UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-K

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For the fiscal year ended: December 31, 2012

OR

For the transition period from: _____________ to _____________

Commission file number: 000-25663

Ecosphere Technologies, Inc.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (772) 287-4846

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o   No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o   No þ

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

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

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the closing price as of the last business day of the registrant’s most recently completed second fiscal quarter, June 30, 2012, was approximately $71,700,000.

The number of shares outstanding of the registrant’s common stock, as of March 29, 2013, was 153,618,062.

INDEX

PART I

ITEM 1.

BUSINESS.

Ecosphere Technologies, Inc. (“Ecosphere”, “ETI”, “we”, “us”, “our” or the “Company”), is a water engineering, technology licensing and innovative manufacturing company that develops environmentally responsible water treatment solutions for industrial markets throughout the world. The Company is a leader in emerging advanced oxidation processes and has an extensive portfolio of intellectual property that includes five United States (“U.S.”) patents and additional patents pending for the Ecosphere Ozonix® process. The patented Ecosphere Ozonix® process is a revolutionary advanced oxidation process (“AOP”) that is currently being used by energy exploration companies to treat and recycle wastewater, reduce costs, increase treatment efficiencies and eliminate liquid chemicals from wastewater treatment operations around the United States.

Our Business Strategy

Since 2007, our management team has been executing on a business strategy that is driven by “Open Innovation” and innovative manufacturing. “Open Innovation” is a concept that was developed by Dr. Henry Chesbrough, the Executive Director of the Center for Open Innovation at the Haas School of Business at the University of California, Berkeley.  The Open Innovation concept provides a formula whereby small companies can rapidly develop and deploy new technologies and then license those technologies to larger organizations for rapid market penetration.  In response to this concept, we developed the “Open Innovation Network”, our product development lifecycle that can be characterized by the following six stages:

1.

Identify a major environmental water challenge,

2.

Invent new technologies and file patents,

3.

Partner with industry leaders,

4.

Commercialize and prove the technology with ongoing services paid for by customers and industry leaders,

5.

License the patented, commercialized technologies to well capitalized partners, and

6.

Create recurring revenues and increase shareholder value.

From inception in 1998, we have designed, developed, manufactured and commercialized technologies that are currently solving some of the world’s most critical water challenges.  Our patented Ozonix® technology is a high volume, AOP designed to treat and recycle industrial wastewater without the use of toxic chemicals.

In addition to Ozonix®, we have developed an extensive portfolio of intellectual property that includes over 30 patents and trademarks that have been filed and approved in various locations around the world.  These patented technologies can be purchased and licensed for use in large-scale and sustainable applications across industries, nations and ecosystems.  Companies that license our patented technologies are able to improve their financial metrics while also reducing their ecological and environmental footprints.  Our current focus is on licensing Ecosphere’s patented Ozonix® technology, although our other technologies and patents remain a viable part of our long-term licensing strategy.

Our Ozonix® Technology

Our patented Ozonix® technology offers customers a chemical-free alternative to high-volume water treatment and recycling for a diverse range of industries including, but not limited to, oil and gas, mining, municipal wastewater treatment, power generation, metals, industrial, pulp and paper, food and beverage, agriculture, pharmaceuticals, manufacturing and more.  Ecosphere's patented Ozonix® water treatment technology is unique because it uses a proprietary combination of advanced oxidation processes rather than chemicals to treat and recycle industrial wastewater.  Ozonix® combines various forms of advanced oxidation including ozone, hydrodynamic cavitation, acoustic cavitation, and electro-oxidation into one process to oxidize organic and inorganic materials found in industrial wastewaters for re-use and offers broad-spectrum water treatment capabilities.  This includes the destruction and oxidation of organic matter, bacteria, biofilms, heavy metals, hydrocarbons and sulfides that are typically found in industrial wastewaters.

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Recent Developments

We continued to execute our business strategy in 2012 and have completed all of the six stages required to prove our business model and “Open Innovation” strategy, with respect to the commercialization and licensing of our patented Ozonix® technology and its ability to reduce and/or eliminate chemicals used during industrial wastewater treatment.  

Since 2008, Ecosphere Energy Services, LLC ("EES") our 52.6% owned subsidiary, has recycled over 2.8 billion gallons of flowback and produced water for over 700 oil and natural gas wells in the United States. EES is currently providing its services to subsidiaries of Southwestern Energy Company (“Southwestern”) and Newfield Exploration Company (“Newfield”) two major energy companies engaged in natural gas production. In March 2011, Ecosphere and EES signed an exclusive long-term agreement with Hydrozonix, LLC to license its Ozonix® technology and business model to treat oil and gas exploration waters for the domestic U.S. onshore oil and gas industry. This exclusive Ozonix® license has been contingent upon Hydrozonix maintaining orders of two Ozonix® EF80 units per quarter. Ecosphere has manufactured 12 Ozonix® EF80 units to date for Hydrozonix and recently completed Units 13 and 14. The Hydrozonix agreement was the major contributor to the Company’s over $31 million in revenues in 2012.

As a result of Hydrozonix’s failure to issue a binding purchase order for Units 13-14 and make the required progress payments, the Company’s revenue prospects for the first quarter of 2013 are uncertain as of the filing of this Report.  On March 31, 2013, we issued a notice to Hydrozonix, which gave them until April 15^th to cure the failure to make payment.  If Hydrozonix does not pay for Units 13-14 and issue a binding purchase order for Units 15-16 with the appropriate progress payment by April 15, 2013 we will not be able to recognize the sale of these units in the first quarter of 2013. If Hydrozonix loses its exclusivity by not purchasing units 13-14 and ordering units 15-16 by April 15^th, we will aggressively market Units 13-14 to oil and gas service companies that are well positioned and well capitalized to service the major oil and gas exploration companies. This effort will help to maximize our market penetration of Ozonix® into the domestic and global oil and gas exploration and production market. See Item 1. “Description of Business – Hydrozonix Agreement” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation.”

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CURRENT BUSINESS

Overview

Through EES, our 52.6% majority owned subsidiary, Ecosphere is engaged in successfully providing high volume, mobile water treatment and recycling services to major energy exploration companies throughout the United States utilizing Ecosphere’s patented Ozonix® technology.  The industry acceptance of this technology is demonstrated by the Company providing water treatment and recycling services on over 700 oil and natural gas wells to date, and the Exclusive Sublicense and Manufacturing Agreement signed with Hydrozonix for water treatment in the U.S. onshore oil and gas exploration and production industry (the “Hydrozonix Agreement”).  The revenues over the past three years from servicing the oil and gas industry prove that the Ecosphere Ozonix® technology is commercially viable and have fueled the continuing development of Ozonix® technologies. Additional energy applications where our technologies will allow companies to optimize revenues and recycle the bulk of their production waters outside of global hydraulic fracturing include offshore oil and natural gas production, enhanced oil recovery, as well as coal and power generation applications to treat various wastewaters.  

Ecosphere’s patented Ozonix® technology has the ability to treat industrial wastewaters or drinking waters without using liquid chemicals in a variety of industries.  While EES has an exclusive license for global energy applications, Ecosphere owns 100% of all non-energy related Ozonix® applications.  These industries include mining, agriculture, and municipal wastewater, as well as the others listed in the section titled “Other Ozonix® Wastewater Treatment Applications” of this Report.  

The Company continues to actively seek customers, financial partners and licensees to expand its Ozonix® technologies into other industries and markets in the U.S. and globally.  The Company recently signed a letter of intent to expand the Ozonix® technology into the mining industry and is engaged in meaningful discussions with parties concerning one other vertical.

Water and Energy

The two most important resources for the world are water and energy.  Water and energy production are two highly interconnected sectors. Energy is used throughout the water production and distribution system to supply water to its various end users.  Water is essential to the production of energy.  At present, water is used to cool power generation plants, flows through turbines at hydroelectric dams, irrigates crops used to produce biofuels, and is pumped underground to crack open rock formations allowing oil and gas to flow to the surface via the wellbore.  The role of water in the energy sector is increasingly critical as many future sources of fossil fuels, including oil sands and unconventional natural gas and oil reserves, are water intensive to induce production.  Other energy sources that may be useful for combating climate change, such as carbon capture and storage, biofuels, and nuclear power, also require large volumes of water.  It is estimated that agriculture uses 70% of all freshwater withdrawals whereas energy uses only 8% of freshwater withdrawals.  However, growing populations and growing demand from other industries will likely squeeze energy’s already thin share of water, especially in those parts of the world experiencing water scarcity.  When constraints on water resources are coupled with pressures to reduce greenhouse gas emissions, the challenges for new energy projects grow exponentially.  Therefore, there is a burgeoning demand for finding and implementing solutions that reduce water use and increase water recycling.

Resource Plays: Oil and Natural Gas

Oil and natural gas recovered from resource plays are now considered to be the next step forward in the fossil-fuel or hydrocarbon recovery challenge.  The large volume and long-term production from these resource plays are driving greater exploration and exploitation opportunities.  On a global basis, resource plays represent a potentially recoverable resource equal to or exceeding the known conventional natural gas reserves in the world.

In a conventional oil and gas field, vertical wells are drilled into conventional sandstone and carbonate hydrocarbon reservoirs, which can be as deep as one to six miles beneath the surface.  With resource plays, the oil and natural gas trapped in unconventional, low porosity and permeability, sandstone, carbonate and shale formations is accessed by horizontal well bores of up to two miles in length.  The oil and natural gas is brought to the surface using a technique known as hydraulic fracturing, which fractures these reservoirs and allows the flow of hydrocarbons to the surface.  The success of hydraulic fracturing in these unconventional reservoirs is driving the explosive growth of exploiting these previously nonproducing reservoirs.  Hydraulic fracturing employs large volumes of water, proppants such as sand or bauxite, and chemicals (unless the Ozonix® process is used), to open fractures in the reservoir rock that in turn allow the flow of gas or oil to the surface.  An energy company will typically use between 3,000,000 and 5,000,000 gallons of water to hydraulically fracture a single well.

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Hydraulic fracturing fluid is created by taking fresh or brackish water, often taken from surface water systems such as rivers or ponds, and mixing it with chemical additives such as biocides, to eliminate the aerobic and anaerobic bacteria found in the source water, and scale inhibitors, to prevent chemical corrosion within the steel-cased wellbore.  After the hydraulic fracturing process occurs, this fluid returns to the surface as flowback and produced water via the well bore.  Oil and gas producers are then forced to deal with these wastewaters.  These wastewaters are typically contaminated with highly resistant bacteria, biofilms, sulfur, heavy metals and high concentrations of salt that also comes from the formation.  Additionally, a wide range of the liquid chemicals used to initially fracture the well are present.  

The conventional method of handling this wastewater is to dispose of it either in deep injection disposal wells or in evaporation ponds.  These methods require extensive trucking of the water, which is expensive and harmful to the environment.  To counteract this expense and harm, Ecosphere developed Ozonix®, which is currently being used by many of the leading oil and gas operators around the United States to treat and recycle their flowback and production waters.  Typically, Ozonix® is used at the well site to condition flowback and production fluids in order to create clean brine with a product we call Ecos-Brine®.  This bacteria and scale free fracturing fluid is then used to hydraulically fracture oil and natural gas wells. This allows operators to reduce their water consumption, control their water handling, transportation and treatment costs and to reduce their overall environmental impact.

ECOSPHERE ENERGY SERVICES, LLC

Ecosphere has issued EES, a majority-owned subsidiary of the Company, an exclusive worldwide license, solely for the energy field of use, for the Ecosphere Ozonix® technology.

EES, a leader in the field of advanced water treatment, provides energy exploration and production companies with an environmentally friendly water treatment solution that allows them to recycle flowback and produced waters during hydraulic fracturing operations. The patented Ecosphere Ozonix® process is a revolutionary AOP that is currently being used by energy exploration companies around the United States to reduce costs, increase treatment efficiencies and reduce the use of liquid biocide and scale inhibiting chemicals. A recipient of Frost & Sullivan's 2012 North American Product Leadership Award in Disinfection Equipment for Shale Oil and Gas Wastewater Treatment, Ecosphere and EES have enabled oil and gas customers to treat, recycle and reuse over 2.8 billion gallons of water on more than 700 oil and natural gas wells in major shale plays around the United States since 2008.  In February 2013, we were nominated to be an Energy Innovation Pioneer for the IHS CERA Week.  This program aims to identify the most innovative and distinctive new technologies in the energy spectrum.  HIS CERA Week has been held for the past 32 years.

Ecosphere developed the Ecosphere Ozonix® technology in the second half of 2007 and began testing it in late 2007 and mid 2008-thru 2009 in the Barnett Shale producing area of North Texas, and Woodford Shale area of Oklahoma.  This testing proved that the Ecosphere Ozonix® process is able to efficiently and cost-effectively oxidize organic and inorganic materials in flowback and produced water to provide a pre and post treatment solution to the disposal of this wastewater by remediating it and allowing its reuse in the hydraulic fracturing process.

In July 2009, the Corporation Commission of Oklahoma approved a permit application by Newfield Exploration (“Newfield”) to build and operate an Ozonix® water recycling plant to treat flowback and produced waters to a level that could be discharged to the ground for soil farming.  Although this was a major accomplishment for the Company, Newfield elected to use Ozonix® to treat and recycle water for reuse within their drilling operations.  As of the date of this filing, we still provide Ozonix® water treatment and recycling services to Newfield Exploration in Oklahoma.

In the first quarter of 2009, we manufactured and began testing a new Ozonix® product line built specifically for oil and gas hydraulic fracturing operations, the Ozonix® Ecos-Frac® series. In July 2009, the Company entered into a Master Service Agreement with two subsidiaries of Southwestern and received a work order under this agreement for the deployment of Ozonix® Ecos-Frac® units to pre-treat water used to fracture natural gas wells in the Fayetteville Shale.  Following the expiration of that Agreement in November 2012, we have continued to provide services to Southwestern under our Master Services agreement and have recently been awarded a bid for current and future work. EES continues to service Southwestern Energy today and our Ozonix® technology allows them to treat and recycle a significant amount of their production waters. This Agreement and the most recently received Southwestern work order have demonstrated the effectiveness of the Ozonix® Ecos-Frac® product line and has been integral to the continued development of Ecosphere’s patented Ozonix® technology, which has now been used to successfully treat and recycle over 2.8 billion gallons of water on over 700 oil and natural gas wells around the United States.

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Hydrozonix Agreement

Because of the Hydrozonix Agreement, our EES business plan has been to maintain our existing service operations for our two energy customers and support Hydrozonix, as they continue to expand operations in other major resource plays in the domestic, onshore oil and gas production market. Hydrozonix has been servicing its energy customers in the Eagle Ford shale play and the Permian Basin, as well as conducting pilots in all major shale plays around the United States.  Hydrozonix has been successful at obtaining numerous Master Service agreements with major energy producers. Because of the Hydrozonix agreement, we have been limited to servicing our two energy customers in the U.S. We are exploring potential strategic relationships to extend the use of our patented Ozonix® technology beyond oil and gas exploration in a variety of energy related industries and applications both in the U.S. and globally.

In March 2011, Ecosphere and EES entered into the Hydrozonix Agreement.  Under this Agreement, Hydrozonix is required to purchase two Ozonix® EF80 units per quarter for two years in order to maintain its exclusivity.  Following the expiration of the two-year period, Hydrozonix must purchase eight Ozonix® EF80 units per year to continue its exclusivity.  Ecosphere delivered the initial two Units in September 2011 and has continued to deliver two Ozonix® units per quarter through the end of 2012.  In 2013, Ecosphere commenced production of Units 13-14 but Hydrozonix failed to immediately issue a purchase order or make the required progress payments.

In February 2013 Ecosphere entered into an Agreement with Hydrozonix through which Hydrozonix issued a contingent purchase order for Units 13-14 and is required to pay for the two Ozonix® EF80 units by March 31, 2013, subject to a 15 day cure period.  If Hydrozonix has failed to pay for Units 13-14 and issue a binding purchase order for Units 15-16 with the appropriate progress payment by April 15, 2013, it shall lose its exclusivity.  Under that February 2013 Agreement, Hydrozonix agreed that if they failed to make the payments for Units 13-14 and issue the purchase order and deposit for Units 15-16, they would in fact lose their exclusivity without any further legal recourse.  This agreed  concession was important to Ecosphere since it eliminated any potential delay and attendant legal expenses in regards to this issue.  More importantly, the agreed upon terms allow EES to immediately open up the market to our patented Ozonix® technology for all of the major service companies to have access to, as opposed to having just one licensee. For one or more quarters, our revenues might be reduced and we may experience cash flow issues.  If Hydrozonix is able to cure their failure to pay for Units 13-14 and order Units 15-16 by April 15^th and continue purchasing Ozonix® EF80 units per our agreement, we will support them in their exclusive licensee role. We view the Hydrozonix relationship much like Apple did with AT&T and the IPhone where the early exclusive relationship benefited both the intellectual property company (Apple) and the exclusive value added reseller (AT&T). After that initial period Apple expanded its value added reseller base by adding Verizon and other value added resellers to market its products.  If Hydrozonix is not able to secure their financing per our signed Agreement, we will pursue an aggressive strategy to attract additional partners to be able to gain more market share for our Ozonix® technology in the U.S. onshore oil and gas exploration industry.

Onshore Oil and Gas Produced Water Recycling

The produced water market is expected to grow from $5 billion in 2010 to $9.9 billion in 2025; and the need for clean reusable water will increase accordingly.  The produced water treatment equipment market is also set to grow from $693 million in 2010 to $2.9 billion in 2025.  Hydraulic fracturing, or “fracking,” requires millions of gallons of water to be mixed with very fine sand forced down the well at high pressure in order to produce oil or natural gas. During the first few weeks of operations, millions of gallons of contaminated flowback water return to the surface. Prior to the introduction of Ozonix®, this flowback water had to be loaded into tanker trucks and hauled away to deep-injection disposal sites or evaporating ponds.  Ecosphere’s patented Ozonix® technology has eliminated the need for wastewater trucking and allows operators to re-use 100% of their treated water. Ozonix® provides long-term resource sustainability to end users and also provides operators with a total water management solution for on-site microbial control and scale-inhibition.

Offshore Oil and Gas Produced Water Recycling

Offshore drilling has accounted for approximately one-quarter of total U.S. natural gas production over the past two decades and almost 30% of total U.S. oil production in recent years.  We believe that our Ozonix® technology can be used to treat produced and flowback water for re-injection into the formations for both onshore and offshore drilling programs.  This process is known as enhanced oil or gas recovery.  It is a process where the flowback and produced waters are presently treated with chemicals and or membrane systems to kill bacteria and remove scale so that the produced fluids may be used to keep the pressure in the formation where the oil or gas is being recovered.  Entrance into the offshore market will be dependent upon the identification of the appropriate licensee and a determination as to the opportunity cost versus expansion into other applications and territories.

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Coal Applications

Coal mining and coal-fired power plants are a part of the field of use for EES’ Ozonix® technology license.  Coal continues to remain one of the world’s primary resources for producing electricity. It also has a much-debated reputation for being an unclean energy source and is highly regulated. One of the greatest challenges facing coal mining operators and coal-fired power plant operators is how to minimize the environmental impact of their operations while increasing production output. With its unique and patented Ozonix® technology, Ecosphere can help operators increase production capacity, while adhering to environmental regulations.  We believe we can reduce the sulphur and pyrite irons from the mined coal and thereby increase profitability for mining operators and assist end users including coal fired power plants in meeting stringent environmental standards.

Favorable Environment

There is a large “green” movement in the U.S. for identifying, developing and using cleaner and more eco-friendly sources of energy.  President Barack Obama’s stated objective is to transform the entire U.S. economy and move it onto a greener path.  He links energy and climate change to national security, citing the nation’s dependence on fossil fuels, and foreign oil imports in particular, as a dangerous and urgent threat.  President Obama has said that clean energy is a high priority for his administration.

On December 7, 2009, the U.S. Patent and Trademark Office announced its pilot program to expedite the examination of patent applications directed to certain green technology inventions.  Secretary of Commerce, Gary Locke, indicated that the pilot program was limited to the first 3,500 of the “most promising inventions.”  Ecosphere was awarded four Ozonix® patents under this pilot program and has more recently received a fifth patent for the Ecosphere Ozonix® process which was issued after the expiration of the pilot program.

Competition

We have been unable to identify any other company in the world that can provide oil and gas operating companies with clean, bacteria-free hydraulic fracturing fluid at the flow rate of the frac i.e., up to 120 bbls per minute or 5,000 gallons per minute without the use of chemicals.  Although competitors are coming to market with alternatives to traditional chemical fracturing processes, we are not aware of any other company that has a commercial, mobile wastewater treatment process that eliminates the use of liquid chemicals on the front end of a hydraulic fracturing treatment in real time.  Because most oil and gas operating companies are using chemicals in their completions solutions, Ecosphere’s primary competitors/substitutes (on the front end) continue to be the major chemical companies, such as Nalco (a division of Ecolab, Inc.) and Champion that manufacture and sell chemicals to oil and gas operators.  See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Energy companies use a myriad of different approaches to dealing with wastewaters and production fluids, which are byproducts of hydraulic fracturing.  The primary method of dealing with these waters throughout the U.S. is hauling them to permitted underground injection sites.  In some cases vapor distillation technology is being used to treat flowback and produced waters at disposal facilities.  We treat flowback and produced waters at the well site allowing our energy customers to treat and recycle 100% of their produced and flowback waters.  We believe our Ecosphere Ozonix® technology is a more cost effective alternative that energy companies prefer due to cost considerations, treatment effectiveness and the mobility of our solution.

Our competitive advantages include cost and the ability to recycle much higher volumes of flowback and produced waters.  The footprint of the Ecosphere Ozonix® mobile water treatment technology is considerably smaller than the footprint of competitive solutions to treat the same volumes of flowback and produced waters and has been further reduced with the development of the Ozonix® EF80.  Unlike our competition, the Ecosphere Ozonix® process does not need a particular water temperature or pH level with expansion capability to receive continuous water flow for treatment at high volume. Ozonix® gives operators broad-spectrum treatment capabilities at the well site.

It should be noted that our competitors, including the major chemical companies and pressure pumping companies, like Halliburton, Schlumberger and Baker Hughes all have more robust financial, management, engineering, technical, sales, and marketing resources than we do.  Despite the competitive advantages of our competitors, Ecosphere has treated more than 2.8 billion gallons of fracturing fluid on more than 700 oil and natural gas wells around the United States.

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Manufacturing

We design, develop and manufacture all Ozonix® units at our Company headquarters in Stuart, Florida using our in-house production facilities and a network of selected original equipment manufacturers to supply components.  Our design engineering and manufacturing teams continue to improve our products at this manufacturing and production facility.

We have invested in proven development techniques including CAD/CAM, Finite Element Analysis and Modeling.  In addition, during 2010, Ecosphere secured an adjacent building to provide for expansion of our manufacturing capabilities and we have continued to invest in additional machining tools and equipment to bring more fabrication in-house.  This reduces both our cost and time to completion for units being built in this facility.  We also believe that there is a benefit in increased quality.  We have also expanded our manufacturing staff capabilities through training or specialized hires.  We expect to continue this investment, as we believe this will produce significant benefits in terms of higher quality, faster completion and lower costs.  Certain processes and components will continue to be fabricated offsite. We also continue to invest in maintaining our ISO 9000 certification.

Sales and Marketing

We rely on our officers for the coordination of our sales and marketing efforts. Management uses our website, www.ecospheretech.com, and search engine optimization marketing programs as well as inbound marketing techniques to bring potential customers to our website to learn about our unique technologies and product offerings.  We have developed a marketing and communications strategy with our website design team to place our Company information and ads on various industry websites.  Current marketing opportunities include attendance at key trade shows, presentations to industry and analyst groups and one on one conferences as appropriate. The Company employs a Director of Business Development who is working with management to expand our business to other industry applications, as well as assisting in expanding business for EES.  In 2012 the Company engaged ICR, Inc. ("ICR") to serve as its integrated investor and public relations firm.  As part of its public relations services, ICR provides the Company with business coverage, which helps promote the Company's patented Ozonix® technology.  

Government Regulation and Environmental Laws

There are numerous state and federal regulatory legislative initiatives under consideration.  While passage of broad sweeping legislation at the federal level does not seem likely in in the current political climate, there are a number of state regulatory initiatives that may regulate disposal of produced water in deep injection wells and require disclosure of chemicals used in hydraulic fracturing. We believe any regulatory initiative would likely have a positive effect on the adoption of our Ozonix® technology that enables reduced usage of toxic liquid chemicals and 100% recycling of flowback and produced waters. Such bans on disposal of flowback and produced water in wells is likely to encourage the recycling of these waters with the Ozonix® process.  Conversely, banning hydraulic fracturing, as Vermont has done, or imposing a moratorium as New York did, can have an adverse effect since it removes a potential source of business for our Ozonix® technology.  Additionally, some local communities have either banned hydraulic fracturing or imposed moratoriums.  

Additionally, the coal industry faces heavy environmental regulation at all levels starting at the federal level where the Environmental Protection Agency (the “EPA”) implements regulations under the Clean Air Act.  The EPA’s general regulatory thrust has been to zealously protect the environment and ameliorate climate change; at the same time business interests are treated less favorably.  In 2012, the EPA imposed a moratorium known as the “new source performance standards” on new coal-fired plants, plus other rules that are forcing utilities to shut down older plants and invest billions of dollars in facility upgrades.  Under the new source performance standards, all future power plants running on coal or gas must not emit more than 1,000 pounds of carbon dioxide per megawatt-hour.  While the average U.S. natural gas plant emits 800 to 850 pounds per megawatt-hour, coal plants emit an average of 1,768 pounds of carbon dioxide per megawatt-hour.

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ECOSPHERE EXPLORATION AND MINING SERVICES, LLC

Ecosphere Exploration and Mining Services, LLC ("EEMS") is a wholly-owned subsidiary of the Company.  Our management team is planning to implement a strategy similar to that employed with EES, which is to apply the Ozonix® process to recycle water and reduce toxic chemicals used in the mining and processing of gold, silver, and other valuable minerals.  EEMS will partner with select mining companies as EES did in the oil and gas industry to commercialize the Ozonix® process for mining applications other than coal, which is part of the EES license.  We believe that the use of toxic chemicals like cyanide and sulfuric acid in the mining industry is a tremendous business opportunity for us.  Water recovery and pollution problems caused by mining include acid mine drainage, metal soil contamination and increased contaminated sediment levels in streams, lakes and rivers.  These issues can be managed using our Ozonix® process.  The EPA estimates that there are more than 600,000 mines in the United States, most of which are abandoned, and that have polluted over 180,000 acres of reservoirs and lakes, and 12,000 miles of streams.  Without remediation and reclamation of these mines, they will continue to discharge toxic metals in water streams.  Our research indicates that the Ecosphere Ozonix® process produces a much safer and stronger oxidant that can be used in place of these toxic chemicals to increase ore recovery rates and decrease the use of the toxic chemicals.  Additionally, our Ozonix® process can be utilized to treat toxic water storage sites.  

In February 2013, we entered into a letter of intent with a Colorado-based company named Dominion Water LLC which is under common ownership with a group that owns gold and silver mining properties.  The company is led by businessman Tom Weins who is a former Colorado state senator. Additionally, one of the principals of this group is Mr. Jimmac Lofton, a member of our board of directors. The purpose of the letter of intent is to prove the feasibility of using our Ozonix® technology in order to improve the recovery of gold and silver ore from mining operations as well as to treat and recycle the mining wastewater which is created in the operations.  Assuming we are successful, we expect to enter into a definitive sublicense agreement providing this third party with exclusive rights to exploit our Ozonix® in mining (other than coal) in the State of Colorado.

Other Ozonix® Wastewater Treatment Applications

We intend to market the Ecosphere Ozonix® technology wherever there are large volumes of industrial wastewaters and drinking waters that need innovative solutions to treat, recycle and reuse water resources.  Since 2008, Ecosphere has been focused on hydraulic fracturing as part of the onshore oil and natural gas completions process.  Our potential markets for Ozonix® include all industries around the world that use liquid chemicals to treat water for microbial control and scale-inhibition.  We are focused on developing strategic partnerships to deploy our technology in a wide variety of global industrial and municipal wastewater applications.  The Ecosphere Ozonix® technology has broad spectrum treatment capabilities in a multitude of industry segments.  There is an inherent “uniqueness” of the Ecosphere Ozonix® technology when compared to traditional chemical water treatment technologies that it either replaces or with which it is combined to offer improved operational efficiencies and cost savings.  In addition, the following offers a very broad overview of some segments of industries where thousands of potential clients exist.  These primary applications include, but are not limited to (not including mining):

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Energy Wastewater – Beyond oil and gas well completion, our patented Ozonix® technology has applications in other parts of the energy business including conventional and nuclear power plants, as well as coal-fired power plant operations.

·

Municipal Wastewater – Wastewater discharged into municipal wastewater systems travels to local wastewater treatment plants where it is treated before being discharged into the environment.  According to the U.S. Census, in 2000, there were 15,591 wastewater treatment facilities in the U.S. with a total capacity of 42.225 billion gallons per day.

·

Industrial Wastewater – Diminishing water supplies, increasing water acquisition costs and stricter environmental standards are forcing industries to target increased water-efficiency and reuse for a number of industrial environments including but not limited to food and beverage, textile, pulp and paper, automotive, aerospace and pharmaceutical processing facilities.

·

Agricultural Wastewater – As reported by the EPA, agriculture nonpoint source pollution is the leading source of water quality impacts on surveyed rivers and lakes as surveyed in the 2000 National Water Quality Inventory provided to Congress.  Agriculture is a highly intensified industry in many parts of the world, producing a range of wastewaters including sediment and nutrient runoffs, pesticides and animal wastes requiring a variety of treatment technologies.  The disposal of many of these wastes can pose serious health problems.

·

Marine Wastewater – The water taken up at sea and released in port is often responsible for the introduction of invasive aquatic species that can take over occupied areas, facilitate the spread of disease, alter the underwater seascape and jeopardize the ability of native species to obtain food.  Today, there are international, national, state and local agencies that regulate global water treatment standards for a range of marine industries including but not limited to aquaculture, ballast wastewater and on-board water processing.

8

Ecosphere’s patented Ozonix® technology provides solutions for treating and recycling wastewater in the energy business and in many other industries as illustrated below in an excerpt from our 2011 Annual Shareholders' Meeting investor presentation:

Other Technologies

In addition to the Ozonix® technology, the Company presently owns several other technologies that are completed and available for global marketing.  Among these technologies is our Ecos LifeLink®.  We completed the design and engineering for our mobile micro-utility system in late 2006.  This Ecos LifeLink® unit has the capacity to provide power, telecommunications and clean water in remote regions of the world without using fossil fuel.

Research and Development

The Ecosphere Ozonix® technology is the result of a research and development journey that began with the Company’s innovation to use water under high pressure to remove coatings from the hulls of ships.  The process required a method for treating the resulting waste stream, a mixture of water and ship coatings which contained numerous and varied metals and other chemical compounds.  The Company experimented with a variety of conventional filtration and separation technologies and settled on a combination of reverse osmosis and media filtration units.

9

In the aftermath of the September 11, 2001, terrorist attacks on the World Trade Center there was a growing fear that future attacks might be directed toward poisoning municipal water supplies.  In response to this perceived threat, the Company designed, engineered and built the first mobile water filtration unit to be tested and verified by the EPA for treating contaminated water from a terrorist attack.  This unit was modified and used to provide the City of Waveland, Mississippi with drinking water after their municipal treatment plant was destroyed by Hurricane Katrina.

In 2007, as the Company was in the process of selling its ship stripping technology, the Company became aware of the vast amounts of water being used in the hydraulic fracturing of oil and natural gas wells.  The Company’s founder was convinced that he and his team of engineers and industry consultants could develop an alternative to the industry practice of using toxic chemicals and trucking flowback water, generated by the fracturing process that was being injected into disposal wells deep underground. We were successful and our experience operating on location at the well site provided the impetus for the further improvements made to our technology in 2010 which were designed to reduce the number of units needed on the well site, first from 12 units to six units (EF20) and ultimately to two units (EF80) which is the latest Ozonix® unit we now manufacture today.  In some shale plays, where a well is fractured at up to 80 barrels a minute, one Ozonix® EF80 system has the capacity to treat the water on the front end of the hydraulic fracturing operation.

The development of our patented Ecosphere Ozonix® technology has permeated throughout the operations of our Company during the journey from cleaning water used to strip coatings from large ships to today’s game changing technology, a non-chemical alternative for the treatment of wastewater in a multitude of industries and applications.  Virtually every undertaking of the Company since its inception has contributed to the development of this technology.

Given the preceding, the amount of investment in research and development by the Company extends far beyond the amount allowed to be recognized by Generally Accepted Accounting Principles (“GAAP”) which amounted to $28,290, $247,107 and $163,328 for the years ended December 31, 2012, 2011 and 2010, respectively.

Intellectual Property

In addition to five recently approved patents for the Ecosphere Ozonix® technology, Ecosphere holds an extensive portfolio of intellectual property and clean technologies.  Four patents were filed as patent applications under the Obama Administration’s Green Technology Fast Track program that began December 1, 2009 with three granted in 2010 and one in 2011.  In November 2012, we received our fifth patent for Ozonix®.  Our intellectual property portfolio includes registered and pending patents, trademarks, copyrights and trade secrets.  Our material intellectual property was invented by our founder, Chief Executive Officer and Chief Technology Officer, Mr. Dennis McGuire, and assigned to us.  We believe our intellectual property portfolio will act as a barrier to entry for other competitors who may seek to provide competing technology.  In 2012, the Company filed five U.S. patent applications and two international patent applications for various water treatment technologies.

The following is a list of intellectual property assets owned by the Company:

·

U.S. Patent No. 8,318,027

·

U.S. Patent No. 7,943,087

·

U.S. Patent No. 7,699,994

·

U.S. Patent No. 7,785,470

·

U.S. Patent No. 7,699,988

·

U.S. Patent No. 5,628,271

·

U.S. Patent No. 5,849,099

·

U.S. Patent No. 6,287,389

·

U.S. Patent No. 6,425,340

·

U.S. Patent No. 6,595,152

·

U.S. Patent No. 6,604,696

·

U.S. Patent No. 7,100,844

·

U.S. Patent No. 6,745,108

Employees

At March 29, 2013, we had 72 total employees of which one was part-time.  This includes 20 EES employees.  None of our employees are covered by a collective bargaining agreement.  We believe that our relationships with our employees are good.

10

ITEM 1A.

RISK FACTORS.

Investing in our common stock involves a high degree of risk.  You should carefully consider the following risk factors before deciding whether to invest in Ecosphere.  Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also impair our business operations or our financial condition.  If any of the events discussed in the risk factors below occur, our business, consolidated financial condition, results of operations or prospects could be materially and adversely affected.  In such case, the value and marketability of the common stock could decline, and you may lose all or part of your investment.

Risk Factors Relating to Our Company

Our ability to continue as a going concern is in doubt absent Hydrozonix or another third-party purchasing units from us.

In 2012, 76 % of our revenue was generated from the sale of Ozonix® units under the Hydrozonix Agreement.  If Hydrozonix does not pay us for the Ozonix® units described in the risk factor below and we are unable to locate another party to purchase Ozonix® units from us, our cash flows from operating activities will substantially decrease.  In such event, our ability to continue as a going concern is in doubt and we may not be able to remain in business unless we complete a significant financing or other transaction.

If we do not receive a binding purchase order for Units 13-14, we may not have cash to meet our obligations or pay our future operating expenses.

In early January 2013 we commenced construction of Units 13-14 for Hydrozonix consistent with past practice.  However, we did not get a binding purchase order.  In February, we received a conditional purchase order which did not provide for any interim payment.  See Item 1.  “Description of Business – Hydrozonix Agreement.”  We are relying upon Hydrozonix or some other source to supply the necessary liquidity.  On February 6^th, we agreed with Hydrozonix that if it did not pay us by April 15^th for Units 13-14 and place a binding purchase order for Units 15-16 with the required down payment, it will lose its exclusivity.  As a result of Hydrozonix’ failure to pay us, we have incurred substantial liability to suppliers and used our existing cash resources (including borrowing from EES) to pay our overhead and make limited payments to vendors.  Our continued viability is dependent upon receiving the required funds from Hydrozonix.  If we encounter liquidity problems for the reasons outlined above, we will need immediate financing unless we are able to quickly sell Units 13-14 to a third party.  

If Hydrozonix does not meet its purchase requirements, our results of operations may be harmed.    

We rely heavily on the Hydrozonix Agreement.  In 2012, 76% of our revenue was generated from the sale of Units, spare parts and upgrades to Hydrozonix under the Hydrozonix Agreement.  In order for Hydrozonix to maintain their exclusivity under the Agreement, it must purchase and pay for Units 13-16 and thereafter meet minimum purchase requirements.  If Hydrozonix loses its exclusivity, we will need to sell Units 13-14 to a third party, and EES will need to begin a quest for customers willing to purchase Ozonix® units and service oil and gas drillers like Hydrozonix or expand its current service business which was limited to two customers under the Hydrozonix Agreement.  Because Hydrozonix may maintain its exclusivity, EES has been unable to seek alternatives.  Thus we expect cash flow difficulties in the short run at least and continued uncertainty.

If we do not generate positive cash flow, we will be required to engage in a future financing.

Assuming we receive the balance of the loan proceeds and/or payment from Hydrozonix, we will continue to be dependent upon future cash flows from Hydrozonix, our ability to monetize our intellectual property or future financing.  If we need further financing, our recent convertible note agreement provides that the lenders have a senior position. Because of the continued volatility and disruption in worldwide capital and credit markets, potential deteriorating conditions in the U.S., ongoing financial issues in Europe, and difficulties which microcap companies have in raising capital, the lack of available credit for companies like us and our stock price, we may be hampered in our ability to raise the necessary working capital.  Even if we do find a source of additional capital, we may not be able to negotiate terms and conditions for receiving the additional capital that are acceptable to us.  Any future capital investments may dilute or otherwise materially and adversely affect the holdings or rights of our existing shareholders.  In addition, new equity or debt securities issued by us to obtain financing could have rights, preferences and privileges senior to our common stock.  We cannot give you any assurance that any additional financing will be available to us, or if available, will be on terms favorable to us.  If we need to raise capital and we do not raise the necessary working capital, we may not be able to remain operational or we may have to scale back our operations.

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If we are unable to replace the income generated from the Southwestern contract due to lower forecasted demand for our services, we may not have positive cash flows.

Assuming Hydrozonix resumes paying us or we are able to replace it with one or more additional customers which purchase the same number of units at the same price, we may still not have positive cash flow.  Beginning in August 2012 Southwestern Energy initially reduced its use of our Ozonix® technology and by December 2012 ceased using our services, although it resumed in February 2013..  If Hydrozonix maintains its exclusivity, the Hydrozonix Agreement precludes us from serving customers other than Southwestern Energy and Newfield Exploration.  Thus, we will be dependent upon developing another source of revenues in one or more verticals.  We cannot assure you we will achieve this goal.

Although we believe we have the only robust chemical-free solution for treating water including frac flowback water and produced water stemming from the drilling of oil and gas wells, we face severe competition from a number of sources including a major drilling contractor and various chemical companies which may adversely affect our future results of operations and financial condition.

Halliburton, a leading drilling contractor, introduced its CleanSuite hydraulic fracturing technologies offering a variety of environmentally friendly alternatives to the use of hydraulic fracturing fluid additives including CleanStim, CleanStream and CleanWave.  CleanStim is a fracing fluid system comprised of materials sourced from the food industry.  CleanStream is a process developed by Halliburton that uses ultraviolet light to control the growth of bacteria in hydraulic fracturing fluid, in contrast to the ozone which is used in our Ozonix® process.  CleanWave uses electrical current to coagulate suspended matter in the fluid.  Halliburton represents a significant competitive threat since it is involved in the drilling and fracturing of many wells which provides it with the advantage of selling an additional service.  In addition, Halliburton was recently ranked 118 in Fortune 500 companies.  Thus, it has substantially greater financial, technical and other resources and presents a significant competitive threat.  We cannot assure you that our Ozonix® technology will be able to compete with Halliburton.  In addition, various chemical companies continue to assert competitive alternatives to the Ozonix® process including "green" chemical alternatives. See Item 3. “Legal Proceedings” for a discussion of an arbitration proceeding we recently initiated against Halliburton alleging it stole our trade secrets and seeking $300 million in damages.

If the current price of natural gas decreases, energy companies may reduce their drilling operations in shale deposits, which could adversely affect the attractiveness of our Ecosphere Ozonix® business. 

In early 2008, with high prices for natural gas, energy companies began profitably drilling in shale areas.  These operations rely on enormous supplies of clean water.  Much of the water used in drilling oil and natural gas wells and the resulting water that flows back in a polluted state creates an opportunity for our Ecosphere Ozonix® technology.  Horizontal drilling in shale areas is very expensive; however, if prices for natural gas are sufficiently high this expense can be justified.  If current prices decline, horizontal drilling may not be cost-effective and the lack thereof may adversely affect our Ecosphere Ozonix® technology.

Because our Ecosphere Ozonix® systems are designed to provide a solution which competes with existing methods; we are likely to face resistance to change, which could impede our ability to commercialize this business.

Our Ecosphere Ozonix® systems are designed to provide a solution to environmental challenges created by contaminated water.  Specifically, we believe it can provide a solution to the disposal of wastewater in the oil and gas, mining, marine, coal and other industries.  Currently, large and well-capitalized companies provide services in these areas.  These competitors have strong relationships with their customers’ personnel, and there is a natural reluctance for businesses to change to new technologies.  This reluctance is increased when potential customers make significant capital investments in competing technologies.  Because of these obstacles, we may face substantial barriers to commercializing our business.

If chemical companies engage in predatory pricing, our licensee may lose customers, which could materially and adversely affect us.

In the oil and gas business, energy companies traditionally have used liquid chemicals to treat the water used to fracture wells.  The chemical companies represent a significant competitive factor.  The chemical companies which supply chemicals to oil and gas drillers may, in order to maintain their business relationship with drillers, drastically reduce their price and seek to undercut the pricing at which we can realistically charge for our products or services.  While predatory pricing that is designed to drive us or any sub-licensee out of business may be illegal under the United States anti-trust and other laws, we may lose customers as a result of any future predatory pricing and be required to file lawsuits against any companies who engage in such improper tactics.  Any such litigation may be very expensive which will further impact us and affect their financial condition.  As a result, predatory pricing by chemical companies could materially and adversely affect us.

12

If we do not achieve broad market acceptance of our clean technology products, we may not be successful.

Although all of our products and services serve existing needs, our delivery of these products and services is unique and subject to broad market acceptance.  As is typical of any new product or service, the demand for, and market acceptance of, these products and services are highly uncertain.  We cannot assure you that any of our products and services will be commercialized on a widespread basis.

To date, we have only generated revenue from the United States onshore oil and gas business, although in 2013 we recently signed a letter of intent for the mining industry. We cannot assure you that these pilots will result in revenue to us in 2013 or at all.

If the markets for our products and services fail to develop on a meaningful basis, if they develop more slowly than we anticipate or if our products and services fail to achieve sufficient market acceptance, our business and future results of operations could be adversely affected.

Our growth strategy reflected in our business plan may not be achievable or may not result in profitability.

Our growth strategy reflected in our business plan may not be able to be implemented at all or rapidly enough for us to achieve profitability.  Our growth strategy is dependent on several factors, such as our ability to respond to the technological needs of our customers and others in the markets in which we compete and a degree of market acceptance of our products and services.  We cannot assure you the potential customers we intend to target will purchase our products or services in the future or that if they do, our revenues and profit margins will be sufficient to achieve profitability.

If there is an economic downturn, our customers may delay in paying us or not pay us at all.  This would have a material adverse effect on our future operating results and financial condition.

One of the effects of an economic downturn is that businesses may maintain their cash reserves and delay paying their creditors whenever possible.  As a trade creditor, we lack the leverage which secured lenders and providers of other essential services have.  If the economy deteriorates, we may find that our oil and gas customers and our future customers may delay in paying us.  This could result in a number of adverse effects upon us including increasing our borrowing costs, reducing our profit margins, severely impacting liquidity and reducing our ability to grow our business which could have a material adverse effect on Ecosphere.

Because our operating results have and may continue to fluctuate dramatically, particularly from quarter to quarter, investors should not rely upon our results in any given quarter as being part of a trend.

In the past, our quarterly operating results fluctuated and may continue to do so in the future as a result of a number of factors, including the following:

·

Our receipt of orders and cash flow from existing and new customers including Hydrozonix;

·

The availability of components from our suppliers for Ecosphere Ozonix® systems;

·

Operating results from our Ecosphere Ozonix® units and the announcement of future agreements for our Ecosphere Ozonix® units;

·

Our raising necessary working capital and any associated costs which will be charged as expenses to our future results of operations;

·

Our continuing to develop new technologies;

·

Pricing pressures;

·

General economic and political conditions;

·

Our ability to finance new verticals and develop commercial relationships for those verticals;

·

Our sales or licensing of our technologies.

Very recently our reliance on Hydrozonix has placed us in a precarious financial position.  Unless Hydrozonix pays us for Units 13-14 by April 15, 2013, we will report a substantial decline in revenues and a large operating loss for the quarter ending March 31, 2013.

As a result of these and other factors, we have experienced, and may continue to experience, fluctuations in revenues and operating results.  As a consequence, it is possible that fluctuations in our future operating results may cause the price of our common stock to fall.

If we cannot manage our growth effectively, we may not become profitable.

Businesses which grow rapidly often have difficulty managing their growth.  We have been growing rapidly.  If this growth continues, we will need to expand our management by recruiting and employing experienced executives and key employees capable of providing the necessary support.  We cannot assure you that our management will be able to manage our growth effectively or successfully.  Our failure to meet these challenges could cause us to lose money, and your investment could be lost.

13

Because our business model is centered on partnering with third parties, we will not be able to control key aspects of the commercialization of our business, which can adversely affect our future results of operations.

Our business model is to invent and develop technologies and once we prove that they are commercially viable, we partner with larger and financially stable companies, which would conduct our operations.  Thus our ability to commercialize our future business will be dependent upon third parties, which we will not be in a position to control and, as a result, we could be adversely affected if the third parties do not pursue their agreements with us in the manner we anticipate.

If federal and state legislation and regulatory initiatives relating to horizontal drilling are passed, it could materially and adversely affect our results of operations.

EES’ business relies upon supplying chemical-free solutions for cleaning the large amounts of water used in hydraulic fracturing applications.  Objections have been raised by environmentalists, some land owners and some government officials including environmental authorities that there have been adverse side effects affecting the purity of the water supply as a result of the injection of chemicals and water in connection with horizontal drilling.  Although we believe that EES has a chemical-free solution which should result in increased business, we cannot assure you that legislation or rules will not be passed or action taken by environmental authorities that will preclude the use of horizontal drilling.  At the state level, certain states have implemented moratoriums and certain obligations on oil gas companies using horizontal drilling.  See Item 1. “Description of Business - Government Regulation”.  The adoption of any future federal or state laws or implementing regulations imposing reporting or permitting obligations on, or otherwise limiting, the horizontal drilling process could make it more difficult to perform, or even prohibit oil and gas companies from using horizontal drilling, to complete gas and oil wells.  These additional costs to drillers could result in reduced oil and gas drilling.  This would reduce our potential service revenue and adversely affect our ability to sell Ozonix® Units. If this were to occur more widely in the United States, the demand for EES’ services may be eliminated or substantially reduced.  If any such federal or state legislation on horizontal fracturing were passed, our revenues and results of operations could be adversely affected.  

If we are unable to protect our proprietary technology, our business could be harmed.

Our intellectual property including our patents is our key asset.  In addition to our existing patents, we have filed United States patent applications covering certain technologies.  If one or more patents are not issued by the United States, the value of our other technologies could be materially reduced.  Competitors may also be able to design around our patents and to compete effectively with us.  The cost to prosecute infringements of our intellectual property or the cost to defend our products against patent infringement or other intellectual property litigation by others could be substantial.  We cannot assure you that:

·

Pending and future patent applications will result in issued patents;

·

Patents we own or which are licensed by us will not be challenged by competitors;

·

The patents will be found to be valid or sufficiently broad to protect our technology or provide us with a competitive advantage; and

·

We will be successful in defending against future patent infringement claims asserted against our products.

Both the patent application process and the process of managing patent disputes can be time consuming and expensive.  In addition, changes in U.S. patent laws could prevent or limit us from filing patent applications or patent claims to protect our products and/or technologies or limit the exclusivity periods that are available to patent holders.  In September 2011, the Leahy-Smith America Invents Act, or the Leahy-Smith Act, was recently signed into law and includes a number of significant changes to U.S. patent law, including the transition from a "first-to-invent" system to a "first-to-file" system and changes to the way issued patents are challenged.  These changes may favor larger and more established companies that have more resources than we do to devote to patent application filing and prosecution.  The U.S. Patent and Trademark Office recently issued new Regulations effective March 16, 2013 to administer the Leahy-Smith Act.  Accordingly, it is not clear what, if any, impact the Leahy-Smith Act will ultimately have on the cost of prosecuting our patent applications, our ability to obtain patents based on our discoveries and our ability to enforce or defend our issued patents.  However, it is possible that in order to adequately protect our patents under the "first-to-file" system, we will have to allocate significant additional resources to the establishment and maintenance of a new patent application process designed to be more streamlined and competitive in the context of the new "first-to-file" system, which would divert valuable resources from other areas of our business.  In addition to pursuing patents on our technology, we have taken steps to protect our intellectual property and proprietary technology by entering into confidentiality agreements and intellectual property assignment agreements with our employees, consultants, corporate partners and, when needed, our advisors.  Such agreements may not be enforceable or may not provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements, and we may not be able to prevent such unauthorized disclosure.  Monitoring unauthorized disclosure is difficult, and we do not know whether the steps we have taken to prevent such disclosure are, or will be, adequate.

14

If we are subject to intellectual property infringement claims, it could cause us to incur significant expenses and pay substantial damages.

Third parties may claim that our equipment or services infringe or violate their intellectual property rights.  Any such claims could cause us to incur significant expenses and, if successfully asserted against us, could require that we pay substantial damages and prevent us from using licensed technology that may be fundamental to our business service delivery.  Even if we were to prevail, any litigation regarding its intellectual property could be costly and time-consuming and divert the attention of our management and key personnel from our business operations.  We may also be obligated to indemnify our business partners in any such litigation, which could further exhaust our resources.  Furthermore, as a result of an intellectual property challenge, we may be prevented from providing some of our services unless we enter into royalty, license or other agreements.  We may not be able to obtain such agreements at all or on terms acceptable to us, and as a result, we may be precluded from offering some of our equipment and services.

Risks Related to Our Common Stock

Because our common stock does not trade on a securities exchange, a number of investors can not purchase our common stock, which has a depressive effect on our stock price.

Our common stock trades on the Bulletin Board which is not a national securities exchange.  As a result of that and our stock price being under $5.00 most institutions can not buy our stock and brokers generally can not recommend to investors that they buy our stock.  If an active market for our common stock is not sustained, the price may decline in the future.

Because we are subject to the “penny stock” rules, brokers cannot generally solicit the purchase of our common stock which adversely affects its liquidity and market price.

The SEC has adopted regulations which generally define “penny stock” to be an equity security that has a market price of less than $5.00 per share, subject to specific exemptions.  The market price of our common stock on the Bulletin Board has been substantially less than $5.00 per share and therefore we are currently considered a “penny stock” according to SEC rules.  This designation requires any broker-dealer selling these securities to disclose certain information concerning the transaction, obtain a written agreement from the purchaser and determine that the purchaser is reasonably suitable to purchase the securities.

These rules limit the ability of broker-dealers to solicit purchases of our common stock and therefore reduce the liquidity of the public market for our shares.

Due to factors beyond our control, our stock price may be volatile.

Any of the following factors could affect the market price of our common stock:

·

The resolution of our present liquidity problems;

·

Our announcements of and progress with commercialization in other business besides U.S. onshore oil and gas;

·

Our failure to generate increasing revenues;

·

Our failure to receive purchase orders;

·

Short selling activities;

·

The loss of key personnel;

·

Our failure to achieve and maintain profitability;

·

Actual or anticipated variations in our quarterly results of operations;

·

Announcements by us or our competitors of significant contracts, new products, acquisitions, commercial relationships, joint ventures or capital commitments;

·

The loss of major customers or product or component suppliers;

·

The loss of significant business relationships;

·

Our failure to meet financial analysts’ performance expectations;

·

Changes in earnings estimates and recommendations by financial analysts; or

·

Changes in market valuations of similar companies.

In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted.  A securities class action suit against us could result in substantial costs and divert our management’s time and attention, which would otherwise be used to benefit our business.

15

We may issue preferred stock without the approval of our shareholders, which could make it more difficult for a third party to acquire us and could depress our stock price.

Our Board may issue, without a vote of our shareholders, one or more additional series of preferred stock that have more than one vote per share.  This could permit our Board to issue preferred stock to investors who support our management and give effective control of our business to our management.  Additionally, issuance of preferred stock could block an acquisition resulting in both a drop in our stock price and a decline in interest of our common stock.  This could make it more difficult for shareholders to sell their common stock.  This could also cause the market price of our common stock shares to drop significantly, even if our business is performing well.

If the holders of our outstanding securities exercise or convert their securities into common stock, we will issue a substantial number of shares, which will materially dilute the voting power of our currently outstanding common stock.

As of March 29, 2013, we had 153,618,062 shares of our common stock outstanding, 5,984,485 shares underlying warrants, 2,438,775 shares underlying outstanding convertible notes and 70,424,944 shares underlying stock options.  If the holders of the securities described in this risk factor exercise or convert their securities, it will materially dilute the voting power of our outstanding common stock.

An investment in Ecosphere will be diluted in the future as a result of the issuance of additional securities, the exercise of options or warrants or the conversion of outstanding preferred stock.

In order to raise additional capital to fund our strategic plan, we may issue additional shares of common stock or securities convertible, exchangeable or exercisable into common stock from time to time, which could result in substantial dilution to investors.  We cannot assure you that we will be successful in raising additional capital.

Because our management and employees do not solely by virtue of their ownership of our common stock control Ecosphere, it is possible that third parties could obtain control and change the direction of our business.

Our officers and directors beneficially own approximately 5.9 million shares of our common stock or 3.8% of the shares actually outstanding.  By including shares of common stock which are issuable upon exercise of outstanding options held by them, they beneficially own approximately 41 million shares or 22%.  If all of our equity equivalents outstanding as of March 29, 2013 were exercised, we would have 217,517,498 shares outstanding.  For that reason, a third party could obtain control of Ecosphere and change the direction of our business.

Since we intend to retain any earnings for development of our business for the foreseeable future, you will likely not receive any dividends for the foreseeable future.

We have not and do not intend to pay any dividends in the foreseeable future, as we intend to retain any earnings for development and expansion of our business operations.  As a result, you will not receive any dividends on your investment for an indefinite period of time.

Because almost all of our outstanding shares are freely tradable, sales of these shares could cause the market price of our common stock to drop significantly, even if our business is performing well.

As of March 29, 2013, we had 153,618,062 shares of common stock outstanding of which our directors and executive officers own approximately 5.9 million shares which are subject to the limitations of Rule 144 under the Securities Act.  Most of the remaining outstanding shares, including a substantial amount of shares issuable upon exercise of options, are and will be freely tradable.

In general, Rule 144 provides that any non-affiliate of Ecosphere, who has held restricted common stock for at least six months, is entitled to sell their restricted stock freely, provided that we stay current in our SEC filings.  After one year, a non-affiliate may sell without any restrictions.

An affiliate of Ecosphere may sell after six months with the following restrictions:

(i)

we are current in our filings,

(ii)

certain manner of sale provisions, and

(iii)

filing of Form 144.

16

Because almost all of our outstanding shares are freely tradable and a number of shares held by our affiliates may be freely sold (subject to Rule 144 limitation), sales of these shares could cause the market price of our common stock to drop significantly, even if our business is performing well.

Because we may not be able to attract the attention of major brokerage firms, it could have a material impact upon the price of our common stock.

It is not likely that securities analysts of major brokerage firms will provide research coverage for our common stock since the firm itself cannot recommend the purchase of our common stock under the penny stock rules referenced in an earlier risk factor.  The absence of such coverage limits the likelihood that an active market will develop for our common stock.  It may also make it more difficult for us to attract new investors at times when we require additional capital.

ITEM 1B.

UNRESOLVED STAFF COMMENTS.

None.

ITEM 2.

PROPERTIES.

Ecosphere rents three contiguous buildings in Stuart, Florida comprising an aggregate of 21,100 square feet of space.  Our aggregate monthly rent is $16,769.  The first building houses the corporate offices, the second building provides warehouse, manufacturing and testing space and the third building provides additional warehouse and machine shop space.  All of these buildings are rented on a month-to-month basis.

EES leases a building in Conway, Arkansas, comprising approximately 7,500 square feet of space which comprises our administrative offices and equipment maintenance facility for our operations in Arkansas.  The aggregate monthly rent is $3,300.  The lease expires in October 2013.

ITEM 3.  

LEGAL PROCEEDINGS.

From time to time, we are involved in litigation in the ordinary course of business.  We are not presently a defendant in any material litigation.  In February 2013, the Company initiated an arbitration proceeding against Halliburton Energy Services, Inc. (“Halliburton”) before the American Arbitration Association, alleging that Halliburton misappropriated Ecosphere’s trade secrets and proprietary technical business and strategic information.  The Company is seeking to recover $300 million in damages alleging that Halliburton breached a Non-Disclosure Agreement with the Company and thereafter misappropriated the Company’s trade secrets relating to the Company’s green technology business model, to treat and recycle wastewater related to hydraulic fracturing operations for oil and gas.  As of the date of this Report, Halliburton has not filed an answer but the Company expects it to contest the allegations.

As previously disclosed in the Company’s Form 10-K filed on March 15, 2012, in February 2007, Kamimura International Associates (“KIA”) filed a lawsuit against the Company, and the Company filed a counterclaim against KIA.  In December 2012, the Company entered into a Settlement Agreement with KIA in which the Company agreed to pay KIA a total of $100,000 with the first payment of $25,000 due within 15 days of the Settlement Agreement and the balance to be paid in monthly installments of $2,083 beginning February 1, 2013.

In 2011 a vendor obtained a judgment against the Company in Louisiana for $51,911. The Company has not paid the judgment which was entered in Louisiana in a lawsuit filed by a vendor and, to its knowledge, no attempt has been made to enforce the judgment.

ITEM 4.

MINE SAFETY DISCLOSURES.

Not applicable.

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PART II

ITEM 5.

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

Our common stock is quoted on the Over-the-Counter Bulletin Board, or the Bulletin Board under the symbol “ESPH”.  The following table provides the high and low bid price information for our common stock for the periods indicated as reported by the Bulletin Board.  The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.  We have approximately 1,336 holders of record of our common stock.  On March 29, 2013, our common stock closed at $0.46.

Dividend Policy

We have not paid any cash dividends on our common stock and do not plan to pay any such dividends in the foreseeable future.  Our Board of Directors, or Board, will determine our future dividend policy on the basis of many factors, including results of operations, capital requirements, and general business conditions.

Recent Sales of Unregistered Securities

In addition to those unregistered securities previously disclosed in reports filed with the Securities and Exchange Commission, or the SEC, we have sold securities without registration under the Securities Act of 1933, which we refer to as the “Securities Act”.  Unless stated, all securities are shares of common stock.

(1)

The securities were issued in reliance upon the exemption provided by Section 4(a)(2) and Rule 506 under the Securities Act.

(2)

The securities were issued in reliance upon the exemption provided by Section 4(a)(2) under the Securities Act.

(3)

The securities were issued in reliance upon the exemption provided by Section 3(a)(9) under the Securities Act.

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Stock Performance Graph

This graph compares the cumulative total return of our Common Stock to the cumulative total return of the Russell 2000 Stock Index and a perceived peer company Hekmann Corporation (HEK), for the period from December 31, 2007 to December 31, 2012.  The graph assumes that the value of the investment in our Common Stock and each index was $100 at December 31, 2006 and that dividends (if any) were reinvested.

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ITEM 6.

SELECTED FINANCIAL DATA.

————————

(1)

The Company adopted ASC 815-40 effective January 1, 2009.  Under ASC 815-40 the Company recorded a liability for the fair value of warrants and the embedded conversion options of certain convertible debt agreements as of January 1, 2009 in the amount of $10,218,158.  Under ASC 815-40, the fair value of these liabilities is calculated at each reporting date with the change in liability recorded in other income or expense.  The Company estimates the fair value of these liabilities using the BSM option pricing model and Monte Carlo simulations.

The change in fair value of derivative instruments in other expense was $12,787,666 for the year ended December 31, 2010 as compared to $3,446,612 for the year ended December 31, 2009. This change in 2010 resulted primarily from a large increase in the fair value of the liability for derivative instruments in the first quarter of 2010 due to the increase in the market price of the Company’s common stock from $0.48 per share as of December 31, 2009 to $1.50 per share as of March 31, 2010.  As of December 31, 2010, there are no remaining convertible notes which generate a derivative liability for the Company.  In addition, the number of warrants requiring derivative accounting treatment was reduced from 16.9 million warrants at December 31, 2009 to 1.7 million warrants at December 31, 2010 through a combination of exercises by holders and through holders agreeing to modify the warrant terms to eliminate the requirement to treat the warrants as derivative instruments, in exchange for extending the expiration date of the warrants.  Additionally, the number of warrants further decreased in 2011 to approximately 1.2 million and to 1.0 million in 2012.  As such, we anticipate that future other income and expense from these financial instruments will diminish as evidenced by their nominal impact to results in fiscal 2011 and 2012.

(2)

Amounts include accrued dividends.

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ITEM 7.  

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

You should read the following discussion in conjunction with our audited historical consolidated financial statements, which are included elsewhere in this Form 10-K.  Management’s Discussion and Analysis of Financial Condition and Results of Operations contain statements that are forward-looking.  These statements are based on current expectations and assumptions, which are subject to risk, uncertainties and other factors.  Actual results may differ materially because of the factors discussed in the subsection titled “Risk Factors” which are located in Item 1A.

Company Overview

Ecosphere is a water engineering, technology licensing and innovative manufacturing company that develops environmental water treatment solutions for industrial markets throughout the world. The Company is a leader in emerging advanced oxidation processes and has an extensive portfolio of intellectual property that includes five U.S. patents for the Ecosphere Ozonix® process. The patented Ecosphere Ozonix® process is a revolutionary advanced oxidation process that is currently being used by global energy exploration companies to reduce costs, increase treatment efficiencies and eliminate liquid chemicals from wastewater treatment operations around the United States.  In 2013, we are actively engaged in expanding our Ozonix® technology outside of the oil and gas business.

2012 Highlights

·

We delivered eight Ozonix® EF80 units under the Hydrozonix Agreement during the year ended December 31, 2012.  

·

2012 revenues increased to approximately $31.1 million from approximately $21.1 million in 2011; for 2012, net income before net income allocation to non-controlling interest was approximately $1.1 million compared to a loss of approximately $5.9 million for 2011;

·

Including the $1.1 million allocated to the minority EES partners, we distributed approximately $6.7 million to EES members including Ecosphere;

·

In 2012, we had positive cash flow for the second consecutive year and reported net income before minority interest allocation of approximately $1.1 million;

·

The Company has been chosen for the 2012 Artemis Top 50 Water Tech Listing for the last three consecutive years.  The Artemis Top 50 is the water industry's benchmark for innovation that will matter.  It identifies the new solutions that will meet the world's water challenges.  The Top 50 are considered some of the most promising start-ups in the emerging high tech wave in water; and

·

The Company was awarded the Frost & Sullivan’s 2012 "North American Product Leadership Award in Disinfection Equipment for Shale Oil and Gas Wastewater Treatment."  The Excellence in Best Practices Awards are presented each year to companies that are predicted to encourage significant growth in their industries, have identified emerging trends before they became the standard in the marketplace, and have created advanced technologies that will catalyze and transform industries in the near future.  Frost & Sullivan's Product Leadership Award is a prestigious recognition of the Company's accomplishments in wastewater treatment for the U.S. oil and natural gas industry.  

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CRITICAL ACCOUNTING ESTIMATES

Use of Estimates

The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent 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. Significant estimates in the accompanying consolidated financial statements include the allowance for doubtful accounts receivable, valuation of inventory, estimates of costs to complete and earnings on uncompleted contracts, estimates of costs to complete and earnings on uncompleted contracts, estimates of depreciable lives and valuation of property and equipment, estimates of amortization periods for intangible assets, restructuring charges, valuation of equity-based instruments issued for other than cash, warranty reserve, valuation of derivatives and the valuation allowance on deferred tax assets.

Revenue Recognition

For each of our revenue sources we have the following policies:

Equipment and Component Sales

Revenues and related costs on production type contracts are recognized using the “percentage of completion method” of accounting in accordance with ASC 605-35, Accounting for Performance of Construction-Type and Certain Production Type Contracts (“ASC 605-35”).  Under this method, contract revenues and related expenses are recognized over the performance period of the contract in direct proportion to the costs incurred as a percentage of total estimated costs for the entirety of the contract.  Costs include direct material, direct labor, subcontract labor and any allocable indirect costs.  All unallocable indirect costs and corporate general and administrative costs are charged to the periods as incurred.  However, in the event a loss on a contract is foreseen, the Company will recognize the loss as it is determined.  Contract costs plus recognized profits are accumulated as deferred assets, and billings and/or cash received are recorded to a deferred revenue liability account.  The net of these two accounts for any individual project is presented as "Costs and estimated earnings in excess of billings on uncompleted contracts," an asset account, or "Billings in excess of costs and estimated earnings on uncompleted contracts," a liability account.  

Production type contracts that do not qualify for use of the percentage of completion method, the Company accounts for these contracts using the “completed contract method” of accounting in accordance with ASC 605-35-25-57.  Under this method, contract costs are accumulated as deferred assets, and billings and/or cash received is recorded to a deferred revenue liability account, during the periods of construction, but no revenues, costs, or profits are recognized in operations until the period within which completion of the contract occurs.  Costs include direct material, direct labor, subcontract labor and any allocable indirect costs.  All unallocable indirect costs and corporate general and administrative costs are charged to the periods as incurred.  However, in the event a loss on a contract is foreseen, the Company will recognize the loss as it is determined.  The deferred asset (accumulated contract costs) in excess of the deferred liability (billings and/or cash received) is classified as a current asset under "Costs in excess of billings on uncompleted contracts".  The deferred liability (billings and/or cash received) in excess of the deferred asset (accumulated contract costs) is classified under current liabilities as "Billings in excess of costs on uncompleted contracts".

A contract is considered complete when all costs except insignificant items have been incurred; the equipment is operating according to specifications and has been accepted by the customer.

The Company may manufacture products in anticipation of a future contract.  Since there are no binding contracts relating to the purchase of these products, ASC 605-35 is not applicable.  Accordingly, revenue is recognized when persuasive evidence of an arrangement exists, products are delivered to and accepted by the customer, economic risk of loss has passed to the customer, the price is fixed or determinable, collection is reasonably assured, and any future obligations of the Company are insignificant.

Field Services

Revenue from water treatment contracts is earned based upon the volume of water processed plus additional period based contractual charges and is recognized in the period the service is provided.  Payments received in advance of the performance of services or of the delivery of goods are deferred as liabilities until the services are performed or the goods are delivered.

Some projects the Company undertakes are based upon our providing water processing services for fixed periods of time.  Revenue from these projects is recognized based upon the number of days the service has been provided during the reporting period.

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Aftermarket Part Sales

The Company recognizes revenue from the sale of aftermarket parts during the period in which the parts are delivered to the buyer.

Royalties

Revenue from technology license royalties will be recorded as the royalties are earned.

The Company includes shipping and handling fees billed to customers in revenues and handling costs in cost of revenues.

Stock-Based Compensation

The Company follows the provisions of ASC Topic 718-20-10, Compensation – Stock Compensation that establishes standards surrounding the accounting for transactions with employees in which an entity exchanges its equity instruments for services.  Under ASC 718-20-10, we recognize an expense for the fair value of our outstanding stock options generally over the requisite service period of the employee service.  We follow the measurement and recognition provisions of ASC 505-50 Equity Based Payments to Non-Employees for non-employee stock-based transactions.

We estimate the fair value of each stock option at the grant date by using the Black-Scholes-Merton ("BSM") option pricing model based upon certain assumptions, which are contained in Note 16 to our consolidated financial statements contained in this report.  The BSM option pricing model requires the input of highly subjective assumptions including the expected stock price volatility.

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Comparison of the Year ended December 31, 2012 with the Year ended December 31, 2011

The following table sets forth a modified version of our Consolidated Statements of Operations that is used in the following discussions of our results of operations:

RESULTS OF OPERATIONS

Comparison of the Year Ended December 31, 2012 to the Year Ended December 31, 2011

The Company reported net income applicable to Ecosphere common stock of $0.1 million during the year ended December 31, 2012 (the "2012 Period") as compared to a net loss applicable to Ecosphere common stock of $7.7 million for the year ended December 31, 2011 (the "2011 Period").  The major driver of the variance in earnings is the Company's entering into the Hydrozonix Agreement in March 2011 and delivering its initial units beginning in the third quarter of 2011.  

Revenues

Revenues for the 2012 Period increased $10 million over 2011 Period.  The increase in revenue is driven largely by the Company selling eight Ozonix® EF80 units under the Hydrozonix Agreement in 2012 versus four units sold in 2011.  

In addition, in the 2012 Period the Company began engaging in the sale of aftermarket parts, services, upgrades and enhancements related to the EF80 units in use by Hydrozonix.  Such activities resulted in $1.1 million in revenues in the 2012 Period.

Partially offsetting the increase in revenues discussed above was a decline in the services business as Southwestern Energy ceased using our services in November 2012, although it resumed in February 2013.

The three months ended March 31, 2013 is being driven by Hydrozonix’s failure to pay for Units 13-14.  While we have not been paid as of the filing of this Report, Units 13-14 have passed benchmark testing overseen by Hydrozonix.  This means that they have been manufactured in accordance with Hydrozonix’s specifications.

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Costs and Expenses

Equipment Sales and Licensing Costs (exclusive of depreciation)

Equipment sales and licensing costs amounted to $16.4 million for the 2012 Period as compared to $8.3 million during the 2011 Period.  These costs represent the cost of the manufacture of the EF80 water treatment units sold to Hydrozonix.  The increase in costs is due to building eight units in the 2012 Period versus four EF80 units in the 2011 Period.

Field Services Costs (exclusive of depreciation)

The cost of providing field services was $2.5 million compared to $2.6 million in the 2011 Period.  Included in these costs for both periods are payroll related expenses for field personnel and parts and supplies used in support of the operation of Ozonix® water treatment systems and Ecos-Frac® products, which were lower due to (i) lower sales volume in the 2012 Period, (ii) efficiencies in our processes resulting in part from additional multiple well pad processing sites, and (iii) lower gas costs in the Period.  Largely offsetting the impact of these favorable factors were fixed costs incurred during downtime in the fourth quarter of the 2012 Period.

Aftermarket Part Costs (exclusive of depreciation)

The costs associated with the sale of aftermarket parts amount to $0.8 million for the 2012 Period.  The Company began engaging in the sale of aftermarket parts, services, upgrades and enhancements related to the Ozonix® EF80 units in service by Hydrozonix.

Salaries and Employee Benefits

The decrease in salaries and employee benefits of $4.8 million was primarily the result of a decrease in non-cash stock-based compensation expense in the 2012 Period compared to the 2011 Period.

Professional Fees

The decrease in professional fees of $0.5 million was largely driven by the 2011 Period costs being driven up by fees associated with the negotiation of the Hydrozonix Agreement.

Research and Development

Research and development expenses were de minimis in the 2012 Period given the Company's focus on manufacture of developed technology versus the 2011 Period wherein the technology was in the final stages of development.

Restructuring Charge Reversal

Revisions to previous estimates of restructuring costs associated with the June 2009 closing of the Company's New York office resulted in a reversal of $62,000 of expense in the 2012 Period.

Gain on Sale/Disposal of Fixed Assets, Net

The Company sold a water treatment unit that had been part of its historical fixed assets.  The net book value of such unit was written off pursuant to a September 2010 impairment charge.  The Company incurred costs of $33,933 to bring the unit to saleable condition.  Such costs are included in capital expenditures.  The Company received proceeds of $206,000 for the unit and, accordingly, recognized a gain of $172,067 on the transaction.  Partially offsetting this gain was a loss on the disposal of certain demo equipment amounting to $29,610.

Income (Loss) From Operations

Income from operations 2012 Period was $1.2 million compared to a loss of $5.3 million for the 2011 Period.  See discussion above under "Revenues" and "Costs and Expenses" for further details.  

Interest Expense

Interest expense was $0.4 million and $0.6 million for the years ended December 31, 2012 and 2011, respectively.  The decline in 2012 is the result of a decrease in the weighted average debt outstanding during the 2012 Period as compared to the same period in 2011.  During the 2012 Period, the Company reduced outstanding net debt by $0.7 million.  In addition, during the 2012 Period, the Company converted $0.8 million face value in convertible notes into common stock.

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Change in Fair Value of Derivative Instruments

The Company recorded non-cash gains of $41,374 in the 2012 Period and $152,888 in the 2011 Period related to the change in fair value of derivative instruments.  The 2012 valuation of liabilities was based on a 6% obligation when compared to total liabilities while 2011 represented 7%.

The Company records a liability for the fair value of warrants with repricing provisions.  Under ASC 815-40, the fair value of these liabilities is calculated at each reporting date with the change in liability recorded in other income or expense.  The Company estimates the fair value of these liabilities using the BSM option pricing model and Monte Carlo simulation. 

Noncontrolling Interest of Consolidated Subsidiary

The noncontrolling interest in consolidated subsidiary income was $0.8 million for the 2012 Period as compared to $1.7 million for the 2011 Period.  These amounts represent the amount of the income of EES for the respective periods which has been allocated to the non-controlling equity members of EES.  

Net Income (Loss) Applicable to Common Stock of Ecosphere Technologies, Inc.

Net income (loss) applicable to common stock of Ecosphere was $0.1 million for the 2012 Period, compared to a net loss applicable to common stock of $7.7 million for the 2011 Period.  Basic and diluted net income per common share was $0.00 for the year ended December 31, 2012 as compared to a basic and diluted net loss per common share of $0.05 for the year ended December 31, 2011.  The weighted average number of shares outstanding was 148,989,308 and 143,989,520 for the years ended December 31, 2012 and 2011, respectively.  Fully diluted weighted average shares outstanding were 154,568,010 and 143,989,520 for the years ended December 31, 2012 and 2011, respectively.

26

Comparison of the Year ended December 31, 2011 with the Year ended December 31, 2010

The following table sets forth a modified version of our Consolidated Statements of Operations that is used in the following discussions of our results of operations:

RESULTS OF OPERATIONS

Comparison of the Year Ended December 31, 2011 to the Year Ended December 31, 2010

The Company reported a net loss applicable to Ecosphere common stock of $7.7 million during the year ended December 31, 2011 as compared to a net loss applicable to Ecosphere common stock of $22.2 million for the year ended December 31, 2010 (the "2010 Period").  The major driver of the variance in net loss is the accounting for change in fair value of derivative instruments that impacted the prior year comparative period as discussed below.  Loss from operations of $5.3 million for the 2011 Period compares favorably with a prior year loss from operations of $8.6 million.  It should be noted that the 2011 Period loss from operations includes certain significant non-cash components including approximately $6.7 million of stock-based compensation expense.  The Company actually reported over $2.6 million of cash flow from operations for the 2011 Period.

Revenues

Revenues for the year ended December 31, 2011 increased $12.1 million over year ended December 31, 2010.  The increase in revenue is driven by the Company selling its first four Ozonix® EF80 units under the Hydrozonix Agreement which amounted to $11.5 million.  The remainder of the revenue increase was from ongoing services contracts.  The increase was the result of increased volume of activities in our business of pretreating water to fracture oil and natural gas wells and the processing of flowback and produced waters.

27

Costs and Expenses

Equipment Sales and Licensing Costs (exclusive of depreciation)

During the 2011 period, these costs represented the cost of the manufacture of the Ozonix® EF80 water treatment units sold to Hydrozonix.  We build the Ozonix® EF80 units under a “cost plus” formula whereby the buyer pays in advance for the components and labor costs to build the units.  Cost of Revenues for equipment sales and licensing was $8.3 million and covered the building of four EF80 units.  The first two units were “capped” at a maximum build cost to the client of $2.75 million which was subsequently increased to $2.8 million with the increase in capacity from 60 to 80 barrels per minute.  From the third unit on, there is no cap on the cost of the components and labor, which will ensure that operating income will not be impacted by cost variances.

Field Services Costs (exclusive of depreciation)

The cost of providing field services for the 2011 Period was $2.6 million, which was a reduction of $0.8 million from the 2010 Period.  Included in these costs for both periods are the payroll related costs of field personnel and parts and supplies used in support of the operation of Ozonix® water treatment system and Ecos-Frac® products which were lower despite higher sales volume in the 2011 Period.  Such favorability is the result of efficiencies in our processes resulting in part from additional multiple well pad processing sites, as well as lower gas costs in the 2011 Period.  

Salaries and Employee Benefits

Salaries and employee benefits increased by $1.3 million largely as a result of higher non-cash compensation expense related to option grants in 2011.

Administrative and Selling

Administrative and selling expenses decreased by $0.1 million due to greater efficiencies being achieved.

Professional Fees

Professional fees were consistent with the prior year.

Depreciation and Amortization

The $0.2 million increase in depreciation and amortization expense is due to additional capital equipment purchased for the manufacture of EF80 units.

Research and Development

The $0.1 million increase in R&D costs was incurred in making improvements in the Ozonix® process and technologies.

Impairment Reserve

The Company recorded a charge of $116,000 in the 2010 Period to reserve for the impairment in the value of the Company’s non-Ozonix® water treatment system which was previously installed in the tactical water filtration truck.  There was no impairment charge in 2011.

Restructuring Reserve

The Company recorded a charge of $50,000 in the 2010 Period, compared to no charge in the 2011 Period.  The 2010 charge was required to increase the restructuring reserve which was recorded in 2009 based upon the Company’s decision to close the New York office.

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Loss From Operations

Loss from operations for the year ended December 31, 2011 was $5.3 million compared to a loss of $8.6 million for the year ended December 31, 2010.  See discussion above under "Revenues" and "Costs and Expenses" for further details.  

Interest Expense

Interest expense was $0.6 million and $1.2 million for the years ended December 31, 2011 and 2010, respectively.  The decline in 2011 is the result of a decrease in the weighted average debt outstanding during the 2011 Period as compared to the same period in 2010.  During the 2011 Period, the Company reduced outstanding debt by $0.8 million.  This reduction in debt was almost entirely due to the retirement of two interest bearing notes that the Company’s subsidiary EES had with one of its minority members.  In the 2010 period, the Company converted $2.1 million in convertible notes and $0.4 million in related party debt into common stock.

Change in Fair Value of Derivative Instruments

The Company recorded a non-cash gain of $152,888 related to the change in fair value of derivative instruments for the year ended December 31, 2011.

The Company adopted ASC 815-40 effective January 1, 2009.  Under ASC 815-40 the Company recorded a liability for the fair value of warrants and the embedded conversion options of certain convertible debt agreements as of January 1, 2009 in the amount of $10.2 million.  Under ASC 815-40, the fair value of these liabilities is calculated at each reporting date with the change in liability recorded in other income or expense.

The change in fair value of derivative instruments in other expense was $12.8 million for the year ended December 31, 2010.  This change in 2010 resulted primarily from a large increase in the fair value of the liability for derivative instruments in the first quarter of 2010 due to the increase in the market price of the Company’s common stock from $0.48 per share as of December 31, 2009 to $1.50 per share as of March 31, 2010.  As of December 31, 2010, there were no remaining convertible notes which generate a derivative liability for the Company.  In addition, the number of warrants requiring derivative accounting treatment has been reduced from 16.9 million warrants at December 31, 2009 to 1.7 million warrants at December 31, 2010 and further to 1.2 million at December 31, 2011 through a combination of exercises by holders and through holders agreeing to modify the warrant terms to eliminate the requirement to treat the warrants as derivative instruments, in exchange for extending the expiration date of the warrants.  As such, we anticipate that future other income and expense from these financial instruments will continue to diminish.

Non-controlling Interest of Consolidated Subsidiary

The non-controlling interest of consolidated subsidiary income was $1.7 million for the year ended December 31, 2011 as compared to a loss of $0.5 million for the year ended December 31, 2010.  This 2011 Period amount represents the amount of the income of EES for the year ended December 31, 2011 which has been allocated to the non-controlling equity members of the subsidiary.  

Net Loss Applicable to Common Stock of Ecosphere Technologies, Inc.

Net loss applicable to common stock of Ecosphere was $7.7 million for the year ended December 31, 2011, compared to a net loss applicable to common stock of $22.2 million for the year ended December 31, 2010.  Net loss per common share was $0.05 for the year ended December 31, 2011 as compared to a net loss per common share of $0.17 for the year ended December 31, 2010.  The weighted average number of shares outstanding was 143,989,520 and 131,502,601 for the years ended December 31, 2011 and 2010, respectively.  The net loss of $7.7 million contained various non-cash items including $6.7 million of stock based compensation expense.

29

LIQUIDITY AND CAPITAL RESOURCES

Cash Flows from Operating Activities:

Net cash provided by operating activities was $3.9 million for the year ended December 31, 2012, compared to net cash provided by operating activities of $2.6 million for the year ended December 31, 2011 and net cash used in operating activities of $1.3 million for the year ended December 31, 2010.  This represents the second consecutive year in which we had positive cash flow from operations.  Cash provided by operating activities in the 2012 Period resulted from the net income applicable to common stock of $0.1 million along with non-cash charges of $4.7 million, partially offset by a $1.0 million use of cash resulting from working capital changes.  

2012 Period

Non-cash charges included (i) stock based compensation expense of $1.5 million, (ii) depreciation and amortization of $2.3 million, (iii) $0.8 million in income allocable to our EES partners, (iv) $0.2 million of non-cash interest, offset by (v) $0.1 million, net in other miscellaneous non-cash charges.

Changes in working capital amounted to a use of $1.0 million in cash and were largely the result of decreases in payables and an increase in receivables and inventory driven by increased business activity pursuant to the Hydrozonix Agreement and timing.

2011 Period

Cash provided in operating activities in the 2011 Period of $2.6 million resulted from the net loss applicable to common stock of $7.7 being exceeded by non-cash charges of $10.9 million, partially offset by a $0.6 million use of cash resulting from working capital changes.  

Non-cash charges included (i) stock based compensation expense of $6.7 million, (ii) depreciation and amortization of $2.2 million, (iii) $1.7 million in income allocable to our EES partners, (iv) $0.3 million of non-cash interest, and (v) $0.2 million in other miscellaneous non-cash charges offset by (vi) $0.2 million in income related to fair value adjustment of warrant derivative liabilities.

Changes in working capital amounted to a use of $0.6 million in cash and were largely the result of decreases in payables and an increase in receivables which were partially offset by increases in accrued expenses all of which are driven by increased business activity in both of our operating segments and timing.

2010 Period

The cash impact of the 2010 Period net loss of $22.2 million was largely offset by (i) non-cash expenses of $8.5 million (ii) an increase in the fair value of the liability for derivative instruments of $12.8 million (iii) an increase in accounts payable of $0.4 million, and (iv) an increase in accrued expenses of $0.4 million.  These impacts were partially offset by a decrease in deferred revenue of $0.7 million and the $0.5 million allocation of the EES net loss to the non-controlling equity members.

Cash Flows from Investing Activities:

The Company’s net cash used in investing activities was $0.2 million during the 2012 Period compared to $0.6 million and $1.8 million during the 2011 Period and 2010 Period, respectively.

2012 Period

The Company invested $0.4 million in equipment to support the manufacturing and marketing processes and sold a previously written off water filtration unit, which was part of the Company's fixed assets, realizing approximately $0.2 million in proceeds.

2011 Period

The Company invested $0.4 million in equipment and leasehold improvements related to its manufacturing facility and made approximately $0.2 million of upgrades to existing equipment in order to enhance its ability to perform under the Hydrozonix Agreement for a total of $0.6 million.

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2010 Period

The Company invested $2.0 million to build new equipment and update old equipment and invested $0.2 million in vehicles and leasehold improvements.  These expenditures were partially offset by the release of restricted cash of $0.4 million that had been held in escrow for certain convertible note agreements which were converted into common stock in 2010.

Cash Flows from Financing Activities:

The Company used $3.2 million in financing activities in the 2012 Period largely made up of distributions to its EES subsidiary's minority members.  The Company’s net cash provided by financing activities was de minimis in the 2011 Period and was $2.0 million for the 2010 Period.  Proceeds from financing activities including the issuance of notes and stock option and warrant exercises were largely offset by repayments of debt in the 2011 Period.

2012 Period

The Company's net cash used in financing activities consisted primarily of $3.2 million in distributions paid to EES’ minority members.  In addition, the Company received (i) $0.3 million in proceeds from warrant and option exercises, and (ii) $0.1 million in proceeds from warrant modifications.  Offsetting the proceeds noted above was approximately $0.4 million in net debt repayments over borrowings.

2011 Period

The Company's net cash provided by financing activities consisted primarily of proceeds from (i) the issuance of convertible debt and warrants of $1.6 million (ii) proceeds from the exercise of warrants and options of $0.8 million, and (iii) $0.2 million in equipment financing.  Cash used in financing activities included payments on related party notes of $2.4 million and repayments on vehicle, insurance and equipment financings of approximately $0.2 million.

2010 Period

During the 2010 Period, the Company received $0.4 million from the issuance of convertible notes and warrants, $0.5 million from the sale of common stock and warrants, $1.2 million in connection with the exercise of options and warrants to purchase shares of common stock, $0.8 million for exchanging warrants and cash for new warrants and $42,000 from vehicle financing.  These sources were used make payments on notes payable of $0.7 million, vehicle and insurance finance payments of $0.2 million and to make payments on capital leases of $13,080.  

Liquidity

During the year ended December 31, 2012, the Company relied upon the liquidity and positive cash flow provided by the Hydrozonix Agreement.  The unanticipated failure of Hydrozonix to issue a binding purchase order for Units 13-14 and make progress payments as those Units are being manufactured have created significant working capital difficulties for the Company.  Through March 29, 2013, the Company has incurred costs of approximately $3.3 million for materials and direct labor in building Units 13-14 even though it does not have a binding purchase order from Hydrozonix.  The Company’s senior management made a decision to complete the Units during the quarter ending March 31, 2013 so that if Hydrozonix tenders payment by April 15, 2013, the Company can deliver the Units and recognize revenue during the first quarter.  In February 2013, we received a conditional purchase order from Hydrozonix which did not provide for any interim payment.  In the event Hydrozonix does not pay for Units 13-14 and issue a binding purchase order for Units 15-16 with the appropriate progress payment by April 15, 2013 they will lose exclusivity and we will undertake to aggressively market Units 13-14 to other operators within the domestic oil and gas industry and seek to establish strategic partnerships that maximize the market penetration of the Ozonix® technology.

Beginning late in the fourth quarter of 2012 and continuing during 2013, the Company negotiated a $3.4 million convertible note financing with two United Kingdom funds.  Initially, the Company pursued this financing as a way to finance the expansion of the Company’s business into additional verticals.  As the Company’s cash flow difficulties mounted, the Company was able to borrow $750,000 through the issuance of the first phase of the convertible note financing with the understanding that the lenders would advance the remaining $2,650,000 if the Company meets a milestone by March 15^th.  We did not meet this milestone but are hopeful that if Hydrozonix pays for Units 13-14, the lender will advance the remaining sum since the purpose of the loan was to grow our business outside of United States onshore oil and gas services. We are relying upon either Hydrozonix to make the required payments or locate some additional financing.  Under the letter agreement with Hydrozonix entered into on February 6^th, the Company agreed with Hydrozonix that if it did not pay the Company by April 15^th for Units 13-14 and place a binding purchase order for Units 15-16 with the required down payment, Hydrozonix will lose its exclusivity.

31

We are in discussions with a prominent investment banking firm to sell our 52.6% of EES (or all of it if the other EES members agree) and raise capital for us.  We cannot predict the timing or assure you we will be successful in meeting our liquidity needs through either of these avenues or otherwise.  The sale of EES is consistent with our open innovation business model described on page 1 of this Report.

Additionally, the Company has $1.2 million of convertible notes which mature through March 31, 2013.  The Company is seeking to extend the notes.

The Company’s senior management is exploring other possible financing arrangements but has not entered into any letters of intent and, as a result, the Company is uncertain how it can meet its continued working capital needs. The Company has sufficient cash left to pay critical suppliers and payroll through April 15, 2013.  One possibility of improving working capital is for the Company to rapidly sell Units 13-14 to a third party if Hydrozonix fails to make the required payments to us on April 15^th.  The Company has engaged in a number of discussions to this effect but has not entered into any letters of intent.  If the Company is not able to inject funds in order to provide liquidity, the Company may have to suspend operations.  See Item 1A. “Risk Factors.”

In 2012, 76% of our revenue was generated from the sale of Ozonix® units under the Hydrozonix Agreement.  If Hydrozonix does not pay us for the Ozonix® units and we are unable to locate another party to purchase Ozonix® units from us, our cash flows from operating activities will substantially decrease.  In such event, our ability to continue as a going concern is in doubt and we may not be able to remain in business unless we complete a significant financing or other transaction.

The Company’s technology has been successfully utilized on over 700 wells.  Management believes that the value of its technology has been sufficiently demonstrated to market participants to allow the Company to more accurately communicate the value of its technologies to potential strategic partnerships and alliances.  Management believes that, based upon the success of its technologies to date, the fair market value of the rights to the global energy market segments granted to its majority owned subsidiary, EES, significantly exceeds the market capitalization of the Company based on the publicly quoted market prices for its common stock.  The Company believes that the realization of this excess fair market value will allow it to obtain additional equity or debt financing, on favorable terms, to fund its increasing penetration of the global energy markets and development of other segments, such as mining and waste water treatment.

The Company’s exclusive arrangement with Hydrozonix has provided significant cash flows from operations, allowing EES to pay dividends in excess of $6.7 million in 2012.  Management believes that EES will continue to generate significant positive cash from operations from the U.S. oil and gas market segment, either through the continued execution of the exclusive arrangement with Hydrozonix, or through aggressive marketing efforts focused on the U.S. oil and gas market segment should Hydrozonix forfeit its exclusive rights. Because of the exclusivity Hydrozonix currently enjoys, EES has been limited in the permitted activities it can undertake related to the U.S. oil and gas market segment.  Management has been developing a marketing plan for the U.S. oil and gas market segment, which it will begin implementing immediately proceeding the lapse of Hydrozonix’s exclusivity, which will occur on April 15, 2013 unless Hydrozonix pays the Company approximately $5.6 million for units 13 and 14, provides a binding purchase order for Units 15 and 16, and provides required escrow financing for the build out of Units 15 and 16.

The Company, through its majority-owned subsidiary, EES, has entered into discussions with potential partners and strategic alliances in the Middle East, Canada and with various offshore exploration entities.  Management believes that the successful execution of any of these alliances will provide additional sources of cash flows from operations.  The Company is also in discussions with these potential partners regarding the utilization of the Ecosphere technologies for solutions outside of oil and gas exploration.

Upon securing additional financing, we plan to make significant additional capital expenditures related to the development of technologies and manufacture of equipment focused on solutions outside of the global oil and gas industries, such as mining and municipal waste water treatment, as well as enhancements to the applicability of our technology to the oil and gas industries.  The amount will depend upon the amount of financing and ongoing discussions with third parties interested in using our OzonixÒ technology outside of the oil and gas industry.

Contractual obligations:

32

CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

This report includes forward-looking statements including our liquidity and anticipated revenues, our intentions regarding building EF80s, expectations from the Hydrozonix Agreement, expectations regarding offshore drilling, expectations and opportunities from our mining subsidiary, continuing to seek financial partners for the Ozonix® technology, and our belief regarding the impact of future government laws and regulations on hydraulic fracturing.  

All statements other than statements of historical facts contained in this report, including statements regarding our future financial position, liquidity, business strategy and plans and objectives of management for future operations, are forward-looking statements.  The words “believe,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “could,” “target,” “potential,” “is likely,” “will,” “expect” and similar expressions, as they relate to us, are intended to identify forward-looking statements.  We have based these forward-looking statements largely on our current expectations and projections about future events and financial.

Other sections of this report may include additional factors which could adversely affect our business and financial performance.  New risk factors emerge from time to time and it is not possible for us to predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any risk factor, or combination of risk factors, may cause actual results to differ materially from those contained in any forward-looking statements.

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk.  Our cash balance as of December 31, 2012 was held in insured depository accounts, of which approximately $0.1 million exceeded insurance limits.   

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

See pages F-1 through F-44.

ITEM 9.

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

None.

ITEM 9A.

CONTROLS AND PROCEDURES.

Disclosure Controls

We carried out an evaluation required by Rule 13a-15 of the Securities Exchange Act of 1934, or the Exchange Act, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined in Exchange Act Rule 13a–15(e).  Disclosure controls and procedures are designed with the objective of ensuring that (i) information required to be disclosed in an issuer's reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

The evaluation of our disclosure controls and procedures included a review of our objectives and processes and effect on the information generated for use in this report.  This type of evaluation is done quarterly so that the conclusions concerning the effectiveness of these controls can be reported in our periodic reports filed with the SEC.  We intend to maintain these controls as processes that may be appropriately modified as circumstances warrant.

Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information which is required to be included in our periodic reports filed with the SEC as of the end of the period covering this report.

33

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f).  Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2012 based on the criteria set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2012.

However, a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  Management necessarily applied its judgment in assessing the benefits of controls relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected.  The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.  Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and may not be detected.

The effectiveness of our internal controls over financial reporting as of December 31, 2012, has been audited by Salberg & Co. P.A., an independent registered public accounting firm, as stated in their report which appears in Item 8 of this Annual Report on Form 10-K.

Changes in Internal Control Over Financial Reporting

During our most recent fiscal quarter, there has not been any change in our internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f) that has materially affected, or is reasonably likely to affect, our internal control over financial reporting.

ITEM 9B.

OTHER INFORMATION.

None

34

PART III

ITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.

Except as set forth in the following paragraph, the information required by this Item 10 of Form 10-K is incorporated by reference from our 2013 Proxy Statement. The 2013 Proxy Statement will be filed with the SEC within 120 days after the end of the fiscal year to which this Report relates.  

We have adopted a Code of Ethics that applies to all of our directors and employees, including our Chief Executive Officer and Chief Financial Officer.  We will provide a copy of the Code of Ethics to any person without charge, upon request.  The request for a copy can be made in writing to Ecosphere Technologies, Inc., 3515 S.E. Lionel Terrace, Stuart, Florida 34997, Attention: Corporate Secretary.

ITEM 11.

EXECUTIVE COMPENSATION.

The information required by this Item is incorporated by reference from our 2013 Proxy Statement.

ITEM 12.

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

The information required by this Item is incorporated by reference from our 2013 Proxy Statement.

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.

The information required by this Item is incorporated by reference from our 2013 Proxy Statement.

ITEM 14.

PRINCIPAL ACCOUNTING FEES AND SERVICES.

The information required by this Item is incorporated by reference from our 2013 Proxy Statement.

35

PART IV

ITEM 15.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES.

(a)   Documents filed as part of the report.

(1)

Financial Statements.  See Index to Consolidated Financial Statements, which appears on page F-1 hereof.  The financial statements listed in the accompanying Index to Consolidated Financial Statements are filed herewith in response to this Item.

(2)

Financial Statements Schedules.  All schedules are omitted because they are not applicable or because the required information is contained in the consolidated financial statements or notes included in this report.

(3)

Exhibits

36

———————

*

Management compensatory agreement

**

Filed pursuant to a confidential treatment request for certain portions of this document.

***

Attached as Exhibit 101 to this report are the Company’s financial statements for the year ended December 31, 2012 formatted in XBRL (eXtensible Business Reporting Language).  The XBRL-related information in Exhibit 101 to this report shall not be deemed “filed” or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, and is not filed for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liabilities of those sections.

Copies of this report (including the consolidated financial statements) and any of the exhibits referred to above will be furnished at no cost to our shareholders who make a written request to Ecosphere Technologies, Inc., 3515 S.E. Lionel Terrace, Stuart, Florida 34997 Attention: Mrs. Jacqueline McGuire.

37

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

38

INDEX TO FINANCIAL STATEMENTS

F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of:

Ecosphere Technologies, Inc.

We have audited the accompanying consolidated balance sheets of Ecosphere Technologies, Inc. and Subsidiaries ("the Company") as of December 31, 2012 and 2011, and the related consolidated statements of operations, changes in equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2012. We also have audited Ecosphere Technologies, Inc.'s. and Subsidiaries internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company's internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall consolidated financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

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

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ecosphere Technologies, Inc. and Subsidiaries as of December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Ecosphere Technologies, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Note 1 to the consolidated financial statements, the Company has seen a recent significant decline in its working capital primarily relating to delays in receiving additional purchase orders and related funding from a significant customer (see Note 20 - concentrations). This matter raises substantial doubt about the Company's ability to continue as a going concern. Management’s Plan in regards to this matter is also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/S/ Salberg & Company, P.A.

SALBERG & COMPANY, P.A.

Boca Raton, Florida

April 2, 2013

2295 NW Corporate Blvd., Suite 240 • Boca Raton, FL 33431-7328

Phone: (561) 995-8270 • Toll Free: (866) CPA-8500 • Fax: (561) 995-1920

www.salbergco.com • info@salbergco.com

Member National Association of Certified Valuation Analysts • Registered with the PCAOB

Member CPAConnect with Affiliated Offices Worldwide • Member AICPA Center for Audit Quality

F-2

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS