with another judgment that was given in the same matter between the same parties and that is still valid; or (v) at the time the action was brought in the foreign court, a suit in the same matter and between the same parties was pending before a court or tribunal in Israel.

Provisions of Israeli law may delay, prevent or make difficult an acquisition of Commtouch, which could prevent a change of control and therefore depress the price of our shares.
 
Israeli corporate law regulates mergers and acquisitions of shares through tender offers, requires special approvals for transactions involving significant shareholders and regulates other matters that may be relevant to these types of transactions. Furthermore, Israeli tax law treats stock-for-stock acquisitions between an Israeli company and a foreign company less favorably than does U.S. tax law. For example, Israeli tax law may subject a shareholder who exchanges his Ordinary Shares for shares in a foreign corporation to immediate taxation or to taxation before his investment in the foreign corporation becomes liquid. These provisions may adversely affect the price of our shares.

 
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As a foreign private issuer whose shares are listed on the NASDAQ Capital Market, we may follow certain home country corporate governance practices instead of certain NASDAQ requirements.

As a foreign private issuer whose shares are listed on the NASDAQ Capital Market, we are permitted to follow certain home country corporate governance practices instead of certain requirements of the NASDAQ Marketplace Rules.

Among other things, we may follow home country practice with regard to composition of the board of directors and quorum at shareholders' meetings.  In addition, we may follow our home country law, instead of the NASDAQ Marketplace Rules, which require that we obtain shareholder approval for certain dilutive events, such as for the establishment or amendment of certain equity based compensation plans, an issuance that will result in a change of control of the company, certain transactions other than a public offering involving issuances of a 20% or more interest in the company and certain acquisitions of the stock or assets of another company.

A foreign private issuer that elects to follow a home country practice instead of NASDAQ requirements, must submit to NASDAQ in advance a written statement from an independent counsel in such issuer's home country certifying that the issuer's practices are not prohibited by the home country's laws.  In addition, a foreign private issuer must disclose in its annual reports filed with the Securities and Exchange Commission or on its website each such requirement that it does not follow and describe the home country practice followed by the issuer instead of any such requirement.  Accordingly, our shareholders may not be afforded the same protection as provided under NASDAQ's corporate governance rules.
 
Item 4. Information on the Company.
 
Overview
 
The legal name of the Company is Commtouch Software Ltd., and its principal executive offices are located at 4A Hazoran Street, Poleg Industrial Park, P.O.Box 8511, Netanya 42504, Israel, where our telephone number is 011–972–9–863–6888. The Company was incorporated under the laws of the State of Israel on February 5, 1991 and its legal form is a company limited by shares. Its Articles of Association are on file in Israel with the office of the Israeli Registrar of Companies and available for public inspection at that office. The Company’s wholly owned subsidiary, Commtouch Inc., is located at 292 Gibraltar Drive, Suite 107, Sunnyvale, California 94089, where our telephone number is (650) 864–2000.
 
We are a provider of email defense and URL filtering solutions to enterprise customers and OEM distribution partners, including real-time anti-spam, Zero-Hour virus outbreak detection and Global View Mail Reputation services, as well as a URL Filtering service and Zero-Hour Web Security Engine solution. The Company offers its solutions to small, medium and large enterprises through a variety of third party distribution channels. The solutions are also available for integration with security, content filtering, anti-virus and other filtering solutions through alliances and strategic technology partnerships.  At the core of Commtouch’s email defense offerings is Commtouch’s proprietary Recurrent Pattern Detection (RPD)™ technology which, in general terms, analyzes messages associated with mass email outbreaks and directs the blocking of such emails, without the need to analyze individual messages.  At the core of Commtouch’s URL filtering solutions is its “in the cloud” infrastructure, which analyzes various feeds from worldwide sources pertaining to URLs, and provides a ranking of the URLs tailored to the needs of each customer.
 
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Additional Detail on Commtouch Offerings

We offer a Software Development Kit or "SDK" comprised of multiple components, which is built on our proprietary Recurrent Pattern Detection™ technology; each different component enables third-party vendors to integrate a Company offering. Two components, known as ctasd and ctengine, represent alternative methods of enabling third-party vendors to integrate the Commtouch anti-spam solution into their existing offerings. Both ctengine and ctasd provide these manufacturers or service providers with full spam identification and spam classification services from the Commtouch Detection Centers (described below). The SDK communicates fully with a remote Detection Center, receiving results to queries about suspicious messages and acting according to set policies on the customer side. These same two components also enable integration of the Company’s Zero-Hour™ virus outbreak protection. This solution provides customers with the ability to block malevolent software (or as known in the industry "malware"), including email borne viruses, in real time, at the moment the initial attack occurs. During the initial attack phase, traditional anti-virus vendors are typically analyzing messages to determine whether they are indeed infected with a virus. It is this critical lag in response time by traditional anti-virus vendors that the Zero-Hour solution has been developed to remedy.
 
A third component of the SDK, known as ctipd, enables integration of the Company’s Mail Reputation Service. The Reputation Service is typically integrated into a device that sits at the perimeter of the organization, deciding which email traffic to allow to enter the organization, and which to block. It accomplishes this by receiving classification data from a Commtouch Detection Center about the sender of each email message.   During 2007, the Company launched an advanced version of this Reputation Service known as “GlobalView”.
 
Products that may benefit from integration of the SDK solution include:
 
 
Anti-virus applications;
 
 
Content filtering solutions;
 
 
Firewall systems;
 
 
Security servers; and
 
 
Other network appliances
 
We also offer an enterprise anti-spam and Zero-Hour virus outbreak detection solution, consisting of both a software element, or the “Enterprise Gateway”, and a service component, or a Commtouch “Detection Center”. At the Enterprise Gateway, messages are filtered at the customer organization’s entry point, before being distributed to recipients, with added user-level controls and a top level of secure spam and virus detection services from the Detection Center, all allowing for real-time reaction to worldwide attacks. At the heart of the solution, however, is the Detection Center, which detects new spam and virus attacks as soon as they are launched and distributed over the Internet. The Detection Center provides real-time spam and virus detection services to enterprise customers by maintaining constant communication with Enterprise Gateways that are locally installed at customer premises in different locations worldwide. The Detection Center collects information from multiple sources about new attacks, analyzes the input using Commtouch patented technology, identifies and detects spam/viruses, classifies the data, matches its stored information against outstanding queries for spam/virus detection from Enterprise Gateways and replies in real-time back to the Enterprise Gateways with a prioritized resolution.
 
Lastly, during late 2008, the Company released its URL filtering services. These services analyze and categorize for customers of our OEM partners the source of URLs being accessed by such customers, mainly in order to prevent a) the possibility of malware attacks being propogated by malicious URLs, b) access to non-business related websites by employees and c) access by children to inappropriate websites.
 
Competitive Landscape
 
The markets in which Commtouch competes are intensely competitive and rapidly changing. However, we believe there is no single competitor that offers the complete package of anti–spam, anti-virus, IP reputation and web defense protections that Commtouch provides.
 
The principal competitive factors in our industry include price, product functionality, product integration, platform coverage and ability to scale, worldwide sales infrastructure and global technical support. Some of our competitors have greater financial, technical, sales, marketing and other resources than we do, as well as greater name recognition and a larger installed customer base. Additionally, some of these competitors have research and development capabilities that may allow them to develop new or improved products that may compete with product lines we market and distribute, possibly at a lower cost.  Our success will depend on our ability to adapt to these competing forces, to develop more advanced products more rapidly and less expensively than our competitors, and to educate potential customers as to the benefits of using our products rather than developing their own products.
 
 
12

 
 
Commtouch’s GlobalView Mail Reputation Service competes in an evolving market. While the space remains relatively immature, there are some established vendors, including TrendMicro, that are offering reputation-based solutions. In some cases, while the product positioning may be new, the underlying solutions may be mature – for example, Spamhaus repositioning its RBL, or “Real-time Block List”, service as a commercial reputation service. In addition, there are several startups competing in this space, perhaps the most notable being Karmasphere.
 
In the market for email defense solutions, there are fewer providers offering somewhat ineffectual “content filtering” solutions (solutions focusing solely on the content of potential spam email) than in the past, and more sophisticated offerings that compete with our solutions. Email defense providers offering forms of software (gateway), multi-functional appliances and managed service solutions and which may be viewed as both competitors and potential customers to Commtouch include Symantec (Brightmail), TrendMicro, McAfee (including the recently acquired Secure Computing) and Cisco (IronPort).  Email defense providers offering solutions on an OEM basis similar to Commtouch’s business model, and which may be viewed as direct competitors, include Cloudmark, Mailshell and Mail-Filters.
 
The market for real-time virus protection products is constantly evolving, as those promoting the proliferation of viruses continually seek new distribution techniques. Commtouch’s offering differs from traditional anti-virus solutions in that we are offering an additional, complementary solution to signature and heuristic-based anti-virus engines. For this reason, our Zero-Hour virus outbreak protection engine has been licensed by several anti-virus companies, including F-Secure and VirusBuster.  If virus distribution methods continue to migrate from email to other formats, there may be less of a demand for our Zero-Hour solution and more of a demand for a web security product, such as our URL filtering solutions.
 
In the market for web security solutions, there are fewer providers offering somewhat ineffectual “content filtering” solutions (solutions focusing solely on “Black & White” lists) than in the past, and more advanced offerings that compete with our URL filtering solutions. Web security defense providers offering forms of software (gateway), multi-functional appliances and managed service solutions and which may be viewed as both competitors and potential customers to Commtouch include McAfee (Secure Computing), WebSense, IBM (ISS) and  Cisco (Fastdata).  Web defense providers offering solutions on an OEM basis similar to Commtouch’s business model, and which may be viewed as direct competitors, include BrightCloud, RuleSpace and Puresight. 
 
We expect that the markets for email and web defense solutions will continue to become more consolidated, with companies having greater resources than ours increasing their presence in this market by acquiring or forming strategic alliances with our competitors or business partners. Some examples of this in the email defense field are the acquisitions of IronPort by Cisco, CipherTrust by Secure Computing, Brightmail by Symantec Corp. and Microsoft of both Frontbridge and Sybari Software.  Some examples of this in the web defense field are the acquisitions of Fastdata by Cisco, SurfControl by WebSense and Secure Computing by McAfee.
 
See also disclosure under “Item 3. Key Information– RISK FACTORS—Business Risks—We have many established competitors who are offering a multitude of solutions to the problems of spam/virus distribution and web-related security threats.”
 
Sales and Marketing
 
We utilize third party distribution channels to sell our products.  Generally, our software is provided to OEM customers, who in turn integrate the software into their product offerings for sale of our services to their customers.  We are paid service fees under a variety of fee structures, including fixed fee and fee sharing arrangements.
 
Our enterprise anti-spam and Zero-Hour anti-virus solutions also are sold through resellers, who pay us pre-negotiated fees from each sale closed with a reseller’s customer.
 
All Company sales are managed by the Company’s and its U.S. subsidiary’s business development departments, each of which consists of a department head and a relatively small number of business development professionals.  The Company’s marketing efforts are aimed mainly at potential OEM customers.  The marketing department is concentrated in the Company’s Israel office, though our personnel travel internationally in furtherance of the Company’s marketing goals.
 
 
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Intellectual Property
 
We regard our patented and patent pending anti–spam and anti-virus technology, copyrights, service marks, trademarks, trade secrets and similar intellectual property as critical to our success, and rely on patent, trademark and copyright law, trade secret protection and confidentiality and/or license agreements with our employees, customers, partners and others to protect our proprietary rights. During 2004, we purchased a United States patent, Patent No. 6,330,590, which we believe to be an integral part of our patent strategy aimed at protecting our proprietary anti-spam technology.  During 2005, we filed in the United States two anti-spam related patent applications, claiming priority for prior periods based on filings of U.S. Provisional Patent Applications, and one virus outbreak detection related patent application.  [In early 2009, we abandoned one of the two anti-spam patent applications filed during 2005, as well as the virus outbreak detection patent application].  During 2006, we filed in the United States a patent application relating to the prevention of spam in streaming systems (i.e. voice and video related email).  During 2008, we filed a U.S. Provisional Patent Application for anti-malware data center aggregate, the subject of which remains unpublished and thus confidential. We are only actively maintaining our registered trademark for "COMMTOUCH", which is registered in the U.S., Canada, Israel, European Union, China, Mexico, Norway, Taiwan, Russian Federation, South Korea and Australia. A previous registration of "PRONTO" in Canada is still in force, but we are not maintaining this registration and it will lapse. Since at least September 2003, we are have claimed trademark rights in “RPD” and “Recurrent Pattern Detection”, as applicable to our email defense solutions.  We have also been claiming trademark rights in Zero-Hour in relation to our virus outbreak detection product (and more recently one of our web security products) and GlobalView in relation to our IP reputation product.
 
It may be possible for unauthorized third parties to copy or reverse engineer certain portions of our products or obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights in the United States or abroad will be adequate or that competing companies will not independently develop similar technology.
 
Other parties may assert infringement claims against us. We may also be subject to legal proceedings and claims from time to time in the ordinary course of our business, including claims of alleged infringement by us and/or our licensees of the trademarks and other intellectual property rights of third parties. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources.
 
Government Regulation
 
Laws aimed at curtailing the spread of spam have been adopted by the United States federal government, i.e. CAN-SPAM Act, and some individual U.S. states, with the CAN-SPAM Act superseding some state laws or certain elements thereof.  See also disclosure under “Item 3. Key Information– RISK FACTORS—Business Risks— “Tighter governmental enforcement of regulations could decrease the distribution of unsolicited bulk (spam) email and malicious software and decrease demand for our solutions, or increase our cost of doing business.”  Despite this legislation, we have not seen abatement in the amount of spam traffic on the Internet; rather, a continuing increase in large numbers that is being distributed in more sophisticated ways.  The continuing growth and development of the spam market may prompt calls for even more stringent Internet user protection laws that would limit the ability of companies and individuals promoting or delivering spam online, and thus potentially negatively affect our business.
 
The propagation of email viruses, whether through email or web sites, which are aimed at destroying or stealing third party data, is illegal under standard state and federal law outlawing theft, misappropriation, conversion, etc., without the need for special legislation prohibiting such activities on the Internet.  Despite the existence of these laws, sources for Internet viruses continue to spread multi-variant viruses seemingly without much fear of recrimination.  New laws providing for more stringent penalties could be adopted in various jurisdictions, but it is unclear what, if any, affect these would have on the anti-virus industry in general and our Zero-Hour Virus Outbreak Detection and URL filtering solutions in particular.
 
Employees
 
As of December 31, 2008, 2007 and 2006, we had 69, 60 and 46 employees, respectively. None of our U.S. employees are covered by a collective bargaining agreement. As of December 31, 2008, our employees were categorized as follows:
 
 
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LOCATION
 
General &
Administrative
   
Sales &
Marketing
   
Research &
Development
   
Hosting
(Operations)
   
TOTAL:
 
ISRAEL OFFICE
    9       13       31       -       53  
U.S. OFFICE
    3       9       -       4       16  
 
We believe that our relations with our employees are good.
 
Israeli law and certain provisions of the nationwide collective bargaining agreements between the Histadrut (General Federation of Labor in Israel) and the Coordinating Bureau of Economic Organizations (the Israeli federation of employers’ organizations) apply to Commtouch’s Israeli employees. These provisions principally concern the maximum length of the workday and workweek, minimum wages, contributions to a pension fund, insurance for work–related accidents, procedures for dismissing employees, determination of severance pay and other conditions of employment. Furthermore, pursuant to such provisions, the wages of most of Commtouch’s Israeli employees are subject to cost of living adjustments, based on changes in the Israeli Consumer Price Index. The amounts and frequency of such adjustments are modified from time to time.  Pursuant to an order issued in December 2007 by the Israeli Minister of Industry, Trade and Labor, new provisions relating to pension arrangements in the collective bargaining agreements will apply to all employees in Israel, including our employees.  According to these provisions, all employees employed for at least nine months during 2008 and six months commencing in 2009 will be entitled to pension benefits to be funded by preset monthly contributions of the employee and the employer.  Israeli law generally requires the payment of severance pay upon the retirement or death of an employee or upon termination of employment by the employer or, in certain circumstances, by the employee. We currently fund our ongoing severance obligations by making monthly payments for insurance policies and by an accrual. A general practice in Israel followed by Commtouch, although not legally required, is the contribution of funds on behalf of certain employees to an individual insurance policy known as “Managers’ Insurance.” This policy provides a combination of savings plan, insurance and severance pay benefits to the insured employee. It provides for payments to the employee upon retirement or death and secures a substantial portion of the severance pay, if any, to which the employee is legally entitled upon termination of employment. Each participating employee contributes an amount equal to 5% of such employee’s base salary, and the employer contributes between 13.3% and 15.8% of the employee’s base salary. Full–time employees who are not insured in this way are entitled to a savings account, to which each of the employee and the employer makes a monthly contribution of 5% of the employee’s base salary. We also provide certain Israeli employees with an Education Fund, to which each participating employee contributes an amount equal to 2.5% of such employee’s base salary, and the employer contributes an amount equal to 7.5% of the employee’s base salary, up to a certain maximum base salary set by law.
 
Description of Property
 
All of our facilities are leased. Our headquarters, in Netanya, Israel, is approximately 1,007.4 square meters, and it houses senior management, research and development, sales, marketing and administrative personnel.  Our subsidiary’s Sunnyvale, California office, which is approximately 3,600 square feet in size, houses administrative, sales and hosting (operations) personnel.
 
Geographic Information
 
The Company conducts its business on the basis of one reportable segment (see also Note 1 of  Notes to the Financial Statements for a brief description of the Company’s business). The Company has adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information".
 
 
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Revenues for Last Three Financial Years
 
See Item 5. Operating and Financial Review and Prospects - “Revenue Sources” and the F pages to this Form 20-F below. Below is a breakdown of our revenues by location (in thousands):
 
   
Year December 31,
 
   
2006
   
2007
   
2008
 
                   
Israel
  $ 344     $ 742     $ 1,080  
North America
    4,525       6,424       8,018  
Europe
    1,715       2,735       3,160  
Asia
    493       1,038       1,497  
Other
    157       311       337  
                         
    $ 7,234     $ 11,250       14,092  
 
We have had only negligible capital expenditures and divestitures in the last three financial years.
 
Item 4A.  Unresolved Staff Comments.
 
None.
 
Item 5. Operating and Financial Review and Prospects.
 
The following discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. This discussion contains forward–looking statements based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward–looking statements. For example, the words “expects,” “anticipates,” “believes,” “intends,” “plans,” “seeks” and “estimates” and similar expressions are intended to identify forward–looking statements. Commtouch’s actual results and the timing of certain events may differ significantly from those projected in the forward–looking statements. Factors that might cause future results to differ materially from those projected in the forward–looking statements include, but are not limited to, those set forth under “Item 3. Key Information-Risk Factors” and in the Company’s other filings with the SEC.
 
Overview
 
From 2003 through 2008, the focus of our business has been the development and selling, through reseller and OEM distribution channels, anti-spam, Zero-Hour virus outbreak detection and IP reputation solutions to enterprise class customers.  While no uniform definition of spam exists, the Company generally defines “spam” as the sending of unsolicited bulk email for commercial and non–commercial purposes.  During late 2008, we released our first URL filtering solutions for the web security market.
 
In January 2008, the Company completed a 3:1 reverse stock split of the Company's share capital following approval of the Board of Directors and shareholders. As a result of this action, every three ordinary shares, par value NIS 0.05 each (including all authorized, issued and outstanding ordinary shares and all outstanding warrants and options to purchase ordinary shares) were combined into one ordinary share bearing a par value of NIS 0.15 each. All of the Company's authorized, issued and outstanding ordinary shares (including all outstanding warrants and options to purchase ordinary shares) as of December 31, 2008 and 2007, have been restated to reflect the effect of the reverse stock split.
 
Critical Accounting Policies and Estimates
 
Operating and Financial Review and Prospects are based upon the Company’s consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Management believes the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the consolidated financial statements are accounting for stock-based compensation, revenue recognition, accounting for income taxes and commitments and contingencies.
 
 
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Accounting for Stock–Based Compensation:

On January 1, 2006, we adopted SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS No. 123(R)") which requires the measurement and recognition of compensation expense based on estimated fair values for all share-based payment awards made to employees and directors. SFAS No. 123(R) supersedes Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), for periods beginning in fiscal year 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 ("SAB 107") relating to SFAS No. 123(R). We have applied the provisions of SAB 107 in its adoption of SFAS No. 123(R). SFAS No. 123(R) requires companies to estimate the fair value of equity-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as an expense over the requisite service periods in our consolidated statements of operations.
 
We estimate the fair value of stock options granted using the Black-Scholes option pricing model. The option-pricing model requires a number of assumptions, of which the most significant are the expected stock price volatility and the expected option term. Expected volatility was calculated based upon actual historical stock price movements. The expected term of options granted is based upon historical experience and represents the period of time that options granted are expected to be outstanding. The risk-free interest rate is based on the yield from U.S. treasury bonds with an equivalent term. We have historically not paid dividends and has no foreseeable plans to pay dividends. We recognize the related expenses over the vesting period using the straight line method.
 
Revenue recognition
 
Revenue is recognized when the earnings process is complete, as evidenced by an agreement between the customer and the Company, when delivery has occurred or services have been rendered, when the fee is fixed or determinable and when collection is probable. The service component of the Company’s solutions is considered essential to the functionality of the software components. Furthermore, the software components cannot be used on a standalone basis, or with another party’s service. The customer has no ability to run the software or the SDK on its own hardware. As the software portion of the product cannot stand on its own, the Company considers each sale as a service arrangement. Therefore, revenues deriving from our services are recognized ratably over the service term, which generally includes a term period of one year to three years.  The Company’s revenue recognition policy is discussed in Note 2 of Notes to Consolidated Financial Statements.
 
Commitments and Contingencies
 
Commtouch periodically records the estimated impacts of various conditions, situations or circumstances involving uncertain outcomes. These events are called “contingencies”, and Commtouch’s accounting for such events is prescribed by Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”). SFAS No. 5 defines a contingency as “an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.”
 
SFAS No. 5 does not permit the accrual of gain contingencies under any circumstances. For loss contingencies, the loss must be accrued if (1) information is available that indicates it is probable that the loss has been incurred, given the likelihood of the uncertain future events; and (2) that the amount of the loss can be reasonably estimated.
 
The accrual of a contingency involves considerable judgment on the part of management. Commtouch uses its internal expertise, and outside experts (such as lawyers, tax specialists and engineers), as necessary, to help estimate the probability that a loss has been incurred and the amount (or range) of the loss. The Company has recorded contingencies in situations where management determined it was probable a loss had been incurred and the amount could be reasonably estimated.
 
 
17

 
 
Valuation of investments
 
Fair values of marketable securities are estimated using quoted market prices where available. Our marketable securities consist of highly-rated federal backed student loan securities. Generally we classify our investments as available for sale. Changes in fair value of investments classified as available for sale are not recognized to income during the period, but rather are recognized as a separate component of equity until realized.
 
Commencing February 2008, all of the Company’s ARS (comprised of five securities) suffered from failed auctions Subsequent to balance sheet date, .on January 5, 2009, all of the Company’s ARS were purchased by the bank at full par value amounting to a total of $ 2,000.  By agreeing to the settlement with the bank, the Company is essentially stating that it no longer has the intent of holding the ARS  until recovery, as it will now recover any unrealized loss through the settlement offer, and accordingly, the ARS's were classified as trading securities as of December 31, 2008.
 
Accounting for income taxes
 
On January 1, 2007, we adopted FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes,” or FIN 48, which contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with Statement of Financial Accounting Standards 109, “Accounting for Income Taxes.”,” or SFAS No. 109. The first step is to evaluate the tax position taken or expected to be taken in a tax return by determining if the weight of available evidence indicates that it is more likely than not that, on an evaluation of the technical merits, the tax position will be sustained on audit, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement.  .  No provision was recorded as a result of the adoption of FIN 48 or for the year ended December 31, 2008. . In addition, no provision was recorded as of December 31, 2008 and 2007.
 
The Company and its subsidiary have provided a valuation allowance in respect to the deferred tax assets resulting from operating loss carryforwards and other temporary differences. Management currently believes that since the Company and its subsidiary have a history of losses it is more likely than not that the deferred tax regarding the loss carryforwards and other temporary differences will not be realized in the foreseeable future.
 
Revenue Sources
 
Service Fees.
 
We recognize revenues from anti-spam, Zero-Hour virus outbreak detection, GlobalView Reputation and URL filtering/web security services. Revenues from these services are recognized when persuasive evidence of an arrangement exists, services are provided, the fee is fixed or determinable and collectibility is probable. Revenues derived from these services are recognized ratably over the life of the service period.
 
Patent License Fees.
 
We also recognize revenues from our patent licensing program. Revenues from patent licenses are recognized when persuasive evidence of an arrangement exists, delivery has occurred and the Company has no further obligations, the fee is fixed or determinable and collectibility is probable.
 
 
18

 
 
Results of Operations
 
The following table sets forth financial data for the years ended December 31, 2006, 2007 and 2008 (in thousands):
 
   
2006
   
2007
   
2008
 
                   
Revenues
  $ 7,234     $ 11,250     $ 14,092  
Cost of revenues
    901       1,411       1,828  
Gross profit
    6,333       9,839       12,264  
Operating expenses:
                       
Research and development
    1,763       2,187       3,152  
Sales and marketing
    2,686       3,453       3,992  
General and administrative
    2,299       2,589       3,189  
Total operating expenses
    6,748       8,229       10,333  
Operating income (loss)
    (415 )     1,610       1,931  
Financial income (expenses), net
    274       527       346  
Equity in losses of affiliate
    (49 )     -       -  
                         
Net income (loss) before taxes
    (190 )     2,137       2,277  
Taxes on income
    -       28       7  
                         
Net income (loss)
  $ (190 )   $ 2,109     $ 2,270  
 
Comparison of Years Ended December 31, 2008 and 2007
 
Revenues. Revenues increased by $2.8 million from $11.3 million in 2007 to $14.1 million in 2008.  The increase is mainly due to a growth in market share, especially in the international market. The number of OEMs increased by 32 in 2008 and amounted to 116 as of December 31, 2008.
 
Cost of Revenues. Cost of revenues increased by $0.4 million from $1.4 million in 2007 to $1.8 million in 2008. The increase in 2008 is mainly due to higher facility costs and hosting expenses following the open of a fourth data center in Japan aiming to serve the increasing number of customers. Cost of revenues did not increase in the same proportion as sales in 2008 due to economies of scale. Most costs of revenues are fixed and are not affected by increases or decreases in revenues.
 
Research and Development. Research and development expenses increased by 44% and amounted to $3.2 million in 2008 compared to $2.2 million in 2007. The increase is due to recruitment of more employees as part of the Company’s decision to develop new products. Research and development expenses include $319,000 of expenses in connection with SFAS No. 123(R).
 
Sales and Marketing. Sales and marketing expenses increased by 16% and amounted to $4.0 million compared to $3.5 million in 2007. The increase is mainly due to recruitment of employees and increased selling and marketing activity. In 2008, sales and marketing expenses included $298,000 expenses in connection with SFAS No. 123(R)
 
General and Administrative. General and administrative expenses increased by 23% from $2.6 million in 2007 to $3.2 million in 2008. The increase is mainly due to the recruitment of two new employees. In 2008, general and administrative expenses included $833,000 expenses in connection with SFAS No. 123(R).
 
 
19

 
 
Financial Income (Expenses), Net. Financial income (expenses), net, decreased by 34% from net income of $527,000 in 2007 to net income of $346,000 in 2008.  The decrease is primarily due to less interest income derived from declining interest rates throughout 2008, earned on the company's cash deposits.
 
Comparison of Years Ended December 31, 2007 and 2006
 
Revenues. Revenues increased by $4.1 million from $7.2 million in 2006 to $11.3 million in 2007.  The increase is due to an increase in market share, especially in the international market. The number of OEMs increased by 35 in 2007 and amounted to 88 as of December 31, 2007.
 
Cost of Revenues. Cost of revenues increased by $0.5 million from $0.9 million in 2006 to $1.4 million in 2007. The increase in 2007 is mainly due to higher facility costs and hosting expenses aiming to serve the increasing number of customers. Cost of revenues did not increase in the same proportion as sales in 2007 due to economies of scale. Most costs of revenues are fixed and are not affected by increases or decreases in revenues.
 
Research and Development. Research and development expenses increased by 24% and amounted to $2.2 million in 2007 compared to $1.8 million in 2006. The increase is due to recruitment of more employees as part of the Company’s decision to develop new products. Research and development expenses include $246,000 of expenses in connection with SFAS No. 123(R).
 
Sales and Marketing. Sales and marketing expenses increased by 29% and amounted to $3.5 million compared to $2.7 million in 2006. The increase is mainly due to recruitment of employees and increased selling and marketing activity. In 2007, sales and marketing expenses included $194,000 expenses in connection with SFAS No. 123(R)
 
General and Administrative. General and administrative expenses increased by 13% from $2.3 million in 2006 to $2.6 million in 2007. The increase is mainly due to the recruitment of two new employees. In 2007, general and administrative expenses included $544,000 expenses in connection with SFAS No. 123(R).
 
Financial Income (Expenses), Net. Financial income (expenses), net, increased by 92% from net income of $274,000 in 2006 to net income of $527,000 in 2007.  The increase is primarily due to interest income derived from the increase in cash levels in 2007 compared to 2006 and from higher interest rates.
 
Equity in Losses of Affiliate.  In 2006, the Company recorded losses that occurred in Imatrix, an affiliated entity, up to the carrying amount of its investment as of December 31, 2006.  In 2007, since Imatrix did not incur income in excess of its cumulative losses, no equity loss was recorded with respect to such affiliate. Due to our dilution in the equity ownership and lack of significant in influence in Imatrix, the investment has been accounted for under the cost method as of December 31, 2007.
 
Quarterly Results of Operations (Unaudited)
 
The following table sets forth certain unaudited quarterly statements of operations data for the eight quarters ended December 31, 2008. This information has been derived from the Company’s consolidated unaudited financial statements, which, in management’s opinion, have been prepared on the same basis as the audited consolidated financial statements, and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the quarters presented. This information should be read in conjunction with our audited consolidated financial statements and the notes thereto included elsewhere in this report. The operating results for any quarter are not necessarily indicative of the operating results for any future period.
 
 
20

 

   
Three Months Ended
 
   
Mar. 31,
   
Jun. 30,
   
Sept. 30,
   
Dec. 31,
   
Mar. 31,
   
Jun 30,
   
Sept. 30,
   
Dec. 31,
 
   
2007
   
2007
   
2007
   
2007
   
2008
   
2008
   
2008
   
2008
 
   
(in thousands)
 
   
(unaudited)
 
                                                 
Revenues
  $ 2,405     $ 2,617     $ 2,930     $ 3,298     $ 3,401     $ 3,568     $ 3,622     $ 3501  
Cost of revenues
    286       346       357       422       449       459       466       454  
Gross profit
    2,119       2,271       2,573       2,876       2,952       3,109       3,156       3,047  
Operating expenses:
                                                               
Research and
                                                               
development
    456       539       559       633       781       792       780       799  
Sales and marketing
    826       810       874       943       1,015       967       1,043       967  
General and administrative
    661       627       620       681       869       839       797       684  
Total operating expenses
    1,943       1,976       2,053       2,257       2,665       2,598       2,620       2,450  
Operating income
    176       295       520       619       287       511       536       597  
Financial income
                                                               
(expenses), net
    91       188       119       129       120       71       108       47  
Net income
    267       483       639       748       407       582       644       644  
Taxes on income
                      28       7                    
Net income
  $ 267     $ 483     $ 639     $ 720     $ 400     $ 582     $ 644     $ 644  
                                                                 
Basic
                                                               
Net income per share
  $ 0.01     $ 0.02     $ 0.03     $ 0.03     $ 0.02     $ 0.02     $ 0.02     $ 0.03  
                                                                 
Diluted net income per share
  $ 0.01     $ 0.02     $ 0.02     $ 0.03     $ 0.01     $ 0.02     $ 0.02     $ 0.02  
 
Up through early 2006, we had a history of incurring operating losses, and we cannot be certain that we will continue to achieve profitability on a quarterly or annual basis in the future. A relatively large expense in a quarter could have a negative effect on our financial performance in that quarter. Additionally, as a strategic response to a changing competitive environment, we may elect from time to time to make certain pricing, service, marketing or acquisition decisions that could have a negative effect on our quarterly financial performance. Other factors that may cause our future operating results to fluctuate include, but are not limited to:
 
 
Our ability to successfully develop and market our email defense solutions to new markets, both domestic and international;
 
 
Our ability to successfully develop and market new, modified or upgraded solutions, as may be needed;
 
 
The continued market acceptance of our new email defense solutions;
 
 
Our ability to expand our workforce with qualified personnel, as may be needed;
 
 
Unanticipated bugs or other problems affecting the providing of our email defense solutions to customers;
 
 
The success of our resellers’ and OEM partners’ sales efforts to potential customers;
 
 
The solvency of our resellers and OEM partners and their ability to allocate sufficient resources towards the marketing of our email defense solutions to their potential customers;
 

 
21

 
 
 
Our OEM partners’ ability to effectively integrate our solutions into their product offerings;
 
 
The rate of adoption of email defense solutions by customers;
 
 
The substantial decrease in information technology spending;
 
 
The pricing of our solutions;
 
 
Our ability to timely collect fees owed by resellers and OEM partners;
 
 
Our ability to add space and equipment to our current Detection Centers in a timely and effective manner to match the rate of growth in our business, plus our ability to build new Detection Centers as worldwide demand for our products may require; and
 
 
The effectiveness of our customer support, whether provided by our resellers and OEM partners, or directly by Commtouch.
 
In addition to the factors set forth above, our operating results will be impacted by the extent to which we incur non–cash charges associated with stock–based arrangements with employees and non–employees.
 
New Accounting Pronouncements
 
In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS No. 157-2, “Effective Date of FASB Statement No. 157” ("FSP 157-2"), to delay the effective date of FASB Statement 157 for one year for certain non-financial assets and non-financial liabilities, excluding those that are recognized or disclosed in financial statements at fair value on a recurring basis (that is, at least annually).  For purposes of applying the FSP 157-2, non-financial assets and non-financial liabilities include all assets and liabilities other than those meeting the definition of a financial asset or a financial liability in FASB Statement 159. FSP 157-2 defers the effective date of Statement No. 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of FSP 157-2. The Company does not expect the adoption of FSP 157-2 to have a material impact on its financial position, results of operations or cash flows.

In December 2007, the FASB issued SFAS 160, ‘‘Noncontrolling Interests in Consolidated Financial Statements’’ (‘‘SFAS 160’’). SFAS 160 amends ARB 51, ‘‘Consolidated Financial Statements’’, to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It also clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. SFAS 160 also changes the way the consolidated income statement is presented by requiring consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. It also requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. SFAS 160 requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated and requires expanded disclosures in the consolidated financial statements that clearly identify and distinguish between the interests of the parent owners and the interests of the noncontrolling owners of a subsidiary. SFAS 160 is effective for fiscal periods, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company does not expect the adoption of SFAS 160 to have a material impact on its financial position, results of operations or cash flows.
 
In March 2008, the FASB issued Statement 161 “Disclosures about Derivative Instruments and Hedging Activities” ("SFAS 161") an amendment to FASB No. 133.  This statement changes the disclosure requirements for derivative instruments and hedging activities.  Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.  This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  Early application is encouraged.  The Company does not expect the adoption of SFAS 161 to have a material impact on its financial position, results of operations or cash flows.

 
22

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business Combinations" ("SFAS 141R"). SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. Earlier adoption is prohibited. The Company does not expect the adoption of SFAS 141R to have a material impact on its financial position, results of operations or cash flows.
 
In May 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles". SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of non-governmental entities that are presented in conformity with generally accepted accounting principles in the United States. It is effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board amendments to AU Section 411, "The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles". The Company does not expect a material impact on its consolidated financial statements from adoption of SFAS No. 162.
 
Liquidity and Capital Resources
 
We have financed our operations from positive operating cash flows, the issuance of equity securities and, to a lesser extent, from private loans and research and development grants from the Israeli government.
 
On May 8, 2006, the Company entered into a small financing transaction with one private investor, whereby the Company received $100,000 against the issuance of 31,153 Ordinary Shares and warrants to purchase an additional 23,364 Ordinary Shares.
 
As of December 31, 2007 and December 31, 2008, we had approximately $14.4 million and $16.4 million of cash and cash equivalents and marketable securities, respectively. The increase was due to positive operating cash flow and receipt of proceeds from the exercise of warrants and options in the amount of $0.8 million, less $1.3 million expended in our Ordinary Share buyback plan (see discussion under Item 16E. “Purchases of Equity Securities by the Issuer and Affiliated Purchasers”).
 
In 2008, net cash provided by operating activities was approximately $3.0 million. The increase in operating cash flow was mainly due to our net income in 2008. Net cash used in financing activities in 2008 was approximately $0.5 million, due to option and warrant exercises and the buy beck activity. Net cash provided by investing activities in 2008 was $0.3 million and consisted primarily of a decrease in short term cash deposits of $0.9 million, and purchase of property and equipment in the amount of $0.5 million. As of December 31, 2007 and December 31, 2008, we had working capital of $11.8 million and $14.8 million, respectively.
 
As of December 31, 2008, marketable securities of the Company represent short-term municipal ARS, which are purchased at par (100) and are valued at par (100) as at December 31, 2008. They are all invested in triple A rated securities. Such investments in the United States may be in excess of insured limits and are not insured in other jurisdictions. Commencing February 2008, the ARS (comprised of five securities) suffered from failed auctions. On January 5, 2009, the Company’s entire ARS portfolio was purchased by the bank at full par value, amounting to a total of $2 million. Therefore, there is no effect on the statement of operations in 2008 from such securities as of December 31, 2008.
 
Based on the cash balance at December 31, 2008, current projections of revenues and related expenses, the Company believes it has sufficient cash to continue operations at least through March 2010.
 
 
23

 
 
Contractual obligations
 
The following table summarizes our outstanding contractual obligations as of December 31, 2008 (in thousands):
 
Contractual Obligation
 
Payments due by period
(USD in thousands)
 
   
Total
   
Less than 1
year
   
1-3 years
   
3-5 years
   
More than 5
years
 
Operating lease obligation
  $ 736     $ 460     $ 276     $ -     $ -  
                                         
Other Long-term liabilities reflected on the Company’s Balance Sheet - Accrued severance pay
    857       -       -       -       857  
                                         
Other Long-term asset reflected on the Company’s Balance Sheet - severance pay fund
    (720 )     -       -       -       (720 )
                                         
Net - severance pay liability
    137       -       -       -       137  
                                         
Total
  $ 873     $ 460     $ 276     $ -     $ 137  
 
Effective Corporate Tax Rates
 
Our tax rate will reflect a mix of the U.S. statutory tax rate on our U.S. income and the Israeli tax rate discussed below. Israeli companies are generally subject to corporate tax on their taxable income. The applicable corporate tax rate was 27% in 2008 and will be further progressively reduced to the following tax rates:  2009 - 26%, 2010 and thereafter - 25%.

As of December 31, 2008, the Company's net operating loss carry forwards for tax purposes amounted to approximately $78 million, which may be carried forward and offset against taxable income in the future, for an indefinite period.

As of December 31, 2008, for federal income tax purposes, our U.S. subsidiary had net operating loss carry-forwards of approximately $ 92 million. These losses may offset any future U.S. taxable income of the U.S. subsidiary and will expire in the years 2009 through 2025. In light of the subsidiary's history of operating losses, the Company has recorded a valuation allowance for all of its deferred tax assets.

Utilization of U.S. net operating losses may be subject to substantial annual limitation due to the "change in ownership" provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitations may result in the expiration of net operating losses before utilization.

The Company and its subsidiary have provided valuation allowances in respect to the deferred tax assets resulting from operating loss carry forwards and other temporary differences. Management currently believes that since the Company and its subsidiary, until recently, has had a history of losses, it is more likely than not that the deferred tax assets regarding the loss carry forwards and other temporary differences will not be realized in the foreseeable future.

24

 
Impact of Inflation and Currency Fluctuations

Most of our sales are in U.S. dollars, and the rest are mainly in Euros. However, a portion of our costs relates to our operations in Israel. A substantial portion of our operating expenses in Israel, primarily our research and development expenses are denominated in NIS. Costs and revenues not denominated in U.S. dollars are re-measured to U.S. dollars, when recorded, at prevailing rates of exchange. This is done for the purposes of our financial statements and reporting. As a result, we are exposed to risk to the extent that the value of the U.S. dollar decreases against the NIS.  In that event, the U.S. dollar cost of our operations will increase and our U.S. dollar-measured results of operations will be adversely affected, as occurred in 2007 and the first half of 2008, when the NIS appreciated against the U.S. dollar, which resulted in a significant increase in the U.S. dollar cost of our operations.  Also, in the event that the U.S. dollar appreciates against the Euro, our revenues will decrease. Consequently, we are and will be affected by changes in the prevailing NIS/U.S. dollar and Euro/ U.S. dollar exchange rates.
 
The annual rate of inflation in Israel was 3.8% in 2008, 3.4% in 2007 and (0.1%) in 2006. The NIS appreciated against the U.S. dollar by approximately (1.6%) in 2008 and (8.9%) in 2007 and depreciated against the U.S. dollar by approximately 8.24% in 2006. The representative dollar exchange rate for converting the NIS to U.S. dollars, as reported by the Bank of Israel, was NIS 3.802 for one U.S. dollar on December 31, 2008. The representative dollar exchange rate was NIS 4.135 at March 16, 2009. Because exchange rates between the NIS and the dollar fluctuate continuously, exchange rate fluctuations and especially larger periodic devaluations will have an impact on our operating results and period–to–period comparisons of our results. The effects of foreign currency re–measurements are reported in the consolidated financial statements for relevant periods in the statement of operations.
 
Item 6. Directors, Senior Management and Employees
 
The following table presents information with respect to our directors’ beneficial ownership of our Ordinary Shares as of December 31, 2008.  Beneficial ownership is determined in accordance with the rules of the SEC and includes voting or investment power, with respect to shares. To our knowledge, except under applicable community property laws or as otherwise indicated, the persons named in the table have sole voting and sole investment control and rights to receive economic benefits with respect to all shares beneficially owned. The applicable percentage of ownership for each director is based on 25,206,659 Ordinary Shares outstanding as of December 31, 2008. Ordinary Shares issuable upon exercise of options and other rights held and exercisable on or within sixty days of December 31, 2008 are deemed outstanding for the purpose of computing the percentage ownership of the director holding those options and other rights.
 
Name and
Position
 
Age
 
Ordinary
Share
Beneficial
Ownership
>1% 
 
Number of
Ordinary Shares
Beneficially Owned
 
Number of Options and Warrants included
in Beneficial Ownership
                 
Amir Lev, Director, President and CTO
 
48
 
3%
 
761,131
 
599,980 options, at exercise prices ranging from $0.0375 to $6.60 per Ordinary Share.  Expiration dates range from 8/15/11 to 8/4/15
                 
Aviv Raiz, Director (1)
 
50
 
21.6%
 
5,535,869
 
50,000 options, at exercise prices ranging from $3.12 to $6.60 per Ordinary Share.  Expiration dates range from 12/30/11 to 12/14/13. Also, 333,333 warrants, with an exercise price of $1.95, expiring in early October 2010
                 
Gideon Mantel, Director, Chairman of the Board and CEO
 
49
 
4.6%
 
1,207,175
 
804,149 options, at exercise prices ranging from $0.0375 to $6.60.  Expiration dates range from 8/15/11 to 8/4/15
 
25

 
Hila Karah, Director(1)(3)
 
40
 
<1%
 
<1%
   
                 
Lloyd E. Shefsky, Director(2)(3)(4)
 
68
 
1.4%
 
345,383
 
115,103 options, at exercise prices ranging from $1.17 to $6.60. Expiration dates range from 12.30.11 to 3.29.15.
                 
Yair Shamir, Director (Outside Director) (2)(3)(5)
 
64
 
4.4%
 
1,099,158
 
9,375 options, at exercise prices ranging from $1.58 to $4.10.  Expiration dates range from 3.31.14 to 12.15.14
                 
Yair Bar-Touv, Director (Outside Director) (1)(2)
 
48
 
<1%
 
<1%
   
 
(1)
Member of the Compensation Committee
 
(2)
Member of the Audit Committee
 
(3)
Member of the Nominating Committee
 
(4)
Mr. Shefsky’s ownership information includes his individual holdings and holdings of LENE L.P. (134,265 Ordinary Shares), in which Mr. Shefsky currently holds a relatively nominal, limited partnership interest.
 
(5)
Mr. Shamir’s ownership interest includes 1,099,158 Ordinary Shares purchased by Catalyst Private Equity Partners II, for which Mr. Shamir acts as Chairman and Managing Partner.  Mr. Shamir’s options, as noted in the table above, are also held on behalf of Catalyst.
 
Other Senior Management Employees:
 
The following table sets forth the names and positions of our senior  management employees:
 
Name
 
Age
 
Ownership >1%
 
Position
Gideon Mantel
 
49
 
See table above
 
CEO and Chairman of the Board
Amir Lev
 
48
 
See table above
 
President and Chief Technical Officer
Ron Ela
 
38
 
(1)
 
Chief Financial Officer
Avner Amram
 
47
 
(1)
 
Executive Vice President, GM Americas, Commtouch Inc.
Gary Davis
 
47
 
(1)
 
Vice President, General Counsel and Corporate Secretary
Ronen Rosenblatt
 
43
 
(1)(2)
 
Vice President, Research and Development Commtouch Software Ltd.
Ido Hadari
 
35
 
(1)
 
Vice President, International Sales and Business Development, Commtouch Software Ltd.
Jay Goldin
 
40
 
(1)
 
Vice President, Business Development North America
Yossi Maslaton
 
42
 
(1)
 
Vice President, Network Operations & Customer Services
Asaf Greiner
 
34
 
(1)
 
Vice President, Web Security Products
Rebecca Herson
 
39
 
(1)
 
Vice President, Marketing
 
(1)
less than 1%
 
 
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(2)
During early 2009, Ronen Rosenblatt joined the Company as Vice President of Research and Development.
 
Amir Lev is a co–founder of Commtouch and has served as its Chief Technology Officer and as a Director since its inception in 1991. Mr. Lev was also the General Manager of Commtouch from January 1997 through April 2000, and in May 2000 became President. Mr. Lev received a B.A. in Computer Science and Economics from Hebrew University, Jerusalem.
 
Aviv Raiz has served as a Director since December 2005.  He is the founder and President of Eurotrust Ltd.  Mr. Raiz has been active in the foreign exchange markets for the past twenty years, and has been a private equity investor in several high-tech, bio-tech and Internet companies for the past ten years. He holds an M.B.A. from Tel Aviv University.
 
Gideon Mantel is a co–founder of Commtouch and served as its Chief Financial Officer from its inception in February 1991 until October 1995, when he became Commtouch’s Chief Operating Officer. In November 1997, he became Commtouch’s Chief Executive Officer, and in December 2006, he was confirmed as Chairman of the Board. He has also served as a Director of Commtouch since inception. Mr. Mantel received a B.A. in Political Science and an M.B.A. from Tel Aviv University.
 
Hila Karah joined the Board of Directors in March 2008. Ms. Karah has been the CIO of Eurotrust Ltd. since 2006, and has been a private and public equity investor in several high-tech, bio-tech and Internet companies since 2000. Prior to her joining Eurotrust, she served as a partner financial analyst at Perceptive Life Sciences Ltd., a New York-based hedge fund. Prior to her position at Perceptive, Ms. Karah was a research analyst at Oracle Partners Ltd., a health care-focused hedge fund based in Connecticut. Ms. Karah holds a BA in Molecular and Cell Biology from the University of California, Berkeley, and has studied at the UCB-UCSF JMP.
 
Lloyd E. Shefsky has served as a Director of Commtouch since October 2003.  He is a Clinical Professor of Entrepreneurship and Co-Director of the Center for Family Enterprises at the Kellogg School of Management and has taught in several countries. In 1970, he founded the Chicago law firm, Shefsky & Froelich Ltd., where has been Of Counsel since 1996. Since 1981 he has represented the Government of Israel throughout the Midwestern U.S. For nearly forty years he has represented hundreds of entrepreneurs and their companies, and during the past twenty-five years, such representation has included numerous Israeli companies with U.S. operations.  Mr. Shefsky authored Entrepreneurs Are Made Not Born, which was translated into five foreign languages. He received his J.D. from the University of Chicago Law School, a B.S.C. from De Paul University (accounting), is a member of the Illinois and Florida Bars, and has a CPA certificate in Illinois.
 
Yair Shamir joined the Board of Directors as an Outside Director under the Israel Companies Law in March 2008.  Mr. Shamir is the Chairman and Managing Partner of Catalyst Investments and the Chairman of IAI, Israeli Aerospace Industries.  From 2004 to 2005, Mr. Shamir was Chairman of El Al, Israeli Airlines and lead the privatization process of the firm.  From 1997 to 2005, Mr. Shamir served as Chairman and CEO of VCON Telecommunications Ltd.  From 1995 to 1997, Mr. Shamir served as executive vice president of the Challenge Fund-Etgar L.P.  From 1994 to 1995, he served as Chief Executive Officer of Elite Food Industries, Ltd.  From 1988 to 1993, Mr. Shamir served as Executive Vice President and General Manager of Scitex Corporation, Ltd. Mr. Shamir served in the Israeli Air Force as a pilot and commander from 1963 to 1988. During his term in the Air Force, Mr. Shamir attained the rank of colonel and served as head of the electronics department, the highest professional electronics position within the Air Force.  He currently serves as a director of DSP Group Corporation and also serves as director of other private hi-tech companies.  Mr. Shamir holds a B.Sc. Electronics Engineering from the Technion, Israel Institute of Technology.
 
Yair Bar-Touv joined the Board of Directors as an Outside Director under the Israel Companies Law in March 2008.  Mr. Bar-Touv is formerly the CIO of a leading government enterprise specializing in analytic software solutions for knowledge discovery (text and data mining) of large volumes of data, with a focus on changing the ways enterprise organizations make decisions with regards to primary business processes.  Mr. Bar-Touv is also the former CEO of Elron Telesoft  and co-CEO of NCC, a leading Systems Integrator operating in Israel and the USA, which was acquired in 1997 by Elron Electronics.  Mr. Bar-Touv holds an M.Sc in Computer Engineering from the Technion Institute of Technology (1987) and a B.Sc in Electronic Engineering from Ben-Gurion University (1981).
 
 
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Ron Ela joined Commtouch in July 2006 as its Chief Financial Officer. A Certified Public Accountant, Mr. Ela formerly held management positions at two Israeli-based Nasdaq listed companies, and most recently held the role of Controller at Verint Systems Ltd., a wholly–owned subsidiary of Verint Systems Inc. During the five years prior to that time, Mr. Ela served as Deputy Controller and subsequently Controller for Partner Communication Ltd. Also, Mr. Ela spent 3 years in public accounting with Kesselman & Kesselman, a member of PricewaterhouseCoopers in Israel. Mr. Ela has a B.A. in business administration majoring in accounting from the College of Management Academic Studies.
 
Avner Amram joined Commtouch in 1996 and currently serves as Executive Vice President and General Manager, Americas. Mr. Amram has over 17 years of experience in the areas of technology, operational management and leadership, and is also a founder of CVDO. Before 2002, Mr. Amram served as COO of Commtouch and was responsible for worldwide operations. Mr. Amram also held a number of positions at Commtouch prior to being appointed COO. From 1995 to 1996, Mr. Amram served as project manager for Medatech, a leading provider of customer relationship management (CRM) solutions, developing and managing complex installations at large organizations. Prior to Medatech, Mr. Amram acted as General Manager of Fuga Nursery in Israel, where he was responsible for operations, production, marketing and distribution. Mr. Amram holds a Bachelors of Science (BSC), in Computer Engineering and graduated Cum Laude from the Technion, Israel Institute of Technology.
 
Gary Davis joined Commtouch in September 1999 and serves as Vice President, General Counsel and Corporate Secretary. Mr. Davis has over 20 years of legal experience in both private law firm and corporate practices. Mr. Davis is certified to practice law in both the State of Israel and California. Prior to September 1999, Mr. Davis was in–house counsel to Israel Military Industries and Elta Electronics Industries. He received a B.A. in Political Economy of Industrial Societies from U.C. Berkeley and a J.D. in law from Golden Gate University.
 
Ronen Rosenblatt rejoined Commtouch in January 2009 and serves as Vice President of research and development. For the past 18 years, he has held executive positions in the Israeli hi-tech industry ranging from start–ups to publically traded companies. Mr. Rosenblatt served as VP of research and development at Commtouch in its early stages until 2000 and most recently, he served as Vice President of research and development at NiceVision, a division of Nice Systems. Previously, Mr. Rosenblatt served in technology and business executive roles in several startup companies, including Xacct, a provider of industry-leading mediation software for telecom service providers that was acquired by Amdocs, Savantis, and Gigaspaces. He earned a Bachelor of Science degree from Tel-Aviv University and an Executive MBA from the Recanati School of Business.
 
Ido Hadari joined Commtouch in 2008 and serves as Vice President, International Sales and Business Development. Mr. Hadari has over a decade of business management and sales experience, most recently at Interwise, an enterprise voice and web conferencing provider that was acquired by AT&T. At Interwise, where he worked for the past eight years, he held various senior business development and channel management positions with responsibilities for regional sales in Europe and Asia, and global strategic alliances. He holds a BA magna cum laude in Business Administration and Economics from Hebrew University, Jerusalem.
 
Jay Goldin joined Commtouch in March 2006, as the Vice President Business Development, North America.  Prior to joining Commtouch, Mr. Goldin was a consultant to networking and security companies, including Commtouch.  Mr. Goldin was a founder of Digital Fountain, a wireless and media networking technology company, where he served as Vice President of Business Development.   He also co-founded Alyanza Infosystems, and was a management consultant with Pacific Rim Consulting Group.  Mr. Goldin received his M.B.A and A.B. in Economics from Stanford University.
 
Yossi Maslaton joined Commtouch in 1998 and has served as Vice President of Network Operations and Customer Services since early 2005.  Before 2005 he was Director of Service Operations.  With over 20 years of experience in the fields of Information Technology and Networking, Mr. Maslaton is responsible for the operations of Commtouch's data centers and customer services, servicing tens of millions of users daily with the highest standards of uptime.  From 1991 to 1998 Mr. Maslaton was Manager of Information Systems and labs for RND Networks, a group of hi-tech startups in the network-routing field.  Prior to that, Mr. Maslaton managed the technical field-operations of a large project for the Israel Defense Forces in the areas of distributed computing systems and radio communications.
 
Asaf Greiner joined Commtouch in 2008 and serves as Vice President of Web Security Products. Mr. Greiner has over a decade of experience in executive and entrepreneurial roles, previously serving as Director of Business Innovation at Aladdin Knowledge Systems, a company specializing in software and Internet security. Previously he co-founded and acted as general manager of beeFENCE, a network security company, and Aduva, a Linux lifecycle management company that was acquired by SUN Microsystems. He holds an MBA summa cum laude from The Interdisciplinary Center, Herzliya and a BA in Business and Economics from Hebrew University, Jerusalem.
 
 
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Rebecca Steinberg Herson joined Commtouch in April 2006 as Director of Marketing. Currently, she serves as Vice President, Marketing, orchestrating the company's global marketing strategy and activities. Prior to joining Commtouch, Ms. Herson served as Vice President of Marketing at Redmatch, a software start-up. Previously, she led marketing initiatives at Whale Communications (acquired in 2006 by Microsoft), Orckit Communications (Nasdaq: ORCT) and at various not-for-profit organizations. As the head of marketing for six years at Whale, an Internet security company, she was responsible for launching numerous hardware/software products and held a key role in establishing the company as a market leader in the secure remote access field. Ms. Herson holds a BA magna cum laude from Yale University, and an MS in Management from Boston University.
 
Election of Directors
 
Directors (other than outside directors, as explained below) are elected by shareholders at the annual general meeting of the shareholders and hold office until the next annual general meeting following the general meeting at which such director is elected and until a successor is elected, or until the director is removed. An annual general meeting must be held at least once in every calendar year, but not more than fifteen months after the preceding annual general meeting. Directors may be removed and other directors may be elected in their place or to fill vacancies in the Board of Directors at any time by the holders of a majority of the voting power at a general meeting of the shareholders. Until a vacancy is filled by the shareholders, the Board of Directors may appoint new directors temporarily to fill vacancies on the Board of Directors. The Amended and Restated Articles of Association of Commtouch authorize the shareholders to determine, from time to time, the number of directors. The maximum number of directors is currently fixed at ten directors, though only seven directors are currently serving on the Board of Directors. There are no family relationships among any of the directors, officers or key employees of Commtouch.
 
Alternate Directors
 
The Amended and Restated Articles of Association of Commtouch provide that any director may appoint another person to serve as an alternate director and may remove such alternate. Any alternate director possesses all the rights and obligations of the director who appointed him, except that the alternate has no standing at any meeting while the appointing director is present, the alternate may not in turn appoint an alternate for himself (unless the instrument appointing him otherwise expressly provides) and the alternate is not entitled to remuneration. A person who is not qualified to be appointed as a director may not be appointed as an alternate director. Unless the appointing director limits the time or scope of the appointment, the appointment is effective for all purposes until the appointing director ceases to be a director or terminates the appointment. The appointment of an alternate director does not in itself diminish the responsibility of the appointing director as a director.
 
Independent and Outside Directors
 
The Israel Companies Law requires Israeli companies with shares that have been offered to the public in or outside of Israel to appoint at least two outside directors. No person may be appointed as an outside director if the person or the person’s relative, partner, employer or any entity under the person’s control has or had, on or within the two years preceding the date of the person’s appointment to serve as outside director, any affiliation with the company or any entity controlling, controlled by or under common control with the company. The term affiliation includes:
 
 
an employment relationship;
 
 
a business or professional relationship maintained on a regular basis;
 
 
control; and
 
 
service as an office holder.
 
No person may serve as an outside director if the person’s position or other business activities create, or may create, a conflict of interest with the person’s responsibilities as an outside director or may otherwise interfere with the person’s ability to serve as an outside director. If, at the time outside directors are to be appointed, all current members of the Board of Directors are of the same gender, then at least one outside director must be of the other gender.  At least one of the outside directors is required to have "financial and accounting expertise," unless another member of the audit committee, who is an independent director under the NASDAQ Marketplace Rules, has "financial and accounting expertise," and the other outside director or directors are required to have "professional expertise," all as defined under the Israel Companies Law.
 
 
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Outside directors are to be elected by a majority vote at a shareholders’ meeting, provided that either:
 
 
such majority includes at least one–third of the shares held by non–controlling shareholders who are present and voting at the meeting; or
 
 
the total number of shares held by non–controlling shareholders voting against the election of the director at the meeting does not exceed one percent of the aggregate voting rights in the company.
 
The initial term of an outside director is three years and may be extended for an additional period of three years. Outside directors may be removed only by the same percentage of shareholders as is required for their election, or by a court, and then only if the outside director ceases to meet the statutory qualifications for their appointment or if they violate their fiduciary duty to the company. Each committee of a company’s Board of Directors must include at least one outside director and the audit committee (the existence of which is required under the Israel Companies Law) must include all outside directors. An outside director is entitled to compensation as provided in the regulations adopted under the Israel Companies Law and is otherwise prohibited from receiving any other compensation, directly or indirectly, in connection with service provided as an outside director.
 
Mr. Shamir and Mr. Bar-Touv currently serve as the Company’s outside directors.
 
In addition, the NASDAQ Capital Market currently requires Commtouch to have at least a majority of independent directors, as defined under Marketplace Rule 4200(a)(15), on the Board of Directors and to maintain an audit committee of at least three members, each of whom must:
 
 
(i)
be independent as defined under Marketplace Rule 4200(a)(15);
 
 
(ii)
meet the criteria for independence set forth in Rule 10A-3(b)(1) under the Securities Exchange Act of 1934, as amended, or “Exchange Act”, as set forth below (subject to the exemptions provided in Exchange Act Rule 10A-3(c);
 
 
(iii)
not have participated in the preparation of the financial statements of the Company or any current subsidiary of the Company at any time during the past three years; and
 
 
(iv)
be able to read and understand fundamental financial statements, including a company’s balance sheet, income statement and cash flow statement.
 
Under limited circumstances, the Company may have one audit committee member not independent in accordance with the above, but such a member would only be able to serve for a maximum of two years.
 
Exchange Act Rule 10A-3(b)(1) requires that members of the audit committee meet that rule’s definition of independence, which requires that an audit committee member may not, except in his or her capacity as a director or committee member, (i) accept directly or indirectly any consulting, advisory, or other compensatory fee from the Company or any of its subsidiaries (except for fixed amounts of compensation under a retirement plan for prior service with the Company, provided that such compensation is not contingent in any way on continued service), and (ii) be an “affiliated person” of the Company or any of its subsidiaries.

NASDAQ rules also require that the Company certify that it has, and will continue to have, at least one member of the audit committee who has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight  responsibilities.  Also, under Item 401(h) of Regulation S-K, the Company is currently obligated to disclose whether or not it has a “financial expert” on its audit committee, as defined under this regulation (See Item 16A. Audit Committee Financial Expert).
 
The three directors who serve on our audit committee, Mr. Shamir, Mr. Bar-Touv and Mr. Shefsky, qualify as independent directors under NASDAQ Marketplace Rules (including Exchange Act Rule 10A-3). Furthermore, Mr. Shamir and Mr. Bar-Touv meet the qualification requirements for outside directors, as required under the Israel Companies Law.
 
 
30

 
 
The Company has identified the following Board members as “Independent directors” pursuant to NASDAQ Marketplace Rule 4200(a)(15):

 
a.
Yair Bar-Touv
 
b.
Yair Shamir
 
c.
Aviv Raiz
 
d.
Hila Karah
 
e.
Lloyd Shefsky
 
Pursuant to a recent amendment to the Israeli Companies Law, an Israeli company, whose shares are publicly traded, may elect to adopt a provision in its articles of association pursuant to which a majority of its board of directors will constitute individuals complying with certain independence criteria prescribed by the Israel Companies Law.  We have not included such a provision in our articles of association since our board of directors complies with the independence requirements of the NASDAQ and Securities and Exchange Commission regulations described above.
 
Audit Committee
 
As noted above in the discussion under “Independent and Outside Directors”, the Israel Companies Law requires public companies to appoint an audit committee. The responsibilities of the audit committee include identifying irregularities in the management of the Company’s business, approving management compensation and approving related party transactions as required by law. An audit committee must consist of at least three directors meeting the independence standards under the NASDAQ Marketplace Rules and must include all outside directors under the Israel Companies Law, all as described above. Furthermore, the Israel Companies Law specifically prohibits the chairman of the Board of Directors, any director employed by or otherwise providing services to a company and a controlling shareholder or any relative of a controlling shareholder from being a member of the audit committee. Our Audit Committee is in compliance with the noted requirements.
 
Compensation Committee
 
The Compensation Committee is responsible for determining salaries, incentives and other forms of compensation for Commtouch’s directors and its executive officers.  The Compensation Committee is also responsible for administering the various stock option plans, including the issuance of grants of options to employees of the Company and its subsidiary.
 
Nominating Committee
 
The committee’s responsibilities include identifying individuals qualified to become board members and recommending director nominees to the board.
 
Internal Auditor
 
Under the Israel Companies Law, the Board of Directors must appoint an internal auditor, nominated by the audit committee. The role of the internal auditor is to examine, among other matters, whether a company’s actions comply with relevant law and orderly business procedure. Under the Companies Law, the internal auditor may be an employee of the company but not an interested party or office holder, or a relative of an interested party or office holder, and he or she may not be the company’s independent accountant or its representative. The Company engaged a qualified internal auditor during 2008.
 
Approval of Certain Transactions; Obligations of Directors, Officers and Shareholders
 
The Israel Companies Law codifies the fiduciary duties that office holders, including directors and executive officers, owe to a company. An office holder’s fiduciary duties consist of a duty of care and a duty of loyalty. Each person listed in the first table that appears above at the beginning of this Item 6 is an office holder.
 
 
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The duty of loyalty requires an office holder to act in good faith and for the benefit of the company, including to avoid any conflict of interest between the office holder’s position in the company and such person’s personal affairs, avoiding any competition with the company, avoiding exploiting any corporate opportunity of the company in order to receive personal advantage for such person or others, and revealing to the company any information or documents relating to the company’s affairs which the office holder has received due to his or her position as an office holder. A company may approve any of the acts mentioned above provided that all the following conditions apply: the office holder acted in good faith and neither the act nor the approval of the act prejudices the good of the company, and the office holder disclosed the essence of his personal interest in the act, including any substantial fact or document, a reasonable time before the date for discussion of the approval.

The duty of care requires an office holder to act with a level of care that a reasonable office holder in the same position would employ under the same circumstances.  This includes the duty to use reasonable means to obtain information regarding the advisability of a given action submitted for his or her approval or performed by virtue of his or her position and all other relevant information material to these actions.

Under the Israel Companies Law, all arrangements as to compensation of office holders who are not directors require approval of the Board of Directors unless the Articles of Association provide otherwise. Arrangements regarding the compensation of directors also require audit committee and shareholder approval.
 
The Israel Companies Law requires that an office holder promptly disclose any personal interest that he or she may have and all related material information known to him or her, in connection with any existing or proposed transaction by the company. "Personal interest," as defined by the Companies Law, includes a personal interest of any person in an act or transaction of the company, including a personal interest of his relative or of a corporation in which that person or a relative of that person is a 5% or greater shareholder, a holder of 5% or more of the voting rights, a director or general manager, or in which he or she has the right to appoint at least one director or the general manager.  "Personal interest" does not apply to a personal interest stemming merely from holding shares in the company.
 
The office holder must make the disclosure of his personal interest no later than the first meeting of the company's board of directors that discusses the particular transaction.  This duty does not apply to the personal interest of a relative of the office holder in a transaction unless it is an "extraordinary transaction."  An “extraordinary transaction” is defined as a transaction not in the ordinary course of business, a transaction that is not on market terms, or a transaction that is likely to have a material impact on the company’s profitability, assets or liabilities, and a "relative" as a spouse, siblings, parents, grandparents, descendants, spouse’s descendants and the spouses of any of the foregoing.
 
In the case of a transaction that is not an extraordinary transaction, after the office holder complies with the above disclosure requirement, only Board approval is required unless the Articles of Association of the company provide otherwise.  Our Amended and Restated Articles of Association do not provide otherwise.  Such approval must determine that the transaction is not adverse to the company’s interest. If the transaction is an extraordinary transaction, then in addition to any approval required by the Articles of Association, it also must be approved by the audit committee and by the Board and, under specified circumstances, by a meeting of the shareholders. An Israeli company whose shares are publicly traded shall not be entitled to approve such a transaction unless, at the time the approval was granted, two members of the audit committee were outside directors and at least one of them was present at the meeting at which the audit committee decided to grant the approval. An office holder who has a personal interest in a matter that is considered at a meeting of the Board of Directors or the audit committee generally may not be present at this meeting or vote on this matter unless a majority of the board of directors or the audit committee has a personal interest in the matter.  If a majority of the board of directors or the audit committee has a personal interest in the transaction, shareholder approval also would be required.
 
The Israel Companies Law applies the same disclosure requirements to a controlling shareholder of a public company, which includes a shareholder that holds 25% or more of the voting rights if no other shareholder owns more than 50% of the voting rights in the company. Extraordinary transactions, including a private placement, with a controlling shareholder or in which a controlling shareholder has a personal interest, and the terms of compensation of a controlling shareholder who is an office holder, require the approval of the audit committee, the Board of Directors and the shareholders of the company. The shareholder approval must either include at least one–third of the disinterested shareholders who are present, in person or by proxy, at the meeting or, alternatively, the total shareholdings of the disinterested shareholders who vote against the transaction must not represent more than one percent of the voting rights in the company.
 
 
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Under the Israel Companies Law, a shareholder has a duty to act in good faith towards the company and other shareholders and refrain from abusing his or her power in the company, including, among other things, in respect to his or her voting at the general meeting of shareholders on the following matters:
 
 
any amendment to the Articles of Association;
 
 
an increase of the company’s authorized share capital;
 
 
a merger; or
 
 
approval of interested party transactions that require shareholder approval.
 
In addition, any controlling shareholder, any shareholder who can determine the outcome of a shareholder vote and any shareholder who, under the company’s Articles of Association, can appoint or prevent the appointment of an office holder, is under a duty to act with fairness towards the company. The Israel Companies Law provides that a breach of the duty of fairness will be governed by the laws governing breach of contract. The Israel Companies Law does not describe the substance of this duty.
 
Insurance, Indemnification and Exculpation of Directors and Officers; Limitations on Liability
 
The Israel Companies Law permits a company to insure an office holder in respect of liabilities incurred by him or her as a result of the breach of his or her duty of care to the company or to another person, or as a result of the breach of his or her duty of loyalty to the company, to the extent that he or she acted in good faith and had reasonable cause to believe that the act would not prejudice the company. A company can also insure an office holder for monetary liabilities as a result of an act or omission that he or she committed in connection with his or her serving as an office holder. Moreover, a company can indemnify an office holder for (a) any monetary liability imposed upon such a office holder for the benefit of a third party pursuant to a court judgment, including a settlement or an arbitrator’s decision, confirmed by a court, (b) reasonable legal costs, including attorney’s fees, expended by a office holder as a result of an investigation or proceeding instituted against the office holder by a competent authority, provided that such investigation or proceeding concludes without the filing of an indictment against the office holder and either i) no financial liability was imposed on the office holder in lieu of criminal proceedings  or ii) financial liability was imposed on the office holder in lieu of criminal proceedings but the alleged criminal offense does not require proof of criminal intent, and (c) reasonable litigation expenses, including legal fees, actually incurred by such a office holder or imposed upon the office holder by a court order, in a proceeding brought against the office holder by or on behalf of the company or by others, or in a criminal action in which he was acquitted, or in a criminal action which does not require proof of criminal intent in which he was convicted.  The Companies Law further provides that the indemnification provision in a company’s articles of association (i) may be an obligation to indemnify in advance, provided that, other than litigation expenses, it is limited to events the board of directors can foresee in light of the company’s actual activities when providing the obligation and that it is limited to a sum or standards the board of directors determines is reasonable in the circumstances, and (ii) may permit the company to indemnify an officer or a director after the fact.
 
Furthermore, a company can, with one limited exception, exculpate an office holder in advance, in whole or in part, from liability for damages sustained by a breach of duty of care to the company.
 
All of these provisions are specifically limited in their scope by the Companies Law, which provides that a company may not indemnify or exculpate an officer or director nor enter into an insurance contract that would provide coverage for any monetary liability incurred as a result of (i) a breach by the officer or director of the duty of loyalty, unless the officer or director acted in good faith and had a reasonable basis to believe that the act would not prejudice the company, in which case the company is permitted to indemnify and provide insurance to but not to exculpate; (ii) an intentional or reckless breach by the officer or director of the duty of care, other than if solely done in negligence; (iii) any act or omission done with the intent to derive an illegal personal benefit; or (iv) any fine levied or forfeit against the director or officer.
 
Our Amended and Restated Articles of Association allow us to insure, exculpate and indemnify office holders to the fullest extent permitted by law provided such insurance, exculpation or indemnification is approved in accordance with the Israel Companies Law. We have acquired directors’ and officers’ liability insurance covering the officers and directors of Commtouch and its subsidiary for certain claims. At the annual meeting of shareholders held on November 18, 2002, the shareholders approved a form of indemnification, exculpation and insurance agreement that is applicable to all our directors.  The form of this agreement, as well as related provisions in our Amended and Restated Articles of Association, were amended at the annual meeting of shareholders held on December 30, 2005.
 
 
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Compensation of Directors and Executive Officers
 
The directors of Commtouch can be remunerated by Commtouch for their services as directors to the extent such remuneration is approved by Commtouch’s audit committee, Board of Directors and shareholders. Through 2008, directors did not receive cash compensation for their services.  However, at the annual meeting in December 2008, shareholders approved the payment of cash compensation, in addition to equity compensation (options), according to the following:
 
 
a.
NIS 31,700 base annually per director, as linked to the applicable Israeli consumer price index, payable in four equal installments at the beginning of each calendar quarter; and
 
b.
NIS 1,590 per director per face to face Board or committee meeting or NIS954 (60% of NIS 1590) in case of telephonic participation at such meeting, payable at the beginning of each calendar quarter following the quarter during which a Board member participated in a meeting. No separate per meeting compensation will be paid for committee meetings that are held on the same day immediately prior or subsequent to a Board meeting.  In that event, a Board and committee meeting will be considered one meeting.
 
c.
For non-Israeli based directors, the amounts set forth will be paid in United States dollars, according to the representative rate of exchange published by the Bank of Israel on the date of payment.
 
Directors also are reimbursed for their expenses for each Board of Directors meeting attended. See Item 10 “Amended and Restated 1999 Non-employee Directors Stock Option Plan” for a discussion of director compensation in the form of option grants. During 2008, options to purchase 491,984 Ordinary Shares were granted to directors and executive officers under the Company’s stock option plans at a weighted average exercise price of $ 3.20 per share. The aggregate direct remuneration paid by Commtouch to all directors and executive officers (11 persons) in 2008 was approximately $669 thousand. During the same period Commtouch accrued or set aside approximately $42 thousand for the same group to provide pension, retirement or similar benefits. As of December 31, 2008, directors and executive officers of Commtouch (8 persons) held an aggregate of 2,655,541 stock options to purchase a like number of Ordinary Shares, with 1,622,543 of those options having vested.
 
Options to Purchase Securities from Registrant or Subsidiaries
 
As of December 31, 2008, options to purchase 4,039,228 Ordinary Shares had been granted to then existing employees, consultants, executive officers and non–employee directors under the Company’s stock option plans, net of forfeited options, and there were 1,447,361 shares available for grant under all plans. Of the number of options granted, had not been exercised and had exercise prices ranging from $0.0375 to $6.60 per share and a weighted average per share exercise price of approximately $2.77, and were held by 56 persons.  These options have termination dates ranging from March 2009 to August 2015.
 
Employee Stock Option Plans
 
Employees, including executive officers and other management employees, participate in the Company’s employee option plans. The Commtouch Software Ltd. 2006 U.S. Stock Option Plan, primarily covering the granting of options to employees and consultants based in the United States, was adopted on December 15, 2006 and has a term of ten years.  The Commtouch Software Ltd. Amended and Restated Israeli Share Options Plan, primarily covering the granting of options to employees, consultants and directors based in Israel, was adopted on June 22, 2003 and has a term of ten years.   While Israeli based directors receive their grants under the Israeli plan, the principal terms of their grants are identical to those of non-Israeli based directors receiving their grants under the non-employee director plan (discussed below).
 
Some previous employee option plans have either terminated or were amended and restated, though options remain outstanding and exercisable under those plans.  Such plans include the Amended and Restated 1996 CSI Stock Option Plan which expired on January 1, 2006 and the Amended and Restated 1999 3(i) Share Option Plan, which was replaced by the above described Israeli Share Option Plan.

All employee stock option plans are administered by the Compensation Committee. Subject to the provisions of the employee stock plans and applicable law, the Compensation Committee has the authority to determine, among other things, to whom options may be granted; the number of Ordinary Shares to which an option may relate; the exercise price for each share; the vesting period of the option and the terms, conditions and restrictions thereof, including accelerated vesting on change of control provisions; to amend provisions relating to such plans; and to make all other determinations deemed necessary or advisable for the administration of such plans.

 
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Amended and Restated 1999 Non–Employee Directors Stock Option Plan
 
New non-employee directors are currently entitled to an initial grant of 50,000 options. Non-employee directors who are reelected at the annual meeting of shareholders are entitled to additional grants of 16,667 options.
 
The Company’s Non–Employee Directors Plan was extended by an additional ten years at the annual meeting of shareholders held on December 15, 2008. Under this plan, each option becomes exercisable at a rate of 1/16th of the option shares every three months, and has an exercise price equal to the fair market value of the Ordinary Shares on the grant date of such option. Up through 2004, each option granted had a maximum term of ten years, but would terminate earlier if the optionee ceased to be a member of the Board of Directors. Options granted to directors during 2005 - 2007 have a maximum term of six years.  At the annual meeting of shareholders of December 30, 2005, shareholders approved an amendment to the Non-Employee Directors Plan to allow for the acceleration of unvested options for any director who has served the company for at least three years, unless the director resigned voluntarily or was removed from the Board of Directors due to a failure to perform any of his/her duties to the Company.
 
Employees
 
See Item 4: Employees
 
Item 7. Major Shareholders and Related Party Transactions.
 
The following table presents information with respect to beneficial ownership of our Ordinary Shares as of December 31, 2008, including:
 
 
each person or entity known to Commtouch to own beneficially more than five percent of Commtouch’s Ordinary Shares, and
 
 
all executive officers and directors as a group.
 
Beneficial ownership is determined in accordance with the rules of the SEC and includes voting or investment power, with respect to shares. To our knowledge, except under applicable community property laws or as otherwise indicated, the persons named in the table have sole voting and sole investment control and rights to receive economic benefits with respect to all shares beneficially owned. The applicable percentage of ownership for each shareholder is based on 25,206,659 Ordinary Shares outstanding as of December 31, 2008. Ordinary Shares issuable upon exercise of options and other rights held and exercisable on or within sixty days of December 31, 2008 are deemed outstanding for the purpose of computing the percentage ownership of the person holding those options and other rights and for all directors and officers as a group, but are not deemed outstanding for computing the percentage ownership of any other person.  Major shareholders in the Company have the same voting rights as all other shareholders.
 
MAJOR SHAREHOLDERS OF ORDINARY SHARES
 
Amount
   
Percent of
 
   
Owned
   
Class
 
Aviv Raiz*
    5,535,869 **     21.6 %
                 
All directors and executive officers as a group at 12.31.08 (8 persons)
    9,127,567 ***     33.5 %
 
 *This shareholder of record resides in Israel.
**Includes 50,000 options and 333,333 warrants, exercisable into a like number of Ordinary Shares.
***Includes 1,670,793 options exercisable into a like number of Ordinary Shares.  Also, this number includes 134,265 shares held by LENE L.P., in which Mr. Lloyd Shefsky holds a relatively small limited partner interest, without any control over partnership management, and b) 1,099,158 Ordinary Shares purchased by Catalyst Private Equity Partners II, for which Mr. Yair Shamir acts as Chairman and Managing Partner.

Based on a review of the information provided to us by our transfer agent, as of December 31, 2008, there were 86 holders of record of our Ordinary Shares, including 54 holders of record residing in the United States holding 21,539,386 Ordinary Shares, or approximately 86% of the aggregate 25,206,659 Ordinary Shares outstanding as of such date.  These numbers are not representative of the number of beneficial holders of our shares nor is it representative of where such beneficial holders reside since many of these ordinary shares were held of record by brokers or other nominees (including one U.S. nominee company, CEDE & Co., which held approximately 80% of our outstanding Ordinary Shares as of such date).

 
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Significant Changes in Percentage Ownership During the Past Three Years
 
 
·
Aviv Raiz participated in the private placements of October 31, 2004 (the preferred share issuance) and October 2, 2005, acquiring 500,000 convertible Series A Preferred Shares, 4 million Ordinary Shares and 2 million warrants exercisable into a like number of Ordinary Shares.  Subsequent to the preferred share round of October 2004, Mr. Raiz has also purchased in private transactions 1.1 million convertible Series A Preferred Shares from certain investors who participated in that round.  The shareholdings referenced in this paragraph are in their original, pre-reverse split format. Together with his holdings from purchases on the open market, which continued during 2008, and director options vesting within 60 days of December 31, 2008, Mr. Raiz beneficially holds 21.6% in the Company.  Mr. Raiz is a director of the Company.
 
Interest of Management and their Family Members in Certain Transactions
 
There were no material related party transactions during 2008 or through the date of filing of this Form 20-F.
 
Item 8. Financial Information.
 
See Item 18: Financial Statements.  If the Company decides to distribute a cash dividend out of income that has been tax exempt due to an “approved enterprise” status under the Law for the Encouragement of Capital Investments, 5719-1959, the amount of cash dividend will be subject to corporate tax at the rate then in effect under Israeli law. The Company has never declared or paid cash dividends on its Ordinary Shares and does not currently anticipate paying any cash dividends during 2009. The Company intends to retain future earnings to finance the development of its business and for other corporate purposes.
 
We are not a party to any litigation, and we are not aware of any threatened litigation which, in the aggregate, would be material to the business of the Company.

Except as otherwise disclosed in this Annual Report, there has been no material change in our financial position since December 31, 2008.
 
Item 9. The Offer and Listing.
 
The Company’s Ordinary Shares have been traded publicly on NASDAQ as follows:
 
 
a.
From July 13, 1999 through June 29, 2004, under the symbol “CTCH” (up to June 7, 2002 on the National Market, and subsequently on the Small Cap Market, which during 2005 was renamed the “Capital Market”);
 
 
b.
From June 30, 2004 through June 26, 2005, under the symbol “CTCHC”;
 
 
c.
From June 27, 2005 through January 1, 2008, under the symbol “CTCH”;
 
 
d.
From January 2, 2008 through January 29, 2008, under the symbol “CTCHD”; and
 
 
e.
From January 30, 2008, under the symbol CTCH.
 
The following table lists the high and low closing sales prices for the Company’s Ordinary Shares, for the periods indicated:

 
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High
   
Low
 
             
2004:
  $ 3.72     $ 0.81  
                 
2005:
  $ 3.90     $ 1.35  
                 
2006:
  $ 4.08     $ 2.10  
                 
2007:
  $ 7.44     $ 3.69  
                 
2008:
  $ 6.22     $ 1.50  
                 
2007:
               
First Quarter
  $ 4.80     $ 3.69  
Second Quarter
  $ 6.15     $ 4.41  
Third Quarter
  $ 7.44     $ 4.89  
Fourth Quarter
  $ 7.41     $ 5.73  
                 
2008:
               
First Quarter
  $ 6.22     $ 3.68  
Second Quarter
  $ 4.40     $ 2.77  
Third Quarter
  $ 3.45     $ 2.15  
Fourth Quarter
  $ 2.50     $ 1.50  
                 
Most Recent Six Months:
               
                 
September 2008
  $ 3.00     $ 2.15  
October 2008
  $ 2.50     $ 1.55  
November 2008
  $ 1.98     $ 1.65  
December 2008
  $ 1.75     $ 1.50  
January 2009
  $ 2.12     $ 1.77  
February 2009
  $ 2.06     $ 1.79  
 
Item 10. Additional Information.
 
We are registered under the Israel Companies Law as a public company with registration number 52-004418-1.  The objective stated in our memorandum of association is to engage in any lawful activity.
 
DESCRIPTION OF SHARES
 
Set forth below is a summary of the material provisions governing our share capital. This summary is not complete and should be read together with our Memorandum of Association and Amended and Restated Articles of Association, copies of which are filed with this report or have been filed as exhibits to certain of our prior filings with the SEC.
 
As of December 31, 2008 , our authorized share capital consisted of 55,353,340 Ordinary Shares, NIS 0.15 par value. As of December 31, 2008, there were 25,206,659 Ordinary Shares issued and outstanding.

 
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DESCRIPTION OF ORDINARY SHARES
 
All issued and outstanding Ordinary Shares of Commtouch are duly authorized and validly issued, fully paid and nonassessable.
 
The Ordinary Shares do not have preemptive rights. Our Memorandum of Association, Amended and Restated Articles of Association and the laws of the State of Israel do not restrict in any way the ownership or voting of Ordinary Shares by non–residents of Israel, except with respect to subjects of countries which are in a state of war with Israel.
 
DIVIDEND AND LIQUIDATION RIGHTS
 
The Ordinary Shares are entitled to their full proportion of any cash or share dividend declared.
 
Subject to the rights of the holders of shares with preferential or other special rights that may be authorized, the holders of Ordinary Shares are entitled to receive dividends in proportion to the sums paid up or credited as paid up on account of the nominal value of their respective holdings of the shares in respect of which the dividend is being paid (without taking into account the premium paid up on the shares) out of assets legally available therefor and, in the event of our winding up, to share ratably in all assets remaining after payment of liabilities in proportion to the nominal value of their respective holdings of the shares in respect of which such distribution is being made, subject to applicable law. Declaration of a dividend requires Board of Directors approval.
 
Under current Israeli regulations, any dividends or other distributions paid in respect of Ordinary Shares purchased by non–residents of Israel with certain non–Israeli currencies (including U.S. dollars) will be freely repatriable in such non–Israeli currencies at the rate of exchange prevailing at the time of conversion, provided that Israeli income tax has been paid on, or withheld from, such payments.
 
MODIFICATION OF CLASS RIGHTS
 
If at any time the share capital is divided into different classes of shares, then, unless the conditions of allotment of such class provide otherwise, the rights, additional rights, advantages, restrictions and conditions attached or not attached to any class, at any given time, may be modified, enhanced, added or abrogated by resolution at a meeting of the holders of the shares of such class.
 
SPECIAL PROVISIONS IN AMENDED AND RESTATED ARTICLES OF ASSOCIATION RELATING TO DIRECTORS
 
The discussion regarding approval of director compensation and transactions with the Company under “Item 6. Directors, Senior Management and Employees - Approval of Certain Transactions; Obligations of Directors, Officers and Shareholders” is incorporated herein by reference.
 
VOTING, SHAREHOLDER MEETINGS AND RESOLUTIONS
 
Holders of Ordinary Shares have one vote for each share held on all matters submitted to a vote of shareholders.
 
An annual general meeting must be held once every calendar year at such time (not more than 15 months after the last preceding annual general meeting) and at such place, either within or outside the State of Israel, as may be determined by the Board of Directors. The quorum required for a general meeting of shareholders consists of at least two shareholders present in person or by proxy and holding at least one–third of the voting rights of the issued share capital. A meeting adjourned for lack of a quorum may be adjourned to the same day in the next week at the same time and place, or to such time and place as the Board of Directors may determine in a notice to shareholders. At such reconvened meeting any two shareholders entitled to vote and present in person or by proxy will constitute a quorum. Generally, shareholder resolutions will be deemed adopted if approved by the holders of a majority of the voting power represented at the meeting, in person or by proxy, and voting thereon.  For certain matters as described under the Israel Companies law, there is a requirement that the majority include the affirmative vote of at least one-third of the votes cast by shareholders who are not controlling shareholders of the Company or interested parties in the matter to be voted upon (or their representatives) or, alternatively, the total shareholdings of the votes cast against the proposal (other than by the Company’s controlling shareholders or interested parties in the matter to be voted upon) must not represent more than one percent of the voting rights in the Company.

 
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ANTI–TAKEOVER PROVISIONS UNDER ISRAELI LAW
 
Under the Companies Law, a merger is generally required to be approved by the shareholders and board of directors of each of the merging companies. If the share capital of the company that will not be the surviving company is divided into different classes of shares, the approval of each class is also required. In addition, a merger can be completed only after 30 days have passed from the shareholders’ approval of each of the merging companies, all approvals have been submitted to the Israeli Registrar of Companies and at least fifty days have passed from the time that a proposal for approval of the merger was filed with the Registrar.
 
The Companies Law provides that an acquisition of shares in a public company must be made by means of a tender offer if as a result of the acquisition the purchaser would become a 25% shareholder of the company, unless there is already another 25% shareholder of the company. Similarly, the Companies Law provides that an acquisition of shares in a public company must be made by means of tender offer if as a result of the acquisition the purchaser would become a 45% shareholder of the company, unless someone else already holds 45% of the voting power of the company. These rules do not apply if the acquisition is made by way of a merger. Regulations promulgated under the Companies Law provide that these tender offer requirements do not apply to companies whose shares are listed for trading outside of Israel if, according to the law in the country in which the shares are traded, including the rules and regulations of the stock exchange on which the shares are traded, either:
 
 
there is a limitation on acquisition of any level of control of the company; or
 
 
the acquisition of any level of control requires the purchaser to do so by means of a tender offer to the public.
 
Finally, Israeli tax law treats specified acquisitions, including a stock–for–stock swap between an Israeli company and a foreign company, less favorably than does U.S. tax law. For example, Israeli tax law may subject a shareholder who exchanges his Ordinary Shares for shares in a foreign corporation to taxation before it would become taxable in the United States, even though the investment has not become liquid.
 
TRANSFER OF SHARES AND NOTICES
 
Fully paid Ordinary Shares that are issued and not subject to any legal restrictions on transference may be transferred freely. Each shareholder of record is entitled to receive at least twenty-one days' prior notice (and for certain matters, thirty-five days’ prior notice) before the date of a shareholder meeting and at least five days notice before the record date for the meeting. For purposes of determining the shareholders entitled to notice and to vote at such meeting, the Board of Directors may fix a record date not exceeding 40 days prior to the date of any shareholder meeting.
 
CHANGES IN OUR CAPITAL
 
Changes in our capital are subject to the approval of the shareholders by a majority of the votes of shareholders present by person or by proxy and voting at the shareholders meeting.
 
ACCESS TO INFORMATION
 
We file reports with the Israeli Registrar of Companies regarding our registered address, our registered capital, our shareholders of record and the number of shares held by each, the identity of the directors and details regarding security interests on our assets. In addition, Commtouch must file with the Israeli Registrar of Companies its Amended and Restated Articles of Association and any further amendments thereto. The information filed with the Registrar of Companies is available to the public. In addition to the information available to the public, our shareholders are entitled, upon request, to review and receive copies of all minutes of meetings of our shareholders.

 
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We are subject to certain of the information reporting requirements of the Exchange Act.  As a “foreign private issuer,” we are exempt from the rules and regulations under the Exchange Act prescribing the furnishing and content of proxy statements, and our officers, directors and principal shareholders are exempt from the reporting and “short-swing” profit recovery provisions contained in Section 16 of the Exchange Act, with respect to their purchase and sale of the ordinary shares.  In addition, we are not required to file reports and financial statements with the SEC as frequently or as promptly as U.S. companies whose securities are registered under the Exchange Act.  However, we file with the SEC an Annual Report on Form 20-F containing financial statements audited by an independent accounting firm.  We also furnish quarterly reports on Form 6-K containing unaudited financial information after the end of each calendar quarter.  We post our Annual Report on Form 20-F on our Website (www.commtouch.com) promptly following the filing of our Annual Report with the Securities and Exchange Commission. The information on our website is not incorporated by reference into this Annual Report.

This report and other information filed or to be filed by us can be inspected and copied at the public reference facilities maintained by the SEC at:

100 F Street, NE
Public Reference Room
Washington, D.C. 20549

The SEC maintains a Web site at www.sec.gov that contains reports, proxy and information statements, and other information regarding registrants that make electronic filings with the SEC using its EDGAR system.
 
TRANSFER AGENT AND REGISTRAR
 
The transfer agent and registrar for our Ordinary Shares is Wells Fargo Bank, N.A. Shareowner Services of St. Paul, Minnesota.
 
MATERIAL CONTRACTS DURING PAST TWO YEARS
 
Equity Investment. Commtouch made a $750 thousand investment in Mirapoint, a secure messaging vendor and an OEM licensee, as part of Mirapoint's larger financing round in the fourth quarter of 2007.  In connection therewith, Commtouch received a minority ownership interest in Mirapoint of approximately 7%.
 
Amended and Restated Articles of Association
 
See the discussion under Item 4 “Information on the Company- Overview” for instructions on how to locate the Company’s Amended and Restated Articles of Association. In addition, the Articles are incorporated by reference to this Form 20-F under Exhibit 1.2 below.
 
EXCHANGE CONTROLS
 
Non-residents of Israel who own our ordinary shares may freely convert all amounts received in Israeli currency in respect of such ordinary shares, whether as a dividend, liquidation distribution or as proceeds from the sale of the ordinary shares, into freely-repatriable non-Israeli currencies at the rate of exchange prevailing at the time of conversion (provided in each case that the applicable Israeli income tax, if any, is paid or withheld).

Until May 1998, Israel imposed extensive restrictions on transactions in foreign currency.  These restrictions were largely lifted in May 1998.  Since January 1, 2003, all exchange control restrictions have been eliminated although there are still reporting requirements for foreign currency transactions.  Legislation remains in effect, however, pursuant to which currency controls can be imposed by administrative action at any time.

 
40

 

The State of Israel does not restrict in any way the ownership or voting of our ordinary shares by non-residents of Israel, except with respect to subjects of countries that are in a state of war with Israel.
 
ISRAELI TAXATION AND INVESTMENT PROGRAMS
 
The following is a summary of the principal tax laws applicable to companies in Israel, including special reference to their effect on us, and Israeli government programs benefiting us. This section also contains a discussion of the material Israeli tax consequences to you if you acquire Ordinary Shares of our company. This summary does not discuss all the acts of Israeli tax law that may be relevant to you in light of your personal investment circumstances or if you are subject to special treatment under Israeli law. To the extent that the discussion is based on new tax legislation which has not been subject to judicial or administrative interpretation, we cannot assure you that the views expressed in this discussion will be accepted by the tax authorities. The discussion should not be understood as legal or professional tax advice and is not exhaustive of all possible tax considerations.
 
General Corporate Tax Structure

Generally, Israeli companies are subject to “Corporate Tax” on their taxable income. On July 25, 2005, the Knesset (Israeli Parliament) approved the Law of the Amendment of the Income Tax Ordinance (No. 147), 2005, which prescribes, among others, a gradual decrease in the corporate tax rate in Israel to the following tax rates: in 2006 - 31%, in 2007 - 29%, in 2008 - 27%, in 2009 - 26% and in 2010 and thereafter - 25%.
 
Tax Benefits under the Law for the Encouragement of Industry (Taxes), 1969

The Law for the Encouragement of Industry (Taxes), 1969, generally referred to as the Industry Encouragement Law, provides several tax benefits for industrial companies. An industrial company is defined as a company resident in Israel, at least 90% of the income of which in a given tax year exclusive of income from specified government loans, capital gains, interest and dividends, is derived from an industrial enterprise owned by it. An industrial enterprise is defined as an enterprise whose major activity in a given tax year is industrial production activity.

Under the Industry Encouragement Law, industrial companies are entitled to a number of corporate tax benefits, including:
 
 
·
deduction of purchase of know-how and patents and/or right to use a patent over an eight-year period ;
 
·
the right to elect, under specified conditions, to file a consolidated tax return with additional related Israeli industrial companies and an industrial holding company;
 
·
accelerated depreciation rates on equipment and buildings.
 
·
Expenses related to a public offering on TA stock exchange and as of 1.1.2003 on recognized stock markets outside of Israel, are deductible in equal amounts over three years.

Under some tax laws and regulations, an industrial enterprise may be eligible for special depreciation rates for machinery, equipment and buildings. These rates differ based on various factors, including the date the operations begin and the number of work shifts. An industrial company owning an approved enterprise may choose between these special depreciation rates and the depreciation rates available to the approved enterprise.

Eligibility for benefits under the Industry Encouragement Law is not subject to receipt of prior approval from any governmental authority.

We believe that we currently qualify as an industrial company within the definition of the Industry Encouragement Law. We cannot assure you that the Israeli tax authorities will agree that we qualify, or, if we qualify, that we will continue to qualify as an industrial company or that the benefits described above will be available to us in the future.

 
41

 
 
Special Provisions Relating to Measurement of Taxable Income

Our company is taxed until tax year 2007 (including) under the Income Tax Law (Inflationary Adjustments), 1985, generally referred to as the Inflationary Adjustments Law. The Inflationary Adjustments Law is highly complex and represents an attempt to overcome the problems presented to a traditional tax system by an economy undergoing rapid inflation. Its features, which are material to us, are summarized as follows:
 
 
·
Where a company’s equity, as calculated under the Inflationary Adjustments Law, exceeds the depreciated cost of its fixed assets (as defined in the Inflationary Adjustments Law), a deduction from taxable income is permitted equal to the excess multiplied by the applicable annual rate of inflation. The maximum deduction permitted in any single tax year is 70% of taxable income, with the unused portion permitted to be carried forward, linked to the Israeli consumer price index. The unused portion that was carried forward may be deductible in full in the following year.
 
 
·
Where a company’s depreciated cost of fixed assets exceeds its equity, then the excess multiplied by the applicable annual rate of inflation is added to taxable income. (hereinafter: “inflation supplement”). Note, the inflation supplement will only be added to the corporate income but not to other incomes such as capital gains.
 
 
·
Subject to specified limitations, depreciation deductions on fixed assets and losses carried forward are adjusted for inflation based on the change in the consumer price index.

In February 2008, the Inflationary Adjustments Law was repealed.
 
Capital Gains Tax on Sales of Our Ordinary Shares
 
Israeli law generally imposes a capital gains tax on the sale of any capital assets by residents of Israel, as defined for Israeli tax purposes, and on the sale of assets located in Israel, including shares in Israeli companies, by both residents and non-residents of Israel, unless a specific exemption is available or unless a tax treaty between Israel and the shareholder’s country of residence provides otherwise. The law distinguishes between real gain and inflationary surplus. The inflationary surplus is a portion of the total capital gain which is equivalent to the increase of the relevant asset’s purchase price which is attributable to the increase in the Israeli consumer price index or, in certain circumstances, a foreign currency exchange rate, between the date of purchase and the date of sale. The real gain is the excess of the total capital gain over the inflationary surplus.
 
As of January 1, 2006, the tax rate applicable to capital gains derived from the sale of shares, whether listed on a stock market or not, is 20% for Israeli individuals, unless such shareholder claims a deduction for financing expenses in connection with such shares, in which case the gain will generally be taxed at a rate of 25%. Additionally, if such shareholder is considered a “material shareholder” at any time during the 12-month period preceding such sale, i.e., such shareholder holds directly or indirectly, including with others, at least 10% of any means of control in the company, the tax rate shall be 25%. Israeli companies are subject to the Corporate Tax rate on capital gains derived from the sale of shares, unless such companies were not subject to the Adjustments Law (or certain regulations) at the time of publication of the aforementioned amendment to the Tax Ordinance that came into effect on January 1, 2006, in which case the applicable tax rate is 25%. However, the foregoing tax rates do not apply to: (i) dealers in securities; and (ii) shareholders who acquired their shares prior to an initial public offering (that may be subject to a different tax arrangement).

 
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Non-Israeli residents are exempt from Israeli capital gains tax on any gains derived from the sale of shares of Israeli companies publicly traded on a recognized stock exchange or regulated market outside of Israel, provided however that such capital gains are not derived from a permanent establishment in Israel, such shareholders are not subject to the Adjustments Law, and such shareholders did not acquire their shares prior to an initial public offering. However, non-Israeli corporations will not be entitled to such exemption if an Israeli resident (i) has a controlling interest of 25% or more in such non-Israeli corporation, or (ii) is the beneficiary or is entitled to 25% or more of the revenues or profits of such non-Israeli corporation, whether directly or indirectly.
 
In some instances where our shareholders may be liable to Israeli tax on the sale of their ordinary shares, the payment of the consideration may be subject to the withholding of Israeli tax at the source.
 
Pursuant to the Convention Between the government of the United States of America and the government of Israel with Respect to Taxes on Income, as amended (the “U.S.-Israel Tax Treaty”), the sale, exchange or disposition of ordinary shares by a person who (i) holds the ordinary shares as a capital asset, (ii) qualifies as a resident of the United States within the meaning of the U.S.-Israel Tax Treaty and (iii) is entitled to claim the benefits afforded to such person by the U.S.-Israel Tax Treaty, generally, will not be subject to the Israeli capital gains tax. Such exemption will not apply if (i) such Treaty U.S. Resident holds, directly or indirectly, shares representing 10% or more of our voting power during any part of the 12-month period preceding such sale, exchange or disposition, subject to certain conditions, or (ii) the capital gains from such sale, exchange or disposition can be allocated to a permanent establishment in Israel. In such case, the sale, exchange or disposition of ordinary shares would be subject to Israeli tax, to the extent applicable; however, under the U.S.-Israel Tax Treaty, such Treaty U.S. Resident would be permitted to claim a credit for such taxes against the U.S. federal income tax imposed with respect to such sale, exchange or disposition, subject to the limitations in U.S. laws applicable to foreign tax credits. The U.S.-Israel Tax Treaty does not relate to U.S. state or local taxes.
 
Taxation of Non-Resident Holders of Shares
 
Non-residents of Israel are subject to income tax on income accrued or derived from sources in Israel. Such sources of income include passive income such as dividends, royalties and interest, as well as non-passive income from services rendered in Israel. On distributions of dividends other than bonus shares, or stock dividends, income tax is withheld at the source at the following rates: for dividends distributed on or after January 1, 2006 - 20%, or 25% for a shareholder that is considered a “material shareholder” at any time during the 12-month period preceding such distribution, unless a different rate is provided in a treaty between Israel and the shareholder’s country of residence. Under the U.S.-Israel Tax Treaty, the maximum tax on dividends paid to a holder of ordinary shares who is a Treaty U.S. Resident is 25%. Furthermore, dividends not generated by an Approved Enterprise (or Benefited Enterprise) paid to a U.S. corporation holding at least 10% of our issued voting power during the part of the tax year which precedes the date of payment of the dividend and during the whole of its prior tax year, are generally taxed at a rate of 12.5%.

For information with respect to the applicability of Israeli capital gains taxes on the sale of ordinary shares by United States residents, see above “— Capital Gains Tax on Sales of Our Ordinary Shares.”
 
U.S. TAX CONSIDERATIONS REGARDING ORDINARY SHARES ACQUIRED BY U.S. TAXPAYERS
 
EACH INVESTOR SHOULD CONSULT WITH HIS OR HER OWN TAX ADVISOR AS TO THE PARTICULAR U.S. FEDERAL INCOME TAX CONSEQUENCES OF THE PURCHASE, OWNERSHIP AND SALE OF ORDINARY SHARES, INCLUDING THE EFFECTS OF APPLICABLE STATE, LOCAL, FOREIGN OR OTHER TAX LAWS AND POSSIBLE CHANGES IN THE TAX LAWS
 
Subject to the limitations described in the next paragraph, the following discussion summarizes the material U.S. federal income tax consequences to a “U.S. Holder” arising from the purchase, ownership and sale of the Ordinary Shares.  For this purpose, a “U.S. Holder” is a holder of Ordinary Shares that is:  (1) an individual citizen or resident of the United States, including an alien individual who is a lawful permanent resident of the United States or meets the substantial presence residency test under U.S. federal income tax laws; (2) a corporation (or entity treated as a corporation for U.S. federal tax purposes) or a partnership (other than a partnership that is not treated as a U.S. person under any applicable U.S. Treasury Regulations) created or organized under the laws of the United States or the District of Columbia or any political subdivision thereof; (3) an estate, the income of which is includable in gross income for U.S. federal income tax purposes regardless of source; (4) a trust if a court within the United States is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have authority to control all substantial decisions of the trust; (5) a trust that has a valid election in effect to be treated as a U.S. person to the extent provided in U.S. Treasury regulations, or (6) any person otherwise subject to U.S. federal income tax on a net income basis in respect of the Ordinary Shares, if such status as a U.S. Holder is not overridden pursuant to the provisions of an applicable tax treaty.

 
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This summary is for general information purposes only and does not purport to be a comprehensive description of all of the U.S. federal income tax considerations that may be relevant to a decision to purchase our Ordinary Shares.  This summary generally considers only U.S. Holders that will own our ordinary shares as capital assets.  Except to the limited extent discussed below, this summary does not consider the U.S. federal tax consequences to a person that is not a U.S. Holder, not does it describe the rules applicable to determine a taxpayer’s status as a U.S. Holder.  This summary is based on the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), final, temporary and proposed U.S. Treasury Regulations promulgated thereunder, administrative and judicial interpretations thereof, and the U.S./Israel Income Tax Treaty, all as in effect as of the date hereof and all of which are subject to change, possibly on a retroactive basis, and all of which are open to differing interpretations.  Commtouch will not seek a ruling from the U.S. Internal Revenue Service (“IRS”) with regard to the U.S. federal income tax treatment of an investment in our Ordinary Shares by U.S. Holders and, therefore, can provide no assurances that the IRS will agree with the conclusions set forth below.
 
This discussion does not address all of the aspects of U.S. federal income taxation that may be relevant to a particular shareholder based on such shareholder’s particular circumstances and in particular does not discuss any estate, gift, generation-skipping, transfer, state, local or foreign tax considerations.  In particular, this discussion does not address the U.S. federal income tax treatment of a U.S. Holder who is:  (1) a bank, life insurance company, regulated investment company, or other financial institution or “financial services entity”; (2) a broker or dealer in securities or foreign currency; (3) a person who acquired our Ordinary Shares in connection with employment or other performance of services; (4) a U.S. Holder that is subject to the U.S. alternative minimum tax; (5) a U.S. Holder that holds our Ordinary Shares as a hedge or as part of a hedging, straddle, conversion or constructive sale transaction or other risk-reduction transaction for U.S. federal income tax purposes; (6) a tax-exempt entity; (7) real estate investment trusts; (8) a U.S. Holder that expatriates out of the United States or a former long-term resident of the United States; or (9) a person having a functional currency other then the U.S. dollar.  This discussion does not address the U.S. federal income tax treatment of a U.S. Holder that owns, directly or constructively, at any time, Ordinary Shares representing 10% or more of our voting power.  Additionally, the U.S. federal income tax treatment of persons who hold Ordinary Shares through a partnership or other pass-through entity are not considered.  Each prospective investor is advised to consult his or her own U.S. tax advisor with respect to the specific U.S. federal and state income tax consequences to such person of purchasing, holding or disposing of Ordinary Shares.
 
Taxation of Dividends Paid On Ordinary Shares
 
Subject to the discussion under the heading “Passive Foreign Investment Companies” below, a U.S. Holder will be required to include in gross income as ordinary income the amount of any distribution paid on Ordinary Shares (including the amount of any Israeli tax withheld on the date of the distribution), to the extent that such distribution does not exceed our current and accumulated earnings and profits, as determined for U.S. federal income tax purposes.  The amount of a distribution which exceeds our earnings and profits will be treated first as a non-taxable return of capital, reducing the U.S. Holder’s tax basis for the Ordinary Shares to the extent thereof, and then capital gain.  Corporate holders generally will not be allowed a deduction for dividends received.  In general, preferential tax rates not exceeding 15% for “qualified dividend income” and long-term capital gains are applicable for U.S. Holders that are individuals, estates or trusts (these preferential rates are scheduled to expire for taxable years beginning after December 31, 2010, after which time dividends are scheduled to be taxed at ordinary income rates and long-term capital gains are scheduled to be taxed at rates not exceeding 20%).  For this purpose, “qualified dividend income” means, inter alia, dividends received from a “qualified foreign corporation.”  A “qualified foreign corporation” is a corporation that is entitled to the benefits of a comprehensive tax treaty with the United States which includes an exchange of information program.  The IRS has stated that the Israel/U.S. Tax Treaty satisfies this requirement and we believe we are eligible for the benefits of that treaty.

 
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In addition, our dividends will be qualified dividend income if our shares are readily tradable on Nasdaq or another established securities market in the United States.  Dividends will not qualify for the preferential rate if we are treated, in the year the dividend is paid or in the prior year, as a passive foreign investment company (“PFIC”).  If our beliefs concerning our PFIC status are correct, dividend distributions with respect to our shares should be treated as qualified dividend income, subject to the U.S. Holder satisfying the holding period and other requirements.  A U.S. Holder will not be entitled to the preferential rate:  (i) if the U.S. Holder has not held our Ordinary Shares or ADRs for at leash 61 days of the 121 day period beginning on the date which is 60 days before the ex-dividend date, or (ii) to the extent the U.S. Holder is under an obligation to make related payments on substantially similar property.  Any days during which the U.S. Holder has diminished its risk of loss on our Ordinary Shares are not counted towards meeting the 61-day holding period.  Finally, U.S. Holders who elect to treat the dividend income as “investment income” pursuant to Code section 163(d)(4) will not be eligible for the preferential rate of taxation.
 
The amount of a distribution with respect to our Ordinary Shares will be measured by the amount of the fair market value of any property distributed, and for U.S. federal income tax purposes, the amount of any Israeli taxes withheld therefrom.  (See discussion above under “Taxation of Non-Resident Holders of Shares.”)  Cash distributions paid by us in NIS will be included in the income of U.S. Holders at a U.S. dollar amount based upon the spot rate of exchange in effect on the date the dividend is includible in the income of the U.S. Holder, and U.S. Holders will have a tax basis in such NIS for U.S. federal income tax purposes equal to such U.S. dollar value.  If the U.S. Holder subsequently converts the NIS, any subsequent gain or loss in respect of such NIS arising from exchange rate fluctuations will be U.S. source ordinary exchange gain or loss.
 
Distributions paid by us will generally be foreign source income for U.S. foreign tax credit purposes.  Subject to the limitations set forth in the Code, U.S. Holders may elect to claim a foreign tax credit against their U.S. income tax liability for Israeli income tax withheld from distributions received in respect of the Ordinary Shares.  In general, these rules limit the amount allowable as a foreign tax credit in any year to the amount of regular U.S. tax for the year attributable to foreign source taxable income.  This limitation on the use of foreign tax credits generally will not apply to an electing individual U.S. Holder whose creditable foreign taxes during the year do not exceed $300, or $600 for joint filers, if such individual’s gross income for the taxable year from non-U.S. sources consists solely of certain passive income.  A U.S. Holder will be denied a foreign tax credit with respect to Israeli income tax withheld from dividends received with respect to the Ordinary Shares if such U.S. Holder has not held the ordinary shares for at leash 16 days out of the 31-day period beginning on the date that is 15 days before the ex-dividend date or to the extent that such U.S. Holder is under an obligation to make certain related payments with respect to substantially similar or related property.  Any day during which a U.S. Holder has substantially diminished his or her risk of loss with respect to the Ordinary Shares will not count toward meeting the 16-day holding period.  A U.S. Holder will also be denied a foreign tax credit if the U.S. Holder holds the Ordinary Shares in an arrangement in which the U.S. Holder’s reasonably expected economic profit is insubstantial compared to the foreign taxes expected to be paid or accrued.  The rules relating to the determination of the U.S. foreign tax credit are complex, and U.S. Holders should consult with their own tax advisors to determine whether, and to what extent, the are entitled to such credit.  U.S. Holders that do not elect to claim a foreign tax credit may instead claim a deduction for Israeli income taxes withheld, provided such U.S. Holders itemize their deductions.
 
Sale or Exchange of Ordinary Shares
 
Except as provided under the PFIC rules described below, upon the sale, exchange or other disposition of our Ordinary Shares, a U.S. Holder will recognize capital gain or loss in an amount equal to the difference between such U.S. Holder’s tax basis for the Ordinary Shares and the amount realized on the disposition (or its U.S. dollar equivalent determined by reference to the spot rate of exchange on the date of disposition, if the amount realized is denominated in a foreign currency).  The gain or loss realized on the sale or exchange or other disposition of Ordinary Shares will be long-term capital gain or loss if the U.S. Holder has a holding period of more than one year at the time of the disposition.

 
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In general, gain realized by a U.S. Holder on a sale, exchange or other disposition of Ordinary Shares will generally be treated as U.S. source income for U.S. foreign tax credit purposes.  A loss realized by a U.S. Holder on the sale, exchange or other disposition of Ordinary Shares is generally allocated to U.S. source income.  However, U.S. Treasury Regulations require such loss to be allocated to foreign source income to the extent certain dividends were received by the taxpayer within the 24-month period preceding the date on which the taxpayer recognized the loss.  The deductibility of a loss realized on the sale, exchange or other disposition of ordinary shares is subject to limitations.
 
Tax Consequences If We Are a Passive Foreign Investment Company
 
We would be a passive foreign investment company, or PFIC, if either:
 
 
·
75% or more of our gross income (including our pro rata share of gross income for any company, U.S. or foreign, in which we are considered to own 25% or more of the shares by value), in a taxable year is passive (the “Income Test”); or
 
 
·
At least 50% of our assets, averaged over the year and generally determined based upon value (including our pro rata share of the assets of any company in which we are considered to own 25% or more of the shares by value), in a taxable year are held for the product of, or produce, passive income (the “Asset Test”).
 
Passive income generally consists of dividends, interest, rents, royalties, annuities and income from certain commodities transactions and from notional principal contracts.  Cash is treated as generating passive income.
 
If we are or become a PFIC, each U.S. Holder who has not elected to treat us as a qualified electing fund by making a “QEF election”, or who has not elected to mark the shares to market (as discussed below), would, upon receipt of certain distributions by us and upon disposition of our Ordinary Shares at a gain, be liable to pay U.S. federal income tax at the then prevailing highest tax rates on ordinary income plus interest on such tax, as if the distribution or gain had been recognized ratably over the taxpayer’s holding period for the Ordinary Shares.  In addition, when shares of a PFIC are acquired by reason of death from a decedent that was a U.S. Holder, the tax basis of such shares would not receive a step-up to fair market value as of the date of the decedent’s death, but instead would be equal to the decedent’s basis if lower, unless all gain were recognized by the decedent.  Indirect investments in a PFIC may also be subject to special U.S. federal income tax rules.
 
The PFIC rules would not apply to a U.S. Holder who makes a QEF election for all taxable years that such U.S. Holder has held the Ordinary Shares while were are a PFIC, provided that we comply with certain reporting requirements.  Instead, each U.S. Holder who has made such a QEF election is required for each taxable year that we are a PFIC to include in income such U.S. Holder’s pro rata share of our ordinary earnings as ordinary income and such U.S. Holder’s pro rata share of our net capital gains as long-term capital gain, regardless of whether we make any distributions of such earnings or gain.  In general, a QEF election is effective only if we make available certain required information.  The QEF election is made on a shareholder-by-shareholder basis and generally may be revoked only with the consent of the IRS.  Although we have no obligation to do so, we intend to comply with the applicable information reporting requirements for U.S. Holders to make a QEF election.
 
A U.S. Holder of PFIC shares which are traded on certain public markets, including the NASDAQ, can elect to mark the shares to market annually, recognizing as ordinary income or loss each year an amount equal to the difference as of the close of the taxable year between the fair market value of the PFIC shares and the U.S. Holder’s adjusted basis in the PFIC shares.  Loses are allowed only to the extent of net mark-to-market gain previously included income by the U.S. Holder under the election for prior taxable years.
 
In light of the complexity of PFIC rules, we cannot assure you that we have not been or are not a PFIC or will avoid becoming a PFIC in the future.  U.S. holders who hold Ordinary Shares during a period when we are a PFIC will be subject to the foregoing rules, even if we cease to be a PFIC. U.S. Holders are urged to consult their tax advisors about the PFIC rules, including QEF and mark-to-market elections.  For those U.S. Shareholders who determine that we were a PFIC in any our taxable years  and notify us in writing of their request for the information required in order to effectuate the QEF Election described above, we will promptly make such information available to them.

 
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Information Reporting and Withholding
 
A U.S. Holder may be subject to backup withholding (currently at a rate of 28%, but scheduled to increase to 31% for taxable years beginning after December 31, 2010) with respect to cash dividends and proceed from a disposition of Ordinary Shares.  In general, back-up withholding will apply only if a U.S. Holder fails to comply with certain identification procedures.  Backup withholding will not apply with respect to payments made to certain exempt recipients, such as corporations and tax-exempt organizations.  Backup withholding is not an additional tax and may be claimed as a credit against the U.S. federal income tax liability of a U.S. Holder, provided that the required information is timely furnished to the IRS.
 
Non-U.S. Holders of Ordinary Shares
 
Except as provided below, an individual, corporation, estate or trust that is not a U.S. Holder generally will not be subject to U.S. federal income or withholding tax on the payment of dividends on, and the proceeds from the disposition of, our Ordinary Shares.
 
A non-U.S. Holder may be subject to U.S. federal income or withholding tax on a dividend paid on our Ordinary Shares or the proceeds from the disposition of our Ordinary Shares if:  (i) if such item is effectively connected with the conduct by the non-U.S. Holder of a trade or business in the United States or, in the case of a non-U.S. Holder that is a resident of a country which has an income tax treaty with the United States, such item is attributable to a permanent establishment or, in the case of gain realized by an individual non-U.S. Holder, a fixed place of business in the U.S.; (ii) in the case of a disposition of our Ordinary Shares, the individual non-U.S. Holder is present in the U.S. for 183 days or more in the taxable year of the sale and certain other conditions are met; (iii) the non-U.S. Holder is subject to U.S. federal income tax pursuant to the provisions of the U.S. tax law applicable to U.S. expatriates.
 
In general, non-U.S. holders will not be subject to the 28% backup withholding with respect to the payment of dividends on our Ordinary Shares if payment is made through a paying agent, or office of a foreign broker outside the United States. However, if payment is made in the United States or by a U.S. related person, non-U.S. Holders may be subject to backup withholding, unless the non-U.S. Holder provides on an applicable Form W-8 (or a substantially similar form) a taxpayer identification number, certifies to its foreign status, or otherwise establishes an exemption. A U.S. related person for these purposes is a person with one or more current relationships with the United States.
 
Non-U.S. holders generally may be subject to backup withholding at a rate of 28% on the payment of the proceeds from the disposition of our Ordinary Shares to or through the U.S. office of a broker, whether domestic or foreign, or the office of a U.S. related person, unless the non-U.S. Holder provides a taxpayer identification number, certifies to its foreign status or otherwise establishes an exemption. Non-U.S. Holders will not be subject to backup withholding with respect to the payment of proceeds from the disposition of ordinary shares by a foreign office of a broker.
 
The amount of any backup withholding from a payment to a non-U.S. Holder will be allowed as a credit against such holder’s U.S. federal income tax liability and may entitle such holder to a refund, provided that the required information is timely furnished to the IRS.
 
Item 11. Qualitative and Quantitative Disclosure about Market Risk.
 
We develop our technology in Israel and seek to provide our services worldwide. As a result, our foreign currency exposures give rise to market risk associated with exchange rate movements of the U.S. dollar, our functional and reporting currency, against the NIS and Euro. We are exposed to the risk of fluctuation in the U.S. dollar/NIS and the U.S. dollar/Euro exchange rate. Our shekel-denominated expenses consist principally of salaries and related personnel expenses, as well as vehicle lease payments. Although the majority of our revenues are in US dollars, a substantial portion of our sales are derived from the Euro currency. Neither a ten percent increase nor decrease in current exchange rates would have a material effect on our consolidated financial statements in the next six months.

Due to the fact that we do not have any material debt, we have concluded that there is currently no material interest market risk exposure.

 
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Therefore, no quantitative tabular disclosures are provided.
 
Item 12. Description of Securities Other than Equity Securities.
 
Not applicable.
 
PART II
 
Item 13. Defaults, Dividend Arrearages and Delinquencies.
 
Not applicable.
 
Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds.
 
In early January 2008, the Company performed a 3:1 reverse stock split of the Company's share capital. As a result of this action, every three ordinary shares, par value NIS 0.05 each (including all authorized, issued and outstanding ordinary shares and all outstanding warrants and options to purchase ordinary shares) were combined into one ordinary share bearing a par value of NIS 0.15 each. Other than this reverse stock split, no material modifications to the rights of security holders occurred since January 1, 2008 to date.
 
Item 15. Controls and Procedures.
 
(a) As of December 31, 2008, we performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and our management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of December 31, 2008, to provide reasonable assurance that the information required to be disclosed in filings and submissions under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified by the SEC’s rules and forms, and that such information related to us and our consolidated subsidiary is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions about required disclosure.
 
(b) and (c) Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as such term is defined in Rule 13a-15(f) under the Security Exchange Act. Our internal control over financial reporting system was designed 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.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and even when determined to be effective can only provide reasonable assurance with respect to financial statements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
Our management assessed our internal control over financial reporting as of December 31, 2008. Our management based its assessment on criteria established in Internal Control- Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission. Based on this assessment, our management has concluded that, as of December 31, 2008, our internal control over financial reporting is effective.
 
(d) Our independent registered public accounting firm, Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young Global, independently assessed the effectiveness of the Company's internal control over financial reporting. Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young Global, has issued an attestation report in respect of our internal control over financial reporting as of December 31, 2008, which is included under Item 18 on page F-3, F-4 of this annual report.

 
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(e) During the period covered by this annual report on Form 20-F, there were no  changes to our internal control over financial reporting that occurred during the year ended December 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
Item 16. Reserved
 
Item 16A. Audit Committee Financial Expert.
 
The Board of Directors of the Company has determined that Mr. Yair Shamir, a member of the Audit Committee, is an audit committee financial expert as that term is defined in Item 16A of Form 20-F and is independent as that term is defined in each of NASDAQ Marketplace Rule 4200(a)(15) and SEC Rule 10A-3(b)(1).
 
Item 16B. Code of Ethics.
 
The Company, by way of Board of Directors resolution, has adopted a Code of Ethics applicable to its senior financial officers, including its principal executive, financial and accounting officers.  The Code of Ethics is posted on the Company’s website at www.commtouch.com, under the link to “investor relations”.
 
Item 16C. Principal Accountant Fees and Services.
 
Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young Global, has served as our Independent Registered Public Accounting Firm for each of the fiscal years in the three-year period ended December 31, 2008, for which audited financial statements appear in this annual report on Form 20-F. The following table presents the aggregate fees for professional and other services rendered by Kost, Forer, Gabbay & Kasierer for 2008 and 2007:

   
Year ended December 31,
 
   
2008
   
2007
 
   
Fees
   
Fees
 
             
Audit fees (1)
  $ 151,000     $ 107,000  
Tax and other (2)
  $ 21,000     $ 72,500  
Total
  $ 172,000     $ 179,500  

(1) Audit fees consist of fees billed for the annual audit services engagement and other audit services, which are those services that only the Independent Registered Public Accounting Firm can reasonably provide, and include the group audit including checking our internal control over Financial reporting; statutory audits; consents; attest services; and assistance in connection with documents filed with the SEC. These fees also include the attestation of our internal control over financial reporting.

 (2) Tax fees include fees billed for tax compliance services, including the preparation of original and amended tax returns and claims for refund; tax consultations, such as assistance and representation in connection with tax audits and appeals, transfer pricing, and requests for rulings or technical advice from taxing authority; and tax planning services.

Audit Committee Pre-approval Policies and Procedures

Below is a summary of our current Policies and Procedures:
 
The main role of the Company’s audit committee is to assist the Board of Directors in fulfilling its responsibility for oversight of the quality and integrity of the accounting, auditing and reporting practices of the Company. The Audit Committee oversees the appointment, compensation, and oversight of the Company’s independent registered public accounting firm engaged to prepare or issue an audit report on the financial statements of the Company. The audit committee’s specific responsibilities in carrying out its oversight role include the approval of all audit and non-audit services to be provided by the external auditor and the quarterly review of the firm’s non-audit services and related fees. These services may include audit services, audit-related services, tax services and other services, as described above. It is the policy of the audit committee to approve in advance the particular services or categories of services to be provided to the Company periodically. Additional services may be pre-approved by the audit committee on an individual basis during the year.  The audit committee did not avail itself of section (c)(7)(i)(C) of Rule 2-01 of Regulation S-X during 2007, which allows for an exemption from the pre-approval process under certain limited circumstances.

 
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Item 16D. Exemptions from the Listing Standards for Audit Committees.

Not applicable.

Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers.

In July 2008, the Company announced the commencement of an Ordinary Share buyback plan, under which the Company contemplates purchasing up to $4 million worth of its Ordinary Shares through the end of 2009.  As of February 2, 2009, the Company had expended $1,570 thousand to repurchase 824,578 Ordinary Shares at an average price of $1.87 per share.  Repurchases during 2008 are summarized in the following table:

ISSUER PURCHASES OF SECURITIES
Period
 
Total Number
of Shares
Purchased
   
Average Price
Paid per Share
   
Total Number
of Shares
Purchased as
Part of Publicly
Announced
plan
 
Maximum US
dollar Value that
May Yet Be
Purchased Under
the plan
September 1 – September 30
    36,032       2.44       36,032    
                           
October 1 – October 31
    303,563       1.98       303,563    
                           
November 1 – November 30
    171,193       1.82       171,193    
                           
December 1 - December 31
    195,290       1.67       195,290    
                           
Total
    706,078       1.91       706,078  
 $2,666 thousand

Item 16F. Change in Registrant’s Certifying Accountant.

Not applicable.

Item 16G. Corporate Governance.

Under NASDAQ Marketplace Rule 4350, or Rule 4350, foreign private issuers, such as our Company, are permitted to follow certain home country corporate governance practices instead of certain provisions of Rule 4350.   We do not comply with the following requirements of Rule 4350, and instead follow Israeli law and practice with respect to such corporate governance practices:

 
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Nasdaq Marketplace Rule 4350(b)(1)(A) requires that an annual report be delivered to shareholders in accordance with three alternative delivery methods set forth in the rule.  One of those delivery methods allows for the posting of the annual report on the Company’s website.  However, that method also requires that i) a prominent undertaking be posted on the website indicating that, upon request, shareholders may receive a hard copy of the annual report free of charge, and ii) simultaneous with this posting, the Company issue a press release stating that its annual report has been filed with the SEC (or other appropriate regulatory authority). This press release must also state that the annual report is available on the Company's website and include the website address and that shareholders may receive a hard copy free of charge upon request.
 
While the Company’s most current annual report on Form 20-F, inclusive of consolidated financial statements, is available on its website at www.commtouch.com, and the Company has indicated publicly that it will provide copies of that report free of charge, upon shareholder request, nevertheless the Company is not in strict compliance with the Nasdaq rule.  The Company does not include a statement on its website in the form noted above and does not issue a press release upon the posting of the annual report to its website; rather, the Company is following its home country practice (in Israel, which, in addition to the Company’s activities noted above, also enables shareholders to inspect the Company’s annual consolidated financial statements in person at its principal offices).
 
Under the Israel Companies Law, an Israeli public company whose shares are traded only on a stock exchange outside of Israel – such as Commtouch – must, unless its Articles of Association provide otherwise, mail a copy of its annual financial statements to each shareholder entitled to receive notice of a general meeting no later than 14 days prior to the date of the general meeting.  At the Company’s annual meeting of shareholders in December 2005, shareholders approved an amendment to the Company’s Articles of Association enabling the Company to deliver its annual report to shareholders in the manner currently employed by the Company, as noted above.
 
As a foreign private issuer listed on the NASDAQ Capital Market, we may also follow home country practice with regard to, among other things, composition of the board of directors, director nomination process and regularly scheduled meetings at which only independent directors are present.  In addition, we may follow our home country practice, instead of the NASDAQ Marketplace Rules, which require that we obtain shareholder approval for certain dilutive events, such as for the establishment or amendment of certain equity based compensation plans, an issuance that will result in a change of control of the company, certain transactions other than a public offering involving issuances of a 20% or more interest in the company and certain acquisitions of the stock or assets of another company. A foreign private issuer that elects to follow a home country practice instead of NASDAQ requirements, must submit to NASDAQ in advance a written statement from an independent counsel in such issuer’s home country certifying that the issuer’s practices are not prohibited by the home country’s laws. In addition, a foreign private issuer must disclose in its annual reports filed with the Securities and Exchange Commission or on its website each such requirement that it does not follow and describe the home country practice followed by the issuer instead of any such requirement. Accordingly, our shareholders may not be afforded the same protection as provided under NASDAQ’s corporate governance rules.

See Item 6 “Directors, Senior Management and Employees” and Item 10 “Additional Information” for a detailed description of the significant ways in which the registrant’s corporate governance practices differ from those followed by U.S. companies under the listing standards of the NASDAQ Capital Market.

 
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PART III
 
Item 17. Financial Statements.
 
The Company has responded to Item 18
 
Item 18. Financial Statements.
 
See pages F-1 to F-26.
 
 
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COMMTOUCH SOFTWARE LTD. AND ITS SUBSIDIARY

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2008

U.S. DOLLARS IN THOUSANDS

INDEX

   
Page
     
Reports of Independent Registered Public Accounting Firm
 
F-2 -F-3
     
Consolidated Balance Sheets
 
F-4 - F-5
     
Consolidated Statements of Operations
 
F-6
     
Statements of Changes in Shareholders' Equity
 
F-7 - F-8
     
Consolidated Statements of Cash Flows
 
F-9 - F-10
     
Notes to Consolidated Financial Statements
 
F-11 - F-26

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F-1

 
 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of

COMMTOUCH SOFTWARE LTD.

We have audited the accompanying consolidated balance sheets of Commtouch Software Ltd. ("the Company") and its subsidiary as of December 31, 2007 and 2008, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2008. 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. 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company and its subsidiary as of December 31, 2007 and 2008, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 30, 2009 expressed an unqualified opinion thereon.

Tel-Aviv, Israel
KOST FORER GABBAY & KASIERER
March 30, 2009
A Member of Ernst & Young Global

 
F-2

 
 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of

COMMTOUCH SOFTWARE LTD.

We have audited Commtouch Software Ltd.'s ("Commtouch" or the "Company") internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the "COSO criteria"). Commtouch's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.

We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed 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. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Commtouch maintained in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Commtouch and its subsidiary as of December 31, 2007 and 2008, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2008 and our report dated March 30, 2009 expressed an unqualified opinion thereon.

Tel-Aviv, Israel
KOST FORER GABBAY & KASIERER
March 30, 2009
A Member of Ernst & Young Global

 
F-3

 

COMMTOUCH SOFTWARE LTD. AND ITS SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands

   
December 31
 
   
2007