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EX-10.2 - EXHIBIT 10.2 - Pegasi Energy Resources Corporation.ex102.htm
EX-31.2 - EXHIBIT 312.HTM - Pegasi Energy Resources Corporation.ex312.htm
EX-10.1 - EXHIBIT 10.1 - Pegasi Energy Resources Corporation.ex101.htm
EX-31.1 - EXHIBIT 31.1 - Pegasi Energy Resources Corporation.ex311.htm
EX-32.1 - EXHIBIT 32.1 - Pegasi Energy Resources Corporation.ex321.htm
 
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 

FORM 10-Q

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2011

OR

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

FOR THE TRANSITION PERIOD FROM ____________ TO ____________
 
COMMISSION FILE NUMBER: 333-134568

PEGASI ENERGY RESOURCES CORPORATION
(Exact name of registrant as specified in its charter)

Nevada
 
20-4711443
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
 
218 N. Broadway, Suite 204
Tyler, Texas 75702
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: 903- 595-4139

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a small reporting company.  See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
 Large accelerated filer o
 Accelerated filer o
 Non-accelerated filer o
 Smaller reporting company x
(Do not check if a smaller reporting company)
 
                                                                                    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2) of the Act. Yes  ¨ No   x .

There were 33,660,801 shares of the registrant's common stock outstanding as of May 11, 2011.


 
 
 
1

 






PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED MARCH 31, 2011

TABLE OF CONTENTS

 
Page
PART I - FINANCIAL INFORMATION
   
Item 1. Financial Statements
3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
12
Item 3. Quantitative and Qualitative Disclosures About Market Risk
17
Item 4. Controls and Procedures
17
   
PART II - OTHER INFORMATION
 
Item 1. Legal Proceedings
19
Item 1A. Risk Factors
19
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
19
Item 3. Defaults Upon Senior Securities
19
Item 4. (Removed and Reserved)
19
Item 5. Other Information
19
Item 6. Exhibits
19
   
SIGNATURES
20


 
2

 
 

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.
 PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED BALANCE SHEETS

   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
(Unaudited)
       
Assets
           
Current assets:
           
   Cash and cash equivalents
  $ 651,711     $ 249,802  
   Accounts receivable, trade
    375,846       186,669  
   Accounts receivable, related parties
    11,502       13,002  
   Joint-interest billings receivable, related parties, net
    15,669       192,700  
   Joint-interest billing receivable, net
    29,074       29,627  
   Assets held for sale
    300,347       300,347  
   Other current assets
    34,944       52,440  
Total current assets
    1,419,093       1,024,587  
                 
Property and equipment:
               
   Equipment
    73,099       83,711  
   Pipelines
    722,809       722,937  
   Leasehold improvements
    7,022       7,022  
   Vehicles
    50,663       50,663  
   Office furniture
    135,689       135,689  
   Website
    15,000       15,000  
Total property and equipment
    1,004,282       1,015,022  
Less accumulated depreciation
    (341,952 )     (334,668 )
Property and equipment, net
    662,330       680,354  
                 
Oil and gas properties:
               
   Oil and gas properties, proved
    11,790,039       11,762,909  
   Oil and gas properties, unproved
    9,103,877       9,044,960  
   Capitalized asset retirement obligations
    219,040       219,040  
Total oil and gas properties
    21,112,956       21,026,909  
Less accumulated depletion and depreciation
    (1,061,917 )     (1,018,100 )
Oil and gas properties, net
    20,051,039       20,008,809  
                 
Other assets:
               
   Restricted cash – leasing program
    166,570       394,693  
   Restricted cash – drilling program
    723,910       793,611  
   Certificates of deposit
    78,049       77,947  
Total other assets
    968,529       1,266,251  
                 
Total assets
  $ 23,100,991     $ 22,980,001  

The accompanying notes are an integral part of these consolidated financial statements.
 
 
3

 

PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED BALANCE SHEETS (CONTINUED)



   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
(Unaudited)
       
Liabilities and Stockholders' Equity
           
Current liabilities:
           
   Cash overdraft
  $ 537,946     $ 340,118  
   Accounts payable
    1,030,338       658,316  
   Accounts payable, related parties
    1,483,960       1,321,979  
   Revenues payable
    279,087       124,723  
   Interest payable, related party
    552,783       394,704  
   Liquidated damages payable
    181,751       173,802  
   Other payables
    31,881       27,893  
   Current portion of notes payable
    2,006       1,976  
   Current portion of notes payable, related party
    8,160,646       8,160,646  
Total current liabilities
    12,260,398       11,204,157  
                 
Lease program deposits
    166,570       394,693  
Drilling prepayments
    723,910       793,611  
Notes payable
    2,313       2,826  
Asset retirement obligations
    323,192       317,279  
Total long-term liabilities
    1,215,985       1,508,409  
                 
Total liabilities
    13,476,383       12,712,566  
                 
Commitments and contingencies (Note 5)
               
                 
Stockholders' equity:
               
   Preferred stock: $0.001 par value; 5,000,000 shares authorized;
               
      None issued and outstanding
    -       -  
  Common stock: $0.001 par value; 125,000,000 shares authorized; 33,660,801 shares issued and outstanding at March 31, 2011 and 33,610,801 shares at December 31, 2010
    33,661       33,611  
   Additional paid-in capital
    19,923,354       19,903,404  
   Accumulated deficit
    (10,332,407 )     (9,669,580 )
Total stockholders' equity
    9,624,608       10,267,435  
                 
Total liabilities and stockholders' equity
  $ 23,100,991     $ 22,980,001  


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


 
4

 


PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

    Three Months Ended March 31,  
   
2011
   
2010
 
Revenues:
           
  Oil and gas
  $ 201,166     $ 177,716  
  Condensate and skim oil
    8,699       6,638  
  Transportation and gathering
    147,457       67,388  
Total revenues
    357,322       251,742  
                 
Operating expenses:
               
  Lease operating expenses
    101,500       76,261  
  Pipeline operating expenses
    39,032       19,158  
  Cost of gas purchased for resale
    94,814       47,058  
  Depletion and depreciation
    61,713       41,195  
  General and administrative
    587,586       515,314  
Total operating expenses
    884,645       698,986  
Loss from operations
    (527,323 )     (447,244 )
                 
Other income (expenses):
               
  Interest income
    102       191  
  Interest expense
    (161,178 )     (134,096 )
  Liquidated damages
    (7,949 )     (5,126 )
  Other income
    5,068       (5,723 )
Total other income (expenses)
    (163,957 )     (144,754 )
                 
Loss from continuing operations before income tax benefit
    (691,280 )     (591,998 )
                 
Income tax benefit
    (9,959 )     -  
                 
Loss from continuing operations
    (681,321 )     (591,998 )
Income (loss) from discontinued operations (net of tax expenses of $9,959 and $0, respectively)
    18,494       (90,879 )
                 
Net loss
  $ (662,827 )   $ (682,877 )
                 
Basic and diluted loss per share:
Loss from continuing operations
    (0.02 )     (0.02 )
Income (loss) from discontinued operations
    0.00       (0.00 )
Net loss
  $ (0.02 )   $ (0.02 )
                 
Weighted average shares outstanding
    33,627,468       33,610,801  


The accompanying notes are an integral part of these consolidated financial statements.
 
 
5

 


PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

 
    Three Months Ended March 31,  
   
2011
   
2010
 
Operating Activities
           
 Net loss
  $ (662,827 )   $ (682,877 )
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
               
  Depletion and depreciation
    61,713       61,017  
  Accretion of discount on asset retirement obligations
    5,913       4,506  
  Stock issued for consulting services
    20,000       -  
  Loss on abandonment of equipment
    -       5,727  
  Gain on sale of equipment
    (4,872 )     -  
  Changes in operating assets and liabilities:
               
    Accounts receivable, trade
    (189,177 )     (30,709 )
    Accounts receivable, related parties
    1,500       (1,272 )
    Joint-interest billing receivable, net
    553       -  
    Joint-interest billings receivable, related parties, net
    177,031       (3,911 )
    Other current assets
    17,496       24,974  
    Accounts payable
    372,022       98,793  
    Accounts payable, related parties
    161,981       66,850  
    Revenues payable
    154,364       14,376  
    Interest payable, related party
    158,079       131,046  
    Liquidated damages payable
    7,949       5,126  
    Other payables
    3,988       (11,942 )
Net cash provided by (used in) operating activities
    285,713       (318,296 )
                 
Investing Activities
               
Additions to certificate of deposit
    (102 )     (190 )
Purchases of oil and gas properties
    (86,047 )     (19,070 )
Purchases of property and equipment
    -       (84,920 )
Proceeds from sale of property and equipment
    5,000       -  
Net cash used in investing activities
    (81,149 )     (104,180 )
                 
Financing Activities
               
Payments on notes payable
    (483 )     (1,716 )
Cash overdraft
    197,828       -  
Proceeds from borrowing on notes payable, related party
    -       623,000  
Net cash provided by financing activities
    197,345       621,284  
                 
Net increase in cash and cash equivalents
    401,909       198,808  
Cash and cash equivalents at beginning of period
    249,802       127,176  
                 
Cash and cash equivalents at end of period
  $ 651,711     $ 325,984  
                 
Supplemental Disclosure of Cash Flow Information
               
Cash paid during the period for interest
  $ 3,564     $ 4,221  
                 
Noncash disclosure - stock issued for consulting services
  $ 20,000     $ -  
                 
The accompanying notes are an integral part of these consolidated financial statements.



 
6

 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011 AND 2010


1.  NATURE OF OPERATIONS
 
Pegasi Energy Resources Corporation (“PERC” or the “Company”) is engaged in the exploration and production of natural gas and oil through the development of a repeatable, low-geological risk, high-potential project in the active East Texas oil and gas region.  The Company's business strategy, which it designated as the “Cornerstone Project”, is to identify and exploit resources in and adjacent to existing or indicated producing areas within the Rodessa field area.  PERC’s principals spent over three years and invested over $3.5 million in equity for data harvesting, prospect evaluation and acreage acquisitions for the Cornerstone Project.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

a)  Basis of Presentation

The accompanying unaudited interim consolidated financial statements of PERC have been prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States of America and the rules of the Securities and Exchange Commission (the “SEC”), and should be read in conjunction with PERC’s audited consolidated financial statements for the year ended December 31, 2010, and notes thereto, which are included in the Company’s annual report on Form 10-K filed with the SEC on March 31, 2011.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the Company’s consolidated financial position and the consolidated results of operations for the interim periods presented have been reflected herein.  The consolidated results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.  The notes to consolidated financial statements, which would substantially duplicate the disclosures required in the Company’s 2010 annual consolidated financial statements, have been omitted.

b)  New Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.  This standard requires reporting entities to provide information about movements of assets among Levels 1 and 2 of the three-tier fair value hierarchy established by SFAS No. 157 (FASB ASC 820).  The guidance is effective for any interim and annual reporting periods that begin after December 15, 2009.  The Company adopted ASU No. 2010-06 in the first quarter of 2010 and the adoption did not have a material impact on the Company’s disclosures.  The standard also requires entities to provide a reconciliation of purchases, sales, issuance, and settlements of anything valued with a Level 3 method.  This guidance is effective for fiscal years beginning after December 15, 2010, and for interim and periods within those fiscal years. The Company adopted the guidance in the first quarter of 2011 and the adoption did not have a material impact on the Company’s disclosures.

c)  Reclassifications

 Certain reclassifications have been made to the comparative consolidated financial statements to conform to the current period’s presentation.

3.  NOTES PAYABLE, RELATED PARTY
 
Notes payable, related party consisted of the following at:

  
 
March 31,
2011
   
December 31,
2010
                 
Note payable to Teton (the “Teton Renewal Note”) in the amount of $6,987,646 dated June 1, 2010, including interest at 8%, with all principal and  interest due on the maturity date of June 1, 2011 (however see third amendment below).    Renewed original note which matured May 21, 2010.  Secured by a stock pledge and security agreement.
  $
6,987,646
    $
6,987,646
 
Original unsecured promissory note payable in the amount of $1 million dated October 14, 2009 to Teton (the “Teton Promissory”).  Additional funds added by amendment two to the note results in funds available of $1.5 million, including interest of 6.25%, with all interest and principal due on the maturity date of April 2, 2011 (however see fifth amendment below).
   
1,173,000
     
1,173,000
 
Total notes payable, related party
   
8,160,646
     
8,160,646
 
Less current portion
   
(8,160,646)
     
(8,160,646)
 
Total long-term notes payable, related party
 
$
-
   
$
-
 

 
 
7

 

PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011 AND 2010
 
On June 1, 2010, a Promissory (Teton Renewal Note) note was executed to renew and extend the original note payable (Teton Note) which matured May 21, 2010.  The renewal note’s principal balance of $6,987,646 is the total of the outstanding principal of $5,952,303 and accrued and unpaid interest of $1,035,343 on the original note.  Interest payments were due on the note on October 1, 2010; January12, 2011; and April 1, 2011. Effective October 1, 2010 an amendment to the Teton Renewal Note was executed to eliminate the October 1, 2010 interest payment.  Effective January 2, 2011, a second amendment was executed which eliminated the January 1, 2011 interest payment.  The final maturity date of the Teton Renewal Note was unchanged and remained June 1, 2011.  Teton has the right, but not the obligation to convert all or a portion of the indebtedness at any time after May 1, 2008, unless the debt is repaid before such date.  This option will continue in existence as long as any balance remains outstanding on the note.

Effective April 1, 2011, a third amendment was executed which eliminated the April 1, 2011 interest payment and extended the maturity date of the note from June 1, 2011 to June 1, 2013 at which time all outstanding principal and accrued and unpaid interest of the note will be due.  The amendment also added an event of default whereby Teton may declare default on the note if the Company does not raise funds during or as a result of their engagement with a placement agent whom they initially engaged on March 25, 2011.

The Teton Promissory was amended effective January 1, 2010 to eliminate the requirement of interest payments to be made on January 1, 2010; April 1, 2010; and October 1, 2010.  A second amendment was executed which increased the available balance to $1,500,000 effective March 2, 2010.  Effective July 1, 2010, a third amendment to the Teton Promissory was executed to eliminate the interest payment required on July 1, 2010 and to extend the maturity date of the note to January 2, 2011. Effective January 2, 2011, a fourth amendment was executed to extend the maturity date of the note from January 2, 2011, to April 2, 2011 at which time all outstanding principal and accrued  and unpaid interest will be due.

Effective April 2, 2011, a fifth amendment was executed which eliminated the April 2, 2011 interest payment and extended the maturity of the note from April 2, 2011 to June 1, 2013 at which time all outstanding principal and accrued and unpaid interest of the note will be due.  The amendment also added an event of default whereby Teton may declare default on the note if the Company does not raise funds during or as a result of their engagement with a placement agent whom they initially engaged on March 25, 2011. In addition, the amendment granted Teton the right, to convert the outstanding balance on the Promissory note into shares of PERC’s common stock at a fixed conversion price of $0.60 per share. 
 
On May 1, 2007, a “memorandum of Understanding” was executed to grant Teton the right to convert the outstanding balance on the Teton Note into shares of PERC’s common stock at a fixed conversion price of $1.20 per share.  Teton has the right, but not the obligation to convert all or a portion of the indebtedness at any time after May 1, 2008, unless the debt is repaid before such date.  This option will continue in existence as long as any balance remains outstanding on the note.

On March 3, 2009, a “Second Amendment to Renewal Promissory Note and Loan Modification Agreement” (the “Second Amendment”) was executed, which amended the Teton Note.  This agreement added $550,000 of additional cash proceeds and $20,000 of advances payable to the outstanding balance of the Teton Note and pledged substantially all of the Company’s assets to secure repayment of the note.  The Second Amendment confirmed that the fixed conversion price of $1.20 per share would remain for the portion of the note payable balance that existed prior to its execution, and a fixed conversion price of $1.60 was agreed upon for conversion of the additional funds.

In May 2009, the third and fourth amendments to the Teton Note were executed.  The third amendment deferred the May 21, 2009 interest payment to September 21, 2009 and the fourth amendment added $350,000 of additional funds to the outstanding balance of the Teton Note.  In September 2009, the fifth amendment was executed, which added $175,000 of additional funds to the outstanding balance of the Teton Note and deferred the interest payment due date from September 21, 2009 to October 21, 2009.  In February 2010, the seventh amendment to the Teton Note, dated May 21, 2007, was executed.  This amendment amended the sixth amendment, executed in October 2009, to defer the October 21, 2009 interest payment to February 21, 2010.  The seventh amendment eliminated the February 21, 2010 interest payment.  The final maturity date of the Teton Note was unchanged and remained May 21, 2010.  Upon maturity, the outstanding principal and accrued and unpaid interest on this note was renewed and extended to a maturity date of June 1, 2011.  See the Teton Renewal Note above.  The maturity date was subsequently extended to June 1, 2013.

 
8

 

PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011 AND 2010

 
4.  SEGMENT INFORMATION

The following information is presented in accordance with FASB ASC Topic 280, Segment Reporting.  The Company is engaged in oil and gas exploration and production, saltwater disposal and pipeline transportation.  PERC is engaged in the exploration and production of natural gas and oil.  Pegasi Operating, Inc. (“POI”), a wholly-owned subsidiary of PERC, conducts the exploration and production operations.  TR Rodessa operates a 40-mile gas pipeline and gathering system which is used to transport hydrocarbons to market to be sold.  59 Disposal operates a saltwater disposal facility which disposes saltwater and flow-back waste into subsurface storage  and  also  sells  the  skim  oil  it  separates  from  the  saltwater.  The assets of this company are currently being held for sale and we have reported it as a discontinued operation (see Footnote 8).  The Company identified such segments based on management responsibility and the nature of their products, services, and costs.  There are no major distinctions in geographical areas served as all operations are in the United States.  The Company measures segment profit (loss) as income (loss) from operations.  Business segment assets are those assets controlled by each reportable segment.  The following table sets forth certain information about the financial information of each segment as of March 31, 2011 and December 31, 2010 and for the three months ended March 31, 2011 and 2010.

   
Three Months Ended
March 31,
2011
   
Three Months Ended
March 31,
2010
 
             
Business segment revenue:
           
     Oil and gas
  $ 201,166     $ 177,716  
 Condensate and skim oil
    8,699       6,638  
 Transportation and gathering
    147,457       67,388  
Total revenues
  $ 357,322     $ 251,742  
                 
Business segment profit (loss):
               
     Oil and gas
  $ (95,487 )   $ 15,633  
     Condensate and skim oil
    8,699       6,638  
     Transportation and gathering
    (4,197 )     (19,910 )
     General corporate
    (436,338 )     (449,605 )
Loss from operations
  $ (527,323 )   $ (447,244 )
                 
Depletion and depreciation:
               
     Oil and gas
  $ 45,610     $ 25,940  
     Transportation and gathering
    11,799       7,492  
      Assets held for sale
    -       19,822  
     General corporate
    4,304       7,763  
Total depletion and depreciation
  $ 61,713     $ 61,017  


   
Three Months Ended
 March 31,
2011
   
Three Months Ended
March 31,
2010
 
Capital expenditures:
           
     Oil and gas
  $ 86,047     $ 19,070  
     Transportation and gathering
    -       -  
     Assets held for sale
    -       84,920  
     General corporate
    -       -  
Total capital expenditures
  $ 86,047     $ 103,990  
                 
 
 
 
9

 

PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011 AND 2010
 
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Business segment assets:
           
     Oil and gas
  $ 21,154,514     $ 20,538,826  
     Transportation and gathering
    630,089       712,561  
     Assets held for sale
    300,347       300,347  
     General corporate
    1,016,041       1,428,267  
Total assets
  $ 23,100,991     $ 22,980,001  
                 

5. COMMITMENTS AND CONTINGENCIES

Along with the Company's counsel, management monitors developments related to legal matters and, when appropriate, makes adjustments to record liabilities to reflect current facts and circumstances.  Management has recorded a liability related to its registration rights agreement with investors that provides for the filing of a registration statement for the registration of the shares issued in the offering in December 2007, as well as the shares issuable upon exercise of related warrants.  The Company failed to meet the deadline for the effectiveness of the registration statement and therefore was required to pay liquidated damages of approximately $100,000 on the first day of effectiveness failure, or July 18, 2008.  An additional $100,000 penalty was required to be paid by the Company every thirty days thereafter, prorated for periods totaling less than thirty days, until the effectiveness failure was cured, up to a maximum of 18% of the aggregate purchase price, or approximately $1,800,000.  The Company’s registration became effective on August 21, 2008.  At March 31, 2011, management reevaluated the status of the registration statement and determined an accrual of $181,751 was sufficient to cover any potential payments for liquidated damages.  The damages are reflected as liquidated damages payable of $181,751 and $173,802 in the accompanying consolidated balance sheets as of March 31, 2011 and December 31, 2010, respectively. 

6.  FAIR VALUE OF FINANCIAL INSTRUMENTS

In accordance with the reporting requirements of FASB ASC Topic No. 825, Financial Instruments, the Company calculates the fair value of its assets and liabilities which qualify as financial instruments under this statement and includes this additional information in the notes to consolidated financial statements when the fair value is different than the carrying value of these financial instruments.  The estimated fair values of accounts receivable, accounts payable and other current assets and accrued liabilities approximate their carrying amounts due to the relatively short maturity of these instruments.  The carrying value of long-term debt approximates market value due to the use of market interest rates.  

7.  RESTRICTED CASH – LEASING PROGRAM

Leasing Program

During the first quarter of 2010, the Company executed agreements with two independent oil and gas companies regarding leasing specific areas on the Cornerstone Project.  The agreements include both extensions and renewals of existing leaseholds that the Company currently holds and acquisitions of new leaseholds in order to expand the Company’s acreage position.  Funds received from these companies are restricted to the leasing programs and are considered released when they are spent in accordance with the agreements.  Total funds of $5,438,000 were received on these programs, $5,123,459 was spent on leasing activities and $147,971 was refunded leaving a balance of $166,570 in restricted cash and lease program deposits at March 31, 2011.

Drilling Program

During the last quarter of 2010, the Company executed participation and operating agreements with various independent oil and gas companies regarding the drilling of the Norbord and Swamp Fox wells.   Funds received from these companies are restricted to the drilling programs and are considered released when they are spent in accordance with the agreements.  Total funds of $2,249,980 were received on these programs and $1,526,070 was spent on drilling activities leaving a balance of $723,910 in restricted cash and drilling prepayments at March 31, 2011.


 
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PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011 AND 2010


8.  DISCONTINUED OPERATIONS

The Company’s wholly-owned subsidiary, 59 Disposal Inc., operates a saltwater disposal facility which disposes saltwater and flow-back waste into subsurface storage.  The disposal activities have diminished over the past twelve months and in January 2011, the Company offered for sale certain assets of the subsidiary.  It held a letter of intent from a potential buyer for the purchase of certain of 59 Disposal’s assets which was valid for thirty days after its signing on March 1, 2011.   Although the letter of intent has expired, the Company is continuing negotiations with the potential purchaser with an anticipated closing of the sale in 2011.

At March 31, 2011, assets of 59 Disposal to be included in the sale have a net book value of $300,347 and have been included in the consolidated balance sheets as assets held for sale.  The negotiated sales price is more than the net book value of the equipment so no impairment has been recorded.  Current assets and liabilities of 59 Disposal, including accounts receivable of $34,233, accounts payable of $51,641, related party payables of $111,679, interest payable of $1,550 and notes payable, related party, of $23,244  as of March 31, 2011, will be retained by the Company under the negotiated sale provisions.

The following schedule details 59 Disposal’s property and equipment to be included in the sale as of March 31, 2011:

   
Cost
   
Accumulated
Depreciation
   
March 31, 2011
Net Book Value
 
Lease & well equipment
  $ 597,740     $ 318,916     $ 278,824  
Buildings
    19,916       2,353       17,563  
Office furniture & equipment
    6,550       2,590       3,960  
    $ 624,206     $ 323,859     $ 300,347  

Following is summarized information regarding the discontinued operations:

Revenues of discontinued operations amounted to $82,650 and $36,504 for the three months ended March 31, 2011 and 2010.
 
    Three Months Ended  
   
March 31,
   
March 31,
 
   
2011
   
2010
 
             
Income (loss) from discontinued operations
  $ 28,453     $ (90,879 )
Income tax expense – discontinued operations
    (9,959 )     -  
Income (loss) from discounted operations, net of tax
  $ 18,494     $ (90,879 )

9.  SUBSEQUENT EVENTS

The notes payable, related party, were amended effective April 2011.  See Footnote 3 for details of such amendments.

The Company is currently in negotiations to sell a 35% portion of a pipeline they own.  Negotiations are anticipated to close in approximately thirty to forty-five days.  Current plans are to use the proceeds to refurbish a pipeline near the Norbord well which is expected to potentially double production from that well.
 
 
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward Looking Statements

This Management's Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements that reflect management's current views with respect to future events and financial performance. You can identify these statements by forward-looking words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate” and “continue,” or similar words.  Those statements include statements regarding the intent, belief or current expectations of us and members of our management team as well as the assumptions on which such statements are based. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risk and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements.

Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the SEC.  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations of the Company should be read in conjunction with the Consolidated Financial Statements and notes related thereto included in this Quarterly Report on Form 10-Q. Important  factors not  currently  known  to management  could  cause  actual  results  to differ  materially  from  those in forward-looking  statements.  We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results over time. We believe that our assumptions are based upon reasonable data derived from and known about our business and operations.  No assurances are made that actual results of operations or the results of our future activities will not differ materially from our assumptions.  Factors that could cause differences include, but are not limited to, expected market demand for our products, fluctuations in pricing for materials, and competition.

Company Overview

We are an independent energy company engaged in the exploration and production of natural gas and oil through the development of a repeatable, low-geological risk, high-potential project in the active East Texas oil and gas region.  We currently hold interests in properties located in Marion and Cass County, Texas, home to the Rodessa oil field.  The field has historically been the domain of small independent operators and is not a legacy field for any major oil company.

Our business strategy, which we designated as the “Cornerstone Project”, is to identify and exploit resources in and adjacent to existing or indicated producing areas within the Rodessa field area. We intend to develop and produce reserves at a low cost and will take an aggressive approach to exploiting our contiguous acreage position through utilization of “best in class” drilling, (i.e. using the latest drilling techniques available and seismic technology).  We believe that we are uniquely familiar with the history and geology of the Cornerstone Project area based on our collective experience in the region as well as through our ownership of a large proprietary database which details the drilling history of the Cornerstone Project area since 1980.  We believe implementing our drilling strategy and using new drilling and completion techniques will enable us to find significant gas and oil reserves in the Cornerstone Project area.
 
We conduct our main exploration and production operations through our wholly-owned subsidiary, POI.  We conduct additional operations through two other wholly-owned subsidiaries: (i) TR Rodessa and (ii) 59 Disposal.

TR Rodessa owns an 80% undivided interest in and operates a 40-mile natural gas pipeline and gathering system which we currently use to transport our hydrocarbons to market.  Excess capacity on this system is used to transport third-party hydrocarbons.

59 Disposal owns an 80% undivided interest in and operates a saltwater disposal facility which disposes saltwater and flow-back waste into subsurface storage.  The disposal activities have diminished over the past twelve months and in January 2011, we offered for sale certain assets of the subsidiary.  We held a letter of intent from a potential buyer for the purchase of certain of 59 Disposal’s assets which was valid for thirty days after its signing on March 1, 2011.  Although the letter of intent has expired, we are continuing negotiations with the potential purchaser with an anticipated closing of the sale in 2011..

 
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Plan of Operations


We intend to continue to use our competitive strengths to advance our corporate strategy.  The following are key elements of that strategy:

·
Develop the Cornerstone Project in East Texas through a lease renewal and lease acquisition program along with a drilling program. We will focus our near-term efforts on our leasing program and development drilling on existing acreage. We expect this drilling program to increase our proved reserve and cash flow profile.  In late 2010, we completed drilling the Norbord #1 well to 7,005 feet in the Travis Peak formation.  The deliverability rate is estimated at 3,381 MCF (a thousand cubic feet) per day and 55.2 BBLSPD (barrels per day).  Based on the success of this well, we will begin a developmental drilling program in midyear 2011. We have a gross working interest of 25% in the well as we have been carried for the cost of the well.
 
The Swamp Fox #1 test well was drilled to a total depth of 7,000 feet in December 2010.  The well is presently waiting on fracture stimulation after testing oil in the Pettit formation.  We need to obtain financing before the fracture stimulation can be started.
 
·
Apply management expertise in the Cornerstone Project area and recent developments in drilling and completion technology to identify new drilling opportunities and enhance production. We plan to maximize the present value of our vertical wells by utilizing a shotgun-dual or sawtooth production technique.  We will also implement the latest drilling, fracturing and completion techniques including shotgun duals to develop our properties as well as horizontal drilling. These horizontal wells will primarily target the Bossier formation and we anticipate these wells will yield significantly higher hydrocarbon flow rates than our vertical wells.  We plan to begin our horizontal drilling programs in the second half of 2011.
 
·
Continue to lease underdeveloped acreage in the Cornerstone Project area. We are continuing our leasing program to support our present and future drilling plans with existing funding. The program includes renewing existing leasehold and acquiring new leaseholds.  We are using our extensive proprietary database to help optimize additional drilling locations and to acquire additional acreage.  We intend to target acreage with exploitation and technology upside within the Cornerstone Project area. Most properties in the Cornerstone Project area are held by smaller independent companies that lack the resources to exploit them to the fullest extent. We intend to pursue these opportunities to selectively expand our portfolio of properties. These acreage additions will complement our existing substantial acreage position in the area and provide us with significant additional drilling inventory.
 
·  
Maintain a conservative and flexible financial strategy. We intend to continue focusing on maintaining a low level of corporate overhead expense in addition to continued utilization of outsourcing, when appropriate, to maximize cash flow. We believe this internally-generated cash flow, coupled with reserve-based debt financing when appropriate, will provide the optimal capital structure to fund our future drilling activity.

In order to implement our strategy, we will first need to raise additional capital to develop our properties.  We are seeking to raise additional capital within the industry and from financial institutions.  We currently do not have any contracts or commitments for funding and there are no guarantees that we will be able to raise funds on terms acceptable to us, if at all.  We may also consider farm-out agreements, whereby we would lease parts of our properties to other operators for drilling purposes and we would receive payment based on the production.  We anticipate the cost of a horizontal oil well will be approximately $5 million and a vertical shallow gas well to be approximately $1 million.

Our oil and gas assets are located in Cass and Marion counties in northeast Texas.  As of March 31, 2011, we operated 10 wells.  

As of April 1, 2011, our leasehold position at 100% interest is 25,362 gross acres and 16,359 net acres of which  Pegasi’s net acres is approximately 9,280,. Our leasing program consists of renewing expiring leases and leasing previously unleased acreage.  We began discussions with two independent oil and gas companies during the first quarter of 2010 regarding leasing specific areas on the Cornerstone Project.  Agreements were finalized in the middle of February and late March 2010 and could result in up to $4,000,000 and $4,700,000, respectively, in lease acquisitions. We have presently spent approximately $5.1 million of the funds.  This includes both extensions and renewals of existing leasehold that we currently hold and acquisitions of new leaseholds in order to expand our acreage position.   The participating companies are paying 100% of the cost for a 50% interest in the acreage, resulting in no cost to us.  We believe that this will result in follow-up drilling opportunities.  We also finalized drilling agreements with various independent oil and gas companies in 2010 that have provided approximately $2.2 million in funds towards the drilling of the Norbord and Swamp Fox wells.
 
 
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If we are able to obtain funding, our main emphasis will be to explore for oil with horizontal drilling.  The present discussions are based on pursuing an aggressive drilling program where we would be carried for an interest in any wells at no cost to us.  In addition, any funds raised could be used to apply fracture treatment to the Harris #2 and Childers #2 as well as deepening the Childers #1 and Harris #1.  The deepening will be to a minimum depth to complete the wells in the Cotton Valley formation and possibly deeper in order to evaluate the Cotton Valley Lime formation.

Results of Operations

Three Months Ended March 31, 2011 Compared to Three Months Ended March 31, 2010.

Summarized Results of Operations

   
2011
   
2010
   
Increase (Decrease)
 
Total revenues
  $ 357,322     $ 251,742       105,580  
Total operating expenses
    884,645       698,986       185,659  
Loss from operations
    (527,323 )     (447,244 )     80,079  
Total other income (expenses)
    (163,957 )     (144,754 )     19,203  
Loss from continuing operations before income tax benefit
    (691,280 )     (591,988 )     99,282  
Income tax benefit
    (9,959 )     -       9,959  
Loss from continuing operations
    (681,321 )     (591,998 )     89,323  
Income (loss) from discontinued operations, net of tax expense
    18,494       (90,879 )     109,373  
Net  loss
  $ (662,827 )   $ (682,877 )     (20,050 )

Revenues:  Total revenues for the three months ended March 31, 2011 totaled $357,322, compared to $251,742 for the three months ended March 31, 2010.  Production revenues of oil and gas increased $23,450 to $201,166 for the three months ended March 31, 2011 compared to $177,716 for the three months ended March 31, 2010.  Although oil prices increased for the three months ended March 31, 2011 compared to the three months ended March 31, 2010, our oil production decreased, resulting in a $10,119 decrease in oil revenue.  This was offset by an increase in gas production from the Norbord well which began production in December 2010.  Gas prices decreased from the three months ended March 31, 2010 to the three months ended March 31, 2011, however, the increase in production from the Norbord well resulted in an overall $33,268 increase in gas revenues.  Transportation and gathering revenue increased $80,069 to $147,457 for the three months ended March 31, 2011 compared to $67,388 for the three months ended March 31, 2010.  The increase was mainly due to the Norbord gas being carried on the pipeline beginning in December 2010.
 
Expenses:  Total operating expenses for the three months ended March 31, 2011 were $884,645, compared to $698,986 for the three months ended March 31, 2010 resulting in a total increase of $185,659.  This increase is comprised of an increase in general and administrative expenses, cost of gas purchased for resale, and lease operating expenses.

Lease Operating Expenses: Total lease operating expenses for the three months ended March 31, 2011 were $101,500 compared to $76,261 for the three months ended March 31, 2010 which resulted in an increase of $25,239.  The primarily reason for the increase was the Norbord well starting production in December 2010 so that its initial lease operating charges were during the first quarter of 2011.

Cost of Gas Purchased for Resale:  The $47,756 increase in cost of gas purchased for resale to $94,814 for the three months ended March 31, 2011 from $47,058 for the three months ended March 31, 2010 was primarily due to a higher volume produced in 2011 due to the Norbord well starting production in December 2010.

General and Administrative Expense:  The $72,272 increase in general and administrative expense to $587,586 for the three months ended March 31, 2011 from $515,314 for the three months ended March 31, 2010 was primarily due to an increase in accounting fees and consulting fees.  The increase in accounting fees was due to issues in obtaining required reports in a timely manner for the 10-K.  The increase in consulting fees is related to fees paid with the issuance of shares of stock.

Other Income (Expenses):  Total other expenses for the three months ended March 31, 2011 were $163,957, compared to $144,754 of other expenses for the three months ended March 31, 2010 resulting in an increase of $19,203.  The primary reason for this increase was due to the addition of the accrued and unpaid interest on the Teton note being added to the principal balance of the Teton Renewal Note on June 1, 2010 which resulted in higher interest expense.
 
 
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Income (Loss) from Discontinued Operations:  The gain from discontinued operations for the three months ended March 31, 2011 was $18,494, compared to a loss of $90,879 for the three months ended March 31, 2010.  This $109,373 increase was due to an increase in disposal activity and a decrease in operating costs.  In the first quarter of 2011, the potential purchaser of certain assets of 59 Disposal agreed to provide an average of ten to twelve trucks per week to the disposal plant until they are able to complete the negotiations.  This caused an increase in disposal revenue.  Also, in the first quarter of 2010, a workover was done on the Whitfield well which resulted in higher operating expenses.

Net Loss:  As a result of the above described revenues and expenses, we incurred a net loss of $662,827 for the three months ended March 31, 2011 as compared to a net loss of $682,877 for the three months ended March 31, 2010.

Liquidity and Capital Resources

We held $651,711 in cash at March 31, 2011, made up of a majority of our cash accounts.  However, at March 31, 2011, several cash accounts had an overdraft which totaled $537,946, resulting in net cash of $113,765.  We also had a cash overdraft of $340,118 at December 31, 2010.  The increase in the cash overdraft is related to purchases of oil and gas properties and using cash to cover operating expenses.  In addition, our trade accounts payable have increased by $372,022 due to the drilling activity on the Norbord #1 and Swamp Fox #1 wells during the last quarter of 2010.

Cash Flows

The following table summarizes our cash flows for the three months ended March 31, 2011 and 2010:

   
Three Months Ended March 31,
 
   
2011
   
2010
 
Total cash provided by (used in):
           
Operating activities
  $ 285,713     $ (318,296 )
Investing activities
    (81,149 )     (104,180 )
Financing activities
    197,345       621,284  
Increase  in cash and cash equivalents
  $ 401,909     $ 198,808  

Cash provided by all operating activities for the three months ended March 31, 2011 totaled $285,713, compared to $318,296 used in operating activities for the three months ended March 31, 2010.  The increase of $604,009 in cash provided is primarily due to additional cash provided by increases in the following accounts; joint interest billing receivables, related parties of $180,942, accounts payable of $273,229, accounts payable, related parties of $95,131, and revenue payable of $139,988. This increase in cash provided was offset by a decrease of $158,468 in accounts receivable.

Cash used in investing activities for the three months ended March 31, 2011 was $81,149, compared to $104,180 for the three months ended March 31, 2010 for a net change of $23,031.  There were no property and plant purchases in the first three months of 2011 however we spent $84,920 in property and equipment purchases in the first three months of 2010 for the workover done on the Whitfield well.  This decrease was partially offset by an increase in lease and well equipment, and intangible drilling and completion costs for work done on the Norbord and Swamp Fox wells.   These costs increased from $19,070 for the first three months of 2010 to $86,047 for the first three months of 2011.

Cash provided by financing activities for the three months ended March 31, 2011 totaled $197,345, compared to $621,284 for the three months ended March 31, 2010, resulting in a decrease in cash of $423,939.  No advances were received on the related party note payable during the three months ended March 31, 2011; however, we received proceeds of $623,000 on it during the three months ended March 31, 2010.  This decrease in cash received was offset by an increase of $197,828 in our cash overdrafts for the three months ended March 31, 2011.  There were no cash overdrafts at March 31, 2010.

Sources of Liquidity

Our two main sources of liquidity continue to be from funds generated by production promotion fees and financing from a related party in the form of notes payable.  During 2010, we received promotion fees which paid for a portion or all of our cost in a proposed drilling well as well as prospect fees associated with the transactions. Any shortfall in revenue to cover costs has been covered by utilizing financing from a related party in the form of notes payable and delaying payment of accounts payable.  We believe that the proceeds from production and continued promotion of prospects, joint ventures with industry partners, and our anticipated selling of our disposal plant will be sufficient to finance our operations for 2011. In addition, future acquisitions and future exploration, development, production and marketing activities, as well as administrative requirements (such as salaries, insurance expenses, general overhead expenses, legal compliance costs and accounting expenses) will require a substantial amount of additional capital and cash flow.
 
 
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We are pursuing sources of additional capital through various financing transactions or arrangements, including joint venturing of projects, debt financing, equity financing or other means.  We have aggressively contacted many potential investors both within the industry as well as institutional investors to secure additional financing.  Additional financing would be used for drilling opportunities and additional lease funding in the near future, along with working capital purposes.  We do not have any commitments or agreements for financing, and we cannot assure you that additional funding will be available on terms acceptable to us, if at all.
 
Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our consolidated financial condition, revenues, results of operations, liquidity or capital expenditures.

Critical Accounting Policies
 
Our critical accounting policies, including the assumptions and judgments underlying them, are disclosed in the notes to consolidated financial statements which accompany the consolidated financial statements included in our annual report on Form 10-K filed with the SEC on March 31, 2011.  These policies have been consistently applied in all material respects and address such matters as revenue recognition and depreciation methods.  The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the recorded amounts of revenues and expenses during the reporting period.  Actual results could differ from these estimates. 
 
Accounts Receivable

We perform ongoing credit evaluations of our customers’ financial condition and extend credit to virtually all of our customers.  Collateral is generally not required, nor is interest charged on past due balances.  Credit losses to date have not been significant and have been within management’s expectations.  In the event of complete non-performance by our customers, our maximum exposure is the outstanding accounts receivable balance at the date of non-performance.

Property and Equipment

Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets, which range from five to thirty-nine years.  Expenditures for major renewals and betterments that extend the useful lives are capitalized.  Expenditures for normal maintenance and repairs are expensed as incurred.  Upon the sale or abandonment, the cost of the equipment and related accumulated depreciation are removed from the accounts and any gains or losses thereon are recognized in the operating results of the respective period.

Oil and Gas Properties

We use the full-cost method of accounting for our oil and gas producing activities, which are all located in Texas.  Accordingly, all costs associated with the acquisition, exploration, and development of oil and gas reserves, including directly-related overhead costs, are capitalized.

All capitalized costs of oil and gas properties, including the estimated future costs to develop proved reserves, are amortized on the units-of-production method using estimates of proved reserves.  Investments in unproved properties and major development projects are not amortized until proved reserves associated with the projects can be determined or until impairment occurs.  If the results of an assessment indicate that the properties are impaired, the amount of the impairment will be added to the capitalized costs to be amortized.
 
In addition, the capitalized costs are subject to a “ceiling test,” which limits such costs to the aggregate of the “estimated present value,” discounted at a ten percent interest rate, of future net revenues from proved reserves, based on current economic and operating conditions, plus the lower of cost or fair market value of unproved properties and less the income tax effects related to the properties.

Sales of proved and unproved properties are accounted for as adjustments of capitalized costs with no gain or loss recognized, unless such adjustments would significantly alter the relationship between capitalized costs and proved reserves of oil and gas, in which case the gain or loss is recognized in the operating results of the respective period.
 
 
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Revenue Recognition

We utilize the accrual method of accounting for natural gas and crude oil revenues, whereby revenues are recognized based on our net revenue interests in the wells.  Crude oil inventories are immaterial and are not recorded.

Gas imbalances are accounted for using the entitlement method.  Under this method, revenues are recognized only to the extent of our proportionate share of the gas sold.  However, we have no history of significant gas imbalances.

Income Taxes

Deferred income taxes are determined using the “liability method” in accordance with FASB ASC Topic 740, Income Taxes.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
 
Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which such temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the operating results of the period that includes the enactment date.  In addition, a valuation allowance is established to reduce any deferred tax asset for which it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized.

Item 3.   Quantitative and Qualitative Disclosures about Market Risk

Not required under Regulation S-K for “smaller reporting companies.”

Item 4.  Controls and Procedures.

(a) Evaluation of disclosure controls and procedures.

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of March 31, 2011. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Based on management’s evaluation, our chief executive officer and chief financial officer concluded that, as a result of the material weaknesses described below, our disclosure controls and procedures are not designed at a reasonable assurance level and are ineffective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.  The material weaknesses, which relate to internal control over financial reporting, that were identified are: 

a)  
We did not maintain sufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of GAAP commensurate with our complexity and our financial accounting and reporting requirements. We have limited experience in the areas of financial reporting and disclosure controls and procedures.  Also, we do not have an independent audit committee.  As a result, there is a lack of monitoring of the financial reporting process and there is a reasonable possibility that material misstatements of the consolidated financial statements, including disclosures, will not be prevented or detected on a timely basis; and

b)  
Due to our small size, we do not have a proper segregation of duties in certain areas of our financial reporting process.  The areas where we have a lack of segregation of duties include cash receipts and disbursements, approval of purchases and approval of accounts payable invoices for payment. This control deficiency, which is pervasive in nature, results in a reasonable possibility that material misstatements of the consolidated financial statements will not be prevented or detected on a timely basis.

We are committed to improving our financial organization. As part of this commitment, we will look to increase our personnel resources and technical accounting expertise within the accounting function by the end of 2011 to resolve non-routine or complex accounting matters. In addition, when funds are available, which we expect to occur by the end of 2011, we will take the following action to enhance our internal controls: Hiring additional knowledgeable personnel with technical accounting expertise to further support our current accounting personnel, which management estimates will cost approximately $100,000 per annum. We currently engage an outside accounting firm to assist us in the preparation of our consolidated financial statements. As necessary, we will engage consultants in the future in order to ensure proper accounting for our consolidated financial statements.
 
 
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Management believes that hiring additional knowledgeable personnel with technical accounting expertise will remedy the following material weakness: insufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of GAAP commensurate with our complexity and our financial accounting and reporting requirements.

Management believes that the hiring of additional personnel who have the technical expertise and knowledge with the non-routine or technical issues we have encountered in the past will result in both proper recording of these transactions and a much more knowledgeable finance department as a whole. Due to the fact that our internal accounting staff consists solely of a Chief Financial Officer, additional personnel will also ensure the proper segregation of duties and provide more checks and balances within the department. Additional personnel will also provide the cross training needed to support us if personnel turn over issues within the department occur. We believe this will greatly decrease any control and procedure issues we may encounter in the future.

(b) Changes in internal control over financial reporting.

We regularly review our system of internal control over financial reporting and make changes to our processes and systems to improve controls and increase efficiency, while ensuring that we maintain an effective internal control environment. Changes may include such activities as implementing new, more efficient systems, consolidating activities, and migrating processes. There were no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



 
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PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are currently not aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse affect on our business, consolidated financial condition or operating results.

Item 1A. Risk Factors.

Not required under Regulation S-K for “smaller reporting companies.”

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
 
None.

Item 3. Defaults Upon Senior Securities.

None

Item 4. (Removed and Reserved)


Item 5. Other Information.

None.

Item 6. Exhibits.
 
10.01
Form of Third Amendment to Promissory Note, effective as of April 1, 2011, by and among Pegasi Energy Resources Corporation, Pegasi Operating Inc., TR Rodessa, Inc., 59 Disposal, Inc. and Teton, Ltd.

10.02
Form of Fifth Amendment to Promissory Note, effective as of April 2, 2011, by and among Pegasi Energy Resources Corporation, Pegasi Operating Inc., TR Rodessa, Inc., 59 Disposal, Inc. and Teton, Ltd.

31.01
Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.02
Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.01
Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 
 
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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
PEGASI ENERGY RESOURCES CORPORATION
 
 
Date:  May 16, 2011
By: /s/ MICHAEL NEUFELD
 
 
Michael Neufeld
 
 
Chief Executive Officer (Principal Executive Officer)
 
     
Date:  May 16, 2011
By: /s/ RICHARD LINDERMANIS
 
 
Richard Lindermanis
 
 
Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)
 


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