UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: March 31, 2007 -------------------------------------------- [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE EXCHANGE ACT For the transition period from _____ to _____ Commission file number 000-28831 --------------------------------- China Direct Trading Corporation ------------------------------------------------------------------------------- (Exact name of small business issuer as specified in its charter) Florida 84-1047159 - -------------------------------------------------------------------------------- (State or other jurisdiction (IRS Employer of incorporation or organization) Identification No.) 10400 Griffin Road, Suite 109, Cooper City, Florida 33328 ------------------------------------------------------------------------------- (Address of principal executive offices) (954) 252-3440 Issuer's telephone number (Former name, former address and former fiscal year, if changed since last report.) APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDING DURING THE PRECEDING FIVE YEARS Check whether the registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court. Yes [] No [] Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes [ ] No [X ] APPLICABLE ONLY TO CORPORATE ISSUERS State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practical date: March 31, 2007 Approximately 560,865,870 shares Transitional Small Business Disclosure Format (check one). Yes ; No X ---- ----- PART I ITEM 1. FINANCIAL STATEMENTS CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited) March 31, December 31, 2007 2006 ------------------ ------------------ Assets: Current assets: Cash $ 156,537 $ 198,084 Accounts receivable - net 116,400 560,475 Inventory 143,939 69,895 Deposit on inventory - 19,569 Notes receivable from former subsidiary 202,150 202,150 Prepaid expense 17,129 16,162 ------------------ ------------------ Total Current Assets 636,155 1,066,335 ------------------ ------------------ Fixed assets: Computer equipment/software 5,999 5,422 Communications equipment 2,014 2,014 Machinery and equipment 115,364 98,514 Furniture and fixtures 5,665 4,965 Less: Accumulated Depreciation (85,665) (80,571) ------------------ ------------------ Total Fixed Assets 43,377 30,344 ------------------ ------------------ Other non-current assets: Note receivable from former subsidiary - long term 228,329 225,560 Goodwill 1,936,020 1,936,020 Deposits 18,725 16,775 ------------------ ------------------ Total other non-current assets 2,183,074 2,178,355 ------------------ ------------------ Total assets $ 2,862,606 $ 3,275,034 ================== ================== 1 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Continued) (Unaudited) March 31, December 31, 2007 2006 ------------------ ------------------ Liabilities and Stockholders' Deficit: Current Liabilities: Accounts payable and accrued expenses $ 356,422 $ 416,539 Customer deposits 18,235 - Due to related parties 300,000 400,000 Notes and loans payable to related parties - current maturities 496,213 726,759 ------------------ ------------------ Total Current Liabilities 1,170,870 1,543,298 ------------------ ------------------ Long-Term Liabilities: Notes and loans payable to related parties 782,383 767,589 Investor loans payable - 54,038 ------------------ ------------------ Total Long-Term Liabilities 782,383 821,627 ------------------ ------------------ Total Liabilities 1,953,253 2,364,925 ------------------ ------------------ Stockholders' Deficit: Preferred Stock, Series A, par value $.001 per share Authorized 100,000,000 shares, Issued 6,266 shares at March 31, 2007 and 607,000 shares at December 31, 2006 7 607 Preferred Stock, Series B, par value $.10 per share Authorized 100,000,000 shares, Issued 942,030 shares at March 31, 2007 and 1,193,769 shares at December 31, 2006 94,203 119,377 Common Stock, par value $.0001 per share Authorized 600,000,000 shares, Issued 560,865,870 shares at March 31, 2007 and 536,406,750 shares at December 31, 2006 56,087 53,642 Related party receivable - (1,775,864) Additional paid-in capital 2,666,024 4,166,747 Accumulated deficit (1,906,968) (1,654,400) ------------------ ------------------ Total Stockholders' Deficit 909,353 910,109 ------------------ ------------------ Total Liabilities and Stockholders' Deficit $ 2,862,606 $ 3,275,034 ================== ================== See accompanying notes. 2 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) For the Three Months Ended March 31, 2007 2006 ------------------ ------------------ Revenues $ 211,042 $ 169,672 Cost of Sales (138,015) (144,464) ------------------ ------------------ Gross Profit 73,027 25,208 ------------------ ------------------ Operating Expenses: Sales and marketing 13,688 13,583 Compensation 95,615 57,540 Professional fees 47,207 18,221 Consulting 66,875 - Other General and administrative 78,723 29,823 ------------------ ------------------ Total Operating Expenses 302,108 119,167 ------------------ ------------------ Net Operating Income (Loss) (229,081) (93,959) ------------------ ------------------ Other Income (Expense): Miscellaneous income 750 - Interest income 3,267 - Interest expense (27,504) (68) ------------------ ------------------ Total Other Income (Expense) (23,487) (68) ------------------ ------------------ Net Income (Loss) from continuing operations (252,568) (94,027) Discontinued Operations Income (Loss) from discontinued operations - 136,745 ------------------ ------------------ Net Income (Loss) $ (252,568) $ 42,718 ================== ================== Weighted Average Shares Outstanding 543,997,861 543,122,028 ================== ================== Income (Loss) per Common Share Continuing operations $ - $ - Discontinued operations - - ------------------ ------------------ Net Income (Loss) $ - $ - ================== ================== See accompanying notes. 3 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the Three Months Ended March 31, 2007 2006 ------------------ ----------------- CASH FLOWS FROM OPERATING ACTIVITIES: Continuing operations: Net Income (Loss) $ (252,568) $ 42,718 Adjustments necessary to reconcile net loss to net cash used in operating activities: Income from discontinued operations - (136,745) Stock issued for accrued expenses 106,813 - Stock issued for expenses 75,000 - Depreciation 5,094 - (Increase) decrease in advances - - (Increase) decrease in accounts receivable 444,075 - (Increase) decrease in inventory (54,475) - (Increase) decrease in prepaids (967) - (Increase) decrease in deposits (1,950) - (Increase) decrease in interest receivable (2,769) - Increase (decrease) in accounts payable & accrued expenses (60,117) 50,126 Increase (decrease) in due to/from related parties (100,000) - Increase (decrease) in accrued interest on notes payable 17,184 - Increase (decrease) in deposits from customers 18,235 - ------------------ ----------------- Net Cash Used in continuing operations 193,555 (43,901) Net Cash Used in discontinued operations - (765,152) ------------------ ----------------- Net Cash Used in operating activities 193,555 (809,053) ------------------ ----------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of fixed assets (18,127) - ------------------ ----------------- Net cash provided by (used in) continuing activities (18,127) - Net cash provided by (used in) discontinued activities - (306,112) ------------------------------------- Net cash provided by (used in) investing activities (18,127) (306,112) ------------------ ----------------- 4 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (Unaudited) For the Three Months Ended March 31, 2007 2006 ------------------ ----------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from sale of stock 5,000 - Payments on notes payable to related parties (221,975) - Cash acquired in acquisition - - Proceeds from loans - 60,000 ------------------ ----------------- Net cash provided by (used in) continuing activities (216,975) 60,000 Net cash provided by (used in) discontinued activities - 1,693,570 ------------------ ----------------- (216,975) 1,753,570 ------------------ ----------------- Net (Decrease) Increase in cash and cash equivalents (41,547) 638,405 Cash and Cash Equivalents at beginning of period 198,084 9,090 ------------------ ----------------- Cash and Cash Equivalents at end of period $ 156,537 $ 647,495 ================== ================= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 27,504 $ 68 Franchise and income taxes $ - $ - SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: On February 21, 2007, the Company issued 468,750 shares of common stock for notes payable of $15,000 and accrued interest of $1,761. On March 16, 2007, the Company issued 1,835,050 shares of common stock for investor loans payable of $50,000 and accrued interest of $5,052. See accompanying notes. 5 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES This summary of accounting policies for China Direct Trading Corporation and Subsidiaries is presented to assist in understanding the Company's financial statements. The accounting policies conform to generally accepted accounting principles and have been consistently applied in the preparation of the financial statements. The unaudited financial statements as of March 31, 2007 and for the three month periods ended March 31, 2007 and 2006 reflect, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to fairly state the financial position and results of operations for the three months. Operating results for interim periods are not necessarily indicative of the results which can be expected for full years. ORGANIZATION AND BASIS OF PRESENTATION China Direct Trading Corporation (formerly "CBQ, Inc."), a Florida corporation, was initially incorporated September 18, 1986 under the laws of the State of Delaware under the name "Yorkshire Leveraged Group, Incorporated", and then changed its situs to Colorado in 1989 by merging into a Colorado corporation, named "Freedom Funding, Inc." Freedom Funding, Inc. then changed its name to "CBQ, Inc." by amendment of its Articles of Incorporation on November 25, 1998. In May 2004, the Company changed its name to China Direct Trading Corporation and reincorporated from the State of Colorado to the State of Florida. Souvenir Direct, Inc. was incorporated on September 9, 2002 under the laws of the State of Florida. On December 1, 2003, China Direct Trading Corporation issued 97 million shares common stock to acquire 100% of the outstanding common stock of Souvenir Direct, Inc. in a reverse acquisition. At this time, a new reporting entity was created. Souvenir Direct, Inc. is considered the reporting entity for financial reporting purposes. Also on December 1, 2003, an additional 414,628,300 shares of common stock were issued to the previous owners of CBQ, Inc. In February 2004, the Company established a new subsidiary, China Pathfinder Fund, LLC, a Florida limited liability company. During 2005, the name was changed to Overseas Building Supply, LLC to reflect its shift in business lines from business development to trading Chinese- made building supplies. On January 27, 2006, the Company entered into a Purchase Agreement with Complete Power Solutions ("CPS") to acquire 51% of the member interests of CPS. CPS was organized by William Dato on September 20, 2004, as a Florida limited liability company to distribute power generators in Florida and adjacent states. The Company subsequently sold its 51% membership interest in CPS, pursuant to a Purchase and Settlement Agreement dated and effective as of December 31, 2006. On September 13, 2006 the Company entered into a Stock Purchase Agreement with Capstone Industries, Inc., a Florida corporation (Capstone). Capstone was incorporated in Florida on May 15, 1996 and is engaged primarily in the business of wholesaling novelties to retailers in the United States. NATURE OF BUSINESS The Company is engaged in the business of marketing and selling novelty, gift, and promotional items, and, with the acquisition of Capstone on September 13, 2006, the sale of portable booklights in North America. The items are typically manufactured in the People's Republic of China by third-party contract manufacturing companies. During the period that the Company owned a 51% interest in CPS (January 27, 2006 through December 31, 2006), the Company, through CPS, engaged in the business of power generators in Florida and adjacent states. 6 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CASH AND CASH EQUIVALENTS The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents, to the extent the funds are not being held for investment purposes. ALLOWANCE FOR DOUBTFUL ACCOUNTS An allowance for doubtful accounts is established as losses are estimated to have occurred through a provision for bad debts charged to earnings. The allowance for bad debt is evaluated on a regular basis by management and is based on upon management's periodic review of the collectibility of the receivables. This evaluation in inherently subjective and requires estimated that are susceptible to significant revisions as more information becomes available. As of March 31, 2007, management has determined that the accounts receivable are fully collectible. As such, management has not recorded an allowance for doubtful accounts. INVENTORY The Company's inventory, which is recorded at the lower of cost (first-in, first-out) or market, consists of finished goods for resale by Capstone, totaling $143,939 at March 31, 2007 and $69,895 as of December 31, 2006. In addition, Overseas Building Supplies had deposits on inventory of $19,569, representing payments made for inventory not received by the Company as of December 31, 2006. PROPERTY AND EQUIPMENT Fixed assets are stated at cost. Depreciation and amortization are computed using the straight- line method over the estimated economic useful lives of the related assets as follows: Computer equipment 3 - 7 years Computer software 3 - 7 years Machinery and equipment 3 - 7 years Furniture and fixtures 3 - 7 years The Company follows FASB Statement No. 144 (SFAS 144), "Accounting for the Impairment of Long-Lived Assets." SFAS 144 requires that long-lived assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the related carrying amount may not be recoverable. When required, impairment losses on assets to be held and used are recognized based on the fair value of the asset. Long-lived assets to be disposed of, if any, are reported at the lower of carrying amount or fair value less cost to sell. No impairments were recognized by the Company during 2006. Upon sale or other disposition of property and equipment, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is included in the determination of income or loss. Expenditures for maintenance and repairs are charged to expense as incurred. Major overhauls and betterments are capitalized and depreciated over their estimated economic useful lives. Depreciation expense was $5,095 and $3,450 for the three months ended March 31, 2007 and 2006, respectively. 7 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill and other intangible assets are recorded under the provisions of the Financial Accounting Standards Board (FASB) Statement No.142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 requires that an intangible asset that is acquired either individually or with a group of other assets (but not those acquired in a business combination) shall be initially recognized and measured based on its fair value. Goodwill acquired in business combinations is initially computed as the amount paid by the acquiring company in excess of the fair value of the net assets acquired. Costs of internally developing, maintaining and restoring intangible assets (including goodwill) that are not specifically identifiable, that have indeterminate lives, or that are inherent in a continuing business and related to an entity as a whole, are recognized as an expense when incurred. An intangible asset (excluding goodwill) with a definite useful life is amortized; an intangible asset with an indefinite useful life is not amortized until its useful life is determined to be no longer indefinite. The remaining useful lives of intangible assets not being amortized are evaluated at least annually to determine whether events and circumstance continue to support an indefinite useful life. If and when an intangible asset is determined to no longer have an indefinite useful life, the asset shall then be amortized prospectively over its estimated remaining useful life and accounted for in the same manner as other intangibles that are subject to amortization. An intangible asset (including goodwill) that is not subject to amortization shall be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of the intangible assets with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess. In accordance with SFAS 142, goodwill is not amortized. It is the Company's policy to test for impairment no less than annually, or when conditions occur that may indicate an impairment. The Company's intangible assets, which consist of goodwill of $1,936,020 recorded in connection with the Capstone acquisition, were tested for impairment and determined that no adjustment for impairment was necessary as of March 31, 2007, whereas the fair value of the intangible asset exceeds its carrying amount, In addition, the Company initially recorded goodwill of $1,567,214 in connection with the CPS acquisition. Effective December 31, 2006, the Company disposed of its interest in CPS and, accordingly, wrote off this amount, which is included in the loss from discontinued operations on the consolidated statement of income (loss). NET INCOME (LOSS) PER COMMON SHARE Basic earnings per common share were computed by dividing net loss by the weighted average number of shares of common stock outstanding during the year. In periods where losses are reported, the weighted average number of common shares outstanding excludes common stock equivalents because their inclusion would be anti-dilutive. Diluted loss per common share for the years ended December 31, 2006 and 2005 are not presented as it would be anti-dilutive. At December 31, 2006 and 2005, the total number of potentially dilutive common stock equivalents was 85,748,980 and 7,060,000, respectively. PRINCIPLES OF CONSOLIDATION The consolidated financial statements for the three months ended March 31, 2007 and 2006 include the accounts of the parent entity and its wholly-owned subsidiaries Souvenir Direct, Inc., Overseas Building Supply, LLC (formerly China Pathfinder Fund, LLC), and Capstone Industries, Inc. 8 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The results of operations attributable to Capstone are included in the consolidated results of operating beginning on September 13, 2006, the date on which the Company's interest in Capstone was acquired. The results of operations attributable to the Company's interest in its former subsidiary, CPS, for the period of time in which majority interest in CPS was held by the Company (January 27, 2006 through December 31, 2006) are included in the loss from discontinued operations on the consolidated statement of income (loss). All significant intercompany balances and transactions have been eliminated. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying value of the Company's financial instruments, including accounts payable and accrued liabilities at March 31, 2007 and December 31, 2006 approximates their fair values due to the short-term nature of these financial instruments. RECLASSIFICATIONS Certain reclassifications have been made in the 2006 financial statements to conform with the 2007 presentation. There were no material changes in classifications made to previously issued financial statements. REVENUE RECOGNITION Product Sales are recognized when an agreement of sale exists, product delivery has occurred, pricing is final or determinable, and collection is reasonably assured. Allowances for sales returns, rebates and discounts are recorded as a component of net sales in the period the allowances are recognized. In addition, accrued liabilities contained in the accompanying balance sheet include accruals for estimated amounts of credits to be issued in future years based on potentially defective product, other product returns and various allowances. These estimates could change significantly in the near term. ADVERTISING AND PROMOTION Advertising and promotion costs, including advertising, public relations, and trade show expenses, are expensed as incurred. Advertising and promotion expense was $13,688 and $91,786 for the three months ended March 31, 2007 and 2006, respectively. SHIPPING AND HANDLING The Company's shipping and handling costs, incurred by Capstone, are included in selling expenses and amounted to $2,220 for the three months ended March 31, 2007. INCOME TAXES The Company accounts for income taxes under the provisions of Financial Accounting Standards Board (FASB) Statement No. 109 (SFAS 109), "Accounting for Income Taxes." SFAS 109 requires recognition of deferred income tax assets and liabilities for the expected future income tax consequences, based on enacted tax laws, of temporary differences between the financial reporting and tax bases of assets and liabilities. The Company and its subsidiaries intend to file consolidated income tax returns 9 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) STOCK-BASED COMPENSATION On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payments, SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options, based on estimated fair values. SFAS 123(R) supersedes the Company's previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations, applied for periods through December 31, 2005. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). The Company has applied the provision of SAB 107 in its adoption of SFAS 123(R). The Company adopted SFAS 123(R) using the modified prospective application transition method, which requires the application of the accounting standard as of January 1, 2006, the first date of the Company's fiscal year. The Company's consolidated financial statements as of and for the year ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective method, the Company's consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of the grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expenses over the requisite service periods in the Company's consolidated statements of income (loss). Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25, as allowed under SFAS No. 123, Accounting for Stock-Based Compensation, (SFAS 123). Under the intrinsic value method, compensation expense under fixed term option plans was recorded at the date of grant only to the extent that the market value of the underlying stock at the date of grant exceeded the exercise price. Accordingly, for those stock options granted for which the exercise price equaled the fair market value of the underlying stock at the date of grant, no expense was recorded. Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. There was no stock-based compensation expense attributable to options for the three months ended March 31, 2007 and 2006 for compensation expense for share-based payment awards granted prior to, but not vested as of December 31, 2005. Such stock-based compensation is based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123. Compensation expense for share-based payment awards granted subsequent to December 31, 2005 are based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), the Company adopted the straight-line single option method of attributing the value of stock-based compensation expense. As stock-based compensation expense is recognized during the period is based on awards ultimately expected to vest, it is subject to reduction for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. As of and for the three months ended March 31, 2007, there were no material amounts subject to forfeiture. The Company has not accelerated vesting terms of its out-of-the-money stock options, or made any other significant changes, prior to adopting FASB 123(R), Share-Based Payments. The Company recognizes compensation expense paid with common stock and other equity instruments issued for assets and services received based upon the fair value of the assets/services or the equity instruments issued, whichever is more readily determined. 10 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) As of the date of this report the Company has not adopted a method to account for the tax effects of stock-based compensation pursuant to SFAS 123(R) and related interpretations. However, whereas the Company has substantial net operating losses to offset future taxable income and its current deferred tax asset is completely reduced by the valuation allowance, no material tax effects are anticipated. During the year ended December 31, 2005, the Company valued stock options using the intrinsic value method prescribed by APB 25. Since the exercise price of stock options previously issued was greater than or equal to the market price on grant date, no compensation expense was recognized. STOCK-BASED COMPENSATION EXPENSE Stock-based compensation expense for the three months ended March 31, 2007 included $75,000, consisting of $25,000 included in employee compensation and $50,000 for consulting fees. Stock-based compensation expense for the three months ended March 31, 2006 was $0. RECENT ACCOUNTING STANDARDS In September 2006, the FASB issued SFAS No. 157, "Accounting for Fair Value Measurements." SFAS No. 157 defines fair value, and establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosure about fair value measurements. SFAS No. 157 is effective for the Company for financial statements issued subsequent to November 15, 2007. The Company does not expect the new standard to have any material impact on the financial position and results of operations. In September 2006, the staff of the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 ("SAB 108") which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 becomes effective in fiscal 2007. Management is evaluating the financial impact of this pronouncement. In December 2006, the FASB approved FASB Staff Position (FSP) No. EITF 00-19-2, "Accounting for Registration Payment Arrangements" ("FSP EITF 00-19-2"), which specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, "Accounting for Contingencies". FSP EITF 00-19-2 also requires additional disclosure regarding the nature of any registration payment arrangements, alternative settlement methods, the maximum potential amount of consideration and the current carrying amount of the liability, if any. The guidance in FSP EITF 00-19-2 amends FASB Statements No. 133, "Accounting for Derivative Instruments and Hedging Activities", and No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity", and FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure requirement for Guarantees, Including Indirect Guarantees of Indebtedness of Others", to include scope exceptions for registration payment arrangements. FSP EITF 00-19-2 is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to the issuance date of this FSP, or for financial statements issued for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years, for registration payment arrangements entered into prior to the issuance date of this FSP. The adoption of this pronouncement is not expected to have any material impact on the Company's financial position, results of operations or cash flows. 11 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In October 2005, the FASB issued FSP FAS 123(R)-2, "Practical Accommodation to the Application of Grant Date as Defied in FASB Statement No. 123(R)", which provides clarification of the concept of mutual understanding between employer and employee with respect to the grant date of a share-based payment award. This FSP provides that a mutual understanding of the key terms and conditions of an NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) award shall be presumed to exist on the date the award is approved by management if the recipient does not have the ability to negotiate the key terms and conditions of the award and those key terms and conditions will be communicated to the individual recipient within a relatively short time period after the date of approval. This guidance was applicable upon the initial adoption of SFAS 123(R). The adoption of this pronouncement did not have an impact on the Company's financial position, results of operations, or cash flows. In February 2007, the FASB issued SFAS no, 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"). SFAS 159 provides companies with an option to report selected financials assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. Generally accepted accounting principles have required different measurement attributes for different assets and liabilities that can create artificial volatility in earnings. The FASB has indicated it believes that SFAS 159 helps to mitigate this type of accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS 157 and SFA No. 107, "Disclosures about Fair Value of Financial Instruments." SFAS 159 is effective for the Company as of the beginning of fiscal year 2009. The adoption of this pronouncement is not expected to have an impact on the Company's financial position, results of operations or cash flows. PERVASIVENESS OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and the differences could be material. NOTE 2 - CONCENTRATIONS OF CREDIT RISK AND ECONOMIC DEPENDENCE Financial instruments that potentially subject the Company to credit risk consist principally of cash and cash equivalents and accounts receivable. The Company has no significant off-balance-sheet concentrations of credit risk such as foreign exchange contracts, options contracts or other foreign hedging arrangements. CASH AND CASH EQUIVALENTS The Company at times has cash and cash equivalents with its financial institution in excess of Federal Deposit Insurance Corporation (FDIC) insurance limits. The Company places in cash and cash equivalents with high credit quality financial institution which minimize these risks. As of March 31, 2007, the Company [Capstone] has cash in excess of FDIC limits of approximately $56,000. ACCOUNTS RECEIVABLE The Company grants credit to its customers, substantially all of whom are retail establishments located throughout the United States. The Company typically does not require collateral from customers. Credit risk is limited due to the financial strength of the customers comprising the Company's customer base and 12 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - CONCENTRATIONS OF CREDIT RISK AND ECONOMIC DEPENDENCE (CONTINUED) their dispersion across difference geographical regions. The Company monitors exposure of credit losses and maintains allowances for anticipated losses considered necessary under the circumstances. MAJOR CUSTOMERS During the years ended December 31, 2006 and 2005, the Company received approximately 49% and 40% respectively, of its gross revenues from its top three customers. The loss of these customers would adversely impact the business of the Company. During the years ended December 31, 2006 Capstone received approximately 71% of its gross revenues from its top two customers. As of December 31, 2006, approximately 68% (or $440,386) of the Company's accounts receivable were from these two customers. The loss of these customers would adversely impact the business of the Company. MAJOR SUPPLIERS The Company's major suppliers are from the People's Republic of China and to a lesser extent a variety of Pacific Rim countries. The Company relies on 30 manufacturing concerns in China for its products. The loss of these Chinese manufacturing sources would adversely impact on the business of the Company. In addition, Capstone has certain vendors from which it purchased at least ten percent of merchandise during 2006. During the year ended December 31, 2006, the Capstone purchased approximately 96% of its merchandise for two suppliers (one at 86% and another at $10%). The loss of these suppliers would adversely impact the business of the Company. NOTE 3 - DUE TO RELATED PARTIES During 2003 and 2004, a former officer of the Company paid $300,000 to settle a previously filed lawsuit on behalf of the Company. This $300,000 has been included in due related parties at March 31, 2007 and December 31, 2006. Also included in due to related parties, as of December 31, 2006, is accrued but unpaid officer's compensation of $100,000, payable to the Company's CEO. During the three months ended March 31, 2007, the $100,000 accrued compensation was converted into 3,031,000 shares of common stock. NOTE 4 - NOTES AND LOANS PAYABLE TO RELATED PARTIES OVERSEAS BUILDING SUPPLY - NOTES PAYABLE TO SHAREHOLDERS On September 1, 2004, Overseas Building Supplies, LLC (f/k/a China Pathfinder Fund, LLC), a wholly-owned subsidiary of the Company, executed notes payable of $15,000 to three shareholders of the Company, including $5,000 to CEO. The notes carry an interest rate of 5% per annum and are payable in twelve equal monthly installments with the first installment due and payable on January 31, 2006. As of December 31, 2006, the total amounts due on these loans was $16,761, including accrued interest. During the three months ended March 31, 2007, these notes were converted into 468,750 shares of common stock. 13 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 - NOTES AND LOANS PAYABLE TO RELATED PARTIES (CONTINUED) CHINA DIRECT - NOTES PAYABLE TO CHIEF EXECUTIVE OFFICER On June 29, 2006, the Company executed a $250,000 note payable to the CEO of the Company. The note carries an interest rate of 7% per annum and is payable if full, with accrued interest, on June 30, 2007. The proceeds from this note were used to advanced funds to CPS. As of December 31, 2006, the total amount payable on the note was $258,750, including $8,750 of accrued interest. As of March 31, 2007, the total amount payable on the note was $263,125, including $13,125 of accrued interest. The Company may, at its option, pay the entire unpaid principal and accrued interest (but not less than the entire amount) with restricted shares (Rule 144) of Company common stock. However, the Company may not pay off the principal and accrued interest with shares of common stock, if such issuance would cause the Company to issue a number of shares that would equal or exceed 18% of the shares of stock issued and outstanding as of the conversion date. The value of each share of stock to be issued in the conversion of stock for debt shall be $.10 per share. On September 15, 2006, the Company executed a $750,000 promissory note payable to the CEO of the Company, secured by the accounts receivable of the note holder. The note carries an interest rate of 8% per annum. Interest is payable each calendar quarter, commencing with the quarter ended December 31, 2006. All principal is payable if full, with accrued interest, on December 31, 2008. At the option of the note holder, any quarterly interest or the principal may be paid in cash or in shares of the Company's common stock or a combination of cash or shares. Any shares issued shall have a value of $ .08 per share for purposes of calculating the amount of principal or interest paid by the issuance of each share. The proceeds from this note were used to funds to Capstone acquisition. As of December 31, 2006, the total amount payable on the note was $767,589, including $17,589 of accrued interest. As of March 31, 2007, the total amount payable on the note was $782,383, including $32,383 of accrued interest. The carrying amount of the collateral, the Company's accounts receivable at March 31, 2007 and December 31, 2006 was $116,400 and $560,475, respectively. OVERSEAS BUILDING SUPPLIES - NOTES PAYABLE TO CHIEF EXECUTIVE OFFICER On December 14, 2006, Overseas Building Supply received proceeds from a note payable of $2,500 to the CEO. The note carries an interest rate of 8% per annum and is due on demand. At March 31, 2007 and December 31, 2006, the total amount due on this loan was $2,560 and $2,510, respectively. CHINA DIRECT AND SOUVENIR DIRECT - LOANS PAYABLE TO CHIEF EXECUTIVE OFFICER In addition, during the period from August 24, 2006 through November 30, 2006, the CEO made loans to the Company totaling $490,000, including $10,000 to the Company's wholly owned subsidiary, Souvenir Direct, Inc. The loans carry interest of 8% and are payable on demand. In November 2006, the Company repaid $50,000 of this amount. As of December 31, 2006, the total amount payable on these loans was $448,738, including $8,738 of accrued interest. At March 31, 2007, the total amount payable on these loans was $230,528, including $12,503 of accrued interest. Based on the above, the total amount payable to the CEO as of March 31, 2007 and December 31, 2006 was $1,278,596 and $1,494,348, respectively, including accrued interest of $58,071 and $36,848, respectively. 14 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 - NOTES AND LOANS PAYABLE TO RELATED PARTIES (CONTINUED) The maturities under the notes and loans payable to related parties for the next five years are: Year Ended December 31, - ------------------------------------------- 2007 $ 496,213 2008 782,383 2009 - 2010 - 2011 - -------------- Total future maturities $ 1,278,596 ============== NOTE 5 - INVESTOR LOANS PAYABLE In March, 2006, the Company executed notes payable to an investor of $25,500 and $24,500, totaling $50,000. The notes carry an interest rate of 10% per annum and are payable if full, with accrued interest, in March 2008. The notes are secured by shares of the Company's common stock and convertible into the Company's common stock. As of December 31, 2006, the total amount payable on the notes was $54,038, including $4,038 of accrued interest. Interest shall be payable, at the option of the note holder, in cash or in shares of the Company's common stock. The number of common shares to be issued as payment of accrued and unpaid interest shall be determined by dividing the total amount of accrued and unpaid interest to be converted in common stock by the Conversion Price. The Note shall be convertible (in whole or in part), at the option of the note holder, into a number of fully paid and non-assessable shares of common stock, by dividing that portion of the outstanding principal balance plus any accrued but unpaid interest as of the conversion date by the Conversion Price. The Conversion Price shall mean a price no lower than $ .03 and higher than $ ..04 which will be the average of the closing bid price (adjusted for stock splits, combinations, certain dividends and distributions, reclassification, exchange or substitution, reorganization, merger, consolidation or sales of asses, issuances of additional shares of common stock, and issuance of common stock equivalents) for ten days trading preceding the conversion date. In March 2007, the note holders elected to convert the notes payable and accrued interest, totaling $55,052, into a total of 1,835,050 shares of the Company's common stock, at a conversion price of $ .03 per share. NOTE 6 - LEASES On September 1, 2005, the Company entered into a lease agreement for approximately 1,200 square feet of office space. The lease requires monthly lease payments of $1,775. The lease expired August 31, 2006 and, through the date of this report, the Company is leasing the space on a month-to-month basis, in anticipation of moving to larger offices and showrooms. The current office space is used as the corporate headquarters. It is located at 10400 Griffin Road, Suite 109, Cooper City, Florida 33328. The Company also rents a storage facility on a month-to-month basis. Monthly rentals for the storage facility are approximately $150. Capstone's operating facility was leased by a company that is 100% owned by the former sole shareholder. Rental expense under these leases was approximately $5,645 and $6,000 for the three months ended March 31, 2007 and 2006, respectively. 15 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7 - COMMITMENTS EMPLOYMENT AGREEMENTS On December 1, 2003, the Company entered into an employment agreement with Howard Ullman, the Company's President and CEO that provides for annual compensation of $200,000. For 2006 and 2007, Mr. Ullman has agreed to reduce his compensation to $100,000. As of December 31, 2006 and through the date of this report, such compensation has been accrued but unpaid. On January 27, 2006, the Company entered into an employment agreement with William Dato, the President of CPS, the Company's formerly majority-owned subsidiary, which provided for annual compensation of $100,000. Upon the sale of the Company's interest in CPS, the employment agreement was terminated. LICENSE AGREEMENT Capstone entered into a marketing agreement for design and marketing services. These agreements call for royalty payments to be paid either at fixed periodic amounts or at varying rates, based on sales volume of specified products. Capstone did not renew the royalty agreement in 2006 and did not incur royalty expense for the year ended December 31, 2006. LINE OF CREDIT Capstone had a line of credit with a financial institution, with an available limit of $300,000 during 2005 and a portion of 2006. As of December 31, 2006 and 2005, Capstone did not have an outstanding balance related to the line of credit. Capstone terminated the line effective October 18, 2006 NOTE 8 - STOCK TRANSACTIONS COMMON STOCK In June, 2006, 1,000 shares of the company's series "A" preferred stock, beneficially owned by the Company's CEO, were exchanged for 1,000,000 shares of the Company's common stock. In June 2006, the Company issued 500,000 shares of common stock for compensation valued at $37,500. In June 2006, the Company issued 834,722 shares of common stock for consulting fees and professional services valued at $25,111. In July 2006, the Company issued 250,000 shares of common stock for consulting fees valued at $8,750. In July 2006, options were exercised for 4,000,000 shares of the Company's common stock for $72,000. In August 2006. the Company issued 250,000 shares of common stock for legal fees valued at $25,250. In September 2006, the Company issued 5,000,000 shares of common stock for accrued directors fees valued at $175,000. In September 2006, 800,000 shares of the Company's common stock were returned to the treasury and cancelled. In September 2006 options were exercised for 25,000 shares of the Company's common stock for $1,150. In September 2006, 20,000,000 shares of the Company's common stock held by the Company's CEO were exchanged for 300,300 shares of the Company's series "B" preferred stock. 16 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8 - STOCK TRANSACTIONS (CONTINUED) In October 2006, options were exercised by the Company's CEO for 1,975,000 shares of the company's common stock for $9,875. In October 2006, the Company issued 250,000 shares of common stock for consulting fees valued at $11,750. In February 2007, the Company issued 1,428,571 shares of common stock for consulting fees valued at $50,000. The shares were valued at $.035 per share. In February 2007, the Company issued 250,000 shares of common stock for cash of $5,000. In February 2007, the Company issued 468,750 shares of common stock for notes payable totaling $16,761. In March 2007, the Company issued 3,031,000 shares of common stock for accrued compensation of $100,000. In March 2007, the Company issued 757,575 shares of common stock for officers compensation valued at $25,000. The shares were valued at $.033 per share. In March 2007, the Company issued 1,835,050 shares of common stock for investor loans payable totaling $55,051. For issuances of shares of common stock during the periods described above, the Company issued restricted shares (Rule 144). The shares issued were valued by the Company based upon the closing price of the shares on the date of issuance. The value of these shares issued for services was charged to expense, unless they were in consideration for future services, in which case they were recorded as deferred consulting fees. Shares retired / cancelled were recorded at par value. SERIES "A" PREFERRED STOCK A total of 8,100 shares of series "A" preferred stock were issued in 2004, and, in May 2005, 100 shares were returned to the treasury and cancelled. In January 2006 the Company issued 600,000 shares of series "A" preferred stock, convertible into 50,738,958 shares of the Company's common stock, in connection with the acquisition of a 51% majority interest in CPS. The shares were valued at $1,200,000. In January 2007 (effective December 31, 2006), the 600,000 shares of series "A" convertible preferred issued to CPS were returned to the treasury and cancelled, in connection with the Company's sale of its interest in CPS. The shares were valued at $1,775,864. None of the preferred shares were converted to common shares. At December 31, 2006, the shares had not been returned, and a related party receivable of $1,775,864 was recorded. During the three months ended March 31, 2007, these shares were returned to the treasury and cancelled. In June, 2006, 1,000 shares of the company's series "A" preferred stock, beneficially owned by the Company's CEO, were exchanged for 1,000,000 shares of the Company's common stock. In February 2007, 734 shares of the Company's series "A" preferred stock were exchanged for 73,400 shares of the Company's common stock. As of March 31, 2007, a total of 6,266 shares of series "A" preferred stock were issued and outstanding, and are convertible into common shares, at a rate of 1,000 shares of common stock for each share of series "A" preferred stock and are redeemable at the option of the Company. 17 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8 - STOCK TRANSACTIONS (CONTINUED) SERIES "B" PREFERRED STOCK In January 2006 the Company sold 657,000 shares of its series "B" preferred stock for cash of $637,000, including 387,000 shares to the Company's CEO and the remaining shares to other directors of the Company. During the three months ended March 31, 2007, 15,000 shares of the Company's series "B" preferred shares issued to a director were exchanged for 990,000 shares of the Company's common stock. In September 2006 the Company issued 300,030 shares of its series "B" preferred stock to the Company's CEO in exchange for 20,000,000 shares of its common stock held by the CEO. In September, 2006 the Company issued an additional 236,739 shares of its series "B" preferred stock in connection with the acquisition of 100% of the voting interest of Capstone Industries, Inc. The shares were valued at $1,250,000. During the three months ended March 31, 2007, 236,739 shares of the Company's series "B" preferred stock was converted into 15,624,774 shares of the Company's common stock. The series "B" preferred shares are convertible into common shares, at a rate of 66.66 shares of common stock for each share of series "B" preferred stock. WARRANTS The Company has issued stock warrants to its officers and directors for a total of 5,975,000 shares of the Company's common stock. The warrants expire between November 11, 2011 and July 20, 2014. The warrants have an exercise price of $.03 to $.05. The Company issued a stock warrant to each of two former officers of the Company in December 2003 for a total of 35,000 shares of the Company's common stock. Each of the stock warrants expires on July 20, 2014,and entitles each former officer to purchase 10,000 and 25,000 shares, respectively, of the Company's common stock at an exercise price of $0.05. The Company issued a stock warrant for 50,000,000 shares of common stock to Dutchess Private Equities Fund, II, L.P. ("Dutchess"), as part of an investment agreement between Dutchess and the Company. As part of the agreement, Dutchess was to invest up to $2,500,000 to purchase the Company's common stock. The warrant was to expire August 3, 2014. On February 16, 2005, the Company and Dutchess agreed to postpone the implementation of the foregoing financing arrangement. As of the date of this report, the Company and Dutchess have agreed not to proceed with this financing arrangement and the aforementioned warrant has been cancelled. OPTIONS In 2005, the Company authorized the 2005 Equity Plan that made available 10,000,000 shares of common stock for issuance through awards of options, restricted stock, stock bonuses, stock appreciation rights and restricted stock units. On May 20, 2005 the Company granted non-qualified stock options under the company's 2005 Equity Plan for a maximum of 250,000 shares of the Company's common stock for $0.02 per share. The options expire May 25, 2015 and may be exercised any time after May 25, 2005 During the years end December 31, 2006 and 2005, and through the date of this report, none of these options were exercised by the option holder. 18 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9 - BUSINESS ACQUISITIONS AND DISPOSALS COMPLETE POWER SOLUTIONS On January 27, 2006, the Company entered into a Purchase Agreement (the "Purchase Agreement") with William Dato and Complete Power Solutions ("CPS") pursuant to which the Company acquired 51% of the member interests of CPS owned by Mr. Dato for a purchase price consisting of the payment of $637,000 in cash and the delivery of 600,000 shares of Company's Series A Convertible Preferred Stock (the "Series A Preferred Stock") having a stated value of $1,200,000, which Series A Preferred Stock are convertible into 50,739,958 shares of the Company's Common Stock at the demand of Mr. Dato. The cash paid in the transaction was obtained from capital provided to the Company for use in connection with acquisitions by Howard Ullman, our Chief Executive Officer and President, and certain of our directors and principal shareholders. On January 26, 2007, the Company entered into a Purchase and Settlement Agreement (the "Settlement Agreement"), dated and effective as of December 31, 2006, with William Dato and CPS whereby: (a) CPS repurchased the 51% membership interest owned by China Direct in return for the transfer of the 600,000 shares of the Company's "Series A Preferred Stock", which are convertible into 50,739,958 shares of the Company's common stock, and (b) the issuance of a promissory note by CPS to China Direct for 225,560, bearing annual interest at 7% with interest-only payments commencing on July 1, 2007 and thereafter being paid quarterly on April 1st, July 1st, October 1st, and January 1st until the principal and all unpaid interest thereon shall become due and payable on the maturity date, being January 6, 2010 (the "2007 Promissory Note"). The 2007 Promissory Note also provides that the principal amount may be automatically increased by an amount of up to $7,500 if the amount of a customer claim is settled for less than $7,500. As of the date of this report the principal amount has not been increased by an amount up to $7,500, as described above. The shares were valued at $1,775,864 based on the market value of the common stock the shares are convertible into. As of December 31, 2006, the balance due on the $225,560 was classified on the Company's balance sheet as an amount due from former subsidiary. This item was classified as long-term as of December 31, 2006, in anticipation of its conversion to a note receivable, the maturiy of which is more than one year from the balance sheet date. Subsequently, upon execution of the 2007 Promissory Note on January 26, 2007, the Company reclassified the balance as a long-term note receivable from former subsidiary. At March 31, 2007, the balance due was $228,329, which included accrued interest receivable of $2,769. CPS is also indebted to China Direct under a promissory note in the original principal amount of $250,000, executed by William Dato on June 27, 2006 and payable to China Direct, bearing interest at 7% per annum and maturing on June 30, 2007, subject to extension (the "2006 Promissory Note") and subject to offset by (i) $41,600 owed by an affiliate of China Direct to the CPS funds advanced by CPS for portable generators that were never delivered and (ii) $15,000 as an agreed amount paid to compensate CPS for certain refunds required to be made by CPS (which amounts have been first applied to accrued and unpaid interest due September 30, 2006 and December 31, 2006 and then applied to quarterly interest payable on the principal of the 2006 Promissory Note to maturity (June 30, 2007) and then to reduce the principal amount of the 2006 Promissory Note to $210,900 . As of March 31, 2007, the balance due on the 2006 Promissory note was $202,150, which reflects the offsets listed above, plus accrued interest of $8,750. The Company disposed of its interest in CPS to further its goal of focusing on its Capstone Industries consumer product business line in an effort to achieve sustained profitability from low-coast, low inventory consumer products that are direct shipped from Chinese and other low cost contract manufacturing sources to the Company's customers. In connection with the disposal of CPS, the Company recorded a gain from discontinued operations of $149,424 at December 31, 2006. The gain from discontinued operations consists of the following unaudited amounts: 19 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9 - BUSINESS ACQUISITIONS AND DISPOSALS (CONTINUED) (Unaudited) For the Years Ended December 31, 2006 2005 ------------------- ------------------- Net loss from discontinued operations $ (518,902) $ - Net gain on disposal of discontinued operations 668,326 - ------------------- ------------------- Income (Loss) from discontinued operations $ 149,424 $ - ------------------- ------------------- CAPSTONE INDUSTRIES On September 13, 2006 the Company entered into a Stock Purchase Agreement (the Purchase Agreement) with Capstone Industries, Inc., a Florida corporation (Capstone), engaged in the business of producing and selling portable book lights and related consumer goods, and Stewart Wallach, the sole shareholder of Capstone. Under the Stock Purchase Agreement the Company acquired 100% of the issued and outstanding shares of Capstone Common Stock in exchange for $750,000 in cash (funded by a note payable to the Company's CEO and $1.25 million of the Company's series B Preferred Stock, $0.01 par value per share, which Series "B" stock is convertible into 15.625 million "restricted" shares of China Direct Common Stock, $0.0001 par value (common stock). China Direct has agreed to register shares of Common Stock under the Securities Act of 1933, as amended, to cover conversion of the Series "B" Stock issued to Mr. Wallach in the acquisition of Capstone. China Direct will operate Capstone as a wholly-owned subsidiary. As of the date of this report these share have not been registered. The Capstone acquisition was recorded as follows: Cash $ 33,676 Accounts receivable 208,851 Inventory 340,109 Prepaid expenses 7,500 Property and equipment 16,127 Goodwill 1,936,020 Accounts payable and accrued expenses (417,283) Loan payable to China Direct (125,000) ----------- Total purchase price $2,000,000 ---------- Capstone was acquired to expand the Company's customer base and sources of supply, the value of which contributed to the recording of goodwill. For tax purposes, the goodwill is expected to be amortized as an IRC Sec. 197 intangible over a period of fifteen years from date of acquisition. 20 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 - INCOME TAXES As of December 31, 2006, the Company had a net operating loss carryforward for income tax reporting purposes of approximately $1,206,000 that may be offset against future taxable income through 2026. Current tax laws limit the amount of loss available to be offset against future taxable income when a substantial change in ownership occurs. Therefore, the amount available to offset future taxable income may be limited. No tax benefit has been reported in the financial statements, because the Company believes there is a 50% or greater chance the carryforwards will expire unused. Accordingly, the potential tax benefits of the loss carryforwards are offset by a valuation allowance of the same amount. 2006 2005 --------------- ---------------- Net Operating Losses $ 247,230 $ 214,430 Valuation Allowance (247,230) (214,430) --------------- ---------------- $ - $ - =============== ================ The provision for income taxes differ from the amount computed using the federal US statutory income tax rate as follows: 2006 2005 --------------- ---------------- Provision (Benefit) at US Statutory Rate $ (59,187) $ (150,382) Accrued but Unpaid Officers Compensation 20,500 - Accrued but Unpaid Interest on Officer Loans 8,174 - Meals and Entertainment 47 533 Depreciation (2,334) 92 Increase (Decrease) in Valuation Allowance 32,800 149,757 --------------- ---------------- $ - $ - =============== ================ The Company evaluates its valuation allowance requirements based on projected future operations. When circumstances change and causes a change in management's judgment about the recoverability of deferred tax assets, the impact of the change on the valuation is reflected in current income. NOTE 11 - LEGAL SETTLEMENTS ITC/INFO TECH In June 2001, ITC/INFO Tech ("Claimant") obtained a default award of $79,000 against the Company. The award was based on non-payment for computer goods shipped by ITC to two subsidiaries of the Company. The Company has offered to settle the award for shares of restricted stock, but the Claimant has refused to accept such an offer to date. The Claimant has made no effort to enforce its award since June 2001. As of March 31, 2007 and December 31, 2006, the award amount has been included in the accrued expenses of the Company. TRADE SHOW CONTRACT The Company is a defendant to another lawsuit concerning a trade show contract for approximately $25,000, but the Company does not believe that this lawsuit is material in respect of potential liability of the Company. The Company has been and intends to vigorously defend itself in this lawsuit. In August 2006, this lawsuit was settled for $25,000. 21 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12 - CONTINGENCIES CELESTE TRUST REG., ESQUIRE TRADE, ET AL. V. CBQ, INC AND DEPOSIT ON ACQUISITION OF TREASURY STOCK Celeste Trust Reg., Esquire Trade, et al. v. CBQ, Inc. (Case# 03 Civ. 9650 RMB; US District Court, SDNY, 12/4/2003). A lawsuit filed against company by three plaintiffs on or about December 4, 2003, but which the company did not receive notice of until the week of February 18, 2004 or thereabouts. The Plaintiffs purchased debentures issued by Socrates Technologies Corporation (STC), a public Delaware corporation in 2000. When the Company purchased the assets of two STC subsidiaries in March 2001, the plaintiffs allege that the Company promised to issue to the Plaintiffs and others the consideration that was to be paid to STC for the acquired assets and to so do in order to compensate the plaintiffs for their investment in the STC debentures, which were apparently in default at that time. The total consideration paid for the STC subsidiaries' assets were 7.65 million shares of company Common Stock and a Promissory Note made by the Company for $700,000 principal amount. The Company has defended against the Plaintiffs' claims to date. If the Plaintiffs win a judgment on their claims, the judgment, if collected, would prove potentially ruinous the Company, unless a settlement involving no cash was arranged between the parties to the lawsuit. The Plaintiff's claims include a claim for receipt of the money due under the Promissory Note with a principal amount of $700,000. The Company lacks the cash flow or cash reserves or funding resources to pay such a claim, either in a lump sum or over time. If the Plaintiffs are awarded the claimed damages against the Company in this lawsuit, the Company would be unable to pay such damages, either in a lump-sum or under a schedule, and would be insolvent. On January 25, 2005, the U.S. District Court for the Southern District of New York ("Court") dismissed without prejudice the lawsuit against China Direct Trading Corporation in the previously reported civil case styled CELESTE TRUST REG., ESQUIRE TRADE, ET AL. V. CBQ, INC. (Case# 03 Civ. 9650 RMB; US District Court, Southern District for New York, 12/4/2003). The lawsuit was dismissed in a response to China Direct Trading Corporation's motion to dismiss. The Plaintiffs were entitled to refile the lawsuit if they an amended complaint on or before March 1, 2005. The Plaintiffs filed an amended complaint with the Court on February 24, 2005. On July 20, 2006, the Court dismissed the amended complaint by the Plaintiffs, but did not rule on Plaintiffs' motion for default judgment, which China Direct filed an opposing motion, against Networkland, Inc. and Technet Computer Services, Inc., two dormant companies. The Plaintiffs attempted to appeal the dismissal of the amended complaint, but the U.S. Circuit Court of Appeals for the Second Circuit did not accept that appeal because the Court had not decided the motion for default judgment against the other defendants. To date, the plaintiffs have not taken any actions known to me to resolve this impediment to an appeal of the dismissal of the amended complaint China Direct does not believe that the claim of the Plaintiffs is valid and China Direct intends to aggressively defend against this lawsuit. China Direct does not have the financial wherewithal to pay the damages sought by the Plaintiffs. No estimate of the outcome may be made at this time, but the plaintiffs have failed to date to pursue the steps necessary to file an appeal of the Court's dismissal of their complaint against China Direct. The lawsuit claims that China Direct owes to the Plaintiffs the consideration paid for the acquisition of the assets of Networkland, Inc. and Technet Computer Services, Inc. in March 2001 because the plaintiffs were secured creditors of the sole shareholder of those two companies and the assets sold to China Direct were covered by Plaintiff's lien against the sole shareholder of Networkland, Inc. and Technet Computer Service Corporation. 22 CHINA DIRECT TRADING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12 - CONTINGENCIES (CONTINUED) SUN TRUST BANK DISPUTE. SUN TRUST BANK LINE OF CREDIT AND TERM NOTE Prior to being acquired by the company, Quantum Technology Group had a $4 million line of credit with Crestar Bank, which was subsequently acquired by Sun Trust. This line of credit was guaranteed by Quantum and five individual guarantors, including Ray Kostkowski, Anne Sigman, Skip Lewis, and Anthony Saunders. This line of credit was opened during April, 2000. On August 8, 2000, the Company acquired all of the shares of Quantum. Sun Trust asserted that $1.3 million of the line of credit had been used, and was owing to Sun Trust, as well as line of credit, a $200,000 term loan from Sun Trust to Quantum, approximately $200,000 in accrued interest and $100,000 in attorney fees -- all of which SunTrust had sought to collect from the individual guarantors. Sun Trust had not sued the Company and has not raised its prior threat to sue in 2005. RAS Investment, Inc., a company affiliated with Anne Sigman, a former employee of the Company, has advised the Company that RAS has acquired the Sun Trust note and has demanded payment in cash or stock. As of the date of this Report, the Company's position remains as before, that is, that the Company is not obligated to pay the Sun Trust debts and any claims made to collect that debt could be defeated by several potential defenses and counterclaims. CYBERQUEST, INC. As reported previously, the Company has received two claims from certain former shareholders of Cyberquest, Inc. that they hold or own approximately 70,000 shares of a class of the Company's redeemable preferred stock that was issued in the Company's 1998 acquisition of Cyberquest. Cyberquest ceased operations in 2000-2001 period. The Company has investigated these claims and has not been able to date to substantiate any of the claims to date and the claimants have not pursued their claims beyond an initial communication asserting ownership of these shares of serial preferred stock. The Company has not received any further claims or communications since mid-2006. NOTE 13 - DISCONTINUED OPERATIONS On December 31, 2006, Complete Power Solutions, a 51% owned subsidiary of the Company, was sold, and is no longer a subsidiary of the Company. Operating results of this discontinued operation for the three months ended March 31, 2006 are shown separately in the accompanying consolidated statement of operations. The operating results of this discontinued operation for the three months ended March 31, 2007 and 2006 consist of: (Unaudited) (Unaudited) For the Three Months Ended For the Three Months Ended March 31, March 31, 2007 2006 ----------------- ----------------------- Sales $ $ Cost of sales - 2,342,137 Sales and marketing - (1,738,081) Compensation - (78,203) Professional fees - (99,877) General and administrative - (13,647) Interest expense - (129,261) Minority interest - (14,941) Net Income (Loss) - (131,382) ----------------- ----------------------- $ - $ 136,745 ================= ======================= 23 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION GENERAL - This discussion should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's annual report on Form 10-KSB for the year ended December 31, 2006. Plan of Operations. The Company's plan of operations since the fourth quarter of Fiscal Year 2006 has been to focus on expanding Capstone's consumer products, including its private branding efforts, and OBS' building supplies business. The Company will devote its available resources and funding to the expansion of Capstone. Except for occasional short-term loans from Mr. Ullman and other members of management, China Direct's operating subsidiaries have to rely on revenues from operations to cover their overhead and expansion efforts. The Company's current plan of operations is to focus on development of Capstone as its primary business and such an effort may include pursuit of and sale of Chinese-made products in North America under the Capstone name or under private brand names promoted by the Company. The Company is seeking opportunities that potentially and immediately enhance our sales revenues and net worth as well as possibly contribute a positive cash flow and enhance shareholder value beyond the capability of our current core business line. As such, we are interested in investing in or acquiring companies that could benefit from exploiting the Company's financial and contacts with Chinese manufacturing firms. Our strategic plan has traditionally been to remain a trading company with low overhead and focused on exploiting its contacts with Chinese manufacturers to meet our customers' needs. We have shifted our strategic plan to focus on promoting Capstone low-tech consumer products - both those under the Capstone name and under the private branding efforts. Secondary in our strategic plan will be promoting OBS' sale of Chinese-made roofing tiles in Florida and the Southeast. While we will explore opportunities to sell other Chinese-made building supplies in that market and the certain parts of the Southern U.S., we intend to focus on the roofing tiles as the most likely, in our opinion, the Chinese-made building products to find market demand in the U.S. This opinion is based on discussions and marketing efforts with building suppliers in Florida and other parts of the U.S. We received in early January 2006, a credit line commitment of $500,000 (increased to $647,000) from its chief executive officer and president, Howard Ullman, and three Company directors, Jeffrey Postal, Lorenzo Lamadrid and Laurie Holtz (collectively, the "lenders"). The credit line is to be used solely to fund the cash portion of any acquisition or investment by the Company The funding was used to acquire the 51% membership interest in CPS. Pursuant to a December 31, 2006 settlement agreement, the purchase of the 51% membership interest by the Company in CPS was rescinded and the loan was repaid in full. The Company may incur significant post-merger or acquisition registration costs in the event management wishes to register a portion of their shares for subsequent sale. The Company will also incur significant legal and accounting costs in connection with the acquisition including the costs of preparing post- effective amendments, Forms 8-K, agreements and related reports and documents. While the Company believes that Capstone will be able to generate sufficient cash flow to pay its direct overhead costs and internal planned growth in fiscal year 2007, OBS does not generate sufficient cash flow at this time to fund its operations or any business development efforts and marketing and sales efforts in fiscal year 2007. With respect to Capstone and OBS, the Company will not have sufficient funds (unless it is able to raise funds in a private placement or debt financing) to undertake any significant business development, or extensive marketing, in terms of scope of campaign and geographical reach, of new products. Accordingly, following any future acquisition, the Company will, in all likelihood and unless the acquired business generates sufficient cash flow and profits, be required to either seek debt or equity financing or obtain funding from third parties, in exchange for which the Company may be required to give up a substantial portion of its interest in the acquired product or to issue large number of shares of its capital stock. There is no assurance that the Company will be able either to obtain additional financing or interest third parties in providing funding for the further development, marketing and manufacturing of any products acquired. 24 RESULTS OF OPERATIONS - For the three months ended March 31, 2007, the Company had a net loss from continuing operations of approximately $253,000. For the three months ended March 31, 2006, the Company had net loss from continuing operations of approximately $94,000. The increase in the net loss from continuing operations was mainly due to additional overhead from the acquisition of Capstone. For the three months ended March 31, 2006, the Company had net income from discontinued operations of approximately $137,000. The net income from discontinued operations for the three months ended March 31, 2006 was due to the revenues from Complete Power Solutions for the quarter. Complete Power Solutions was disposed of as December 31, 2006. Total Revenues - For the three months ended March 31, 2007 and 2006, the Company had total sales of approximately $211,000 and $170,000 respectively, for an increase of approximately $41,000. The increase in revenue was due to the acquisition of Capstone. Costs and Expenses - For the three months ended March 31, 2007 and 2006, the Company had cost of sales of approximately $138,000 and $144,000, respectively. Operating expenses increased approximately $183,000, from $119,000 in 2006 to $302,000 in 2007. The cost of rent and other general and administrative costs increased in 2007 as compared to 2006 due to additional overhead from the acquisition of Capstone. Stock-based expenses for the three months ended March 31, 2007 increased by approximately $75,000 as compared to 2006. Expenses were approximately $75,000 for the three months ended March 31, 2007 compared to $0 in 2006. Liquidity and Capital Reserves. Historically, the Company has not generated enough cash flow from operations to cover its overhead costs and the cost of growth. The inadequacy of cash flow and the inability of the Company to consistently obtain funding and ongoing funding on commercially reasonable terms have undermined the former business operations of the Company and forced the Company to obtain funding from management and through the sale of Company securities. As a small business and a penny stock company, the Company will continue to face difficulty in obtaining financing or funding on reasonable commercial terms. The Company expects future development and expansion will be financed through cash flow from operations and other forms of financing such as the sale of additional equity and debt securities, capital leases and other credit facilities. There are no assurances that such financing will be available on terms acceptable or favorable to the Company. Further, the increase in the number of shares of common stock in the public markets may reduce the ability or appeal of the Company to future sources of possible financing or funding. Government Regulations. The Company is subject to all pertinent Federal, State, and Local laws governing its business. The Company is subject to licensing and regulation by a number of authorities in its State or municipality. These may include health, safety, and fire regulations. Impact of Inflation. To date, the Company has not experienced any significant effect from inflation. The Company's major expenses have been the cost of marketing its product lines to customers in North America. That effort involves mostly sales staff traveling to make direct marketing and sales pitches to customers and potential customers., trade shows around North America and visiting China to maintain and expand distribution and manufacturing relationships and channels. The Company generally has been able to meet increase in costs by raising prices of its products. Country Risks. Almost all of the Company's contract manufacturing operations and sources of products are located in China. As such , the Company is subject to significant risks not typically faced by companies operating in or obtaining products from North America and Western Europe. Political, economic and trade conflicts between the United States and China, including possible conflict over North Korea's nuclear weapons program or the independence of Taiwan, could severely hinder the ability of the Company to obtain products and fill customer orders from the Company's current Chinese manufacturing sources. Further, Chinese commercial law is still evolving to accommodate increasing capitalism in Chinese society, especially in terms of commercial relationships and dealings with foreign companies, and can be unpredictable in application or principal. The same unpredictability exists with respect to the central Chinese government, which can unilaterally and without prior warning impose new legal, economic and commercial laws, policies and procedures. This element of unpredictability heightens the risk of doing business in China. 25 China is also under international pressure to value its currency in a manner that would increase the value of Chinese currency in respect of other world currencies and thereby increase the cost of Chinese goods in the world market. The Company does not believe that such revaluation of Chinese currency would adversely impact its business because of the low-cost nature of the Company's products and the fact that U.S. dollars is the currency of use in all of the Company's commercial transactions. ITEM 3. CONTROLS AND PROCEDURES The Company's Chief Executive Officer and Chief Financial Officer are responsible for establishing and maintaining disclosure controls and procedures for the Company. (a) Evaluation of Disclosure Controls and Procedures As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's President, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Based upon the evaluation, the Company's President concluded that, as of the end of the period, the Company's disclosure controls and procedures were effective in timely alerting him to material information relating to the Company required to be included in the reports that the Company files and submits pursuant to the Exchange Act. (b) Changes in Internal Controls Based on his evaluation as of March 31, 2007, there were no significant changes in the Company's internal controls over financial reporting or in any other areas that could significantly affect the Company's internal controls subsequent to the date of his most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Other than as set forth below, the Company is not a party to any material pending legal proceedings and, to the best of its knowledge, no such action by or against the Company has been threatened. The Company is subject to legal proceedings and claims that arise in the ordinary course of its business. Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters will not have material adverse effect on its financial position, results of operations or liquidity. CELESTE TRUST REG., ESQUIRE TRADE, ET AL. V. CBQ, INC.: The Plaintiff's complaint in Celeste was dismissed by the U.S. District Court for the Southern District of New York in early 2005 for failure to have all essential parties to the dispute as parties to the lawsuit. The Plaintiffs filed an amended complaint prior to the March 1, 2005 deadline for doing so. The Company defended against the Plaintiff's amended complaint, which added two former, now defunct, subsidiaries involved in the STC transaction as defendants. The assets of Networkland, Inc. and Technet Computer Services Corporation were acquired by the Company on March 15, 2001 and that transaction is at the heart of the dispute in the Celeste case. The Court also dismissed the Plaintiff's amended complaint on July 20, 2006. The Plaintiffs filed an appeal in September 2006 to the adverse order issued by the Court dismissing the amended complaint. The appeal, however, was not accepted by the Court in October 2006 because there is a pending, unresolved motion for default judgment against the other defendants, Networkland, Inc. and Technet Computer Services Corporation, who are two former subsidiaries of Socrates Technologies Corporation, a defunct Delaware corporation, and not owned by or affiliated with China Direct. The staff attorney for the 2nd Circuit stated that said motion must be resolved before the Court will entertain any appeal. The Company is not a party to the pending motion for default judgment before the trial court; however, the Company filed an opposition to the motion for default judgment. As of date of this Report, the 26 Company is not aware of any action by the plaintiffs to date to resolve or remove the pending motion for default judgment against the other defendants in order to clear the way for an appeal of the judgment entered in favor of for Company by the Court. While the Company is confident of prevailing in this matter, the Company is uncertain at this time of the final outcome motion for default against the other defendants or whether the plaintiffs intend to pursue this litigation further. CELESTE TRUST REG., ESQUIRE TRADE, ET AL. V. CBQ, INC. (Case# 03 Civ. 9650 RMB; US District Court, SDNY, 12/4/2003). A lawsuit filed against company by three plaintiffs on or about December 4, 2003, but which the company did not receive notice of until the week of February 18, 2004 or thereabouts. The Plaintiffs purchased debentures issued by Socrates Technologies Corporation (STC), a public Delaware corporation in 2000. When the Company purchased the assets of two STC subsidiaries in March 2001, the plaintiffs allege that the Company promised to issue to the Plaintiffs and others the consideration that was to be paid to STC for the acquired assets and to so do in order to compensate the plaintiffs for their investment in the STC debentures, which were apparently in default at that time. The total consideration paid for the STC subsidiaries' assets were 7.65 million shares of company Common Stock and a Promissory Note made by the Company for $700,000 principal amount. The Company has defended against the Plaintiffs' claims to date. If the Plaintiffs win a judgment on their claims, the judgment, if collected, would prove potentially ruinous the Company, unless a settlement involving no cash was arranged between the parties to the lawsuit. The Plaintiff's claims include a claim for receipt of the money due under the Promissory Note with a principal amount of $700,000. The Company lacks the cash flow or cash reserves or funding resources to pay such a claim, either in a lump sum or over time. If the Plaintiffs are awarded the claimed damages against the Company in this lawsuit, the Company would be unable to pay such damages, either in a lump-sum or under a schedule, and would be insolvent. SUNTRUST BANK CLAIM. Prior to being acquired by the company, Quantum Technology Group ("QTG"), a now defunct subsidiary, had a $4 million line of credit with Crestar Bank (Crestar was subsequently acquired by Sun Trust). This line of credit was guaranteed by Quantum and five individual guarantors, including Ray Kostkowski, Anne Sigman, Skip Lewis, and Anthony Saunders. This line of credit was opened during April, 2000. On August 8, 2000, the Company acquired all of the shares of QTG. Sun Trust asserted that $1.3 million of the line of credit had been used, and was owing to Sun Trust, as well as line of credit, a $200,000 term loan from Sun Trust to QTG, approximately $200,000 in accrued interest and $100,000 in attorney fees -- all of which SunTrust had sought to collect from the individual guarantors, not the company. RAS Investment, Inc., a company apparently affiliated with Anne Sigman, a former employee of the Company, advised the Company in 2004 that RAS has acquired the Sun Trust note and demanded payment in cash or stock. As of the date of this Report, the Company's position remains as before, that is, that the Company is not obligated to pay the Sun Trust debts and any claims made to collect that debt could be defeated by several potential defenses and counterclaims. The Company has not received any further claims by RAS Investment, Inc. in this matter and the Company is uncertain at this point if RAS Investment, Inc. intends to pursue the aforementioned claims. CYBERQUEST, INC.: The Company received two claims from certain former shareholders of Cyberquest, Inc. in 2006. They claimed to hold or own approximately 70,000 shares of a class of the Company's redeemable preferred stock issued in the Company's 1998 acquisition of Cyberquest. Cyberquest ceased operations in 2000-2001 period. The Company has investigated these claims and has not been able to date to substantiate any of the claims to date and the claimants have not pursued their claims beyond an initial communication asserting ownership of these shares of serial preferred stock. The Company has not received any further claims or communications since the late summer of 2006. The Company is uncertain at this point if the claimants will pursue or press the aforementioned claim of preferred stock ownership. No director, officer or affiliate of the Company, or owner of record of more than five percent (5%) of the securities of the Company, or any associate of any such director, officer or security holder is a party adverse to us or has a material interest adverse to us in reference to pending litigation. We are not currently a party to any other legal proceedings that we believe will have a material adverse effect on our financial condition or results of operations. 27 ITEM 2. CHANGES IN SECURITIES In February 2007, the Company issued 1,428,571 shares of common stock for consulting fees valued at $50,000. The shares were valued at $.035 per share. In February 2007, the Company issued 250,000 shares of common stock for cash of $5,000. In February 2007, the Company issued 468,750 shares of common stock for notes payable totaling $16,761. In March 2007, the Company issued 3,031,000 shares of common stock for accrued compensation of $100,000. In March 2007, the Company issued 757,575 shares of common stock for officers compensation valued at $25,000. The shares were valued at $.033 per share. In March 2007, the Company issued 1,835,050 shares of common stock for investor loans payable totaling $55,051. During the three months ended March 31, 2007, 15,000 shares of the Company's series "B" preferred shares issued to a director were exchanged for 990,000 shares of the Company's common stock. During the three months ended March 31, 2007, 236,739 shares of the Company's series "B" preferred stock was converted into 15,624,774 shares of the Company's common stock. In February 2007, 734 shares of the Company's series "A" preferred stock were exchanged for 73,400 shares of the Company's common stock. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None/Not Applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS None/Not Applicable. ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS 2.1 Purchase Agreement, dated January 27, 2006, by and among China Direct Trading Corporation, William Dato and Complete Power Solutions, LLC. + 2.1.1 Purchase and Settlement Agreement by and among China Direct Trading Corporation, Complete Power Solutions, LLC, William Dato and Howard Ullman, January 26, 2007 ++ 2.1.1.1 Stock Purchase Agreement, dated September 15, 2006, by and among China Direct Trading Corporation, Capstone Industries, Inc. and Certain Selling Shareholders 1/4 3.1 Articles of Incorporation of the Company * 3.1.1 Articles of Incorporation of China Direct Trading Company, a wholly-owned subsidiary of the Company ** 28 3.2 By-laws of the Company*** 10.1 Voting Agreement, dated January 27, 2006, by and among China Direct Trading Corporation, William Dato and Howard Ullman. + 10.2 Operating Agreement, dated January 27, 2006, for Complete Power Solutions, LLC. + 10.3 Employment Agreement, dated January 27, 2006, among William Dato, China Direct Trading Corporation and Complete Power Solutions, LLC. + 10.4 Form of July 20, 2005 sales agency agreement between China Direct Trading Corporation and Sutter's Mill Specialties. + 10.5 Form of Non-Qualified Stock Option+ 14 Code of Ethics Policy, dated December 31, 2006+++ 31 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.++++ 32 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.++++ - ------------------------------------------ * Incorporated by reference to Annex C to the Special Meeting Proxy Statement, dated April 15, 2004, filed by China Direct Trading Corporation with the Commission on April 20, 2004. ** Incorporated by reference to Annex G to the Special Meeting Proxy Statement, dated April 15, 2004, filed by China Direct Trading Corporation with the Commission on April 20, 2004. *** Incorporated by reference to Annex D the Special Meeting Proxy Statement, dated April 15, 2004, filed by China Direct Trading Corporation with the Commission on April 20, 2004. **** Incorporated by reference to Annex H the Special Meeting Proxy Statement, dated April 15, 2004, filed by China Direct Trading Corporation with the Commission on April 20, 2004. + Incorporated by reference to Exhibit 2 to the Form 8-K filed by China Direct Trading Corporation with the Commission on January 31, 2006. ++ Incorporated by reference to Exhibit 2 to the Form 8-K filed by China Direct Trading Corporation with the Commission on January 26, 2007. (0) Incorporated by reference to Exhibit 2.1 to the Form 8-K filed by China Direct Trading Corporation with the Commission on September 18, 2006. +++ Incorporated by reference to Exhibit 14 to the Form 10KSB filed by China Direct Trading Corporation with the Commission on April 17, 2007. ++++ Filed Herein (b) Reports on Form 8-K filed. The following reports were filed during the last quarter of the 2007 fiscal year: Form 8-K, February 1, 2007; Form 8-K/A, February 28, 2007; Form 8-K, April 25, 2007; and Form 8-K, May 4, 2007. 29 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, this 11th day of May, 2007. China Direct Trading Corporation May 14, 2007 /s/ Stewart Wallach Stewart Wallach CEO and President (Principal Executive Officer) (Principal Financial and Accounting Officer)