Spy (XSPY) 10-Q 2009 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2009

OR

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

For the transition period from                    to                    

Commission File Number: 000-51071

ORANGE 21 INC.

(Exact name of registrant as specified in its charter)

Delaware	33-0580186
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
2070 Las Palmas Drive, Carlsbad, CA 92011	(760) 804-8420
(Address of principal executive offices)	(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required 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.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

Large accelerated filer  ¨ Accelerated filer  ¨ Non-accelerated filer  ¨ Smaller reporting company  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of August 12, 2009, there were 11,864,327 shares of Common Stock, par value $0.0001 per share, issued and outstanding.

ORANGE 21 INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

PART I	FINANCIAL INFORMATION	3
	Item 1. Financial Statements	3
	Consolidated Balance Sheets as of June 30, 2009 (Unaudited) and December 31, 2008	3
	Consolidated Statements of Operations (Unaudited) for the three and six months ended June 30, 2009 and 2008	4
	Consolidated Statements of Cash Flows (Unaudited) for the three and six months ended June 30, 2009 and 2008	5
	Notes to Unaudited Consolidated Financial Statements	6
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
	Item 4T. Controls and Procedures	20
PART II	OTHER INFORMATION	21
	Item 1. Legal Proceedings	21
	Item 1A. Risk Factors	21
	Item 5. Other Information	27
	Item 6. Exhibits	28
Signatures		27

2

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Thousands, except number of shares and per share amounts)

	June 30, 2009			December 31, 2008
	(Unaudited)
Assets
Current assets
Cash	$	1,165		$	471
Accounts receivable, net		5,911			6,991
Inventories, net		9,173			11,698
Prepaid expenses and other current assets		1,304			1,607
Income taxes receivable		197			171
Total current assets		17,750			20,938
Property and equipment, net		4,852			5,417
Intangible assets, net of accumulated amortization of $661 and $601 at June 30, 2009 and December 31, 2008, respectively		345			401
Other long-term assets		74			67
Total assets	$	23,021		$	26,823
Liabilities and Stockholders’ Equity
Current liabilities
Lines of credit	$	4,401		$	5,787
Current portion of capital leases		331			483
Current portion of notes payable		504			484
Accounts payable		4,666			8,635
Accrued expenses and other liabilities		3,617			3,868
Income taxes payable		233			214
Total current liabilities		13,752			19,471
Capitalized leases, less current portion		664			754
Notes payable, less current portion		653			357
Deferred income taxes		407			391
Total liabilities		15,476			20,973
Stockholders’ equity
Preferred stock: par value $0.0001; 5,000,000 authorized; none issued		—			—
Common stock: par value $0.0001; 100,000,000 shares authorized; 11,864,155 and 8,176,850 shares issued and outstanding at June 30, 2009 and December 31, 2008, respectively		1			1
Additional paid-in-capital		40,232			37,432
Accumulated other comprehensive income		855			902
Accumulated deficit		(33,543	)		(32,485	)
Total stockholders’ equity		7,545			5,850
Total liabilities and stockholders’ equity	$	23,021		$	26,823

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

3

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Thousands, except per share amounts)

	Three Months Ended June 30,						Six Months Ended June 30,
	2009			2008			2009			2008
	(Unaudited)						(Unaudited)
Net sales	$	9,116		$	13,984		$	16,537		$	25,538
Cost of sales		4,930			7,039			8,720			13,149
Gross profit		4,186			6,945			7,817			12,389
Operating expenses:
Sales and marketing		1,918			3,498			3,682			6,450
General and administrative		2,036			2,674			4,183			5,136
Shipping and warehousing		239			522			510			1,029
Research and development		286			343			511			633
Total operating expenses		4,479			7,037			8,886			13,248
Loss from operations		(293	)		(92	)		(1,069	)		(859	)
Other expense:
Interest expense		(73	)		(143	)		(165	)		(321	)
Foreign currency transaction gain (loss)		122			(3	)		183			(208	)
Other income		19			3			2			33
Total other income (expense)		68			(143	)		20			(496	)
Loss before income taxes		(225	)		(235	)		(1,049	)		(1,355	)
Income tax expense (benefit)		29			38			9			(231	)
Net loss	$	(254	)	$	(273	)	$	(1,058	)	$	(1,124	)
Net loss per share of Common Stock
Basic	$	(0.02	)	$	(0.03	)	$	(0.10	)	$	(0.14	)
Diluted	$	(0.02	)	$	(0.03	)	$	(0.10	)	$	(0.14	)
Shares used in computing net loss per share of Common Stock
Basic		11,864			8,168			11,004			8,166
Diluted		11,864			8,168			11,004			8,166

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

4

ORANGE 21 INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Thousands)

	Six Months Ended June 30,
	2009			2008
	(Unaudited)
Operating Activities
Net loss	$	(1,058	)	$	(1,124	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		906			1,005
Deferred income taxes		13			(337	)
Share-based compensation		325			271
(Recovery of) provision for bad debts		(114	)		211
Loss (gain) on sale of property and equipment		2			(3	)
Impairment of property and equipment		34			68
Change in operating assets and liabilities:
Accounts receivable		1,196			1,916
Inventories, net		2,529			(2,244	)
Prepaid expenses and other current assets		300			734
Other assets		(3	)		134
Accounts payable		(3,803	)		1,266
Accrued expenses and other liabilities		(248	)		(463	)
Income tax payable/receivable		(7	)		(46	)
Net cash provided by operating activities		72			1,388
Investing Activities
Purchases of property and equipment		(251	)		(925	)
Proceeds from sale of property and equipment		16			3
Purchase of intangibles		(2	)		(14	)
Net cash used in investing activities		(237	)		(936	)
Financing Activities
Line of credit (repayments) borrowings, net		(1,353	)		427
Principal payments on notes payable		(248	)		(251	)
Proceeds from issuance of notes payable		566			—
Principal payments on capital leases		(310	)		(203	)
Proceeds from sale of common stock, net of issuance costs of $396		2,476			—
Net cash provided by (used in) financing activities		1,131			(27	)
Effect of exchange rate changes on cash		(272	)		229
Net increase in cash		694			654
Cash at beginning of period		471			555
Cash at end of period	$	1,165		$	1,209
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	178		$	335
Income taxes	$	3		$	—
Summary of noncash financing and investing activities:
Acquisition of property and equipment through capital leases	$	66		$	128

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

5

ORANGE 21 INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Organization and Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements of Orange 21 Inc. and its subsidiaries (the “Company”) have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States for interim financial information and with the instructions to Form 10-Q and Article 8-03 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements.

In the opinion of management, the unaudited consolidated financial statements contain all adjustments, consisting of normal recurring items, considered necessary for a fair presentation of the Company’s financial position, results of operations and cash flows. Operating results for the three and six months ended June 30, 2009 are not necessarily indicative of the results of operations for the year ending December 31, 2009. The consolidated financial statements contained in this Form 10-Q should be read in conjunction with the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

Capital Resources

If the Company is able to achieve anticipated net sales, manage its inventory and manage operating expenses, the Company believes that its cash on hand and available loan facilities will be sufficient to enable the Company to meet their operating requirements for at least the next 12 months. Otherwise, changes in operating plans, lower than anticipated net sales, increased expenses or other events, including those described in Item 1A, “Risk Factors,” may require the Company to seek additional debt or equity financing in the future. Due to current economic conditions, on March 13, 2009, the Company temporarily reduced its employee-related expenses by approximately 10% in the U.S., which reductions are currently continuing into the third quarter 2009, and approximately 20%-30% in salary costs at its Italian-based subsidiary, LEM, which reductions lasted approximately ten weeks. The reductions were and are being achieved through a combination of temporarily-reduced salaries and work schedules as well as mandatory vacation leave. The reductions at LEM were partly offset by reimbursements through the Italian government to minimize the effects on the employees. In addition, the Company is in the process of streamlining its Italian manufacturing and sales operations, which the Company expects could provide additional savings.

The Company’s future capital requirements will depend on many factors, including its ability to maintain or grow net sales, its ability to manage expenses and expected capital expenditures among other issues. The Company may be required to seek additional equity or debt financing in the future, which may result in additional dilution of its stockholders. Additional debt financing would result in increased interest expense and could result in covenants that would restrict its operations. The Company relies on its credit line with BFI Business Finance (“BFI”), San Paolo IMI and other credit arrangements to fund working capital needs. The recent unprecedented disruptions in the credit and financial markets and resulting decline in general economic and business conditions may adversely impact the Company’s access to capital through its credit line and other sources. Under the terms of the Company’s Loan Agreement with BFI (Note 7), BFI may reduce the Company’s borrowing availability in certain circumstances, including, without limitation, if in its reasonable business judgment the Company’s creditworthiness, sales or the liquidation value of the Company’s inventory have declined materially. Further, the Loan Agreement provides that BFI may declare the Company in default if the Company experiences a material adverse change in its business or financial condition or if BFI determines that the Company’s ability to perform under the Loan Agreement is materially impaired. The current economic environment could also cause lenders and other counterparties who provide the Company credit to breach their obligations to the Company, which could include, without limitation, lenders or other financial services companies failing to fund required borrowings under the Company’s credit arrangements. Any of the foregoing could adversely impact the Company’s business, financial condition or results of operations.

Also, if the Company requires additional financing as a result of the foregoing or other factors, the capital markets turmoil could negatively impact the Company’s ability to obtain such financing. The Company’s access to additional financing will depend on a variety of factors (many of which the Company has little or no control over) such as market conditions, the general availability of credit, the overall availability of credit to its industry, its credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of its long-term or short-term financial prospects. If future financing is not available or is not available on acceptable terms, the Company may not be able to fund its future needs which could also restrict its operations.

Nasdaq Transfer

As a result of the Company no longer meeting the continued listing standards for the Nasdaq Global Market, on May 8, 2009, the Company transferred the listing of its common stock from the Nasdaq Global Market to the Nasdaq Capital Market. As reported in the Company’s Form 10-K for the year ended December 31, 2008, the Company was not in compliance with the $10 million minimum stockholders’ equity requirement for continued listing on the Nasdaq Global Market. The Nasdaq Capital Market is one of the three market tier designations for Nasdaq-listed stocks, and operates in substantially the same manner as the Nasdaq Global Market. The Nasdaq Capital Market currently lists the securities of approximately 550 companies. The Company’s trading symbol remained “ORNG.” Securities listed on the Nasdaq Capital Market must satisfy all applicable qualification requirements for Nasdaq securities and all companies listed on the Nasdaq Capital Market must meet certain financial requirements and adhere to Nasdaq’s corporate governance standards.

2. Recently Issued Accounting Pronouncements

Effective April 1, 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 165, “Subsequent Events”(“SFAS No. 165”). SFAS No. 165 establishes general standards for accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. SFAS No. 165 sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, identifies the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures that should be made about events or transactions that occur after the balance sheet date. In preparing these consolidated financial statements, the Company evaluated the events and transactions that occurred between June 30, 2009 and August 13, 2009, the date these consolidated financial statements were issued.

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 168”). SFAS No. 168 replaces SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” establishes the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with Generally Accepted Accounting Principles. SFAS No. 168 is effective for interim and annual periods ending after September 15, 2009 and is not expected to have a material impact on the Company’s consolidated financial statements.

6

3. Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net income or loss by the weighted-average number of common shares outstanding during the period. Diluted earnings per share is calculated by including the additional shares of common stock issuable upon exercise of outstanding options and warrants and upon vesting of restricted stock, using the treasury stock method. The following table lists the potentially dilutive equity instruments, each convertible into one share of common stock, used in the calculation of diluted earnings per share for the periods presented:

	Three Months Ended June 30,		Six Months Ended June 30,
	2009	2008	2009	2008
	(Thousands)		(Thousands)
Weighted average common shares outstanding - basic	11,864	8,168	11,004	8,166
Assumed conversion of dilutive stock options, restricted stock and warrants	—	—	—	—
Weighted average common shares outstanding - dilutive	11,864	8,168	11,004	8,166

The following potentially dilutive instruments were not included in the diluted per share calculation for periods presented as their inclusion would have been antidilutive:

	Three Months Ended June 30,		Six Months Ended June 30,
	2009	2008	2009	2008
	(Thousands)		(Thousands)
Stock options	1,407	1,058	1,407	1,058
Restricted stock	3	30	3	30
Warrants	147	147	147	147
Total	1,557	1,235	1,557	1,235

4. Comprehensive Income (Loss)

Comprehensive income (loss) represents the results of operations adjusted to reflect all items recognized under accounting standards as components of accumulated other comprehensive income (loss). Total comprehensive income (loss) for the three months ended June 30, 2009 and 2008 was $0.4 million and ($0.3 million), respectively. Total comprehensive loss for the six months ended June 30, 2009 and 2008 was ($1.1 million) and ($0.2 million), respectively. The components of accumulated other comprehensive income, net of tax, are as follows:

	June 30, 2009		December 31, 2008
	(Thousands)
Equity adjustment from foreign currency translation	$	444	$	530
Unrealized gain on foreign currency exposure of net investment in foreign operations		411		372
Accumulated other comprehensive income	$	855	$	902

5. Accounts Receivable

Accounts receivable consisted of the following:

	June 30, 2009			December 31, 2008
	(Thousands)
Trade receivables	$	7,969		$	10,068
Less allowance for doubtful accounts		(756	)		(1,052	)
Less allowance for returns		(1,302	)		(2,025	)
Accounts receivable, net	$	5,911		$	6,991

7

6. Inventories

Inventories consisted of the following:

	June 30, 2009		December 31, 2008
	(Thousands)
Raw materials	$	1,642	$	1,679
Work in process		873		909
Finished goods		6,658		9,110
Inventories, net	$	9,173	$	11,698

The Company’s balances are net of an allowance for obsolescence of approximately $1,072,000 and $1,284,000 at June 30, 2009 and December 31, 2008, respectively.

7. Financing Arrangements

Credit Facilities

On February 26, 2007, Spy Optic, Inc., the Company’s wholly owned subsidiary, entered into a Loan and Security Agreement (“Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million, which was subsequently modified on December 7, 2007 and February 12, 2008 to extend the maximum borrowing capacity to $8.0 million and affect certain other changes. Actual borrowing availability under the Loan Agreement is based on eligible trade receivable and inventory levels of Spy Optic, Inc. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5% with a minimum monthly interest charge of $2,000. The Company granted BFI a security interest in substantially all of Spy Optic, Inc.’s assets as security for its obligations under the Agreement. Additionally, the obligations under the Loan Agreement are guaranteed by Orange 21 Inc. The Loan Agreement renews annually in February for one additional year unless otherwise terminated by either the Company or by BFI. The Loan Agreement renewed in February 2009 until February 2010.

The Loan Agreement imposes certain covenants on Spy Optic, Inc., including, but not limited to, covenants requiring the Company to provide certain periodic reports to BFI, inform BFI of certain changes in the business, refrain from incurring additional debt in excess of $100,000 and refrain from paying dividends. Spy Optic, Inc. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy Optic, Inc. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy Optic, Inc. any amounts remaining after payment of all amounts due under the Loan Agreement. To secure its obligations under the guaranty, Orange 21 Inc. granted BFI a blanket security interest in substantially all of its assets. The Company was in compliance with the covenants under the Loan Agreement at June 30, 2009. At June 30, 2009 and December 31, 2008, there were outstanding borrowings of $2.8 million and $3.8 million, respectively, under the Loan Agreement. The interest rate at June 30, 2009 was 5.8% and availability under this line was $1.5 million.

The Company had a 1.3 million Euros line of credit in Italy with San Paolo IMI for LEM S.r.l., the Company’s wholly owned subsidiary and primary manufacturer (“LEM”), which was reduced at June 30, 2009 to 0.8 million Euros and further reduced at July 31, 2009 to 0.7 million Euros. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At June 30, 2009, there was no availability under this line of credit. At June 30, 2009 and December 31, 2008, outstanding amounts under this line of credit amounted to $1.6 million and $1.9 million, respectively. The interest rate at June 30, 2009 was 3.0%.

As a result of the reductions in the Italian line of credit with San Paolo IMI, LEM entered into an unsecured note with San Paolo IMI during June 2009. The note is guaranteed by Eurofidi, a third party, and bears interest at EURIBOR 3 months interest rate plus 1.27% spread, payable in quarterly installments due from June 2009 through September 2013.

8

8. Notes Payable

Notes payable at June 30, 2009 consist of the following:

	(Thousands)
Unsecured San Paolo IMI long-term debt guaranteed by Eurofidi, EURIBOR 3 months interest rate plus 1.27% spread, payable in quarterly installments due from June 2009 through September 2013	$	565
Unsecured San Paolo IMI long-term debt, EURIBOR 6 months interest rate plus 1.0% spread, payable in half year installments due from March 2007 to February 2011		373
Unsecured long-term debt, EURIBOR 1-month interest rate plus 1.5% spread, payable in half year installments due from December 2005 to December 2010		80
Unsecured long-term debt, fixed interest rate at 0.5%, payable in half year installments due from December 2005 to December 2010		32
Secured notes payable for software purchases, 4.55% interest rate with monthly payments of $15,000 due through August 2009 and 7.45% interest rate with monthly payments of $4,200 due through March 2010. Both secured by software.		107
		1,157
Less current portion		(504	)
Notes payable, less current portion	$	653

9. Fair Value of Financial Instruments

In April 2009, the Company adopted FSP No. FAS 107-1 and APB 28-1, “InterimDisclosures about Fair Value of Financial Instruments.” FSP No. FAS 107-1 and APB 28-1 requires disclosures about fair value of financial instruments in interim as well as in annual financial statements. The Company’s financial instruments include cash, accounts receivable and payable, short-term borrowings and accrued liabilities. The carrying amount of these instruments approximates fair value because of their short-term nature. The carrying fair value of the Company’s long-term debt, including the current portion approximates fair value as of June 30, 2009. The estimated fair value has been determined based on rates for the same or similar instruments.

10. Share-Based Compensation

Stock Option Activity

	Shares		Weighted- Average Exercise Price		Weighted-Average Remaining Contractual Term (years)	Aggregate Intrinsic Value
						(Thousands)
Options outstanding at December 31, 2008	1,278,500		$	5.02
Granted	895,000		$	1.15
Forfeited	(370,000	)	$	3.72
Expired	(396,250	)	$	6.50
Options outstanding at June 30, 2009	1,407,250		$	2.48	8.79	$	8,000
Options exercisable at June 30, 2009	382,138		$	5.26	7.25	$	—

Intrinsic value is defined as the difference between the relevant current market value of the common stock and the grant price for options with exercise prices less than the market values on such dates. During the three and six months ended June 30, 2009 and 2008, the Company received $0 in cash proceeds from the exercise of stock options.

On May 26, 2009, the Compensation Committee of the Board of Directors (the “Committee”) of the Company determined, in accordance with the terms of the Company’s 2004 Stock Incentive Plan, as amended, to reprice certain outstanding options held by A. Stone Douglass, the Company’s Chief Executive Officer and Chairman of the Board of Directors, and Jerry Collazo, the Company’s Chief Financial Officer. Specifically, the exercise price for Mr. Douglass’ option to purchase 250,000 shares of the Company’s common stock granted on September 29, 2008 was reduced from $3.28 to $1.50 and the exercise prices of Mr. Collazo’s options to purchase 20,000 and 150,000 shares of the Company’s common stock granted on October 12, 2006 and August 29, 2007, respectively, were reduced from $4.89 and $5.38, respectively, to $1.50 (the foregoing options held by Messrs. Douglass and Collazo are referred to herein as, the “Options”). The reduced price of $1.50 represents a 103% premium over the closing price of the Company’s common stock on May 22, 2009, the last trading day before the Committee’s decision to reprice the Options. Other than the change to the exercise price, the terms of the Options remain in effect and unchanged. The forgoing description of the amendments to the Options is only a summary and is qualified in its entirety by the complete text of the amendments to the Options attached hereto as Exhibits 10.48, 10.49 and 10.50.

In determining to reprice the Options, the Committee considered the fact that the Options had exercise prices well above the recent trading prices of the Company’s common stock and, therefore, no longer provided sufficient incentives for Messrs. Douglass and Collazo, and determined that repricing the Options was in the best interest of the Company and its stockholders.

9

Restricted Stock Award Activity

The Company periodically issues restricted stock awards to certain key employees subject to certain vesting requirements based on future service.

	Shares		Weighted- Average Grant Date Fair Value
Non-vested at December 31, 2008	22,500		$	5.01
Awarded	92,743			0.91
Released	(96,701	)		1.08
Forfeited	(16,042	)		5.01
Non-vested at June 30, 2009	2,500		$	5.01

The Company recognized the following share-based compensation expense during the three and six months ended June 30, 2009 and 2008 in accordance with SFAS No. 123(R):

	Three Months Ended June 30,						Six Months Ended June 30,
	2009			2008			2009			2008
Stock options
General and administrative expense	$	88		$	120		$	212		$	242
Cost of sales		6			—			12			—
Sales and marketing		3			—			5			—
Shipping and warehouse		1			—			1			—
Research and development		1			—			1			—
Restricted stock
General and administrative expense		53			11			54			20
Cost of sales		37			—			37			—
Sales and marketing		5			2			3			4
Research and development		1			3			—			5
Total		195			136			325			271
Income tax benefit		(66	)		(46	)		(111	)		(92	)
Stock-based compensation expense, net of taxes		129			90			215			179

The following table summarizes the approximate unrecognized compensation cost for the share-based compensation awards and the weighted average remaining years over which the cost will be recognized:

	Total Unrecognized Compensation Expense		Weighted Average Remaining Years
	(Thousands)
Stock options	$	1,003	2.73
Restricted stock awards		107	0.95
Total	$	1,110

11. Related Party Transactions

Customer Sales

At June 30, 2009, Simo Holdings, Inc. (fka No Fear, Inc., “No Fear”) and its affiliates beneficially owned approximately 11% of the Company’s outstanding common stock. In addition, No Fear and its subsidiaries, No Fear Retail Stores, Inc. (“No Fear Retail”) and MX No Fear Europe SAS (“MX No Fear”), own retail stores in the U.S. and Europe that purchase products from the Company. Aggregated sales to the No Fear Retail stores during the three months ended June 30, 2009 and 2008 were approximately $302,000 and $595,000, respectively, which included approximately $297,000 in sales achieved through product credit given to Mark Simo, the Company’s former Chief Executive Officer, in conjunction with the Settlement Agreement and Mutual General Release (the “Settlement Agreement”) discussed below. Aggregated sales to these stores during the six months ended June 30, 2009 and 2008 were approximately $302,000 and $793,000, respectively, which included approximately $297,000 in sales achieved through product credit given to Mr. Simo in conjunction with the Settlement Agreement. Accounts receivable due from these stores amounted to $214,000 and $429,000 at June 30, 2009 and December 31, 2008, respectively.

Aggregated sales to the MX No Fear stores during the three months ended June 30, 2009 and 2008 were approximately $66,000 and $55,000, respectively. Aggregated sales to the MX No Fear stores during the six months ended June 30, 2009 and 2008 were approximately $121,000 and $220,000, respectively. Accounts receivable due from the MX No Fear stores amounted to $94,000 and $429,000 at June 30, 2009 and December 31, 2008, respectively.

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On April 30, 2009, the Company entered into a Settlement Agreement, dated as of April 28, 2009, by and among the Company’s three wholly owned subsidiaries, Spy Optic, Inc., Spy S.r.l. (“Spy Italy”) and LEM (collectively, the “Orange 21 Parties”), and Mark Simo, No Fear, No Fear Retail and MX No Fear, (collectively, the “No Fear Parties”). The Settlement Agreement relates to various disputes among the parties regarding outstanding accounts receivable owed to the Company by No Fear Retail and MX No Fear and certain claims by Mr. Simo regarding his compensation for services he rendered as former Chief Executive Officer of the Company.

Pursuant to the Settlement Agreement, No Fear and its subsidiaries agreed to pay all outstanding accounts receivable due to the Company as follows: (1) an aggregate of approximately 307,000 Euros to Spy Italy on the execution of the Settlement Agreement, approximately 46,000 Euros of which was being satisfied by a return of certain goggle products and (2) an aggregate of approximately $429,000 to Spy Optic, Inc., approximately $71,000 of which was paid on the execution of the Settlement Agreement with the remainder paid in monthly installments of approximately $71,000 over five months (the “Installment Payments”). In exchange, the Company agreed to provide Mr. Simo, or such other No Fear parties as Mr. Simo may designate, with product credits in the aggregate amount of $600,000 for compensation for services rendered as the former Chief Executive Officer of the Company, less applicable payroll tax withholdings, to purchase products from the Company. The product credits accrue as follows: (1) $350,000 on the execution of the Agreement and (2) $50,000 per month for five months thereafter subject to payment of the applicable Installment Payment in full. The Company recorded an additional $300,000 expense in the first quarter of 2009 for Mr. Simo’s compensation as discussed above. The remaining $300,000 was expensed in prior periods.

Additionally, pursuant to the Settlement Agreement, No Fear issued to the Company a promissory note in the amount of approximately $357,000 (the “No Fear Note”) to memorialize the Installment Payments. Interest of 10%, compounded annually, will accrue if No Fear fails to make timely payment of any of the Installment Payments. The No Fear Note is secured by a pledge of 446,808 shares of the Company’s common stock held by No Fear, pursuant to a stock pledge agreement.

Pursuant to the Settlement Agreement, the Orange 21 Parties on the one hand and the No Fear Parties on the other hand each released the other with respect to any and all claims arising from or related to past dealings of any kind between the parties. The Agreement was signed on April 28, 2009, but its effectiveness was conditioned upon receipt of all funds required to be delivered on execution, which did not occur until April 30, 2009. As of August 4, 2009, the Company has received payments of approximately $284,000 from No Fear and approximately 261,000 Euros (approximately $344,000 in U.S. Dollars) from No Fear MX Europe in accordance with this settlement agreement. The remaining balance of approximately $142,000 due from No Fear is to be paid in two monthly payments of approximately $71,000. As of August 4, 2009, both the Orange 21 Parties and the No Fear Parties are in compliance with the terms of the Settlement Agreement and therefore, the Company believes that the balances above for No Fear Retail and MX No Fear are collectible and therefore no reserve for bad debt has been recorded as of June 30, 2009.

12. Commitments and Contingencies

Operating Leases

The Company leases its principal administrative and distribution facilities in Carlsbad, California and a warehouse facility in Varese, Italy, which is used primarily for international sales and distribution. LEM leases four buildings in Italy that are used for office space, warehousing and manufacturing. In addition, the Company utilizes some third party warehousing in the United States. The Company also leases certain computer equipment, vehicles and temporary housing in Italy. Rent expense was approximately $153,000 and $197,000 for the three months ended June 30, 2009 and 2008, respectively. Rent expense was approximately $338,000 and $399,000 for the six months ended June 30, 2009 and 2008, respectively.

Athlete Contracts

The Company has entered into endorsement contracts with athletes to actively wear and endorse the Company’s products. These contracts are based on minimum annual payments and may include additional performance-based incentives and/or product-specific sales incentives.

Product Development and Design Services

In January 2009, the Company entered into a non-exclusive agreement with Bartolomasi, Inc. for the design and development of sunglasses, goggles and RX frames. Bartolomasi, Inc. has agreed to provide services to the Company as an independent consultant through January 4, 2011 and to be bound by confidentiality obligations. Under the agreement, Bartolomasi, Inc. assigns all ideas, inventions and other intellectual property rights created or developed on the Company’s behalf during the term of the agreement to the Company. The agreement may be terminated by either party with or without cause upon 60 days prior written notice. The agreement has minimum monthly payments totaling $180,000 per annum in both 2009 and 2010.

Litigation

From time to time the Company may be party to lawsuits in the ordinary course of business. The Company is not currently a party to any material legal proceedings.

13. Operating Segments and Geographic Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company’s management in deciding how to allocate resources and in assessing performance. The Company designs, produces and distributes sunglasses, snow and motocross goggles, and branded apparel and accessories for the action sports, motorsports, snowsports and youth lifestyle markets. The Company owns its primary manufacturer LEM located in Italy. LEM manufactures products for non-competing brands in addition to most of the Company’s sunglass products. Results for LEM reflect operations of this manufacturer after elimination of intercompany transactions. The Company operates in two business segments: distribution and manufacturing.

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Information related to the Company’s operating segments is as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2009			2008			2009			2008
	(Thousands)						(Thousands)
Net sales:
Distribution	$	8,003		$	12,497		$	14,533		$	23,153
Manufacturing		1,113			1,487			2,004			2,385
Intersegment		1,322			4,402			2,936			7,819
Eliminations		(1,322	)		(4,402	)		(2,936	)		(7,819	)
Total	$	9,116		$	13,984		$	16,537		$	25,538
Operating income (loss):
Distribution	$	45		$	(542	)	$	(303	)	$	(1,397	)
Manufacturing		(338	)		450			(766	)		538
Total	$	(293	)	$	(92	)	$	(1,069	)	$	(859	)
Net income (loss):
Distribution	$	117		$	(601	)	$	(210	)	$	(1,402	)
Manufacturing		(371	)		328			(848	)		278
Total	$	(254	)	$	(273	)	$	(1,058	)	$	(1,124	)

	June 30, 2009		December 31, 2008
	(Thousands)
Tangible long-lived assets:
Distribution	$	1,445	$	1,915
Manufacturing		3,407		3,502
Total	$	4,852	$	5,417

The Company markets its products domestically and internationally, with its principal international market being Europe. Revenue is attributed to the location from which the product was shipped. Identifiable assets are based on location of domicile.

	Three Months Ended June 30,
	U.S. and Canada		Europe and Asia Pacific		Consolidated		Intersegment
			(Thousands)				(Thousands)
	2009						2009
Net sales	$	7,198	$	1,918	$	9,116	$	1,322
	2008						2008
Net sales	$	10,807	$	3,177	$	13,984	$	4,402
	Six Months Ended June 30,
	U.S. and Canada		Europe and Asia Pacific		Consolidated		Intersegment
			(Thousands)				(Thousands)
	2009						2009
Net sales	$	12,951	$	3,586	$	16,537	$	2,936
	2008						2008
Net sales	$	19,472	$	6,066	$	25,538	$	7,819

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	June 30, 2009		December 31, 2008
	(Thousands)
Tangible long-lived assets:
U.S. and Canada	$	1,038	$	1,418
Europe and Asia Pacific		3,814		3,999
Total	$	4,852	$	5,417

14. Rights Offering

On January 22, 2009, the Company launched a rights offering to raise a maximum of $7.6 million pursuant to which holders of the Company’s common stock, options and warrants, were entitled to purchase additional shares of the Company’s common stock at a price of $0.80 per share (the “Rights Offering”). The proceeds from the Rights Offering are expected to be used for general corporate purposes, which may include research and development, capital expenditures, payment of trade payables, working capital and general and administrative expenses. The Company may also use a portion of the net proceeds to acquire or invest in complementary businesses, products and technologies, although the Company has no current plans, commitments or agreements with respect to any such transactions.

In the Rights Offering, stockholders, option holders and warrant holders as of 5:00 p.m., New York City time January 21, 2009, were issued, at no charge, one subscription right for each share of common stock then outstanding or subject to outstanding options or warrants (whether or not currently exercisable). Each right entitled the holder to purchase one share of the Company’s common stock for $0.80 per share.

The Rights Offering was conducted via an existing effective shelf registration statement on Form S-3. An aggregate of 9,544,814 subscription rights were distributed in the Rights Offering entitling the Company’s stockholders, option holders and warrant holders to purchase up to 9,544,814 shares of the Company’s common stock at a price of $0.80 per share. The subscription rights were not transferable and were evidenced by subscription rights certificates. Fractional shares were not issued in the Rights Offering. The subscription rights issued pursuant to the Rights Offering expired at 5:00 p.m., New York City time, on March 6, 2009. The Company also reserved the right to allocate unsubscribed shares to other investors at $0.80 per share.

As of August 4, 2009, approximately 3.6 million shares of the Company’s common stock had been purchased in the Rights Offering for an aggregate of approximately $2.9 million, including approximately $0.5 million in proceeds from the purchase of unsubscribed shares. Costs related to the Rights Offerings during the six months ended June 30, 2009 were approximately $396,000.

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

This Quarterly Report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Quarterly Report. Additionally, statements concerning future matters such as the development of new products, our ability to increase manufacturing capacity and sales levels, manage expense levels and other statements regarding matters that are not historical facts are forward-looking statements.

Although forward-looking statements in this Quarterly Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to the following: matters generally affected by the domestic and global economy, such as changes in consumer discretionary spending, changes in the value of the U.S. dollar, Canadian dollar and the Euro, and changes in commodity prices; the ability to source raw materials and finished products at favorable prices; risks related to our history of losses; risks related to our ability to manage growth; risks related to the limited visibility of future orders; the ability to identify and work with qualified manufacturing partners and consultants; the ability to expand distribution channels and retail operations in a timely manner; unanticipated changes in general market conditions or other factors, which may result in cancellations of advance orders or a reduction in the rate of reorders placed by retailers; the ability to continue to develop, produce and introduce innovative new products in a timely manner; the ability to identify and execute successfully cost control initiatives; uncertainties associated with our ability to maintain a sufficient supply of products and to successfully manufacture our products; the performance of new products and continued acceptance of current products; the execution of strategic initiatives and alliances; uncertainties associated with intellectual property protection for our products; and other factors described in Item 1A of Part II of this Quarterly Report under the caption “Risk Factors,” as well as those discussed elsewhere in this Quarterly Report. Readers are urged not to place undue reliance on forward-looking statements, which speak only as of the date of this Quarterly Report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Quarterly Report. Readers are urged to carefully review and consider the various disclosures made in this Quarterly Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Quarterly Report and in the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2008, previously filed with the Securities and Exchange Commission.

Overview

We design, develop and market premium products for the action sports, motorsports, snowsports and youth lifestyle markets. Our principal products, sunglasses and goggles, are marketed primarily under the brands, Spy™ and SpyOptic™. These products target the action sport and power sports markets, including surfing, skateboarding, snowboarding, ski and motocross, and the youth lifestyle market within fashion, music and entertainment. We have built our Spy^® brand by developing innovative, proprietary products that utilize high-quality materials and optical lens technology to convey performance, style, quality and value. We sell our products in approximately 3,000 retail locations in the United States and Canada and internationally through approximately 3,000 retail locations serviced by us and our international distributors. We have developed strong relationships with key multi-store action sport and youth lifestyle retailers in the United States, such as Sun Diego, Industrial Skateboards, Tilly’s Clothing, Shoes & Accessories and Zumiez, Inc., and a strategically selective collection of specialized surf, skate, snow and motocross stores.

We focus our marketing and sales efforts on the action sports, motorsports, snowsports and youth lifestyle markets, and specifically, persons ranging in age from 17 to 35. We separate our eyewear products into two groups: sunglasses, which includes fashion, performance sport and women-specific sunglasses, and goggles, which includes snowsport and motocross goggles. In addition, we sell branded sunglass and goggle accessories. In managing our business, we are particularly focused on ensuring that our product designs are keyed to current trends in the fashion industry, incorporate the most advanced technologies to enhance performance and provide value to our target market.

We began as a grassroots brand in Southern California and entered the action sports and youth lifestyle markets with innovative and performance-driven products and an authentic connection to the action sports and youth lifestyle markets under the Spy Optic™ brand. We have two wholly owned subsidiaries incorporated in Italy, Spy Optic, S.r.l. (“Spy Italy”) and LEM S.r.l. (“LEM”) (our primary manufacturer), and a wholly owned subsidiary incorporated in California, Spy Optic, Inc. (“Spy U.S.”), all of which we consolidate in our financial statements. We were incorporated as Sports Colors, Inc. in California in August 1992. From August 1992 to April 1994, we had no operations. In April 1994, we changed our name to Spy Optic, Inc. In November 2004, we reincorporated in Delaware and changed our name to Orange 21 Inc.

The information contained in, or that can be accessed through, our website is not a part of this Annual Report. References in this Annual Report to “we,” “our,” “us” and “Orange 21” refer to Orange 21 Inc. and our consolidated subsidiaries, Spy Optic, S.r.l., LEM S.r.l. and Spy Optic, Inc., except where it is made clear that the term means only the parent company.

Results of Operations

Three Months Ended June 30, 2009 and 2008

Net Sales

Consolidated net sales decreased 35% to $9.1 million for the three months ended June 30, 2009 from $14.0 million for the three months ended June 30, 2008. We believe that the decrease is largely due to a decline in the economy and consumer discretionary spending.

Domestic net sales represented 79% and 77% of total net sales for the three months ended June 30, 2009 and 2008, respectively. Foreign net sales represented 21% and 23% of total net sales for the three months ended June 30, 2009 and 2008, respectively.

Cost of Sales and Gross Profit

Our consolidated gross profit decreased 40% to $4.2 million for the three months ended June 30, 2009 from $6.9 million for the three months ended June 30, 2008. Gross profit as a percentage of sales decreased to 46% for the three months ended June 30, 2009 from 50% for the three months ended June 30, 2008 largely due to a $0.4 million reduction in capitalized inventory overhead due to decreased inventory levels and purchasing in the U.S. during the three months ended June 30, 2009.

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Sales and Marketing Expense

Sales and marketing expense decreased 45% to $1.9 million for the three months ended June 30, 2009 from $3.5 million for the three months ended June 30, 2008. The decrease is primarily due to reduced sales commissions of $0.6 million as a result of declining sales and the restructuring of sales compensation plans and due to reductions of certain marketing expenditures, including point-of-purchase displays and materials of $0.2 million, athletes, depreciation, employee-related expenses, tradeshows and events. Marketing expense reductions are primarily due to an overall effort by management to improve efficiencies and cut costs to be more in line with the decline in sales due to the current economic conditions.

Employee-related decreases were a result of temporary plant and office shutdowns both in the U.S. and in Italy, reduction in workforce through no replacement of certain terminated employees and as a result of a temporary 10% reduction in compensation for our Spy U.S. employees and 20% to 30% reduction of salary expense in Italy resulting from a ten-week government-subsidized leave program at LEM whereby certain employees’ work schedules were reduced. As part of this program at LEM, the Italian government subsidized a portion of employees’ salaries to minimize the effect on the employees and us. Both the reduction at Spy U.S. and the program at LEM began on March 13, 2009. These efforts at Spy U.S and at LEM were and are currently aimed at reducing expenses during the current global economic downturn.

General and Administrative Expense

General and administrative expense decreased 24% to $2.0 million for the three months ended June 30, 2009 from $2.7 million for the three months ended June 30, 2008 largely due to employee-related expenses as discussed above as well as decreases in bad debt expense of $0.1 million, board fees, rent expense for the closure of a third party warehouse in Canada, bank charges for renegotiated rates, insurance expense, operating leases, and various other reductions made in an effort to maximize efficiencies and reduce overall costs. Decreases were partly offset by an increase of $0.1 million in legal fees.

Shipping and Warehousing Expense

Shipping and warehousing expense decreased 54% to $0.2 million for the three months ended June 30, 2009 from $0.5 million for the three months ended June 30, 2008 primarily due to decreases in employee-related expenses as discussed above and third party warehousing costs as Spy Italy closed its outsourced warehouse in the Netherlands. The closure is expected to improve efficiencies at Spy Italy in future periods.

Research and Development Expense

Research and development expense decreased 17% to $286,000 for the three months ended June 30, 2009 from $343,000 for the three months ended June 30, 2008 primarily due to decreases in employee-related expenses as discussed above and reduced design and development consulting costs.

Other Net Income (Expense)

Other net expense decreased 148%. Other net income for the three months ended June 30, 2009 was $68,000 and other net expense for the three months ended June 30, 2008 was ($143,000). The change is primarily due to the change in foreign currency transaction gains and (losses) of $122,000 and ($3,000) during the three months ended June 30, 2009 and 2008, respectively, and a decrease in interest expense of $70,000 due to reduced borrowing levels and lower interest rates.

Income Tax Provision

The income tax expense for the three months ended June 30, 2009 and 2008 was $29,000 and $38,000, respectively. The effective tax rate for the three months ended June 30, 2009 and 2008 was 13% and 16%, respectively. The change in the effective tax rate was primarily due to the recording of a full valuation allowance in both the U.S. and Italy at June 30, 2009.

Net Income (Loss)

A net loss of $254,000 was incurred for the three months ended June 30, 2009 compared to a net loss of $273,000 for the three months ended June 30, 2008.

Six Months Ended June 30, 2009 and 2008

Net Sales

Consolidated net sales decreased 35% to $16.5 million for the six months ended June 30, 2009 from $25.5 million for the six months ended June 30, 2008. We believe that the decrease is largely due to a decline in the economy and consumer discretionary spending.

Domestic net sales represented 78% and 76% of total net sales for the three months ended June 30, 2009 and 2008, respectively. Foreign net sales represented 22% and 24% of total net sales for the six months ended June 30, 2009 and 2008, respectively.

Cost of Sales and Gross Profit

Our consolidated gross profit decreased 37% to $7.8 million for the six months ended June 30, 2009 from $12.4 million for the six months ended June 30, 2008. Gross profit as a percentage of sales decreased to 47% for the six months ended June 30, 2009 from 49% for the six months ended June 30, 2008 largely due to a $0.5 million reduction in capitalized inventory overhead due to decreased inventory levels and purchasing in the U.S. during the six months ended June 30, 2009 and due to unabsorbed overhead costs at LEM due to decreased sales and decreased plant hours during 2009 due to the reduction in employee-related costs discussed above.

Sales and Marketing Expense

Sales and marketing expense decreased 43% to $3.7 million for the six months ended June 30, 2009 from $6.5 million for the six months ended June 30, 2008. The decrease is primarily due to reduced sales commissions of $0.8 million as a result of declining sales and the restructuring of sales compensation plans as well as reductions of certain marketing expenditures, including point-of-purchase displays and materials of $0.5 million, employee-related expenses of $0.3 million, athletes of $0.2 million, advertising of $0.2 million, depreciation of $0.1 million due to disposal of vehicles, travel, tradeshows and events and various other expenses. Marketing expense reductions are primarily due to an overall effort by management to improve efficiencies and cut costs to be more in line with the decline in sales due to the current economic conditions.

General and Administrative Expense

General and administrative expense decreased 19% to $4.2 million for the six months ended June 30, 2009 from $5.1 million for the six months ended June 30, 2008 largely due to a decrease in bad debt reserve of $0.4 million for related parties, No Fear and MX No Fear as a result of the Settlement Agreement with the No Fear Parties discussed in Note 11 to the unaudited consolidated financial statements. The Company also experienced decreases in legal fees, consulting and outside services, audit fees, employee-related expenses as discussed above and various other decreases as a result of other reductions made in an effort to maximize efficiencies

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and reduce overall costs. Decreases were partly offset by $0.3 million in additional compensation expense incurred as a result of the Settlement Agreement with Mark Simo, the Company’s former Chief Executive Officer (“CEO”), for compensation related to services rendered as our former CEO. See further discussion about the Settlement Agreement with the No Fear Parties in Note 11 to the unaudited consolidated financial statements

Shipping and Warehousing Expense

Shipping and warehousing expense decreased 50% to $0.5 million for the six months ended June 30, 2009 from $1.0 million for the six months ended June 30, 2008 primarily due to decreases in employee-related expenses as discussed above and decreases in third party warehousing costs as Spy Italy closed its outsourced warehouse in the Netherlands. The closure is expected to improve efficiencies at Spy Italy in future periods.

Research and Development Expense

Research and development expense decreased 19% to $0.5 million for the six months ended June 30, 2009 from $0.6 million for the six months ended June 30, 2008 primarily due to decreases in employee-related expenses as discussed above and design and development consulting costs.

Other Net Income (Expense)

Other net expense decreased 104%. Other net income for the six months ended June 30, 2009 was $20,000 and other net expense for the six months ended June 30, 2008 was ($496,000). The change is primarily due to the change in foreign currency transaction gains and (losses) of $183,000 and ($208,000) during the six months ended June 30, 2009 and 2008, respectively, and a decrease in interest expense of $156,000 due to reduced borrowing levels and lower interest rates.

Income Tax Provision/(Benefit)

The income tax expense for the six months ended June 30, 2009 was $9,000 compared to income tax benefit of ($231,000) for the six months ended June 30, 2008. The effective tax rate for the six months ended June 30, 2009 and 2008 was 1% and 17%, respectively. The change in the effective tax rate was primarily due to the recording of a full valuation allowance in both the U.S. and Italy at June 30, 2009.

Net Income (Loss)

A net loss of $1.1 million was incurred for each of the six months ended June 30, 2009 and 2008.

Liquidity and Capital Resources

Cash flow activities

Cash provided by or used in operating activities consists primarily of net income (loss) adjusted for certain non-cash items, including depreciation, amortization, deferred income taxes, provision for bad debts, share-based compensation expense and the effect of changes in working capital and other activities. Cash provided by operating activities for the six months ended June 30, 2009 was approximately $72,000 which consisted of a net loss of approximately $1.1 million, adjustments for non-cash items of approximately $1.2 million and approximately $36,000 used in working capital and other activities. Working capital and other activities includes a $1.2 million decrease in accounts receivable due to timing of cash receipts and a decrease in sales, a $2.5 million decrease in net inventories due to management’s efforts to decrease inventory levels through improved planning and purchasing, partly offset by a $4.1 million decrease in accounts payable and accrued liabilities due to timing of invoices received and payments.

Cash provided by operating activities for the six months ended June 30, 2008 was approximately $1.4 million, which consisted of a net loss of approximately $1.1 million, adjustments for non-cash items of approximately $1.2 million and $1.3 million provided by working capital and other activities. Working capital and other activities includes a $1.9 million decrease in accounts receivable due to timing of cash receipts and a $0.8 million increase in accounts payable and accrued liabilities due to timing of invoices received and payments, partly offset by a $2.2 million increase in inventory due mainly to the receipt of snow goggles for third and fourth quarter sales.

Cash used in investing activities during the six months ended June 30, 2009 was $0.2 million and was primarily attributable to the purchase of fixed assets, including computer and software and point-of-purchase displays purchased at Spy Italy and molds, tooling and software at LEM.

Cash used in investing activities during the six months ended June 30, 2008 was $0.9 million and was primarily attributable to the purchase of fixed assets.

Cash provided by financing activities for the six months ended June 30, 2009 was $1.1 million and was attributable to $2.5 million in net proceeds received from the sales of common stock in conjunction with our Rights Offering, described below and $0.6 million in proceeds received at LEM from the issuance of a notes payable, partly offset by $1.4 million in net payments on our lines of credit and $0.6 million for notes payable and capital lease principal payments.

Cash used in financing activities for the six months ended June 30, 2008 was $27,000 and was attributable to $454,000 for notes payable and capital lease principal payments partly offset by $427,000 million in net borrowings on our lines of credit.

Rights Offering

On January 22, 2009, we launched a rights offering to raise a maximum of $7.6 million pursuant to which holders of our common stock, options and warrants, were entitled to purchase additional shares of our common stock at a price of $0.80 per share (the “Rights Offering”). The proceeds from the Rights Offering are expected to be used for general corporate purposes, which may include research and development, capital expenditures, payment of trade payables, working capital and general and administrative expenses. We may also use a portion of the net proceeds to acquire or invest in complementary businesses, products and technologies, although we have no current plans, commitments or agreements with respect to any such transactions.

In the Rights Offering, stockholders, option holders and warrant holders as of 5:00 p.m., New York City time January 21, 2009, were issued, at no charge, one subscription right for each share of common stock then outstanding or subject to outstanding options or warrants (whether or not currently exercisable). Each right entitled the holder to purchase one share of our common stock for $0.80 per share.

The Rights Offering was conducted via an existing effective shelf registration statement on Form S-3. An aggregate of 9,544,814 subscription rights were distributed in the Rights Offering entitling our stockholders, option holders and warrant holders to purchase up to 9,544,814 shares of our common stock. The subscription rights were not transferable and were evidenced by subscription rights certificates. Fractional shares were not issued in the Rights Offering. The subscription rights issued pursuant to the Rights Offering expired at 5:00 p.m., New York City time, on March 6, 2009. We reserved the right to allocate unsubscribed shares to other investors at $0.80 per share. As of August 4 2009, approximately 3.6 million shares of our common stock have been purchased in the Rights Offering for an aggregate of approximately $2.9 million, including approximately $0.5 million in proceeds from the

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purchase of unsubscribed shares. Costs related to the Rights Offerings during the six months ended June 30, 2009 were approximately $396,000.

Credit Facilities

On February 26, 2007, Spy U.S. entered into a Loan and Security Agreement (“Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million, which was subsequently modified to extend the maximum borrowing capacity to $8.0 million and to effect certain other changes. Actual borrowing availability under the Loan Agreement is based on eligible trade receivable and inventory levels of Spy U.S. Loans extended pursuant to the Loan Agreement will bear interest at a rate per annum equal to the prime rate as reported in the Western Edition of the Wall Street Journal from time to time plus 2.5%, with a minimum monthly interest charge of $2,000. We granted BFI a security interest in substantially all of Spy U.S.’s assets as security for its obligations under the Loan Agreement. Additionally, the obligations under the Loan Agreement are guaranteed by Orange 21 Inc. The Loan Agreement renews annually in February for one additional year unless otherwise terminated by either us or by BFI. The Loan Agreement renewed in February 2009 until February 2010.

The Loan Agreement imposes certain covenants on Spy U.S., including, but not limited to, covenants requiring it to provide certain periodic reports to BFI, inform BFI of certain changes in the business, refrain from incurring additional debt in excess of $100,000 and refrain from paying dividends. Spy U.S. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy U.S. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy U.S. any amounts remaining after payment of all amounts due under the Loan Agreement. To secure its obligations under the guaranty, Orange 21 Inc. granted BFI a blanket security interest in substantially all of its assets. We were in compliance with the covenants under the Loan Agreement at June 30, 2009. At June 30, 2009, there were outstanding borrowings of $2.8 million under the Loan Agreement, bearing an interest rate of 5.8% and availability under this line of $1.5 million.

We had a 1.3 million Euros line of credit in Italy with San Paolo IMI for LEM, which was reduced at June 30, 2009 to 0.8 million Euros and further reduced at July 31, 2009 to 0.7 million Euros. Borrowing availability is based on eligible accounts receivable and export orders received at LEM. At June 30, 2009, there was no availability under this line of credit. At June 30, 2009 there were outstanding borrowings of $1.6 million under this line of credit, bearing and interest rate of 3.0%.

As a result of the reductions in the Italian line of credit with San Paolo IMI, LEM entered into an unsecured note with San Paolo IMI during June 2009. The note is guaranteed by Eurofidi, a third party, and bears interest at EURIBOR 3 months interest rate plus 1.27% spread, payable in quarterly installments due from June 2009 through September 2013.

Future Capital Requirements

If we are able to achieve anticipated net sales, manage our inventory and manage operating expenses, we believe that our cash on hand and available loan facilities will be sufficient to enable us to meet our operating requirements for at least the next 12 months. Otherwise, changes in operating plans, lower than anticipated net sales, increased expenses or other events, including those described in Item 1A, “Risk Factors,” may require us to seek additional debt or equity financing in the future.

Due to current economic conditions, on March 13, 2009, we temporarily reduced our employee-related expenses by approximately 10% in the U.S., which reductions are currently continuing into the third quarter, and approximately 20%-30% in salary costs at our Italian-based subsidiary, LEM, which reductions lasted approximately ten weeks. The reductions were and are being achieved through a combination of temporarily-reduced salaries and work schedules as well as mandatory vacation leave. The reductions at LEM were partly offset by reimbursements through the Italian government to minimize the effects on the employees and us. In addition, we are in the process of streamlining our Italian manufacturing and sales operations, which we expect could provide additional savings.

Our future capital requirements will depend on many factors, including our ability to maintain or grow net sales, our ability to manage our expenses and our expected capital expenditures among other issues. We may be required to seek additional equity or debt financing in the future, which may result in additional dilution of our stockholders. Additional debt financing would result in increased interest expense and could result in covenants that would restrict our operations. We rely on our credit line with BFI, San Paolo IMI and other credit arrangements to fund working capital needs. The recent unprecedented disruptions in the credit and financial markets and resulting decline in general economic and business conditions may adversely impact our access to capital through our credit line and other sources. Under the terms of our Loan Agreement, BFI may reduce our borrowing availability in certain circumstances, including, without limitation, if in its reasonable business judgment our creditworthiness, sales or the liquidation value of our inventory have declined materially. Further, the Loan Agreement provides that BFI may declare us in default if we experience a material adverse change in our business or financial condition or if BFI determines that our ability to perform under the Loan Agreement is materially impaired. The current economic environment could also cause lenders and other counterparties who provide us credit to breach their obligations to us, which could include, without limitation, lenders or other financial services companies failing to fund required borrowings under our credit arrangements. Any of the foregoing could adversely impact our business, financial condition or results of operations.

Also, if we require additional financing as a result of the foregoing or other factors, the capital markets turmoil could negatively impact our ability to obtain such financing. Our access to additional financing will depend on a variety of factors (many of which we have little or no control over) such as market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of our long-term or short-term financial prospects. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future needs which could also restrict our operations.

Off-balance sheet arrangements

We did not enter into any off-balance sheet arrangements during the six months ended June 30, 2009 or 2008, nor did we have any off-balance sheet arrangements outstanding at June 30, 2009 and December 31, 2008.

Income Taxes

In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on the level of historical operating results and the uncertainty of the economic conditions, we have recorded a full valuation allowance for our U.S. operations at June 30, 2009 and December 31, 2008. At June 30, 2009 and December 31, 2008, we have recorded a full valuation allowance for our wholly owned subsidiaries, Spy Italy and LEM.

Backlog

Historically, purchases of sunglass and motocross eyewear products have not involved significant pre-booking activity. Purchases of our snow goggle products are generally pre-booked and shipped primarily from August to October.

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Seasonality

Our net sales fluctuate from quarter to quarter as a result of changes in demand for our products. Historically, we have experienced greater net sales in the second half of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products. We generally sell more of our sunglass products in the first half of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales will continue. As a result, our net sales and operating results have fluctuated significantly from period-to-period in the past and are likely to do so in the future.

Inflation

We do not believe inflation has had a material impact on our operations in the past, although there can be no assurance that this will be the case in the future.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosures. On an ongoing basis, we evaluate our estimates, including those related to inventories, sales returns, income taxes, accounts receivable allowances, share-based compensation, impairment testing and warranty. We base our estimates on historical experience, performance metrics and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results will differ from these estimates under different assumptions or conditions.

We apply the following critical accounting policies in the preparation of our consolidated financial statements:

Revenue Recognition and Reserve for Returns

Our revenue is primarily generated through sales of sunglasses, goggles and apparel, net of returns and discounts. Revenue is recognized in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104 (“SAB 104”), Revenue Recognition. Under SAB 104, revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. These criteria are usually met upon delivery to our “common” carrier, which is also when the risk of ownership and title passes to our customers.

Generally, we extend credit to our customers after performing credit evaluations and do not require collateral. Our payment terms generally range from net-30 to net-90, depending on the country or whether we sell directly to retailers or to a distributor. Our distributors are typically set up as prepay accounts; however, credit may be extended to certain distributors, usually upon receipt of a letter of credit. Generally, our sales agreements with our customers, including distributors, do not provide for any rights of return or price protection. However, we do approve returns on a case-by-case basis in our sole discretion. We record an allowance for estimated returns when revenue is recorded based on historical data and make adjustments when we consider it necessary. The allowance for returns is calculated using a three step process that includes: (1) calculating an average of actual returns as a percentage of sales over a rolling twelve month period; (2) estimating the average time period between a sale and the return of the product (10 and 4.7 months at June 30, 2009 for Spy U.S. and Spy S.r.l., respectively), and (3) estimating the value of the product returned. The reserve is calculated as the average return percentage times gross sales for the average return period less the estimated value of the product returned and adjustments are made as we consider necessary. The average return percentage has ranged from 8.2% to 9.7% and 1.8% to 5.5% during the past two years at Spy U.S. and Spy S.r.l., respectively, with 9.4% and 5.5% used at June 30, 2009 for Spy U.S. and Spy Italy, respectively. If Spy U.S. were to use 9.7% (the highest average return rate in the past two years) it would have resulted in approximately $45,000 increase to the liability, which would have resulted in a reduction in net sales for the six months ended June 30, 2009. Historically, actual returns have been within our expectations. If future returns are higher than our estimates, our earnings would be adversely affected.

Accounts Receivable and Allowance for Doubtful Accounts

Throughout the year, we perform credit evaluations of our customers, and we adjust credit limits based on payment history and the customer’s current creditworthiness. We continuously monitor our collections and maintain a reserve for estimated credits which is calculated on a monthly basis. We make judgments as to our ability to collect outstanding receivables and provide allowances for anticipated bad debts and refunds. Provisions are made based upon a review of all significant outstanding invoices and overall quality and age of those invoices not specifically reviewed. In determining the provision for invoices not specifically reviewed, we analyze collection experience, customer credit-worthiness and current economic trends.

If the data used to calculate these allowances does not reflect our future ability to collect outstanding receivables, an adjustment in the reserve for refunds may be required. Historically, our losses have been consistent with our estimates, but there can be no assurance that we will continue to experience the same credit loss rates that we have experienced in the past. Unforeseen, material financial difficulties experienced by our customers could have an adverse impact on our profits.

Share-based Compensation Expense

We account for share-based compensation in accordance with SFAS No. 123(R), “Share-Based Payment” (“SFAS No. 123(R)”), which requires us to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the consolidated statement of operations over the period during which the employee is required to provide service in exchange for the award—the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The grant-date fair value of employee share options and similar instruments is estimated using option-pricing models adjusted for the unique characteristics of those instruments.

Determining Fair Value under SFAS No. 123(R)

Valuation and Amortization Method. Consistent with the valuation method used for the disclosure only provisions of SFAS No. 123, we are using the Black-Scholes option-pricing valuation model (single option approach) to calculate the fair value of stock option grants. For options with graded vesting, the option grant is treated as a single award and compensation cost is recognized on a straight-line basis over the vesting period of the entire award.

Expected Term. The expected term of options granted represents the period of time that the option is expected to be outstanding. We estimate the expected term of the option grants based on historical exercise patterns that we believe to be representative of future behavior as well as other various factors.

Expected Volatility. We estimate our volatility using our historical share price performance over the expected life of the options, which management believes is materially indicative of expectations about expected future volatility.

Risk-Free Interest Rate. We use risk-free interest rates in the Black-Scholes option valuation model that are based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the options.

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Dividend Rate. We have not paid dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Therefore, we use an expected dividend yield of zero.

Forfeitures. SFAS No. 123(R) requires companies to estimate forfeitures at the time of grant and revise those estimates in subsequent reporting periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. The impact of the adoption of SFAS No. 123(R) related to forfeitures was not material to our financial statements.

Inventories

Inventories consist primarily of raw materials and finished products, including sunglasses, goggles, apparel and accessories, product components such as replacement lenses and purchasing and quality control costs. Inventory items are carried on the books at the lower of cost or market using the weighted average cost method for LEM and first in first out method for our distribution business. Periodic physical counts of inventory items are conducted to help verify the balance of inventory.

A reserve is maintained for obsolete or slow moving inventory. Products are reserved at certain percentages based on their probability of selling, which is estimated based on current and estimated future customer demands and market conditions. Historically, there has been variability in the amount of write offs, compared to estimated reserves. These estimates could vary significantly, either favorably or unfavorably, from actual experience if future economic conditions, levels of consumer demand, customer inventory or competitive conditions differ from expectations.

Income Taxes

We account for income taxes pursuant to the asset and liability method, whereby deferred tax assets and liabilities are computed at each balance sheet date for temporary differences between the consolidated financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income. We consider future taxable income and ongoing, prudent and feasible tax planning strategies in assessing the value of our deferred tax assets. If we determine that it is more likely than not that these assets will not be realized, we will reduce the value of these assets to their expected realizable value, thereby decreasing our net income. Evaluating the value of these assets is necessarily based on our management’s judgment. If we subsequently determine that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.

We have established a valuation allowance against our deferred tax assets in each jurisdiction where we cannot conclude that it is more likely than not that those assets will be realized. In the event that actual results differ from our forecasts or we adjust the forecast or assumptions in the future, the change in the valuation allowance could have a significant impact on future income tax expense.

We are subject to income taxes in the United States and foreign jurisdictions. In the ordinary course of our business, there are calculations and transactions, including transfer pricing, where the ultimate tax determination is uncertain. In addition, changes in tax laws and regulations as well as adverse judicial rulings could materially affect the income tax provision.

Foreign Currency and Derivative Instruments

The functional currency of each of our foreign wholly owned subsidiaries, Spy Italy, LEM and our Canadian division is the respective local currency. Accordingly, we are exposed to transaction gains and losses that could result from changes in foreign currency. Assets and liabilities denominated in foreign currencies are translated at the rate of exchange on the balance sheet date. Revenues and expenses are translated using the average exchange rate for the period. Gains and losses from translation of foreign subsidiary financial statements are included in accumulated other comprehensive income (loss).

Recently Issued Accounting Pronouncements

Effective April 1, 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 165, “Subsequent Events”(“SFAS No. 165”). SFAS No. 165 establishes general standards for accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. SFAS No. 165 sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, identifies the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures that should be made about events or transactions that occur after the balance sheet date. In preparing these consolidated financial statements, we evaluated the events and transactions that occurred between June 30, 2009 and August 13, 2009, the date these consolidated financial statements were issued.

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 168”). SFAS No. 168 replaces SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” establishes the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with Generally Accepted Accounting Principles. SFAS No. 168 is effective for interim and annual periods ending after September 15, 2009 and is not expected to have a material impact on our consolidated financial statements.

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Item 4T. Controls and Procedures

Disclosure Control and Procedures

Management, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (Exchange Act)) as of June 30, 2009, the end of the period covered by this report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed is recorded, processed, summarized and reported within the time frames specified by the SEC’s rules and forms. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2009.

Changes in Internal Control over Financial Reporting

During the fiscal quarter ended June 30, 2009, there were no changes in our internal control over financial reporting identified in connection with the evaluation described above that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

From time to time we may be party to lawsuits in the ordinary course of business. We are not currently a party to any material legal proceedings.

Item 1A. Risk Factors

Risks Related to Our Business

You should consider each of the following factors as well as the other information in this Quarterly Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case, the trading price of our common stock could decline. You should also refer to the other information set forth in this Quarterly Report, including our financial statements and the related notes.

Economic conditions and the resulting decline in consumer spending could continue to adversely affect our business and financial performance.

Our performance depends on general economic conditions and their impact on consumer confidence and discretionary consumer spending, which have deteriorated significantly over the past year and may remain depressed for the foreseeable future. Our business and financial performance, including our sales and the collection of our accounts receivable, may continue to be adversely affected by the current decrease and any future decrease in economic activity in the United States or in other regions of the world in which we do business. Further, economic factors such as a reduction in the availability of credit, increased unemployment levels, higher fuel and energy costs, rising interest rates, adverse conditions in the housing markets, financial market volatility, recession, reduced consumer confidence, acts of terrorism and other factors affecting consumer spending behavior could adversely affect demand for our products. If consumer spending continues to decline, we will not be able to improve our sales. In addition, reduced consumer spending may cause us to lower prices or suffer increases in product returns, which would have a negative impact on gross profit.

Current economic conditions could adversely impact our liquidity and our ability to obtain financing, including counterparty risk.

On February 26, 2007, Spy U.S. entered into a Loan and Security Agreement (the “Loan Agreement”) with BFI Business Finance (“BFI”) with a maximum borrowing capacity of $5.0 million, which was extended to $8.0 million. We rely on this credit line with BFI and other credit arrangements to fund working capital needs. The recent unprecedented disruptions in the credit and financial markets and resulting decline in general economic and business conditions may adversely impact our access to capital through our credit line and other sources. Under the terms of our Loan Agreement, BFI may reduce our borrowing availability in certain circumstances, including, without limitation, if in its reasonable business judgment our creditworthiness, sales or the liquidation value of our inventory have declined materially. Further, the Loan Agreement provides that BFI may declare us in default if we experience a material adverse change in our business or financial condition or if BFI determines that our ability to perform under the Loan Agreement is materially impaired.

We had a 0.8 million Euros line of credit in Italy with San Paolo IMI for LEM, which was reduced from 1.3 million Euros during June 2009 and further reduced at July 31, 2009 to 0.7 million Euros. We rely on this line of credit to fund working capital needs at LEM. Under the terms of this line of credit, San Paolo may further reduce the line of credit at its discretion.

The current economic environment could also cause lenders and other counterparties who provide us credit to breach their obligations to us, which could include, without limitation, lenders or other financial services companies failing to fund required borrowings under our credit arrangements. Any of the foregoing could adversely impact our business, financial condition or results of operations.

Also, if we require additional financing as a result of the foregoing or other factors, the capital markets turmoil could negatively impact our ability to obtain such financing. Our access to additional financing will depend on a variety of factors (many of which we have little or no control over) such as market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of our long-term or short-term financial prospects.

Fluctuations in foreign currency exchange rates could harm our results of operations.

We sell a majority of our products in transactions denominated in U.S. Dollars; however, we purchase a substantial portion of our products from our manufacturers in transactions denominated in Euros. As a result, weakening of the U.S. Dollar in first half of 2008 increased our cost of sales substantially. If the U.S. Dollar weakens against the Euro again in the future, our cost of sales could further increase. We also are exposed to gains and losses resulting from the effect that fluctuations in foreign currency exchange rates have on the reported results in our consolidated financial statements due to the translation of the operating results and financial position of our Italian subsidiaries Spy Italy and LEM, and due to net sales in Canada. Between January 1, 2008 and August 5, 2009, the Euro exchange rate has ranged from U.S. $1.23 to U.S. $1.60. Between January 1, 2008 and August 5, 2009, the Canadian Dollar exchange rate has ranged from U.S. $0.77 to U.S. $1.03. For the six months ended June 30, 2009 and 2008, we had a net foreign currency gain and a net foreign currency loss of $0.2 million and ($0.2 million), respectively, which represented approximately one percent of our net sales for each period.

The effect of foreign exchange rates on our financial results can be significant. Therefore we have engaged in the past, and may in the future engage in, certain hedging activities to mitigate over time the impact of the translation of foreign currencies on our financial results. Our hedging activities have in the past reduced, but have not eliminated, the effects of foreign currency fluctuations. Factors that could impact the effectiveness of our hedging activities include the volatility of currency markets and the availability of hedging instruments. The degree to which our financial results are affected has depended in part upon the effectiveness or ineffectiveness of our hedging activities. As of June 30, 2009, we were not engaged in any foreign currency hedging activities.

We have a history of significant losses. If we do not achieve or sustain profitability, our financial condition and stock price could suffer.

We have a history of losses and we may continue to incur losses for the foreseeable future. As of June 30, 2009, our accumulated deficit was $33.5 million and, during the six months ended June 30, 2009, we incurred a net loss of $1.1 million. We have not achieved profitability for a full fiscal year since our initial public offering. If we are unable to maintain or grow our revenues, or if we are unable to reduce operating expenses sufficiently, we may not be able to achieve full fiscal year profitability in the near future or at all. Even if we do achieve full fiscal year profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If we are unable to achieve full fiscal year profitability within a short period of time, or at all, or if we are unable to sustain profitability at satisfactory levels, our financial condition and stock price could be adversely affected.

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Our future capital needs are uncertain, and we may need to raise additional funds in the future which may not be available on acceptable terms or at all.

Our capital requirements will depend on many factors, including:

• acceptance of, and demand for our products;

• the costs of developing and selling new products;

• the extent to which we invest in new equipment and product development;

• the number and timing of acquisitions and other strategic transactions;

• the costs associated with the growth of our business, if any; and

• our ability to realize additional savings through streamlining our operations.

Although we believe we have sufficient funds to operate our business over the next twelve months, our existing sources of cash and cash flows may not be sufficient to fund our activities.

As a result, we may need to raise additional funds, and such funds may not be available on favorable terms, or at all, particularly given current economic conditions and the recent turmoil in the capital markets. Furthermore, if we issue equity or convertible debt securities to raise additional funds, our existing stockholders may experience dilution, and the new equity or debt securities may have rights, preferences, and privileges senior to those of our existing stockholders. If we incur additional debt, it may increase our leverage relative to our earnings or to our equity capitalization. If we cannot raise funds on acceptable terms, we may need to scale back our expenditures and we may not be able to develop or enhance our products, execute our business plan, take advantage of future opportunities, or respond to competitive pressures.

If we are unable to continue to develop innovative and stylish products, demand for our products may decrease.

The action sports and youth lifestyle markets are subject to constantly changing consumer preferences based on fashion and performance trends. Our success depends largely on the continued strength of our brand and our ability to continue to introduce innovative and stylish products that are accepted by consumers in our target markets. We must anticipate the rapidly changing preferences of consumers and provide products that appeal to their preferences in a timely manner while preserving the relevancy and authenticity of our brand. Achieving market acceptance for new products may also require substantial marketing and product development efforts and expenditures to create consumer demand. Decisions regarding product designs must be made several months in advance of the time when consumer acceptance can be measured. If we do not continue to develop innovative and stylish products that provide greater performance and design attributes than the products of our competitors and that are accepted by our targeted consumers, we may lose customer loyalty, which could result in a decline in our net sales and market share.

We may not be able to compete effectively, which will cause our net sales and market share to decline.

The action sports and youth lifestyle markets in which we compete are intensely competitive. We compete with sunglass and goggle brands in various niches of the action sports market including Anon Optics, Von Zipper, Electric Visual, Arnette, Oakley, Scott and Smith Optics. We also compete with broader youth lifestyle brands that offer eyewear products, such as Quiksilver, and in the broader fashion sunglass sector of the eyewear market, which is fragmented and highly competitive. We compete with a number of brands in these sectors of the market, including brands such as Armani, Christian Dior, Dolce & Gabbana, Gucci, Prada and Versace. In both markets, we compete primarily on the basis of fashion trends, design, performance, value, quality, brand recognition, marketing and distribution channels.

The purchasing decisions of consumers are highly subjective and can be influenced by many factors, such as marketing programs, product design and brand image. Several of our competitors enjoy substantial competitive advantages, including greater brand recognition, a longer operating history, more comprehensive lines of products and greater financial resources for competitive activities, such as sales and marketing, research and development and strategic acquisitions. Our competitors may enter into business combinations or alliances that strengthen their competitive positions or prevent us from taking advantage of such combinations or alliances. They also may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or consumer preferences.

If our marketing efforts are not effective, our brand may not achieve the broad recognition necessary to our success.

We believe that broader recognition and favorable perception of our brand by persons ranging in age from 17 to 35 is essential to our future success. Accordingly, we intend to continue an aggressive brand strategy through a variety of marketing techniques designed to foster an authentic action sports and youth lifestyle company culture, including athlete sponsorship, sponsorship of surfing, snowboarding, skateboarding, wakeboarding, and motocross events, vehicle marketing, internet and print media, action sports industry relationships, sponsorship of concerts and music festivals and celebrity endorsements. If we are unsuccessful, these expenses may never be offset, and we may be unable to maintain or increase net sales. Successful positioning of our brand depends largely on:

• the success of our advertising and promotional efforts;

• preservation of the relevancy and authenticity of our brand in our target demographic; and

• our ability to continue to provide innovative, stylish and high-quality products to our customers.

To increase brand recognition, we must continue to spend significant amounts of time and resources on advertising and promotions. These expenditures may not result in a sufficient increase in net sales to cover such advertising and promotional expenses. In addition, even if brand recognition increases, our customer base may decline or fail to increase and our net sales may not continue at present levels or may decline.

If we fail to develop new products that are received favorably by our target customer audience, our business may suffer.

We are continuously evaluating potential entries into or expansion of new product offerings. In expanding our product offerings, we intend to leverage our sales and marketing platform and customer base to develop these opportunities. While we have generally been successful promoting our sunglasses and goggles in our target markets, we cannot predict whether we will be successful in gaining market acceptance for any new products that we may develop. In addition, expansion of our business strategy into new product offerings will require us to incur significant sales and marketing expenses. These requirements could strain our management and financial and operational resources. Additional challenges that may affect our ability to expand our product offerings include our ability to:

• increase awareness and popularity of our existing Spy^® brand;

• establish awareness of any new brands we may introduce or acquire;

• increase customer demand for our existing products and establish customer demand for any new product offering;

• attract, acquire and retain customers at a reasonable cost;

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• achieve and maintain a critical mass of customers and orders across all of our product offerings;

• maintain or improve our gross margins; and

• compete effectively in highly competitive markets.

We may not be able to address successfully any or all of these challenges in a manner that will enable us to expand our business in a cost-effective or timely manner. If new products we develop are not received favorably by consumers, our reputation and the value of our brand could be damaged. The lack of market acceptance of new products we develop or our inability to generate satisfactory net sales from any new products to offset their cost could harm our business.

Substantially all of our assets are pledged to secure obligations under our outstanding indebtedness.

Spy U.S. granted a security interest in substantially all of its assets to BFI as security for its obligations under the Loan Agreement. Spy U.S. also established a bank account in BFI’s name into which collections on accounts receivable and other collateral are deposited (the “Collateral Account”). Pursuant to the deposit control account agreement between Spy U.S. and BFI with respect to the Collateral Account, BFI is entitled to sweep all amounts deposited into the Collateral Account and apply the funds to outstanding obligations under the Loan Agreement; provided that BFI is required to distribute to Spy U.S. any amounts remaining after payment of all amounts due under the Loan Agreement. Additionally, Orange 21 Inc. guaranteed Spy U.S.’s obligations under the Loan Agreement and granted BFI a blanket security interest in substantially all of its assets as security for its obligations under its guaranty.

If Spy U.S. defaults on any of its obligations under the Loan Agreement, BFI will be entitled to exercise its remedies under the Loan Agreement and applicable law, which could harm our results of operations and reputation. Specifically, the remedies available to BFI include, without limitation, increasing the applicable interest rate on all amounts outstanding under the Loan Agreement, declaring all amounts under the Loan Agreement immediately due and payable, assuming control of the Collateral Account or any other assets pledged by Spy U.S. or Orange 21 Inc. and directing our customers to make payments directly to BFI. Our results of operations and reputation may be harmed by BFI’s exercise of its remedies.

Our business could be harmed if we fail to maintain proper inventory levels.

We place orders with our manufacturers for some of our products prior to the time we receive orders for these products from our customers. We do this to minimize purchasing costs, the time necessary to fill customer orders and the risk of non-delivery. We also maintain an inventory of selected products that we anticipate will be in high demand. We may be unable to sell the products we have ordered in advance from manufacturers or that we have in our inventory. Inventory levels in excess of customer demand may result in inventory write-downs, and the sale of excess inventory at discounted prices could significantly impair our brand image and harm our operating results and financial condition. Conversely, if we underestimate consumer demand for our products or if our manufacturers fail to supply the quality products that we require at the time we need them, we may experience inventory shortages. Inventory shortages might delay shipments to customers, negatively impact retailer and distributor relationships and diminish brand loyalty, thereby harming our business.

Our manufacturers must be able to continue to procure raw materials and we must continue to receive timely deliveries from our manufacturers to sell our products profitably.

The capacity of our manufacturers, including our subsidiary LEM, to manufacture our products is dependent in substantial part, upon the availability of raw materials used in the fabrication of sunglasses and goggles. Any shortage of raw materials or inability of a manufacturer to manufacture or ship our products in a timely manner, or at all, could impair our ability to ship orders of our products in a timely manner and could cause us to miss the delivery requirements of our customers. As a result, we could experience cancellation of orders, refusal to accept deliveries or a reduction in purchase prices, any of which could harm our net sales, results of operations and reputation. Our manufacturers, including LEM, have experienced in the past, and may experience in the future, shortages of raw materials and other production delays, which have resulted in, and may in the future result in, delays in deliveries of our products of up to several months. In addition, LEM provides manufacturing services to other companies under supply agreements. The inability of LEM and our other suppliers to manufacture and ship products in a timely manner could result in breaches of the agreements with our customers, which could harm our results of operations, reputation and demand for our products.

If we are unable to recruit and retain key personnel necessary to operate our business, our ability to develop and market our products successfully may be harmed.

We are heavily dependent on our current executive officers and management. The loss of any key employee or the inability to attract or retain qualified personnel, including product design and sales and marketing personnel, could delay the development and introduction of, and harm our ability to sell our products and damage our brand. We believe that our future success is significantly dependent on the contributions of A. Stone Douglass, who became our Chief Executive Officer in October 2008 as well as Jerry Collazo, our Chief Financial Officer, and Stefano Lodigiani, our General Manager of LEM and Director of Operations, Italy. The loss of the services of Mr. Douglass, Mr. Collazo or Mr. Lodigiani would be difficult to replace. Our future success may also depend on our ability to attract and retain additional qualified management, design and sales and marketing personnel. We do not currently have key man insurance on Mr. Douglass or Mr. Collazo. We do carry key man life insurance on Mr. Lodigiani for $1.0 million. If our management team is unable to execute on our business strategy, our business may be harmed, which could adversely impact our branding strategy, product development strategy and net sales.

If we are unable to maintain and expand our endorsements by professional athletes, our ability to market and sell our products may be harmed.

A key element of our marketing strategy has been to obtain endorsements from prominent action sports athletes to sell our products and preserve the authenticity of our brand. We generally enter into endorsement contracts with our athletes for terms of one to three years. There can be no assurance that we will be able to maintain our existing relationships with these individuals in the future or that we will be able to attract new athletes or public personalities to endorse our products in order to grow our brand or product categories. Further, we may not select athletes that are sufficiently popular with our target demographics or successful in their respective action sports. Even if we do select successful athletes, we may not be successful in negotiating commercially reasonable terms with those individuals. If we are unable in the future to secure athletes or arrange athlete endorsements of our products on terms we deem to be reasonable, we may be required to modify our marketing platform and to rely more heavily on other forms of marketing and promotion which may not prove to be as effective as endorsements. In addition, negative publicity concerning any of our sponsored athletes could harm our brand and adversely impact our business.

Any interruption or termination of our relationships with our manufacturers could harm our business.

We purchase substantially all of our sunglass products from our wholly owned subsidiary, LEM and over half of our goggle products are manufactured by OGK in China. We expect to continue to manufacture more than half of our goggles through OGK in 2009. We do not have long-term agreements with any of our manufacturers other than LEM or with vendors that supply raw materials to LEM. We cannot be certain that we will not experience difficulties with our manufacturers, such as reductions in the availability of production capacity, errors in complying with product specifications, insufficient quality control, failures to meet production deadlines or increases in manufacturing costs and failures to comply with our requirements for the proper utilization of our intellectual property. Many of our manufacturers have extended credit to us and there can be no assurances that they will continue to do so on commercially reasonable terms or at all. If our relationship with any of our manufacturers is interrupted or terminated for

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any reason, including the failure of any manufacturer to perform its obligations to us, we would need to locate alternative manufacturing sources. The establishment of new manufacturing relationships involves numerous uncertainties, and we may not be able to obtain alternative manufacturing sources in a manner that would enable us to meet our customer orders on a timely basis or on satisfactory commercial terms. If we are required to change any of our major manufacturers, we would likely experience increased costs, substantial disruptions and delays in the manufacture and shipment of our products and a loss of net sales.

Any failure to maintain ongoing sales through our independent sales representatives or maintain our international distributor relationships could harm our business.

We sell our products to retail locations in the United States and internationally through retail locations serviced by us through our direct sales team and a network of independent sales representatives in the United States, and through our international distributors. We rely on these independent sales representatives and distributors to provide customer contacts and market our products directly to our customer base. Our independent sales representatives are not obligated to continue selling our products, and they may terminate their arrangements with us at any time with limited notice. We do not have long-term agreements with all of our international distributors. Our ability to maintain or increase our net sales will depend in large part on our success in developing and maintaining relationships with our independent sales representatives and our international distributors. It is possible that we may not be able to maintain or expand these relationships successfully or secure agreements with additional sales representatives or distributors on commercially reasonable terms, or at all. Any failure to develop and maintain our relationships with our independent sales representatives or our international distributors, and any failure of our independent sales representatives or international distributors to effectively market our products, could harm our net sales.

We face business, political, operational, financial and economic risks because a significant portion of our operations and sales are to customers outside of the United States.

Our European sales and administration operations as well as our primary manufacturers are located in Italy. We are subject to risks inherent in international business, many of which are beyond our control, including:

• difficulties in obtaining domestic and foreign export, import and other governmental approvals, permits and licenses and compliance with foreign laws, including employment laws;

• difficulties in staffing and managing foreign operations, including cultural and regulatory differences in the conduct of business, labor and other workforce requirements;

• transportation delays and difficulties of managing international distribution channels;

• longer payment cycles for, and greater difficulty collecting, accounts receivable;

• ability to finance our foreign operations;

• trade restrictions, higher tariffs or the imposition of additional regulations relating to import or export of our products;

• unexpected changes in regulatory requirements, royalties and withholding taxes that restrict the repatriation of earnings and effect our effective income tax rate due to profits generated or lost in foreign countries;

• political and economic instability, including wars, terrorism, political unrest, boycotts, curtailment of trade and other business restrictions; and

• difficulties in obtaining the protections of the intellectual property laws of other countries.

Any of these factors could reduce our net sales, decrease our gross margins or increase our expenses.

If we fail to secure or protect our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our net sales or increase our costs.

We rely on patent, trademark, copyright, trade secret and trade dress laws to protect our proprietary rights with respect to product designs, product research and trademarks. Our efforts to protect our intellectual property may not be effective and may be challenged by third parties. Despite our efforts, third parties may have violated and may in the future violate our intellectual property rights. In addition, other parties may independently develop similar or competing technologies. If we fail to protect our proprietary rights adequately, our competitors could imitate our products using processes or technologies developed by us and thereby potentially harm our competitive position and our financial condition. We are also susceptible to injury from parallel trade (i.e., gray markets) and counterfeiting of our products, which could harm our reputation for producing high-quality products from premium materials. Infringement claims and lawsuits likely would be expensive to resolve and would require substantial management time and resources. Any adverse determination in litigation could subject us to the loss of our rights to a particular patent, trademark, copyright or trade secret, could require us to obtain licenses from third parties, could prevent us from manufacturing, selling or using certain aspects of our products or could subject us to substantial liability, any of which would harm our results of operations.

Since we sell our products internationally and are dependent on foreign manufacturing in Italy and China, we also are dependent on the laws of foreign countries to protect our intellectual property. These laws may not protect intellectual property rights to the same extent or in the same manner as the laws of the U.S. Although we will continue to devote substantial resources to the establishment and protection of our intellectual property on a worldwide basis, we cannot be certain that these efforts will be successful or that the costs associated with protecting our rights abroad will not be significant. We have been unable to register Spy as a trademark for our products in a few selected markets in which we do business. In addition, although we have filed applications for federal registration, we have no trademark registrations for Spy for our accessory products currently being sold. We may face significant expenses and liability in connection with the protection of our intellectual property rights both inside and outside of the United States and, if we are unable to successfully protect our intellectual property rights or resolve any conflicts, our results of operations may be harmed.

We may be subject to claims by third parties for alleged infringement of their proprietary rights, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.

From time to time, we may receive notices of claims of infringement, misappropriation or misuse of other parties’ proprietary rights. Some of these claims may lead to litigation. Any intellectual property lawsuit, whether or not determined in our favor or settled, could be costly, could harm our reputation and could divert our management from normal business operations. Adverse determinations in litigation could subject us to significant liability and could result in the loss of our proprietary rights. A successful lawsuit against us could also force us to cease sales or to develop redesigned products or brands. In addition, we could be required to seek a license from the holder of the intellectual property to use the infringed technology, and it is possible that we may not be able to obtain a license on reasonable terms, or at all. If we are unable to redesign our products or obtain a license, we may have to discontinue a particular product offering. If we fail to develop a non-infringing technology on a timely basis or to license the infringed technology on acceptable terms, our business, financial condition and results of operations could be harmed.

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If we fail to manage any growth that we might experience, our business could be harmed and we may have to incur significant expenditures to address this growth.

If we experience growth in our operations, our operational and financial systems, procedures and controls may need to be expanded and we may need to train and manage an increasing number of employees, any of which will distract our management team from our business plan and involve increased expenses. Our future success will depend substantially on the ability of our management team to manage any growth effectively. These challenges may include:

• maintaining our cost structure at an appropriate level based on the net sales we generate;

• implementing and improving our operational and financial systems, procedures and controls;

• managing operations in multiple locations and multiple time zones; and

• ensuring the distribution of our products in a timely manner.

We incur significant expenses as a result of being a public company.

We incur significant legal, accounting, insurance and other expenses as a result of being a public company. The Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the SEC and NASDAQ, have required changes in corporate governance practices of public companies. These rules and regulations have, and will continue, to increase our legal and financial compliance costs and make some activities more time-consuming and costly. These rules and regulations have also made, and will continue to make, it more difficult and more expensive for us to obtain director and officer liability insurance.

Our eyewear products and business may subject us to product liability claims or other litigation, which are expensive to defend, distracting to our management and may require us to pay damages.

Due to the nature of our products and the activities in which our products may be used, we may be subject to product liability claims or other litigation, including claims for serious personal injury, breach of contract, shareholder litigation or other litigation. Successful assertion against us of one or a series of large claims could harm our business by causing us to incur legal fees, distracting our management or causing us to pay damage awards.

We could incur substantial costs to comply with foreign environmental laws, and violations of such laws may increase our costs or require us to change certain business practices.

We use numerous chemicals and generate other hazardous by-products in our manufacturing operations. As a result, we are subject to a broad range of foreign environmental laws and regulations. These environmental laws govern, among other things, air emissions, wastewater discharges and the acquisition, handling, use, storage and release of wastes and hazardous substances. Such laws and regulations can be complex and change often. Remediation of chemicals or other hazardous by-products could require substantial resources which could reduce our cash available for operations, consume valuable management time, reduce our profits or impair our financial condition. Contaminants have been detected at some of our present facilities in Italy. We have undertaken to remediate these contaminants. The remediation is expected to cost approximately 425,000 Euros, involves the purchase and installation of new paint booths, and is expected to be completed by September 30, 2009.

In the event we are unable to remedy any deficiency we identify in our system of internal controls over financial reporting, or if our internal controls are not effective, our business and our stock price could suffer.

Under Section 404 of the Sarbanes-Oxley Act, or Section 404, management is required to assess the adequacy of our internal controls, remediate any deficiency that may be identified for which there are no compensating controls in place, validate that controls are functioning as documented and implement a continuous reporting and improvement process for internal controls. As part of this continuous process, we may discover deficiencies that require us to improve our procedures, processes and systems in order to ensure that our internal controls are adequate and effective and that we are in compliance with the requirements of Section 404. If any deficiency we may find from time to time is not adequately addressed, or if we are unable to complete all of our testing and any remediation in time for compliance with the requirements of Section 404 and the SEC rules thereunder, we would be unable to conclude that our internal controls over financial reporting are effective, which could adversely affect investor confidence in our internal controls over financial reporting.

We may not successfully integrate any future acquisitions, which could result in operating difficulties and other harmful consequences.

We expect to consider opportunities to acquire or make investments in other technologies, products and businesses from time to time that could enhance our capabilities, complement our current products or expand the breadth of our markets or customer base, although we have no specific agreements with respect to potential acquisitions or investments. We have limited experience in acquiring other businesses and technologies. Potential and completed acquisitions, including our acquisition of LEM, and strategic investments involve numerous risks, including:

• problems assimilating the purchased technologies, products or business operations;

• problems maintaining uniform standards, procedures, controls and policies;

• unanticipated costs associated with the acquisition;

• diversion of management’s attention from our core business;

• harm to our existing business relationships with manufacturers and customers;

• risks associated with entering new markets in which we have no or limited prior experience; and

• potential loss of key employees of acquired businesses.

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our stockholders would be diluted.

Risks Related to the Market for Our Common Stock

Our stock price may be volatile, and you may not be able to resell our shares at a profit or at all.

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The trading price of our common stock fluctuates due to the factors discussed in this section and elsewhere in this report. For example, between January 1, 2008 and August 4, 2009, our stock has traded as high as $5.00 and as low as $0.55. In addition, the trading market for our common stock may be influenced by the public float that exists in our stock from time to time. For example, although as of August 12, 2009 we have approximately 11.9 million shares outstanding, approximately 8.8 million, which is approximately 74%, of those shares are held by 10 stockholders. If any of those investors were to decide to sell a substantial portion of their respective shares, it would place substantial downward pressure on our stock price. We also have 1,407,250 shares of our common stock reserved for the exercise of outstanding stock options, of which 382,138 were fully vested and exercisable as June 30, 2009. Additionally, in connection with our initial public offering, we issued warrants to purchase up to 147,000 shares of common stock to Roth Capital Partners, LLC, and an affiliate, which are fully vested as of June 30, 2009. All 11,864,327 of our outstanding shares of common stock at August 12, 2009 may be sold in the open market, subject to certain limitations.

The trading market for our common stock also is influenced by the research and reports that industry or securities analysts publish about us or our industry. If one or more of the analysts who cover us were to publish an unfavorable research report or to downgrade our stock, our stock price likely would decline. If one or more of these analysts were to cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.

We may not maintain the listing of our common stock on the NASDAQ Capital Market

Our ability to raise additional capital may be dependent upon our stock being quoted on the NASDAQ Capital Market. In order to maintain our listing on the NASDAQ Capital Market, we will need to regain compliance with certain minimum listing standards, including maintaining a minimum bid price of $1.00 for our common stock. Ordinarily, companies listed on NASDAQ would receive a deficiency notice from NASDAQ if their common stock has traded below the $1.00 minimum bid price for 30 consecutive business days, at which point NASDAQ’s rules provide for a 180 calendar day “grace” period to regain compliance. Due to market conditions, however, on October 16, 2008, NASDAQ announced it was suspending enforcement of the minimum $1.00 closing bid price and market value of publicly held shares requirements. After several extensions of the rules suspensions, enforcement of these rules resumed on Monday, August 3, 2009, and NASDAQ has indicated that there will be no further extensions. If our common stock continues to trade below the $1.00 minimum bid price for 30 consecutive business days following the end of NASDAQ’s enforcement suspension, we would likely receive a deficiency notice. Following receipt of a deficiency notice related to the minimum bid price, we would be afforded the 180 calendar day “grace” period. To regain compliance during this time, our common stock must trade at or over the $1.00 minimum bid price for at least 10 consecutive days. If we were to fail to regain compliance during this grace period, our common stock could be delisted.

If we are delisted, we would expect our common stock to be traded in the over-the-counter market, which could adversely affect the liquidity of our common stock. Additionally, we could face significant material adverse consequences, including:

• a limited availability of market quotations for our common stock;

• a reduced amount of news and analyst coverage for us;

• a decreased ability to issue additional securities or obtain additional financing in the future;

• reduced liquidity for our stockholders;

• potential loss of confidence by collaboration partners and employees; and

• loss of institutional investor interest and fewer business development opportunities.

Fluctuations in our operating results on a quarterly and annual basis could cause the market price of our common stock to decline.

Our operating results fluctuate from quarter to quarter as a result of changes in demand for our products, our effectiveness in managing our suppliers and costs, the timing of the introduction of new products and weather patterns. Historically, we have experienced greater net sales in the second and third quarters of the fiscal year as a result of the seasonality of our products and the markets in which we sell our products, and our first and fourth fiscal quarters have traditionally been our weakest operating quarters due to seasonality. We generally sell more of our sunglass products in the first half of the fiscal year and a majority of our goggle products in the last half of the fiscal year. We anticipate that this seasonal impact on our net sales will continue. As a result, our net sales and operating results have fluctuated significantly from period to period in the past and are likely to do so in the future. These fluctuations could cause the market price of our common stock to decline. You should not rely on period-to-period comparisons of our operating results as an indication of our future performance. In future periods, our net sales and results of operations may be below the expectations of analysts and investors, which could cause the market price of our common stock to decline.

Our expense levels in the future will be based, in large part, on our expectations regarding net sales and based on acquisitions we may complete. Many of our expenses are fixed in the short term or are incurred in advance of anticipated sales. We may not be able to decrease our expenses in a timely manner to offset any shortfall of sales.

Delaware law and our corporate charter contain anti-takeover provisions that could delay or discourage takeover attempts that stockholders may consider favorable.

Provisions in our certificate of incorporation may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:

• the establishment of a classified Board of Directors requiring that not all directors be elected at one time;

• the size of our Board of Directors can be expanded by resolution of our Board of Directors;

• any vacancy on our board can be filled by a resolution of our Board of Directors;

• advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted upon at a stockholders’ meeting;

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• the ability of the Board of Directors to alter our bylaws without obtaining stockholder approval;

• the ability of the Board of Directors to issue and designate the rights of, without stockholder approval, up to 5,000,000 shares of preferred stock, which rights could be senior to those of common stock; and

• the elimination of the right of stockholders to call a special meeting of stockholders and to take action by written consent.

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, or Delaware law. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging, combining or otherwise engaging in a business combination (as such term is defined in the statute), with us. The provisions in our charter and Delaware law could discourage potential takeover attempts and could reduce the price that investors might be willing to pay for shares of our common stock in the future, resulting in the market price being lower than it would be without these provisions.

Our board of directors has recently resolved to make several modifications to our bylaws, and, subject to approval of our stockholders at our upcoming annual meeting, our certificate of incorporation. These changes would affect several of the anti-takeover provisions described above. These changes are described in greater detail in Item 5. Other Information, below, as well as in detail in our Preliminary Proxy Statement for the upcoming annual meeting to be held September 10, 2009 filed with the U.S. Securities and Exchange Commission on its electronic EDGAR database.

Item 5. Other Information

Audit committee member appointed

Effective August 10, 2009, our Board of Directors (“Board”) appointed Seth Hamot to serve as a member of the Board’s Audit Committee to fill the vacancy created by Theodore Roth’s resignation on July 31, 2009.

Mr. Hamot has served on our Board since February 2009. He has served as Managing Member of Roark, Rearden & Hamot Capital Management, LLC (“RRHCM”) since 1997 and was the owner of its corporate predecessor, Roark, Rearden & Hamot, Inc. RRHCM is the investment manager to Costa Brava Partnership III L.P., an investment fund, whose principal business is to make investments in, buy, sell, hold, pledge and assign securities. Mr. Hamot is also President of Roark, Rearden & Hamot LLC, the general partner of Costa Brava. Prior to 1997, Mr. Hamot was one of the partners of the Actionvest entities. Mr. Hamot is currently on the board of directors, compensation committee and is serving as the chairman of the board of directors of TeamTech Global, Inc., (NASDAQ:TEAM) a provider of IT and business processing solutions. Mr. Hamot is also on the board of directors of Telos Corporation, a networking and security products and services provider. Mr. Hamot graduated from Princeton University in 1983 with a degree in Economics.

Amendment to bylaws

On August 10, 2009, our Board approved an amendment and restatement of our bylaws (collectively, the “Amendment”), effective as of the same date. While the Amendment is effective as of August 10, 2009, many of the terms that the Amendment modifies in our bylaws are also set forth in our certificate of incorporation and, under Delaware law to the extent that there are any inconsistencies between our certificate of incorporation and our bylaws, our certificate of incorporation controls. As described in detail in our preliminary proxy statement filed with the SEC on August 10, 2009, at our annual meeting of stockholders scheduled for September 10, 2009, our stockholders are being asked to vote on an amendment and restatement of our certificate of incorporation, which will effect several changes to our certificate of incorporation that are the same as the changes to our bylaws set forth in the Amendment. The amendment and restatement of our certificate of incorporation has already been approved by our Board, subject to approval by our stockholders. If the proposal to amend our certificate of incorporation is not approved by our stockholders, the more restrictive terms of our certificate of incorporation will continue to control over our bylaws.

Pursuant to the Amendment and proposed changes to our certificate of incorporation that have been proposed, our charter and bylaws will be modified to provide, among other things:

• That our Board will no longer be classified and all of our directors will be elected annually;

• That special meetings of the stockholders may be called upon the written request of any stockholder or stockholders holding in the aggregate 20% or more of our voting stock – previously special meetings of our stockholders could only be called by our Chairman of the Board, Chief Executive Officer or a majority of our Board;

• For specific procedures for delivering proxies and other communications electronically;

• That our stockholders may act by written consent on all matters other than (1) electing directors or (2) approving a sale of the Company or substantially all of our assets, a merger, acquisition or consolidation of or by the Company, or any other transaction involving a change in control of the Company – previously our stockholders were not permitted to act by written consent;

• That our stockholders may fill vacancies on our Board at an annual or special meeting – previously the power to fill vacancies was vested solely with our Board; and

• That directors may be removed with or without cause by holders of a majority of our shares entitled to vote on election of directors – previously directors could only be removed for cause.

The foregoing description of the Amendment is only a summary and is qualified in its entirety by the complete text of our newly adopted Amended and Restated Bylaws attached hereto asExhibit 3.4.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Orange 21 Inc.
Date: August 13, 2009	By	/s/ Jerry Collazo
		Jerry Collazo
		Chief Financial Officer

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Item 6. Exhibits

Exhibit Number	Description of Document
3.2	Restated Certificate of Incorporation (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
3.4	Amended and Restated Bylaws
4.1	Form of Common Stock Certificate (incorporated by reference to Form S-1 (File No. 333-119024) declared effective on December 13, 2004)
10.47*	Settlement Agreement and Mutual General Release dated April 28, 2009 by and between the Company, Spy Optic, Inc., Spy S.r.l. and Lem S.r.l., on the one hand, and Mark Simo, Simo Holdings, Inc. (fka No Fear, Inc.), No Fear Retail Stores, Inc. and MX No Fear Europe SAS, on the other hand
10.48	Amendment No. 1 to Orange 21 Inc. Notice of Stock Option Grant and Stock Option Agreement, dated as of May 26, 2009, by and between the Company and A. Stone Douglass
10.49	Amendment No. 1 to Orange 21 Inc. Notice of Stock Option Grant and Stock Option Agreement, dated as of May 26, 2009, by and between the Company and Jerry Collazo
10.50	Amendment No. 2 to Orange 21 Inc. Notice of Stock Option Grant and Stock Option Agreement, dated as of May 26, 2009, by and between the Company and Jerry Collazo
31.1	Section 302 Certification of the Company’s Chief Executive Officer
31.2	Section 302 Certification of the Company’s Chief Financial Officer
32.1	Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)
32.2	Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)

* Portions of the exhibit have been omitted pursuant to a request for confidential treatment.

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